Analysts Debate: Is Baidu Still a Top Stock?

The Motley Fool has been making successful stock picks for many years, but we don't always agree on what a great stock looks like. That's what makes us "motley," and it's one of our core values. We can disagree respectfully, as we often do. Investors do better when they share their knowledge.

In that spirit, we three Fools have banded together to find the market's best and worst stocks, which we'll rate on The Motley Fool's CAPS system as outperformers or underperformers. We'll be accountable for every pick based on the sum of our knowledge and the balance of our decisions. Today, we'll be discussing Baidu (BIDU +0.84%), China's largest search engine.

Baidu by the numbers
Here's a quick snapshot of Baidu's most important numbers:

Sources: Morningstar and Yahoo! Finance.

Sean's take
In late 2011 I went against the crowd and predicted that Baidu would have a particularly rough 2012 based on my TMFULOI valuation model. That call actually turned out to be quite prescient (and lucky, may I add), as Baidu shed 15% of its value in last year, all while the broad-based S&P 500 advanced 11.5%. As we enter into 2013, I figured it would be prudent for the three of us to re-examine Baidu given its dominance in the growing Chinese search engine market.

The way I see it, there are just as many positives as there are negatives with Baidu. In the plus column, Baidu controls the majority of Chinese search traffic, about 80%. Google, once a formidable opponent, shut down its search operations in China due to unfavorable search regulations in 2010. The remaining search engines, while growing like wildfire, are still like buzzing flies to Baidu, including Qihoo, Sohu's Sogou.com, and SINA's Weibo.com which is more like a Facebook/Twitter hybrid than a search engine.

Given Baidu's size, it's able to exert considerable pricing control on its advertisers and is at the forefront of China's rapid growth. Although China is still predominantly in the mid-stages of industrializing its country, newfound wealth among China's middle class has given more than 500 million users in the country access to the Internet. All told, China's five-year growth rate of 76.9% is phenomenal, and it's quite likely that it can grow at a pace exceeding 25% for at least the next few years.

On the other side of the coin we have the threat of Chinese Internet regulation, an infestation of "flies," and a valuation concern.

The biggest threat to Baidu's dominance is the Chinese government putting its foot down on individual users' freedom. Not even two weeks ago Chinese regulators threatened to require Internet users to register with their full names in order to access the Internet. The threat of increasing regulations like this is a concern to all investors in Baidu, Qihoo, Sohu, and the like.

Don't overlook the emergence of Qihoo 360 or Sohu's Sogou.com, either. These search engines may be just the buzzing of flies to Baidu, but Qihoo went from a relative no-name to possessing 10% of all Chinese market share in a matter of weeks by giving users the simple choice of selecting its own search engine, or choosing between Baidu's or Google's. With so few choices available in China, Sogou and Qihoo have a genuine shot to outpace Baidu's growth rate and take market share.

Finally, Baidu's valuation has me concerned. Although its metrics have come down considerably from a year ago, I still have concerns about paying 17 times cash flow and 11 times sales for a company whose growth rate is slowing down.

Weighing both sides of the coin, I've determined that Baidu's long-term value and uniquely dominant position within China are intriguing, but I'd only be comfortable placing a limit CAPScall buy order at $80, where the valuation would make more sense to me.

Travis' take
I have to preface my analysis of Baidu by stating that any investment in China scares me. I've seen companies crushed by China's lack of IP protection and I've seen company SEC filings turn out to be frauds, leaving me very wary of any investment in China.

With that said, Baidu seems to have everything going for it. Huge target market, growing number of computer and Internet users, and a government that keeps its biggest potential rival from making a move into the country. But even a quick look at the most recent earnings release exposes some huge red flags.

First, if I'm going to pay 10.7 times sales and 17.4 times next year's earnings I better be getting a lot of growth for it. But Baidu's growth appears to be slowing quickly. Management expects 37.6% to 41.8% growth in the fourth quarter of 2012, which is well below the 76.9% five-year CAGR in the table above. Sequentially, management even sees a potential decline in revenue.

