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Baidu (NASDAQ:BIDU) is making a controversial expansion into the smartphone market. But given the search engine’s dominance in mainland China and imminent iPhone integration, analysts argue Baidu stock is largely undervalued.

Baidu's plan to launch an economic smartphone with its own operating system, Baidu Cloud, is an ambitious strategy to exploit the rising mobile market in China - “a big future,” remarks internet expert Liu Xingliang.

Releasing the ¥899 phone ($142) targeting lower-end customers is arguably a crucial step for the company to help carve market share from companies like Tencent (OTCPK:TCEHY), who enjoy early entry advantage.

“It is both a defense and an offense strategy,” says technology critic Jia Jinghua. Most mobile users now access Baidu through third-party internet browsers or applications. Both Apple (NASDAQ:AAPL) and Android (NASDAQ:GOOG) smartphones use Google as a default search engine - a big threat to Baidu stock, says Jia.

Internet growth in China has reached a ceiling with netizen increases slowing. This makes the search for new profit growth one of the company’s priorities.

While Baidu essentially monopolizes Chinese internet search with a market share of nearly 80%, its mobile market share is only around 37%. This is not far ahead of runner-ups easou.com and SOSO.com with roughly 22% and 20% respectively, according to iResearch.

A proprietary smartphone with Baidu’s own mapping, search, and keyword input baked-in will give mobile users more access to Baidu’s services and products - and most importantly, its ads.

“To internet companies, it is equal to buying traffic,” says Liu. Unlike the higher-end market dominated by Apple and Samsung (OTC:SSNLF), lower-end customers are not sensitive towards brand names. So as a latecomer, Liu argues, Baidu still has a chance to swipe market share from Tencent.

So-called “cabbage-priced” smartphones are sold as loss-leaders, signifying the great ambition internet companies have to absorb market share, even at a cost. According to Jia, the competition has bordered on vicious, and the quality and reception of these phones remains to be seen.

The mobile internet in China is still in its formative stage, where internet companies are rushing in and fighting for market share. Jia argues real competition will arrive in two to three years with the establishment of a well-built 3G network with broader coverage.

Baidu’s advance into the smartphone market is not without its problems. Analyst worry about Baidu's cash flow and innovation ability. “In terms of entering into the hardware realm, according to its current capability, we don’t think it’s a wise choice,” said Dundas Deng, internet analyst with Guotai Junan International.

Research and development expenses, one of the most important factors for developing smartphones, remain the biggest hurdle for the company. For a search engine operator like Baidu to develop hardware, the cost is going to be high and will tighten the company’s cash flow, states Deng.

Baidu reported research and development expenses of ¥440 million ($69 million) for the first quarter of 2012, dwarfed by Google’s $1.44 billion and Apple’s $841 million.

Despite the debate over its smartphone, Baidu’s dominance in mainland China remains unchallenged and will continue for the foreseeable future says Deng, especially with such a high entry barrier for search engines. With Google’s exit from the market, its search engine is having a hard time providing stable services within the area, which prompted Baidu to announce its new partnership with Apple’s next new iPhone after its contract with Google terminates.

Deng gives Baidu stock a target price of $200, which represents 27.6 times PE and 1.4 times PEG from 2011 to 2014. Baidu stock is currently in free-fall from its peak in mid-April at $151, and is now trading at $114 a share.

Source: Baidu: Seriously Undervalued?