Baidu is the dominant search engine in China with multiple search related subsidaires. Baidu is currently trading at an incredibly low valuation because its money losing subsidaires and the recent clean up of its advertising system are hindering its true earning power . However, the market is not taking into account that Baidu’s search business is a resilient and fast growing business with a winner-take-all characteristics and a high barrier to entry. On a conservative basis, the search business is trading at a low valuation of 10x 2015 EBIT, an incredibly cheap price for a great business with tremendous growth in the next few years. Baidu’s revenue and share price should recover in a few quarters as the negative perception of the company disappears.

The Wonderful Search Business

Winner-takes-all market

Baidu’s search business is a great business with winner-take-all characteristics that generates large free cash flows via pay for performance advertising. Even after a decade of existence, search is still one of the best ways that advertisers can reach its desired customers. Through the users’ inquiries, search engines like Baidu can directly target relevant advertising to users, a method that other platforms cannot be able to replicate.

The search business has a monopoly/duopoly industry structure where the largest player usually dominates the majority of the market. This is because search engines have zero switch cost, a positive reinforcing cycle and image advantage.

Zero Switch Cost

Search is a cutthroat business since the user can change search engines at any time at little effort if they are not satisfied with the result. Therefore, the theoretical cost of switching to the alternative search engine would be zero and most users would only concentrate their search inquiries to the best search engine. Why would users utilize a subpar search engine if there is a better one? As a result of the low switch cost, there is usually a dominant search engine in every geographic market.

Positive reinforcing cycle

Popular search engines have more data to use and to mine compared to less popular search engines. As more users search through a search engine, the search engine with large sets of data refine results to a higher degree of accuracy, which in turn attracts more users and increases user retention. As the accuracy of the results increases, more users would search through the search. This reinforcing measure is incredibly powerful since the winner will dominate the market with more accurate results while smaller players will find it difficult to compete.

Brand Perception and Image

The popular search engine tends to have a strong brand image since it is trusted as the single best source of finding information. Hence, “google’ and “googling” are part of the western dictionary while “baidu it” is part of the Chinese dictionary in China. In markets where one search engine dominates, it is perceived that the dominant player has all the information. If the dominant search does not have the answer, it is perceived that other search engines would not have the answer either. To give an example of the brand perception, Robin Li, the CEO of Baidu, said “if you cannot find anything on the other search engines, you may be able to find it on Baidu. If you cannot find it on Baidu, you cannot find it anywhere else”.[i]

The value of the search engines’ brand is also indicated in brand value surveys such as MillwardBrown. According to the MillwardBrown’s report on top 100 most valuable Chinese Brands, the brand value of Baidu is fifth most valuable in the China. On the other hand, Google is ranked the number 1 most valuable brand in the world by the same source. [ii]

These factors all contribute to Baidu’s dominant 80% market share of search engine advertising revenues.

Source: China Internet Watch

Some incredible numbers

Looking at Baidu’s search engine on a quantitative basis, it is without a doubt that Baidu is a great business with a great moat and a great economical goodwill.

Here is the return on capital of Baidu since 2007.

Invested Capital = Working Capital + Fixed Assets – Short Term Investments – Cash

Return on Capital = [EBIT*(1-tax rate)]/ Invested Capital

On a conservative basis, assuming that all the invested capital was invested in the search business and not invested in the other subsidiaries and assuming that all of the revenue pre-2013 came from search, the return on capital was near 50% in the past few years.

Barrier to Entry

Search engines have a strong barrier to entry such as winner-takes-all dynamics, network effect and scale advantage preventing competitors to enter the field.

Starting from scratch?

A competitor would have a hard time starting a search engine from scratch. Not only would the competitor need to spend billion of dollars to establish the search infrastructure and the advertising network, but the competitor would also need to create a website on par with Baidu. As previously mentioned, due to the zero switch cost, positive reinforcing cycle and brand perception, a start-up search engine would need to be significantly better than its competitors in order to gain market share.

Network Effect – Two-sided market

The network effect of the search engine (a two-sided network made of marketing customers and users) does not allow competitors to enter easily. Any successful competitor would need to have users and advertisers on the platform. An additional user would improve the whole platform because the search inquiries will improve the appeal of advertising on the platform for advertising customers. An additional advertiser would improve the whole platform because it would fund and support the search engine. As the result of the two-sided market, it would be incredibly hard for a competitor to take away an user or an advertiser from the resilient platform.

Source: Baidu Investor Presentation

Scale Advantage

Because the industry is a winner take all industry, the small competitors of the industry would continuously lose money due to the high fixed costs of the business. Unless a competitor can gain a significant amount of market share, the competitor will continuously lose money.

