Why Baidu Inc. Will Recover From The Hospital Scandal

  • Because of the Hospital Ad scandal, Baidu's share price is at 2013 type levels (sub $170 a share). I smell opportunity.
  • Even if Baidu's earnings takes a hit in the near term, it has a huge e-commerce tailwind which will return the company to meaningful growth.
  • The shift into non search products will affect profitability but will also lay the foundation for peer leading growth.

There is no doubt that the fundamentals for Baidu (NSDQ:BIDU) going forward look very strong indeed. Why? Well the online search giant, incredibly only serves less than 2% of current Chinese small and medium enterprises which illustrates the huge potential the company has ahead of it. Combine this with the fact that only 30% of the Chinese population currently have internet access, and one can easily see that it is these types of companies that will be able to weather a possible draw-down in the Chinese economy. Nevertheless, the press has turned really negative since news broke of the hospital scandal as investors seem to be thinking twice about Baidu as a long term investment. Will this latest scandal permanently derail Baidu's long term growth potential? Let's discuss.

First of all, with the share price now trading at around $170 a share, we now are trading at levels similar to those back in 2013 when the company did $5.2 billion in top line sales along with earnings of $1.71 billion. To put things in perspective, Baidu's twelve-month trailing top line is $10.42 billion with its bottom line at about $5 billion. This should give investors a sense of how cheap the stock is at present compared to historical valuations. Moreover, the stock's valuation metrics have hit the floor. Baidu's PE ratio is 11.7 compared to 5 year average of 38 and its sales multiple is 5.5 compared to the 5 year average of 15.2.

The fear surrounding the stock at the moment is whether a regulation or policy amendment surrounding internet advertising will affect Baidu's sales growth, but I believe this will come to nothing in the end. Look, we live in the digital age where it is extremely easy to advertise whatever one wants. The student and his family have to take responsibility here also for undergoing the operation at this facility. It is easy to throw the baby out with the bathwater but the student and his family in the end made the decision to get operated on at that hospital (irrespective of whether Baidu delivered the ad or not). What will happen is that hospitals who don't have regulatory approval won't be able to advertise on Baidu, but I bet these are in the minority and don't even make up 1% of the 20 to 30% revenue Baidu currently collects from healthcare search ads.

Another factor that is going to play into Baidu's growth story is its "average revenue per customer" metric which has been growing steadily. This is where Baidu's sheer size comes into play as more customers invariably means more clicks and over time more information. Now half of Baidu's staff are engineers and it would be dumb to believe that Baidu won't be able to extract more revenue from its customers over time due to higher engagement levels. This is where Baidu has an advantage over its western counterparts. The likes of Facebook (NSDQ:FB) and Twitter (NYSE:TWTR) have their home markets practically saturated at this point and future growth is only going to come from either international user growth or higher engagement levels. Baidu doesn't have this problem. As incomes rise in the east, you are going to see more businesses advertising on Baidu which has to turn into earnings growth over time.

Further, Baidu definitely has the balance sheet to keep on investing in its infrastructure to ensure it keeps competitors at bay in this highly competitive market. Margins may fall in the near term (as we witnessed in the first quarter) due to investment in non-search products and other products but these initiatives will enable the company to sell more advertising over time. Investors have to look at the negative earnings growth last quarter with this in mind. Investments are undoubtedly going to weigh on margins and earnings, but its balance sheet is up to the task despite operating margins falling to 14% in the first quarter. The firm's cash balance rose to $11.07 billion and shoreholders' equity value also rose in the quarter. Furthermore, I don't see debt as an issue. Therefore, when you see a company making long term investments without adversely affecting the balance sheet in any way, it has to be a good thing. Western tech companies have shown that mobile, video and online to offline investments will bear fruit. Investors need only be patient before these investments bear fruit.

To sum up, I expect Baidu to bounce back quickly after the hospital scandal  which took place recently in China. We are only in the first innings of meaningful e-commerce growth in China and Baidu is cash rich and willing to invest its capital to ensure a more prosperous future for its shareholders.

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  • I do not hold any positions in the stocks mentioned in this post and don't intend to initiate a position in the next 72 hours
  • I am not an investment advisor, and my opinion should not be treated as investment advice.
  • I am not being compensated for this post (except possibly by Amigobulls).
  • I do not have any business relationship with the companies mentioned in this post.
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