Playing Chicken with China

Back in mid-January, Google announced plans to stop censoring search results on their Chinese site.

Advocates of free speech are cheering, but Google investors are shaking their heads. Since the announcement, Google shares (NASDAQ: GOOG) are down 6%, while shares of Baidu (NASDAQ: BIDU) — their largest Chinese competitor — have soared more than 40%.

This 3-month chart captures the move:

Lights Out?

People have written off Google's future in China. Insiders like Peter Lui, Google's former controller for the Asia-Pacific Region, think the damage is irreparable.

In an interview with Bloomberg, Mr. Lui insists that "There is no way Google can ever come back," saying the U.S. firm has "burnt bridges and they've burnt the Google brand in China."

But Google is in a stronger position than most people think. Today they have about 35% of the Chinese search market, compared to Baidu's 60%+. Big G had just 13% of the market when they opened Google.cn and agreed to China's censorship policy. There's a reason for that growth: Google's technology is way ahead of Baidu's.

Overreacting Analysts

But analysts are acting as if Google's share of the market is going to disappear overnight. For now at least, that isn't the case. Users in China are being forwarded from Google.cn (the Chinese site) to Google.com.hk (the Hong Kong domain).

China's great firewall will block politically sensitive searches — think "Tianamen Square massacre" — but everyday searches are still going through just fine. You can monitor which Google services are currently available in mainland China here.

For now, Google can claim a moral victory. And rightly so... After all, they're not the ones doing the filtering. Bejing is.

But if they really wanted to "pull out" of China like everyone is saying, they would block traffic from the entire country to protest the censorship.

Here's the bottom line: Unless Bejing decides to block access to Google.com.hk (which would cause an uproar), Google will still have a strong presence in China. Search ads will still run, and they've stated that their sales and R&D teams aren't leaving.

Investing Implications

Even though I think the whole China thing has been overblown, I wouldn't short BIDU here. The best stock to buy is a beast, and anyone who steps in front of it at this point is insane. Plus, there's always the possibility that Bejing does block all Google traffic, but I don't think it's likely.

Either way, Baidu is too pricey for me here and it could be nearing the end of its run. A year ago this was a $169 stock; today it trades at $603.

If you own Google stock like I do, I don't think this is a good enough reason to sell it. Sure, the company's a little pricey — trading at a trailing P/E of 27 — but it's still growing nicely. It's one of the most well-run companies in the world, and they have the smartest engineers in the business. Besides, China is only a tiny percentage of revenue today.

Here are some key stats for BIDU and GOOG:

Google (NASDAQ: GOOG)

• Price: $563
• Market Cap: $179b
• Price/Earnings (trailing): 27.5x
• Price/Earnings (forward, estimated): 18x
• Quarterly revenue growth (year over year): 17.10%
• Cash and equivalents: $24.5b
• Debt: 0

Baidu (NASDAQ: BIDU)

• Price: $604
• Market Cap: $20b
• Price/Earnings (trailing): 95x
• Price/Earnings (forward, estimated): 40x
• Quarterly revenue growth (yoy): 40%
• Cash and equivalents: $671m
• Debt: 0