A good example of the scale disadvantage would be Sogou, Sohu’s search engine and the third largest search engine in China.

Sohu historically had less than 10% of the market share of the Chinese search market. Due to the small scale of its operations, the search engine was not profitable for an entire decade. In 2013, Tencent sold its Soso search engine (Soso is the named of Tencent’s search engine) in exchange for 36.5% of Sogou. In addition, search queries on Tencent would then be directed to Sogou. This combination increased the scale and network effects of Sogou which increased the profitability of Sogou. The loss was reduced in 2014 and has turned positive in 2015 due to the increased scale.

Another good example of the scale advantage is Baidu’s dominance in mobile search. Although Baidu is not the first to work on mobile search, it was able to secure its dominance by paying phone manufacturers and telecommunication companies to install Baidu’s search app. To give an idea on the size of the payouts, according to J.P. Morgan’s analysts, Baidu would have paid RMB 6.7 billion of the high mobile penetration in 2014[iii]. The recent $1.9-billion-dollar acquisition of 91 Wireless in 2013 also helped in securing a foothold in mobile since 91 Wireless was the third largest app store in China and could promote Baidu’s search app. Because of these actions, Baidu’s mobile search dominance is much higher than its desktop search dominance. These strategies could not have been deployed if Baidu was not large enough and not highly profitable.

Chinese Advantage – an entrenched player

Unlike the other large size search engines, Baidu has a competitive advantage in China due to its understanding of the Chinese market and the support from the Chinese government.

Linguistic

Unlike western companies, Baidu has the local advantage in China. Baidu can adjust its search to Chinese preferences and to the Chinese language better than other western companies (more specifically Google and Bing). A simple example would be when Google first entered it named its search engine “Guge” (Guge translates to valley song), which created an outrage among the internet users since the meaning did not sync well with the educated and affluent users of search engines. [iv] According to a poll conducted on Sina, 85 percent of respondents thought GuGe was a bad idea. A website named NoGuGe.com was even created to oppose the new Google name. [v]

Political advantage

The government of China also does not mind the dominance of Baidu and prefers a major search engine over a fragmented market, as long as the dominance is not harmful to the citizens. The main reason is that a major search engine can assist the Chinese government censor content and protect government’s interests. That is something that western internet companies like Google cannot guarantee because they are constantly under scrutiny from the US government. For example, Google had to testify in a congress hearing on its dealing with the Chinese government.[vi] This problem is not faced by Baidu since it is a Chinese company. Since its founding, Baidu is very respectful of the Chinses authorities and has always followed the Chinese government’s laws carefully. The top management of Baidu has many connections with the ruling part. For example, Robin Li was appointed to be part of the top political advisory body in China.[vii]

A brief story of Google’s entrance into China would highlight the political advantage that Baidu has within China. Most of the story can be found in the book In the Plex: how Google thinks, works, and shapes our lives. Before 2002, Google.com was accessible in China even though it did not have an office in China. The service has been used by educated Chinese citizens in order to find information outside of China. Without Google officially entering China, the market share of Google at that time was estimated to be around 25% of the whole search market. However, on September 3 2002, Google has been blocked in China for mysterious reasons and unblocked two weeks later. This was most likely a strategic move made by the Chinese government to control the western search engine.

After a few years, Google decided that it would enter China since having a division in China is better than not having any presence in China. Thus, on January 27 2006, Google.cn went online. The next few years were incredibly tough for the Chinese division of Google because of the constant intervention by the Chinese government. According to Google’s own blog, the Chinese government continuously slowed down and shut down Google. This was seen by the Google team as a way to give an advantage to the native search engine, Baidu. An excerpt of the blog is shown below.

“Within China, however, Google.com has proven to be both slow and unreliable. Indeed, Google’s users in China struggle with a service that is often unavailable. According to our measurements, Google.com appears to be unreachable around 10% of the time. Even when Chinese users can get to Google.com, the website is slow (sometimes painfully so, and nearly always slower than our local competitors), and sometimes produces results that, when clicked on, stall out the user’s browser. The net result is a bad user experience for those in China. The cause of the slowness and unreliability appears to be, in large measure, the extensive filtering performed by China’s licensed Internet Service Providers (ISPs).” [viii]

Finally, Google had enough of the Chinese government when it found our that the Chinese government has hacked its system and obtained the emails of Chinese dissidents. This prompted Google to stop censoring its search results and move its operations to Hong Kong. The official statement made by Google is shown below.

“We also made clear that these attacks and the surveillance they uncovered—combined with attempts over the last year to further limit free speech on the web in China including the persistent blocking of websites such as Facebook, Twitter, YouTube, Google Docs and Blogger—had led us to conclude that we could no longer continue censoring our results on Google.cn.

