Chronic pain

Baidu sell-off understates long-term health risks

Baidu's selloff may be misdiagnosing the long-term effects of its current health woes. Chinese regulators have ordered the country's top search engine to rein in healthcare advertising after a scandal. Investors may be underestimating the broader damage to Baidu's business model.

The $59-billion giant has faced fierce criticism following the death of Wei Zexi, who underwent an experimental cancer treatment he found through a Baidu search. This prompted China's internet regulator to launch an investigation into the company's advertising practices.

The outcome is that Baidu will have to vet medical, pharmaceutical and other healthcare related products and services more carefully before featuring them in search results. Regulators are also cracking down on search-related advertising. Like Google, Baidu lets sellers pay for prominent adverts which it displays next to normal search results. Previously, the best slots went to the highest bidders. From now on, Baidu will have to take advertisers' credibility into account when ranking results. Paid ads also can't account for more than 30 per cent of search results on a page.
 

This type of regulatory micro-management could impose acute financial pain. Revenue from search advertising brought in 84 per cent of Baidu's total revenue last year. Analysts at Jefferies reckon health care makes up a quarter of the search portion.

Baidu is expected to generate total revenue of 81.5 billion yuan ($12.5 billion) in 2016, according to Eikon. Applying last year's 51 per cent operating margin for its search business and a 14 per cent corporate tax rate suggests health care-related search would add 7.4 billion yuan to its bottom line. If the crackdown shrinks that business by a third, net income will be 2.44 billion yuan lower - equivalent to knocking 18 per cent off this year's forecast earnings.

Baidu's 80 per cent share of China's online search market may allow it to recoup that income by charging legitimate advertisers more. However, the risk is that regulators will start holding the company similarly accountable for adverts in areas like education, finance and takeaway food. Baidu's US-listed shares have fallen by 13 per cent since news of the scandal broke. That seems a benign diagnosis for what may prove to be a long-term ailment.