What Is Baidu Due to Buy?

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It's time to get excited about China's dot-coms again.

Wedding bells are in the air after the country's leading video-sharing website operator Youku (NYS: YOKU) agreed to acquire its closest rival earlier this week.

I haven't been a big fan of China's growing, yet profitless, video-sharing space, but the deal was a real eye-opener. Youku was willing to pay a 159% premium for the shares of a reeling Todou -- based on last week's close -- and the market was not only cool with that, but actually bid shares of Youku up sharply.

This is the first major, recent acquisition between Chinese Internet speedsters. When you pair that up with privatization efforts on behalf of Alibaba and Shanda Interactive earlier this year, you realize that China's starting to see how cheap its online growth stocks have become.

Born on the Baidu
This brings us to Baidu (NAS: BIDU) . China's dot-com darling isn't about to be snapped up, but it's in the perfect position to do the snapping.

The Wall Street Journal's China Real Time Report speculates that Baidu may be ready to roll up its sleeves and begin bidding on the bustling streaming scene.

"Everyone fears someone will do a deal with Baidu, which would direct all video searches through their search engine," a banker close to the Youku deal tells China Real Time Report. "Being marginalized leads to a vicious cycle, where you can't raise capital, can't spend on premium content."

It's a good point, but is the very profitable Baidu about to get its hands dirty in serving up chunky video files that have proven tricky to monetize? After all, one of the more shocking aspects out of the latest quarterly reports from Youku and Tudou is that as fast as revenue may be growing, costs of revenue are growing even faster.

It's not a very good business model right now. Just because Baidu -- which commands 78% of the country's search market -- would send preferred traffic to its own video site doesn't mean that it would be profitable.

However, the shot fired in the Youku-Tudou deal comes from the starter pistol for the mergers and acquisition activity that's about to take place in China. The sector that has been undeservedly out of favor for far too long is about to heat up, and Baidu may as well strike now before the prices move higher.

Diving into the shopping bag
What would you buy if you were Baidu? The cheapest niche right now is online gaming. Most of the companies behind China's popular online multiplayer fantasy games are trading at forward earnings multiples in the mid-single digits.

Unfortunately, online gaming is something that is unlikely to interest Baidu. The margins are great. The opportunities for Internet ad revenue are huge. The market just wouldn't understand. Let's turn our attention to three targets that make more sense.

  • Sohu (NAS: SOHU) : A Chinese company that's been making a big splash in video lately. Unlike Youku and Tudou, longtime portal standout Sohu is very profitable, but margins have been taking a hit in light of its digital video boom. Revenue soared 42% in its latest quarter, but adjusted earnings climbed just 10% higher. However, Sohu fetches a much lower earnings multiple than Baidu, making a deal accretive to the bottom line. As a bonus, Sohu also has the fast-growing Sogou search engine that Baidu can work with.
  • Yandex (NAS: YNDX) : Why should Baidu be hogtied to China? Sure, there are 1.3 billion people in the world's most populous nation, but Baidu is in the process of opening offices to expand throughout Asia. Why not expand even farther by reaching out to Eastern Europe? Russia's top search engine has been growing briskly, but there are concerns about management's ability to act like a public company.
  • SINA (NAS: SINA) : A dot-com darling snapping up another dot-com darling would turn heads, but the company behind the fast-growing Sina Weibo website would be a good fit for Baidu to build on its display advertising business. SINA was also a factor in Youku overpaying for Tudou, since acquiring a small stake in Tudou last summer helped raise the profile of Tudou usage on Weibo. Baidu and the slower-growing SINA could do some amazing things together, especially if it results in the combined margins gravitating closer to Baidu's performance.

Bullish on Baidu
A bullish call on Baidu has served me well on Motley Fool CAPS over the years. True to the CAPScall initiative, I'm not going to give up on it now. Baidu has soared 1,562% since I recommended it to Rule Breakers newsletter subscribers six years ago, but now it's time to discover the next rule-breaking multibagger. It's a free report. Want it? Get it.

At the time this article was published Longtime Fool contributor Rick Munarriz calls them as he sees them. He does not own shares in any of the stocks in this story. Rick is also part of theRule Breakersnewsletter research team, seeking out tomorrow's ultimate growth stocks a day early.Motley Fool newsletter serviceshave recommended buying shares of Baidu, Sohu.com, and Sina. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not 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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