Why Baidu’s Margin Pressure Is Set To Continue In 2016

  • Baidu has reportedly been seeking a new round of private funding to develop one of its fast-growing Offline 2 Online (O2O) ventures.
  • Baidu had earlier stated that it intends to sink $3.2B  into its O2O businesses over the next three years.
  • This is likely to keep Baidu stock depressed in 2016.

Chinese stocks have performed abysmally in 2015 primarily due to the turmoil in Chinese stock markets. Leading Internet stocks including Baidu (NASDAQ:BIDU) and Alibaba (NYSE:BABA) have been especially hard hit, with Baidu stock down 14.8% YTD while Alibaba stock is down 21.2%. This comes in sharp contrast to 2014 when both stocks soared. In the case of Baidu, the stock has fallen out of favor with the investing world due to the company’s rapidly contracting bottom line.

Baidu’s top line is still growing at a healthy clip: during the last quarter the company reported revenue of $447.0 million, good for 35.9% Y/Y growth. Baidu’s bottom line, however, is where the company’s troubles started: Baidu reported non-GAAP EPS of $1.43, a large 26.7% Y/Y decline. The big problem here is that this is something that has been going on for a number of quarters now. Baidu’s shrinking margins has been orchestrated by the company’s heavy investments in O2O, or online-to-offline, ventures. And this is not something that is set to change any time soon, if recent developments are any indication.

China’s Caixin.com recently reported that Baidu had quietly been seeking for $300M-$500M in funding for Baidu Takeout Delivery, one of its O2O ventures with the other two being Baidu Nuomi, an ecommerce web operator, and Qunar, an online travel agency. According to Caixin.com, Baidu has filed the details in a non-public prospectus. Baidu begun seeking the funds in November and will complete the process in January of 2016.

The Chinese search giant plans to use the funds to expand the takeout platform which apparently has been growing at a blistering clip. Baidu Takeout Delivery will realize GMV of $1.23B in 2015, with the figure expected to more than triple to $3.85B in 2016. Baidu reported during the last quarter that its O2O businesses had a combined GMV of $9.5 billion. That large figure is enhanced by Qunar, China’s second-largest online travel agency with triple-digit top line growth.

It’s perhaps not a coincidence that Alibaba recently announced that it was planning to invest $1.25B for a 27.7% stake in Ele.me, a leading O2O food delivery service. This will be Alibaba’s largest O2O investment to-date. It appears as if the food delivery service is one of the hottest O2O businesses right now, and O2O players are ready to invest huge sums of money in the business.

Baidu had earlier revealed that it plans to spend $3.2B over the next three years to grow its O2O businesses. But given developments such as the recent round of funding in Baidu Takeout Delivery, it won’t come as a surprise if it exceeds that amount by a wide margin. Baidu is looking to grow its O2O businesses at any cost, including seeking private rounds of investor funding.

Now there is nothing wrong with Baidu or Alibaba investing heavily in O2O. The problem is that the model is still very new and largely untested. Moreover the companies are currently not making any money from it. Baidu is usually more transparent than Alibaba about divulging information about its O2O businesses. During the last earnings call, the company had this to say about the venture:

They're all growing very, very fast and together with our peers and competitors, we are educating the Chinese consumers the better way to order services. So eventually, we will be able to take a cut, a sizeable cut from that, but whether that's three-year or five-year, it's really hard to tell at this point.

Baidu is not only not making any money from its O2O businesses, but does not see that happening soon. The good part is that O2O will help Baidu’s GMV, a critical growth metric for ecommerce companies, to continue expanding at a healthy clip. The bad part is that the company’s heavy investments in the space will continue eating into its margins.

The good part about Baidu is that its core search business still remains in the pink of health. Despite intense competition from the likes of Qihoo 360 and Sougou, Baidu’s Chinese market share reading of 70% makes it more dominant in China than Alphabet Inc-C (NASDAQ:GOOG) whose U.S. market share clocks in at around 65%, is in the U.S.

Investor Takeaway

Baidu’s margin pressure due to its ongoing investments in O2O ventures is not likely to ease off any time soon. This might keep the Baidu stock depressed in 2016. The good thing, however, is that investors have sort of come to expect it and it’s mostly baked in Baidu stock. This makes  Baidu stock a good investment for the long haul.

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