Here Are The Key Factors Underlying Our Valuation For Baidu

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BIDU
Baidu

Touted as the Google of China, Baidu (NASDAQ:BIDU) is positioned as the market leader for online search within the country. During the first quarter of 2015, the company’s revenue rose by 34% annually and its operating margin came in at 16.9%. Baidu’s stock has seen some weakness during 2015, due to slowing top-line growth and concerns pertaining to rising competition in the industry. Notwithstanding these challenges, we believe Baidu is attractively positioned for long-term growth, owing to the massive growth opportunities present in the Chinese Internet market.

See our complete analysis of Baidu here

What Are The Major Ways Through Which Baidu Derives Its Revenues?

Segment

2014 Revenue (Y-o-Y Growth) Q1 2015 Revenue (Y-o-Y Growth)

Online marketing services

$7,816.0 million (52.5%)

$2,019 million (33.5%)

Other

$89.8 million (293.1%)

$34 million (74.1%)

Total revenues

$ 7,905.8 million (53.6%)

$2,053 million (34.0%)

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Baidu mainly derives its revenues from online marketing, wherein it offers advertising services on various products such as web search products, location-based products and services, entertainment products (IQiyi and PPS), security products, as well as other Internet properties. Being the market leader for search in China, search advertising contributes for the highest share of Baidu’s revenues, and also comprises for nearly 70% of our valuation for the company. This is followed by display advertising and online video, which account for 14% and 6% of our valuation respectively.

Who Are Baidu’s Customers And How Does It Sell Its Services?

Baidu caters to a diverse set of online marketing customers including small and medium business enterprises, large domestic companies, as well as multinational companies. It recorded 813,000 active online marketing customers across various industries such as financial services, medical and healthcare, information technology services, software and online games, tourism and ticketing, and transportation during 2014. And in Q1 2015, its active online marketing customers rose by 17.5% year-over-year to 524,000.

The company’s search-based online marketing services’ include pay-for-performance (P4P) services as well as other services such as BrandZone (which acts as a branding display marketing product integrating text, images and videos).

What Are The Major Operating Expenses For Baidu?

Operating Expenses

2012 2013 2014 Q1 2014

Q1 2015

Cost of Revenues (as a % of Revenue)

28.9% 35.9% 38.5% 40.4%

41.9%

SG&A expenses (as a % of Revenue)

11.2% 16.2% 21.2% 21.2%

23.2%

R&D expenses (as a % of Revenue)

10.3% 12.9% 14.2% 13.4%

18.0%

Total operating expenses (as a % of Revenue)

50.5% 65.0% 73.9% 75.0%

83.1%

Operating Margin (%)

49.5% 35.0% 26.1% 25.0%

16.9%

Cost of revenue represents the most major component within Baidu’s operating expenses, accounting for nearly 40% of the overall revenue. This expense further includes other cost heads such as traffic acquisition costs, bandwidth costs, depreciation and operating costs of servers and other equipment, and content costs. Out of these, traffic acquisition costs is the most significant component, that accounts for almost a third of the overall cost of revenue.

Baidu’s costs have spiralled over the recent past — during the first quarter of 2015, the company’s selling, general and administrative (SG&A) expenses, and research and development (R&D) expenses rose by 47.2% and 79.1% respectively, owing to increased promotional activity for mobile products and services, as well as increased headcount for product development.

What Are The Key Opportunities For Baidu?

Solid Growth Potential In The Chinese Internet Market

The Chinese Internet market has significant growth potential as the Internet penetration rate in the country is still less than 50%. Nearly 557 million users accessed Internet through mobile in China during 2014, and this figure could rise sharply in the coming years, fueled by increasing adoption of smartphones. [1] At the same time, Baidu has shown success in monetizing the mobile platform — mobile revenue contributed for around half of its overall revenues during Q1 2015.

In order to leverage these overall trends in the Chinese Internet industry, Baidu is exploring various growth opportunities such as online to offline (O2O), mobile marketing, and focusing on key verticals including education, financial services and healthcare.

What Are The Key Risks To The Business?

Top-line Growth Is Slowing While Expenses Are Soaring

Baidu’s top-line growth has slowed in the recent past in line with the gradual maturity of the company’s business model. While annual revenue growth stood at 59.1% in Q1 2014, the same came down to 34.0% during the most recent quarterly results. At the same time, acceleration in expenses has resulted in decreased margins for the company. We expect this margin-related pressure to persist in the near-term.

Market Share Could Come Under Threat

Though Baidu has been able to retain its market leadership (around 90% share) on mobile search, this business could come under increased threat from rivals such as Qihoo 360 and Sohu. The under-pricing of ad units by these other players, could also impact Baidu’s ability to raise ad prices in the future.

We have a price estimate of $212 for Baidu, which is broady in line with the current market price.

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Notes:
  1. China Internet: 649 Million Users, 86% On Mobile; Advertising Trends, Barron’s Asia, February 3, 2015 []