Bottom line: Baidu’s heavy spending on new businesses is rapidly eroding its profits, a strategy that looks acceptable over the short-term but should be abandoned within a year or two if it fails to produce results.
online search leader Baidu
I have to commend online search leader Baidu (Nasdaq: BIDU) for steadily maintaining strong revenue growth of 30 percent or more over the last few years, even as China’s overall economy has started to slow and the company faces growing challenges from new rivals. But that said, Baidu‘s costs seem to be rising even faster that its revenue, which has led to anemic profit growth in its latest quarterly results.
At the end of the day, investors should be most concerned about profits at any company, since a stock price is directly tied to the bottom line. But Baidu seems to be less interested these days in profits. The company is indeed facing many challenges, both to its core search business and also as it expands into new areas, which is driving the rising costs. But it also needs to learn to bring those costs under control, to roughly in line with revenue growth, or risk facing the wrath of investors.
Frustration with Baidu
Investors were clearly feeling some frustration with Baidu over its latest results, bidding down the stock by 4.2 percent during the latest trading session before the report came out, and then lopping off another 6.3 percent in after-hours trade after they saw the numbers. Of course it’s worth noting the initial sell-off was probably more tied to an earlier rout in China’s domestic stock markets, which tumbled more than 8 percent on the day. But the after-hours dip clearly reflected investor disappointment at the report.
In this case investors were clearly focused on the bottom line, which rose by an anemic 3.3 percent in the second quarter as Baidu’s profit grew just slightly to 3.66 billion yuan ($590 million). (company announcement; Chinese article) Investors had been expecting a much higher number, with a Bloomberg poll setting the average forecast at 3.9 billion yuan (English article)
The 3.3 percent profit rise was actually a slight improvement from the previous quarter, when Baidu’s bottom line posted a rare 3.4 percent decline. But both of those figures were well below 27 percent and 34 percent profit growth that Baidu posted in the previous 2 quarters before that, as heavy spending cut into its earnings.
Strong Revenue Growth
Baidu’s revenue growth actually looked relatively impressive in the latest quarter, jumping by 38 percent to 16.6 billion yuan, and forecast to grow by a similar amount in the current quarter. But the company’s costs grew by a much higher 55 percent, as Baidu spent heavily on new product development and also on building up its capabilities in the hotly contested emerging area of online-to-offline (O2O) products and services.
So should investors be worried about the spending binge? I’ve written about this topic before, specifically related to Baidu’s move into new product areas. After years of unsuccessfully trying to build new businesses organically, Baidu has recently found a better model of buying existing well-run companies, and then giving them access to its huge financial resources to help them grow quickly. That strategy has helped to fuel the rise of Baidu-controlled online travel site Qunar (Nasdaq: QUNR), as well as its fast-growing online video unit iQiyi.
I personally have no problem with this strategy of using a successful, profitable business to subsidize a money-losing one. But Baidu also needs to be careful to avoid prolonged spending wars with its equally wealthy rivals like Tencent (HKEx: 700) and Ctrip (Nasdaq: CTRP). At the end of the day, I would advise investors to give Baidu a bit more time to show its heavy spending on new businesses can produce positive results. But if those results fail to materialize within a year or two, we should reasonably expect to see Baidu try to bring its costs back under control to more appropriate levels.