One need look no further than Google (NASDAQ:GOOG) to see the kind of revenue that Internet search is capable of generating. Despite dabbling in everything from tablets to streaming video, operating systems, mobile phones and even incomprehensible spherical home entertainment units, Google still gets over 95% of its revenue from advertising — over $36 billion in 2011 — and that advertising is directly tied to its search engine.
This primer in the importance of search engines is in honor of two companies you might never have heard of: Baidu Inc. (NASDAQ:BIDU), and smaller Qihoo 360 Technology (NYSE:QIHU). Baidu and Qihoo are currently battling over Internet search in China, a market that dwarfs the U.S., even though it is still in an early growth phase.
China vs. U.S. Internet Use
For Americans, who average roughly 20 hours per week online, the Internet is something that’s taken for granted as a basic right. More than 80% of U.S. homes have broadband Internet, there are more mobile phones (a majority of those web-capable smartphones) than there are people, most major metropolitan areas now have access to 4G, high-speed wireless and our biggest gripe is download caps.
In China, it’s a very different story. It’s difficult to accurately measure Internet access in terms of home use, but it remains a fraction of U.S. numbers. However, many Chinese Internet users access the web via Internet cafes, work computers and smartphones. With China’s huge population, the sheer numbers are staggering (despite much lower overall penetration): as many as 485 million people online, with 318 million of these accessing the web via their mobile phones.
On the political side, the Chinese government remains strict in terms of control of what it deems to be sensitive information online — to that end, Twitter, for example, is blocked in that country.
Despite the technical and political challenges, Chinese Internet users are right behind their American counterparts, spending nearly 19 hours per week online. Baidu and Qihoo are two of the country’s better-known Internet names. Here’s a quick look at each:
Baidu: Sometimes referred to as “the Chinese Google,” Baidu also generates the majority of its revenues from online ads. In its most recent quarter, Baidu reported revenue of $860 million (up 60% year-over-year) and a 50% profit increase to $442 million. Those are nowhere near Google numbers, but considering that Baidu serves primarily the Chinese market (while Google is used globally), they’re pretty good.
Qihoo: Describing itself as an “Internet platform company,” Qihoo claims 411 million monthly users for whom it provides mobile and PC-based security, web access and an app store. The company makes most of its money through online advertising, which made the recent announcement that it was launching its own search engine and making that the default choice for its users — hardly surprising. Although Qihoo’s revenues doubled to $72.8 million in the most recent quarter, its profits were down to $7 million, with much of the nearly 40% decline attributable to costs associated with the search engine launch. While Qihoo wasn’t on the radar for Chinese search in 2011, with more than 400 million monthly users logging on and finding its new search engine as the default, the company is poised to significantly grow that ad revenue. Or it would, if not for …
The Potential Lawsuit
Word on the street has Baidu looking at the possibility of seeking legal action against Qihoo. There are indications Baidu is losing traffic to Qihoo’s new browser — which means Qihoo could be scooping up ad revenue not just from Google, but from Baidu as well — while positioning itself as a solid No. 2 choice for Chinese web users, behind Baidu.
The basis of any legal action looks to be based on the “mechanics” of Qihoo’s search engine, which means we might see a claim about proprietary technology or source code being infringed upon. While China has long been accused of being a hotspot for IP theft and piracy, the government recently launched a program designed to crack down on intellectual property violations, so any legal action could have teeth.
Waiting in the Wings
Of course, it would be unlikely in a market the size of China’s that Baidu (and now Qihoo) would have things all to themselves. There are other search engines, although they compete for a very small fraction of the market (combining for under 5% of Chinese search engine revenue). Among these niche operators are Soso, Youdau and Sohu’s (NASDAQ:SOHU) Sogou, the biggest player among this lower-tier of search engines, with roughly 2.4% of the market.
Emerging vs. Mature
Google’s home market — the U.S. — is a mature one when it comes to Internet use. Almost all homes have Internet access of some description, so growth in search revenue is expected to be organic, increasing slowly with population growth and more time spent online. The same holds true for much of its international market as well.
China, on the other hand, has an estimated 815 million people who currently lack Internet access. As this remaining population gains Internet access — and it will — the potential online ad market in China could explode.
And while Baidu has positioned itself to take full advantage of this rapid growth, it suddenly finds that it no longer has the market to itself. The battle for search customers and online ad revenue between Baidu and Qihoo is just beginning, but the stakes are more than 1 billion Internet users (today there are roughly 2.3 billion Internet users worldwide). A company that can sew up this huge surge of new online visitors through its search engine stands to rake in ad revenue and truly become the “Google of China.”
At the moment, Baidu looks likely to remain on top, but will see its search share cut by Qihoo (unless it can stop it through legal action). According to a Globe & Mail story, in its first week of operation, Qihoo’s search engine cost Baidu between 4 and 8 percentage points of share — a number that could rise to between 15% and 18% later this year.
As a result, Germany’s Deutsche Bank dropped its target for Baidu from $186 to $137. Qihoo shares are up nearly 60% in the past month, and the company has said revenue for the third quarter may hit $82 million, which would be growth of 70%. A surge in one of the other, smaller players (such as Sogou) also is possible, although less likely.
BIDU’s trailing P/E of 30, while expensive, still is half that of QIHU’s, and Baidu seems unlikely to be pushed from the top. Although both companies will see a big boost from growing Chinese Internet use, Baidu — the one that looks to get the lion’s share and become China’s Google to Qihoo’s Yahoo (NASDAQ:YHOO) — is the one I’d stick with.
As of this writing, Brad Moon did not hold a position in any of the aforementioned securities.