Description

Company Overview

Baidu’s core business is search advertising, which contributes to ~85% of total revenues and is highly profitable with an operating margin of over 50%. At the consolidated level, Baidu’s overall operating margin was around 50% from 2010 to 2012, but since then it has been in steady decline to 23.1% in Q2-15 as the company invests in mobile, video, and its latest initiatives in online-to-offline (“O2O”) services.

Specifically, in addition to search advertising, Baidu’s other notable businesses include the following, all of which are currently not profitable:

• iQiyi: online video
• O2O services
  • Qunar: online travel
  • Nuomi: group buy
  • Baidu Takeout Delivery

Thesis

The recent decline in share price provides an attractive opportunity to buy a high quality search advertising business at a bargain. In addition, we have a free option on the company’s attempt to capture a multi-trillion dollar O2O market.

Baidu released its Q2-15 earnings on 7/27/15, surprising the street with a much higher than expected investment spend on its O2O initiatives, for which the company has committed 20 billion RMB over the next 3 years. Baidu’s stock price dropped sharply by 14% from $197.68 pre-earnings to $170.01 as of 7/29/15, a level that we haven’t seen since June 2014.

It seems that the street is concerned with whether Baidu can succeed in the O2O war with other public companies and well-funded private companies. I think it’s helpful to assess Baidu’s efforts in O2O from a different perspective. Specifically, I’d like to answer the following questions: 

1. Does it make sense strategically for Baidu to pursue the O2O market? I think so. First, this is a HUGE market. Management estimates the addressable market size at RMB 10 trillion, including restaurants, takeout food and grocery delivery, entertainment, online travel, and other verticals. It’s hard to judge how accurate this estimate is, but I’m comfortable that the addressable market is very big. Second, it seems like a natural extension for Baidu to not only connect people with information, but also connect them with goods and services. By creating this O2O network, and providing capabilities such as local delivery service, Baidu is essentially making it easier for SMEs to create their presence online and be included in the Baidu O2O ecosystem - benefiting everyone as a result of network effects. Finally, Baidu is well positioned to executive this vision given its strong brand name, technology leadership, massive amounts of traffic, one of the largest on-the-ground sales force, a deep pocket, and importantly strong management commitment. In summary, I believe this is the right direction for the company.

2. Can Baidu afford such a large investment? To put the investment commitment of 20 billion RMB over the next 3 years into perspective, this is approximately 26% of Baidu’s current cash balance of 76 billion RMB. In addition, Baidu’s core search advertising business can generate ~28 billion RMB in operating profit in 2015 alone. Clearly, Baidu can afford this investment.

3. What if Baidu fails at the end? My base case assumes 0 value from these initiatives. Even if they fail, we would be left with a very attractive search advertising business. In this case, these investments would eventually stop and the consolidated operating margin would revert back to the ~50% level. Therefore, we should focus on Baidu’s core search advertising business when valuing the company.

Valuing the Core Search Advertising Business 

Based on consensus estimates, Baidu will likely generate total revenues of $10.8 billion in 2015E. Assume 85% from search advertising and a normalized operating margin of 50%, tax rate of 20%, and share count of 353mm, I get to a 2015E EPS of $10.40 for the core business. Based on a 20x forward P/E multiple, the implied share price is $208, representing a 22% upside from the current share price.

Catalyst

Top line acceleration

Slow down in investments