Is Baidu the Next Enron?

With shares of Baidu (NASDAQ:BIDU) trading at around $111.66, is BIDU an OUTPERFORM, WAIT AND SEE or STAY AWAY? Let’s analyze the stock with the relevant sections of our CHEAT SHEET investing framework:

C = Catalyst for the Stock’s Movement

If you’re long Baidu, then the title may have already angered you. The results found here were based on research, and this is simply passing along information that might be valuable to the reader. I dug deeper than usual because the numbers seemed unrealistic.

During my research, there was one thing that stood out to me more than anything else. When Enron was on top of the world, Wall Street firms referred to it as a Black Box. This meant that the company didn’t provide any real substance as to how they achieved such incredible results. As far as Wall Street firms were concerned, as long as Enron continued to deliver and everyone was making money, no one asked any questions. This is important because at the current time, institutional investors in Beijing refer to Baidu as a Black Box. There are great results, but there isn’t much detail as to how those results are being achieved. All that said, it should be noted that Baidu’s stock has slowed over the past two years whereas Enron’s stock never quit. This should actually be looked at as a positive because if the books were being cooked, Baidu would likely do everything in its power to keep the stock price moving higher at all times.

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Even if Baidu’s numbers are 100 percent legit, there is still danger in this area. As you might already know, the SEC has cracked down on Chinese affiliates of top U.S. accounting firms. These accounting firms are now required to produce auditing documents of foreign companies if listed on U.S. exchanges. The bad news for Baidu is that if even one of these companies is showed to have been cheating, it will take most Chinese stocks down with it. Investors will assume that cheating is rampant. The good news for Baidu is that progress will require cooperation between the SEC and the Chinese government. The Chinese government is superb at stalling. Therefore, this could be an extremely long process. Prior to moving on to the next topic, it should be mentioned that many small-cap Chinese stocks failed an audit and were de-listed in 2011….

The next potential catalyst is the Chinese economy. It had been humming for several years, but that pace wasn’t sustainable. We saw a slowdown, but China followed our lead and went the stimulus route. It’s difficult to predict how long the global economy can stay on this sugar high, but if it’s another two years, it would be a shame to miss out. Then again, everything could come crashing down to reality tomorrow. That’s why it’s best to invest in the safest companies. It would be difficult to sell the point that Baidu qualifies for that category.

Then there’s the Variable Interest Entity, otherwise known as VIE. Investors seem to have forgotten about this issue. Why? Greed. Greed is more powerful than people want to admit. When you’re making money, you will look for every reason to ignore danger signs and potential consequences. Getting back to VIE, this means that foreign shareholders have no claim to the underlying assets of the company. Basically, you own shares in a company in the Cayman Islands, which has a contract with the underlying company. It might be fun to own stock in a Chinese company that’s in a protected industry, but investing isn’t about having fun. It’s about making money. Why not own shares of Google (NASDAQ:GOOG) and not have to worry about a cataclysmic drop in the stock price?

In an attempt to remain as objective as possible, the other side must also be considered. If all of these fears are unfounded, then many issues that have held Baidu back are removed and the stock soars to new highs. This is definitely a possibility.

Now let’s take a look at some important numbers for Baidu…

E = Equity to Debt Ratio Is Strong

The debt-to-equity ratio and balance sheet for Baidu are both strong. Google is not a direct competitor, but it’s listed for comparative purposes. Baidu has a profit margin of 47.51 percent whereas Google has a profit margin of “only” 22.20 percent. I find it difficult to believe that Baidu is that more efficient than one of the best companies in the largest economy in the world.

Debt-To-Equity

Cash

Long-Term Debt

BIDU

0.10

$3.40 Billion

$460.15 Million

GOOG

0.09

$45.72 Billion

$2.99 Billion

QIHU

0.00

$348.19 Million

$0

 

T = Technicals on the Stock Chart Are Mixed

Baidu has outperformed Google and Qihoo 360 Technology Co. (NYSE:QIHU) over the past three years. Qihoo is another potential threat to Baidu. It’s much smaller than Baidu right now, but it’s looking to expand its reach in search. It’s taking a fearless approach to taking market share away from Baidu.

1 Month

Year-To-Date

1 Year

3 Year

BIDU

14.19%

10.89%

-12.71%

137.80%

GOOG

0.92%

0.14%

13.35%

22.12%

QIHU

21.73%

2.83%

90.81%

-0.94%

 

At $111.66, Baidu is trading above its 50-day SMA and 100-day SMA, but below its 200-day SMA.  

50-Day SMA

98.99

100-Day SMA

106.22

200-Day SMA

115.73

 

E = Earnings Have Been Lights-Out  

Are revenue and earnings too good to be true? That’s up for you to decide. But keep one thing in mind. Even if they’re 100 percent accurate, how will that pace be sustainable?

2007

2008

2009

2010

2011

Revenue ($)in billions

239.14

460.54

651.60

1.17B

2.25B

Diluted EPS ($)

0.25

0.44

0.63

1.53

3.02

 

When we look at last quarter on a YoY basis, we see an improvement in revenue and earnings. That shouldn’t come as a surprise to anyone.

9/2011

12/2011

3/2012

6/2012

9/2012

Revenue ($)in millions

654.70

710.90

677.10

858.80

994.60

Diluted EPS ($)

0.84

0.93

0.85

1.24

1.37

 

T = Trends Support the Industry

The industry is doing very well, and Baidu has gone along for the ride. Some might say Baidu is a driver of the industry in China. While that’s logical, it’s difficult to put your utmost confidence in a company that is unregulated.

Conclusion

If Baidu’s numbers are real, then it’s one of the best companies in the world, as well as one of the greatest companies in history. Therefore, the potential is extraordinary. However, there are many red flags.

Baidu is a STAY AWAY.

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