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4 Silver Linings in Baidu's Bad Quarter

Rick Aristotle Munarriz
October 30, 2012

If Baidu (Nasdaq: BIDU  ) was trading today, it wouldn't be pretty.

The leading Chinese search engine posted mixed results on Monday night, and the top-line outlook for the current quarter is even worse.

Revenue climbed 50% to $994.6 million during the third quarter, shy of the 53% surge that analysts were forecasting. The news gets better on the bottom line. Earnings soared 60% to $478.6 million -- or $1.37 a share. Wall Street was betting on net income of $1.28 a share.

That's pretty impressive, especially when you divide that profitability by revenue to arrive at net profit margins of 48.2%. Good luck finding a stateside company cranking out margins like that. Corporate taxes will take a big bite out of even the nimblest of overachievers. Baidu is clearly benefiting from its lean and scalable model, assisted by a refreshingly low effective tax rate of 13.5%.

Unfortunately, that lower tax rate -- and a more than doubling of interest income earned -- helped boost net margins. It's a bit of an illusion, you see. Operating profits grew at merely a 48% clip, actually failing to keep up with Baidu's revenue growth.

However, the real problematic part of the report is Baidu's guidance. It now sees revenue growing by 38% to 42% during the fourth quarter, representing a slight sequential dip. Wall Street was angling for sequential improvement on a 46% year-over-year spurt.

Over the weekend, I went over four reasons why Baidu should close higher this week. That's starting to seem like a bad call, but let's dive a little deeper into where the four reasons stand in light of what we now know.

1. Baidu is still growing at a heady rate
There were a few analysts turning bearish on Baidu in recent weeks, and the challenges that they were pointing out are materializing.

Qihoo 360's (NYSE: QIHU  ) launch of a rival search engine this summer is making an impact. If not, it's just a matter of growth in China decelerating. To be fair, it's probably a combination of both.

However, what's so bad about growing revenue by nearly 50% during the past three months and a midpoint that implies a 40% year-over-year pop during the final three months of the year? Based on Baidu's close on Friday, the stock is fetching just 18 times forward earnings. Baidu's growth would have to slow a lot more than that in order to not justify its valuation on an earnings basis.

2. Baidu has a history of surpassing expectations
Baidu had beaten Wall Street's profit targets for 13 consecutive quarters heading into Monday night's report. Well, that streak is now at 14 straight quarters.

Cynics will argue that the boosts in interest income and a lower effective tax rate handed Baidu the beat, but the streak is still impressive. The weak revenue guidance for the new quarter may raise questions about its ability to keep this streak going, but it's easier to bet for Baidu than against it on a streak like this.

3. Qihoo 360, at best, is Bing
Qihoo 360's foray into search is still a wild card. This isn't's (Nasdaq: SOHU  ) Sogou, which has been toiling away for years on a sliver of the Chinese search market. This certainly isn't Google's (Nasdaq: GOOG  ) partial surrender in China, a move that opened the door for Baidu to grow its market to as much as 80% earlier this year.

Qihoo 360 is turning heads, but will they stay th