Valuations for internet technology companies are literally all over the place. On one end of the spectrum sits LinkedIn (click ticker for report: ) and Amazon (click ticker for report: )—fast growing firms with sky-high PE multiples and tremendous credit given to the long-run. On the other end, we have Apple (click ticker for report: ) generating fantastic amounts of free cash flow, and trading with a single-digits forward PE. Chinese search giant Baidu (click ticker for report: ) falls closer to Apple, and we think shares look incredibly cheap at current levels. Let’s take a closer look at the search giant.
Valuation
Baidu’s valuation on a discounted cash flow basis looks extremely reasonable. We estimate shares to be worth $108-$200, with $154 representing our mid-point. This equates to roughly 83% upside from current levels! Our valuation includes a relatively steep year-over-year decline in operating margins, as well as a material slowdown in earnings growth.
On a relative valuation, Baidu trades at a discount to peers like Facebook (click ticker for report: ) and LinkedIn, which seems justifiable based on the shift toward mobile and social advertising. However, the Chinese search giant also trades at a discount to Google (click ticker for report: ) and Yahoo (click ticker for report: ). Google continues to grow at a brisk rate and is one of our Best Ideas Newsletter constituents, but we think the future growth of Baidu looks far more compelling than Yahoo.
China’s Google
Baidu holds a market-leading position in search, and many have dubbed it “China’s Google.” Although Google’s proven itself to be a formidable foe in many global search markets, the Chinese government banned Google over censorship issues, ensuring Baidu faces relatively little competition. Google accounts for less than 5% of search market share in China. Qihoo (QIHU), a software security and search competitor, as well as Sougu, Soso, Bing (click ticker for report: ), and Yahoo all hold less than 10% market share.
While Qihoo has taken some market share from Baidu, we think Baidu possesses a first-mover and network advantage that lends itself to maintaining market share. Google’s market share in the US is only now approaching 70%, and Baidu owns even stronger share in China. As long as Baidu’s market share remains above the 64%-66% range, we think it will continue to be the premier destination for search ads in China.
Mobile monetization for Baidu has been a struggle—as it was initially for Google and Facebook. Mobile advertising will be a huge growth engine in the Chinese internet space, and its decision to open its platform up to international developers could create useful applications, leading to increased profitability. Essentially, we think Baidu will figure out how to best monetize mobile search.
Therefore, we are anticipating revenue will grow at a compounded annual growth rate (CAGR) of 23% over the next five years, and we believe earnings per share growth can also compound at a nice double-digit clip. Our earnings expansion could prove conservative if the firm slows capital expenditure spending (lower depreciation) or improves operating margins.
We also believe there’s a possibility for the company to partner with Apple in the mobile space. Although Apple may have its own designs, it is clear at this point that Apple and Google are no longer allies, so we think Apple would be enticed to join forces with a Google foe. Of course, Apple has yet to obtain market share in China comparable to what it has in the US, and Baidu already has a phone partnership with Lenovo that could make an Apple/Baidu relationship harder to consummate.
The China Discount
We can’t help but think some of the weakness can be attributed to a China discount. The amount of public equity market frauds is simply astounding, with established US companies like Caterpillar (click ticker for report: ) getting duped into paying high prices for companies with inflated/fake earnings. In addition to frauds, there is a great deal of valid skepticism surrounding the country’s economic growth. A lot of the value of an advertising vehicle like Baidu lies in consumption. If economic growth stagnates (or is stagnating), consumption, and thus advertising spending, could take a large hit. Reports of China’s “ghost cities” do not help its case.
All things considered, we think Baidu looks like a wonderful business poised to capitalize on search advertising tailwinds. However, we find it difficult to get past the China Discount. Baidu has no history of accounting irregularities or frauds, but there have been complaints from CCTV regarding the validity of Baidu’s search results. These concerns aren’t much different from what we’ve heard about Google in the US, but it could lead to further market share losses if concerns resurface. Still, we’re wary of Chinese firms, so if we do decide to add shares to the portfolio of our Best Ideas Newsletter, it will not be a huge position.