Baidu.com (BIDU)

Baidu, the most popular internet search engine in China, generates almost 100% of its revenue from online advertising. Like Google, Baidu displays advertising based on the keywords or phrases typed by users of its search engine. If the user then clicks on an advertising (a click-through), the advertiser pays Baidu an agreed-upon price per click. Site traffic drives click-throughs, which drive revenue.

According to research firm iResearch, Baidu held 63% of the Chinese search market share compared to Google's 26%, based on the number of uses in the second quarter of 2008. Baidu has managed to build its brand almost solely by word of mouth. Baidu has continually increased its share in China's search market through improving users search experience and developing products to cater to Chinese Internet users. The use of search engines is free and, we believe, habit-forming. We think users are unlikely to switch without some substantial functional improvement. Furthermore, Baidu has thousands of content partners, constituting the market's largest advertising network in China. Assuming that Baidu can maintain its search engine market share, growth in Internet advertising revenue will be driven by the pace of increases in the number of broadband users and online spending.

Of course, intense competition and regulatory changes could erode Baidu's competitive advantages. Chinese advertisers can choose other advertising networks, particularly those of Google, Alibaba (which is 40% owned by Yahoo), Sohu, and Tencent. Because Baidu searches are conducted mainly in Chinese, Google and Yahoo have the advantage of offering searches in other languages. Moreover, Internet portals attract millions of users by providing services in addition to search.

Baidu's financial results for the second quarter again exceeded the market consensus. With China's most popular search engine, Baidu has an advantage over rivals in China's fast-growing online advertising market. In addition, Baidu continues to expand its product lines to attract users and boost revenue. Although fierce competition from Google prevents Baidu from building a wide economic moat and Baidu's Japan expansion will continue to negatively affect its financial results, we think Baidu currently undervalued based on its growth prospects. Therefore, we are maintaining Buy recommendation for Baidu's stock.

Read full report on Baidu.com - ADR

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