So earlier today we stopped censoring our search services—Google Search, Google News, and Google Images—on Google.cn. Users visiting Google.cn are now being redirected to Google.com.hk, where we are offering uncensored search in simplified Chinese, specifically designed for users in mainland China and delivered via our servers in Hong Kong.”

In summary, Baidu definitely had an advantage due to the Chinese government. In the words of Eric Schmidt, “The deck in China has been rigged in Robin Li’s favour in China. Every once in a while, a gift is handed to you. We handed one to Robin” [ix] The deck would continue be rigged against Western companies in China and would prevent any western search engine to dominate China.

Industry Trends

There are many industry trends that are incredibly compelling for the future of Baidu. Data from different sources suggest that the long-term consumer and advertising trends would likely continue in the 5-10 years and that Baidu will likely benefit immensely from the trends.

Long Term Consumers Trends

The internet penetration in China is at 50% which is low compared to other developed or developing countries (Brazil-58%, United States-87.4%, Russia-70.5%, Germany-86.2%). The penetration should increase further in the next decade as more Chinese citizens embrace the technology and lower tier cities adopt the internet. With more internet users, Baidu can attract more customers, thus earning more on advertising fees.

Chinese Internet Penetration Rate – Source: World Bank

Urban vs. Rural Internet Penetration – Source: China Internet Watch

The Chinese public is also spending more and more time online compared to other platforms. As more content become more available online, online will become more dominant in Chinse citizens’ lives. Thanks to the growth of the online platform, more queries would also be generated on Baidu. This trend should also continue further as online media becomes more popular.

Source: China Internet Watch

Another competing long term is that the GDP per capital of Chinese consumers is growing and the level of discretionary spending is also growing at a fast pace. This trend would create opportunities for a lot of companies like iQiyi as more consumers are more willing to pay for discretionary products and are willing to upgrade to more expensive services. Following this trend, advertisers in China would also spend more on advertising since their potential market of customers has expanded in size and spending.

Source: World Bank

Long Term Advertising Trends

The advertising trends in China is also incredibly competing. According to Hillhouse Capital’s data, online advertising spending in China would likely surpass TV advertising spending and the online advertising spending would be around 50% of the whole advertising spending, growing at around 20%+ a year.

Source: Hillhouse Capital

In addition, according to iResearch, the search engine advertising market share has historically been around 30% of the whole online advertising spending. Since Baidu represent 80%+ of the market, the Baidu’s revenue represents around 25% of online advertising and should grow in line with the rise of online advertising spending.

Source: iResearch

Therefore, all these long term trends have translated into more revenue and profit growth for Baidu in the past decade as shown below.

The number of marketing customers has grown at a CAGR of 47% and the average revenue per customer has grown at a CAGR of 40% for the last five years.

As the trends continue in the next few years, Baidu’s revenue should grow alongside of the online advertising industry, as more customers use its services and bid up the prices of its advertising properties on Baidu’s platform.

Subsidiaries

Apart from the search business and Ctrip, the rest of Baidu’s subsidiaries are high-growth money losing businesses. The other businesses are quite promising, but it is incredibly hard to evaluate if the subsidiaries will have as much success as Baidu has had with its search business.

Qunar – Ctrip

One of the most significant subsidiaries of Baidu was their stake in Qunar. Back in 2011, Baidu bought a majority stake (around 55%) of Qunar for a total of $306 million. The rationale behind the acquisition is that Baidu would be able to vertically integrate the monetization of travel search results. Before the acquisition, search inquires on Baidu would be directed onto other websites while the other websites would be able to monetize the travel inquiries. After the acquisition, Baidu can transfer/direct most of its queries to Qunar and benefit financially from the transfer of queries.

When Baidu first acquired a stake in Qunar, Qunar’s business model was very similar to Baidu’s business model since Qunar used to be a pure travel search website and Qunar used to generate most its revenue from pay-for-performance advertising. In the past few years, Qunar has expanded its business model with great success by acting at times as an agent for bookings and taking some inventories. This transformation in business model put Qunar and Ctrip head to head since Ctrip uses an agency business model as the main source of revenue.

Given that the online travel business has strong network effects, scale advantage and zero switch cost, a large market share would allow the largest player to dominate the market and earn high profits in the long run. With the long-term rewards in mind, Ctrip and Qunar competed furiously in undercutting the other in prices. The situation got to a point where both players were barely making any money (Ctrip was making around $58 million in 2015 while Qunar was losing $1 billion dollar).

