Baidu Breaks Out…to the Downside

06/25/2012 4:56 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Competition in the internet search industry in China has soured one of the more reliable trading ranges of recent years, writes MoneyShow’s Jim Jubak, also of Jubak’s Picks.

I hate it when fundamentals mess up a good swing trade. Unfortunately, that’s just what has happened recently with shares of Baidu (BIDU).

Earlier in 2012, you could have made good, and relatively low-risk, money by buying the shares whenever they fell near $115 and selling when they went over $135. Over and over again.

But I wouldn’t advise this trade now, because the fundamentals of Baidu and the rest of China’s Internet sector have changed—for the worse in the short term.

Because of increased competition in the relatively new mobile space, China’s Internet leaders are waging an expensive war for market share. That’s likely to push the shares of Baidu and competitors such as Tencent Holdings (TCEHY) lower as costs rise and earnings growth slows.

Although Baidu owns about 80% of the Chinese Internet search market, it has only a 34% share of the search market for mobile devices. Shenzhen Easou Technology’s Easou search engine has 22% of the mobile search market. (Easou, started in 2005, was China’s first mobile search engine.) Tencent Holdings’ SoSo service is just behind at 21%. (Then there’s Google (GOOG), at 11%).

Baidu’s mobile traffic grew by 20% in the first quarter of 2012 (up from 15% growth in the fourth quarter), but mobile search still amounted to less than 1% of Baidu’s revenue

To increase its share of mobile traffic and its mobile search revenue, Baidu is spending to launch new handset models with pre-installed Baidu apps in cooperation with such manufacturers as Changhong and ZTE (and Apple (AAPL)). The phones come with 100GB of free cloud storage, and sell—in the case of the Baidu Changhong model—at just 899 yuan ($130), versus, say, 1,300 yuan for Shanda’s Bambook.

But building out the cloud computing infrastructure to support those phones (and other parts of Baidu’s strategy) requires capital spending that cuts into operating margins and earnings.

I expect the company’s investments in mobile search to pay off in the future. But at the moment, since keyword ad prices are lower on mobile search, and since ad click-through is lower, investments in mobile search are cutting the company’s profit margin.

On April 25, Credit Suisse lowered its estimate for 2012 earnings per share by 2%, and cut its target price for the New York-traded ADRs to $127.50 from $141.70. Goldman Sachs joined in on June 15, cutting its earnings estimates by 3% to 8% and lowering its target price to $135 from $160.

In recent weeks, the ADRs look like they’ve been trying to carve out a new range from lows of $113 or so on June 1 to highs of $122 to $123 on May 25 and June 7. I don’t think that’s a wide enough range to make this an attractive swing trade, especially with the current uncertainty on China’s growth rate.

My suggestion is to take this one off your list of swing trades, and wait for a stock market willing to look past temporary uncertainties and reward the company’s long-term advantages.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Polypore International as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio here.

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