New Trade BIDU – Short Term Picture Murky, But Playing for Move Higher by Year-End

by Enis September 19, 2012 11:06 am • Commentary

I first became interested in BIDU from a volatility standpoint.  My post from last week focused on the steep differential between Oct and Dec options.  Since the volatility differentials looked interesting, I decided to look in more depth at BIDU’s underlying business.

First off, BIDU is a cash machine.  Its market cap of $40 billion is around 15% that of GOOG, which is closer to $240 billion, but both companies generate free cash flow of a little more than $10 billion per year.  BIDU’s return on assets and return on equity are both above 35%, its projected earnings growth is still above 30% for the next 2 years, and it sports a P/E only slightly higher than GOOG, at close to 30.

Granted, investor confidence in Chinese accounting has been seriously tested on numerous occasions in the past 2 years.  Clearly, investors approach BIDU with a healthy dose of skepticism from an accounting standpoint relative to a global stalwart like GOOG.  But if you believe the figures, then BIDU’s underlying business results are impressive.

The recent weakness in the stock (BIDU is down about 10% YTD) has largely been due to competitive concerns.  Investors are nervous that newcomers are encroaching on BIDU’s turf.  Similar to how YHOO lost out to GOOG in global search almost 10 years ago, QIHU and Tencent have purportedly developed better search algorithms and more user-friendly experiences.  And they’re beginning to chip away at BIDU’s 85-90% market share in Chinese search.  

These headlines hit the tape this week, highlighting the concerns:

• QIHU increased market share of search traffic 1-2pp since last round of checks on 8/27, Deutsche Bank analyst Alan Hellawell says (rates BIDU hold) in note.
• QIHU gained share mainly at expense of BIDU; ests. BIDU has 75%-80% search mkt share vs 80%-85% before QIHU introduced search engine
• QIHU may be gaining share due to conversion of more QIHU browser users to its search engine

It’s certainly concerning for BIDU how quickly QIHU is gaining share (1-2 percentage points in a few weeks is massive).  However, the fundamentals for BIDU are much cheaper than comparable U.S. stocks (like GOOG), though there is clearly a Chinese discount involved here as people are less trustworthy of the Chinese numbers.  I’ve been going back and forth on potential trades on BIDU since I posted the Name That Trade last week.  While I was initially interested in Oct / Dec calendars, I’ve gotten more nervous that little moves this stock until investors get reassurance from the earnings report on Oct 26th.  Until then, it feels like dead money, cheap enough to hold $100, but with enough competitive concern to stay below $120.

A low delta, low decay trade might be ok to try here, such as the Dec 135 / 145 / 155 call fly for $0.70, which is a profitable trade throughout the majority of the upside range in BIDU over the past 2 years, gives you 3 months to expiry, and offers a cheap way to participate in a rebound in BIDU if the QIHU concerns subside.
I’m going to put this trade on, but with the caveat that I don’t expect much movement in the premium for the next month or so.
TRADE: BIDU ($112.50) Bought the Dec 135 / 145 / 155 call fly for $0.71

-Bought 1 Dec 135 call for 2.40

-Sold 2 Dec 145 calls at 1.17

-Bought 1 Dec 155 call for 0.65

Break-Even on Dec Exp:

-Profits btwn 135.69 and 154.29, with max profit of $9.29 with stock at 145 on expiry

-Losses of up to 0.71 between 135.00 and 135.71 and between 154.29 and 155, with max loss of 0.71 below 135.00 and above 155.00 on expiry


Trade Rationale: Vol is fair in Dec, but upside skew is relatively flat, which offers good risk/reward for butterflies.