Why I Was Wrong About Baidu

It's not often that a company you've criticized invites you over for a tour and tea, but that's precisely what happened to me recently in Beijing when I visited Baidu's (Nasdaq: BIDU  ) corporate campus in the northwestern part of the city. And after spending a full day meeting employees and getting a sense of the company's culture and growth strategy, I'm beginning to think that my skepticism of the company has been misguided.

I'll tell you why, but first I need to explain what I used to think.

This story begins 1,800% ago
Baidu went public in 2005, and given the excitement about emerging markets then, the stock nearly doubled on its first day of trading. It's looked expensive to me ever since. One reason for that is Baidu was (and to some extent remains) a Google (Nasdaq: GOOG  ) clone. Like so many Chinese companies, it's taking cues, hints, and ideas from a Western business but gaining a competitive advantage in China thanks to local knowledge.

Although this frustrated me on an intellectual level, I let that frustration cloud my investing assessment of the company. After all, every company learns from its competitors, and it's an asset -- not a liability -- to use that learning to gain a competitive advantage. In Baidu's case, that advantage -- coupled with Google's unwillingness to play ball with the Chinese government on Internet censorship -- has been immense. Baidu's market share in Internet search has increased from less than 70% in 2005 and 2006 to more than 86% today, even as the number of Internet users and searches in China has skyrocketed.

The company's massive sales force is teaching small businesses about keyword advertising, and as a result, its revenue is up 90% annually, and its profit has risen more than 160% annually over the past five years. What's more, Baidu's operating margin has reached an incredible 51%, which shows just how much leverage this business model has. As you might expect, the stock has done well, too: It's almost a 20-bagger.

I remained a skeptic
Yet even as Baidu proved it was a solid company and gained more market share as Google left China, I continued to doubt its future. The stock was selling for more than 50 times EBITDA, so the company's long-term growth potential was clearly factored into the price. But my hypothesis was that over such a long period, China's Internet restrictions would ease and Google would re-enter the market -- bringing a superior search algorithm and brand cachet earned by standing up to censorship. I thought that together, those things would help Google chip away at Baidu's market share and, therefore, at its business.

To be honest, I thought Baidu was a better short than it was a buy, and I wrote in December 2010, after a Wikileaks release revealed that the Chinese government was actively working with Baidu, that investors should buy puts. This looked like a situation where the competitive advantages so many investors perceived in the stock were being artificially created. The stock is up 30% since then.

Don't short this stock
But what I saw at Baidu has me changing my tune. I still don't think Baidu is up to par with Google on the tech or innovation fronts, but the young, flat, and hungry organization is getting there. Baidu is a learning machine, and the company's vision and corporate culture are light-years ahead of its Chinese Internet peers. And with better than 86% market share, it's compiling a lot of data it can use to improve its search algorithm. Google may eventually return to China, but its technological advantage will probably have eroded by then. Add in the fact that ingrained Internet habits are hard to break, and Baidu's market share seems secure.

Baidu has years (maybe decades) of growth ahead. Just 35% of China's 1.4 billion people are online today, which means there's an untapped market in China three times the size of the United States. And the company estimated that it's working with just 1% of China's more than 40 million small- and medium-sized companies, meaning there's much more ad money out there to spend on Baidu. Finally, it's getting smarter about monetizing its search. Baidu used to sell keywords to the highest bidder, but its new platform awards the keyword to the bidder who drives the most revenue. That's a function of the bid plus the number of clicked links and completed transactions. In other words, the companies that offer shoppers the best deals get the most prominent ads -- creating a virtuous cycle that leaves everyone more satisfied.

While Baidu looks expensive at 60 times EBITDA, it's a relative bargain in its peer group -- particularly since it's one of the few that's making more and more money:

Company

EV/EBITDA Ratio

TTM Net Margin

2010 Net Margin

2009 Net Margin

Baidu

59.6 times

45.4%

44.5%

33.4%

Sina (Nasdaq: SINA  )

51.4 times

(6.8%)

(4.7%)

114.9%

Youku.com (Nasdaq: YOKU  )

N/A

(43.0%)

(52.9%)

(118.7%)

Renren.com (NYSE: RENN  )

230.2 times

(83.8%)

(83.8%)

(150.2%)

Sohu.com (Nasdaq: SOHU  )

7.7 times

24.8%

24.3%

28.7%

Qihoo 360 (Nasdaq: QIHU  )

N/A

(16.1%)

14.8%

13.0%

Source: Capital IQ, a division of Standard & Poor's.

So am I buying Baidu?
Just because a stock is relatively a good deal doesn't make it absolutely a good deal. While I'm still torn if I should complete my 180 and buy Baidu, my analysis thus far tells me that at $130 per ADR, the market, in addition to assuming further Internet penetration in China, is pricing in revenue growth from approximately $0.006 per search to $0.035 per search over the next decade. That looks aggressive in that it's greater than 20% annual growth, but conservative in that Google is monetizing its U.S. business today at approximately $0.10 per search.

At this point, I could go either way. While I was definitely wrong about betting against Baidu, I still have some work to do before I'd be comfortable betting on it.

Tim Hanson is co-advisor of Motley Fool Global Gains. He does not own shares of any company mentioned. The Motley Fool owns shares of Google. Motley Fool newsletter services have recommended buying shares of Baidu, Sina, Sohu.com, and Google. 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.


