Morgan Stanley Initiates Coverage of Baidu (BIDU)

Morgan Stanley initiated coverage of Baidu (ticker: BIDU) with an "underweight" rating earlier today. The following are short extracts from the note to clients:

Baidu should be a key beneficiary of the 60%+ compounded medium-term growth in paid search sales in China. However, we believe its growth prospects are more than priced into its stock price. The company's rich valuation implies stellar execution and little margin for error.

A front-runner driven by two engines on paid search highway. We believe Baidu is positioned at a 'sweet spot' of the Chinese Internet to fulfill two needs - the rising hunger of Chinese Internet users for organized information and the desire of small- and medium-size enterprises (SMEs) for cost-effective advertising means. Relative to foreign rivals, Baidu has competitive edges in Chinese search technology and ground sales force. Relative to domestic players, Baidu sets itself apart with its early mover advantages and its leading brand awareness.

Risks include aggressive valuation and rising competition. In our view, an imbalance between the supply and demand for Baidu's shares (only 10% of Baidu's total shares are publicly traded) may be the key driver for its stretched valuation, which is beyond our discounted cash flow (DCF) value, its organic growth rate, and the valuation of other Internet comparables.

Our discounted cash flow (DCF) model implies a share price of US$40, assuming a 13% discount rate plus a free cash flow exit multiple of 11 (at a 4% terminal growth rate). DCF is our preferred methodology for valuing Baidu because it incorporates our long-term view about the company's operations. Relative to listed US and Chinese Internet peers, Baidu's share price is substantially higher in terms of earnings multiples. The company's price/earnings growth (PEG) ratio is 1.9, significantly above the average of around 0.7 for other Chinese Internet companies under our coverage.

BIDU chart.