Caught in the ‘Net

It’s no secret to the Internet community that China is the major battlefield for the top companies in almost all the aspects of the business. Search, e-commerce and gaming are the primary areas of contest, with search being the most viable.

As with many businesses in China, the search industry offers huge growth potential, but the market is still underdeveloped; China’s Internet penetration rate is just 25.4 percent, compared to 72 percent in the US. Furthermore, Pay for Placement (P4P) search advertising revenue in China was USD700 million in 2008, 58 percent of Japan’s search market and 5.4 percent of the US search market.

On the other hand, China surpassed the US as the largest market in terms of search queries in the second quarter of last.


Source: iResearch

Nevertheless, because of the low Internet penetration rate, the annual number of search queries per user is 503 in China, compared to 622 in the US.

But opportunity resides in this low penetration rate, especially if 50 percent of the Chinese population obtains Internet access over the next five years. Given the current pace of China’s economic growth and the growing number of households with Internet access, I would argue that the Chinese users should easily generate more than 350 billion annual search queries.

The two biggest players in the Chinese search arena are Baidu (NASDQ: BIDU), established in 2000, and Google (NASDQ: GOOG); together these two firms account for 96.1 percent of revenue and 95.5 percent of search query market share. Meanwhile, the market share of marginal players has steadily declined.

Google has been one of the most aggressive Western Internet companies in the Chinese market, building its China headquarters in the middle of 2005 and launching google.cn in Jan. 2006.

By 2007 the company had introduced localization strategies and now boasts a 32.5 percent market share, up from 2.1 percent in 2003. Baidu has increased its share from 11.2 percent to 63.5 percent over the same period.

Although Google’s superior search algorithm has enabled it to gain market share rapidly, further growth will be contingent on how the company adjusts to the idiosyncrasies of the Chinese market.

The issue at hand is that information on Chinese websites is very well organized, limiting the appeal and effectiveness of Google’s algorithm. Furthermore, and this has been a problem from the beginning for Google, the Chinese language requires a more sophisticated algorithm than English.

That being said, the industry’s future in China will revolved around mobile search applications on wireless devices, especially as so-called smartphones gain traction.

There are 670 million cellular phones in use in China, but only around 155 million users have access to the Internet via their mobile. And mobile search is still underdeveloped because there were only 95 million search users in China at the end of last year; at present, mobile search revenues account for less than 5 percent of the industry’s revenues.

Baidu offers the best pure exposure to China’s burgeoning Internet search market. The company has obviously a lot to learn from its bigger competitor, but offers more upside if it’s able to execute.

The stock bottomed at around USD100 earlier this year and now trades at USD325. Because of the stock’s high beta, it could endure a substantial price correction; we advise investors to scale into the position if they decide to buy. We will add Baidu to the NW3 Portfolio at a later date, notifying our readers with an e-mail alert.

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