Why Baidu Could Be A Better Bet Than Google

Oct.31.11 | About: Baidu, Inc. (BIDU)

As an economy, China remains one of the global growth leaders. However, taking a look at the performance of its equity markets, one would hardly think that its economy is growing at 4 to 5 times the rate of the US. China’s stock markets have not been reflecting this underlying growth trend trailing US equities. Any hint of a slowdown, currency adjustment, real estate rumor or talks of China’s big customers in the US, Europe or Asia slowing imports, and China’s stocks take a big hit.

Here, the old investment adage aptly fits in: if you have the nicest house in a crappy neighborhood, your home’s valuation will still reflect the surrounding environment, not just the fundamentals of your house. Meaning, the best stock in an embattled market may still be challenging.

Interest rates, inflation fears, bank capital requirements, the health of economies of client nations, supply chain disruptions and concerns about the cost and availability of raw materials have all play their part into swift and steep movements, both up and down, in stock markets.

On September 30, US-listed Chinese companies were clobbered after a securities regulator told Reuters that the Justice Department was investigating accounting irregularities at Chinese companies listed on US exchanges.

Among the casualties was Baidu, Inc. (NASDAQ:BIDU), one of our longest held stocks.

Although this was an isolated incident, the past 12 months have been challenging for Chinese equities which far trail their sector counterparts in the US. Year-to-date, Chinese equity markets are behind the S&P 500 or the Global Dow by a material difference.

Our investment in BIDU is profitable. One reason is that it has changed in position size and even seen a brief exit in late September this year. One of the beauties of liquid equities is the ability to move in and out and change risk profile by position size. The stock moves and moves quickly. Its beta, compared to the S&P 500, is over 1.5 but, then, remember that geopolitical events, currency moves and sentiment towards China, its economy and its pending economic soft or hard “landing” all come into play.

A clear overview of the firm is provided curtsey of a NY Times article published in July.

With an 84 percent market share, according to iResearch, Baidu can see exactly what most of China’s 450 million Internet users look for online, be it the latest political scandal, pop tune or movie schedule. And it is a formidable opponent for other companies, as Google can testify after scaling back its operations in China last year.

But despite its redoubtable position, Baidu finds itself faced with a thorny challenge — keeping both the technocrats in Beijing and the financial analysts on Wall Street happy at the same time.

Another article in Times presents some interesting insights and data.

“Whether private or state-backed, domestic or foreign, competitors can’t tell us what the users can,” said Jennifer Li, the chief financial officer of Baidu. “We handle more daily queries in China than any other search engine does in any single national market. That much data on the intention of users yields real insight into their needs and how to satisfy them.”

Acquisitions are another important part of the company’s strategy. Last month, Baidu announced it would invest $306 million for a majority stake in Qunar.com, China’s leading travel search engine. The announcement came a month after Tencent, its rival and the largest Internet company in China, said it would buy a 16 percent stake in the online travel site Elong.com.

In social networking — where Chinese people spend 6 percent of their time online, according to ComScore — Baidu has failed to enjoy the success of Facebook clones like Renren and Kaixin001. That is a concern for the company if Chinese Web users become more like those in the United States, where about a quarter of Internet browsing time is spent on social networks.

Much of this sounds familiar. Google Inc. (NASDAQ:GOOG) pursues a similar business model here in the US and has greater ex-country market penetration to help it grow. One could easily argue that BIDU follows GOOG. We like and own GOOG but BIDU is growing at twice the pace with one quarter the headcount and nearly a 20% superior operating margin. Fittingly, the market has awarded BIDU with a much higher multiple - P/E just over 65 and its five-year expected P/E/G remains just a hair over one or 0.18 more than GOOG. This level still indicates growth in stock price.

The stock is up ~50% year to date and over 250% over the past two years while GOOG has just seen a growth of just over 10% in last two years. Although it is not a smooth ride, BIDU is on a great run. Its latest earnings report last week confirmed its growth, profitability and investment in its future.

Given that less than one quarter of the population of China is currently online, migration to cities, proliferation of smart phones and other major growth factors, more great things are expected from BIDU. Like all public companies, competition has its sights on the same markets and services but unlike working in the west, the unknowns of government can dramatically work for or against the firm.

Like all stocks, after any earnings pop or rapid price movement we examine position size to assess risk. Balancing today’s price and tomorrow’s growth potential position size is calculated. For now we see a bright future for BIDU but remain vigilant on all external forces.

Disclosure: Mr. Corn is chief investment officer of E5A Funds LLC. Through various equity strategies under his supervision, he is currently long both BIDU and GOOG.