Baidu: Dissecting China's Internet Giant

Jul. 7.14 | About: Baidu, Inc. (BIDU)

Summary

Baidu is the market leader in China's search engine market.

It is facing competition from Alibaba & Tencent, as both are diversifying their business models through acquisitions.

Baidu's acquisition strategy is firmly focused on user migration to mobile. This will continue in 2014, even at the expense of 2014 growth.

After acquiring stakes in a variety of tech firms in China, investors will need to see the results in the company's bottom line.

Baidu is moving into wearable technology and expanding overseas, with services in Thailand, Egypt and Brazil.

Introduction

Baidu (NASDAQ:BIDU) is one of China's BAT trio of tech giants, alongside Tencent (OTCPK:TCEHY) and Alibaba (NYSE:BABA). Whilst it is generally regarded as the "Chinese Google", Baidu manages a large collection of services that caters to all aspects of the largest online population in the world, and continues to grow at a high rate.

As with the vast majority of Chinese firms, Baidu is predominantly domestically focused, with only a small percentage of revenues being derived from overseas. However, Baidu is making moves to establish itself abroad and take on the likes of Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and other western tech giants.

This report analyses Baidu's services, its acquisition strategy, and financial performance, as well as its future outlook.

The Business Model

Baidu's core business is a search engine provider. It allows users to search websites, images, videos and news, much in the same way that a western search engine would, such as Google. The vast majority of Baidu's revenue comes from online marketing, and as of the most recent earnings report, has about 446,000 active online marketing customers.

Whilst Google has a dominant position in most countries, East Asia still remains one of the few places where it isn't the most popular search engine. South Korea's most popular search engine is local firm Naver, Japan and Taiwan favor Yahoo! Japan (NASDAQ:YHOO) and Yahoo! Taiwan, and China's most popular search engine is Baidu. These countries tend to favor local alternatives, and this is prevalent in the Chinese market, albeit partially due to internet restrictions. For example, without using a VPN proxy, my access to Microsoft's Bing has never been slow or unable to load. However, my access to Google varies greatly, and quite often is simply too slow for me to use.

Within China, Baidu's main domestic competitors are Tencent's SoSo, Sohu's (NASDAQ:SOHU) Sogou, Qihoo's (NYSE:QIHU) 360 Search and NetEase's (NASDAQ:NTES) Youdao. Nevertheless, Google China is still popular in China, and is Baidu's main competitor in the market.

Baidu has a dominant search engine market share in the world's largest online nation. In a country with a population of 1.4 billion, the number of people with access to the internet is 568 million. This gives an internet penetration rate of 42.3%, which is substantially lower than that of the United States and Japan, 81% and 79%, respectively.

Depending on which metric you use to measure market share, Baidu currently controls between 60% and 80% of China's search engine market. Based on revenue over the past eight quarters, Baidu's market share has risen gradually from 79.5% to 81.7%, predominantly at the expense of Google China.

Baidu is predominantly based in China, and has no English service, meaning that its service is designed for mainland Chinese users. However, it has made inroads into expanding overseas, particularly with its Baidu Japan service, although this has been generally regarded as a flop. Baidu Japan has less than 1% of the search engine market share in Japan. It is currently targeting South America, the Middle East and South East Asia for expansion.

(Source: http://www.searchblog.asia/topics/seo/japan-search-engine-market-share-2012/)

Aside from the flagship search engine service, Baidu has a wide variety of services to offer to users. Baidu PostBar is the world's first and largest Chinese language searchable online community platform; Baidu Knows is the world's largest interactive knowledge sharing platform, similar to Yahoo Answers; and Baidu Encyclopedia is the world's largest user generated Chinese language encyclopedia, very similar to Wikipedia. Baidu also has a maps service, which is very similar to Google, although Google Maps in China tends to be incorrect, even in Shanghai. It has a Music service which allows users to stream music, similar to Spotify; a proprietary Cloud storage service; a translation service; and its own social media space. Slightly more obscure services include a search engine specifically for senior citizens, patent searches, and a missing persons search service.

Chinese Tech Giants Grow Through Acquisitions

Baidu is one of China's BAT trio of tech giants, along with Alibaba and Tencent. Although each firm's original core business was different, all three have expanded aggressively through acquisitions to compete with each other in many different industries. Originally an online gaming company, Tencent has entered the search engine market with its Soso service, and recently acquired a stake in Jingdong (NASDAQ:JD), a direct competitor to Alibaba's Tmall service. With the success of its WeChat instant messaging application, Tencent has added a WeChat payment system as a direct competitor to Alibaba's Alipay service, which was created in 2004. Tencent also invested in a stake of online travel firm 17u.cn, whose services have been incorporated into Tencent's QQ travel platform.

