1) Sustainable Competitive Advantage: Baidu benefits from high “switching costs,” or the concept that users become accustomed to one search engine and tend to use it by default, without seeking alternatives. Baidu has a strong “Network effect,” or the notion that a growing base of users attracts yet more users which attracts advertisers, boosting ad relevancy and the user experience.
2) Low Penetration Rate: Although Baidu commands 79% of the search engine revenue market share, there are approximately 40 million small and medium-sized businesses registered in China. Of that amount, Baidu currently serves 600,000 clients for a penetration rate of approximately 15%. The market potential for on-line search will only get larger as Baidu collaborates with smart phone manufacturers and network carriers such as China Mobile (NYSE:CHL) to pre-install its search services in new handset models.
3) Distant Competition: In 2010, Baidu’s largest competitor, Google, announced that due to China’s strict online censorship laws, it redirected users to its Hong Kong based search engine service, Google.com.hk. As of the second quarter in 2012, Google maintained a 16% market share for search services in China.
4) Shareholder Friendly Ownership: As of Dec. 31, 2012, Baidu’s co-founder, chairman and CEO, Robin Li, owns approximately 16% of the ordinary shares outstanding. When the management of a business owns a large percentage of company stock, shareholder interests tend to be closely aligned with corporate action and governance. The company initiated a share repurchase program in 2008 and 2009.
5) Valuation: In 2012 Baidu generated more than $1.4 billion in free cash flow with a capital base of $6.7 billion. The business maintains operating margins in excess of 40% and utilizes minimal debt on the balance sheet. Baidu’s revenue has grown by more than 60% in the past three and five years. Most importantly, the business is attractively priced in relation to its intrinsic valuation providing shareholders with a margin of safety and the potential for a satisfactory rate of return over time.
I am Long BIDU.