On October 26 2015, Ctrip decided to throw in the towel and acquire Qunar, instead of dragging out a prologue fight with a probability of losing. Baidu announced that it has exchanged 178,702,519 Class A ordinary shares and 11,450,000 Class B ordinary shares of Qunar Cayman Islands Limited(“Qunar”) for 11,488,381 newly-issued ordinary shares of Ctrip. Because Baidu was the majority shareholder of Qunar, Qunar was essentially being bought by Ctrip. This transaction was a great for Baidu since Baidu now has a 25% stake in an online travel dominant player.

Going forward, Ctrip should be able to generate far more cashflow than before since they have acquired their main competitor. Ctrip will also have a new-found leverage, network and scale that they can use to dominate the whole online travel market and earn a high return in the long run.

Online Travel Agents Revenue Growth – Source: iResearch

Market Share Distribution in 2015 – Source: iResearch

iQiyi

iQiyi is currently the most popular online video provider in China with two revenue model. The first model is an advertising model like Youtube where the user watches an advertisement to watch a video. The second model is an subscription model like Netflix where VIP users pay a small fee (19.8 Yuan – $3) every month for premium video content. So far, iQiyi’s strategy is to invest massively into its premium content, attract as many paying subscribers as possible. The strategy has been quite successful judging from the numbers. iQiyi overtook Tencent Video and Youku recent as the longest time spent video platform; iQiyi also boasts of 20 million paying members on its platform at the beginning of 2016. [x] In addition, the premium content created by iQiyi and licenced by iQiyi has gained a lot of traction in China. For example, “Lao Jiu Men”, an iQiyi produced show, has more than 8 billion views.

It will be only a matter of time before iQiyi becomes profitable since iQiyi is currently more focused in investing heavily into content in order to hit a certain critical scale instead of focusing on the profitability. Once the critical scale is reached in the next few years, iQiyi should become profitable as long as content investment stays relatively constant. It is incredibly hard to predict the future cashflows and profitability of the company. It is however assuring that if iQiyi were to reduce some of its investments into content, it would be profitable. Looking at the 2015 numbers, if iQiyi only spent $100 million on content in 2015 instead of $500 million, it would have generated an operating profit of $100 million dollar. Thus, iQiyi can achieve profitability in the near future, but it would take some time before their platform reaches the desired scale and their content investments curb down.

Source: iResearch

O2O Bets

Just like Google, Baidu has decided to make several large bets to diversify its search engine business. The two big bets that Baidu decided to pursue were takeout delivery and group buying. Baidu expanded into the group buying service by purchasing 59% Nuomi from Renren in 2013 for $160 million and the remaining stake in 2014. Baidu expanded into food delivery by starting its own takeout delivery service. These two businesses have great synergy with Baidu’s search and map services since Baidu can direct food and product inquires to its platforms while Baidu Maps can optimize delivery paths. Although both services are growing at an incredibly fast pace, they are still burning a large amount of cash and will likely burn more cash in the near future. [xi] The O2O bets are beneficial to Baidu because Baidu will eventually terminate the bets if they are not successful. If the bets are successful, the two divisions may be worth a large portion of Baidu’s current market capitalization. Thus, these bets are definitely worthwhile, but only time can determine if the two businesses will succeed in the future.

Source: Analysys International

Others

The other divisions of Baidu are mostly existent for the purpose of reinforcing the core services and advertising revenue stream. For example, Baidu Maps is existent to reinforce the search services and increase the advertising revenue. Users may use Baidu Maps when they are looking for a location on Baidu. Marketing customers may also advertise their businesses on Baidu Maps when people are searching for a location. .

Although the other divisions of Baidu might not generate any significant amount of profits, they are still essentially to Baidu’s ecosystem and important to Baidu’s future endeavours. As an example, Baidu Maps was crucial in the Baidu’s O2O strategy and in the partnership with Uber.

Source: Baidu Investor Presentation – 2012

Recent Scandal and consequences

On April 12 2016, a student named Wei Zexi died of a rare form of caner, synovial sarcoma. Right before his death, he posted a post detailing his experience undergoing his cancer treatment. In the post, he sharply accused Baidu of advertising unproven treatments in its search results since the treatment that he received was not clinically proven. After Wei Zexi’s death, Baidu was flooded with public outrage and public discontent. The main concern on the mind of the Chinese public is Baidu’s lack of corporate responsibilities. From their perspective, Baidu would rather earn additional revenue instead of insuring the public’s best interest. [xii]

Right after the public scrutiny and the announcement of government investigation, Robin Li has called on employees to put values before profit in response. In a letter to employees, Baidu chief executive Robin Li wrote: “If we lose the support of users, we lose hold of our values, and Baidu will truly go bankrupt in just 30 days!” From that letter, the company has also announced the creation a veto group who can veto any unethical decisions and the creation of a 1 billion yuan fund to compensate users misled by paid ads [xiii]

