The world’s largest online search engine reported its full-year earnings last week. Several interpretations have been provided as one can Google that information. Meanwhile, looking at a similar company that is 7,000-plus miles away across the Pacific Ocean should be worthwhile.
Baidu (BIDU, Financial), one-tenth the size of Google's market cap, delivers its quarterly results next month. Both Google, a subsidiary of Alphabet (GOOG, Financial)(GOOGL, Financial), and Baidu have several competitors on their turf but could be safely assumed to be market leaders at this point (1). Interestingly, neither is included in the Standard & Poor 500's top 10 constituents in terms of market capitalization.
Market return
So far, Baidu ADR shares have been underperforming in both the short and long terms compared to the broader S&P 500 index. According to Morningstar data, Baidu had one- and five-year total returns of 10% and 5.8% compared to the index's 24.6% and 14.2%.
Earnings performance
Baidu reported its third quarter earnings on Oct. 27, 2016. The company delivered a -0.71% sales loss to 18.3 billion yuan renminbi ($2.66 billion) compared to the year-earlier quarter and profits surged 9.2% to 3.1 billion yuan renminbi.
In addition to Baidu's 2.6% reduction in operational costs, the Chinese search giant recorded 1.35 billion yuan renminbi in other income for the period compared to 200.6 million yuan renminbi a year earlier. Baidu gave no information on its press release regarding the 1.4 billion yuan renminbi other income. Minus these other income figures, Baidu would have grown its profits by 0.53% compared to the year-earlier period.
Read: Baidu Third Quarter Press Release
Baidu shares were up 2.6% the following day while the S&P 500 closed with -0.31% change. Baidu also expects its fourth quarter fiscal 2016 sales to fall between 1.7% to 4.6% on a year-on-year basis.
"We saw further improvements in customer quality in the third quarter as we continued to implement stricter standards for online marketers.
"During the quarter the growing popularity of our news feed product helped drive user stickiness in search and across the Baidu content ecosystem. We look forward to further innovating through initiatives such as our digital assistant Duer and autonomous cars and to bringing new AI-based applications to market." – Robin Li, chairman and CEO of Baidu
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Valuations
According to GuruFocus data, Baidu ADR shares had trailing price-earnings (P/E) ratio of 12.4 times (industry median of 30), price-book (P/B) ratio of 4.5 times (industry median of 3) and price-sales (P/S) ratio of 5.6 times (industry median of 2.2). The Baidu ADR shares did not provide any dividends in the past year.
(Press Release)
Baidu
The $60 billion Chinese online search giant was incorporated in the Cayman Islands in 2000 and moved into its new headquarters, Baidu Campus, in Beijing's Haidian District in 2009.
The Baidu.com website is the largest website in China and the fourth-largest website globally as measured by average daily visitors and pageviews as of December 2015.
Baidu generates most or all of its business revenues in China – 98.8%, or 66.4 billion yuan renminbi, of its total sales in fiscal 2015.
Other than being China’s largest search engine, Baidu seems to be active in developing its other online businesses. Baidu formed China’s largest online video platform when it acquired a leading P2P online video transmission, personal computer software and mobile applications company – PPStream Inc. – for $370 million and combined it with its controlling stake in iQiyi in 2013.
In the same year, Baidu acquired 91 Wireless Websoft Ltd. for $1.9 billion –Â its largest acquisition. According to Bloomberg, Baidu paid about 63 times the latter’s earnings in that year; 91 Wireless was China’s third most popular store for smartphone apps.
In 2015, Baidu traded its controlling stake in one of China’s leading travel sites, Qunar, which it acquired for $306 million in 2011 for a 25% stake in China’s biggest travel site, Ctrip (CTRP, Financial).
Interestingly, In February 2016, Baidu received a nonbinding proposal from Chairman and CEO Robin Li and Qiyi CEO Yu Gong – called the "Buyer Group." In review, the Buyer Group is a separate entity and Baidu had an as-converted and fully diluted 80.5% stake in Qiyi at the time of the $2.8 billion bid by Buyer Group. In July, the Buyer Group withdrew its offer to acquire Baidu’s stake in Qiyi. Qiyi or iQiyi had 20 million subscribers as of June 2016.
(20-F Filing, Baidu)
Baidu’s business consists of three segments: search services, transaction services and iQiyi.
Search services
Baidu’s search services are keyword-based marketing services targeted at and triggered by internet users’ search queries, which mainly include Baidu’s P4P services and other online marketing services (2).
In 2015, Baidu’s search services grew 27.3% and contributed 82%, or 55.67 billion yuan renminbi, in total company sales. The segment also delivered an impressive 51% operating margin.
Transaction services
Transaction services include Baidu Nuomi, Baidu Takeout Delivery, Baidu Maps, Baidu Connect, Baidu Wallet and others. The segment also carried Qunar’s operations prior to Baidu’s deal with Ctrip, according to company filings.
Baidu Nuomi operates an online local commerce marketplace that connects merchants with users by offering goods and services provided by third-party merchants with discount prices. Meanwhile, Baidu Takeout Delivery operates an online platform on which users can place restaurant delivery orders.
