Deceleration and Competition Spook Baidu Investors

As if its initial 10% decline wasn't enough, Baidu  (NASDAQ: BIDU  ) has slid another 6% since the day after its fourth-quarter earnings release. There are looming doubts regarding the Chinese search king's future in light of decelerating growth and increased competition. These worries present a classic opportunity for patient investors to take advantage of the Street's shortsightedness.

Decelerating growth
Market saturation, new entrants, and increased competition -- these are natural decelerators that market leaders inevitably face at some point. Baidu is experiencing these cycles firsthand. For instance, in 2010 and 2011, year-over-year earnings per share grew by 137% and 88%, respectively. Now, in the company's fourth quarter, EPS increased just 36% from the year-ago quarter.

This EPS deceleration owes partly to deceleration in reported average ad spending per customer. In fact, ad spending growth has taken quite a hit -- down to 8%, year over year, compared to 62% growth in the company's year-ago quarter. Adding to the short-term drama, this is the first quarter the company reported single-digit growth rates in ad spending. Even last quarter, year-over-year ad spending growth was twice as high, at 17%. 

On the expense side, the EPS deceleration is partly due to increased marketing and research and development expenses, as Baidu increases its efforts to fortify its position as a market leader.

For instance, despite a deceleration in revenue to 41% year over year, selling, general, and administrative expenses increased 51.7% from the year-ago quarter, putting pressure on the company's net margin. As management noted, this increase is mainly due to an increase in marketing expenses.

R&D spending growth, up 70% from the year-ago quarter, was also disproportionately greater than revenue growth. In the fourth-quarter earnings call, management claimed the increase reflects "continued emphasis on investing in R&D talent."

Management explained to analysts during the Q&A portion of the call that these elevated levels of R&D expenses as a percentage of revenue are the new norm: "R&D expense as a percent of revenue should be relative largely indicative for you as you look into the years out." 

Qihoo's sudden and fierce assault on Baidu
According to Businessweek, Zhou Honyi, Qihoo 360  (NYSE: QIHU  )  co-founder, made quite the entrance into the Chinese search business, calling Baidu "a monopoly that facilitates 'frauds and fakes,'' in which "'users just click and fall into the trap' of bogus websites." Zhou claims that Qihoo's experience in fighting malware and spam will give it an edge over Baidu, enabling Qihoo's recently launched search engine to better protect its users.

A Baidu spokesman responded to the accusations, calling them "unfounded." Nevertheless, there is no denying Qihoo's no-joke entrance into the Chinese search business.

Baidu's increased marketing and R&D expenses may also reflect efforts to combat this competition. Qihoo has made huge progress by promoting its search engine through its dominant browser. Launched only in August, a comScore report from October 2012 claims that Qihoo already holds 9.6% of China's search market traffic, second only to Baidu's immense 73 of the market%.

Significant growth and necessary investments
Decelerating growth on several key metrics, combined with increased spending on marketing and R&D to stay competitive, has turned shortsighted investors sour on Baidu. But a deeper look reveals a rosier picture for the patient investor.

Growth is decelerating in some areas, but not all. For instance, the growth rate in absolute number of advertising clients is actually growing. In the fourth quarter of 2011, Baidu's active online marketing customers increased 13% from the corresponding period in 2010. In the fourth quarter of 2012, things are looking much brighter: active online marketing customers increased 31% from the year-ago quarter. In other words, Baidu's growth rate of new clients more than doubled over the last fiscal year.

And though growth rates in many areas of Baidu's business have decelerated, they are still significant. Total revenue, for instance, was still up 41.6% for the quarter, year over year, and 53.8% for the full year.

And as far as Baidu's increased spending goes, patient investors should be happy to see the company increasing its marketing and R&D spending. The spending will a) help the company protect its competitive advantage as a market leader, and b) improve its offering with the development of new products and services. As Baidu's chief financial officer, Jennifer Li, stated in the fourth quarter earnings release, "[W]e'll be both stepping up our investments and increasing sales and marketing efforts to ensure Baidu captures the huge opportunities ahead."

Furthermore, the company's R&D investments have enabled it to make progress on several new mobile products that the company is working on internally, including mobile maps with built-in information on popular verticals, a voice-activated search assistant, and an updated mobile browser. These investments will, no doubt, help Baidu immensely in navigating an increasingly mobile environment.

Putting Baidu's R&D expenses as a percentage of revenue into perspective, they still remain about 320 basis points lower than Google's (NASDAQ: GOOGL  ) . And if Google's evolution is indicative of what Baidu investors might expect going forward, an increase in R&D should come as no surprise; Google's R&D expenses grew as a percentage of revenue in eight of the last ten years. Now Google's R&D expenses as a percentage of revenue are more than double what they were ten years ago.

A great buying opportunity
At just 18.5 times earnings, a deceleration in Baidu's super-charged growth rates is already priced into the stock. When compared with Google, the stock looks inexpensive. Despite Baidu's higher revenue and earnings growth rates, Google trades at a significant premium to Baidu, with a P/E of 24.6. The emotional Baidu sell-off is simply an opportunity for the patient investor to acquire a few more shares. On the recent sell-off, I've made my Baidu CAPScall one of my top picks.

Regardless of your short-term view on the Chinese economy, there may be opportunity in Baidu (aka the "Chinese Google"). Our brand new premium report breaks down the dominant Chinese search provider's strengths and weaknesses. Just click here to access it now.


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