As a resolution to the scandal, the government of China passed some advertising regulations on Baidu. From now on., Baidu has to clean up the healthcare advertisements in its search results, prevent medical institutions that had not been approved by the government from being promoted on Baidu, change Baidu’s search rankings so that credulity has a bigger weight than advertising fees and ensure that paid-for promotions do not consist of more than 30% of search results per page. [xiv]

Because of the new regulations and the temporary removal of unlicensed marketing customers, Baidu advertising revenue has decreased this year. In the third quarter, the online market advertising has decreased 6.7% compared to 2015’s third quarter. According to the third quarter earnings call, Robin Li said that the fourth quarter of 2016 should be the bottom of the decline since most marketing customers would have gotten the proper documentation to advertise online; the revenue from search should also recover in 2017.

By the share price of Baidu, it seems that there many facts that Mr. Market is forgetting or not considering some facts when it is valuating Baidu.

One fact that the market is forgetting is that the student’s death is not completely Baidu’s fault. Yes, the procedure advertised on Baidu is not clinically approved and is not a normal procedure. However, the survival rate of synovial sarcoma is around 50% to 60%.[xv] Thus, the fact that Wei Zexi died cannot be completely blamed on Baidu’s advertising.

The second fact that the market is forgetting is that this is the second that such incident has happened in the course of the Baidu’s history. Baidu was involved in a similar scandal in 2008. China Central Television (“CCTV”), the largest state-owned television network in China, reported in its program “News in 30 Minutes” that Baidu had been including websites of medical companies that do not hold proper licenses in its paid search listings for some popular medical terms, while excluding certain websites which did not buy keywords. Baidu resolved the incident by removing the unlicensed marketing customers from their platform. Eventually, Baidu allowed some customers to resume access to Baidu’s P4P paid search platform once their relevant licenses are provided to and reviewed by Baidu.[xvi]

After the 2008 incident, Baidu voluntarily created Phoenix Nest, which is algorithm that cleaned up most of Baidu’s advertising. In the words of the company, Phoenix Nest “is an enhanced algorithm that generates more relevant online marketing and provides customers with additional tools and information to help them better manage their spending and achieve higher ROI”. [xvii] In the end, the effects of the incident were short-lived and Baidu was able to recover quickly as shown below. The previous incident may indicate that the market is overexaggerating the impact of the current scandal.

The third fact that the market is forgetting is that the new regulations may actually be better for the user experience and be better for Baidu in the long run. Having more relevant advertising and less advertising load is better for the user experience. Once the user experience has improved, more users would use the search platform and the platform will become sticker. Better advertising is also better for the advertising customers since their advertising will have a higher ROI. Google realizes this insight and insures that their advertising is always relevant to the user. This insight is shown in the book, How Google Works, Google ranks its results using relevance metrics and not only using monetization metrics for a better user experience because they believe the user experience is most important thing. A search engine with many users can eventually be monetized, but a search engine with no user cannot be monetized at all. The short-term monetization with misleading advertising can jeopardize the long-term sustainability of the search platform. Therefore, the new regulations may actually improve Baidu’s results in the long run although it is hard to observe the benefits of better advertising currently.

Finally, the Baidu platform is much more resilient than what the market is assuming. As shown below with the StatsCounter and in the appendix, the market share of Baidu has not decrease drastically and Chinese public is still using Baidu as their search engine.

Source: StatCounter

Management

Many of Baidu’s critics doubt that Baidu has good corporate governance, Robin Li’s commitments and Robin Li’s abilities to lead Baidu.

Firstly, I do agree that the corporate governance of Baidu is weaker than other tech companies. However, the structure will undergo many changes in the future. From the memo that Robin Li sent to the employees, an oversight committee will be established to monitor and veto the company’s actions.[xviii] This committee would prevent unethical incidents to reoccur in the future and would strengthen Baidu’s corporate governance.

Secondly, Robin Li is an incredibly competent and passionate CEO. Here is a man who was always on top of his class for computer science in China, had the luck and intellect to emigrate to US for his postgraduate degree, patented ranking data retrieval system called hyperlink analysis in 1996 before the Google was created and went back to China to initiate the search market in China. Each individual task listed above required a large amount of intellect, resiliency and competence that Robin still possesses to this day.

Thirdly, Robin Li is still incredibly committed to Baidu and passionate about his job. To this day, with more than $8 billion in net worth, Robin is still waking up every morning at 5am thinking about Baidu’s strategy and Baidu’s next move. He is still paranoid about his company that he founded years earlier and worried about Baidu’s role in the constant changing technology environment. [xix] In addition, Robin’s stake in the company has not changed since 2007; he still has more than 16% of the economic ownership and more than 50% of the voting right of the company. Baidu is Robin’s brain child and Robin will do his best to protect his brain child.

