Baidu is our top pick for the next six months.

Baidu enjoys a near monopoly position in online search in China due to Google's de facto exit. Couple that with its success in transitioning advertisers to its new platform named Phoenix Nest, the company is positioned to capture upside to current growth expectations. BIDU shares could rally by 50% over the next 6 months as Street estimates for the company increase.

The shares have risen 85% year-to-date on the back of Google's decision to exit the Chinese market, and a strong 1Q10 earnings print that offered a beat and raise. The shares trade at what look like a seemingly rich multiples of 60x 2010 EPS and 34x 2010 EBITDA, but with a more defensible PEG of 1.2x. Those valuations are likely to come down as estimates increase. Compare Baidu's valuation to Google’s which trades at 18x 2010 EPS and 11x 2010 EBITDA, and with a PEG of 1.0x. The two companies currently derive over 90% of their revenues from online search. Shares of Google are down 20% year-to-date.

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Consensus sees 2Q10 revenues for Baidu of $266.2mn, up 66% y/y and 40% q/q and GAAP EPS of $0.28. Both the topline and the bottom line consensus estimates are beatable but I suspect estimates will come up ahead of the 2Q10 print.

Full year 2010 EPS is slated to grow near 100%, according to consensus, while 2011 is slated to grow 56%. Compare that to Google which consensus sees 2010 EPS growing 20% in 2010 and 15% in 2011.

Consider the market cap and revenue difference: Google’s market cap is $160bn and Baidu is $25bn, while Google is expected to generate $21bn in net revenues in 2010 compared to Baidu at $1bn.

However, consider that Baidu has essentially zero competition in the Chinese market while Google is facing steep competition from the combination of MicroHoo. Also consider that Internet penetration rates have reached critical mass in almost all countries in which Google operates while Internet penetration rates in China stand at just under 30%. That's 385 million Internet users out of a possible 1.3 billion users. To put that in perspective, the U.S. has a 76% Internet penetration rate with 234 million Internet users. If China were to double its Internet penetration rate, they would have nearly 800 million Internet users. This is a very favorable secular trend for Baidu as the only major online search engine in China and is one clear cut reason to buy the stock.

Over 30% of Google's sales come from European countries where several economies are under distress. Baidu has zero European exposure. Don’t get us wrong, we are still buyers of Google.

Consensus has GAAP EPS of $1.90 in 2011. Applying the current trading multiple to the estimate gets us to a price target of $114, up 50% from current trading levels. If you believe that this multiple is rich then an analytically honest multiple of 50x, in-line with the 3 year EPS growth rate, gets you to a price target of $95, up 25%. A DCF points to a value of $105-$110.

The business should benefit from increased spending from the Phoenix Nest transition and increased customer acquisition. Margins are expanding due to operating leverage. Traffic to the site continues to increase owing to Google's exit, leaving Baidu with more bargaining power over smaller advertises.

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Where we could be wrong:
1. Other online search providers could strengthen their competitive position
2. Given the recent success of Bing in the U.S., Microsoft could decide to aggressively enter the online search market in China.
3. Management could fail to capitalize on their near monopoly position
4. Management could miss gaining traction in mobile and ecommerce
5. Government policies that curtails China's rapid growth rate.
6. Although Baidu has no exposure to Europe, further headlines like the one from Hungary on debt issues are likely to continue to spark a sell-off in the overall markets and in particular for high multiple stocks.