Baidu's (NASDAQ:BIDU) reported $1.73 in EPS (+34% y/y) and $1.93bn in revenue (+59% y/y) both came above consensus, driven by solid ARPU growth (+50% y/y) and customer growth (+4% y/y). The progress on mobile search was on track, now accounting for 30% of Baidu's total revenue (compared with 10% two years ago), and search MAU has reached 500mn in June. Management guided Q3 revenue between $2.1bn to $2.2bn, representing a +51% to +55% y/y growth, above consensus.
So have a good time…
The market reacted positively on Baidu's better than expected Q2 and the bullish guidance since the consensus was already fairly conservative going into the Q. As I mentioned in my preview note (See: Baidu 2Q14 Preview: Competition Heating Up In Mobile Search), I expect Baidu to beat on the topline given that it is still the dominant search engine in China. This quarter showed that mobile search is making that positive impact on Baidu's revenue growth as it continues to innovate around its search and mobile product. For example, Baidu has collaborated with BitAuto (NYSE:BITA) to create one of the largest auto search verticals in China, and refined its mobile app to integrate ecommerce, search and mobile payment to create a product that can deliver a consistent and superior user experience.
I believe the near-term revenue growth of 50%+ for this year is achievable as Baidu is clearly focused on growing its topline by pushing its mobile product and attracting more SME clients. That said, the market can feel that Baidu's revenue growth is secured for now.
The sun can't shine everyday…
Baidu's focus on its topline growth hinges on the assumptions that 1) revenue growth of +50% and +40% next year is achievable in the near-term, and 2) the revenue growth will eventually flow to earnings as Baidu scales down its investments due to greater economies of scale.
I believe that Baidu can achieve near-term revenue growth, but I am skeptical that the investments in mobile and R&D could be scaled back due to the rising competitive pressure from Alibaba-UC Web, Tencent/Sogou and Qihoo (NYSE:QIHU). Management commented that Baidu has not seen meaningful impact from the Alibaba-UC Web partnership on traffic and TAC but it is also worth noting that the Alibaba-UC Web partnership was formed in the latter part of the quarter, so the effects would be minimal. I do not believe that the threat will dissipate and expect Baidu's competitors to ramp up on their mobile search investment as every side has either a financial or a technological advantage, or both. Expect to see early signs of competitive pressure in Q3 print.
I also believe that M&A is necessary at this stage for Baidu to pursue in order to stay competitive. While it is admirable for Baidu's management to focus on organic growth, it is difficult to see Baidu not using its RMB49bn (~$8bn) cash to pursue M&A and strengthen its ecosystem. Baidu's management acknowledged that Baidu's ecosystem is not complete, and I cannot agree more. For example, Alibaba acquired AutoNavi, a strategic and valuable asset for LBS and O2O monetization, while Tencent acquired a strategic stake in NavInfo (Baidu's map content provider), in what could potentially become a full-out takeover. That scenario would leave Baidu without a credible supplier for its map content and place Baidu at a disadvantage. To strengthen its mobile ecosystem, Baidu has to pursue M&A or to risk falling behind Tencent and Alibaba.
Finally, investors also need to know that management once again reiterated its prior guidance of flat earnings growth this year due to the rising investment in mobile. At 42x forward PE and a stock price hitting all-time highs, I feel that the current valuation is too rich for a company that is masking bottom line weakness with top line growth, and facing competitive pressure from the larger and more established internet peers. Reiterating my bearish view and my $172 target price (Please see: Baidu: Time to Take a Break; Initiating With $172 target).
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