12.1 Million Reasons for Baidu to Bounce Back

The bears keep piling up on Baidu (NASDAQ: BIDU  ) .

Nasdaq's bi-monthly update shows that a record 12.1 million shares were sold short as of mid-March. To place those negative wagers in perspective, China's leading search engine only had 8.7 million shares sold short when 2013 began. The number of naysayers has actually more than doubled over the past year.

Is Baidu broken? Can it bounce back?

The bullish counter is that Baidu has never been cheaper. As earnings continue to grow and the share price shrinks, the fallen dot-com darling's valuation contracts. Baidu is now trading at just 16 times this year's projected profitability and less than 13 times next year's target.

Just to put this in context, Russia's Yandex�is going for more than 17 times next year's profit forecast and slower-growing Google (NASDAQ: GOOG  ) is fetching more than 15 times next year's projected earnings.

This wouldn't seem like such a bargain if Baidu's financials were in a state of decline, but clearly they're not.

The long road back for Baidu
Chinese stocks had a rough earnings season earlier this year.

Results for the fourth quarter were generally mixed, but most of China's bustling Internet companies disappointed investors with their guidance for the current quarter. There's a natural seasonal slowdown this time of year, but the sequential weakness was made worse by a late start to the Chinese New Year this time around.

Baidu's guidance -- calling for a 4% to 7% sequential dip in revenue -- wasn't welcome, but many of China's once shining dot-com stars checked in with outlooks calling for double-digit percentage declines.

Qihoo 360 (NYSE: QIHU  ) was one of the rare exceptions. The company behind the leading Internet browser and security software suite that has become a thorn in Baidu's side since rolling out a search engine of its own bucked the trend.

To be fair, Qihoo 360 is also growing a lot faster than most of its online peers. However, Qihoo 360 is also trading at 19 times next year's earnings.

Waiting on good news
Baidu hit a two-year low last week, so for now those 12.1 million shorts are in the black.

What would shake them out? What would make the bears scramble for the exits?

A no-brainer catalyst would be an improving perspective, and that's actually starting to happen. After months of seeing Wall Street pros whittle down their profit targets on Baidu, the pros are starting to turn.

It's not much.

The same analysts that thought Baidu would earn $5.39 a share this year and $6.77 a share next year just a month ago are now perched on $5.40 a share and $6.78 a share, respectively. It's a baby step, but it's a step in the right direction.

The next step would be Wall Street warming up to Baidu with upgrades. The last major analyst move was a downgrade by Stifel Nicolaus last month after the company's disappointing quarterly report.

Baidu can naturally make its own luck here. It reports first-quarter results in four weeks, and nothing would trigger a short squeeze as much as a solid report.

Growth should be there. Even these uninspired analysts see earnings climbing 21% and revenue spiking 43% higher in next month's report.

Would it be great to see margins improve? Yes. Would it be great to see Baidu's net income grow a little faster? Sure. However, the market's in love with Google right now, yet it's slated to grow its profitability just 6% during the same period on a per-share basis. Qihoo 360 is actually expected to post a sharp decline in profitability as it invests in the monetization of its growing traffic.

In a few weeks, Baidu may no longer appear to be the laggard in this lucrative niche.

Don't turn your back on China
Save for a few exceptions -- we meet again, Qihoo 360 -- investors have avoided Chinese stocks in recent months. It's not just Baidu dragging its knuckles on the floor.

However, this is still a potent company with a growing of number of shorts that will have to move the stock higher as they close out their positions. If China gets more restrictive online, the bears will win. If Qihoo 360 somehow gains market share now that it's finally slapping Google ads on its results, the bears will win. If there are accounting shenanigans at Baidu, the bears will win. If China's economy stops growing, the bears will win.

Any of these things will happen, but isn't the more likely scenario that Baidu will once again prove that it's still growing at a clip that's worthy of a far higher multiple? You can't ignore a company serving up 5 billion search queries a day that's cranking out some of the highest margins in the industry.

The bears think they have this one. The chart shows them to be victorious, and there's safety in numbers with the number of shares sold short more than doubling over the past year. However, the nice thing about a beaten-down stock is that it often doesn't take a lot of catalysts to turn things around.

Betting on Baidu?
Regardless of your short-term view on the Chinese economy, there may be opportunity in Baidu (aka the "Chinese Google"). Our brand-new premium report breaks down the dominant Chinese search provider's strengths and weaknesses. Just click here to access it now.