Baidu Stock Needs to Prove It’s Undervalued –

Chinese digital search giant Baidu (NASDAQ:BIDU) — often hailed as the Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL) of China given its leadership position in China’s digital ad search, artificial intelligence and self-driving markets — used to be one of Wall Street’s favorite Chinese tech stocks. That was back in late 2017, when Baidu was firing off 30%-plus revenue growth rates alongside robustly expanding margins. At that time, BIDU stock was at nearly $300.

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Looking back, that seems like eons ago.

Today, Baidu couldn’t look more different. Revenue growth rates have decelerated from 30%-plus, to near zero, as China’s digital ad market has slowed and competition in that market has intensified. Once robustly expanding margins have turned into rapidly compressing margins, as Baidu is being forced to spend more to compete for ad dollars in a crowded landscape. Profits have been wiped out.

So has BIDU stock. Once up near $300, shares today swap hands narrowly above $100.

Zooming out, the most realistic path forward here is for Baidu’s revenue growth trajectory to rebound, margins to normalize and profits to come roaring back. Assuming that happens, then Baidu stock is woefully undervalued at current levels.

But, before BIDU stock rebounds, the numbers need to prove that this is the most realistic path forward. That is, Baidu’s revenue growth rates need to actually improve. Margins need to actually rebound. Profits need to actually grow. Until those things happen, it won’t matter how cheap BIDU stock gets — it won’t bounce back.

The investment implication? Be patient. Wait for the trends to reverse course here. Once they do, buy the dip. Until then, remain sidelined.

Big Picture Remains Favorable for Baidu Stock

Taking a step back, the big-picture fundamentals supporting Baidu stock remain favorable and support the notion that shares are undervalued at current levels.

China’s digital ad market has slowed dramatically over the past few quarters thanks to a broader slowdown across the entire Chinese economy. This is entirely a byproduct of escalating U.S.-China trade tensions. But, this trade war is temporary. Eventually, it will pass. Once it does, China’s economy will get back into steady growth mode, especially the digital economy.

As the digital economy gets back into steady growth mode, the digital ad market — which is a primary component of the digital economy — will similarly get back into steady growth mode. Sure, growth will slow going forward thanks to market saturation. Baidu’s share of the market will continue to drop, too, thanks to rising competition. But, market growth will remain largely above 8% for the next several years, and Baidu will forever remain an important part of the ad ecosystem because search is the backbone of the internet.

Further, Baidu will start to see meaningful revenue contributions from its cloud, AI, smart home and self-driving businesses over the next few years. Those businesses will add firepower to Baidu’s overall revenue growth trajectory. At the same time, renewed revenue growth will help offset spending growth. Margins should rebound.

Baidu projects as a double-digit revenue grower over the next few years, with upside margin drivers. And that combination makes me believe that $15 in earnings per share is doable by fiscal 2025. Based on a market-average 16-times forward earnings multiple and an annual 10% discount rate, that equates to a 2019 price target for BIDU stock of about $150.

Wait for Trends to Improve

To be clear, $150 is 50% higher than $100, so BIDU stock is woefully undervalued at current levels. But, the stock has been persistently undervalued for a long time now, and despite this undervaluation, the stock has simply continued to trend lower.

Why? Because the undervaluation thesis on Baidu stock rests on the idea that revenue and margin trends will reverse course. If they don’t, then BIDU stock isn’t all that cheap. Earnings this year are expected to come in around $4.50 per share. If revenues and margins keep dropping into next year, then 2020 EPS could look something like $4. Baidu stock is a $110 stock. That’s an implied forward earnings multiple of 27.5 — which is not cheap.

Thus, until the revenue and margin trends reverse course, BIDU stock won’t rebound.

Fortunately, it looks like those trends could rebound soon. U.S and China trade tensions are deescalating. Continued deescalation there should provide a nice boost to an already stabilizing and rebounding Chinese economy. As China’s economy continues to rebound, the digital ad market will get back on solid footing. Baidu’s growth rates will improve, which will help offset spending growth, and margins should improve.

As such, the trends should reverse course soon. But it’s best to wait for confirmation of this reversal before buying the dip in BIDU stock.

Bottom Line on BIDU Stock

Baidu stock has been beaten up to deeply undervalued levels. But, shares won’t rebound until currently depressed revenue and margin trends reverse course. This reversal could happen soon, with U.S.-China trade tensions deescalating. If it does happen, then BIDU stock will fly higher.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities. 

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