Baidu Beginning to Show Flaws

Baidu.com, Inc. (BIDU) is the Chinese equivalent of Google Inc. (GOOG). The company not only offers a search engine for users to find relevant internet content, but also hosts a suite of products similar to Google’s offering of productivity, entertainment, communication, and information products.

Most recently, Baidu has launched an instant message service and is currently in the testing stage. In China, instant messaging is a reasonably professional way of communication and it is likely that this medium will be adopted by a large segment of the population. While the service does not produce any revenue, it will go far towards expanding Baidu’s brand name and locking in users.

Late last month, the company issued its earnings report for the first quarter. The results beat expectations with revenue up 108.4% over the past year to $81.9 million (using a fixed currency translation), and earnings per ADR were 0.67 which compares very favorably to the 36 cents earned during the same quarter last year. More importantly, the company issued forward guidance for the second quarter with expectations of $111 to $114 million. This is above the consensus expectations and was enough to send the stock higher for the day.

Yet even with the positive numbers, there appear to be a few concerning issues arising. For starters, management noted that there were 161,000 active online marketing customers which is only up 3.9% sequentially. This hardly shows the kind of robust growth in new customers that one would expect from such a dynamic growth company. While the quarter was not expected to be seasonally strong, this figure still stands out as less than impressive. But the more pressing concern was the increase in Traffic Acquisition Costs [TAC]. This is the commission or portion of revenue that Baidu shares with its affiliates who drive traffic to the site.

Not only did TAC costs increase in nominal terms, the figure came in significantly higher as a portion of revenue. Last year during the first quarter, traffic acquisition costs accounted for 10.3% of revenue. In the same quarter this year the numbers were much higher at 13.3%. That’s a nearly 30% increase in a major cost of goods sold. If this were a car manufacturer and the cost of steel rose by 30%, it would make the front page of every financial journal. At this point, it appears investors are looking past this issue as the incremental revenue is garnering more attention and offering optimistic investors hope.

Another reason for investors' optimism is the fact that the Olympics are just around the corner. Expectations are high as the games have boosted the country’s economic status as well as its information flow. Investors are right in believing that this period will offer the company excessive opportunities to rake in advertising revenue, but one has to begin to wonder if the good news is already baked into the price of the stock. We may currently be in a period where investors “buy the rumor” only to “sell the news” once the higher revenue is realized. In this business, it pays to look at each exciting story with a skeptical eye, especially when a stock is trading at an excessive multiple and running higher into a resistance area.

Finally, there are beginning to be some concerns about the possibility of competition stealing away incremental pieces of market share. While BIDU certainly has the first mover advantage over competition, it is unreasonable to think that in this period of open technology and a dynamically creative workforce, new competitors could not begin to put together a product that rivals Baidu’s offering.

As Alibaba and Yahoo (YHOO) invest in their Chinese presence, and Google partners with China Mobile (CHL), it remains to be seen whether either of these competitors can begin to cut in on Baidu’s dominant presence. It would appear unlikely that either would be able to eclipse Baidu’s solid lead, but even taking a few percentage points away could cause investors to hold a more cautious view and knock the ethereal multiple down a couple of notches. I think it is time to exercise caution on Baidu and may possibly even consider shorting the name should the pattern begin to break down.

BIDU Notes

Disclosure: Author does not have a position in BIDU, GOOG, or YHOO.

Comments

[Brian29]

I agree with your thoughts. Good company but the valuation is crazy
(20x sales??)

[Steve Zhao]

I am sure I buy this argument. Yes, their customer base does not grow as fast as their revenue. Isn't that what expected. Internet over china is like everywhere else and had and continue to undergo consolidation. the big getting bigger and strong getting stronger. You always want to do business with the healthiest companies, ie. the large ones. rather than wast your time and resources with the peanut companies.

[weng ho teng]

No doubt that competition is picking up across various platforms.

I see them keeping their advantage but also like several competitors.

One of the most attractive is MYST.OB.......a tremendous play in 2008 and beyond.

Their subsidiary subaye.com is introducing Subaye English next week............a global B2B site.

[Spirit_Long71]

I definetly agree that the Subaye english site will be one to watch!
Lots of INFO on MYST at InvestorVillage.com!