Is Baidu entering the smartphone market reason to go long?

Rumors flooded the web this weekend that giant Chinese web portal Baidu (BIDU, quote) and Foxconn, the notorious manufacturer of iPhones and iPads, have been holding secret discussions ostensibly over the production of a Baidu-branded phone a la Google’s Nexus. Assuming the rumors’ veracity, is this reason to go long the stock?

Image courtesy hwanghsuhui: http://commons.wikimedia.org/wiki/File:Baidu_Campus.jpgWhile Baidu remains a favorite amongst American investors looking for exposure to the fast-growing Chinese market, along with competitor web portals SOHU (quote) and SINA (quote), Chinese internet firms have traditionally struggled in markets where they must compete on a level playing field.

Baidu’s grasp on the Chinese domestic search market is not the product of superior offerings; rather, it’s the result of Google’s well-publicized pullout of the Chinese domestic market for refusing to censor web searches the Chinese government deemed “sensitive”.

But that’s not the whole story: Google refused to indulge in the blatant piracy facilitation that makes Baidu’s search engine so popular. When Google decided to pull out of China, Baidu maintained a definitive advantage in the search space.

However, this was not due to more sophisticated search algorithms that produced more accurate results (Google’s offerings were superior in this regard); rather, the majority of Chinese searches were produced by youths looking for content related to music, video, and other forms of entertainment. Because of Baidu’s disregard of copyright laws, consumers gravitated to its search platform.

The fact that experts consider Google’s excommunication, along with the censorship of sites like Twitter and Facebook, while their Chinese counterparts are allowed to thrive unabashed protectionism is besides the point. Instead, this is indicative of the inability of Chinese firms to compete in cutting-edge fields when the playing field is level, due to Schumpeterian innovation being anathema to Chinese business culture.

Thus, it’s hard to see Baidu being able to create a revolutionary product that could compete with Samsung or Apple on the high-end, and a number of firms like Nokia (NOK, quote), ZTE, and Huawei have a large first-mover advantage in the lower-end.

While Chinese netizens may flock to Baidu partly as a source of national pride, there’s little evidence this phenomenon will manifest itself in the smartphone market. Baidu commands upwards of 80% of the desktop search market, but its mobile search share is a paltry 35%, with companies like Tencent (TCEHY, quote) not far behind with around 22% of the market.

Baidu has teamed up with Dell (quote) to host their Baidu Yi platform, an Android derivative; yet Dell remains a second-tier player in the Chinese mobile phone sector. Until Baidu partners with a more relevant smartphone developer, Baidu’s platform could stagnate.

While Baidu’s core business of desktop search remains intact, investors must be cognizant of Baidu’s performance in the fast-growing mobile sector going forward. When Baidu reports earnings on Tuesday, investors should pay particular attention to their performance in mobile search given its future importance to the firm. A recent agreement with Apple (AAPL, quote) to use Baidu’s search app on their iOS system could improve their share in this sector.

Baidu will continue to profit as more Chinese access the internet from their home computers. However, Baidu investors should beware the prospect of depressed mobile search share, and that a Baidu phone would not necessarily be a home run for the firm. It could pressure margins going forward, especially if it fails to gain traction against established models.

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