It seems that you can't give away shares in Chinese companies these days. The Hang Seng Index (HSIINDICES: ^HSI) is off 21% from its highs of the early summer, and worries surrounding China's economy itself compound by the day. Amidst all of this, one of the best-known mainland Chinese companies, Baidu Inc (BIDU -4.13%), has seen its share price drop precipitously following disappointing earnings results earlier this year.
Things don't look good at present, but as the old saying goes, "Nothing ventured, nothing gained." If you're willing to look past the travails of today, now is the perfect time to consider adding Baidu to your portfolio. Here's why.
Current travails
Baidu's most recently reported quarter, which ended June 30, 2015, left much to be desired. This was not, however, due to its sales results. Total revenues increased an eye-popping 38.3% year over year, to $2.67 billion. Mobile revenues amounted to 50% of this figure.
Moving further down the income statement, things become considerably less rosy. Operating profit fell 2.5%, to $559.6 million, and net income slid 3.3%, to $590.6 million. How could such a strong top-line showing lead to such an abysmal bottom line, you ask?
The first culprit was research and development costs. Associated with broad expansion efforts, they increased 56.2% over the same period last year. Sound like a lot? Selling, general & administrative expenses ballooned a whopping 81% compared to the year-ago period, due almost exclusively to the company's "online to offline" (O2O) initiative. Baidu is growing -- fast -- but its investment spending is accelerating even faster.
Chasing O2O dreams
There is a battle brewing within Chinese e-commerce. Baidu, which has arguably been late to the game, is playing catch-up in the burgeoning O2O industry. Never heard of it? Me either.
However, after a bit of research, I learned that the term refers to the merger between traditional retail experiences and 21st century e-commerce. The first step of this trend, with the endgame being a seamless O2O experience, is the omnichannel strategy that many retailers stateside are beginning to employ.
O2O seeks to bridge this gap, and the opportunity is huge. Despite fierce competition, Baidu's attempts at gaining a foothold have borne some fruit. In the second quarter, O2O revenue was up 101% year over year.
This is not to say Baidu has an easy path ahead; competitors like Tencent (TCEHY -1.32%) have a head start, and won't take Baidu's entry onto the field lying down. The verdict is obviously out on Baidu's spending here for now, but given the size of the potential opportunity, it seems safe to give management the benefit of the doubt for the time being.
Valuation
Baidu's current valuation is reason enough for investors to consider diving into its shares. It is smaller than Alphabet's (GOOG -0.50%)(GOOGL -0.34%) Google, but a comparison between the two companies is telling:
Baidu Inc:
|
2012 |
2013 |
2014 | |
|---|---|---|---|
|
Total Revenue |
$3.5 billion |
$5 billion |
$7.6 billion |
|
Net Income |
$1.65 billion |
$1.65 billion |
$2.07 billion |
|
Free Cash Flow |
$1.52 billion |
$1.735 billion |
$2.06 billion |
Alphabet Inc:
|
2012 |
2013 |
2014 | |
|---|---|---|---|
|
Total Revenue |
$46 billion |
$55 billion |
$66 billion |
|
Net Income |
$10.7 billion |
$12.92 billion |
$14.44 billion |
|
Free Cash Flow |
$13.35 billion |
$11.3 billion |
$11.4 billion |
The facts speak for themselves. Both search players have grown the top line at a steady clip during the last three years, but Baidu trounced its much bigger peer with revenue growth of 47% annually. Profits and free cash flow growth at both companies have been less impressive, as both have opted to reinvest in new business lines and growth initiatives.
Moving on to investors' valuations of Alphabet and Google, the bullish case for Baidu becomes even stronger:
|
Baidu Inc |
Alphabet Inc | |
|---|---|---|
|
Market Capitalization |
$50.64 billion |
$444.7 billion |
|
Forward Price to Earnings Ratio |
25.23 |
21.3 |
|
Forward Price to Sales Ratio |
$10.63 billion |
$73.43 billion |
|
Projected 5 Year Forward Earnings Growth Rate |
$24.16% |
14.17% |
Both Baidu and Alphabet have been awarded roughly similar valuations, despite the fact that Baidu offers a much stronger growth profile through the end of the decade. This, coupled with the fact that it sports a dominant search engine market share in the world's most-populous nation, means you're not being asked to pay a considerable premium to benefit from these advantages. Granted, Baidu is attracting competition in recent years from the likes of Qihoo 360 Technology Co Ltd-owned 360 and Sohu.com-owned Sogou in its main search business, but the fact remains that Baidu is the 800-pound gorilla of Chinese search.
Foolish final thoughts
I get it... investors are not happy with Baidu's lack of profit growth in recent years, and remain nervous about current competitive pressures. What they seem to be forgetting are the huge advantages Baidu has going for it. The secular trends Baidu stands to benefit from in the coming decades, held up in the light of a more-than-fair valuation compared with Alphabet's, makes Baidu's shares too appealing to ignore. These simple facts make Baidu a screaming buy for people willing to do the Foolish thing, and strongly consider adding Baidu to their portfolios.
