Sunday, October 14, 2007

Is Baidu worthwhile buying now?

Reader's Question: Baidu (Nasdaq: BIDU) set an all-time record high of $359 (intra-day) on Thursday, before plummeting 14% on news of an analyst's reduced revenue forecast. Despite the sharp price swing, the stock closed on Friday at $323, essentially unchanged for the week. Is the stock now a buy? What do you think about future prospects?

First of all, regarding the JP Morgan analyst's 2007Q3 revenue cut from $67.9 million to $65.7 million (that's just 3%), I tend to agree in principle with Jim Cramer's comment that it "means nothing to me"--since it's the company's underlying business that drives the stock price in the long run, not what analysts say or write, and, in any event, the analyst, Dick Wei, maintains his overweight rating on Baidu (Nasdaq: BIDU) with a price target of $400. I also think there's a lot of truth in Cramer's remark that "the stock is going to $500,"--however, I do not know if it will take months or years to get there and, if Baidu's recent trading pattern is any indication, the ride from here to $500 is likely to be a very volatile one.

Revenue Growth Matters

Although cash flow, earnings and the prospect of future dividends are what determine whether a particular stock will rise or fall in the long run, the key driver of growth is top-line revenue, without which there can be no bottom-line profit. As is very clear from the graph below, between 2004 and 2006, Google (Nasdaq: GOOG) overtook Yahoo (Nasdaq: YHOO), Amazon (Nasdaq: AMZN) and eBay (Nasdaq: EBAY) in revenue generation, catapulting the global search leader into first position among Internet companies. Analogously, as if in a Chinese sequel to Google's success story, during 2007 and 2008, Baidu is expected to sprint past the current Chinese Intenet revenue leaders, Sina (Nasdaq: SINA), Sohu (Nasdaq: SOHU) and Netease (Nasdaq: NTES).



Among these U.S.- and China-based Internet companies, only Google and Baidu still show annual growth rates exceeding 50%. For 2007, Google's revenue is expected to expand to 58% above its 2006 level, while Baidu's revenue is forecast to surge 108%. For 2008, while consensus estimates show Google's growth slowing to 37%, Baidu's growth is projected at 78%. The message here is that China, being a younger Internet market with still only about 10% of its 1.3 billion population online, exhibits higher growth. A careful look at the graph below also reveals that revenue growth for the other Chinese Internet companies--Sina, Sohu and Netease--is generally expected to accelerate going into 2008, presumably boosted by the positive impact of the upcoming Beijing Summer Olympics on online ad spending by corporate customers.



Pro Forma Returns

Clearly, Baidu is growing the fastest among the Internet leaders. However, with its stock price having tripled from its 2006 close of $113, it is now trading around a PE of 145 based on expected 2007 earnings, which most people consider nosebleed territory. Before jumping to conclusions based on PE ratio alone, however, let's see how the expected investment return from holding Baidu over the next few years compares to that for the other companies.

Using analyst consensus EPS figures for 2007 and 2008, along with the consensus five-year earnings growth forecasts, we can project where earnings are expected to be five years from now for each company. Letting the five-year growth rate also serve as a proxy for the terminal PE ratio at the five-year horizon (consistent with PEG = 1), we can then calculate a terminal stock price for each company, from which we can derive the pro forma return figures shown in the table below.



Notice that, largely due to their higher expected growth rates, Google and Baidu show the highest pro forma returns, each being a little above 30% per annum. Even if it turns out that the terminal PE ratios end up being just half of what we have assumed, the five-year returns for Google and Baidu will be around 15% per annum, which is still a very respectable long-run rate of return.



Baidu Is Still a Buy

Compared to where we were a year ago--when Baidu was trading around $85 on 2006 EPS of $1.08 and revenue of $105 million--the stock trades at a much richer price today. During the past 12 months, Baidu's stock price has almost quadrupled (to $323 at Friday's close), while expected 2007 EPS at $2.22 is a little more than double the level a year ago, as is expected 2007 revenue at $225 million. No longer can we say that Baidu is cheap; however, it does not look outrageously expensive either.

Today Baidu's market cap is about $11 billion, still just 5.5% of Google's $200 billion, and still inside of the ratio (8.8%) of number of Baidu (3.25 billion) to number Google (37.1 billion) worldwide searches, as reported by ComScore for the month of August If Baidu's market cap quadruples over the next decade, it will approximately reach the level where Yahoo ($38 billion), Amazon ($38 billion) and eBay ($54 billion) presently are--which seems very possible based on the potential size of the Chinese Internet market. Also, as another general indicator of rational valuation, note that Baidu is about four or five times the size of Sina ($3 billion), Sohu ($1.7 billion) and Netease ($2.3 billion), which is in line with the multiple of Google's market cap to that of Yahoo, Amazon and eBay.

