Baidu Inc (ADR) (NASDAQ:BIDU) stock is down 11.5% this year, as a scandal forced it to reevaluate its advertising practices. Recently, it announced third-quarter results. Revenue fell, but this was expected, and CEO Robin Li said that customer quality improved. Profits increased. In some areas, BIDU stock looks strong, but it also faces vulnerabilities. That brings us to the question: Should you buy Baidu stock?
With that as a backdrop, the following are three pros and three cons to owning shares of BIDU.
Three Pros to Baidu Stock
Baidu Stock Pro No. 1: Leading Search Engine in China
Google is talking about re-entering China, but this involves its Google Play store, not the search engine itself. If Google wanted to bring its search engine back into China, it would have to comply with the Chinese Communist Party’s rules on censorship.
Baidu dwarfs its biggest local competitors, such as Qihoo 360 and Sogou.com, which is owned by Sohu.com Inc (NASDAQ:SOHU). And barriers to entry in the search business are relatively high, since new entrants would lack the necessary user data.
Baidu Stock Pro No. 2: Dominant Mapping Service in China
Baidu enjoys a 70% market share in mapping inside China, with 300 million monthly active users. Here, BIDU stock once again benefits from Google’s absence in China: the Great Firewall blocks Google Maps. Uber China (now part of Didi Chuxing) partnered with Baidu Maps.
BIDU’s expertise with mapping will help it capitalize on self-driving cars. This is particularly important as China is the world’s largest car market. Both Chinese and foreign automakers will need software for driverless cars, which Baidu will develop. BYD (OTCMKTS:BYDDF), a major Chinese electric vehicle producer, uses BIDU’s AutoBrain on its vehicles. Baidu is more familiar with China’s roads than Google, and this gives it an advantage.
Baidu Stock Pro No. 3: Core Business Is Very Profitable
The lack of competition in China’s search market allows BIDU to enjoy high margins. In 2015, Baidu enjoyed a net profit margin of 50.71%. BIDU’s margins fell in 2013 and 2014, but rose again in 2015. The margin has held steady despite Baidu growing revenues by more than a factor of four.
And there is room for search to grow. According to an estimate by Internet Live Stats, only 52.2% of the population in China were Internet users in 2016.
Three Cons to Baidu Stock
Baidu Stock Con No. 1: Risks of Doing Business in China
Investors should not look at individual stocks without considering the macro picture, including the political context. Chinese stocks may trade at a discount to their American counterparts, but this is not without reason. Investing in China involves a degree of political risk that you would not encounter in Canada or Singapore.
In China, the rule of law lacks firmness. The Chinese Communist Party rules China, and the law is simply that which pleases the Party. This makes things unpredictable, which Baidu acknowledged in its 2015 annual report: “There are substantial uncertainties regarding the interpretation and application of PRC laws and regulations, including, but not limited to, the laws and regulations governing our business.”
Like Alibaba Group Holding Ltd (NYSE:BABA) and other Chinese internet stocks, BIDU is a variable interest entity. As explained here, Chinese law forbids foreign ownership in certain industries, so the VIE structure is created to get around this. A holding company in a tax haven such as the Cayman Islands is created, and Baidu contracts a share of its profits to this entity. So BIDU stock investors don’t actually own “Baidu” itself, but rather shares of this holding company.
This leads to two problems.
First, if BIDU’s management took actions that were against the interests of shareholders, its only recourse would be to the Chinese government. Would China side with foreign investors against the Chinese management?
Second, the official stance on the VIE structure remains unclear. The Chinese government could potentially rule it illegal.
Finally, a BIDU vice president known as the “Prince of Baidu” resigned last week after admitting improper dealings with a BIDU takeover target.
Baidu Stock Con No. 2: Dependence on Search and Ad Revenue
In an unpredictable world, having a diversified revenue stream is key. However, BIDU derives an estimated 96% of its revenue from advertising. Alibaba only derives 59% of revenue from ads. Tencent (OTCMKTS:TCEHY) gets revenue from multiple sources, including gaming, social networks and e-commerce.
After a Chinese student died in May from undergoing treatment advertised on Baidu, the Chinese government tightened regulations on medical advertising. This led to a decline in ad revenue for Baidu in the third quarter, the first decline in BIDU’s history. BIDU also advertises financial products, and BIDU could face a similar backlash if problems result. Furthermore, Ad revenue may move from search results to social networks such as Tencent’s WeChat.
In 2015, the last full year available, Baidu earned 83% of revenue from search. Again, this is risky, particularly since search is changing. In the future, users will rely more on virtual assistants such as Alexa, which don’t display ads.
This threatens search engines like Baidu and Google and as an article on Fox Business points out: “The question is, what happens to that revenue stream when today’s text-based search becomes subsumed under voice-based Smart Search queries? What happens to the ads? That’s right, they disappear, along with the text.”
Baidu Stock Con No. 3: Diversifying Would Lower Margins
But if Baidu did diversify into other areas, this would result in lower margins. Other markets, such as video streaming and online-to-offline services are much more competitive than search.
Players in China’s streaming space include Baidu’s iQiyi, Alibaba’s Youku-Tudou, LeTV and Tencent. Similar to the U.S. with Netflix, Inc. (NASDAQ:NFLX), video streaming is not very profitable in China, and providers must spend a lot on content. Competition will keep content prices high and margins low. The same is true for online-to-offline services that connect app users to stores.
Bottom Line on BIDU Stock
With the election of Donald Trump, it looks like volatility will go through the roof. Investors will reappraise market risks. Money will probably flow to defensive stocks, such as Procter & Gamble Co (NYSE:PG) and gold. Baidu stock isn’t as richly valued as Netflix, but as a high-beta stock there is certainly some downside.
Now is not the time to buy BIDU stock.
As of writing, Lucas Hahn did not hold a position in any of the aforementioned securities.