How much is the dragon in the window?
China’s Internet search engine, Baidu.com, was created little more than a year after Google. In this case, professors Joseph Piotroski and George Foster (Stanford) look at Baidu’s strategy, particularly with regard to online advertising. The question posed by the case is that of the valuation of Baidu as it goes public in 2005
While pro-forma income statements, balance sheets, cash flow statements and other financial information provided in the exhibits enable students to propose valuations for the company, the actual text of the case (see reference below) is devoted to Baidu’s positioning in the Chinese advertising market and provides an inside look Baidu’s strategy as well as its competitors.
China’s advertising market
From 1995 to 2005 China’s advertising market grew at a faster rate than the Chinese economy: 17% (CAGR) as compared to 11% for Chinese GDP. Despite the growth, the potential remained great as the Chinese market at $10 billion had a ways to go before catching up to the American market ($178 billion).
Online advertising was a very recent but fast-growing segment in the market. In 2001 it had constituted less than 1% of the market but by 2005 had risen to close to 5% ($423 million). Paid search accounted for nearly a quarter of that market. In paid search, an advertiser pays for the placement of Web links in keyword search results. Internet search engines could use a fixed fee or a pay for performance (P4P) model. The P4P model was more popular as it offered greater transparency on return on advertising. The P4P fee brought together a price per click (PPC), a click-through rate (CTR) and search traffic (ST): P4P fee=PPC x CTR x ST.
Taking on international and domestic rivals
Baidu was founded by Robin Yanhong Li and Eric Yong Xu in early 2000, a little more than a year after Google. By 2005 it had become the top search engine in China by traffic as well as the leader in the paid search market. It had turned profitable in 2004 and revenues were estimated to grow six-fold from RMB 290 million (approximately $ 35 million) in 2005 to RMB 1870 million (over $220 million) in 2010.
Compared to its international competitors (Yahoo which allied itself with Alibaba in 2005, and Google), Baidu adopted a China-specific strategy. The founders developed products that were specific to the China market, as opposed to Google which modified global products to fit the Chinese audience. In particular, Baidu invested heavily in search technique R&D, collaborating with university scientists, to tackle the specific problems posed by Chinese language searches.
On top of that technological savvy, they displayed an eye for the specificities of the Chinese Internet market. Realizing that music stood out in China’s Internet space, they were the first to launch an MP3 search service. This offering led to a fourfold growth of search traffic in one year.
A second key component of Baidu’s strategy was to build its P4P revenue by tapping the huge market of Chinese SMEs (potentially 20 million customers). Rather than just sell directly to the advertisers, it built a multi-tiered network of distributors. This meant appointing an exclusive distributor to operate in a city or a region. These regionally-based distributors could offer services more relevant to a specific geography than could a national distributor. The distributors could use their local contacts and knowledge to build business. Furthermore, Baidu had to pay only 33% of its revenue to regional distributors whereas national distributors took 50%. Some 60 distributors and 360 sub-distributors thus generated about 60% of Baidu’s P4P revenue. By 2005, some 40,000 advertisers were availing themselves of Baidu’s P4P option.
To overtake its domestic rivals, Baidu’s strategy focused on search and technology R&D. The two main domestic portals Sina and Sohu had retreated from search after the bursting of the Internet bubble to focus on portal development. When portal development did not turn out as expected, they licensed search technologies from the likes of Google and Baidu. But users tended to prefer the originals and Sina and Sohu found themselves forced to develop, somewhat belatedly, in-house search technology.
The challenges
The case authors discuss some of the risks or challenges facing Baidu. Baidu’s P4P clients did not sign fixed-term contracts which entailed the risk of early exits. Baidu had also to confront a second challenge, click fraud (a search engine artificially generating clicks to increase its advertising revenue or a competitor artificially generating clicks to increase the advertiser’s costs). The deep pockets of some of its competitors constituted a third risk. Google in particular had been able to spend $750 million globally on capital expenditures in 2005 whereas Baidu’s Chinese capital expenditures had been only $10 million. On the other hand, Google had a tense relationship with the Chinese state, in particular over content filtering issues, and it was only in mid 2005 that the Chinese government allowed Google to establish a mainland office in China. Finally, the options of senior managers would be fully vested in 2007, creating the risk of management turnover.
Going public
For its IPO, Baidu had three logical possibilities. One was to stay at home with a listing on the Shaghai or Shenzen exchanges. But Baidu was registered in the Cayman Islands and therefore constituted, from a Chinese standpoint , a wholly foreign-owned company, making it ineligible for listing on a Chinese exchange. That left three other foreign candidates: Hong Kong, London and NASDAQ. Because NASDAQ had a strong technology association, greater security analyst coverage than London and Hong Kong, and finally a base of investors willing to take risks on young technology companies, Baidu opted for NASDAQ, filing its IPO in August 2005.
Having provided a detailed overview of the online advertising market in China, the authors invite their readers to embark on the valuation exercise. Multiple exhibits allow the users of the case to calculate values using the discounted cash flow (DCF) model, the economic profit (EVA) model and comparative multiple valuation model. Let the calculators hum – and then, as they say in Monte Carlo, rien ne va plus…
Reference:
ECCH: Stanford A-197
“Baidu.com, Inc.: Valuation at IPO”
Professor Joseph Piotroski (Stanford), Professor George Foster (Stanford), Jennie Tung, Sara Gaviser Leslie, Ning Jia (Tsinghua University), Martin Haemmig (CeTIM).
Published March 2010
