Emerging market search engines 2013
01 October 2013 - Suhail Suleman
The bursting of the dot.com bubble in 2000 has left many investors sceptical about the long-term investment appeal of technology companies. In many cases this reticence is quite justified – no single industry better illustrates the idea of creative destruction than technology. Former industry leaders who, as recently as five years ago, looked unassailable in their positions, are today struggling for survival. Nokia and Blackberry (previously RIM) are prime examples of this, but even Microsoft fails to convince investors about its long-term appeal, despite powering 90%+ of the desktop computers in the world. Apple was briefly the most valuable company in the world, but today plays second fiddle to Samsung in mobile phones (in terms of volumes). Skype revolutionised internet-based calling, but has largely been replaced by myriad VoIP and video calling options offered by handset manufacturers and other service providers. Of all the technology sectors, the search industry stands out as having revolutionised the way people use the internet and maintained its relevance. Pioneered by Google (who was in fact a late entrant to the industry), search is one of the few technology industries that has increased its earnings power consistently over the last decade. There are many intrinsic qualities of search providers that make them such attractive investments (at the right price).
At its core, search is about filtering information available on the internet in response to a query. It is impossible to trawl through the entire internet each time someone conducts a search – this process would take so long that by the time it was completed the information would be totally out of date. To overcome this, search engines are constantly browsing the internet and taking snapshots of pages that can later be quickly searched for relevance in response to a query. Brute force comes in handy here – the greater the storage capacity of the search server, the more pages can be browsed and the more information that can be summarised. Since any provider with sufficient capital can do this, one might wonder what determines success between rival search engines. First-mover advantage can help – to the extent that it creates a loyal user base – but this alone is not enough. Many early search pioneers that were subsequently surpassed by Google can attest to this. The ultimate determinant of success in search is the relevance of the results returned in response to a query. Each search provider has its own proprietary algorithm to filter information and return the best results in the most relevant order. Over and above this, a successful search engine refines its methodology by learning from how the search results are used. The technical term for this is ‘machine learning’ and it is a key differentiator between providers. In simple terms, the more users a search provider has the more its algorithm can evolve to provide more relevant search results. A virtuous cycle ensues that allows a single search engine to establish itself as a clear market leader, that thereafter is very difficult to dislodge, provided it continues to refine and enhance its technological edge.
Naturally, the provision of search services is not done for altruistic reasons but for the purposes of somehow generating revenue. The bulk of revenue comes from advertising, and search providers can offer advertisers something that no other medium can – highly specific information on the client conducting a search. A search provider uses everything it can to build a profile of the user: The IP address of a PC gives away its location and a user’s browsing history will paint a reasonable profile of the user – age, gender, relationship status, income level, likes, dislikes and a whole host of other personal traits that are surprisingly easy to piece together from a user’s internet history. This information, together with the context of the search, then allows the search engine to display advertisements with greater relevance to the user. In addition, the success of the advertisement can be accurately measured; if the user clicks on the advertisement then it is known that it has been seen and found relevant. In this case the advertiser pays the search engine an agreed rate. If the user does not click on the advertisement then no payment is made. This powerful dynamic is a key reason as to why advertising spend is increasingly moving online, and will continue to do so as legacy industries (like print newspapers) bleed clients. A final point worth noting is that advertisers rarely split their spend according to search market share, but rather disproportionately reward the industry leader which is where they will get the broadest audience and potential highest return. A search share of 70%, as an example, can often lead to a revenue share of over 90%. The benefits of incumbency can thus create very high barriers to entry.
From a return perspective search engines also offer a compelling investment case. Once the initial capital has been spent on server infrastructure the business can be very cash generative, provided the engine maintains its competitive position. Providers typically receive cash upfront to cover the expected number of clicks at the agreed rate, while there is no inventory to speak of. This often leads to a negative working capital cycle (where creditors fund your ongoing operations) in an intellectual industry with no heavy capital spend requirements.
In its nine years since listing, Google has provided an annual return of 26% per annum to those who invested at its IPO (initial public offering). It is by some distance the market leader in all major regions of the world, with two notable exceptions – Russia and China. In these countries, the search markets are dominated by local providers who have held off Google and other rivals through innovation and local knowledge.
