WR Hambrecht analysts James Lee and Xiaofan Zhang recently published a follow-up report on Chinese company Baidu.com, reiterating their "Buy" rating for the company (original report available here). Excerpts follows:
We are reiterating our Buy rating on BIDU shares and our 12-month price target of $130 per share. We believe our thesis has started to emerge based on recent industry developments and data points we gathered from our checks. As stated in our initiation report, we believe that competitor issues, along with Baidu’s improved relevancy, will enable the company to maintain if not extend its market leading position. We believe the results from our channel checks, which we outline in this report, support that view. Heading into Q4, we feel comfortable with the revenue visibility, and expect upside to Q1:07 guidance, as we anticipate the new ranking system will drive ASP, and expect some smaller customers to return to the Baidu platform due to inferior results from other search engines. Our price target is based on 40x our 2008 EPS estimate of $3.15 (ex-FAS123R) plus net cash, which we believe is reasonable compared with our expected long-tem growth rate for the company. Our key points are as follows:
Competitor Issues. As mentioned in our initiation report, we believe that Baidu will likely maintain if not extend its market leading position due to issues faced by its main competitors Google (NASDAQ:GOOG) and Yahoo! (NASDAQ:YHOO). We listed management conflict as a major concern for Baidu’s peers, which was confirmed by the recent departure of Yahoo! China's president after being on the job for just 40 days.
• Strategic disagreement at Yahoo! China. According to our sources, the outgoing Yahoo! President (Xie Wen) had major disagreements with CEO Jack Ma and Yahoo! co-founder Jerry Yang regarding the website’s future initiatives. Mr. Wen’s priority was to align Yahoo! with the emerging trends of user-generated content, making Yahoo! China an interactive platform. On the contrary, the tag team Ma and Yang’s priority resided in more aggressively monetizing Yahoo! China’s existing portal and paid search properties.
• Pressure falls on Yahoo!’s portal and search. We believe Yahoo! China is under a lot of pressure since Alibaba (40% owned by Yahoo!) has not generated the revenue growth the company had expected due to the immaturity of e-commerce in China. At the same time, the auction site’s C2C listing Taobao is currently offered for free, which hurts Alibaba’s profitability (only 2-3% profit margin). With that in mind, we believe Yahoo! China needs to move quickly in monetizing portal and paid search operations, especially when competitors are having success on both fronts.
• Google China also facing conflict at the top. As for Google China, we expect management conflict at the top to remain an ongoing issue. Co-presidents Dr. Kai-Fu Lee and Johnny Zhou continue to pull in opposite directions. Dr. Lee’s philosophy is more in line with the corporate HQ, believing in a globalized platform for Google products. Co-President Johnny Zhou is an advocate of localization in product launch and development, which has gained traction as Google China started to deploy regional sales agents (similar to Baidu’s) for its services. However, we view this conflicting situation as unsustainable over the longer-term, as Mr. Zhou’s frustration has been widely reported by the Chinese press, which could lead to his departure. If this inevitable divorce occurs, we believe it would be a major setback for Google China as existing localized initiatives could be either delayed or even worse, discontinued.
Shift in algorithm drives mid-to-large advertisers. Our recent checks with agencies and advertisers indicated that large advertisers have started to shift more spending onto paid search. Keep in mind that most brand advertisers are still experimenting with search engines, figuring out what keywords to bid for and how much to bid for those keywords.
• Brand advertisers satisfied with early results, but wanted more. Our checks indicate that large advertisers were very satisfied with results from Baidu in terms of quality of leads and costs of per customer acquisition. However, they would like to see an improvement in the click-through rate, as banner ads are generating a high volume of traffic to their websites, but at a significantly higher price per acquisition.
• Baidu CEO confirmed that on Q3 call. Coincidently on the Q3 call, Baidu CEO Robin Li stated that the company has plenty of brand advertisers on its platform, but the search engine could not spend its money fast enough. We believe this led Baidu to improve the relevancy on its ranking system in September, which should drive spending of larger customers.
Data points from resale agents also provide support. Based on our checks with Baidu’s resale agents, after the new pricing and ranking systems were implemented, they are also seeing more activities from mid to large advertisers.
• Larger mix of mid-to-large advertisers. For example, a few agents estimated that the large customer mix is roughly 30% large-, 50% mid- and 20% small-sized customers, compared with more than 80% SMEs last year.
• Smaller businesses moving to cheaper platforms. Small customers resisted initially, causing churn to cheaper platforms such as Yahoo! and Sohu (SOHU: Buy), whose ranking systems are based on bidding price alone.
• Click results more important than price-per-click. In the end, Baidu’s click results speak for themselves, generating many more leads and inquiries vs. its competitors. For example, distributors indicted that what a typical customer spends in a day on Baidu could take a month on Google and Yahoo! to spend. In addition, marketing campaigns and product cycles are time sensitive, and therefore, it is more important for advertisers to receive leads as opposed to be concerned about price-per-click. With that in mind, customers are less price sensitive, paying on average 2-3x for keywords to Baidu. Despite the premium price, advertisers still view paid search as a cheaper alternative vs. traditional media, as it is 10x cheaper than newspaper advertising.
• Broader adoption of new ranking system. After the new ranking system has been instituted for ~3 months, we saw a broader adoption, as some agents indicated that more than 70% of the customers approved the new systems.
Visibility into Q4 looks good based on customer deposits. In terms of visibility heading into Q4, we suggest investors look at the customer deposits account on Baidu’s balance sheet. As of Q3:06, the company had 16.4M in deposits, or approximately 47% of visibility into management’s Q4 guidance of $34-35M, consistent with the past two quarters.
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• Q4 a “wash” quarter. We believe that Q4:06 will be more or less a “wash" quarter, as increased spending from mid- to larger-sized advertisers will likely be offset by smaller businesses moving to cheaper alternatives.
• Upside in Q1 guidance likely. However, we suspect that Q1:07 revenue guidance could provide upside vs. consensus as we anticipate the success in the customer shift will drive ASP, and expect some smaller customers to return to the Baidu platform given the inferior results from other search engines.
Valuation reasonable to growth. Our price target of $130 is based on 40x our 2008 EPS estimate of $3.15 plus $4 in net cash, consistent with our expected long-tem growth rate for the company. On a relative basis, BIDU trades at a premium to peers for 2007E and 2008E PE ratios (56x vs. 27x for 2007 and 35x vs. 22x for 2008), justified by a much higher expected growth rate from 2006-2008 (68% vs. 21%).
BIDU 1-yr chart: