(By Dan Su, CFA)
The shares of Chinese search engine Baidu (BIDU) have taken a beating recently, shedding more than 20% over the past three months, while other major Chinese Internet names like Sina (SINA), NetEase (NTES), and Tencent (00700) were mostly on an upward trend (more than 7% on average). We believe Baidu's weak share performance has been driven largely by investor worries over the competitive disruption from Qihoo 360 (QIHU), which launched its search service in late August, but we think such worries are overblown.
We agree that Qihoo is capable of garnering share in search traffic in the near future, given a large installed base in its popular antivirus and browser services, but the firm is years behind Baidu in search technology and database, which will be crucial in determining whether Qihoo can sustain its appeal to search users over the long term. More important, as a newcomer in paid search, Qihoo is at an early stage in understanding the needs and preferences of ad spenders and in establishing a technology platform and the necessary sales support that can remotely match what Baidu currently offers in order to monetize the search traffic and help advertising clients generate desirable marketing returns on investment.
Our $137 fair value estimate for Baidu implies 30% upside from the current market price. Given its strong competitive position in the attractive search advertising market and impressive record of delivering returns over the years, this narrow-moat name seldom trades at a discount to our fair value estimate. We recommend investors looking for quality growth stories in emerging markets keep Baidu on their radar; however, this is still a high-uncertainty name, and we'd wait for a better price to deploy significant amounts of capital.
Understanding Users Helps Baidu Consolidate Its Lead
We attribute Baidu's leading position in search advertising to superior understanding of the needs and preferences of Chinese Internet users and ad spenders, which the firm has accumulated over the past decade. While strong search and database technology form the cornerstone of Baidu's growth, we think the firm also owes its success to deep local knowledge of a generally young and entertainment-seeking Internet user crowd in China. Designed to address the needs of these users, a number of highly popular services such as Baidu Post Bar, Baidu Knows, and Baidu Encyclopedia have helped the firm gain share in site traffic and search queries.
Baidu did not start off with a leading share of the search market, but over the years it has taken share from rivals large and small. Changes in competitors' growth strategies in China, mainly those of Google and Yahoo, have also helped boost Baidu's market share gains. Baidu currently ranks as number one in site traffic in China and among the top five globally, according to third-party researcher Alexa, and its search engine controls more than three fourths of the search traffic in China. The strong search traffic flow, in turn, has enabled the firm to deepen its understanding of search users' behavior and preferences, helping the search engine serve more targeted advertising for its clients to generate desirable marketing returns on investment.
As such, Baidu has been able to translate the popularity of its services into a growth trajectory that is the envy of many Internet peers in China. Over the past five years, Baidu has increased revenue and net profits at annual rates of 77% and 86%, respectively, while maintaining investment returns in excess of 100% each year. Favorable secular trends of ad spending shifting online from traditional print and broadcast media, coupled with the benefits of better targeting with measurable results, have helped the search engine expand both its client base and average client spending at double-digit rates.
Qihoo Can Be a Disruptive Force in Search…
Qihoo may be able to take some share in search traffic in the near term, given its large user base in network security and browser products, but investor concerns that it poses a material threat to Baidu are largely overblown, in our view.
Qihoo serves more than 400 million users in China by providing free network security, Web browser, and personal navigation page services that are installed on computers and mobile devices, and thus can exert considerable influence over user traffic generated from these terminals. The firm monetizes the user traffic by selling online advertising and online games, generating $168 million in total revenue and $15 million in net profits in 2011. For several years, Qihoo provided search services on its browser and personal navigation pages. Without a search engine of its own, it directed search traffic to the highest bidder among the search engines--Google China--over the past two years, in return for referral commissions. Qihoo reported search referral revenue of $20.2 million in 2011, or about 12% of overall revenue. Baidu stopped paying Qihoo for search traffic in 2010, although we believe it still received traffic from Qihoo if Qihoo users designated Baidu as the default search engine.
Qihoo debuted in the search market in late August, and some initial traffic data from third-party researcher CNZZ (as quoted by various media sources) allowed us to take a peek at the possible share shift in the search market since then.
Search Traffic Share Shift Before and After Qihoo's Entry
The preliminary data suggest that Qihoo gained market share, probably at the expense of Baidu and Google China, while the share of Sogou (majority-owned by Sohu (SOHU)) was stable. The share loss of Baidu and Google China was probably due to Qihoo's directing the search traffic on its browser and personal navigation pages to its own search engine. Sogou seemed little affected, which makes sense as we believe Sogou generated search traffic from the user base of its own browser and Pinyin language input software, which does not overlap much with Qihoo's user base.
…Although Unlikely a Major Challenger to Baidu
We think Qihoo will find it difficult to sustain the traffic share gain, as it will unlikely be able to match Baidu on user experience, given the lack of a deep knowledge base about search users' tastes and preferences, not to mention its narrow range of searchable content. A much broader array of searchable content on Baidu can also help the search engine to defend and even regain traffic share once the initial excitement over Qihoo's search service fades. Baidu users can search for news, Web pages, music, pictures, videos, and maps as well as content in popular online communities Baidu Post Bar and Baidu Knows, which have taken Baidu several years to build to their current scale. On Qihoo's search engine, searches are limited to three categories: news, Web pages, and videos.
