Defending Baidu's Life

I found myself on the defensive earlier this week. Baidu.com (Nasdaq: BIDU  ) posted market-thumping fourth-quarter results on Wednesday night, only to tank 9% lower.

Oh, I know why the stock fell. The company I recommended to Rule Breakers subscribers four months ago initiated top-line guidance for the current quarter that was below where the analysts were perched. Baidu expects to generate $34 million to $35 million in revenue here in the quarter ending in March. Wall Street was looking for revenues to come in just shy of $39 million.

Disappoint and you disappear. I get it. But I think the market's got Baidu all wrong here. I'll tell you why, and I'll show you my math.

Dental floss for mental flaws
The first flaw in the market's reaction is that it assumes Baidu is fading as a growth company. Really? Baidu generated revenue of $16.9 million in last year's opening quarter. The company is telling investors that it is set to grow its top line 101% to 107% higher this quarter. Organically. That kind of speed won't have folks behind you blinking their high beams to get you to move out of the way, right? Sure, Wall Street was hoping for a 131% spurt, but that plays right into a few more flaws in the market's thinking.

The second flaw? The market just doesn't get the seasonality at Baidu. The March quarter has been its slowest, historically. It's not a coincidence that last year's first quarter remains the only period in which Baidu didn't blow past profit targets.

EPS Est.

EPS Actual

Q4 2006

$0.32

$0.45

Q3 2006

$0.26

$0.31

Q2 2006

$0.18

$0.21

Q1 2006

$0.12

$0.11

Q4 2005

$0.07

$0.09

Q3 2005

$0.06

$0.07

Source: Thomson First Call

Analyzing Baidu sequentially a year ago, you will find that the first quarter was also its softest. It posted 18% sequential revenue growth and then bounced back with better than 40% sequential growth in the seasonally superior quarter ending in June.

The third flaw comes from Wall Street's inability to understand the margin expansion that has been taking place at Baidu. Net margins this past quarter clocked in at a stunning 45.1%. Good luck finding a domestic company pulling in that kind of greenery.

Yet that margin improvement has been lost on a skeptical market.

Allow me to illustrate how it will blow up in the faces of the cynical. The company earned $0.45 a share on $34.8 million in revenue this past quarter. Wall Street was looking for $0.32 a share on $34.85 million in revenue. They blew it on the bottom then.

Guess what? They're going to blow it again.

Before the report, analysts had projected $0.33 per share in profits on $39 million in revenue for the March quarter. Wait a minute! $34 million to $35 million sounds a lot like what the company generated this past quarter. Why shouldn't earnings be close to the $0.45 per share it earned?

Unlike some stateside companies such as Netflix (Nasdaq: NFLX  ) that find the quarter ending in March to be a challenging one on margins, given early-year promotional expenditures, Baidu's margins have inched higher with every passing quarter. Look at the first quarter of 2006 sequentially, and you will see that revenues inched 18% higher but earnings per share climbed 22% higher.

In short, Baidu may have warned analysts to lower their top-line targets for the current quarter, but it's also daring analysts to be stupid. Will they feel awkward revising the top line lower and the bottom line substantially higher for the current quarter? If they do, they will probably come up short in projecting Baidu's profitability again.

Keep on keeping on
After earning $1.12 a share last year, what happens if the company earns $0.45 a share for the March quarter? It had earned just $0.11 a share a year earlier, so trailing earnings would clock in at $1.46 after early May's report.

Sales growth slowed to 100%-ish. Profit growth slowed by merely quadrupling. If the stock does nothing between now and then, do you really think the market's going to price this at just 72 times trailing earnings?

Is growth decelerating at Baidu? Sure. However, we're also dealing with a market-share leader that has done pretty much everything right lately. It has grown its market-share lead over distant rivals like Google (Nasdaq: GOOG  ) , Sohu.com (Nasdaq: SOHU  ) , and Yahoo! (Nasdaq: YHOO  ) . It has played nice with Viacom's (NYSE: VIA  ) MTV to clean up its reputation as a musical bad boy. It has even profited from the surrender of others, like when Microsoft (Nasdaq: MSFT  ) handed over its paid search space to Baidu and its network of 108,000 advertisers on MSN China pages.

So everyone seems to be either looking to RSVP to the Baidu party or jealous that they weren't invited. When will the market come around? Meet you back in this space in three months and we'll see if I was right.

Baidu is a recent selection in the Rule Breakers growth stock newsletter service. Many more high-octane stock ideas abound in the stock service, and you can jump on a free trial offer today. Yahoo! and Netflix are Motley Fool Stock Advisor recommendations. Microsoft is an Inside Value pick.

Longtime Fool contributor Rick Munarriz has been to mainland China just once, but he's longing to brush up on Mandarin and give it another go in the future. He does not own shares in any of the companies mentioned in this story, except for Netflix. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.


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