Three Reasons Baidu Is a Buy

| About: Baidu, Inc. (BIDU)
Baidu (NASDAQ:BIDU) is a streaking star in the world of Internet search and positioned to be a market leader in what is now the biggest base of Internet users in the world. They’ve combined a superior search business with the lessons of Western industry leaders to create a more immersive experience than one would expect from such a young company. Hopefully you caught my initial SeekingAlpha coverage of Baidu in August, when the stock was a downright bargain. Since then, we’ve seen a nice run in the stock price and more than a few investors have been handsomely rewarded. In August, there was a significant margin of safety between what I calculated as the price floor and actual market price. In other words, using my assumptions, it was a home run.
This year, I revisited Baidu to get a better gauge of its evolving competitive landscape. In the Internet industry, friends and foes change faster than the seasons. It was worth looking into the new entrants to the Chinese search market and investigating the progress of old competitors. The company's positioning, if anything, seemed to improve since last year as it released several products that set it apart from competitors. After the earnings release last week, I also mentioned my key takeaways from that conference call.
Now that you are all caught up on the happenings of Baidu, I’d like to investigate whether Baidu is still a sound investment. As the stock rises in price and the margin of safety begins to erode, a value investor may be tempted to take profits and run. However, doing so without taking in the whole picture can severely hamstring your total return. The question isn’t whether Baidu will grow, the company most undoubtedly will. The question an investor has to ask is this: is this stock undervalued for the amount of growth in cash flow that I can reasonably expect in the future?
Here are my three reasons to invest in Baidu.
Learning From the West: Baidu is in an excellent position to watch and learn from a market that is several years ahead of its own. The United States is providing BIDU with a Petri dish of search, social networking, e-commerce and other Internet experiments. Now, other companies have had an opportunity to learn from industry leaders such as Google (NASDAQ:GOOG), Facebook, Twitter and more. The difference with Baidu is that the company listens, learns and implements with alarming effectiveness.
Take for example its open application platform. The company is the first search provider to initiate embedded applications in its results. This provides a more immersive search experience. There are more than 2700 apps right now that include games, tools and more. If you are keeping count, Google just recently started putting apps into its Chrome browser.
In addition, one of the things that Baidu is learning is that a social framework will increase switching costs over the long term. Throughout the history of search, people could switch very easily between Lycos, AltaVista, MetaCrawler, Ask, Yahoo, Google, etc., without many costs. However, none of those players could have seen how much the social network would change the face of the Internet; Baidu is privy to this information and has been using it to build its competitive advantage. One of the first things Robin Li, CEO of Baidu, mentioned during the Q4 2010 conference call was this:

Since our early days in 2003, we have been evolving our products to integrate search with users' social interactions online ... We will continue to invest to further evolve this vibrant social product.

The difference between a Yahoo and a Baidu is that the latter built its entire framework with the social aspect of the Internet in mind. Facebook is blocked in China, which leaves Renren.com and Kaixin001.com as the two major providers of social network services with 160 and 93 million users respectively. I am not saying that Baidu should compete head to head with these two services (yet). However, they could all benefit from working with one another right now. Renren, Kaixin001 and Sina (NASDAQ:SINA) can all provide services that Baidu lacks, and vice versa. Renren and Kaixin001 are both preparing for IPOs in the near future.
Other services like Wenku and Qiyi just serve to show that Baidu has its eyes very much set on the future, and is working hard to not rest on its laurels as the rest of the world catches up.
Unique Market Position: Baidu is positioned to be a dominant player in the largest Internet market in history. Many people point to the fact that the company's valuation and price multiples has never been seen in a successful investment over the long run, but the simple fact of the matter is that an opportunity like this has never presented itself.
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My assumptions for Baidu are not far-fetched as many claim when you take the time to consider the market the company represents. With Chinese Internet users at 420 million as of June 2010, or 35% of the population, China is no longer a developing market. Internet users in mainland China are expected to exceed 700 million by 2013. When you compare that with the 230 million users currently in the United States, you can see that the potential market in China is many times that of the United States. Now, I’m not saying that there is as much money in China as there is in the United States but the users are certainly there.
Combine this massive market with Baidu’s dominant market share and forward looking philosophy/technology and you have the potential for something very unique. The country has the largest Internet population in the world and Baidu has the opportunity to be the main Internet portal. This doesn’t end at search; it begins with search and ends when Baidu is the main gateway into what Google calls the “heart of the Internet.”
Value: Some will try and take me to town on my assertion that Baidu is, in fact, undervalued. They will point to myriad factors including high relative price multiples, lack of sustainable competitive edge and unprecedented growth assumptions. My retort is simple: if you’re going to attack my valuation, then you will have to provide a logical argument against one of my assumptions. Most intrinsic to fundamental valuation are growth and discount rates. So, which one of these is the bear worried about?
Growth of 30% is not unreasonable for Baidu over the short to medium term. The company has a long runway of growth, and as I’ve explained earlier, the market is frankly vast. Furthermore, applying a discount rate in the high teens to low twenties accounts for some of the risk potential in terms of competition and government interference. I think the risk is very low that the company fails catastrophically. I have been impressed with the company's executives, and I believe they have their strategic heads on straight. However, there is always risk with a high growth company like this and I believe I have accounted for that.
I don’t feel that either of these assumptions are unreasonable. As a result, I am able to confidently raise my price floor to $145 and ceiling to $255 for Baidu. The wide gap represents the early stage of the Chinese Internet market, the many different competitors and the government factor. The margin of safety is closing, as Baidu approaches $120, but there is still room for an aggressive investor.
Conclusions: Baidu is a great story that has compelling strategic and fundamental reasons for investing. The upside is still very real, and while the company is approaching the bottom of my price target, I am confident that it will continue to provide excellent returns for investors. The company's positioning in social, along with its advanced Phoenix Nest platform and open application platforms differentiates it from other search providers in China. Their government provides cheap loans and blocks foreign entrants, which will also help Baidu embed itself as a symbol of the Chinese Internet. Baidu, I feel, is still a buy.
Disclaimer: This article is to be used for educational and informational purposes only. The author holds no positions in stocks mentioned and does not plan to initiate positions within 72 hours of the posting of this article. Investments are made at your own risk and the conclusions of this article are the author’s own and do not constitute professional investment advice. Understand the risks inherent in investing before making the decision to invest or consult an investment professional for more information. Information contained heretofore is accurate to the best of the author’s knowledge and the author expressly disclaims any liability for accidental omissions of information or errors in fact.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.