Baidu’s management is more shareholder friendly and more ethical than the market perceives. This is shown by the cancellation of the management buyout of iQiyi. Robin Li initially wanted to take iQiyi private and relist in China because iQiyi’s investment into content was a drag on the earnings of Baidu and relisting in China would give iQiyi more value. Since most sell side analyst use Baidu’s earnings to come up with a price on Baidu, Baidu’s shares have not moved much in the past few years as new ventures are eating into Baidu’s earnings. From Robin’s perspective, if he could take away iQiyi’s cash burn from Baidu’s financial statements, Baidu would be valued at a higher price by the market. However, the price that Robin offered was lower than the comparable prices that other video streaming platform were value, so Acacia Partners wrote a letter to Robin (shown in the appendix) and asked Robin to either to come up with a higher price or try to keep iQiyi within Baidu. After reviewing the letter, Robin listened to Acacia Partners and cancelled the management buyout. He could have easily gone through with the buyout given he had the majority voting right, but he instead listened to his shareholders. The ethical cancellation showed Robin’s shareholder friendly attitude and his willingness to listen to shareholders.

Finally, Robin Li sometimes very misunderstood because he is single mindedly focused. When Baidu was first founded, the internet portals were the hottest trend in tech. Many tech companies and tech entrepreneurs were focusing on creating a great internet portal. However, Robin firmly believed that time that search has the most potential since more people would eventually want to find information online. Therefore, he did not pay attention to the internet portal craze. Instead, he focused on creating the best search engine in China. This single-minded focus can be seen today by Baidu’s actions. Baidu is not pursuing the next hot venture, but is deliberately choosing few ventures that have synergies with their main search business. People search for travel deals – Qunar, for videos – iQiyi, for deals – Nuomi and for food takeout – Baidu Takeout. On a TV show, he said that he would let others pursue popular ventures while he would pursue ventures that he thinks are the most promising. [xx]The market seems to completely miss Robin’s vision since Robin has a hard time communicating his vision and is an inner score board type of person.

Capital Allocation

Baidu has a good track record of good capital allocation decisions.

From the inception to late 2000s, Baidu has mostly reinvested its capital into its search business which yielded very high returns. From my previous calculation, the return on capital of Baidu has been around 50% for the past years. Thus, most of the capital reinvested into Baidu have been growing at a rate of 50%.

Baidu’s acquisition strategy has also been very opportunistic. Baidu rarely make acquisitions, but when Baidu decides to acquire a company the acquisition has shown to be very accretive. For example, their acquisition of Qunar and iQiyi have been paying off nicely with IRR above 20% while their acquisition of 91 Wireless has propelled their mobile expansion.

In terms of return of capital, Baidu has never paid any dividends. However, for the first time in history, Baidu bought back $1 billion of its shares at around $164 last year. If my valuation was correct, under my base case, Baidu bought back its shares at around 30% discount to its intrinsic value.

Valuation

Here is my estimate for Baidu’s valuation using a multiple for the search engine and a sum of parts for the whole company.

Search Engine

To be conservative, the multiples ranging from 10 to 17 are used since Baidu’s search engine is a high quality business and should be worth more than 10x EBIT. Putting a multiple of 10x EBIT implies that an investor with an opportunity cost of 10% is assuming that Baidu Search’s cashflow stream will only be growing around 10% each year for the next 10 years. With advertising trends growing at around 20%+ a year, it is very likely that Baidu’s cashflow will grow at a much higher pace than 10% a year for the next decade.

In addition, compared to other search engines, the multiples do not look unreasonable. Using the comparables, Baidu should be worth much more than 15x EBIT.

Source: Used company data and some assumptions to arrive at the multiple and the growth

Ctrip Stake

Baidu’s stake in Ctrip can be calculated using the share price of Ctrip. In the SOTP, the assumed share price of Ctrip is $42. The proportional Ctrip shares can always be shorted and separated from Baidu’s valuation.

Didi Stake

Baidu has a 2.3% stake in Didi. Given the merged company will be worth around $35 billion dollar, Baidu’s stake should be worth around $805 million.[xxi]

iQiyi

As the bear case, the takeover offer of $2.8 billion made by iQiyi’s management is used to value the iQiyi stake. As the base case, the comparable takeover offer of $4.8 billion for Yokou Tudou is used to value iQiyi. As the bull case, 86Research’s $5.8 billion valuation of iQyi is used to value iQiyi.

Baidu Takeout

Baidu Takeout Delivery was valued at $2.5 billion dollar in the last round of financing. [xxii]

Excess Capital

Baidu has an incredible amount of cash and short term securities on its balance sheet. Therefore, taking account the excess capital (cash+short term investments-debt) in SOTP would be reasonable.

