Can Qihoo 360 Close the Revenue Gap With Baidu?

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Baidu (NASDAQ: BIDU  ) has seen excellent growth since Google (NASDAQ: GOOGL  ) exited the Chinese market in 2010. In the last 18 months or so, though, Qihoo 360 (NYSE: QIHU  ) has emerged as the No. 2 search engine in China.

Although the company has gained significant traffic share from Baidu, Qihoo still hasn't ramped up monetization. Analysts at Stifel expect 2014 to be the year Qihoo flips the switch and closes the gap between market share and revenue share, and they upgraded the stock earlier this week.

Product first
Qihoo 360 launched its search engine two summers ago, and its quickly gained 23% of China's search traffic. Meanwhile, Baidu has fallen to attract just two-thirds of Chinese web searches, and Google has fallen to just 1.6% of traffic.

The exciting thing about Qihoo's phenomenal market share gains in the last 18 months is that all of this search traffic is organically driven. Qihoo is relying on its other products -- its security software, its web browser, its Android app store -- to bring people to its search engine, That's a great sign, as the company doesn't even heavily promote search.

Instead, Qihoo's management is focused on making the product the best it can be. On the company's third-quarter conference call, co-founder and CEO Hongyi Zhou explained that if you promote a product before it's reached perfection, users will not stick. He wants a sticky product before he introduces it on a broader basis. He said is in the late stages of the perfection process, so maybe Stifel is right that it will increase revenue share in 2014.

For the long-term investor, though, this process of perfection-promotion-monetization looks like a strong strategy. The idea is to get the biggest return on investment from the company's marketing and sales efforts and not rush things.

The company has a goal of reaching 30% traffic share in 2014, but it could be much more if it transitions to the promotion stage this year.

Flipping the revenue switch
Last summer, the head of Google China, John Liu, stepped down to "pursue other opportunities." It turns out those other opportunities include a big role at Qihoo 360, where he was just hired as Chief Business Officer. Liu's hiring was brought on specifically to "help [Qihoo] execute [its] strategy in search monetization."

No company knows how to monetize its web users better than Google. Enders Analysis Ian Maude estimates Google generated about $29.95 per user in the third quarter. The rest of the competition -- Yahoo!, Facebook, Twitter -- aren't even close to that level of monetization.

Qihoo doesn't currently offer the range of advertising products that Baidu does, so investors should look for the company to begin selling new products spearheaded by Liu. If Qihoo can copy even just a part of Google's success, search can become another major revenue stream for the company.

In its third quarter, Morgan Stanley analysts estimate that Qihoo generated $28 million in search ad revenue. Comparatively, Baidu posted online marketing revenue of $1.45 billion. That's with just three times the traffic share.

In other words, if Qihoo can monetize its traffic at even half the level of Baidu, it could increase its search revenue tenfold without even increasing its traffic. Of course, as more Chinese consumers buy smartphones and get online, the opportunity for both Qihoo and Baidu continues to grow.

Searching for growth in China
In my opinion, both Baidu and Qihoo make great investments as a way to play the growth of the Internet population in China. I like Qihoo a little bit more, as its opportunity in search is just getting started and it has a great ecosystem of users from its security software, browser, and app store. Baidu has been aggressively attacking the mobile market in order to compete with Qihoo's foothold there, but with the growth of the market, there's plenty of room for both companies.

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Adam Levy

Adam has been writing for The Motley Fool since 2012 covering consumer goods and technology companies. He spends about as much time thinking about Facebook and Twitter's businesses as he does using their products. For some lighthearted stock commentary and occasional St. Louis Cardinal mania

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