Baidu

Image Source: Global.Baidu.com.

Baidu (NASDAQ:BIDU) is the dominant online search company in China, which is the country with the largest population of Internet users. After years of not having a robust mobile presence, the company began focusing on building out its mobile-ready site, and in only a few years, mobile has become responsible for more than 50% of total revenue. With the proliferation of mobile came the opportunity to capitalize on the burgeoning online-to-offline (O2O) market.

O2Ois where a transaction begins online, and culminates with an offline interaction. Some examples are making a dinner reservation on your phone using a site such as OpenTable, or buying movie tickets on Fandango. It can be incredibly profitable for a search company like Baidu to be in this space if it's able to gain market share. 

A theoretical evening could involve a young, middle-class Chinese couple deciding to go on a dinner-and-a-movie date. A search for movie reviews on Baidu's search engine also generates a button where they can purchase tickets to pick up at the box office. Baidu gets a small cut and more information about consumer behavior, which leads to higher advertising spends in the future.

After the film, the couple looks through a daily deals site to find a nice discounted dinner nearby. Again, Baidu gets a cut, and more information. 

$3.2 billion during the next three years
Baidu has made the decision to largely eschew growth on a global scale, although it is making strides in certain countries, and instead focus on beefing up its presence domestically. As a part of this, the company announced in June that it would spend $3.2 billion on O2O initiatives during the next three years. It already has a presence in certain O2O areas, but this will be its biggest series of investments in the area to date. 

Baidu earlier this month was the lead investor in a $100 million investment into a Chinese company called Edaixi, which runs an app-based laundry cleaning and delivery service. Customers will arrange for a pickup on their smartphones.

According to a Zacks Equity Research report, the company "will then arrange for the pick up of soiled clothes, their cleaning and subsequent delivery to the customer's doorsteps in 72 hours. The company has around five million customers in 16 Chinese cities, and handles about 100,000 orders per day." While this might have seemed like a pipe dream for China just a few short years ago, it's a reality now, as young professionals continue to pour into cities and have more disposable income to spend on such services. 

This remains merely a fraction of the money that Baidu plans to spend in the O2O space during the next three years. I expect many more strategic bets, both smaller and larger to be placed. Surely not all of them will move the needle for Baidu or even be successful. A few smash hits, however, can strengthen the Baidu ecosystem, and help the company usher in a new era, or as CEO Robin Li calls it, the "Next Baidu."

What does this mean for the stock?
During the past three months, Baidu stock has dropped significantly. I think this has a lot to do with short-term investors worrying that Baidu is investing too much in these new business areas. Short term, this is putting some pressure on earnings, but in the long run, I like the odds of these investments paying off big time. 

These investments are reflected in the company's Q2 SG&A expenses being up 81% year over year, which the company attributed primarily to an increase in promotional spending for O2O. Revenues were up 38.3% YOY, while operating profit actually decreased by 2.5% compared to the same period last year.

The company said that the "O2O & Other [segment] reduced operating margins by 25.3 percentage points and iQiyi reduced operating margins by 5.1 percentage points." iQiyi, which is the company's paid online video platform, and O2O services, are going to require a lot of upfront spending and have hurt margins in the near term.

The upside to these investments is that the company is seeing real gains in mobile and O2O. Mobile search monthly active users, or MAUs, were up 24% YOY, mobile maps MAUs were up 48% YOY, and most impressively, gross merchandise value, or GMV, for O2O services was up 109% YOY. These results will eventually create more revenue, and eventually drop to the company's bottom line.

Baidu stock has been hit hard, losing more than a quarter of its value in the last year, but the underlying business remains very strong. I'll be looking to add at these levels because I believe the investments in O2O, mobile, and video will leave Baidu stronger and much more profitable 10 years from now then they are today.

This is not a quarter-to-quarter story, but one that may take years to play out. I'm willing to wait.

James Sullivan owns shares of Baidu. The Motley Fool recommends Baidu. The Motley Fool owns shares of Baidu. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.