This article is an extract taken from the Forager March 2016 Quarterly Report.
Baidu (Nasdaq:BIDU), is the US-listed, Chinese technology company often described as the Google of China. In many respects, that’s apt—Baidu dominates the search engine market in China as Google does elsewhere. That has been helped by Google withdrawing from China 6 years ago—it’s hard to claim to ‘do no evil’ while allowing the Chinese government to overlord your entire internet infrastructure. Baidu has no such hang ups.
Since 2000, the company has grown at a blistering pace under the continuous watch of founding CEO and major shareholder Robin Li. Sales have grown almost 5-fold from 2011 to 2015 as shown in the accompanying table. So why were we able to buy Baidu in January 2016 at a price almost unchanged from where it traded in 2011? The answer also lies in the chart.
While sales have been growing, headline operating profit margins have been contracting. At first glance, it looks like profitless prosperity and makes the stock appear to be trading at an EBIT multiple of 35 times. But it is largely a mirage.
Depending on how you split it up, Baidu has 3 or 4 main operating divisions, but we’ll consider only two of them here. The most important—which incorporates search and a massive ecosystem that hangs off it, including maps and news—is called Online Marketing. This division provides most of Baidu’s revenue and more than all of its profit. It should generate in excess of US$10bn of sales in 2016 and has extremely fat operating profit margins, a touch over 50%. Baidu’s Online Marketing division is one of those beautiful and rare businesses that needs very little retained capital to grow…and grow.
The other crucial division is Transaction Services, also commonly referred to as O2O (online-to-offline). This is a variety of services, mainly app-based, for mobile users. Baidu Nuomi is where you can book a restaurant table nearby and lock in tickets for the 9 o’clock movie afterwards. Baidu Takeout lets you order food for collection or delivery from any of hundreds of restaurants near your home. You can pay for it all, if you wish, using Baidu Wallet.
These business have been created from scratch in a very short period of time. Today, they generate very little revenue, and huge losses. More than half that massive and growing profit pile from online marketing is being reinvested in startup losses today—research and development for the new interfaces, coupon discounts for users of Nuomi and Takeout, staffing expenses for businesses that generate little revenue and massive content costs for video streaming business iQiyi (the third division). These upfront costs are necessary at the gold rush stage of development of this market; those that don’t incur such costs won’t win. They explain all of the margin deterioration displayed in the chart.
It’s important to note that in most Transaction Services markets, Baidu is number two at best, usually a long way behind a competitor owned by Tencent (SEHK:700), Alibaba (NYSE:BABA) or a joint venture between the two. Lacking first mover advantage, Baidu has opted for the ‘late and hard’ approach. With net cash of US$5bn in the bank and a search business that grows largely without the need for reinvestment, it can afford a fight.
It’s likely that the charge into Transaction Services was partly defensive. Search has became so profitable globally because, compared with every avenue available beforehand, it tremendously reduced the ‘friction’ between an idea popping into a consumer’s head and a transaction being processed. That’s why advertisers love it. The mobile market is developing in such a way that other competitive avenues are emerging—all sorts of apps and chat-based technologies—that also translate ideas into transactions. This is happening more rapidly in China than anywhere else. Baidu wants to be part of it.
The strategy may or may not work. Where our opinion differs from the market is that we think at least one of two things are likely:
1) Some of these Transaction Services bets pay off; and/or
2) The pace of investment in new businesses will slow, if not in absolute dollars then in percentage terms as the core business grows.
Either will allow the core Online Marketing business’s immense profitability to shine again. The stock price is up 20% since the Forager International Shares Fund purchased shares in early February, and its market capitalisation at quarter end was US$66bn. Deduct US$5.1bn for net cash, US$4.1bn for its 20.4% stake in US-listed, Chinese-focused travel group Ctrip.com International, US$2.2bn for its 80.5% stake in iQiyi (currently subject to a privatisation offer from Robin Li) and the company’s enterprise value sits a little below US$55bn.
Any rational businessperson would come to the conclusion that the Online Marketing business alone is worth significantly more than that, and quite possibly worth more than US$100bn. That leaves a lot of room for missteps in Transaction Services and elsewhere without destroying the investment case. The Fund’s weighting to Baidu is a little more than 4%. It’s far from risk-free. But if time is the friend of this wonderful business, we can afford to stick around to see how this one plays out.
It’s worth noting that while the stock trades in US dollars, its business is all transacted in Chinese Renminbi. Any massive devaluation of the Reniminbi would hurt. We’ve largely removed this risk through currency hedging.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.