When last covering Baidu (NASDAQ:BIDU), the stock was under pressure due to fears over SEC bans on auditors in China. At the time in January of 2013, the stock slipped below $160 before an eventual bottom near $140 that April. Investors were encouraged to focus on mobile search growth and ignore the over flamed SEC concerns. Fast-forward to today and the stock is surging beyond $225 based on fast mobile growth. The crazy part is that investors might not be too late to invest in this story.
Baidu remains the leading Chinese language search provider and compares to Google (NASDAQ:GOOG) (NASDAQ:GOOGL) on many fronts including a leading app distribution store and a focus on developing a leading video site similar to YouTube. Regardless, both firms continue to obtain the majority of revenue from search. With the Chinese economy only now shifting toward online commerce, one has to speculate that the vast valuation gap between the two stocks will eventually merge over time.
The Q214 numbers were again characterized by huge revenue and even faster expense growth. All of the numbers below are the Q214 ones compared to the prior year period:
- Revenue grew 58.5% to reach $1.93 billion.
- EPS grew 38.1% to reach $1.73.
- SG&A expenses soared 99.3% to $346.4 million.
- R&D expenses jumped 84.5% to $280 million.
The numbers substantially exceeded estimates with EPS projections of analysts sitting at $1.38. Even more important, revenue forecasts for Q314 reach roughly $2.2 billion. The forecast from the company easily exceeded consensus estimates that were previously below the low-end estimate of $2.16 billion. The revenue estimate is for a substantial sequential increase of around 13%.
Overblown Margin Concerns
The part that really sticks out in the Q214 numbers are the continued growth of operating expenses. Baidu continues to spend aggressively to promote new products and hire more engineers to build out the R&D program. The program to aggressively spend on mobile development was necessitated by the shift toward mobile search and the search gains by Qihoo 360 Technology (NYSE:QIHU). Amazingly, Baidu slumped toward $70 back at the end of 2012 based on fears of losing market share to Qihoo.
Anybody listening to the earnings call can see that margins are the major concern of analysts. The CFO wouldn't budge on aggressive spending plans and a focus on top line growth. While a minor concern, investors need to relax and view the results of the past where the company continues pushing plenty of income to the bottom line. In the recent quarter, net income of $609 million was roughly 31% of revenue. Last year in the second quarter, the operating margin was an incredible 39.5%. If anything, the previous margins weren't sustainable in a competitive market.
In comparison, Google produced operating income margins of 32% during Q214. Considering the less developed market in China, it's actually incredible that Baidu had substantially higher margins previously. The question going forward unanswered in the earnings report is whether Baidu plans to maintain the current margins similar to Google or allow them to decline further.
The hardest part about valuing Baidu is the lack of clarity on forward earnings expectations, but if one assumes the company will ease off on expense growth earnings will surge going forward. Remember that keeping expenses inline with revenue growth would allow for earnings to surge 60%. With the earnings runrate at around $7.50 based on the Q2 report, it's very simple to calculate earnings exceeding $10 for 2015. At the current stock price, Baidu trades at an attractive 22x forward earnings. Remember that Facebook (NASDAQ:FB) with a market cap around $200 billion and similar revenue growth trajectory trades at around 37x forward earnings. In fact, Baidu trades at a comparable valuation to Google that is growing at substantially slower rates.
The below chart compares the one year forward PE ratios for the group of stocks and are slightly higher than the above numbers that use full-year 2015 estimates:
BIDU PE Ratio (Forward 1y) data by YCharts
The clear indication from the above chart is that the Chinese stocks of Baidu and Qihoo continue to trade at substantial discounts to the US listed stocks. The discount may not go away soon, but long-term investors can invest knowing the potential exists for fast earnings growth and multiple expansion.
The recent results from Baidu continue to suggest that the aggressive investments by the company are paying off. Despite the nearly 200% gain off the bottom at the end of 2012, the stock sits at a extreme discount to US companies that compete in a similar area or offer the same growth. As it appears, the stock has a long runway higher.
Disclosure: The author is long BIDU. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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