The Bull Case for Baidu

What is the Chinese word for "déjà vu"? I get a constant feeling of it whenever I listen to the bears fume over BIDU. Haven't we all seen this movie before? I bet these same angry Baidu bears are the same Google -loathing bears we saw the whole way up. Remember those brilliant calls? They did not like Google at $200, definitely a sell at $300, proclaimed extreme overvaluation at $500. They must be screaming bloody murder at $620!

Without a doubt, Baidu is not for the faint of heart. The stock has had and will continue to have dramatic price moves that will take your breath away. Just look at the trading in the stock last week -- two analysts came out and discussed potential weakness in Baidu's short-term revenues. I agree with their view of some potential short-term softness, but nothing in these reports changes the amazing secular growth story that is Baidu.

Both analysts talk about short-term revenue weakness being affected by events such as the cleanup of small and medium Web sites before the Communist Party's Annual Congress this week. In fact, Credit Suisse actually raised its 2008 EPS forecasts by 5%. Let me repeat -- nothing in the reports last week dents the huge secular growth story of Baidu.

And how much credibility do these analysts deserve? Before their report on Baidu on Oct. 12, Credit Suisse had an "underperform" rating (which is Wall Street euphemism for "sell") and a price target of $109. It subsequently raised its target to $143.

Huh? $109 to $143? Did they not get the memo that BIDU hit $359 last week? Even worse, Credit Suisse held its "underperform" rating the whole way up and kept investors out of the stock. And I should pay homage to its view?

To the credit of JPMorgan (the other broker that spoke cautiously), it initiated on Sept. 28 with a Street-high $400 price target. It expects BIDU to earn $4.44 a share in 2008 and $7.45 a share in 2009. Last, week, the JPMorgan spoke of potential short-term weakness in BIDU over the same issue of smaller Web site shutdowns. But, it emphasized, "Any share price pullbacks on the back of these short-term issues offer excellent buying opportunity for the leading Chinese search engine."

Let's look at the raw numbers and where I get my "outrageous" price target. Baidu is expected to grow its forward earnings for 2008 at a 71% clip to $3.80 (consensus estimates). Currently, it trades roughly in line with its growth rate with a forward P/E of 80 times. Given the huge market potential of China and rapid proliferation of internet use across Asia, I think these numbers are way too low. But let's be conservative and assume that Baidu only maintains its current growth rate of 71%. Using consensus EPS estimates, earnings for 2009 will come in at $6.50. Slap on the same multiple as today, and bingo, you get a $520 stock.

Further, my cockeyed earnings estimate is not even the high estimate for 2009. Look in the paragraph above where JPMorgan thinks Baidu will print $7.45 a share for 2009. Tie an 80 times multiple on that and you get nearly $600 a share.

Baidu is already dominating China and is beating Google at its own game. What is being the dominant search engine in one of the greatest growth stories worth to investors? What type of valuation do you put onto that?

If Baidu owns and dominates China -- which it does -- what should it be worth in relation to Google? A quarter of Google's valuation? Half of Google's valuation? Currently, Google has a market capitalization of $192 billion and Baidu has a market cap close to $10.5 billion. So, Baidu is only worth roughly one-twentieth of Google?

To me, this is wrong. There is a fundamental mispricing here -- either Google is overvalued or Baidu is undervalued -- and I strongly believe Google is cheap. At the risk of sparking a bear riot, let me speculate what would happen if Baidu became valued at one-quarter of Google's valuation -- you would get a stock price over $1,600. I don't dare say what price BIDU would trade at if it got half of Google's market cap.

Beyond the numbers, what gives Baidu the "upside edge" over others? I see three key factors: nationalism, teens and sales force.

Nationalism. The Chinese want a Chinese company to win. The marketing problem for Google is that few Chinese citizens use or even want to try using Google search. It is said that in China, the only people who use Google for search are foreigners.

Teens. As we witnessed here in the U.S. with the YouTube generation, it is essential to look to the younger demographic in determining the next big trend. With Internet search in China, Baidu is the clear leader.

Sales force. The business culture in China is focused on relationships. Baidu's strategy involves a much higher level of "hand holding" in its sales process. Baidu has more than 3,000 salespeople (as of the end of the June quarter) compared to Google's 450 total employees in China.

The constant (and correct) criticism of Baidu is that China is controlled by a command economy and a dictatorial government that could just shut it down overnight. This is absolutely true, but I see a different angle on the same story. I look at the flip side of the command society coin where the Chinese government wants Baidu to win -- call it a Chinese version of a monopoly.

What happens in a command economy when the government wants you to win? You win, and you win big. Simply connect the dots -- somebody is going to provide search services in China, somebody will be on top in China, and the Chinese government wants a Chinese company to win the market.

The bottom line is that the Chinese government wants Baidu to win. The Chinese people want Baidu to win. Only the analysts want Baidu to lose. Should you bet with the analysts, who have been wrong the whole way up? Or with the government and wishes of 1.3 billion people? Easy choice.

The company is set to report earnings on Oct. 25. As a cautionary note, volatility should be dramatic. No stock that runs from $84 to $360 and beyond in one year will ever go up in a straight line. Huge angst-ridden declines are the norm. From history, we know that the greatest bull-market stocks often have violent and dramatic declines that will have you waking up in the middle of the night in a cold sweat.

Could this stock see $350? Yes, easily. Could it also see $250? Yes, in a heartbeat. But, in the end, the trend is higher and I agree with the JPMorgan bull that any short-term weakness is an excellent opportunity to build the position. Nobody ever said making big money was easy, right?

The day that I don't hear the Baidu bears screaming "Crazy overvaluation!" is the day BIDU stops its climb, but I'm not holding my breath waiting for that.