Chinese search giant Baidu (NASDAQ: BIDU) is often dismissed as a slow-growth tech stock that has run out of room to grow. Its heavy investments in expanding its ecosystem into adjacent markets have weighed down its bottom line growth, making the stock seem like dead money. Despite those challenges, however, I recently started a new position in Baidu for four main reasons.
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Baidu Image Search. Image source: Author's screenshot.
1. It's still the 800-pound gorilla
Baidu controls roughly 80% of the internet search market in China. That dominant position enables it to expand its ecosystem in the same way as Alphabet's (NASDAQ: GOOG) (NASDAQ: GOOGL) Google. Its sprawling ecosystem now includes Baidu Maps, video streaming site iQiyi, its Duer voice assistant, the Baidu Wallet payment platform, numerous portal sites, and various O2O (online-to-offline) services in its "monolithic" mobile app.
While the profitability of these services varies greatly, they all help Baidu gather data from its users for targeted ads. Last quarter, Baidu's revenue per online marketing customer rose 10.6% annually. This indicates that Baidu still remains a top advertising pick in China, even as other popular apps -- like Tencent's WeChat -- tether more users to their ecosystems. Moreover, China still has an internet penetration rate of just 52%, which means that there may be plenty of room for all these companies to expand without stepping on each other's toes.
2. Its slowdown is temporary
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Baidu fell out of favor with growth investors as its top and bottom line growth seemingly dried up. Last quarter, its revenue fell0.7% annually, its core online marketing revenue slid 6.7%, and its non-GAAP net income rose just 6.3%. Analysts expect itsrevenue to rise 6% this year, but for its earnings to decline 9%.
However, that slowdown was mainly caused by three temporary headwinds. First, Chinese regulators forced Baidu to remove misleading pharmaceutical ads following the death of a student who bought unapproved cancer drugs advertised on the site.Second, Baidu sold its stake in online travel agency Qunar to its rival Ctrip (NASDAQ: CTRP), essentially swapping its stake in Qunar for one in Ctrip but temporarily throttlingrevenue growth.
Lastly, Baidu's heavy investments in R&D are squeezing its margins, but launching new services could boost its long-term growth and widen its moat against rivals like Tencent. That's why analysts believe that Baidu's revenue and earnings will respectively rebound 21% and 33% in fiscal 2017.
3. Growth potential in next-gen markets
Like Google, Baidu is investing heavily in artificial intelligence, driverless cars, and other "next-gen" technologies. Machine learning and AI have become increasingly important to search and advertising companies, since they help gather more data from users to create targeted ads that users are more likely to click on. Baidu has been hiring a lot of top talent in that field -- its chief scientist, Andrew Ng, previously led the Google Brain AI project, and itsnew augmented reality chief Qi Lu was a Microsoft exec specializing in AI.
To showcase its AI efforts, Baidu pitted its AI robot against Google's AlphaGo AI in a battle of facial and voice recognition in early January. It partnered with NVIDIA and HERE Maps to develop mapping systems for autonomous vehicles, and plans to launch a driverless shuttle bus in China in 2018. It also partnered withsmart remote maker Peel to establish a foothold in the growing smart home market.These projects won't generate meaningful revenue for years, but they could greatly expand Baidu's O2O ecosystem over the long term.
4. The stock is still cheap
Baidu currently trades at just 13 times earnings, which is much lower than Google's P/E of 31 and the industry average of 50 for internet information providers. But due to its projected decline in earnings this year, the stock has a forward P/E of 30. While that forward multiple doesn't seem cheap, we should remember that Baidu's earnings are expected to rebound in 2017.
The key takeaway
Baidu will likely remain weighed down by near-term challenges over the next few quarters, but it's still well-positioned to profit from the long-term growth of the Chinese internet market. Baidu may struggle to pull social users away from Tencent and shoppers away from Alibaba, but its dominance of the search-based ad market won't end anytime soon.
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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's Board of Directors. LinkedIn is owned by Microsoft. Leo Sun owns shares of Baidu. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Baidu, and Nvidia. The Motley Fool recommends Ctrip.com International. The Motley Fool has a disclosure policy.