By The Valuentum Team
Baidu's Investment Considerations
- Baidu (NASDAQ:BIDU) provides its users with many channels to find and share information. In addition to its core Chinese web search product, where it controls 60-80% share, the firm powers many popular community-based products, such as Baidu PostBar, Baidu Knows, and Baidu Encyclopedia. The company was founded in 2000 and is headquartered in Beijing.
- It continues to execute on its vast growth opportunities, and is investing to carry the momentum forward. The Internet is going mobile, and in the fourth quarter of 2015, ~56% of the firm's revenue came from mobile (up significantly from previous periods).
- China's Internet space is booming. With the world's largest Internet user population, and a long way to go to reach internet penetration levels of developed countries, China's Internet is growing in both influence and sophistication. Baidu remains at the forefront of this trend. We doubt any firm that is not natively based in China will ever develop a search platform that better serves the country.
- The economic growth uncertainty in China has the potential to significantly impact consumer confidence and discretionary spending in the country. The middle class that had been growing and spending at a rapid rate will now likely cut its internet shopping budget as the economy hits difficult times.
- However, the Baidu platform is highly useful in connecting users with merchants in consumer-oriented services. Growth in China's services sector outpaced overall GDP growth in 2015, and Baidu expects to benefit from the higher growth. The firm sees additional opportunity to continue to penetrate the local services market in both online advertising and transactions.
- Very few management teams are more excited than Baidu's. The executive suite is working on building an ecosystem to drive more "closed loop transactions." Exploiting the huge growth potential ahead is a key priority.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Baidu's 3-year historical return on invested capital (without goodwill) is 104.6%, which is above the estimate of its cost of capital of 11.4%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
The concept of an economic moat - or sustainable competitive advantages - focuses purely on the sustainability and the duration of the competitive advantages that a firm possesses. The concept of an economic moat does not consider the cumulative sum of a firm's potential future economic profit creation, but only that at some point in time in the future, a moaty company will continue to have an economic profit spread and a no-moat firm will not.
Let's examine the problem that arises by focusing exclusively on companies which have economic moats, or sustainable and durable competitive advantages.
In the chart below, we show the probable path of Baidu's ROIC in the years ahead, based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Baidu's free cash flow margin has averaged about 31.6% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Baidu, cash flow from operations increased about 40% from levels registered two years ago, while capital expenditures expanded about 151% over the same time period.
In fiscal 2015, the company reported cash flow from operations of ~$3 billion and capital expenditures of ~$1.2 billion, resulting in ~$1.8 billion in free cash flow, representing a 3% decrease from fiscal 2014.
This is the most important portion of our analysis. Below, we outline our valuation assumptions and derive a fair value estimate for shares.
Our discounted cash flow model indicates that Baidu's shares are worth between $153 and $229 each. The shares are currently trading at ~$194, just above our fair value estimate. This indicates we feel there is slightly more downside risk than upside potential associated with shares at this time.
The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $191 per share represents a price-to-earnings (P/E) ratio of about 31.6 times last year's earnings and an implied EV/EBITDA multiple of about 24.8 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 19.5% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 50.8%. Our model reflects a 5-year projected average operating margin of 21.9%, which is below Baidu's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 6.8% for the next 15 years and 3% in perpetuity. For Baidu, we use a 11.4% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $191 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values.
In the graph above, we show this probable range of fair values for Baidu. We think the firm is attractive below $153 per share (the green line), but quite expensive above $229 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Baidu's fair value at this point in time to be about $191 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Baidu's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The expected fair value of $267 per share in Year 3 represents our existing fair value per share of $191 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Wrapping Things Up
China's Internet space is booming, and so is Baidu. With the world's largest Internet user population, and a long way to go to reach Internet penetration levels of developed countries, China's Internet is growing in both influence and sophistication. We doubt any firm that is not natively based in China will ever develop a search platform that better serves the country.
That being said, we believe the economic growth uncertainty in China has the potential to significantly impact consumer confidence and discretionary spending in the country. The middle class that had been growing and spending at a rapid rate will now likely cut its Internet shopping budget as the economy hits difficult times. The potential resiliency embedded in its services-based platform offers some reassurance in the concerning economic environment, however.
We removed Baidu from our Best Ideas Newsletter portfolio in mid-2014 after a near-doubling of shares, and we've felt comfortable on the sidelines ever since. Baidu currently registers a 7 on the Valuentum Buying Index. This isn't as good as a 10, the best, but not as poor as a 1, the worst on the rating system.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.