INTERNET: Baidu Told to Clean Up Act, Investors Unfazed

Bottom line: Baidu’s shares could see more downside of 5-10 percent as a scandal involving its core search service plays out, but its dominant position means its business is unlikely to suffer a major longer term impact from the crisis.

Baidu ordered to clean up search results
Baidu ordered to clean up search results

It seems that I was wrong when I predicted that a scandal surrounding search leader Baidu (Nasdaq: BIDU) would quickly blow over and not much would change in the company’s misleading ways for displaying search results. The company is still at the center of major headlines In the second week since the scandal broke, this time getting ordered to change the way it displays search results.

That order was part of a broader set of government directives telling Baidu to change its ways, and other reports indicated the company has already taken down ads from thousands of medical companies. Such moves could theoretically have a major impact on Baidu’s lucrative search business, since hospitals, drug companies and medical device makers reportedly account for a very large part of its advertising revenue.

But contrary to what one might expect, Baidu’s stock fell only a relatively mild 2.6 percent in the latest trading session after the clean-up order was announced. What’s more, the stock is only down about 13 percent since the scandal first broke, with most of that coming on a single day after the news first jumped into the headlines.

We’ll return to the surprisingly muted stock reaction shortly and try to interpret what it reflects about investor sentiment. But first let’s review the case that has rocked China’s medical and advertising establishments for the last 2 weeks. That case involves 21-year-old student Wei Zexi, who got cancer and selected an unproven treatment for his disease based on a high ranking for a hospital in Baidu search results.

Wei later died of his illness, but not before complaining loudly about Baidu’s deceptive system that places companies high in its search results based on how much they pay, even though that fact is never clearly disclosed. Public outcry over the case has prompted the government to launch a number of investigations, and this new directive is the first result of those.

The directive was issued jointly by the Internet, commerce and health regulators, and orders Baidu to reform its current system that sells the best search result positions to the highest bidders using an online auction system. (English article; Chinese article) The directive further orders Baidu to remove all medical advertisers that don’t comply with government rules, and create a mechanism to protect consumers from advertisers making misleading claims.

Removing Rogue Advertisers

Other media reports say that Baidu has already removed more than 2,500 medical-related companies from its system as part of its own response to the crisis. (Chinese article) This particular crisis looks somewhat similar to one last year involving e-commerce leader Alibaba (NYSE; BABA), which got in a spat with the commerce regulator over the high volume of trafficking in pirated goods on its popular Taobao C2C online mall.

In both cases the allegations involved a core business for each company, even though the actual illegal activity was coming from third-party companies hosted on Alibaba and Baidu platforms. The earlier scandal ultimately saw Alibaba’s shares tank by about 20 percent in the month after the news broke, before finally stabilizing after investors realized the impact on its e-commerce business would be limited.

So if we take the Alibaba case as a benchmark, that would mean that Baidu shares may still have some more downside, perhaps as much as 5-10 percent, before they finally stabilize. In both the Alibaba and case and now with Baidu, the reality is that both companies are hugely influential in their respective spaces, controlling half of the market or more. That means online advertisers and e-commerce merchants have few similarly attractive alternatives, and thus are unlikely to abandon either company in big numbers.

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