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Own a piece of China's Google wannabe
China's No. 1 search engine, Baidu, holds huge growth potential as it prepares for an IPO. But it has to reckon with some fierce competitors -- and the Chinese authorities.
By Michael Brush
If you missed out on Google, take heart.
This summer, you may get a second chance to own an Internet search giant, since China's version of Google (GOOG, news, msgs) is going public in about a month.
For investors who get in early and think long term, China's most popular search engine, known as Baidu, has a chance to produce healthy gains. Whether its shares will match Google's 200% gain is another question.
Though doing business in China makes Baidus outlook as complex as it is promising, a few things are clear: - Baidu is the leading Internet search engine company in China.
- Its an early-stage company in an emerging Chinese Internet sector only beginning to tap into its potential. That spells plenty of growth ahead.
- Baidu has years' worth of mistakes made by Western Internet companies to learn from.
To be sure, Baidu faces two tough challenges. It must deal with the nuances of being an information provider operating under the thumb of Chinas Communist government. Next, it is going up against Google and other big search-engine powerhouses staking out territory in China -- like Yahoo! (YHOO, news, msgs) and Microsoft (MSFT, news, msgs), the parent of this Web site.
But the competitive landscape tells us that inside these challenges lurk forces that will actually help Baidu dominate the Chinese search space and reward shareholders for several years. Before we get to that, heres a quick primer on Baidu.
Baidu's basics
Pronounced "buy do" in English, the name of the company means a hundred times. It comes from a well-known ancient Chinese poem about a long but ultimately successful search for a beautiful woman in a teeming crowd.
Launched in 2000, Baidu turned profitable just over a year ago. It pulled in just $5.5 million in revenue in the first quarter of 2005 and $13.4 million in 2004. But it has the potential for rapid growth.
Like Google, Baidu sells advertising space on its search site. Ads pop up whenever people search for words similar to the products advertisers are selling. Baidu collects a small fee when users click through those ads.
Baidu unabashedly imitates Google. Its site -- www.baidu.com -- has the same clean, no-frills appearance. Its marketing tag line borrows from the now-common use of Google as a verb in English. Baidu's own ads say: Got a question, Baidu it.
The company runs over 820,000 message boards in a service called Baidu Post Bar. Baidus search box is also on more than 76,000 Web sites in China, in a network it calls Baidu Union. Click-through traffic from this network generates about a fourth of Baidus revenue. And many observers claim that Baidu does a better job with Chinese language search than Google.
And like Google, Baidu is a huge hit. Its the leading search engine and second-most-used Web site in China, according to iResearch. Its also the sixth most popular Web site in the world, according to Alexa, a company that tracks Internet usage.
Pirate trouble
Investors do worry that Baidus traffic may take a hit because nearly a quarter of its visitors seek places to download music and video files -- much of it pirated. Any kind of pressure, legal or otherwise, to curb the availability of links for sites selling bootlegs could hurt. Indeed, Baidu was reportedly pulling down links to pirated entertainment files last week, perhaps because the road show for the initial public offering is about to start.
Related news and commentary on MSN Money
In the long run, however, it probably doesnt matter. I am bullish on Baidu because the search market is ultimately going to be very big in China, says Pacific Growth Equities analyst Jason Brueschke, who covers Chinese Internet stocks. It is still early. (Pacific Growth Equities is not involved in the Baidu IPO.)
For example, the number of Internet users in China should grow 24% a year from 2005 to 2007, according to iResearch, while the number of searches per day will increase 50% a year in the same time frame.
More startling: Just 7.3% of China's population uses the Internet, according to Internet World Stats, compared to 67.3% in the United States. That contrast gives you an idea of the potential for growth, especially when you remember that China has a population of 1.3 billion, compared to 295 million in the U.S.
The Chinese online advertising market was worth $283 million in 2004, or 3% of gross domestic product, compared to 5.7% of GDP in the U.S., says Adrian Au, a portfolio manager at Hamon Asset Management, which manages the Dreyfus Premier Greater China fund (DPCTX). There is a lot of room to grow, he says.
Another factor that will help Baidu: Chinas economy should continue to expand a lot faster than the U.S. economy. China grew 9.5% in the second quarter. Skeptics wonder how long that can last, but Oak Associates economist Ed Yardeni has little doubt. He says the government has to keep stoking 9%-plus growth to reach its goal of creating eight million jobs a year -- part of its strategy for keeping political and social stability.
