Investments in Mobile Weighed on First-Quarter Margins for Baidu; Shares Undervalued

Chinese search engine Baidu BIDU posted a 40% increase in first-quarter revenue that met our expectations, although margins came under pressure due to aggressive investments in mobile Internet. We believe these strategic investments behind product innovation, engineering talents, network infrastructure, and marketing campaigns are critical to fortifying Baidu’s competitiveness in the fastgrowing mobile Internet space over the longer term. We applaud management’s decision to accelerate spending to gain a lead in product offering and customer education, albeit at the expense of near-term profits.

We are sticking to our narrow moat rating for Baidu, but plan to reduce our fair value estimate to $125 per share (from $137) to account for a deeper margin contraction in 2013 and 2014 than what we had modeled. We still think the stock is undervalued, though, trading at 17 times our 2013 EPS and at a 33% discount to our lowered fair value estimate. The next few quarters may continue to be choppy, as Baidu remains in investment mode and cautiously experiments with monetization options. That said, for investors looking for quality long-term growth stories in the emerging markets, Baidu’s shares offer a good value at the current price.

The 40% year-over-year revenue increase was driven by a 28% expansion in the active customer base (to 410,000) and a 9% increase in average spending per customer. Both trends look healthy and are consistent with our view that Baidu should focus on recruiting more small advertising clients (especially in lower-tiered cities) to fuel top growth, which we view as a more sustainable strategy.

The mobile internet is clearly the priority for Baidu. The firm is investing heavily in strategic areas such as cloud computing, voice search, map and in popular verticals (travel, local services, video). Research spending grew by 83% due to new engineering hires, and marketing expenses were up 77% due to customer education and promotional events to drive mobile app installation. The consolidation of loss-making video business iqiyi in the March quarter was another drag on margins. Operating margins contracted by 1200 basis points to 37% in the quarter, and we expect expense growth to outpace that of revenue for the rest of 2013.

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