China’s government launched an investigation into Internet search giant Baidu Inc. following the death of 21-year old college student, Wei Zexi.
Zexi suffered from a rare cancer called synovial sarcoma. After undergoing several rounds of radiation and chemotherapy, his family went online to research treatments in an effort to keep the cancer from recurring. They sought an alternative treatment via Baidu at 200,000 yuan ($31,000) at a Beijing hospital.
Baidu is China’s dominant search engine and, like other search engines, earns a large portion of its revenue from selling ads.
The treatment did not yield the desired results and Baidu was accused of taking money to promote less proven and ineffective treatments in its search results. Incidentally, China has strict laws against false advertising of medical products.
Matt Coffina, editor of StockInvestor, talks about the implications for investors in China to Morningstar markets editor Jeremy Glaser.
You can watch the video here.
I think it's a moral gray area to be sure. The hospital had all the necessary licenses but it actually was outsourcing this immunotherapy program to a third party, a private healthcare provider. So, Baidu verified the license of the hospital, but I don't know that it knew about the relationship with the private third party. The regulations in China have been very not clear about exactly what you can say and not say in an advertisement.
So, Baidu, to some extent, it deserves some criticism and to some extent I think it's been a little bit of a scapegoat for just a poorly regulated healthcare environment in China in general. I mean, you could say Keytruda is advertised in the U.S. I'm sure there's patients for whom it's not effective and that's very unfortunate. But in the U.S. you probably wouldn't blame Google. Google is a lot more careful I think about what kind of advertisements they host versus Baidu. So, it's an unfortunate situation and Baidu bears some of the blame and they have also just been in the spotlight negatively.
What change have the regulators asked them to make?
This investigation concluded with record speed and from when the controversy started till regulators coming back with demands for Baidu, it was about a week.
For one thing, Baidu has to more clearly label advertisements. They did have a little line in gray text that said "a promoted listing." But they want to make it very clear what's an ad, what's an organic search result.
They want Baidu to also incorporate some information about the credibility of the advertiser when ranking search results. So, they can't just put whoever paid them the most at the top of the listing. They have to consider whether it's a credible advertiser.
They don't want more than 30% of a webpage to be ads. So, you need 70% organic listings, 30% ads at most.
They want Baidu to set up a fund to compensate victims of fraudulent advertising.
All of these things Baidu is plans to do by the end of the month.
How will that impact the business?
I think it remains to be seen how meaningful or not they are going to be to Baidu's business. So, we're really only going to find that out as Baidu starts to report results. I mean, I certainly expect it to weigh on the growth rate. It will create some incremental expenses.
On the other hand, it's not clear that some of these changes are really even changes. Again, Baidu had verified that the hospital was licensed appropriately. It's not clear that even this ad would have been prevented by the new restrictions, changes like 30% of web results have to be ads, well, you can just lengthen the webpage so you can get more ads on there.
So, I think there's some element of this that's just trying to cover your butts a little bit and make a good show of it and I think it will weigh on their growth rate, but the total impact, we're going to have to wait and see.
Does this make you rethink the kind of relationship between Chinese internet companies and regulators?
We always knew that investing in China was dangerous. It comes with all sorts of risk that you don't have to worry about when you're investing in the U.S. and I would say those risks have only been getting greater over time.
You have macroeconomic risks. The health of the Chinese economy is certainly slowing down a lot. Our analysts are concerned about debt overhang and excess capacity and all of these sorts of macro risks in China.
Then on the regulatory front, you always knew that the government could come in and do whatever they want. They could really mess with Baidu if they chose to. I don't think that this is a situation clearly of the government messing with them that they initially have it in for Baidu.
But that said, we definitely need to be wary of these red flags. What if regulators had come back and said, you can't advertise healthcare companies at all? That might be 20% or 30% of Baidu's business. They didn't say that. But we have to be aware of the fact that they could have. And what is Baidu really going to do about it except for comply?
There have been other red flags. Recently, the government has indicated they want to take a 1% stake and a board seat in all of major internet companies.
Baidu itself has created some red flags. For example, management has proposed to buy out their online video subsidiary. I never like to see this kind of inside dealing. It's one reason that I've avoided Alibaba and favored Baidu. I think they have fewer related party transactions. But the fact that they even proposed that is a little bit of a red flag.
So, I think investors need to be very cautious and you really need to see a lot of upside to be worth the trouble of investing in China.
That said, I still see that upside today in Baidu. The stock is trading for about 15 times core search earnings. They've been spending a lot of money in noncore areas, things like their online to offline initiative, online video. They have a lot of these noncore money-losing ventures. But if you sort of strip those out core search earnings, it's only trading at about 15% times earnings and the underlying growth rate should still be somewhere in the 20s, around 20% a year, again except for this headwind that they are going to face now this year because of this scandal. So, it's a complicated story. It's not exactly a pound-the-table kind of situation. But for risk-tolerant investors, who see a significant upside and are willing to take on these significant risks, I think it's still a worthwhile holding.
You can watch the video here.
