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Baidu Has a Lot to Prove on Feb. 25

By Rick Munarriz - Feb 17, 2016 at 9:05AM

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A lot is riding on China's leading search engine's quarterly results next week.

Image source: Baidu. 

Shares of Baidu (BIDU -0.61%) are showing signs of life. Baidu stock has soared 11.6% over the past two trading days, arming it with healthy momentum as we head into next week's quarterly report.

There's a lot riding on next Thursday's financial results. The stock has raced back into Mr. Market's fancy since late last week, but it's still trading 30% below last year's springtime highs. 

A combination of market sentiment turning against Chinese growth stocks and Baidu's own issue with contracting margins has weighed on the stock. There's little that Baidu itself can do to restore investor faith in China's dot-com darlings, but it can help make a better case for itself if it can start turning things around on the bottom line.

Growing competition in search may be playing a role in the reason why profit margins peaked in 2012 -- and have fallen every single year since then -- but it's likely a bit part. Baidu is still China's search platform of choice, and there are still juicy markups to be had in serving up sponsored ads that are relevant to search queries. The real culprit that's gnawing away at Baidu's profitability is its decision to diversify in low-margin growth markets including streaming video, app marketplaces, and group-buying websites. 

There are plenty of moving parts heading into Baidu's fourth-quarter announcement. Rumors surfaced late last month that it was going to spin off many of its profit-sapping businesses, a move that would help it unlock its asset value while improving its bottom-line results. Baidu denied the reports, but then last week we saw two executives -- including founder CEO Robin Li -- offer to acquire Baidu's 80.5% majority stake in video streaming site iQiyi. It would be a $2.25 billion transaction for Baidu.

It's a smart move. It would build up Baidu's already bountiful cash, but also eliminate a subsidiary that's been a big drag on its earnings. Li would likely make sure that iQiyi continues to have a working relationship with Baidu, making it the best of both worlds for Baidu. It's the kind of deal that can get margins and earnings moving in the right direction, but we're not likely to see that next week. Revenue is still growing at a healthy clip, but analysts are bracing for Baidu's fourth quarter in a row of a year-over-year decline in earnings from operations.

The disparity between both ends of the income statement is real. Wall Street pros see a year-over-year pop of 32% in revenue for the quarter, held back by a 27% drop in earnings per share. The good news is that analysts feel that earnings growth and margin expansion will return in 2016, but that also places more weight on any kind of outlook that Baidu will provide next week. So, yes, Baidu has a lot to prove a week from tomorrow. A strong report and the favorable momentum that have been established over the past two trading days will continue. If it's a weak report or if guidance leads the market to hose down its year-ahead growth prospects, it's a safe bet that the stock will fall even more below last April's all-time highs.

Rick Munarriz has no position in any stocks mentioned. The Motley Fool owns shares of and recommends 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.

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