Just Baidu It – A Deep Dive on Why China’s Search Darling is Way, Way Overvalued

In the Hutong
1228 hrs.

Baidu’s successful public offering and the punter feeding frenzy that followed has produced a lot of shaking heads among analysts. It’s nice to hear that people outside of China are starting to recognize that this is all a bit much, and I’m personally grateful to Joe MacDonald at AP and Rosalind and Eunice at CNN for giving me a chance to air my views about it all.

Still, I think there’s a lot more to this than people are reporting.

Baidu Ballistics

Clearly, there are three things driving the run-up to preposterous p/e multiples last Friday. First, (and let’s get this out of the way), there was the frenzy that happened among retail investors when a) the words “the Google of China” were carefully whispered into the ether by the professionals charged with positioning the offer, and b) the upward momentum of the issue caught the interest of bored day-traders. We all know where that is going, and most of us are expecting a gradual (or not-so gradual) waning of the passion. So all of the Google/China hype in the price will drain away – in fact, the draining has already begun.

The second thing driving the stock was that Baidu has decent fundamentals – it’s making a profit, it’s weaned itself off of revenue from portals, and it has a management team in place that looks like it will use the proceeds of the offer to improve its search engine technology and market the service.

Third – and this is the big one – is the speculation that at some point somebody with really deep pockets is going to have to buy Baidu, and do so at a high premium over a rational price. The most obvious candidate for that would be Google, who already has a 2.6% stake.

But Baidu is not without challenges.

The Global Competition

Google, long stymied in the market in part because Larry and Sergey had ignored China while building the business at home (a smart move, mind you), is making real progress. They just signed up their first local AdSense client, and pending victory in court against Balmer’s Barristers, they should be soon installing Lee Kaifu as über-Googlian for China. They still have challenges, but their momentum is building. And don’t let the 2.6% holding in Baidu fool you – they’re after building the best position they can.

Yahoo! has been building momentum slowly since acquiring 3721 18 months ago, but that’s about to change. Their purchase of Alibaba, while a head-scratcher, indicates that Terry Semel is once again paying attention to China, and the coming departure of 3721 founder Zhou Hongyi will actually help streamline a preposterously complex management and reporting structure, allowing Yahoo! to be a more nimble player.

MSN has not been much of a challenger to date, and Lee Kaifu’s departure would certainly slow MSN’s Chinese search engine development. MSN is ambitious, however, and will likely start looking for acquisitions.

Competition: The Homeboys

Baidu’s latent challengers are the old men of China’s Internet, Sina.com, Sohu, and Netease, China’s most popular portals, all of whom are developing or upgrading their own search products, Sina’s new iAsk search product (which frankly looks like a Google clone) is of such concern it was mentioned specifically in Baidu’s prospectus.

The strength of these three competitors lies is their experience, their relationship with advertisers, user loyalty, and the high degree of content and functionality they bring to the search product. These will be formidable challengers, and it is widely acknowledged that all are gunning for Baidu.

Whether the competition is the Giants from the Left Coast or the crosstown rivals, the sheer number of competitors and the early stage of the development of the Internet in China (penetration is a mere 7.5% and buying power is still modest) means that search in China is still anyone’s game, and that the likely shakeout is still years in the future. Baidu’s position, however strong today, will be held only against the assaults of at least five other very determined (and in at least three cases, better funded) rivals.

But competition is not the sole challenge Baidu faces.

The Mobile Question

WIth three times as many users as PCs, mobile telecoms has always been the sleeping giant of the Internet in China. Now the mobile Internet is about to explode in China, for three reasons.

First, mobile handset manufacturers are adding more display and data management capabilities to low-end and mid-range phones, and high-end phones are becoming increasingly popular.

Second, China Mobile and China Unicom have both announced their 3G test network plans, plans that are tests in name only. Both call for rollouts that are so wide in geographic scope that it would be more accurate to call them phase-one service launches, including most of China’s “tier-one” cities.

Third, there is now a critical mass of companies offering mobile services that promise carriers sufficient revenues to actually launch 3G.

So with more people walking around with data-ready phones and a network capable of carrying that data, mobile is clearly going to be a large market – probably larger than it is in countries with deeper PC penetration than China’s paltry 3.5%.

And yet, Baidu has very little to show for the mobile net. Nine months ago they introduced a basic search product, but it is short on features and, most important, Baidu hasn’t figured out how to make money from online search. This is a strategic oversight on Baidu’s part, one that is likely to be extremely costly in the long run.

The Acquisition Question

So competition and market changes are not the only fundamental challenges Baidu – and now its shareholders – face. The assumption that Baidu is an acquisition target may be accurate in general, but the event may not be as close as some think.

While a local player might have purchased Baidu in the past, after the IPO the company’s price far exceeds the means of any Chinese Internet firm. This leaves four possibilities.

Yahoo! considered Baidu two years ago, and instead chose to purchase 3721. Having placed their bet on Baidu’s rival (for what now appears to be a comparative bargain price of US$120 million), Yahoo! is unlikely to want a company valued even before the post-IPO run up at nearly $900 million.

Most analysts assume Google is the leading candidate to acquire Baidu, given that it already holds 2.6% of the company. But if Google moves, it won’t move soon. At $3 billion-plus, the price is probably too rich for even Google, and for both strategic and human resource management reasons, Google needs to settle the Lee Kaifu question before it can afford to make a play for Baidu. Further, with its building momentum in China, Google will probably try to do everything it can to prove it doesn’t need Baidu in order to improve its negotiating position.

MSN might move quickly, and it certainly has the stack of greenbacks to snap up Baidu even at its current hype-inflated price. But there are other concerns. Microsoft has made significant strides in improving its standing with China’s regulators under the experienced hand of MS China CEO Tim Cheng and the adult supervision he brought to the enterprise. Nonetheless, Microsoft still makes a lot of people in China nervous, and Redmond paying a huge price for Baidu would make those people even more concerned, perhaps even causing policymakers to wonder whether they were allowing a national treasure slide into the hands of foreigners.

(Kind of like the way Congress apparently felt about CNOOC buying Unocal. And in China, you can bet that Sina, Sohu, Netease, and Yahoo! – via 3721 – would take a few pages from Chevron’s book by sowing FUD among government watchdogs. But I digress.)

Warning Label

So as interesting as this company might be, a bit of due diligence rails against its pricing – not just the pricing at the close of trading on offering day, but the original IPO price itself:

1. A half dozen strong competitors, all well funded.
2. A market in its early stages of development
3. A lack of a compelling, profitable mobile solution in a market where, in the long term, the mobile phone is likely to become the leading Internet access device.
4. The company is clearly an acquisition target, but not anytime soon.
5. An IPO price that valued the company at nearly 500 times trailing earnings, and a first day closing price of four times that.

Baidu is a company to watch. I’m just not putting any money into it right now.