Baidu: Buying At These Prices Should See Double-Digit Returns

| About: Baidu, Inc. (BIDU)

Summary

Baidu is a superior, high-quality business capable of delivering long-term outperformance.

The company share price has been punished through 2015 and 2016 in spite of superior growth.

For investors who can stomach near-term volatility, Baidu likely offers the promise of strong long-term returns.

Baidu (NASDAQ:BIDU) is a business that doesn't seem to get much appreciation lately. It is a high-growth, dominant business that has market leadership in the search sector in China. The company has a great track record of long-term growth. Average annual revenue growth over the last 10 years has come in at close to 82%. Revenue growth over the last couple of years has still averaged over 40%. Yet, the stock has been hammered. It was down 17% in 2015, and down almost 13% year to date. It begs the question whether Baidu represents a long-term opportunity for the patient investor.

A dominant moat that will drive strong returns

I like dominant businesses with natural barriers to entry that help ensure long-term profitability. Baidu has the characteristics of a wide moat business. The company benefits from strong network effects, courtesy of being the dominant search play in China.

Baidu is the "Google of China" and controls close to 80% of the overall share of internet search in the country. This provides a natural monopoly for the business. Users are likely to continue to leverage the dominant search engine if it continues to provides them with the most relevant search results. Having the most users in turn tends to attract the largest share of advertisers willing to pay the most to advertise. Peripheral players tend to be in a distant second place with marginal market share, as Google's own search dominance in the US market illustrates.

A profitable, high-margin business with strong cash flow

Baidu is a business with a high level of profitability that produces significant levels of cash. Its gross margins hover near 60%, and the business manages to retain 25% of revenues as operating margin. While this is a fairly high level of operating profitability, it is notable that this has come down in recent years as a result of Baidu's significant reinvestment back into the business.

The net impact of such strong economics is that free cash flow generation has hovered around 25-30% of revenue, which not bad and not too far behind Alphabet's (GOOG, GOOGL) own 33% revenue to free cash flow conversion.

Growth drivers are in place for the foreseeable future

Baidu is favorably placed in the digital advertising boom in China. Revenues, operating income and EPS have shown annual growth of 50%+ over the last five years.

However, the company's growth potential still remains immense. The overall search advertising market in China has been forecast to grow at strong double-digit rates for the foreseeable future. Internet advertising is still only a portion of the overall advertising market in China, so the runway for growth looks promising.

Baidu will benefit from the continued move of China's population online, and the ongoing trend of advertisers to shift offline advertising online, where people are spending more time. As disposable incomes in China accelerate, so too will online advertising spend. Baidu should be a net beneficiary of these trends. At this stage, a very low-single digit percentage of small and mid-sized businesses in China actually use online advertising to reach potential customers, so the expansion of incremental paying advertisers remains significant.

Baidu has also done a good job of transitioning into mobile search. Mobile revenues surged in the last quarter and accounted for almost 50% of the company's most recent quarterly revenue. Equally impressive, mobile monthly active users ("MAU") increased to over 640 million by the end of 2015. While mobile search currently has lower cost per click ("CPC") than desktop search, I expect this gap will narrow over time as users spend more time on mobile and less on desktop.

New product innovation will extend reach and potential

Baidu has launched a number of new mobile services recently, including a mobile cloud offering as well as mobile navigation and a mobile music streaming service. These new services should help increase the stickiness of search users, if not contribute to incremental revenues. Mobile music streaming and mobile navigation provide new mobile inventory, where the company can leverage existing advertising relationships and offer new properties to advertisers. Baidu's mobile music service now boasts over 150 million MAUs. Baidu also isn't standing still as far as next-generation service innovation is concerned. The company is undertaking its own set of moonshot projects, including the self driving car. These new businesses should eventually help generate new revenue streams.

Risk factors likely manageable

An investment in Baidu isn't without risks, but in my view, these risks are quite manageable. The biggest risk is the mere fact that the business operates in China, which implies an economic and regulatory risk profile that is very unique.

There are suggestions that China's economy is entering a phase of more subdued growth, which could certainly act to reduce advertiser spending over the next few years. This is unlikely to be a significant dampener on Baidu's long-term growth, however.

The digital advertising landscape in China is also in a state of flux as new players develop new value propositions. Tencent (OTCPK:TCEHY) is one to watch as far as capturing a disproportionate share of social advertising as advertisers start to divert dollars away from search toward more personalized content offerings and social commerce.

Valuation looks compelling

In my view, it is clear that Baidu is a great business. In fact, it is a great business with a strong set of growth drivers that should propel growth for quite some time.

I'm interested in investing in a business with a robust market position that has strong growth drivers which will allow superior growth. I think Baidu represents that kind of a business. Analysts are forecasting the company will grow earnings close to 25% annually over the next five years. Given the historic rates of growth that the business has achieved, I think this looks very achievable.

With a TTM P/E ratio of 29x earnings, this suggests a likely rate of return going forward for investors of at least 15% annually if BIDU achieves the level of growth that analysts expect, assuming the company can hold its current valuation premium. A P/E of 29x earnings certainly seems very reasonable for a business expected to grow at 25%. Morningstar currently rates the business 4 stars.

While Baidu's stock price may show a high level of volatility in the near term, those who are willing to hold for an extended period of time should see good investor returns.

Disclosure: I am/we are long BIDU.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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