Selling Strategy Using Baidu/Qihoo 360 As Case Study

If you have followed recent Invest With Color articles you would know how bullish I am on the Chinese internet market as a whole. China has the largest amount of internet users and still only have an adoption rate in the low 40% range. Most of the developed world is hovering around 80% which gives China room to double the amount of internet users. This suggests that companies that currently dominant the internet space in China have a chance to explode in value. Two companies I selected for further analysis based heavily on the Chinese internet market are Baidu (BIDU) and Qihoo 360 (QIHU) with both positions representing large portions of the IWC Stock Portfolio. Both companies command over 80% of the internet search market share in China combined.

Both companies are also pushing the mobile space with smartphones becoming the most common medium for access the internet. Qihoo 360 recently agreed to a $409MM joint venture with the Coolpad Group to increase Qihoo’s mobile presence in China. Baidu on the other hand has made an effort to boost their mobile presence with mobile search traffic surpassing PC traffic for the first time in the third quarter of 2014. Mobile is a big deal because most people in China access the internet through their smartphones and tablets.

The reasons for investing in the Chinese internet market seem to make sense at least to myself. Today could be one of those times when we look back 10-20 years from now and see it as a no brainers similar to e-commerce with Amazon or smartphones with Apple/Samsung or the potential of internet search with Google.

Since the middle of 2013, I have added positions on Qihoo 360 and Baidu at the same time. The reasoning for buying them at the same time was to hedge my bets. Baidu is the established leader in China while Qihoo 360 has been growing at a much faster rate. Investing in both companies allows me to ride one winner if the other lags behind. I must be clairvoyant or something because the exact situation has come to pass. Let’s first take a look at the bright side with the Baidu purchases shown in Figure 1.

Figure 1 - Baidu (BIDU) stock chart since initiating postion

Figure 1 - Baidu (BIDU) stock chart since initiating postion

Baidu had been in my radar when it was middling in the $80/share range and wondering when a catalyst would occur to push them forward. The initial position began at $138.93/share which is much higher than I should have started with. This was due to a slow trigger finger but in this case did not cost me. As more money was accumulated to invest, the larger the Baidu position grew. Besides some dips here and there, Baidu has been increasing steadily for the past couple of years. Currnetly this position has returned over 50% compared to my cost basis which is excellent considering the position began in the middle of 2013.

The next figure results are not so rosy. Figure 2 looks at the same time period and stock purchases for Qihoo 360.

Figure 2 - Qihoo 360 (QIHU) stock chart since initiating postion

Figure 2 - Qihoo 360 (QIHU) stock chart since initiating postion

The initial stock price was purchased at $78.67/share. Two more purchases were made while the stock sky-rocketed to over $120/share. At this time I may have looked like a genius with my return being over 50% return. There was a dip that I attributed to profit taking. What I did not know was that this would be the  start of a gradual decline where the stock price has fallen down to below my initial position. Currently, the paper loss stands at over 30%.

Taking the long-term approach to investing takes some guts but also conviction to your investment thesis. Qihoo 360 has been growing by over 80% for some time now which is excellent growth but also have a slow time monetizing mobile. With the world shifting towards mobile, companies falling behind are treated harshly on Wall Street. One of the major catalysts for Baidu rising as fast as they are is due to their ability to monetize mobile effectively. If Qihoo 360 gets to this point, they will see a similar rise in stock price from these 52 week low levels they are in right now.

What does this do for the Qihoo 360 position. Selling at this point is only an option if the investment thesis has changed signficantly enough. Let’s take a look at Qihoo 360 is trending in terms of earnings and costs. Figure 1 shows how sales, gross profits, general expenses and earnings have changed over the past 5 years. The 2014 numbers are projected based on the performance of the first three quarters of 2014. This was done in order to get an idea of what can be reasonably assumed is Qihoo 360 performance in 2014.

Even with the hit in stock price, Qihoo 360 has been growing at an over 95% clip in terms of sales since 2011. Gross profit has followed step by step with sales. One issue is the rise in expenses which has put a damper on rise in net income. The next graph shows on a year to year basis how each of these metrics have changed.