Downside protection – Valuating Search Engine using conservative DCF

Baidu’s current valuation has a large downside protection. If the search engine is valued using a conservative DCF instead of a SOTP, the valuation would look like the chart below. The assumptions for the DCF would be that Baidu’s search engine would only have a lifespan of 10 years and would only grow at a clip between 12.5% to 20%.

Bull Case

Base Case

Bear Case

Risks

Replacement of search engines: All in one apps like WeChat may harm Baidu in the long run since people would not use Baidu’s search engine to search within WeChat.

Obsolescence of technology: Baidu’s technology may become obsolete and lose market share to its competitors.

One man risk: Robin Li is a crucial executive in Baidu. If something were to happen to him, Baidu may decrease in value.

Currency Risk: The Chinese currency may fluctuate. However, in the long run, these fluctuations should not matter.

Catalysts – Free options

Recovery from the scandal: At the end of 2017, Baidu’s revenue and share price should have recovered. New marketing customers and higher price for advertising should offset the loss of customers from tougher regulation.

AI Potential: Baidu is one of the first companies developing Artificial Intelligence technologies in China. The current successful utilization of AI (Artificial Intelligence) in language search and image recognition assures that Baidu will be in the lead in the development and monetization of AI. In the future, many new applications for AI will likely emerge and expand AI’s potential.

New Investments: Baidu will be start a $200 million venture capital unit that invests in early stage AI, AR and VR projects. Baidu is also establishing a $3 billion investment fund focused on mid and late stage deals in the internet sector. The investments could be beneficial for Baidu in the long run.

Self Driving Car: Baidu already has plans of a commercially viable vehicle by 2019 and a mass production driverless electric cars in five years. [xxiii] If Baidu can successfully build a car that can drive itself, it will be incredibly lucrative for the company. Assuming Baidu can sell 10,000,000 cars at around $30,000 each and assuming that Baidu has a 15% margin on the cars, the earnings from the autonomous cars would add up to Baidu’s current market capitalization.

Geographic Expansion: Baidu intends to expand into Europe where Google is under heavy governmental scrutiny and take market share from Google. This expansion may or may not be successful since Baidu tried to enter Japan in the past and failed.

Other Business Expansion: Baidu can expand into other fields using its currently available technology. For example, Baidu Maps has been critical for Baidu’s O2O business and could lead Baidu to other businesses.

Cut Costs: After reading many sell side analyst report, many analysts like to look at Baidu’s earnings. Thus, if Baidu slows down its expenditures on its investment in content and O2O, Baidu would have a higher earnings and a higher stock price.

Conclusion

At the current price, Mr. Market is underestimating Baidu’s worth. The market is valuing Baidu as a standalone low-growth search engine while Baidu is actually a high-growth search engine with multiple valuable subsidiaries. The market should reflect Baidu’s true value in a few years (most likely by the end of 2017) as revenue and brand image recover from the scandal.

Disclosures

The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written permission.

The author owns shares of Baidu and may decide to buy or sell without notice.

The author is not receiving compensation for the report. The author has no business relationship with any company whose stock is mentioned in this report.

Appendix

Desktop Search Market Share since 2012 (Stat Counter)

Mobile Search Market Share since 2012 (Stat Counter)

Letter from Acacia Partners to Robin Li:

July 18, 2016

Dear Robin,

We write as shareholders of Baidu since September 2012; we presently own more than 2.6 million shares of the Baidu ADRs worth over $400 million. The holding period of our investments typically exceeds seven years, and we hope to be shareholders of Baidu for far longer, as we have long admired your management of the business from a startup to a market leader.

One of your early board members told us that “Robin loves the company like his own child.” And indeed, for the nearly eleven years Baidu has been listed, we have watched you nurture Baidu with the same care, love and integrity with which we would all aspire to raise our own children.

That sense of nurturing therefore leaves us surprised and puzzled by your bid to privatize and purchase Baidu’s online video subsidiary, iQiyi.

We strongly believe that the purchase by you of iQiyi is against the best long-term interest of Baidu and its shareholders, for the following reasons:

We are convinced that the short-term improvement to Baidu’s earnings produced by iQiyi’s sale to you is trivial compared to the potential long-term value created for Baidu shareholders of owning iQiyi within Baidu. We believe the price you have offered for iQiyi is far too low. We are concerned that Baidu’s huge ramp-up in investment in iQiyi this past quarter is tantamount to a big donation by Baidu shareholders to future iQiyi shareholders (including you and your partners in the bid).

We worry that embracing what is an inherent conflict of interest will lead to damage to the reputations of both you and Baidu. It is better for Baidu to be regarded as a key institution, not the extension of the pocketbook of one man.

