Better Buy: Baidu vs. Alibaba

Baidu (BIDU 4.92%) and Alibaba (BABA 3.50%) are two of China's most well-known tech companies. Baidu owns the country's top search engine, while Alibaba owns its biggest e-commerce marketplace and cloud platform.

When I compared these two companies last August, I concluded that Alibaba's stronger revenue and earnings growth, insulation from macro headwinds, and reasonable valuation made it the better investment than Baidu. Both stocks rallied about 30% since that article was published, as the "phase one" trade deal allayed some concerns about Chinese stocks. But will one of these stocks outperform the other through the rest of 2020?

Image source: Getty Images.

Baidu's strengths and weaknesses

Baidu controls 67% of China's online search engine market, according to StatCounter. Its closest competitors are Sogou and Alibaba's Shenma, which claim 19% and 7% shares, respectively.

Baidu generated 73% of its revenue from online ads last quarter. However, its ad revenue declined annually over the past two quarters as it struggled with slower ad spending amid the economic slowdown in China, as well as competition from Tencent's (TCEHY 2.52%) WeChat and ByteDance's TikTok and Toutiao.

Baidu partly offset that slowdown with the growth of its video platform iQiyi (IQ 2.73%), which generates most of its remaining revenue. But iQiyi's growth also weighs down Baidu's operating margins, since the unit still can't generate a profit in China's competitive streaming video market.

Baidu's core turnaround plan is to expand into adjacent markets, including virtual assistants, smart speakers, artificial intelligence, cloud services, and driverless cars. It's also expanding its mobile app into a platform for mini programs, which mirrors Tencent's expansion of WeChat into a mini program ecosystem.

Alibaba's strengths and weaknesses

Alibaba's marketplaces controlled 56% of China's e-commerce market last year, according to eMarketer. Its closest rivals were JD.com and Pinduoduo (PDD 1.92%), which claimed 17% and 7% of the market, respectively.

Alibaba's cloud platform controlled 47% of China's cloud platform market last year, according to Canalys. Its rivals Tencent, Amazon, and Baidu controlled 15%, 9%, and 8% of that growing market, respectively.

Alibaba's core commerce business generated 85% of its revenue last quarter. The rest of its revenue came from its cloud, digital media and entertainment, and innovation initiatives businesses. Yet Alibaba only generates profits from its core commerce business -- and those profits subsidize the growth of its three other unprofitable units.

Alibaba's core commerce revenue rose 40% annually last quarter, but its growth is decelerating. It's propping up the unit's growth with brick-and-mortar stores, overseas and cross-border marketplaces, and investments in third-party logistics, but those newer businesses are eroding the unit's operating margins.

Image source: Getty Images.

Overlapping interests and shared challenges

Baidu and Alibaba compete across multiple markets, including advertising, cloud services, smart speakers, and AI. Alibaba is actually the largest advertising company in China, since Taobao and Tmall generate ad revenue (via product listing fees) for higher rankings. That business undermines Baidu's online search ads, since merchants could spend their ad budgets on Alibaba's listing fees instead.

However, Baidu overtook Alibaba in China's smart speaker market last year with cheaper speakers. Baidu's AI platform also recently bested Google's in an AI competition, and its Apollo platform for autonomous cars has secured over 100 partnerships from major auto and tech companies. In other words, Baidu is aggressively expanding its ecosystem beyond PCs and mobile devices.

Alibaba and Baidu both face intense competition from Tencent. Tencent's WeChat, the top messaging platform in China with 1.15 billion monthly active users, has evolved into an all-in-one platform for payments, e-commerce, search, ride hailing services, gaming, and more -- which gives it a wide moat against both tech giants. Gen Z-oriented platforms like ByteDance's TikTok and Toutiao are also expanding their ecosystems in similar ways.

The growth forecasts and valuations

Baidu's prospects could brighten this year as waning macro headwinds allow Chinese companies to ramp up their advertising spending again. Its operating margins could also expand as it dials back discounts on smart speakers and iQiyi narrows its losses.

Alibaba will likely continue expanding its core commerce business with lower margin strategies to counter discount rivals like Pinduoduo. It could also face fresh antitrust scrutiny over allegations that it's forcing merchants into exclusive deals.

Based on those factors, Baidu's revenue and earnings growth could accelerate next year, while Alibaba's growth decelerates. Baidu's stock also looks cheaper relative to its earnings growth potential next year:

Source: Yahoo Finance, Jan. 20.

Baidu and Alibaba are both solid long-term plays on China's economy. But at current prices, Baidu's accelerating growth, expanding ecosystem, and lower valuation make it a slightly better pick than Alibaba.