Baidu (NASDAQ: BIDU ) recently reported a beat on both the top and bottom line, but there is controversy surrounding the quarter. You can profit when analysts and journalists express concern unnecessarily. Qihoo 360 (NYSE: QIHU ) and Google (NASDAQ: GOOGL ) are competing for market share but the rewards are greatest for the winner. Lets take a look at the company's initiatives and you can decide if the dominant search vendor in the world's largest consumer market is a good investment.
Revenue of $1.57 billion beat estimates of $1.53 billion and EPS of $1.39 beat consensus of $1.37. Revenue guidance of $1.53 billion to $1.58 billion was also ahead of the $1.4 billion estimate. So why are people expressing concern over the quarter? Baidu has jumped on the Internet investment treadmill and turned up the speed to a four-minute mile. In order to stiff arm the competition, it is developing a wide variety of applications that may or may not produce profits for some time.
Investing more in adjacent businesses
On the call, the company stated that there are four areas that are its strategic focus: 1) mobile and cloud, 2) location based services 3) consumer products (gaming, music, literature and social) and 4) expanding internationally. Ok, is that all? It sounds like Baidu plans to take the profits from its successful search business and build out businesses resembling Amazon.com, Waze, Pandora, and Google Books. Any one of these can be a very costly venture, but attempting all of these could cause a Zen Master to lose focus. This sparked fear at the Wall St Journal that profit growth would be elusive going forward and sentiment was echoed by Morgan Stanley, which downgraded the stock from Overweight to Equal Weight yesterday.
Like Google, Baidu's core business began as desktop search and evolved to mobile. The incorporation of the data that is derived from additional businesses is key to maintaining its leadership at a time when advertising is core to the business. Today mobile only accounts for 20% of the company's revenue but that is likely to grow in as smartphone penetration increases with China's 3G rollout and cheaper, more user-friendly tablets become more prevalent. Baidu has to invest in developing this business.
Expecting an Amazon.com hall pass?
The Street's concern is that Baidu, which is a very profitable company, will try to get an Amazon-style hall pass where it doesn't need to produce profit. This seems to be an extreme concern that doesn't really hold water because the company is already generating a healthy level of profits from its core. Today, Baidu has over 100 million active users which will help the company monetize additional services that it does offer.
Competition with Qihoo is the greatest threat...and shrinking
Qihoo is the only real threat today for the company and may not represent a material threat longer term. A year ago, Qihoo had been taking share from Baidu because in August of 2012, it added a free, default search engine to its browser. Similar to the way Microsoft directed traffic to Bing through Internet Explorer, Qihoo directed traffic to its own search engine. As people evaluated Qihoo's search engine, there was a question of whether Bidu would retain its market share. Now, more than a year later, according to Analysys, Baidu has maintained the bulk if the search market share in China with 78.6%.
First prize is a Cadillac
The complexity of investing in any high-growth industry is what to pay for the market leaders. Alec Baldwin said in Glengary Glen Ross, a cutthroat movie about real estate investing:
As you all know first prize is a Cadillac El Dorado. Anyone wanna see second prize? Second prize is a set of steak knives. Third prize is you're fired.
The business of Internet search is much the same, the bulk of the profits go to the winner, the rewards for second place are considerably smaller and most people don't think about the third-place vendor. If you decide to invest in one of the fastest growing, yet stable search markets Baidu is your best bet.
Baidu has huge potential, but it isn't our top stock for 2014
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