Apple Inc.'s Latest Move in China Shows Why Baidu Inc. Needs "Transaction Services," aka Online-to-O

Baidu IPO. Image source: Baidu.

Baidu , with a market cap around $70 billion, is a giant in its own right, but when Apple decides to enter the fray, nearly every other business looks small in comparison to the behemoth with a market cap near $600 billion. Baidu is the dominant online search company in China and is also invested and involved in a number of other businesses. These include online video, "transaction services" (what the company currently calls its online-to-offline, or O2O, efforts), and streaming music. Apple Music launched in China in September as a competitor. Its arrival and Baidu's response show how smart Baidu's management team just might be.

Not going to beat Apple hereAs important as it is for a company to be aggressive in protecting and growing its lines of business, it's equally important to know when victory is unlikely and move on. Apple is an 800-pound gorilla in many areas, with a strong, and growing, foothold in China already from its iPhone, iPad, and Mac sales. Businesses such as Spotify that focus entirely on streaming audio have been threatened by Apple's entry into the market. It's unreasonable to assume that Baidu, where streaming music is low on its list of priorities, will be able to fend off Apple in this area.

Baidu certainly has an upcoming fight with domestic competitors, and perhaps Alphabet, over search engine dominance in China, and is trying to diversify its brand internationally and through new product offerings. It makes relatively little from its music offerings. Baidu Music reportedly has around 150 million users, but it's not clear what portion are paying subscribers ponying up the $1-$2 monthly fee. As VentureBeatreports: "It's unlikely that Baidu sees more than a negligible percentage of paying subscribers. Most will be using the service's basic free offering."

Baidu nevertheless is making efforts to hang on to these users. It announced a partnership withTaihe Entertainment Group, a leading Chinese music provider, and is looking to grow or maintain its existinguser base. However, in the latest earnings call, the word "music" was mentioned only one time. The CFO mentioned it briefly in response to an analyst question. Clearly music is not even atertiary priority for Baidu. Why, then, is Baidu fighting to keep this user base?

Transaction services/online-to-offline is the big opportunityIt's estimated that China's digital-music market could reach $2.8 billion by 2017. This is a nice-sized market to attack, but it pales in comparison with the O2O market that CEO Robin Li has directed his company toward. In the Q2 earnings call, Li said, "O2O opens our total addressable market in China by a factor of more than 10, to a RMB10 trillion [about $1.5 trillion] opportunity."

With a market this large, a slice of the pie could be accretive to even the largest ofcompanies. Having 150 million music users is a good place to start in trying to build out the transaction services business. Baidu remains the dominant search engine in China, but those who subscribe to other Baidu services will have a deeper connection to the company. Keeping these users in the Baidu ecosystem really isn't about the music. It's about everything else that these customers can and will buy in the future: movie tickets, takeout food, dry cleaning services, the list goes on and on.

Baidu's focus is the futureThe focus on growing Baidu's transaction services business is already paying dividends for the company even if it continues to have "a negativemargin impact of 32 percentage points on our overall non-GAAP margins," according to the Q3 conference call. This is a classic story of sacrificing short-term earnings to help capture massive long-term gains. These are the stories that Wall Street tends to miss because of a lack of patience. Here are two of the many areas where Baidu is performing admirably in transaction services and where the company's focus should continue to rest.

Nuomi, Baidu's group-buying site, "grew GMV [gross merchandise volume] 475% year over year."Baidu invested $3.2 billion in the service earlier this year and is already making great strides toward recalibrating thebehavior of Chinese consumers. Online movieticket sales weren't a part of Chinese life just a few years ago, but now, "Nuomi is the top player in the movie ticket vertical and accounts for 15% of all movie theater tickets sold in China, on or offline, as of the end September," the company said. This is apositive development for the company and a trend that I expect to continue.

"Baidu Takeout Delivery grew GMV nearly 12-fold year over year. Baidu Takeout Delivery saw GMV nearly triple quarter on quarter and has the highest ARPU [average revenue per user] among its peers," Li continued. "Takeout Delivery targets the attractive working age demographic who value higher food quality and faster delivery time. Baidu Takeout Delivery leads in 63 cities by working age demographic, according to our internal analysis."

Baidu is a great long-term investment with massivemarket opportunities ahead of it. Short-term investors who focus on the negative margin effects are missing theforest for the trees.

The article Apple Inc.'s Latest Move in China Shows Why Baidu Inc. Needs "Transaction Services," aka Online-to-Offline originally appeared on Fool.com.

James Sullivan owns shares of Apple and Baidu. The Motley Fool owns shares of and recommends Alphabet (A and C shares), Apple, and Baidu. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.