Read/Post Comments (11) | Recommend This Article (26)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 30, 2011, at 12:23 PM, gubbly33 wrote:

    Again, Bad reporting, When will a good reporter do his DD first before he shoots off his yap. Do this, first investigate the company and THEN report your DD...Not shoot off his yap and then do a tour of the company and find out he was really wrong..

    Just Bad press from a Bad reporter , not that anyones on the take from hedge funds who pay peeps to ill report good companies so that they can SHORT THEM....

    lets try something new, REPORT ACCURATE NEWS!

  • Report this Comment On June 30, 2011, at 1:41 PM, methodmass wrote:

    Motley Fool - To 'Entertain'....

    I shouldn't have even commented. Mornons.

  • Report this Comment On June 30, 2011, at 9:14 PM, MDexpat wrote:

    This article is a joke; right? First Hanson rejects Baidu out of hand. Then he gets a dog and pony show and all is forgiven? No Tim, you were right the first time. Baidu

  • Report this Comment On July 01, 2011, at 12:42 AM, thethreestooges wrote:

    Wait till the communist take over it and make it a government own agency. No one will get their money back. Especially the foreign investors. If it is too big and become a threat to the regime, it will become an arm of the government. Be scare, really!

  • Report this Comment On July 01, 2011, at 12:55 AM, somethingnew wrote:

    Tim, I'm glad you are humble enough to admit your mistake. I felt the same way about Baidu and followed all the hype on why it seemed overpriced at the time. I've been keeping those mistakes I made in mind as the next gen of new companies have started to go public, even if the quality of them seems worse. I learn from articles like this because I've made the same mistakes in the past and this gives me more insight as to what mistakes to avoid in the future. Thanks for a great article.

  • Report this Comment On July 01, 2011, at 4:21 AM, jlidallas wrote:

    I too think this article is a big disapointment and lots of misleading facts.

    The word 'mistake' was used many times in this article, but I couldn't see what the mistakes actually are:

    -Fact: The management and company culture was unclear to all American investors for Baidu half a decades back.

    -Fact: You or no one could've foreseen that Google would actually quit Chinese market couple years ago which would leave Baidu all the free Market share.

    -Fact: It's true China has 1.4B population and now only has 35% internet coverage but at least half of the people still live in un-developed rural areas and internet is the least of their worries. 3 times US internet users? No, not in recent decades.

    -Fact: Even though Baidu dominated Chinese seach engine market but their other www attemps have been falling behind Tencent even Sohu

    -Fact: It has ALWAYS been an over-priced stock.

    How can someone call them a long term/growth/value oriented investor if they ever consider buying a stock 50 times EBIDA?

    It's just one of those stock you think isn't worth buying and you didn't and it went up 20 folds anyway and then you think you made a mistake not buying it the first time.

    Well, there was NO mistake not buying Baidu unless you could predict its revenue would grow 90% yearly. You couldn't and no one could. For those who caught the 18 bagger are mostly just lucky.

    Buffet tought us nothing.

  • Report this Comment On July 01, 2011, at 5:24 AM, johnontherock wrote:

    tim was honest enough to admit his flawed investigation into baidu.good reporting should not be influenced by personal bias.even today tim is doubting this young vibrant company.apple looked expensive at 250.00 a share,now look at it.baidu is cheap compared to where it will be in say a year from now and tim should have had the conviction of his courage in admiting he was wrong by recommending baidu as a buy.

  • Report this Comment On July 01, 2011, at 1:32 PM, mbawharton wrote:

    It may go up another 1000% but its P/E simply can't pass my screener, sorry.

  • Report this Comment On July 01, 2011, at 9:18 PM, somethingnew wrote:

    Idk I'm seriously wondering if this is how some companies slip by the 'experts.' It's true, no one could have predicted this but I wonder if the same could not be said for alot of other companies. Walmart is a tired example but a fascinating one for me because my hometown got theirs in 1980. Yet not one person I've talked to, and having my broker's license I've talked to quite a few, have said they seriously thought about buying Walmart back then when I asked them about it. I've asked several older brokers dead on why they didn't see it and I got these embarrassing muddled half answers. The fact is they couldn't have known even though it was everywhere around where I grew up in the midwest. The first Wmt Supercenter was built less than two hours away from where I grew up. There were so much competition back then, kmart, woolworth, korvettes, etc that the retail market was flooded with different discount retailers. Some things I guess you just have to buy on instinct rather than looking at all the numbers and current facts. Although I don't think that's the wisest approach the majority of time when buying into a company, I think that in some cases you just have to buy on that conviction.

  • Report this Comment On July 06, 2011, at 5:36 PM, susan400 wrote:

    why were you wrong on OIL ?

  • Report this Comment On July 21, 2011, at 8:21 AM, bordereiver wrote:

    Well, that got everyone riled up. I finally started using MF a lot because Rule Breakers got me excited. And I remember one of the Fools pointing out that on some of these Rule Breaker stocks (I think it was ISRG) will always look expensive. I was coming over from investing for several years, with some success, the Bufffet morningstar way, value analysis, buy cheap. I still do a lot of that (23 wide moats and 11 narrow moats) but now I'm making good money on stuff like Bidu, QLik, and RAX. None of which is recommended by morningstar. Living in China for several years, and meeting the Bidu General Counsel, and seeing how darned smart those people are, helps me make the step. So my Bidu stock is up 91% - hoping for that 100% mark soon. Maybe its just luck, but then luck does play a role for us investors, doesn't it.

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