Baidu: Thank You, Google

Apr. 2.12 | About: Baidu, Inc. (BIDU)

Baidu (BIDU), the high flying Chinese Internet search engine with 80% of the market share, commands a $51 billion market cap and a price/earnings (P/E) ratio of 48. Is it worth this hefty valuation now? The answer is definitively no. The stock price has been stagnant during most of 2011. Is this likely to continue in 2012? To put the situation in perspective, we have to start with a bit of recent history.

Google (GOOG) made two bad business decisions in China, both with substantial consequences. The first is to choose the wrong person (Kai-Fu Lee) as the CEO in that market (or possibly not allow Mr. Lee to adapt Google to the Chinese market). I do not know whether Google picked the wrong guy or didn't give the guy enough power to do things, but the outcome was the same: Google was already losing ground to Baidu in China prior to 2010. The second is to pull out of China based on political ideology instead of treating it as a business decision. This move had a much bigger impact. Not only did it significantly shrink Google's presence among 20% of the world population -- Google is now virtually not usable in mainland China and Gmail was even for a while blocked -- it also handed Baidu the whole Chinese market. The following chart shows the stock price history for Baidu and Google since 2009.

(Click to enlarge)Click to enlarge

What's behind the chart is what we all learned in economics 101: a monopoly not only has the whole market, it also has more pricing power as the solo service provider. The following table shows Baidu's revenue change from 2007 to 2011.

2007

2008

2009

2010

2011

Revenue

1747

100.00%

3198

100.00%

4448

100.00%

7915

100.00%

14490

100.00%

Gross profit

1100

63.00%

2043

63.87%

2832

63.66%

5766

72.85%

10593

73.11%

Operating income

548

31.37%

1097

34.29%

1605

36.08%

3959

50.02%

7577

52.29%

Net income

630

36.06%

1048

32.77%

1485

33.39%

3525

44.54%

6620

45.69%

Click to enlarge

Source: Baidu, Numbers in CNY million

Pay attention to the percentages. From 2007 to 2009, with Google as its major competitor, Baidu's gross margin was very stable at about 63%, and profit margin at about 35%. In 2010 and 2011, both numbers saw dramatic increases, with gross margin improved to roughly 73%, profit margin to about 45%. In those two years, Baidu's revenue increased 78% and 83% respectively by grabbing Google's previous market share. What a difference Google made!

Due to its stable profit margin (45%), Baidu's profit is almost a fixed portion of its revenue. So the estimation of revenue gives us all the answers about valuation. To do this, I'm going to conduct a very crude guesstimation of the ceiling of search engine market size in China by using the GDP ratio between the U.S. and China. Google gets about $20 billion revenue from the U.S. market. China's GDP is slightly over 1/3 of the United States'. Assuming the U.S. reflects a mature search market for its GDP, that gives roughly $6 billion as Baidu's Chinese search engine market size potential. Baidu's current revenue is $2.3 billion. This suggests it is very unlikely Baidu is going to be able to grow at a percentage of 70%-80% in the future. Let's assume Baidu is now a company at the ceiling level with $6 billion revenue. $6 billion revenue with 45% profit margin gives $2.7 billion profit. As a company at or near that level also has to have a lower growth rate (hence P/E ratio), I use Google's current P/E of 20. That gives Baidu $54 billion market value (very close to Baidu's current market cap of 51 $billion). That is to say, Baidu has all the potential priced in.

Is such a lucrative profit margin (Google's profit margin is about 25%, Microsoft about 33%) going to attract other players to enter the market and compete with Baidu? Unlikely. Baidu and Google combined account for more than 95% of the market. Microsoft's Bing has no meaningful market share in China. If Google has the courage and business savvy, it should reverse its decision and go back to China. China is simply too big and too important to lose for an ideology war that should have been fought by the U.S. government, not the business. But that's perhaps not going to happen. Baidu does face an uncertain political climate and may get hammered from time to time by the Chinese government. But there is no obvious means for the Chinese government to introduce a meaningful business to compete with Baidu. So Baidu is going to enjoy the monopolistic market power while it lasts.

There is another catch: the exchange rate between U.S. Dollar and Chinese Yuan. For political reasons, CNY is pegged to USD at about 1 USD = 6.3 CNY. While inflation in China is rampant, the exchange rate is likely to stay relatively constant for years to come. This gives Baidu an advantage as almost all its revenue is recorded in CNY. And its nominal value will increase by inflation alone.

In conclusion, Baidu's revenue growth rate is likely to slow down significantly in the future, with its five-year average growth in the 20% range and perhaps even lower. Its current stock price has much future growth priced in. The stock price is already ahead of the company itself. Even if it doesn't go down, it's likely to linger around this price level for some time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.