There's also the concern about long-term growth. Sean pointed out a number of competitors from within China, and there's also the possibility that Google will bring search back to China or that Microsoft (MSFT 1.33%) will expand beyond its English-language services for Baidu. Outside of China, there may be even more challenges. Google already dominates developed countries and there's little chance that a Chinese brand would be able to come in and make a big splash. That leaves limited growth opportunities and I think a growth rate that will continue to slow in the future.

Baidu's stock has already fallen from a 52-week high of $154.15 to near $100, and even with its lofty valuation I don't think an underperform is wise right now. Like Sean, I'd be willing to make a limit outperform call but I'd prefer to get an even better value at $70 per share. At that price, I think there would be enough cushion to absorb any challenges that may emerge in the scary Chinese equity market.

Alex's take
Two things about Baidu are taken more or less as fact. First, Baidu is the Chinese Google, with a solid lock on the Middle Kingdom's search market. Second, Baidu has a huge growth runway as Chinese users get online. Both of these facts have been borne out by the company's recent history, during which it's posted growth rates that would be the envy of any tech company, Chinese or not. It's worth considering Baidu's dramatic growth in the past decade:

Sources: World Bank via Google Public Data and Morningstar.

Not only is Baidu's potential user base increasing at breakneck pace, each of those potential users are becoming more and more profitable over time. However, Baidu can't claim 100% of these users -- its actual monthly user base is about 66% of the total Chinese user base, according to my fellow Fool Dan Dzombak. This is right in line with Google's global search engine market share, making further Google comparisons appropriate. What that revised figure means is that Baidu's profit per user (rather than PPCC) was actually $3.14 in 2011, and is set to increase again this year based on the company's net income growing faster (46% over the trailing 12 months vs. 2011's result) than China's connected population (up 19% from 2009 to 2010 and just 12% from 2010 to 2011).

Baidu's PPCC is growing faster than the country's connected user base. If we accept that Google has about 1 billion monthly users, as Dan's table shows, then its trailing-12-month profit per user is just $10.56. Baidu's trailing-12-month profit per user would be $4.59, which is incredible for a company that operates in a country with about a sixth of the per-capita GDP of the United States.

This isn't a full accounting of Baidu's market opportunity, as there are now over 1 billion Chinese mobile subscriptions, and the number of mobile Internet users surpassed the number of desktop Internet users in mid-2012. Baidu's leadership position in desktop search is just as valuable as Google's, and the Chinese search leader has seen impressive mobile search traffic growth. More importantly, its mobile browser, launched in the third quarter of 2012, was already used by millions within weeks of release.

Let's take a look at Baidu's metrics next to Google's, for a rough idea of its potential upside.

Sources: Tracking sites, Yahoo! Finance, and World Bank via Google Public Data.

Raising China's Internet adoption rate to be equal to that of the United States will be a years-long process -- perhaps decades-long. We'll split the difference and assume a 58% adoption rate in the next decade, which would give us 780 million Chinese Internet users. If we split the difference on profit per user, Baidu could generate $7.58 per user. With a 67% market share of 780 million Chinese Internet users, that works out to $3.96 billion in annual net income, which is a 155% upside from Baidu's trailing-12-month net income.

That is probably the upper end of what you can expect out of Baidu going forward, and that doesn't really account for mobile opportunities and other secondary streams that might come online before Baidu reaches this sort of profitability. It also doesn't account for competition, which, as my colleagues have noted, is and will continue to be fierce. I think Baidu can hold off these challenges, and I think it has value over the long term. I know Sean and Travis want to see this stock get cheaper, but I don't see it declining to the levels they've set. I will hold the line at $100 a share, which is where it stood when I wrote this piece -- consider this my outperform call.

Final call
Following a very lengthy discussion where all three of us were able to identify strong points that would make Baidu a formidable long-term outperformer, the aggregate opinion of a limit buy at $70 from Travis, a limit buy at $80 from me (Sean), and a limit buy at $100 from Alex, would place us with a limit order to buy on CAPS at $83.33. Although Baidu is clearly dominant in China's search market, concerns over Chinese corporate governance for Travis, and valuation for me, trump Alex's overwhelming bullishness of this longtime Motley Fool Rule Breakers selection.

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