Baidu: Avoid These High Valuations

| About: Baidu, Inc. (BIDU)
This article is now exclusive for PRO subscribers.

It is widely known that the giants of the Chinese internet business are Baidu (NASDAQ:BIDU), Sina (NASDAQ:SINA), (NASDAQ:SOHU), Tenecent, and UcWEb. However, Baidu operates the most popular Chinese search engine, dominating the market. It has about 80% market share, having benefited when Google (NASDAQ:GOOG) shut down its Chinese search site and redirected visitors to servers in Hong Kong in 2010.

On July 11th, 2012, HSBC Securities initiated research that opined that Baidu's shares had better value than the stocks of its rivals. Not long after, Baidu announced its unaudited financial result for the second quarter that ended June 30, 2012. Its revenue increased 59.8% from the corresponding period in 2011 to $858.8 million. The net income was $436, a 69.6% increase from the corresponding period in 2011. Baidu had about 352,000 active online marketing customers in the second quarter of 2012, representing an 18.1% increase from the corresponding period in 2011.

Baidu said the newest version of its browser would support faster internet access and download, allowing users to run web-based applications. The company intends to invest more than $2 billion in cloud computing over the coming years, according to its chief financial officer, Jennifer Li. Hiring of staff and building data centers for its online data storage will gulp most of the money.

Baidu, accused by some analysts of being slower than Tenecent and WcWeb about mobile web access, also recently announced a new web browser for mobile phones, the most popular way Chinese use to access the internet. The new browser, according Dow Jones newswire, offers tailor-made applications and faster download times than others.

The Chinese search engine giant also intends to expand its customer base. It wants to maintain momentum by rolling out optimized sales processes and more advanced tools to assist current and potential customers increase returns on their online marketing spend. According to Li, Baidu would invest aggressively in expanding its network infrastructure and talent base.

Baidu said in a statement in July that it wants to partner with Microsoft (NASDAQ:MSFT) to provide English-language search results. When the arrangement is formalized, English search queries will be directed from Baidu to Microsoft's Bing search engine.

China has the most populous internet market in the world. The number of people going online use mobile phones, and tablet computers are growing as fast as the overall market. 538 million Chinese went online at the end of July, up 11% from a year earlier, according to the Chinese Internet Network Information Center, a government authorized industry group. Mobile internet users rose 22% to 388 million, or more than 70% of the total. Baidu has 80% of the search engine market, far ahead of second placed Google with 15.7%, according to Analysys International, a research firm. On the surface, Baidu appears to have a great future ahead of it.

I believe this may be a wrong assumption. I think that Baidu is significantly overvalued at the current price of around $112 per share and that its stock could go down in the next few years. While its rivals are devising strategies to gain greater share of the Chinese internet market, Baidu is certain no company can pose a great challenge to its dominance.

Unfortunately, Baidu is faced with rivals determined to get more of the market share. At the moment, Baidu is battling to fend off rival search engine, Qihoo 360, which was launched in August. A Qihoo spokesman said Baidu had been using aggressive measures to preserve its user base. When customers use the Qihoo engine to search for a Baidu-related service, they get directed to the Baidu search engine.

Qihoo decided to select services other than Baidu's in its results. It switched out of Baidu, and its search results emphasize alternative services to help user-experience. Though Baidu has not taken notice of any competitor since the Google shut down , it knows Qihoo can become a problem.

Baidu has also been affected by concerns over a weaker-than-expected advertising market and fears the Chinese economy is slowing down. Consequently, Wallace Cheung, an analyst, cut down Baidu's rating to "underperform" from "neutral" and slashed his target price to $83 from $118. Other analysts believe Baidu's monopoly is waning. Cheung said the company had to face newer rivals such as Qihoo 360 and that it has a hard time making money from mobile search.

Another analyst, Alan Hellawell, wrote that Baidu had lost search traffic market share by 4 to 8% to Qihoo, and that the trend would continue in the next two quarters. He cut the recommendation on Baidu to hold from buy and reduced the target price to $137 from $186.

For me, the problem is that Baidu's current valuation is not reasonable. Baidu's shares have an almost indefensible high price of $112. Consider Sina and Sohu, its rivals and sometimes allies. Sohu recently traded at $38 while Sina was sold for $56 share price. Even more interesting, Sohu trades 1.52 price-to-sales multiple, much cheaper than the industry average of 2.06. At 13.40 price-to-sales multiple, Baidu doesn't offer good valuation. Investors will be surprised to learn that Sohu trades at 14.60 price-to-earning multiple, far below the industry average of 25.07. Baidu's price-to-earning ratio is 28.07.

Investors must pay attention to how much they pay for a stock. They must not be deceived by reports of bumper harvests in China and other emerging markets. Investing in internet companies does not always lead to dividend yield or capital appreciation. Investors must learn from lessons of the past. Baidu's story seems eerily similar to companies that brought about the web 1.0 bubble at the turn of millennium. Companies sold shares at prices that didn't take valuation into account. Thousands of investors made the wrong move by buying into the tech bubble. Investors should consider Sina or Sohu in the short-term and avoid Baidu until it trades at a lower and more reasonable valuation.

Disclosure: I 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.