For anyone already long or interested in buying in at today's levels, I would suggest taking a long-term view, not letting the wild day-to-day gyrations of this particularly volatile stock in a volatile market sector ravage your emotions. Potential upside factors to pay attention to are: incremental growth of Baidu's current 58% Chinese market share (versus Google's 23%), in a leader-grab-more manner, mirroring Google's success in the U.S. market; the possibility that Baidu's deployment in Japan begins to show meaningful revenue; future search enhancements following establishment of new research centers in Shanghai and Tokyo. We should also keep in mind, however, the risk that Google, through its partnership with Sina, could begin to wrest market share away from Baidu.

All in all, I think that Baidu today is still a buy, but with the stock price up some 300% in 12 months, versus year-on-year revenue and profit growth of a "mere" 100%, I cannot be as bullish as I was a year ago. That said, I do see potential for another 300% rise, which would vault Baidu to around $1,300 per share, though this is likely to take another five or ten years. So, unless you like being disappointed, I wouldn't start looking for anything north of $1,000 per share until the Olympics following Beijing, i.e., five years from now in 2012, when the Summer Olympics are in London. Bear in mind, too, that if the Shanghai stock market is a bubble which bursts over the next year, we are likely to have trouble even reaching Wei's target of $400, let alone Cramer's bogey of $500. Let's hope that a year from now we won't find ourselves looking back and reluctantly having to admit that Warren Buffett's recent sale of PetroChina (NYSE: PTR) was prescient--for, at least in the short run, it appears the market is still headed higher.

(Disclosure: Among the stocks mentioned in this article, the author either owns or manages long positions in Baidu, Google, eBay and Netease.)

8 Comments:

Anonymous Anonymous said...

According to Advertising Age website (http://adage.com/datacenter/article.php?article_id=106352), 2006 US top 100 media companies revenue was around $237 bln. Digital advertising was about $ 20 bln, commanding market share of 8.44%. Google market share was about 1.7% in the total available market and 20% of digital advertising.

Based on consensus growth estimates of 33%, Google will be a US $ 58 bln company. Assuming total media spending growth of 3%, tracking US GDP growth, total available market will be around $ 274 bln in 5 years time. It is difficult to project digital advertising growth because that will depend on the willingness of companies to allocate more budgets from traditional to on-line advertising. Google market share will be around 13%(60% of the revenue from US/projected industry revenue). Market capitalization will close to $ 800 bln ++, about 8-10% of US GDP? Is this realistic?

Let’s talk about China. Assuming top 100 US media companies are covering more than 90% of the industry revenue, the total revenue as a percentage of GDP is about 2.6%. It is difficult to judge what is the advertising industry market size in China. USA economy is about 3 times of China. GDP per capita of USA is about 6 times bigger than China. What is the size of the industry and what is the market share of on-line advertising? 1% of advertising industry/GDP is about $ 30 bln. Is on-line advertising industry market share 5% based on this internet source ? China on-line advertising is about $ 1.5 bln(http://lsvp.wordpress.com/2007/05/18/usa-usa-usa-were-number-one/).

Baidu will be a $ 1.7 bln company at the rate of 53% growth in 5 years time. Assuming advertising industry growth of 18% ( double of Chinese economy GDP of 9%), based on $ 30 bln assumption in 2007, 2012 industry size will be around $ 68 bln. Projected Baidu market share will be around 2.5%. Is the number makes sense?

(Disclosure : I do not own Google and Baidu)

15 October 2007

9:11 AM, October 15, 2007  
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6:33 PM, January 14, 2008  
Anonymous Anonymous said...

The one huge assumption that everyone is making about Baidu is that it is a normal company. However, the fact is that the foundation of the company's ad revenue and traffic is built around mp3 search. Already, in 2008 they have been sued a few times, and it is being suggested that Baidu is probably behind the illegal mp3 files itself, which changes the game altogether and puts them firmly into pirate territory without any of the immunity they were hiding behind in their guise as a search engine.
Now, is Baidu worthwhile buying?

7:12 AM, March 01, 2008  
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8:49 PM, February 08, 2010  
Blogger sahaj said...

Lloyd, amazing call! How do you see the future of BIDU?

1:11 AM, June 26, 2010  
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Baidu (BIDU) Stock Quote

6:49 AM, September 15, 2014  

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