Baidu: The Risks and Potential Rewards of This Investment in China

Image: Baidu.com

Baidu (BIDU -0.56%) has been an exciting company, both for Chinese consumers and U.S.-based investors. Thanks to Google's (GOOGL -1.23%) exit from China in 2010, Baidu has been nearly unchallenged in search, and gained from China's remarkable rise in Internet users. Baidu's offerings are very similar to those of Google, with search and advertising comprising its main revenue sources along with video and entertainment content and other online services. Baidu is by far the largest search search engine in China, with around 70% market share. 

Baidu's share price has risen over 1,500% in the last 10 years, leading to a valuation around $70 billion and making it the sixth-largest Chinese company traded in the U.S. Analysts are expecting around 38% year-over-year revenue growth in 2015 and 32% in 2016, which could mean continued share price growth over the next few years. Here's what could spur that growth, as well as the risks ahead.  

3 growth drivers

1. Increased Internet penetration

The number of Internet users in China continues to expand rapidly. There are already nearly twice as many Internet users in China -- 650 million -- as the entire U.S. population. However, the Internet penetration rate in China is still low at just 46%, compared with around 87% Internet penetration in the U.S. Even a 10% higher penetration rate in China would mean about 140 million new potential customers for Baidu. 

But it's not only China where Baidu is seeking to gain from a growing base of new Internet users. The company is also trying to expand in other areas with surging Internet penetration rates, such as Latin America. Baidu launched in Brazil last year, and is preparing to set up a formal Latin American headquarters. Just like in China, rates of Internet usage are surging in Latin America, and Baidu is trying to get on top of the market. 

2. Mobile partnerships

In a related point, the number of Chinese mobile Internet users is also growing rapidly -- by the end of 2014 there were an estimated 550 million mobile users.  In 2015, the number of mobile Internet users is expected to grow nearly 25%. In rural areas of China, many homes will get smartphones before they have access to computers, meaning that mobile will often be their only access to the Internet.

Baidu is aggressively going after mobile search and advertising, and has been partnering with Chinese mobile device makers to get its apps and search tools pre-installed on those devices. This should help Baidu continue to lead the market in mobile. 

3. Driverless cars

There are reports that Baidu has teamed up with Daimler and BMW and could actually have a driverless car to market before Google. So far, Baidu's version looks more like a "connected car' that has features making it easier to drive rather than a fully autonomous car, but that could actually be a good move -- it could be easier to get both the public and Chinese regulators to adopt these connected cars while work on a completely automated driverless car continues. 

2 potential risks: Competition and rising expenses
Of course, when there is big growth in a sector like Chinese mobile activity, there will be competition fighting for market share. Alibaba isa risk for Baidu, as it focuses on providing mobile video streaming content and other entertainment and shopping services.

While Baidu has made great leaps in service offerings and market share, that growth is coming at a price. Baidu's expenses related to selling, general & administrative costs grew over 47% year over year in 2014, and research and development costs grew nearly 80%. 

Of course, continued commitment to R&D is likely going to help Baidu's future growth prospects. Still, these costs are increasing faster than revenue is increasing, and could put a strain on margins and income.

Is the stock worth a buy?
Right now the stock looks expensive at around 35 times earnings. However, consider that by analyst earnings estimates, Baidu's current price is less than 4 times expected 2016 earnings. It's for that reason that KeyBanc recently rated BIDU a buy, with a price target of $255.   

While Baidu's competition and cost risks are certainly something to watch, the company's position at the forefront of growth in the Chinese Internet looks to be a platform for continued earnings growth for years to come.