Shares of Baidu (NASDAQ:BIDU) have risen about 10% over the past 12 months, but the stock has underperformed many of its Chinese technology peers and remains well below its historic high of $250. This might seem odd, since Baidu is China's biggest search engine and seemingly well-positioned to capitalize on rising internet-penetration rates across the country.
To better understand this stock, investors should weigh the company's strengths and weaknesses. Let's take a closer look at why Baidu could either sink or swim this year.
Why Baidu could sink
The biggest growth catalyst for Baidu was Alphabet's (NASDAQ:GOOG) (NASDAQ:GOOGL) Google exit from the mainland Chinese market in 2010, due to a clash with the Chinese government over email-hacking allegations and censorship practices. But there are now signs that Google wants to compromise with Chinese regulators to reenter the market -- which could be bad news for Baidu.
Regulators are reportedly considering allowing Google Scholar, a search engine for educational literature, back into the market. Google is also reportedly in talks with online media and games company NetEase to launch a joint venture to bring Google Play back into China.
Even with Google sidelined, Baidu has been ceding market share in the search market to domestic rivals such as Qihoo 360, and losing market share in the digital ad market to disruptive challengers such as Tencent (NASDAQOTH:TCEHY) -- which has turned its messaging app WeChat into an all-in-one platform for digital services. These challenges are forcing Baidu to boost its spending on similar online-to-offline, or O2O, services for its mobile app -- and those expenses have caused its operating margin to crumble over the past five years:
To make matters worse, increased government scrutiny of internet display ads caused Baidu's revenue growth to slow down last year. In particular, ads for misleading healthcare products were banned, which took a big bite out of Baidu's top line.
Baidu repeatedly highlights its investments on next-generation technologies such as artificial intelligence, but that department suffered big setbacks earlier this year after Baidu's Big Data Lab chief Tong Zhang was poached by Tencent, and Andrew Ng, the company's chief scientist, abruptly resigned.
Lastly, Baidu's valuation remains high in a lofty market. It currently trades at 40 times earnings, which is higher than the industry average of 37 for internet information providers. This leaves it highly vulnerable to a big sell-off across the Chinese tech market.
Why Baidu could swim
On the other hand, the threat of Google reentering China might be overstated, since many Chinese users who are already locked into Baidu's ecosystem of search, location, and cloud-based services won't instantly switch to Google's. Moreover, Baidu has tight connections to the Chinese government -- that's probably why it was approved to launch a state-backed engineering laboratory for deep-learning technologies earlier this year.
Baidu CEO Robin Li also has a seat on the Chinese People's Political Consultative Conference, a political advisory body for the Chinese government. So despite Chinese regulators' recent moves against Baidu, the government will still likely prefer protecting Baidu instead of restoring Google as a full-fledged search engine in China. Google seems to know this -- that's probably why it's reportedly interested in signing a joint venture with Baidu's video-streaming site iQiyi, instead of expanding YouTube into mainland China.
Meanwhile, Baidu's O2O investments could pay off and widen its moat against Tencent. For example, Baidu Wallet -- which grew its activated accounts by 88% annually to 100 million in 2016 -- could still counter Tencent's WePay and comparable mobile-payment services. Baidu could also forge new alliances with companies like SINA, Weibo, and Alibaba -- which are all being threatened by Tencent's growth.
Baidu still controls about 80% of the Chinese search market, and it sees expansion opportunities in other foreign markets such as Brazil, Egypt, Indonesia, Japan, and Thailand. Therefore, it's unlikely that Baidu's revenue growth will fall off a cliff anytime soon.
Despite the company's recent challenges, analysts expect Baidu's revenue to rise 21% this year as it finally moves past regulatory troubles and the confusing share swap of Qunar and Ctrip shares -- which both throttled its growth in 2016.
My verdict: Baidu will tread water (for now)
In my opinion, Baidu will neither sink nor swim this year. Instead, it will likely tread water as investors evaluate the effectiveness of its O2O investments, its ability to counter Tencent, its ability to appease regulators, and the possibility of disruptive players such as Google reentering the market.
Baidu likely faces a limited downside potential, since it remains China's top search engine and one of the most straightforward plays on China's growing internet market. However, its near-term upside could also be limited by concerns that it's being left behind the tech curve by nimbler rivals like Tencent.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Baidu, Tencent, and Sina. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), and Baidu. The Motley Fool recommends Ctrip.com International, NetEase, Sina, and Weibo. The Motley Fool has a disclosure policy.