Could Baidu Get Blown Up?

Imagine you own a business in China. Now imagine that the Chinese government starts running high-profile stories in their media about how you're defrauding your customers, enabling the sale of potentially dangerous pharmaceuticals, and slandering respected academics. Would you be concerned?

I'm guessing you would be, and rightfully so. Companies that attract the wrath of the government in China don't tend to do so well, whether we're talking about Google (Nasdaq: GOOG  ) refusing to play ball on Internet censorship, or Sanlu Group putting melamine in its milk. Google has left the market and given up significant market share, while Sanlu went effectively bankrupt -- and there are many more examples.

This is the worst-case scenario facing Baidu (Nasdaq: BIDU  ) owners today. Following the aforementioned barrage of criticism on China's government-run CCTV last week, Baidu ultimately took to the airwaves itself and, effectively admitting guilt, apologized.

A sign of things to come
Not long ago in this column, I admitted I was wrong about Baidu. Rather than rest on its laurels after Google's exit from China's massive search market, the company has doubled down on innovation and aggressively grabbed market share. Its chunk of the Chinese search market now sits north of 75%. With its search algorithm only getting smarter, and the company devising more and better ways to attract and then monetize traffic, Baidu was starting to look like an investing home run.

But I should have known that success is never that easy in China.

To understand why, let's remember how and why the Chinese government controls the flow of information in the country.

A brief history of censorship
One of the hallmarks of China's communist government is that it controls nearly all of the country's media outlets. Whether in print, on television, or over the radio, the government owns and operates the No. 1 player in each space. Furthermore, to the extent that independent media exists, it must self-censor in accordance with the government's policies. Failure to do so could result in the revocation of a media outlet's operating license, or worse.

There is, however, no explicit list of taboo subjects in China. While it's well-known that the publication of a Tiananmen Square expose or pornography would be verboten, the fact that China's review system is fluid and after-the-fact means that many outlets are even more conservative than they might otherwise have to be. This all plays in the government's favor. A press that doesn't challenge the government means a greater likelihood for stability -- or social harmony, as China's government likes to call it.

Truly disruptive innovation
Yet the Chinese government has found it increasingly hard to keep tabs on the Internet. Because of its user-generated content, lack of a fixed publishing schedule, and the sheer breadth of websites and information, readers, writers, and publishers are getting away with more now than at any other time in China's history. The reactions on Sina's (Nasdaq: SINA  ) domestic microblogging platform Weibo to events such as the recent high-speed rail accident, for example, have been very frank.

This doesn't mean the Internet is open, of course. Many popular foreign websites, including Facebook and Twitter, are blocked in the country, and recent coverage of the brawl that marred a goodwill basketball game between the Bayi Rockets and the Georgetown Hoyas has all but disappeared. But the Internet in China is not the wasteland of absurdity that something like The Global Times, a new English-language state-run Chinese newspaper, is.

For the government, this is a concern. Information is power, and there's enough wrong with the Chinese government (notably, local corruption and abuse of power) to ensure that open, fair, and balanced coverage on the Internet would produce more than a few upset and mobilized citizens. And that might not be the only reason the government is wary. If our experience in U.S. private media is any guide, then the government is losing billions of dollars of advertising revenue from the traditional media it owns to the new media it does not.

When a company undermines the Chinese government's power and hits it in the wallet, expect the state to fight back.

The opening shots of a Chinese civil war?
This is why I believe the recent CCTV campaign may be only the start of a broader effort by the Chinese government to start tilting public opinion against Baidu, in order to enable the government to prosecute the company under the country's anti-monoply law. See, Baidu is currently a beacon of hope for China's tech sector. Not only did it oust foreigner Google, but it's also considered one of the best and most prestigious companies to work for in China. If the Chinese government were to crack down now, it would trigger a likely acrimonious public reaction.

But if the government can demonstrate to the majority of Chinese (and remember that the majority are not online, and therefore not using Baidu) that Baidu is abusing its position and disrupting social harmony, it can make legal action more palatable. That action becomes even more palatable from there if the government makes the case that Baidu is actually a foreign company.

Sound ridiculous? While Baidu is based in Beijing and was founded by and employs Chinese citizens, its ownership is foreign. The top holders other than CEO Robin Li are Baillie Gifford & Co., T. Rowe Price, Fidelity, and Marisco. In fact, because Baidu isn't listed in China, Chinese citizens can't actually own the stock. In other words, if the government crushes the company, it won't affect Chinese investors -- an important point to note.

What happens next
A reading of China's anti-monopoly law shows that it could easily apply to Baidu. Among other things, the law defines monopolistic conduct as "abuse of dominant market positions by business operators" and dominant market condition when "the relevant market share of a business operator accounts for 1/2 or above in the relevant market."

Defrauding customers could easily constitute "abuse," and a 75% or higher share is clearly greater than 50%.

What happens from there? That's where this situation gets interesting. Potential penalties include a fine of up to 10% of the company's previous-year revenue (a relatively immaterial $120 million for Baidu) or, more ominously, an order to "dispose or shares or assets, transfer the business or take other necessary measures to restore the market situation."

Given that the government has recently launched three of its own search engines, including one with China Mobile (NYSE: CHL  ) and one with CCTV, I fear that Baidu could be forced to share its intellectual property -- its critical algorithm -- with competitors in order to restore normalcy in the eyes of regulators. Without a similarly effective actual search engine, no government-run enterprise would ever be able to compete.

The global view
Is the Chinese government willing to go after its own tech sector and slow the country's development in the name of cash and control? The answer to that question depends on how cynical or perhaps even paranoid you are, but it's no surprise that Baidu is apologizing. There's no winning a fight with the Chinese government.

As for foreign investors who have made a lot of money alongside Baidu, if I were one of you (and I wish I were), I would be thinking about using options or some other strategy to protect my gains in the face of this risk. While I admit that the government would be short-sighted and even stupid to declare war on its own economy to preserve its power -- well, I'll leave it there.

Get Tim Hanson's top global stock picks by joining Motley Fool Global Gains. Tim's "Global View" column appears every Thursday on Fool.com.

Tim Hanson is the Fool's lead international advisor and co-advisor of Motley Fool Global Gains. He does not own shares of any company mentioned. Motley Fool newsletter services have recommended buying shares of Google, Baidu, Sina, and China Mobile. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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