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Summary

  • This article highlights important aspects of BIDU's annual report pertaining to expenses, net profit margins, goodwill, and acquisitions.
  • The article provides valuations of BIDU that utilize four different earnings per share estimates for 2014.
  • The markets at the time of writing (4/2/2014) may be pricing in that net profit margins for BIDU in 2014 will be comparable to those in 2013.

Baidu (NASDAQ:BIDU), a Chinese internet search provider, recently filed its annual report for the fiscal year ended December 31st, 2013. Below are some aspects regarding fundamentals from the document that I found to be particularly interesting and an analysis of BIDU's valuation.

Income Statement

Revenue grew strongly over the course of the year, but expenses increased rapidly as well, resulting in almost no change in net income.

(click to enlarge)

BIDU earned 99.6% of its revenue in 2013 from online marketing services, a majority of which came from the company's P4P services. BIDU describes its P4P platform as, "an online marketplace that introduces internet search users to customers who pay us a fee based on click-throughs for priority placement of their links in the search results."

The chart below shows elements of BIDU's income statement as a percentage of total revenues. It reveals that all three components of total operating costs and expenses increased, squeezing the company's net income margin.

2012

2013

Total revenues

100%

100%

Cost of revenues

(28.9%)

(35.9%)

Selling, general and administrative

(11.2%)

(16.2%)

Research and development

(10.3%)

(12.9%)

Total operating costs and expenses

(50.5%)

(65.0%)

Operating profit

49.5%

35.0%

Net income

46.6%

32.4%

For a closer look at what drove the increase in operating costs and expenses, the chart below shows components of cost of revenues and of selling, general and administrative costs as a percentage of total revenues.

2012

2013

Selling and marketing

8.3%

12.6%

General and administrative

3.0%

3.6%

Sales tax and surcharges

7.0%

7.3%

Traffic acquisition costs

8.7%

11.6%

Bandwidth costs

4.8%

6.1%

Depreciation of servers and other equipment

4.8%

4.6%

Operational costs

2.6%

3.7%

Share-based compensation expenses

0.0%

0.1%

As can be seen from the chart, selling and marketing expenses were the primary driver of the increase in selling, general and administrative costs, while increased traffic acquisition costs, and to a lesser extent increased bandwidth costs and operational costs, were the primary drivers of the increase in cost of revenues.

Balance Sheet

There was a pronounced increase in goodwill from 2012 to 2013, both in terms of the total amount in RMB (see first chart below), and as a percentage of total assets (see second chart below).

(click to enlarge)

(click to enlarge)

Goodwill is the difference between the purchase price of a company acquired and the total value of the acquired company's net assets.

Statement of Cash Flows

An item on the statement of cash flows (acquisition of businesses, net of cash acquired) reveals further insight into BIDU's acquisition activity, which was greater than in the previous two years, both in terms of total amount in RMB (see first chart below), and as a percentage of net income and total revenue (see second chart below).

(click to enlarge)

(click to enlarge)

Accounting for the majority of the acquisition activity in 2013 was BIDU's purchase of a company called 91 Wireless, which is a Chinese operator of mobile application marketplaces and mobile games. 9.84 billion RMB out of the total 12.99 billion RMB of goodwill that was acquired in 2013 and added to the goodwill balance came from the acquisition of 91 Wireless. BIDU attributes the goodwill to expected synergies, such as from enhancing the company's position in the mobile market.

It is interesting to note that even if we subtract this one large deal from the amount of goodwill acquired in 2013, it is still greater than the RMB amount acquired in 2012 or 2011. However, it is not greater than the amount acquired in 2011 when calculated as a percentage of total assets.

Next, I will describe a valuation of BIDU.

Valuation

For this analysis, I first assumed that revenue growth for 2014 will be in line with the trend over the past five years and will equal approximately 37 billion RMB. Then, I used four different estimates of earnings per share, EPS, to arrive at four different valuations. The four different estimates of EPS along with their respective scenarios are described below in order of increasing EPS.

In the first, and most pessimistic scenario, net income stays flat, just as it was between 2012 and 2013. This scenario implies that the net profit margin will decrease to 27.8%. In the second scenario, the net profit margin stays constant at 2013's margin of 32.4%. In the third scenario, the net profit margin increases to the average for the past five years, 40.52%. In the fourth, and most optimistic, scenario, the net profit margin returns to the level it was at in 2012, 46.6%.

Then, multiplying a price-to-earnings multiple (P/E) of 30.82 by the EPS estimates in each of the four scenarios yields the following share prices:

Scenario 1

$149.97

Scenario 2

$174.48

Scenario 3

$218.08

Scenario 4

$250.74

Next, these prices are discounted to present value by dividing by the stock's required rate of return. I have estimated this to be 10.94% by using the capital asset pricing model. The following assumptions were inputted into the model: a beta for BIDU of 1.58, a risk-free rate of 2.80%, and an implied equity risk premium of 5.15% (the implied equity risk premium source is Damodaran Online). After discounting, the four scenarios yield the following valuations for BIDU:

Scenario 1

$135.48

Scenario 2

$157.62

Scenario 3

$196.00

Scenario 4

$226.51

Concluding Remarks

BIDU closed at $160.47 per share on April 2nd. Thus, based on the analysis using the above assumptions, plus the assumption that markets at present are efficiently pricing BIDU, it can be inferred that the market is expecting something akin to Scenario 2 for EPS in 2014. To investors that are more optimistic than this scenario, BIDU may seem undervalued. Likewise, to investors that are more pessimistic than this scenario, BIDU at $160.47 will look overvalued.

A major caveat here is that this valuation analysis required making several assumptions, for which the accuracy is impossible to guarantee. Furthermore, small changes in assumptions can lead to large differences in conclusions. I welcome readers to share what their own price targets are and how they arrived at them in the comments section, as well as any thoughts on the above assumptions. Also, I would be interested to hear how optimistic or pessimistic readers are about BIDU's net profit margins going forward. Feel free to share which one of the above four scenarios you think is most likely.

Source: Baidu: Valuation And Annual Report Highlights