Baidu (NASDAQ:BIDU), the ascendant China stock that dominates the Internet in its home country, has been considered bulletproof for a while. It is light years ahead of competitors in market share, BIDU stock is up 49% year-to-date as of the opening bell and at the end of July it posted earnings that nearly doubled the previous year’s numbers.
However, an ugly black storm cloud is on the horizon right now that could wash away much of Baidu’s success. The problem: a highly critical report a few weeks ago from China’s state-run media that criticizes phony search results and advertising practices.
In the People’s Republic, falling out of favor with the government can be the kiss of death for a business, no matter how dominant. So what’s next for Baidu? Is it time to sell BIDU stock?
First, let’s recap the details: In early August, China’s state broadcaster known as CCTV ran a series of reports accusing Baidu of improperly promoting paid search results as well as failing to be transparent with its advertisers. CCTV is very much a government mouthpiece, and frequently influences both political and corporate policies.
But lest you think the government is putting a hit on Baidu without cause, reports indicate that CCTV might have grounds for its criticism. One of the reports includes an undercover reporter posing as an advertiser for a fraudulent weight loss products company, striking a deal with Baidu workers to rank at the top of Baidu’s search results for a fee. Another report accused BIDU of failing to honestly rank results — forgoing complicated algorithms based on popularity and trustworthiness like Google (NASDAQ:GOOG) in favor of simply ranking the best advertisers at the top. There are even instances where legitimate companies were not ranked No. 1 for the actual name of their business or their product, and those terms were instead granted to other paid advertisers.
This is serious business. In 2008, CCTV reported on Baidu search results from fraudulent advertisers. The state-run broadcaster also claimed in 2008 that Baidu was doing a poor job distinguishing from “organic” search results, or web pages people might actually be looking for, from paid advertisements that are also served up based on relevant web searches. The claims resulted in an apology from the company and a massive overhaul of Baidu operations.
The million-dollar question, of course, is what’s next for BIDU stock. In the past 30 days, shares of Baidu have slid almost 9% as opposed to the nearly 5% decline for the broader market. However, longer term the stock is hardly suffering. Shares are up 49% year-to-date in 2011, and almost 250% since Jan. 1, 2010.
What’s more, a spring report pegs Baidu’s market share at nearly 84% — so it’s not like a small defection of users is going to sink the company any time soon. July earnings were simply stunning, with net income rising to $252.6 million or 72 cents per share, a 95% jump from 35 cents a year earlier. Revenues also rose 78.4% to $528.4 million from 2010 numbers.
Most importantly, everyone should acknowledge that even the vaunted search giant Google faces similar complaints about paid search results, fraudulent clicks and other troubles. The Internet is not squeaky clean anywhere, and naturally there will be some ne’er-do-wells who game the system. Baidu is at the top of the food chain in China, and thus faces the same criticisms some Google users levy against the U.S. Internet company. This, despite Google’s motto “don’t be evil.”
There are indeed threats to this strong growth in the wake of the report. After the 2008 report, Baidu had to suspend its highly lucrative “medical” advertising until it could create safeguards to prevent fraudulent companies from sneaking into its search results. Another moratorium could impact the bottom line. What’s more, the CCTV report could anger companies who have been paying for honest ads on Baidu that have been undercut by shady advertising practices. The result could mean a reduction in cost-per-click rates to make amends to these legitimate businesses, which could also hurt Baidu’s revenue.
And of course, new laws and regulations could be coming down the pike soon after this state media report.
Baidu is indeed dominant in China, and that probably will not change anytime soon. Even if all these negative impacts come to pass, it is unlikely a start-up or Western competitor like Google will significantly undercut BIDU.
But investors should take note and be wary. In 2008, the Dow Jones lost about 35% thanks to the financial crisis — but Baidu lost almost twice that, in large part because of the previous critical report by CCTV.
Jeff Reeves is editor of InvestorPlace.com. As of this writing, he did not own a position in any of the stocks named here. Follow him on Twitter via @JeffReevesIP and become a fan of InvestorPlace on Facebook.