Likewise, whilst the majority of Alibaba's revenue comes from its online shopping platforms, Alibaba offers an online messaging service to rival Tencent's QQ and WeChat, as well as a cloud storage service to rival Baidu Yun. In response to the success of WeChat's payment system, Alibaba launched its own mobile messaging service, Laiwang, in 2013, as well as acquired a stake in Sina Weibo (NASDAQ:WB), a more popular Twitter-like microblogging service than Tencent's own Weibo. Alibaba has also acquired a stake in the online video content firm Wasu Media Holding and Youku Tudou (NYSE:YOKU) to rival Baidu's iQiyi and PPStream service.

Finally, in response to slow technological progress in the country's heavily regulated banking industry, the BAT trio have entered the online investment business.

The direction that all three firms are moving in is the migration to mobile. Tencent's WeChat service has been a game changer, with around 300m people using the application to not only connect with friends, but to shop online through Jingdong, pay for taxis, and book restaurant reservations. The result of this is that future acquisitions and business strategy will be focused on facilitating mobile transactions.

Growth Through Acquisitions

Baidu has made acquisitions around its core business, in order to both migrate its services to mobile, and to compete with the services offered by its two largest rivals, Tencent and Alibaba.

In August 2013, Baidu announced that its subsidiary Baidu Hong Kong had acquired 91 Wireless from NetDragon for $1.85bn. 91 Wireless is one of China's largest smartphone app distribution platforms. Because Google Play isn't available in China, and the Android platform has quickly become more popular than the iOS system, independent Android app stores have become very popular. In the 2014 Q1 conference call, Robin Li noted that Baidu had already become the leader in app distribution in China. The company had over 100 million app downloads on a daily basis, due to the integration with 91 Wireless, which should continue to realize significant value.

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In June 2011, Baidu announced a $306m investment in Qunar (NASDAQ:QUNR), the Chinese travel search engine. It allows users to search real time for air and rail tickets, hotels, and tour packages. Prior to Qunar's IPO, Baidu had a 61% stake in Qunar. Given that Qunar is a leading travel search engine service for China's highly fragmented travel industry, the Baidu investment allows it to enter the lucrative travel industry, as a supplement to its core business.

Since its IPO, Qunar's stock price represents a 60% premium from its listing price, so Baidu has already made a strong return on its investment. However, in Qunar's 2014 Q1 earnings report, whilst revenue was growing circa 90%, and forecasted to continue this growth rate in the second quarter of the year, the bottom line was less than impressive. First-quarter loss was $29.5m, increasing from $19.6m in the fourth quarter.

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Online video service iQiyi was launched in 2010 with investments from Baidu and Providence Private Equity Partners. In 2013, Baidu acquired Providence's stake, and iQiyi has since become China's most popular video service, overtaking Youku. According to iResearch, iQiyi attracted 94 million monthly active users in January 2014, compared to Youku's 83.5 million. Likewise, in 2013, Baidu acquired PPStream for $370m, in further consolidation of the video platform market in China. The acquisition allows Baidu to challenge Youku Tudou as China's leading video platform service.

In 2013, Baidu acquired a 59% stake in Renren's (NYSE:RENN) group buying website Nuomi, a Groupon-like service for $160m, and in January 2014 had acquired the rest of the company from Renren. This is an important acquisition as part of Baidu's mobile strategy because Nuomi facilitates location-based services. For example, users can find nearby restaurants via mobile that offer deals.

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From A Valuation Perspective

On April 24th 2014, Baidu reported strong first-quarter results, with EPS of $1.24 beating analyst expectations of $0.21. Baidu continues to post impressive year-on-year and quarter-on-quarter revenue growth. However, in 2013, the gross and operating income decreased slightly. This becomes clearer when looking at the quarter-on-quarter results, as the 2013 Q4 and 2014 Q1 show a two-period decline in profits. Investors will be waiting for 2014 Q2 results to be released to see if this trend continues.

For the second quarter of 2014, Baidu is forecasting total revenues in the range of $1.9bn to $1.95bn, which would represent a YOY increase of between 56.3% and 60.2%, and a QOQ increase of between 24.4% and 27.5%

As of the 31st March 2014, Baidu had $1.4bn of cash and equivalents on its balance sheet. This puts the company in a strong position to continue its acquisition spree. On the 5th June, the company announced that it would issue $1bn of notes for expiry in 2019. These traded on the 10th June, so the company will currently have about $2.4bn of cash on its balance sheet. Investors can expect that the firm will pursue acquisition targets.

Looking Ahead

Acquisitions

Given the note issuance in June 2014, and the assumed $2.4bn in cash and equivalents on the balance sheet, plus $4.6bn in short-term investments, Baidu has a $7bn war chest in which to make acquisitions. CEO Robin Li commented during the release of the 2013 Q4 earnings that although they had spent $2.5bn in mobile products in 2013, Baidu would continue to invest in mobile offerings, even at the expense of profit growth in 2014. This is because investors were encouraged by the growth in mobile revenues. In fact, in the 2014 Q1 conference call, Robin Li noted that mobile was once again the main driver of page view growth, and it is expected to surpass PC as the biggest source of search traffic later in the year. In fact, throughout the whole industry, the migration to mobile has happened rapidly. According to SAP Asia Pacific, around 85% of Chinese are now interested in buying goods and services through their mobile phone, whilst this number was 30% just three or four years ago.