Revenue has increased on average over 120% compared to the previous year which is staggering. This growth trajectory is not sustainable long-term but shows that business is very much still in the hyper growth stage. Gross profit is trending downwards slightly though 2014 still sees gross profit to be around 86% if the fourth quarter tracks with how the first three quarters have performed. Expenses have been an issue but with a growing company should be expected. Typically companies in the hyper growth stage don’t even turn profits. Look at Netflix as an example of high expenses initially being required to grow as fast as possible initially. Qihoo 360 is different as they are turning a profit already and are increasing net income by over 100% on average since 2011.

Qihoo 360 is still a fast growing company with the attractive characterisitcs that led to initiating a position in 2013 to begin with. With the over 50% drop from the 52-week high, how does Qihoo 360 compare with Google and Baidu. Table 1 looks at some valuation metrics to compare all three companies ona relative basis.

Table 1 - Valuation Metrics
Stock Ticker Google (GOOGL) Baidu (BIDU) Qihoo 360 (QIHU)
Market Cap ($$B) $371.4 $75.5 $7.5
Sales ($B) $66.0 $7.9 $1.4
Price to Earnings 27.1 40.1 35.0
Forward Price to Earnings 16.5 22.5 12.5
PEG Ratio 1.70 1.06 1.02
Price to Sales 5.63 9.53 5.39
Price to Book 3.56 9.06 7.17

One thing that pops out is Qihoo 360 is competiting with Baidu with a market cap less than 10% the market cap of Baidu. Qihoo 360 is still a small company relative to giants like Google and Baidu.  Qihoo 360 has the highest price to earnings ratio but the smallest forward P/E ratio. Price to earnings is a metric typically used to find companies with stock prices with great value. One thing that P/E ratio doesn’t capture is growth rate. In terms of PEG (price to earnings to growth) ratio, when projected growth metrics Qihoo 360 is trading at a discount. A rule of thumb is companies with PEG ratios below 1 suggest the company stock is trading at a discount. Qihoo 360 in terms of price to sales and book is also trading at valuations below Baidu. Baidu has seen a run up in stock price which may make them currently fairly valued as opposed to cheaply priced.

Table 2 looks at some of the profitability numbers for the three companies. 

Table 1 - Valuation Metrics
Stock Ticker Google (GOOGL) Baidu (BIDU) Qihoo 360 (QIHU)
Gross Margin (%) 59.5 61.6 80.3
Profit Margin (%) 20.2 28.6 13.8
Return on Assets (%) 11.0 15.8 7.7
Return on Equity (%) 14.0 29.6 19.3
Return on Investment (%) 12.6 16.7 5.5
Insider Ownership (%) 0.2 0.1 23.5
Institutional Ownership (%) 83.0 84.8 65.6

Qihoo 360 has the highest gross margin out of the three but the lowest net profit margin. This is due to higher costs for Qihoo 360 relative to sales compared to Google and Baidu. With a growing company, this is to be expected as they invest in the company to be able to grow as fast as they have in the past. Eventually, the rise in expenses needs to be stabalized which will help the bottom line. Return on assets and equity are in line though on the low side. One statistic I love to see is Qihoo 360 has large insider ownsership. This means the company has a vested interest for the company to perform well in order for the valuation to increase. There is a sense of confidence in the long-term potential for Qihoo 360 when insider ownership is high.

Final Thoughts

Overall the reasons for investing in Qihoo 360 remain the same. The company is growing and investing in themselves in order to compete. With the growing sea that is internet adoption in China, both Baidu and Qihoo 360 should stand to benefit greatly. One regret may be selling a portion of the position during the slide in order to reduce the paper loss. This experience may lead to some type of selling strategy even with companies you love in order to protect the value of the portfolio. In terms of owning now, I still have Qihoo 360 as a potential long-term growth position and at these low valuations, selling now is not something to even be considered at this time. 

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