Internet competition takes toll on Baidu

Shares may push lower as costs rise and earnings growth slows.

By Jim J. Jubak Jun 25, 2012 4:53PM

Image: Businessman in China (Â© Brooklyn Production/Corbis)

I hate it when fundamentals mess up a good swing trade. Unfortunately, that's just what has happened recently with shares of Baidu (BIDU). Earlier in 2012, you could have made good, and relatively low-risk, money by buying the shares whenever they fell near $115 and selling when they went over $135. Over and over again.

But I wouldn't advise this trade now because the fundamentals of Baidu and the rest of China's Internet sector have changed -- for the worse in the short term. Because of increased competition in the relatively new mobile space, China's Internet leaders are waging an expensive war for market share. That's likely to push the shares of Baidu and competitors such as Tencent Holdings (TCEHY) lower as costs rise and earnings growth slows.

Although Baidu owns about 80% of the Chinese Internet search market, it has only a 34% share of the search market for mobile devices. Shenzhen Easou Technology's Easou search engine has 22% of the mobile search market. (Easou, started in 2005, was China's first mobile search engine.) Tencent Holdings' SoSo service is just behind at 21%. Next is Google (GOOG) at 11%. Baidu's mobile traffic grew by 20% in the first quarter of 2012 (up from 15% growth in the fourth quarter), but mobile search still amounted to less than 1% of Baidu's revenue.

To increase its share of mobile traffic and its mobile search revenue, Baidu is spending to launch new handset models with pre-installed Baidu apps in cooperation with such manufacturers as Changhon, ZTE and Apple (AAPL). The phones come with 100GB of free cloud storage and sell, in the case of the Baidu Changhong model, for just 899 yuan ($130) versus, say, 1300 yuan for Shanda's Bambook.

But building out the cloud computing infrastructure to support those phones (and other parts of Baidu’s strategy) requires capital spending that cuts into operating margins and earnings. I expect the company’s investments in mobile search to pay off in the future, but at the moment, since keyword ad prices are lower on mobile search and since ad click-through is lower, investments in mobile search are cutting the company’s profit margin.

On April 25, Credit Suisse lowered its estimate for 2012 earnings per share by 2% and cut its target price for the New York-traded ADRs to $127.50 from $141.70. Goldman Sachs joined in on June 15, cutting its earnings estimates by 3% to 8% and lowering its target price to $135 from $160.

In recent weeks, the ADRs look like they've been trying to carve out a new range from lows of $113 or so on June 1 to highs of $122-$123 on May 25 and June 7. I don’t think that's a wide enough range to make this an attractive swing trade, especially with the current uncertainty on China's growth rate.

My suggestion is to take this one off your list of swing trades and wait for a stock market willing to look past temporary uncertainties and reward the company's long-term advantages.

At the time of this writing, Jim Jubak didn't own shares of any companies mentioned in this post in personal portfolios. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), may or may not own positions in any stock mentioned. The fund did own shares of Apple and Baidu as of the end of March. For a full list of the stocks in the fund as of the end of the most recent quarter, see the fund's portfolio here.

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