Domestic Chinese Growth

Amid the talk of China's real estate boom and impending bust, a prevalent theme is the effect on younger Chinese consumers. With younger buyers being either priced out of the market by the sky high prices in Tier One cities such as Shanghai and Beijing, or unwilling to buy at the highs before the housing market has a correction, China's generation Y has more cash to spend on discretionary goods. Whilst this is an assumption, the logic is valid. China has always had a historically higher savings rate than Western nations, but younger Chinese aren't saving as much as generations before them. Also, given the rapid development of the online retail market, something which I have written extensively about, the opportunity to spend on discretionary goods is much greater than it has ever been. This has a discernible effect on Baidu through a variety of means.

Tencent announced in May that it had acquired an 11% stake in map content provider NavInfo. This has a negative effect on Baidu, because Baidu uses NavInfo's content for its own map services. NavInfo's content is used by 54% of China's mapping market. Also, given that 6% of AutoNavi's share comes from Apple iOS, excluding that share means that Baidu is the current market leader. However, the issue is that for the two map content providers, Alibaba has already fully acquired AutoNavi after a partial acquisition several years before, and now Tencent has acquired a stake in NavInfo. This can be detrimental to Baidu's mapping strategy, and its integration with the rest of Baidu's services. This is because if Tencent acquired the rest of NavInfo, it could cancel the business relationship with Baidu and immediately gain a sizeable share of the market. Therefore, I believe that this situation has put Baidu in a quandary, because there are four ways in which to mitigate this risk. Firstly, Baidu could acquire NavInfo at a sizeable premium. In the long run, this would be beneficial to Baidu; however, in the short run, it wouldn't be the best use of capital. Secondly, if Tencent acquired the rest of NavInfo and cancelled Baidu's business relationship, then Baidu could switch map content providers to Alibaba-controlled AutoNavi. This would be unlikely given that Alibaba could also cancel the business relationship at some point. Thirdly, Baidu could invest and develop its own map content system, which would certainly be costly and less efficient than using AutoNavi. Finally, Baidu could switch to another map content provider of smaller scale. This would be the most suitable short-term solution.

I think that we will see a combination of the third and fourth option, with Baidu acquiring a smaller scale mapping firm in order to develop its own proprietary map content system.

Baidu has entered the wearable health technology market, allowing users to purchase wristbands, blood pressure monitors and scales, which uploads the data to your personal page on the Baidu DuLife site and mobile application.

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International Expansion

Baidu is focusing on expanding its search market in international markets, such as Brazil and Thailand. Baidu made its first moves towards expanding outside of China by moving into other East Asian countries, as user behavior is similar to that in China. Baidu has since expanded into the Arab world, and has now set its sights on Latin America. It opened an office in Brazil at the end of 2013, and has already launched four products in order to understand internet usage in the country. These products are the Hao123 website directory, the PC Faster service which analyses PCs and improves performance, an anti-virus program and a browser. Company representative Yan Di said that although the Brazilian expansion is still in its initial stages, Baidu plans to move into other Latin American countries, starting with Argentina, Chile and Mexico, as they are the strongest economies in the region.

In May 2014, Baidu announced that it appointed Stephen Ng, a leading figure in artificial intelligence, to lead its research team at a new facility in Silicon Valley. Dr Ng is a Stanford computer science professor that has led AI projects at Google, where he won acclaim for a machine learning project where computers learned to recognize cat faces without traditional step-by-step guidance. At Baidu, he will take charge of a 5-year, $300m research initiative. This move can be seen as Baidu being aggressive about competing with Google on its own turf. Baidu's move into Silicon Valley is similar to other Chinese tech firms, as Tencent has opened a game development centre, and Suning has opened a research centre.

Summary

Baidu continues to see strong results as it diversifies its services. The aggressive nature of the competition between the BAT tech trio has led to broad market diversification that makes the trio leaders across the vast majority of online industries within China. Whilst we don't see this level of market monopoly in the west, it puts the trio in a strong position to expand overseas, something that Baidu is actively pursuing.

Baidu's biggest challenge is gaining overseas market share from Google. It is starting its expansion in other emerging economies, where consumer behaviour is similar to that in China. By avoiding Google's key markets, developed economies, Baidu has a strong chance to succeed.

Its acquisition strategy in China is focused on mobile migration, driven by the success of Tencent's WeChat platform. However, the mobile messaging technology is not unique to China, so given Baidu's experience and services for mobile, it should be in a strong position to transfer them to overseas markets.

Overseas expansion and mobile migration are the biggest challenges and linchpins of success for Baidu. Over the coming quarters, investors should be looking for mobile to be generating stronger revenues for Baidu. Over the coming years, international revenues will become more and more important.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.