Baidu Still A Favorite In Chinese Internet Space

| About: Baidu, Inc. (BIDU)
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After the bell on Thursday, Chinese search company Baidu (NASDAQ:BIDU) reported its fourth quarter and full year results. The results were mostly positive. Baidu proved in the quarter it is still the number one Chinese internet name to be invested in, although shares did trade lower on Friday by nearly $5.

Fourth Quarter Results:

The company reported revenues in the quarter of $711 million, which beat analyst estimates by about two million, and was at the top of the range of the guidance they gave last quarter ($691.4 to $711 million). Earnings per share, or ADR, came in at $0.93, beating estimates by two cents. The following chart shows Baidu's fourth quarter results over the past three years. Note, the numbers given are as reported, in Renminbi, not US Dollars, which is what I gave you above. The growth number is the year over year number from 2010 to 2011.

4th Quarter 2009 2010 2011 Growth
Revenues 1,260,894 2,450,905 4,474,093 82.55%
Cost of Revenues 452,559 630,976 1,240,588 96.61%
Gross Margin 808,335 1,819,929 3,233,505 77.67%
Operating Income 462,166 1,274,802 2,297,277 80.21%
Net Income 427,864 1,160,614 2,053,670 76.95%
EPS 12.27 33.22 58.73 76.79%

As you can see, Baidu is still showing very explosive growth, well above 80%. However, Baidu's cost of revenues jumped a bit as well, causing gross margins to decline over the prior year period. The following table shows why the cost of revenues increased more than revenues for the quarter.

Cost of Revenues 2010 2011 Change
Business Tax and Surcharges 160,750 327,624 103.81%
Traffic Acquisition Costs 199,367 353,762 77.44%
Bandwidth Costs 99,202 192,230 93.78%
Depreciation Costs 97,997 214,866 119.26%
Operational Costs 72,047 149,938 108.11%
Share Based Compensation 1,613 2,168 34.41%
Total 630,976 1,240,588 96.61%

Baidu's operational and depreciation costs increased heavily. In fact, all but share based compensation expenses and traffic acquisition costs rose faster than revenues (82.55%), which led to the year over year decline in gross margin, seen in the following table.

Margins 4Q 2009 4Q 2010 4Q 2011
Gross 64.11% 74.26% 72.27%
Operating 36.65% 52.01% 51.35%
Profit 33.93% 47.35% 45.90%

The decline in gross margins continued down throughout the income statement. Baidu made back some of the decreased gross margins thanks to decreased SG&A expenses, which only increased 66.8% year over year. However, Baidu lost a little on the bottom line due to an increased effective tax rate, which jumped from 12.1% to 16.5%, and a net loss attributable to NCI.

Full Year Results:

Here are the key full year numbers for Baidu, again, in the local currency and not dollars.

Full Year 2009 2010 2011 Growth
Revenues 4,447,776 7,915,074 14,500,786 83.20%
Cost of Revenues 1,616,236 2,149,288 3,896,883 81.31%
Gross Margin 2,831,540 5,765,786 10,603,903 83.91%
Operating Income 1,604,937 3,958,768 7,576,659 91.39%
Net Income 1,485,104 3,525,168 6,638,637 88.32%
EPS 42.70 100.96 189.88 88.07%

Baidu did a better job earlier in the year of controlling costs, especially traffic acquisition costs, which only increased 52.4% year over year. This helped full year margins on all three levels to increase from the 2010 year into 2011.

Margins 2009 2010 2011
Gross 63.66% 72.85% 73.13%
Operating 36.08% 50.02% 52.25%
Profit 33.39% 44.54% 45.78%

Baidu has maintained very strong margins, and they remain ahead of American search name Google (NASDAQ:GOOG) and fellow Chinese internet name (NASDAQ:SOHU). For purposes of this argument, I have left out fellow Chinese internet name (NASDAQ:SINA), which has not yet reported 2011 results. More on this later.

Gross 73.13% 65.21% 72.22%
Operating 52.25% 30.98% 29.85%
Profit 45.78% 25.69% 19.10%

Guidance / Valuation:

Baidu issued revenue guidance for the first quarter, with a range of $666.5 million to $688 million. The midpoint of that range is $677.25 million, which is slightly below the roughly $679 million analysts are currently expecting for the quarter.

Baidu shares traded off on Friday, some of that in my opinion was profit taking, but also some investors are again concerned about the valuation. Baidu currently trades at 30 times 2012 earnings, and that is giving some investors pause, especially after the not so spectacular guidance from the company.

Investment Recommendation:

Baidu's earnings report was okay, and Google and Sohu both reported bad quarters. All three names declined after earnings, and I feel the same may be coming for Sina when it reports its earnings (not sure when that will be yet).

We know that China's overall economy is slowing down, and obviously, the growth in these names is slowing down too. However, we saw from Sohu that some areas are slowing down faster than others. Regulation of the internet in China is a massive risk in these names, and every time the word "stricter" comes up, names like Sina decline, sometimes sharply. Sina operates a microblogging service, and if its bloggers are forced to reveal their identities, watch out below.

I liked Baidu at $120 and Sina below $50, but both names have rallied since those points. Baidu's earnings report wasn't great, but it wasn't terrible either (like the one we saw from Sohu). If Sina reports bad numbers, I think the whole sector is due for a decline, and that might provide a decent entry point for Baidu.

At this point, I would stay away from Sina and Sohu until we get a clearer picture of what 2012 will bring. Baidu is the safest investment of the three, and the average analyst price target is about $50 above here, but I wouldn't get in just yet. I think a larger pullback is coming, which should allow you to enter the name between $100 and $120.

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