A Strong Case for Buying Baidu Inc. (ADR)

By Brian Stoffel Markets Fool.com

When the parent company for China's largest search engine,Baidu (NASDAQ: BIDU), reported earnings this month, the results weren't pretty. Revenue was down; the company lost over 18% of its online marketing customers; and if not for a timely investment in Uber China, earnings would have fallen 21%.

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That's a recipe for disaster, and it helps explain why over $3 billion in shareholder value was eliminated in one trading session. But if you're a long-term investor and can take the view from 30,000 feet, a very strong case can be made that now is the time to consider buying shares.

Image source: Getty Images

The elevator pitch

If you're unfamiliar with Baidu or what's been happening recently, here's the elevator pitch: Baidu is by far the biggest and most powerful search engine in China. But rather than rest on its laurels, the company -- led by founder/CEO Robin Li -- has plowed cash back into technologies of the future, including artificial intelligence (AI) and online-to-offline (O2O) initiatives.

There's some risk involved with this under normal circumstances. Reliable advertising income that Baidu's core search engine kicks in reduces that risk. However, last year, a Chinese student died after seeking questionable treatment because of an ad he saw on Baidu. That caused the Chinese government to crack down on Baidu's advertising practices. As you might imagine, it makes the company's forays into AI and O2O more precarious, as the normally reliable stream of advertising revenue has fallen off.

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What we are left with is a company that appears to be floundering. Revenue is falling, earnings are diving, advertisers are leaving, and the stock trades for 45 times earnings.

But that's short-sighted, and I'm backing that assertion up with my own skin in the game. Here's why.

Advertisers will grow... eventually. They have no other choice.

Even I was surprised at just how dramatically the number of advertisers dropped at Baidu. Last year, there were about 555,000 Chinese companies advertising on Baidu's platform. In just 12 months, that number dropped by over 100,000. Most of them are presumably healthcare companies, as they were the ones affected by the government ruling.

But we need to remember that The Age of the Internet is still very young in China. Currently, only 52% of Chinese citizens are on the Internet. That's where the United States wasback in 2001 -- the iPod had just been released and Enron had just gone under.

The difference is that now, virtually everyone is coming online with mobile devices, where Baidu is the dominant search engine. The power of the company's data to serve targeted ads to consumers will win the day. Even during this down quarter, Baidu was able extract $5,099 per online ad customer -- up 14% from roughly $4,470 the same time last year. That speaks to the power of Baidu's platform.

From where I'm sitting, the crackdown on questionable health-related ads created some short-term pain but will spur the company to become even stronger -- and safer -- over the long run.

If even one investment pays off, it will mean big things

Baidu's investments in AI and O2O are also major potential catalysts. "We are thrilled by the opportunities that our existing platform has opened up and are excited to build the next generation of AI-enabled businesses," Li said during the company's release. He added that "we will [maintain] investment in key AI-enabled initiatives such as financial services, cloud, and autonomous driving."

Image source: Getty Images

The O2O side is equally compelling. The company is trying to make it easier for users to purchase things on its platform. If you want to buy a movie ticket, instead of paying on the theater's website, it can be done through Baidu. That's good not only for Baidu, but also for vendors who don't have the expertise or size to set up a payment system themselves.

Already, the number of activated Baidu Wallet accounts, while not a perfect proxy for O2O, reached 100 million in December, up 88% from the end of 2015.

Skin in the game, and a balance sheet to see them through

If these factors aren't enough to persuade you to put your own money into Baidu, consider that the company has more than enough cash to be just fine, and the company's leaders have lots of their own skin in the game.

At the end of last quarter, Baidu had $13 billion in cash and investments. That's against just under $1 billion in long-term debt. In addition, the company produced $2.63 billion in free cash flow over the past year -- a 27% increase from 2015. That means shares now trade for a pretty reasonable 23 times free cash flow.

An investment at today's prices also means you're investing alongside Robin Li. As of the company's last annual report, he owned 16% of shares outstanding. That's a significant sum that's remained high over the years. He is dedicated to creating long-term shareholder value, and if you're patient enough, I believe he will deliver.

And those aren't empty words: Baidu currently makes up 10% of my real-life holdings. If it weren't already so big, I'd be buying more now. But for the time being, I'm content to sit back and (patiently) watch as this all plays out.

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Brian Stoffel owns shares of Baidu. The Motley Fool owns shares of and recommends Baidu. The Motley Fool has a disclosure policy.