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Tapping Growth, Minding Risks in China

Matthew Coffina, CFA
Dan Su, CFA

Matt Coffina: For Morningstar StockInvestor, I'm Matt Coffina.

I'm joined today by Dan Su, who is a senior equity analyst on our consumer team, and we're going to talk about the risks and opportunities of investing in China.

The company that I'm particularly interested in is Baidu, which we own in StockInvestor's real-money Hare portfolio.

Dan, thanks for joining me.

Dan Su: Thanks for having me, Matt.

Coffina: Maybe you could first just lay out the investment case for Baidu. Why has this company grown so quickly historically? Why you expect it to continue growing? And why you think it's cheap right now?

Su: So the growth story of Baidu is actually pretty straightforward. It has a strong search product, as well as a number of other online services that really cater to the relatively young entertainment-seeking Internet crowd in China. So Baidu has built itself into a major traffic hub for Internet users over the past 10 years, and basically monetized its popularity through search advertising along the way. Obviously, I'd mention that the explosive growth in the Internet population in China also helped Baidu.

Looking forward, I see a couple of secular tailwinds that should continue to benefit Baidu. Number one, the ad spend will continue to grow as the economy grows, and the ad budget is increasingly shifting to the online channels from offline--especially to search advertising, given the attractive marketing ROI. Baidu only serves about 2% of the small-business owners in China today, so we see plenty of growth opportunities ahead for the company.

The stock has been under pressure a little bit in the recent couple of months, given investor concerns about the mobile Internet. We agree that mobile monetization for Baidu is probably at an early stage, but we think investors have underestimated the strategic investments that Baidu has made in the recent three to four quarters in terms of Mobile Map, in terms of voice search, cloud computing, and content inventories for consumption on the mobile Internet that, in our view, has positioned the company really well for longer-term growth opportunities on the mobile Internet space.

The stock is cheap, trading at a 25% discount to our fair value estimate, which is at $125, and is trading at 16 times forward earnings, which we view as an attractive valuation for a quality growth story like Baidu.

Coffina: So there are risks that come with investing in emerging markets, and China in particular. Could you just highlight a few of those that U.S. investors might be less familiar with?

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Su: Number one I would mention is capital-allocation decisions. You tend to see a number of large state-owned Chinese companies that are traded in the U.S. Because of the state ownership, that creates an overhang that may prevent these companies from efficiently allocating capital that benefits minority shareholders. So that's something that investors should keep in mind.

And also, regulatory uncertainties. There are sectors that are tightly regulated by the government, so these sectors may be closed off for foreign investments or there is heavy government involvement in terms of setting the rules. So that's something investors should watch out for.

Accounting issues, obviously, are front and center for many of the investors looking to invest in emerging markets, China included. We see more accounting issues with smaller companies that started to trade after reverse mergers and things like that, and we've seen several examples of companies blowing up in the U.S. and in Canada in recent years that started to trade after these kind of transactions. So we'd say, look for companies that began to trade through a regular IPO and underwriting process, audited by the Big Four with no red flags, and operate a legitimate, preferably nationwide, operation in China and in other emerging markets with nationwide, well-known brands that even ordinary consumers are familiar with.

Last, but not least, I'd say currency exchange is something that investors should watch out for. Over the past seven to eight years, investors have seen a one-way 35% appreciation of the Chinese currency against the U.S. dollar. I would say it's probably prudent not to factor in any further significant upside from the currency appreciation. So that's something that investors should keep in mind when looking at Chinese equities.

Coffina: I want to talk a little bit more about the government. It was Google's concerns about censorship that caused it to exit mainland China in 2010, which really opened the door for Baidu to become the only dominant search engine. How do you see Baidu interacting with its regulators?

Su: I'd say that in general for the Internet sector in China, the government involvement is relatively small compared to some other sectors. So other than the requirement to censor some sensitive content as defined by the government, the Internet firms, including Baidu, have a lot of freedom in terms of running their own business.

What I wanted to highlight here is that, even before Google pulled out of China, Baidu was already the largest search engine in the country with revenue share twice that of Google, which we attributed mainly to its competitive advantages based on a good understanding of local users and clients, as well as extensive sales coverage.

So, in my view, as the firm continues to deliver useful products and services that connect to users and clients, Baidu--and for that matter all the other major Internet companies--does not really need special favor from the government in order to perform well. On the other hand, we've seen examples of Internet ventures in China that have strong government backing, but have not been particularly successful after several years of heavy investments.

Coffina: I'm not crazy about Baidu's variable interest entity structure. Can you explain briefly what this is and what Baidu does to protect its shareholders from conflicts of interest?

Su: The variable interest entity structure, or VIE, is a U.S. GAAP-compliant structure that allows foreign businesses to participate in the growth of regulated sectors in China, while complying with government laws and regulations.

So basically … through a series of contractual agreements, the structure can allow businesses that are incorporated outside of China to control the activities of the China-based VIEs without outright equity ownership, and entitle themselves to the bulk of economic returns of the VIE structure. In this way, the structure is set up to make sure that they comply with the FASB rules, so that these companies can consolidate the results of the VIEs in their SEC filings.

In my view, Baidu has done a pretty nice job setting out its VIE structure to help protect the shareholders of the ADR and making sure they can benefit from the economic profits of the VIE. So there are a couple of things that they've done. Number one, through contractual agreements in terms of licensing and technology consulting, the structure makes sure that the bulk of the economic profits of the VIE flows to the ADR, and through equity pledge and equity option purchase agreements, the listed company really tightly controls the equity stake of the VIE even without outright ownership. And through power of attorney agreements with the VIE, the listed Baidu basically controls the board decisions at the VIE level. So they are not going to really walk away from shareholders of the Baidu ADR.

Coffina: Lastly, similar to Facebook and Google in the U.S., Baidu has a dual share class structure that really concentrates voting power in the hands of the CEO, Robin Li. What's your impression of him?

Su: Robin Li has a solid technology background, I would say. He worked on search technology in the Silicon Valley before returning to China to found Baidu. He's very hands-on in terms of setting strategic and technology directions for the company, which we think is a good thing that should serve the firm well. Style-wise, he's very prudent and low key--not the flamboyant Internet venture founder that you typically see--and he's known as a very patient negotiator for strategic assets that Baidu has on its shopping list.

I'd say that Baidu management, and Robin Li in particular, was probably a little bit complacent after 2010, and probably did not fully anticipate how fast the mobile migration was taking place. That said, I'd give Robin Li and his management team credit for responding really quickly to the changes in the mobile Internet space and making strategic investments accordingly that really have positioned the firm well for long-term growth.

Coffina: Great. Thanks for joining me, Dan.

Su: Thanks.

Coffina: So, in conclusion, Baidu is a very rapidly growing company, making a lot of upfront investments in its future, particularly in terms of the transition to mobile advertising.

The stock looks very cheap, trading for about 16 times earnings, and the company has been growing somewhere in the neighborhood of 40% a year.

However, there are some risks that we need to get comfortable with, both specific to the company and that come with investing in China in particular.

For Morningstar StockInvestor, I'm Matt Coffina.