As long-term investors, we fully grasp that smart, long-term CEOs with good operating skills and a sense of net present value can be frustrated by the stock market’s impatience for good results.

Baidu’s prior investments in desktop search, mobile search and online travel all demonstrate a long record of successful operations and patient investment, and we are therefore confident in iQiyi’s long-term promise as well.

As Baidu has itself said over the years of financing the iQiyi investment, iQiyi should be a valuable part of the Baidu ecosystem and an important contribution to Baidu’s value proposition to its users. The experience of Google and YouTube has taught us that the growth of online video advertising is making content and the ability to judge user intent more and more valuable and important.

The loss of iQiyi would deal a blow to Baidu’s ability to become a full-fledged ecosystem for its partners and users. Baidu has talked about continued close cooperation with iQiyi after privatization, but we see that as both operationally challenging and facing many potential long-term conflicts of interest.

Baidu has shared virtually no operating data on iQiyi, so it is difficult for investors such as us to value it and evaluate the merits of your bid. However, from analyzing publicly available information, we are disconcerted by the price you have offered.

Independent research group 86Research issued a report on May 2nd valuing iQiyi at $5.8 billion, more than twice the $2.8 billion valuation that you have put forth in your bid. iQiyi competitor Youku was acquired by Alibaba for $4.8 billion late last year. Third party data suggests that iQiyi leads Youku on a number of important metrics, while growing much faster. Therefore 86Research’s valuation appears directionally plausible to us.

Finally, we have been disturbed to observe what appears to be a huge ramp in investment in iQiyi last quarter. In the four quarters through March this year in which Baidu has disclosed the impact of iQiyi content investment on Baidu profitability, iQiyi investment has consumed 5.1%, 5.4%, 5.9% and then suddenly 8.7% of Baidu’s revenue.

That spike in investment could be perceived as a big donation by Baidu shareholders to future iQiyi shareholders. It is akin to an infusion of cash made after your purchase price had been determined but before the deal has been consummated. This strikes us as particularly disappointing, as Baidu shareholders will never see the benefits of this investment if you privatize our subsidiary.

To date, no one has explained why Baidu should sell iQiyi rather than keep it, or alternatively capitalize it separately and maintain a controlling stake, as Baidu did with Qunar and Baidu Takeout (Waimai). We believe that any of these five choices would be preferable to your proposal of buying iQiyi:

Baidu could keep iQiyi, with enhanced disclosure to ensure iQiyi is valued fairly. Baidu could directly finance iQiyi as it has Baidu Nuomi. Baidu could take iQiyi public via an IPO while maintaining a controlling stake as it did with Qunar. Baidu could spin off iQiyi to shareholders with some cash in it, and Baidu could maintain partial ownership in order to retain the valuable synergies between them. Baidu could do a rights issue permitting all Baidu shareholders—not just special ones—to have a chance to benefit from ownership in iQiyi on equal terms.

Any of these options would help capture the value of iQiyi while enhancing its financing flexibility, ensuring it remains part of the Baidu ecosystem and providing Baidu shareholders with maximum potential value. All of these options seem preferable for both Baidu shareholders and for the reputation of both the company and you personally. Could you please consider one of these options?

Short-term shareholders focused on earnings in the next few quarters may like the idea of reducing long- term investment in Baidu’s future and selling a very valuable asset at a low price.

As long-term owners of Baidu, we think selling iQiyi would be a grave mistake. Your offer to buy out iQiyi is rife with conflicts of interest that we believe in a few years will paint a picture of Baidu corporate governance that is much uglier than the current admiring and respectful view.

Should your buyout of iQiyi succeed for you financially, it is critical for you to understand that the price will not just be the $2.8 billion valuation you have offered for the video subsidiary, but also Baidu’s reputation for good corporate governance, and your personal reputation.

We believe this reputation is worth far more than $2.8 billion, and we hope that you do, too. Thus, we respectfully urge you to withdraw your bid for iQiyi, for the best interests of the company and the many shareholders who believe in you.

Many thanks for the opportunity to share our thoughts.

Sincerely Yours,

Acacia Partners and related Acacia entities

Segment Reporting (2013-2015)

[i] Lessons From China: The Evolution of The Globe’s Largest Search Engine; A Stanford speech in 2009

[ii] Google’s brand is worth $229 billion according 2016 Brandz Top Most Valuable Global Brands

[v] In the Plex. How Google thinks, works and shapes our lives.

[xv] Diagnosis and management of soft tissue sarcoma Author(s): Shiba Sinha and A Howard S Peach Source: BMJ: British Medical Journal, Vol. 342, No. 7789 (15 January 2011), pp. 157-162 Published by: BMJ