This morning Goldman Sachs removed Google Inc. (NASDAQ:GOOG) from its ‘Conviction Buy’ list and Google shares are up slightly today though still down around 15% since January. Credit Suisse, at the same time, downgraded Chinese search giant Baiduk, Inc. (NASDAQ:BIDU) from ‘Neutral’ to ‘Underperform’. Baidu’s shares have lost 2% in trading so far today, but are up about 60% since January.

In Baidu’s favor today was a report from a Beijing research firm that Google’s share of Chinese search revenue fell from 35.6% to 30.9%, while Baidu’s rose from 58.4% to 64%. The WSJ reports that total revenue for search in China during the first quarter totaled $285.6 million, down a bit from $288.6 million in the previous quarter.

When Google moved its servers to Hong Kong in late March, predictions of dire consequences followed. Every acknowledges that the search market in China is still in its infancy, and projected total revenues of less than $1.5 billion for 2010 verify that. The ultimate prize, though, is the vast size of the Chinese market and the potential revenues that are possible.

It is on the back of that potential alone that Baidu’s shares have risen to more than $625/share, its market cap is near $22 billion, and its forward P/E ratio is over 41. The company’s total revenue for 2009 was just over $650 million. If this reminds you of the internet bubble of 2001 or the real estate bubble of 2008, you aren’t alone.

Part of the problem leading to Google’s loss of revenue in China was the uncertainty among advertisers over how the Chinese government would respond to Google’s leaving the mainland for Hong Kong. The reaction was reasonably mild, involving filtering of Google’s search results through China’s ‘Great Firewall’.

Google’s advertising resellers in China told the WSJ that sales “are starting to stabilize” after the initial decline. In fact, at least one research firm has data that show Google’s traffic has increased since the site’s move to Hong Kong. Alexa reports that Google is now getting about 4% of all global internet traffic on its Hong Kong site, a jump of more than 500% in one month and more than 1200% in three months. The moral of the story is that unless the government turns the screws more tightly, Google is probably not going to be any worse off in another month than it was before it left the mainland.

China, where Google made revenues of $300-$400 million annually, is not the search leader’s biggest problem. Its main challenge is coming from an increasingly powerful shift in how people are using the web. The source of the shift is Facebook and its concept of the ‘social graph’, or as Facebook’s founder and CEO calls it, the ‘open graph’.

At its recent F8 Conference, Facebook unveiled a number of tools that are aimed at defining the web as a graph of social connections, not a list of hyperlinks that are easy fodder for search engines like Google. Open Graph allows users to share information about what they like and dislike and, most important, reduces that information to what is essentially a machine-readable form. It is a nascent semantic web.

A Facebook Connection Map with 100 Friends:

Enlarged View of a Slice of the Facebook MAP:

More important even that, Open Graph becomes a platform for serving targeted ads that are based on the likes and dislikes of a user’s social connections. That’s where the money is, and Facebook has a huge lead getting to it.

Facebook also has a few problems. First is security of personal information. Second is the natural inclination of users not to give up personal information so that they can be inundated with ads. Third, is not to give up the information for free. None of these is insurmountable, but Facebook has so far shown a tin ear when it comes to user reaction.

For its part, Google hasn’t captured much enthusiasm for its social networking program called Buzz. The program almost immediately raised privacy concerns among governments. In fact, Google’s Buzz is not substantively different from Facebook’s Open Graph. The difference is that Google’s market cap is about $170 billion and its been around for long enough to get noticed for what it does.

Facebook is getting noticed too, especially in Canada where data privacy concerns over the way it stores personal information caused the country’s privacy commissioner to say that Facebook “opens the possibility that a lot of people can be blackmailed.” That might be an overstatement, but clearly the Canadians are not happy with Open Graph or Buzz.

Another issue staring Google in the face is its seeming floundering around in the smartphone market. The company just pulled its Nexus One phone from a deal with Verizon Wireless. Google’s Android operating system has a 25% share of the OS market, but the Nexus One contributes almost nothing to that. However, Google gives Android away, though, and hoped to make money on the Nexus One.

Google still owns the search space, with more than 85% of global search. Next in line is Yahoo!, with about 5.4%, then Baidu with about 3.5% according to NetMarketShare. Google’s claim on the search space and the advertising revenue that goes with that space is its ability to target and deliver ads. Facebook, if it can straighten out its privacy issues, is capable of doing a better job of targeting.

Both the smartphone space and the social networking space are far more important to Google’s future than the Chinese search space. That’s where the company should be focusing its attention.

Paul Ausick

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