I LOVE GOOGLE. I use it almost every day. I read the news, I look up stuff. For millions of Internet users in China, however, Google isn’t the go-to search engine. For most of them, it’s local portal Baidu. And guess what they look for? MP3 downloads.

 

Yes, music is what drives China’s search engine business. And that’s largely because its Internet users are young. According to government data, 61.5% of web users are below the age of 29. They also don’t have bucket loads of disposable income: About 42.5% of users have a monthly income of RMB1,000 ($206) or less.

 

The Internet is a source of cheap entertainment for them. Sure, it’s a window to a world not utterly controlled by the heavy hand of the state. But, for the bulk of China’s 384 million Internet users, it’s a window to listen to the latest Mando-pop or Lady Gaga hits.

 

Baidu Inc understood that early on and that’s a key reason it has thrived. Last year, it had 60.9% of the market by revenue (threequarters, if measured by traffic). Google was second, with 31.8%, according to Beijing-based consultancy Analysys International. That’s a position it quickly built up in three years and that it is threatening to give up.

 

On Jan 12, citing censorship and cyber-attacks on the Gmail accounts of mainland activists, Google said it was reviewing its business operations in China. As at press time, it was still in talks with the government on operating an unfiltered search engine.

 

Whether Google goes or doesn’t go, most analysts reckon Baidu will gain. If Google stays, it would be in a weakened position to negotiate prices with advertisers, who may prefer to channel their money to local search engines.

 

Since Google’s shock announcement, several investment banks have upgraded their calls and target prices on Baidu, and the Nasdaqlisted company’s share price rose to a one-year high of US$470.25 on Jan 15.

 

Just how much does Baidu stand to gain? First, it’s worth remembering that about half of Google’s China-derived revenues are spent on its international sites. If Google does indeed quit the market, these advertising dollars will likely continue to go to Google’s international sites. That leaves the balance up for the taking, of which Baidu is expected to take 90%, estimates Deutsche Bank.

 

That’s because the other search players in China are puny. Sohu.com has about 1.0% of the market, while Tencent Holdings, China’s largest social networking portal, has a mere 0.7%. The rest is shared by online gaming operator Net Ease.com and other smaller operators. 

 

Deutsche Bank values Baidu at US$544 a share, based on a price to earnings-to-growth (PEG) ratio of one time, which the bank reckons is justified, considering that its peers (which include Sohu, Tencent and Alibaba) trade on average at 0.9 times. On standalone price-to-earnings ratio measures, Baidu’s premium is even starker. Based on last Thursday’s close, the stock is trading at 48.5 times consensus earnings for 2010, versus the sector’s 27 times.

 

Investors appear to be willing to pay those prices, given Baidu’s stranglehold in search. But that’s right now. The search landscape is changing; competitors are beefing themselves up and new players are entering the fray. Alibaba, which owns Taobao, the largest e-shopping portal in China, is preparing to roll out its own search engine. Microsoft, which launched Bing in mid-2006, is stepping up its investments in China.

 

Tencent is ramping up the technology on its SoSo search engine. Sure, SoSo is tiny at the moment but, given Tencent’s huge user base and enormous traffic, it can become a meaningful alternative to Baidu over time. Also, Tencent offers investors exposure to another web offering that is growing explosively in China: online gaming.

 

Search is a fast-growing new business for China’s Internet players, but it is dwarfed by online gaming, which is huge in China. Last year, the value of China’s search market was RMB7.15 billion, according to Analysys International. The market for online games was almost four times that, coming in at RMB26 billion. That market is forecast to swell further to RMB73 billion by 2012.

 

Then, there’s the profitability aspect. “On a per-user basis, online gaming is a higher-margin business,” says Shailesh Naik, CEO of Matchmove Games, a Singapore- based online game service provider. That’s because search is a volume game, requiring massive server farms and powerful web crawlers (computer programmes that browse the web) to deliver the best results. That costs money. In contrast, much of the investment with online games is upfront, at the design stage. For games created in-house, the margins can be extremely lucrative as volumes build up. Moreover, aside from advertising, online games also offer additional revenue streams when gamers make related purchases (such as avatars). And, the interaction time with users tends to be much longer than with search, says Naik.

 

Consensus forecasts put Hong Kong-listed Tencent at 34.3 times this year’s earnings. Its PEG stands at 0.84 times. Last year, it made an estimated RMB5.1 billion in net profit, more than triple what Baidu is calculated to have made. It is bigger, more profitable, and not as expensive. When it comes to Internet plays in China, Baidu may be the clear favourite right now but, in the search for value, Tencent comes out ahead.

 

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