In 2015, transaction services grew by an outstanding 83.3% and contributed 10%, or 7 billion yuan renminbi, in total Baidu sales. The segment presented a disappointing operating loss of 13.15 billion yuan renminbi, compared to 6 billion yuan renminbi the year prior.
iQiyi
Online video platform iQiyi has a content library that includes licensed movies, television series, cartoons, variety shows and other programs.
In 2015, iQiyi sales grew 84.3% and contributed 8%, or 5.3 billion yuan renminbi in total Baidu sales. The segment delivered further losses of 2.38 billion yuan renminbi compared to the year prior period losses of 1.11 billion yuan renminbi.
Overall, Baidu had five-year sales and profit growth and operating margin averages of 53%, 57% and 65.7% (3).
Cash, debt and book value
As of September, Baidu had 78.4 billion yuan renminbi in total cash and 39.7 billion yuan renminbi in debt and capital lease with a debt-equity ratio of 0.45 times compared to the year-prior's 0.67 times.
The Chinese search engine also had 12% of its 164 billion yuan renminbi assets in goodwill and intangibles while having a book value of 88.3 billion yuan renminbi compared to 56.1 billion yuan renminbi year on year.
Cash flow
In its press release, Baidu reported its cash flow in the third quarter. The search giant delivered 16% growth in cash flow from operations year on year to 2.95 billion yuan renminbi.
Capital expenditures were 1.18 billion yuan renminbi leaving Baidu with 1.77 billion yuan renminbi in free cash flow compared to 2.92 billion yuan renminbi the year-earlier quarter.
(20-F, Baidu)
In review, Baidu demonstrated strong operation cash flow growth in recent years, having an 18% three-year growth average.
In addition to the company's amazing profit growth that delivered strong cash flow, the search engine giant also had marked growth in items such as depreciation of fixed assets and computer parts, amortization of intangible assets and licensed copyrights, assets impairments and share-based compensation.
As observed, Baidu's capital expenditures have been consistently growing over the years. Expenditures, which included fixed asset and computer parts acquisitions and capitalization of software costs, grew at a compound annual growth rate of 44.7% to 7.77 billion yuan renminbi in fiscal 2015 from fiscal 2012. This growth rate is identical to Google's in the same time period.
Baidu also had allocated a good amount of cash flow in acquisitions of intangible assets, having a two-year growth rate of 65.7%, compared to Google's 71%.
Baidu also has been actively performing business acquisitions (combinations) in which operations are insignificant – as mentioned in company filings but still reported in the search engine's consolidated figures. In review, Baidu performed its largest acquisition in the past decade in 2013. The Chinese search engine acquired a leading Chinese mobile application marketplace and mobile games operator, 91 Wireless Websoft, for $1.83 billion.
Buyback activities/free cash flow
In fiscal 2015, Baidu performed its only share buyback activity in the past decade, amounting to $1 billion. According to company filings, Baidu repurchased about 6.04 million ADR shares outstanding with an average price paid of $163.98 a share.
Baidu, having its lowest earnings multiple at 12.7 times compared to its historical average in 2015, further authorized another $2 billion share repurchase from October 2015 to October 2017.
As observed, Baidu has been actively reducing its debt in recent years net of short- and long-term loan and notes payable issuance and repayments.
(20-F and Press Release, Baidu)
Finally, Baidu seemed to demonstrate consistent positive growth in free cash flow, albeit slow in recent years, having an average growth rate of 28% since fiscal 2010.
Conclusion
Baidu clearly thinks that its shares are undervalued as the company relentlessly spent its cash flow taking a chunk of it. Baidu has a five-year earnings multiple average of 30 times compared to its trailing multiple of just 12.4 times.
(Operating Profit and Loss Figures, Baidu’s 20-F)
Meanwhile, operational performance other than Baidu’s impressive search business should bring some worry to the company’s investors and caution to the prospecting. As shown in the image above, the company struggled to plugged business holes in its other operations including transaction and iQiyi to deliver, otherwise, profits in.
Nonetheless, Baidu’s recent arrangement with Ctrip should probably help this bloodshed in transaction services while the iQiyi business should still be scrutinized continuously despite its market-leading presence.
Baidu also demonstrated slowing down of overall sales growth in recent years accompanied by lowering profit margins – Baidu had a 59% operating margin in 2015 compared to 73% in 2011.
(Baidu ADR shares at $174.1 a share with a trailing P/E ratio of 12.5 times, GuruFocus)
In January, Stifel upgraded Baidu ADR shares to buy with a target price of $220 per share. Bernstein saw Baidu as an underperform with a $150 per share price while Morgan Stanley downgraded the company’s shares to equal-weight from overweight.
Nonetheless, the market may seem to demonstrate neglect on Baidu’s ADR shares given its sudden surge of buybacks in recent years resulting in a markedly lower trailing earnings multiple compared to its five-year average of 29 times.
Despite negative findings in its businesses aside from the search services, Baidu ADR shares should be a speculative buy with a $190 a share target price, or 28 times forward earnings.
Notes
(1) Me: according to these websites, Wikipedia, Quertime and Wall Street Journal.
(2) 20-F: P4P is Baidu’s auction-based P4P services that enable its customers to bid for priority placement of their links in keyword search results. Baidu’s P4P platform enables its customers to reach users who search for information related to their products or services.
(3) Morningstar data.
Disclosure: I have shares in Google and considering initiating a long position on Baidu ADR shares.
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