More important, we are skeptical that Qihoo has the technology platform or the distributor network/direct salesforce necessary to deliver marketing solutions that appeal to advertisers, and these could take time to build. We think Qihoo will not be content with the search referral commission model it used before, but instead will probably develop a market for keyword search. It could easily take Qihoo several quarters to build a reasonably robust and user-friendly platform that allows advertisers to allocate their ad spending, review search statistics, and measure the effectiveness of the advertising. We estimate that it took Baidu more than a year to develop and roll out the advertising system that it currently uses, in addition to a quarter or two more to work out the kinks in the system.
In addition, we think it requires a considerable amount of time and investment for Qihoo to build from scratch a distributor network and a direct salesforce, which will be crucial in helping the firm reach out to a fragmented client base of small businesses across the country and provide these clients with the necessary technical support to generate satisfactory returns on investment.
Qihoo essentially borrowed a page from Sogou's playbook, but it took Sogou, an eight-year veteran in search, several years to increase its revenue share to 3% by the end of June 2012. We believe Qihoo is trying to replicate Sogou's strategy of driving search traffic from its own sticky products such as browser and language input products. The strategy has served Sogou well in recent years, driving triple-digit-rate increases in search revenue over the past nine consecutive quarters, although it is still trailing Baidu by a wide margin in the ad client base and average client spending. We think the growth trajectory of Sogou in search can provide a useful reference for Qihoo.
Baidu an Attractive Play on Online Advertising
We still believe Baidu is one of the best plays on the favorable secular trends in online ad spending in China. We think the firm is well positioned to gain from the share shift to online advertising in overall ad spending and from a rising adoption of search advertising. Online ad spending grew 45% annually in China over the past four years to reach $7 billion in 2011, according to iResearch, as rising Internet penetration has made the Internet an increasingly attractive marketing platform for advertisers. Starting from about 100 million in 2005, the Internet user population in China reached 540 million in June 2012, representing a 40% penetration rate. We think it's reasonable to assume online ad spending can maintain growth at double-digit rates, as advertisers continue shifting their budgets online to reach Internet users who tend to have higher education and income levels than the national average. Of overall ad spending in China, online ad spending's share is estimated to be in the low teens.
In this booming market, paid search advertising has been an outperformer, increasing its revenue share from 27% in 2007 to an estimated 40% in 2011. We attribute the gain to the benefits of performance-driven marketing (compared to other forms of advertising such as display ads and classifieds). These benefits are particularly relevant to a vast number of small businesses with limited marketing resources, in our view, and should help Baidu and its peers acquire more customers in the coming years. Although Baidu is the dominant player in search advertising in China with more than 75% of the revenue share according to iResearch, we think the firm has barely scratched the surface of its addressable market; it reported 490,000 active clients at the end of 2011, only a fraction of about 40 million small and medium-size businesses registered in China. We think there is ample room for growth as Baidu leverages its nationwide distributor network, a direct sales team of more than 6,000, and a well-run advertising platform to convert new customers. We have modeled Baidu's client base to expand to 720,000 by the end of 2016.
Mobile Search Traffic Needs Attention
We think Baidu needs to move more aggressively to adapt its business to the rapid growth in mobile search traffic. Traditionally, Baidu's business was built around search traffic generated from personal computers, as consumers allocated a block of time to the Web and would typically access search and online activities via fairly large desktop monitors. As one of the main gateways for information and entertainment online, Baidu could conveniently monetize the massive traffic on the search engine in a profitable search advertising business.
In recent years, however, a growing portion of Internet traffic has shifted to mobile devices. Baidu's CEO said mobile traffic now accounts for about 20% of the firm's site traffic, up from nothing a few years ago. We think the mix shift to mobile traffic is likely to continue to gain momentum, and the trend calls for new monetization strategies and research investments from Internet firms.
We believe Baidu and its peers will find it more challenging to strike the right balance between user experience and clients' advertising needs, given the constraints of small cellphone screens. Skepticism among ad clients toward the effect of mobile advertising will probably lead to much lower adoption and to lower keyword prices. We think Baidu is likely to need to pay more to acquire search traffic, mainly through revenue-sharing agreements with handset makers that make Baidu the default search engine on their devices. While acquisition cost of traffic (mainly PC-generated) as a percentage of revenue was below 10% in the past two years, we think Baidu might need to pay slightly more to handset makers, given that it has a narrower lead in mobile search traffic (about 50% share, according to Baidu, compared with more than 75% in PC search traffic) and thus will need the help of handset makers to expand the reach of its mobile search.
We do think Baidu is on the right track in mobile search. Baidu has made itself the default search engine on about 80% of new Android phones in China. Android phones account for two thirds of the smartphone market in China, and we expect Android's share to climb further as Chinese mobile carriers recently began to push aggressively for higher smartphone penetration with lower-end Android phones priced at about $150.
Baidu has launched or updated a series of mobile applications for Web browser, map, language input, and other services that have gained popularity among mobile users. The firm increased share in mobile maps to 17.3% in the second quarter of 2012, from only 3.2% a year ago, after it made mobile map a strategic focus. We expect the launch of free voice-activated navigation can help Baidu further drive up market share in mobile maps. In our view, a strong mobile maps product can pave the way for attractive revenue opportunities in location-based search advertising, although we think revenue contributions will probably be immaterial in the near future. We also applaud the firm's efforts in recent months to better articulate its strategies for mobile Internet and cloud computing and to build a more inclusive platform for application developers.
That said, we believe mobile search remains an open field with a higher number of viable competitors compared with PC search, and Baidu cannot afford to rest on its laurels in this evolving market. The firm has made strides in closing the gaps in mobile product offerings, but in our view, it needs to move more aggressively with differentiated offerings and meaningfully better user experience to assert its lead in mobile search.