Baidu: Strong Future With An Undervalued Stock Price

Baidu (BIDU) is a leading Chinese-language internet service provider. With a market capitalization of $58.99 billion, Baidu's shares are currently trading at $168.58. Year to date, Baidu's stock has gained 61.91% clearly outperforming the broad based S&P 500 and NASDAQ. Primary reasons for this whopping rally were the company's financial growth as well as its complementary acquisition announcements.

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In this article I will provide an overview of the company's financial performance, growth opportunities and projects its fundamentals.

Before going into the discussion of the company's unseen future let us briefly analyze the overview of the company's historical results.

Glance at the Company's History

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During the third quarter of fiscal year 2013 Baidu reported revenues of $1.453 billion (RMB 8.892 Billion) reflecting an increase of 42.3% year over year. This growth was the result of higher ad prices and increased ad volume.

On the other hand, the company reported an operating profit of $545.4 million (RMB 3.338 billion) reflecting an increase of 1.2% from the operating profit of last year. The prime reason for this marginal bottom line growth was a 115.4% increase in the selling, general and administrative expenses and a 77.5% increase in expenses related to research and development. The operating profit translated to a net income of $498 million (RMB 3.048 Billion) reflecting an increase of 1.3% year over year.

The company had a cash balance of $7.075 billion (RMB 43.3 Billion).

Growth Opportunities

According to the data issued by China's Ministry of industry and information technology, total internet users in China are expected to reach 800 million by the end of 2015. This reflects a 35.4% increase from the current internet user base of 591 million (at the end of the first half of 2013).

In addition to this there is an interesting trend exclusive to the Chinese market. More than 78.5% of total internet users use internet-enabled portable devices when online. This is a mass user base and many internet service providers have increased their focus on tailoring their services to more efficiently engage this market.

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The search engine market reached $1.84 billion (11.28 billion Yuan) reflecting a growth of 20.3% compared to reports of the last quarter of the same year. Baidu clearly dominates the industry with a 76.9% share of the total market followed by Google (GOOG), Sogou and others.

Moreover the market scale of China's advertising platforms reached USD 4.7 billion (28.77 billion Yuan) during the third quarter of fiscal year 2013 growing by 24.2% from the last quarter. Baidu occupied 30.8% of the advertisement market share in terms of revenue, Alibaba ranked second with 15.9% while Google came in third place with 5.5%.

Baidu earns almost 99% of its revenues from advertisements and out of this total marketing revenue a major chunk is contributed by search advertisement followed by display advertisement. Besides this, through recent acquisitions, the company has divulged its future plans to diversify its revenue base. During the year the company signed three significant acquisition deals: PPS.TV's streaming video service for $370 million, a $1.9 billion deal to acquire 91 Wireless a leading mobile app marketplace and games operators and lastly the purchasing of a stake in Nuomi an online merchandising platform.

Therefore, it is reasonable to conclude that Baidu will continue to lead the market and achieve profitable results in the coming periods.

Projections

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The basic reference point of my projection was the forecast of Chinese internet users and incremental increase in average number of searches by a single user. During the calculation of incremental growth in the average number of searches I have accounted for the effect of the shift towards mobile or portable device as a medium to connect to the internet. After all if these projections I have calculated the revenue per search realized by Baidu plus a growth rate in search volume and ad prices. In addition to this I have also forecasted the average revenue per display add To calculate the growth rate for this source I have taken care of a number of factors: the average price per display ad has been increase in conjunction with the total number of internet users and expected page views. Moreover I have also included the anticipated increase in total revenues from the acquisition of 91 Wireless. Growth has been calculated on the assumption that Baidu has all of the required skills and resources to better advertise this market place in a way that will eventually increase downloads.

While forecasting the net income I have assumed that all of the expenses will increase at a lower rate compared to the growth in revenues except the SG&A and research and development expenses which have been assumed to grow parallel to revenues.

I have assumed a constant exchange rate based on 26 December 2013's rate.

Valuation

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After projecting the revenues and net income I projected the operating cash flows and expected capital expenditures to calculate the intrinsic value of the company under the framework of the free cash flow valuation method. At the end of the forecasting horizon I have assumed a long-term perpetual growth rate of 2%.

To calculate the discount rate I have used market values to add weight to the WACC, 10 year Treasury yield (as an estimate of the risk free rate) and a market return of 8.8%. Moreover I have used an adjusted beta to account for the reverting nature of the company's beta towards the mean of the market.

After calculations the stock reflects an upside 16.79% from the current stock price of $168.52.

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Besides my own calculations I have also performed a sensitivity analysis of the stock price using different estimates for the long term growth rate and WACC. At the minimum WACC and maximum growth rate the stock has a maximum upside potential of 33% whereas at the maximum WACC and minimum long term growth rate the stock reflects a maximum down side risk of 0%.

Conclusion

Baidu has shown excellent performance in the past and is all set to capitalize on the upcoming industry trends. Moreover, the company is trying to diversify its revenue base which will lower the overall unsystematic risk. I think that a strong future with an undervalued stock price makes this stock a good investment.

Source: Baidu: Strong Future With An Undervalued Stock Price

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)

Business relationship disclosure: The article has been written by a Blackstone Equity Research research analyst. Blackstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Blackstone Equity Research has no business relationship with any company whose stock is mentioned in this article.

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