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By Mark Goldstein

Baidu (NASDAQ:BIDU), the China-based Search Engine famously labeled the Google (NASDAQ:GOOG) of China, recently announced that it was entering the smartphone market with the ChangHong H5018, a device that resembles Nokia's (NYSE:NOK) Lumia 800, but is powered by a hybrid (or "forked") version of Google's Android OS called Baidu Yi.

The obvious question is why a search provider like Baidu is developing its own Android device rather than taking the obvious route and asking known OEMs like Samsung (OTC:SSNLF) or HTC to create one for it. The first answer is that Baidu, taking a page out of Google's playbook, is developing its own smartphone to serve as a delivery mechanism for its services.

The second answer is that going to companies like Samsung and HTC would probably have resulted in a device much more expensive than one that local firms like Huawei or any of the smaller low-cost Chinese OEMs could have produced - especially considering its $140 price-tag.

The two answers are critical; a delivery platform needs to be, by definition, accessible - an expensive device costing hundreds of yuan would make it unattractive for customers in a country where the average monthly wage is estimated to be $360.

What's more, a pricey device would make it unlikely for Chinese mobile firms like China Mobile or China Unicom to subsidize it for its customers. Indeed, the Chinese market is already replete with thousands of low-cost devices capable of basic Internet connectivity at just a third of the ChangHong H5018's price tag. It's more likely that the device will be marketed as a direct-to-retail device.

Interestingly, in 2011, Baidu partnered with Dell (NASDAQ:DELL) to bring the Android-powered Dell Streak V to China, but at $466, it was clearly aimed at the high-end of the market. The announcement of the ChangHong H5018 also seems to imply that the Dell device was meant to serve as a test-bed for future products - perhaps including the ChangHong H5018.

At the very least, having its own handset to tether its users to its search network should allow Baidu to take finer control of the incipient mobile search market in China where it is only one player among several. To wit, while Baidu already has 77% of the desktop search market in China, it doesn t dominate the lower-end mobile search space, trailing its competitor Easou in low-speed WAP traffic, 35% to 36%. Another competitor, Tencent, is not that far behind with 22% of the market.

Moreover, while Baidu controls a similar 35% in the Overall Mobile Search market, Easou, Tencent and Google control 55% of the market combined. For a company used to dominating the search market in one arena (i.e. desktop search), ceding control of 58% in another must be a cause of consternation.

That said, Baidu's smaller mobile market share might be unavoidable: as the largest search engine in China, Baidu has retained a cozy relationship with Chinese regulators that is only occasionally strained. That means that whenever controversies arise, Baidu filters user' search result to block sensitive sites, leading users to use their WAP-based mobile devices to access other search engines that don't adhere to regulators' whims, as Google has learned to its detriment.

Whatever the case, Apple's purported decision to include Baidu among the search engines built into iOS is a welcome development for the search company - at least insofar as it will allow Baidu to retain search users among China's burgeoning middle class, with whom the iPhone is popular. This, however, will not help in the lower-end WAP device market.

Meanwhile, as Web Services, particularly cloud storage, become de rigueur for technology firms, the pressure to introduce copycat services has intensified, especially among rival firms. Clearly, with the advent of Google Drive, Baidu has decided to throw its hat into the online storage arena to round out its Web Services menu - and is intent on using its smartphone as a delivery mechanism.

Specifically, the ChangHong H5018 comes with 300 Gigabytes (NYSE:GB) of free storage on Baidu Netdrive - an astounding proposition considering that popular services like Google Drive, iCloud and Dropbox typically provide between 2 to 5GB for free. Even Microsoft's SkyDrive service provides a maximum of just 25GB free to long-time users.

Based on US rates, the free storage that Baidu is packaging with the ChangHong H5018 is worth as much as $600 per year per device - that's equivalent to the subsidies that AT&T and Verizon pay on their iPhone offerings for the life of a 2-year contract.

To put it in terms of a simple financial analogy: Baidu's cloud strategy is equivalent to selling the top-end 64GB model of the iPhone 4S for a discounted rate of $140 per unit without a monthly fee-based contract.

Clearly, Baidu is expecting big things from Baidu Yi and Baidu Netdrive - but the subsidy it is paying to ensure their success may be too steep, unless it is planning to recoup those earnings down the line through additional search-related ad revenue or perform a bait-and-switch that customers will not appreciate. As it currently stands, the more successful the ChangHong H5018 is, the more money Baidu is in danger of losing.

Conclusion

Baidu's strategy of utilizing smartphones to gain market share for its mobile search and incipient cloud services is commendable. That said, the way it is structured is far from financially sound and represents a soft point going forward, especially for a company that does not have as deep a pool of financial resources that others, like Google, do.

What's more, even Google does not give that much storage away for free and Baidu would have been better off partnering with services like Box, Dropbox or any number of the other online storage incumbents to provide the service to its customers, as firms like Samsung and LG have done with their newer devices.

Baidu currently trades at a Price-Earnings (P/E) Ratio of 34 - that's almost 1.9x that of Google's PE of around 18, significantly higher than that of the S&P500 (21x) and even Apple (13x) and higher still than the search sector's (28x). In that sense, Baidu is trading at a significant premium that its own strategy is in danger of undermining - regardless of how large the Chinese market's potential is.

Consequently, I believe that Baidu's shares could lose as much as 50% of their value in a year's time.

Source: Baidu Could Fall 50% By Mid-2013