Ten years from now China will have one of the largest middle classes on the planet, agrees Brueschke. That group will be more likely to use the Internet he says, because it will be younger and more tech-savvy than the middle class in the U.S. or Europe.
Cheap, for now
Baidu is slated to start trading for $19 to $21 on Nasdaq under the ticker BIDU, in an IPO underwritten by Goldman Sachs (GS, news, msgs), Credit Suisse First Boston and Piper Jaffray.
In that range, Baidu will come public at about 35 times 2006 earnings, says Au of Hamon Asset Management. Assuming the stock does not pop too much on the IPO, that will make it look downright cheap compared with Google. Google has a forward price-earnings ratio of 45, but Baidu has faster growth.
The little red book and the red herring
As good as all this sounds, Baidu investors could face unpleasant surprises, thanks to the heavy hand of the Communist government in the Chinese economy.
Top on the list of potential problems: The government and the Communist Party of China tightly manage the flow of ideas on the Internet as a way to control the political climate. Basically, they dont like references to anything subversive, including the Tiananmen Square protests in 1989, the Falun Gong spiritual group or debates about taxes.
Even publishing unauthorized news of changes in government personnel can spell trouble, says Xiao Qiang, a political refugee from China who runs the Berkeley China Internet Project, at the University of California at Berkeley Graduate School of Journalism. The government has a very strict control mechanism to make sure certain content is filtered, and the search engines are one of the main targets, says Xiao.
Step across the line, and business can suffer. Baidu, for example, was shut down for a week and fined in 2002 for a violation. Last year, the stocks of several Chinese wireless companies were hit when the government cracked down on them for transmitting horoscopes after officials decreed them a no-no because they are based on superstition.
Because of Chinese government restrictions on foreign ownership of Internet content providers, Baidu also has to use a convoluted ownership structure typical of Chinese Internet companies floating shares in the U.S.
Baidu is a Cayman Islands company that operates through subsidiaries in China and through contracts with a China-based company that actually owns the Web sites. This structure hasnt burned investors so far. But theres always a chance that the Chinese government could change the rules at any moment.
No matter how you look at it, it is a potential risk for investment in these Chinese Internet companies, says Mark Lebovitz, a portfolio manager and analyst at Munder Capital Management, which owns Chinese Internet companies.
Working under a government that has such a heavy hand in the economy, however, may actually help Baidu deal with foreign competitors. For example, the nuances of new government directives about whats banned can be hard to follow. A company like Baidu with extensive government contacts could be more agile than foreigner competitors like Google when it comes to toeing the line, says Qiang.
China is sensitive about foreigners controlling Chinese companies. Whats more, it wants to have dominant national champions in key sectors like the Internet, says George Haley, a University of New Haven business school professor and author of "The Chinese Tao of Business: The Logic of Successful Business Strategy." This means if the Chinese government thinks Google is getting too big, the government could take steps to restrain Google and help Baidu, says Haley.
Google dollars at work
Google is still the far bigger fish in the search pond. For one thing, the company has huge financial resources compared to what Baidu will raise in the IPO, says Tom Taulli, an IPO expert at CurrentOfferings.com. This is not a big capital raise. This is a small company, and Google has a ton of cash, he says.
Baidu will collect about $54 million in the upcoming IPO. In its most recent quarter, Google had $590 million in cash flow on revenue of $1.38 billion. Meanwhile, Google is using that financial clout to open up a development center in China, led by Kai-Fu Lee, who was recently hired away from Microsoft.
But Baidu has a big lead in other ways, which should keep it safe in China for a while. Baidu already has a rich network of advertising distributors that reaches deep into the business world, says Robert Eu, an investment banker with WR Hambrecht + Co who works on Asian deals. It will take a while for Google to replicate that. I dont think the people at Baidu are panicked about Google, agrees Brueschke.
Indeed, Brueschke says Googles move into China will actually help Baidu investors because it legitimizes the Chinese search market. And despite potential government opposition, Brueschke doesnt rule out a Google takeover of Baidu sometime down the road -- which could bring Baidu shareholders a juicy premium. Google already owns a 2.6% stake in the company. That sends a signal that Google will consider buying Baidu at some point, says Brueschke.
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