Monday, October 23, 2006

If You Missed Google's Run-Up, "Do Buy" Baidu

Warning: The following message could be good for your financial health, but (as usual) I offer no performance guarantees.

Pause for a moment to reflect upon what you were thinking a couple of years ago in August 2004 when Google (GOOG) went public. If you're like most people (myself included, though I have an excuse--my inaction is consistent with my stated policy of not buying IPOs), you didn't partake of the opportunity to grab a few Google shares. You sat uncomfortably sidelined when Google went public, watching with as much profit-envy as intrigue as the $85 IPO ran up to $100 on the first trading day and vaulted ahead to $200 by the end of December 2004. You rationally waited for the "inevitable" pullback to a more reasonable price level, but this pullback never materialized. Instead of buying into the fray, you passively watched Google's shares surge ahead to $300 by mid-2005 and beyond the $400 mark by year-end. Now, after a solid 2006Q3 earnings report last week, the shares sit perched at $460, close to their all-time high of $475. Following the earnings report, analysts have raised their price targets to as high as $600, reaffirming earlier optimism. At a market cap of $140 billion, a trailing P/E (2005Q4 to 2006Q3) of 58, and a forward P/E of 35 (based on analyst consensus 2007 EPS estimate of $13.07), Google is hardly cheap.

There's also the story of Baidu (BIDU), the dominant Chinese search provider whose stock Google once owned (2.6% of Baidu's shares) but later sold. In contrast to Google's well-publicized success story (and presumably to Google's chagrin), during the past year Baidu has succeeding in further wrestling search market share away from Google in China (up to Baidu 62% vs. Google 25% in August 2006, from Baidu 52% vs. Google 33% in August 2005). With its IPO priced at just $27 in August 2005, Baidu's shares spiked to $151 before closing at $123 on the first trading day. In highly volatile trading, the shares have sagged as low as $45 in February of this year but have since recovered to close at $87 last week. Currently Baidu has a market cap of $2.9 billion, a trailing P/E of 126 (for 2005Q4 to 2006Q3, using analyst consensus EPS estimate of $0.26 for 2006Q3 earnings due out October 31), and a forward P/E of 51 (based on analyst consensus 2007 EPS estimate of $1.69).

Judging from its P/E alone, Baidu is clearly "priced for even higher perfection" than Google. But when we bring longer-term growth into the equation, a different picture emerges. Based on analysts' estimated 5-year earnings growth of 31% for Google and 63% for Baidu, and working with the 2007 forward P/E figures above, we have PEG ratios of 1.1 for Google and a lower 0.8 for Baidu. Upshot: Judging from PEG, Baidu is actually somewhat cheaper than Google.

A few historical financials can help us make an intelligent guess about where Baidu's share price may be heading and just how rapidly. As the graph to the right shows, Google's year-on-year revenue growth has slowed from around 160% in 2004Q1 to the still very respectable 70% reported for 2006Q3. Baidu's revenue growth rides on a substantially higher tier than Google's, having floated in the 170% to 200% range for the past five quarters. Two inferences into Baidu's financial future seem reasonable: a) Conservative: Baidu is about two to three years "younger" than Google, and its growth rate should fall to around 70% sometime around 2008 or 2009; or b) More Aggressive: Baidu's growth rate will remain in the low triple digits (100% to 150%) for at least the next couple of years, driven by both macroeconomic (China's rapid economic growth, massive rural-to-urban migration, stimulus from the upcoming Beijing Summer Olympics) and industry-specific (Baidu's #1 traffic ranking in China, dominant search market share, related product launches) factors.

Both Google and Baidu currently sport healthy net profit margins of around 25% to 30% (see graph). To get a sense of its share growth potential, let's assume that Baidu's profit margins stay where they are, maintained by sufficient R&D spending, with revenue growth being the primary driver of share price over the next few years. Here's how our two scenarios play out:

a) Conservative: Baidu's revenue growth gradually slows from 170% to 70% over the next two years. Annualized revenue advances four-fold from $120 million (based on analysts' estimate of $30 million for 2006Q3) to around $500 million by 2008Q3 (the quarter of the Beijing Summer Olympics). At a 2008Q3 price-to-sales multiple of 13 (equivalent to Google's P/S ratio today, $140 billion/$11 billion), this puts Baidu at a two-year forward valuation of $6.5 billion.

b) More Aggressive: If the market opportunity in China allows Baidu's revenue growth to remain in the 100% to 150% range for at least the next two years, we can expect up to a six-fold increase in annualized revenue to around $700 million by 2008Q3 (still a paltry 6% of Google's current $11 billion annualized revenue stream!). At the same P/S multiple of 13 used above, Baidu's two-year forward valuation would reach $9 billion. However, if Baidu's revenue growth is still hovering around 100% two years from now, the P/S multiple will likely sit higher, somewhere between Google's current 13 (at 70% revenue growth) and Baidu's 24 ($2.9 billion/$120 million, at 170% revenue growth). A mid-range P/S multiple of 18 would indicate a two-year forward valuation of $13 billion.

This quick analysis indicates how Baidu's valuation has the potential to rise from $2.9 billion today to the $6.5 billion to $13 billion range in the next couple of years. Allowing for moderate dilution from stock option exercise, we're looking at the real possibility of a very respectable two- to four-bagger performance by the end of 2008.

Of course, there's potential downside, too--from regulatory risk, music copyright litigation, click fraud accusations, competitive pressures, changing consumer habits, economic recession, etc. However, I think the potential upside is juicy enough to justify buying at least a toehold into the Baidu opportunity (Disclosure: I've recently taken a long position). The shares are now "seasoned" following their August 2005 IPO and the company's five-quarter reporting history gives future projections a sounder footing. At last Friday's close of $87, Baidu's shares are more expensive than they were at their February price-bottom of $45; yet they are also a lot cheaper than they were at their $154 intra-day price peak the day after the IPO.

Given Baidu's growing Chinese search market share and noting just how negative Wall Street analysts presently are on Baidu (current ratings: Google 1.9 (buy) vs. Baidu 3.1 (neutral)), I expect Baidu's earnings numbers easily to surpass analysts' expectations (EPS of $0.26 on $30 million revenue) when the company reports 2006Q3 results on October 31. During the conference call, it will also be interesting to listen for commentary on how Baidu is progressing on its new initiatives: the MTV video distribution alliance announced last week (can popularity of YouTube-style apps for China be far away?), Baidu's collaboration with HP on preloaded search, Baidu Space (a blogging site) launched in July, and Baidupedia (like Wikipedia) launched earlier this year. All of these initiatives complement Baidu's core search and established, "sticky," community-oriented services such as popular Baidu Post Bar (a message board hang-out similar in some ways to Technorati) and Baidu Knows (similar to and launched before Yahoo Answers).

If you overslept the morning the "Google express" left Silicon Valley Station two years ago, don't fret, for it's probably not too late to jump aboard the "Baidu express" while you still can. As I mentioned in a traffic ranking review early last year (incidentally, Baidu has advanced from #6 at that time to #4 today in Alexa's Global Top 500 ranking, now behind only Yahoo, MSN and Google), search remains the rising star of the Internet. In my opinion, there is no company better positioned today than Baidu to harvest the seemingly boundless growth potential the Chinese market offers. (Here's a recent article for further background reading on Baidu.)

By listening carefully, you should be able to hear Baidu's "little engine that could" chugging along on the fast track with its wheels humming "Do buy Baidu, do buy Baidu, do buy Baidu. . . ." All aboard!

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