How long have you held the stock?
We initiated the position in February 2013. We have followed Baidu closely for many years but the opportunity to invest arose as investors had become increasingly worried about new competitors entering the market, as well as the shift occurring, as mobile search becomes more prevalent. This had resulted in the share price declining over 50% from its 2011 high of US$164.36. The Fund’s average entry price was US$93.99.
What do you like about it?
Baidu, China’s version of Google, commands a dominant position within the Chinese search market that is equal, if not stronger, than Google’s in the US. Management has consistently built upon their market position, which currently sits at 70%, after gaining the number one position back in 2010. This has resulted in a very strong margin and return profile for the business with ROE of around 50%. The profitability profile of the business has allowed management to reinvest into its search technologies and ensure its market leadership continues.
On top of its position in the traditional PC based search market, the business is also well positioned, as search traffic shifts to mobile devices. Agreements in place with many handset vendors will mean they are the default search provider on most handset.
How is it better than its competitors?
The dynamics of the Chinese search market have change dramatically over the last five years, with Google exiting the market in 2010. Prior to Google’s exit, Baidu was the number-two player, and was going head-to-head with a competitor that had a far greater capacity to reinvest in the quality of their search product, the driving force behind the user experience longer term. Upon Google’s exit, Baidu has taken over the mantle and now holds a similar position over peers. Baidu’s continued investment in the long tail key words is a significant barrier to entry in this business. Furthermore, competitors cannot simply use price to gain share given the auction model employed in the search model.
What do you like about its management?
Chairman and chief executive officer Robin Li is very much the driving force behind the business. Robin has been with the business from the very beginning, founding the company back in 2000. He has developed a strong track record over the last decade, from both an operational and managerial viewpoint. He has proven to be a very good allocator of capital, both organically and via acquisitions. Robin continues to hold a 16% economic interest in the business and is therefore aligning his interests with minority shareholders.
Where do you see the value?
We believe the concerns surrounding competition in the traditional PC search market are overdone. Globally, we have seen that traffic market share does not translate one for one with advertising market share. The market leader commands a stronger share of advertising dollars compared to their traffic share. As mobile continues to grow as a share of total search traffic, the competitive dynamics in traditional search will also become a diminishing factor. The shift away from traditional PC based search to mobile will have a negative impact on margins and returns, given the inferior economics of the mobile search model. However, the market’s expectations for margins have re-adjusted and now reflect more sustainable assumptions and, in all likelihood, may prove to be too pessimistic. With margin and earning expectations rebased, the market will again start to look at the structural growth that exists within the industry, where advertising spend has grown at 15% per annum over the past five years, and online is growing at a rate of three times faster than the market.
What is your target price on Baidu?
Given the business is currently going through a period of investment into the mobile platform, we look at it on a normalised earnings basis. Normalised earnings for 2015 should be RMB 600 per ADR (1 ADR = 10 shares). Factoring in the growth outlook for the industry longer term and the strong position of the business, we think 25 times is a fair multiple. On this basis, our target price is $US250 (currently trading around $US173).
At what point would you sell it?
The opportunity for share price appreciation in our eyes was twofold when purchasing the initial position. Firstly, there was the potential re-rating as the market become comfortable with the short-term factors impacting the share price (mentioned above). Secondly, the long-term opportunity to participate in the migration to online advertising continues to evolve from the current very low base within China. We would be a seller if the share price reached the mid $200 over the next 12-18 months.
How much has it added (subtracted) to your overall portfolio over the last 12 months?
The position has performed very well as it has easily beat expectations, thanks to progress in monetising mobile search and the market has again started to focus on the benefits of this longer term opportunity. The stock was a 5% position and has appreciated 75%, adding over 3.5 percentage points to performance.
Is it a liquid stock?
Yes, the stock is listed in the US and has a current market capitalisation of US$355 billion and the stock trades over US$500 million per day.
Kevin joined PM CAPITAL as an equities analyst in 2006 after graduating from the University of South Australia with a double degree Bachelor of Applied Finance and Bachelor of Business (Management). Since Joining PM CAPITAL Kevin’s primary responsibility has been analysing Asian equities under the direction of Paul Moore with the purpose of developing the firm’s coverage in the Asian Region. Kevin has also been responsible for managing the Emerging Asia Fund since its inception on July 1st 2008.
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