Baidu of China has approximately 70% market share in search (by queries) and was started by Robin Li and others in 2000. Mr Li still serves as the company’s CEO. Although it has tacit government support (relative to Google) as a home-grown company, it has reached and maintained its position through innovation and hard work. The complexity of the various Chinese languages and their development of an algorithm best suited for Chinese script means that Baidu’s search results are the best in the market. They employ over 9 000 engineers and their head office in Beijing would not look out of place in Silicon Valley.
To monetise this advantage, the company has built up a sales force of 8 600 people to sign up customers as advertisers and to manage accounts. This has coincided with a large shift of advertising from legacy media (TV, radio, print) to online. The trend has also been amplified by the increased size of the advertising market. Today, Baidu has over half a million online customers, with average annual spend of $6 000 each. Five years ago the equivalent figures were 200 000 customers and $1 000 annual spend. The company has invested heavily in managing the transition of search from the desktop platform to mobile and tablet devices, where monetising can be more difficult due to the smaller screen size (less space to display adverts and search results). Despite the compounded 80% annual earnings growth from 2006 to 2012, we believe the company has significant room to grow further as the market is still in its infancy. Less than half the population have regular internet access and this is something currently being addressed by the government and telecommunication providers. The internet takes around 25% of total advertising spend, which is well below where we believe it can go given the amount of time that people with good internet access spend online. Furthermore, search-related advertising accounts for only 40% of total internet advertising. Given the inherent strength of search relative to banner (brand building) advertising, we believe it will capture a larger proportion of the growing advertising pie. Baidu trades on 22 times our estimates of next year’s earnings, adjusting for its sizeable cash balance, but is capable (in our view) of growing earnings at above 20% per year over our forecast horizon, which reduces this multiple rapidly. At $160 per share it is a 2% position in our fund today, having been as high as 4% of fund as recently as July when the share price was below $100.
Yandex is the search leader in Russia, with 62% market share compared to Google’s 30%. Like Baidu, Yandex has benefited partly from first-mover advantage (it was launched in 2000) and its deep knowledge of the Russian market and language. It was founded by entrepreneurs and retains its innovative culture. The company’s total headcount is in the region of 4 000 people, half of whom are in product development (engineers). In contrast, the little publicly available information on Google’s operation in Russia (the company does not report Russia as a separate segment) suggests that they have less than 100 employees on the ground, with the bulk of the intellectual work done in the US. This makes Yandex the employer of choice for any ambitious engineering graduate in Russia. The company is a Russian business, despite forays into parts of the former Soviet empire (which share a language and/or alphabet) and Turkey (which does not). The local Russian focus allows Yandex to produce tailored results and to offer more localised advertising and products that better reflect regional differences in such a vast country.
Many of the core drivers of the Baidu investment case also apply to Yandex; the country is expected to add tens of millions of internet users over time (from the current 50% penetration rate of internet access) and the internet is taking a larger proportion of advertising as its economic appeal becomes apparent. These drivers should enable Yandex to deliver, by our estimates, bottom-line earnings growth of 25% per year for the next six years. As recently as April, Yandex shares were trading at a post-IPO low of $21, which is when we built a small (1%) position in our funds. Since then, the company has re-rated materially, and is now trading above $37 per share. While there are some reasons why investors have re-rated the company, the quantum of the appreciation far exceeds the change in the long-term value of the business and we believe Yandex is overvalued today. Since a key part of our investment philosophy and process is a margin of safety between the current share price and our assessment of fair value, we have sold out of the company. We hope to own Yandex again in the future, but will only do so at the right price.
SUHAIL SULEMAN joined Coronation’s Emerging Markets team in 2007, initially covering the consumer and industrial industries. He currently co-manages the range of Global Emerging Markets funds. Suhail has 11 years’ investment experience.
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Notes to the editor:
Coronation Fund Managers Limited is one of southern Africa’s most successful third-party fund management companies. As a pure fund management business it provides individual and institutional investors with expertise across Developed Markets, Emerging Markets and Africa. Clients include some of the largest retirement funds, medical schemes and multi-manager companies in South Africa, many of the major banking and insurance groups, selected investment advisory businesses, prominent independent financial advisors, high-net worth individuals and direct unit trust accounts. We are 25% staff-owned, have offices in Cape Town, Johannesburg, Pretoria, Durban, Gaborone, Windhoek, London and Dublin and are listed on the Johannesburg Stock Exchange. As at the September 2013 quarter-end, assets under management total R492 billion.