You can fret over China’s macro outlook, but that’s become an excuse to not own cheap companies like China’s leading search engine, Baidu.
The company’s shares are trading at a significant discount amid needless concern about its growth strategy and slowing Chinese economic growth.
Baidu’s valuation no longer reflects the Nasdaq-listed company’s powerful market position in strategically important Chinese internet services. For investors willing to put aside excuses, that’s created an excellent entry point into the stock.
A $US100 billion core business
When the Chinese sit down and search a topic on their desktop, most of them use Baidu, hence the company being dubbed ‘the Google of China’. That dominance is now being translated to the mobile space.
Baidu also owns related assets, with growing dominance in online video, maps, advertising networks and mobile browsers. It’s also a leading player in email, news, private cloud and travel. The only missing ingredient is a mobile operating system like Google’s Android.
That dominance means its core search business and its related advertising network are highly profitable and generating strong annual growth of 30 per cent per annum. EBITDA margins are very impressive at 50 per cent.
But there is room for further expansion. The company is expected to generate $US10 billion of sales by the end of 2015. Baidu can still grow by a factor of 1.5 times before it reaches a similar GDP weighted size as Google’s revenue’s in the United States.
Explore the non-core
Baidu also has a string of stakes in non-core businesses, including holdings in CTrip, China’s dominant travel network; the number one online video streaming service, iQiyi; and Uber China.
One thing investors have been worried about, and which helps explain the undervaluation, is Baidu’s $US3 billion-plus investment in ‘Online to Offline’ businesses (O2O), including coupons, food takeout and movie ticket purchasing.
Baidu is trying to further monetise search by clipping the ticket on related e-commerce.
The investment is currently loss-making, but we believe it makes sense given it leverages Baidu’s core competitive advantage in search, maps and therefore location services.
A healthy margin of safety
We think that in 2016, Baidu’s search business will generate $US5 billion in net profit after tax, and is worthy of a growth multiple valuation of something close to 20 times earnings. That gives it a valuation of around $US100 billion.
The company also has US$5 billion of net cash. We value its non-core assets, including the cash, at US$14 billion.
We give Baidu a total valuation of $US114 billion for a well-managed and high-barrier-to-entry company operating in a growth market.
But that valuation is an almost fifty per cent premium to the stock price of $218/share which puts the market capitalisation at USD75 billion.
That discount gives us a material margin of safety if the O2O business doesn’t work out well, or core search advertising suffers for a few years under a protracted downturn in the Chinese economy.
We always consider individual stock opportunities within a broader macro context. But we’re instinctively wary when ‘macro’ becomes an excuse not to own great companies when they become cheap.
With the bursting of the commodities bubble, Australians are well aware that China poses risks. Growth has slowed on the back of weaker investment and an acceleration of debt accumulation post-GFC.
There will always be excuses not to own a business. In Baidu’s case, it is China’s macro outlook and concerns around its O2O strategy.
Such concerns must be considered but we think we’re being more than compensated by the margin of safety that’s built into the stock.
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