How Baidu Keeps Its Edge

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Few fields move as rapidly as technology. Businesses creating outsized profits and returns for shareholders quickly get a bull's-eye painted on their back as they become targets of other companies looking to disrupt their products by selling cheaper alternatives that still prove "good enough." Not only that, but even if a company continues to dominate its particular field, other changes in technology can shift spending away from their products. Think about how Microsoft still dominates PCs but feels pressure from the sales shift toward mobile devices such as smartphones and tablets.

With that in mind, today we're looking at how Baidu (NAS: BIDU) innovates.

Technology companies can innovate either through acquisitions or by spending more money on research and development. We'll compare Baidu's spending in these areas with that of its closest peers and assess whether the company is investing enough in its future.

Research and development
Over the past five years, Baidu has spent an average of 13% of revenues on R&D. The following table summarizes how Baidu's R&D R&D expenditures relative to revenues compare with some of the company's closest peers in the Internet search industry.

Company

2006

2007

2008

2009

2010

LTM

Baidu9.5%8.1%9.0%9.5%9.1%9.2%
Sohu (NAS: SOHU) 13.1%13.5%11.6%11.1%11.9%12.2%
Google (NAS: GOOG) 11.6%12.8%12.8%12.0%12.8%13.5%
Yandex (NAS: YNDX) N/AN/A13.2%18.5%16.6%16.5%

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years; yearly total is for company fiscal years closing in that period.

There's no way around it: Google has Baidu flat-out beat when it comes to R&D. Last year, Google spent $4.5 billion on research, far outpacing Baidu's minuscule $151 million spend. Surely at some point Google will use its vast resources to make inroads into China, right?

Actually, it probably won't. Although innovation is important, so are local market dynamics and being the first mover in a particular market. Baidu's search results used to be woefully inadequate compared to Google, but local favoritism and the willingness to play by local regulations kept Baidu in the game against Google, while its larger rival became entangled in a high-stakes game of brinksmanship that resulted in its leaving the country.

The end result is that Baidu has managed to increase to a dominant 86% market share within China. Western investors may bristle at the fact that Baidu was essentially a Google clone that used local savvy and politics to assert its dominance, but in the end, its position as China's search leader looks very secure.

So Baidu investors are now looking to a future where the company's focus could broaden to divergent areas across China's Internet industry, much like how Google has expanded to other areas that enhance its search and advertising expertise. For example, Baidu has made noise by talking about developing a mobile operating system. There have also been reports that it could team up with Facebook to launch a China-specific version of the world's largest social network that would compete against Chinese social platforms such as Renren (NYS: RENN) and SINA's (NAS: SINA) Weibo. Other areas Baidu could attack more aggressively include video, where Youku (NYS: YOKU) has been able to establish itself as a market leader.

With search dominance in China largely secured, keep an eye out on how aggressively the company emulates Google's worldwide model of leveraging search dominance into other rapidly growing Web areas. 

Acquisitions 
In technology, some of the best companies have turned growth through acquisitions into an art. IBM has adeptly spun off capital-heavy businesses such as the hard-drive and PC segments, while it focused on acquiring additional services and software expertise that have transformed its business model.

On the opposite end of the spectrum, Hewlett-Packard is often criticized for underinvesting in R&D, to the point that it has to overpay on acquisitions to catch up with its competitors.

Investors should remember, most of all, that companies are valued by the cash flow they can bring in for their shareholders over time. If companies need to continue making purchases in perpetuity to keep growing, that amounts to a reduction in cash flows, and investors should treat acquisition spending as a continuing outflow against cash flow.

Let's take a look at Baidu's free cash flow over the past five years against cash spent on acquisitions.

anImage

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years; yearly total is for company fiscal years closing in that period.

Baidu doesn't have a history of acquisitions. Since 2006, its cash acquisitions total just $9.2 million, a rounding error for a company of its size. While that could change in the future as the company expands into new areas, at this point Baidu's cash flows are a reflection of its organic ability to grow.

Final thoughts
If you're looking to stay updated on Baidu, or any other companies mentioned here, make sure to add them to our free watchlist service, My Watchlist. It's free, and it helps you constantly stay updated on news and analysis on your favorite companies.

At the time this article was published Eric Bleekerowns shares of no companies listed above. You canfollow him on Twitterto see all of his technology and market commentary. The Motley Fool owns shares of Google and Microsoft.Motley Fool newsletter serviceshave recommended buying shares of SINA, Baidu, Sohu.com, Google and creating a covered collar position in Microsoft. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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