Baidu ( BIDU) failed to inspire investors with its first earnings report as a public company. While third-quarter net income and sales both rose more than 170% from a year ago, Baidu's expenses also ballooned, and gross margins fell from the previous quarter. Investors who drove up shares of China's largest search engine by as much as 354% after its Aug. 5 U.S. public offering took this as a bad sign and dumped the stock. Shares in Baidu, whose name is
derived from a Chinese poem , plunged 10% Thursday. "We think Baidu should be spending aggressively at this point both to grow fast and increase market and also to effectively compete with the U.S. and China heavyweights," said Safa Rashtchy, an analyst with Piper Jaffray who rates the shares underperform and doesn't own them, in a note to clients. "In short, this was a good performance, but this type of performance or better was expected of Baidu." Though Rashtchy and Goldman Sachs analyst Anthony Noto both say they remain bullish on the Chinese Internet market, they are less optimistic about Baidu's share price. "We have intentionally established aggressive estimates to make sure that we do not get caught in the 'stock is always expensive trap,'" wrote Noto, who maintained his rating of underperform/attractive on the stock, in a note to clients. "Even with this stance, the valuation is a stretch." Baidu currently trades at a premium to large-cap U.S. and Chinese Internet companies. Using a price-to-earnings multiple of 55 times Goldman's 2006 earnings per share estimate of 59 cents yields an "implied fair value" of around $37.50, according to Noto. On Thursday, the shares fell $7.69 to $73.36. Despite the disappointment over Baidu's performance, don't expect U.S. investors to give up on the China Internet market. Google ( GOOG) bought a stake in Baidu last year. Yahoo! ( YHOO) paid $1 billion for a 40% interest in Alibaba.com in August.
Market researcher IDC estimates that the number of Internet users in China will grow 13.5% between the end of 2004 and 2005, more than 10 times the 1.8% forecast for the U.S. It is the fastest-growing Internet market in the world, said Thomas Forte, an equity analyst with Morningstar in Chicago who doesn't recommend purchase of Baidu. "It is an incredible market, but it is extremely risky," said Forte in an interview. "Because of the large market opportunity that China represents, it's going to remain a hot sector." For Baidu, that means that it will face heightened competition from rivals including Google and Chinese firms such as Sina ( SINA) and Sohu.com ( SOHU), he said.