Feb. 6 (Bloomberg) -- Chen Chen was so disappointed when he learned that Baidu Inc.’s Web site led some patients to seek unlicensed medical care, he started making Web queries through Google Inc. instead.

“I was shocked when I first heard about this,” said Chen, a 22-year-old security guard in Beijing, who’s been using Baidu ever since he started using the Internet. “Now, even if I look up anything through Baidu, I’ll cross-check it through Google just in case.”

Baidu, the leading Internet search engine in China, has seen its traffic decline and stock price slump since November, when a state-run television broadcast criticized its practice of displaying paid search results higher than some free ones, according to Beijing-based research firm Analysys International.

“Until Baidu can clearly demonstrate it has overcome the issues brought up by the negative media reports recently, advertisers will likely pull back spending,” said Steven Chang, chief executive officer at Optimedia China, which buys advertising from Baidu and Mountain View, California-based Google. “Google’s biggest strengths are its ‘Don’t Be Evil’ motto and the integrity of its technology, and the company should attempt to capitalize on them in China.”

Since the controversy, Baidu has taken steps to correct problems highlighted in the report on state-owned Chinese television network CCTV. It removed unlicensed providers of drugs and other medical care from its search screens and says the company is redesigning its site so that paid search results are more distinguishable from free ones, though it still co- mingles them.

Internet Growth

U.S. investors say Baidu’s reforms will be sufficient for the company to maintain its search lead over Google in China. They predict that surging use of the Internet in China will continue to buoy Baidu regardless of the controversy, and that most new Internet users will choose the China-based company over its U.S. competitor.

“Google is not going to win in China,” said West End Capital Management’s Sean Cooper in San Francisco, who owns both Google and Baidu shares. “Baidu is not going to be displaced. All this stuff is going to blow over.”

Yet research firms point to a gain for Google. The U.S. search giant’s share of China’s online advertising market rose 4.4 percentage points last year to 27.8 percent from the prior year, narrowing the lead of Baidu, whose market share rose 2.9 points to 62.2 percent during the same period, Analysys Chief Executive Officer Edward Yu said in an interview.

Catching Up?

Baidu’s lead may shrink further in 2009 as fourth-quarter Internet traffic levels, a leading indicator for advertising revenue trends, point toward a decline for the Chinese company and a gain at Google, Yu said.

Baidu’s fourth-quarter search volumes appeared to fall 3 percent from the preceding quarter, but rose 10 percent from the same period a year ago, according to estimates this month at New York-based Majestic Research Corp. Majestic uses a proprietary method to collect data on Baidu search volumes.

In its broadcast, CCTV interviewed a man only identified as Li who said he visited an unlicensed hospital because its Web link was the first to appear in Baidu’s search results, not knowing it was a paid ad. Following the report, Chairman Robin Li, who co-founded Baidu nine years ago, apologized for the controversy and pledged to remove unlicensed medical companies from the search list.

The outcry hasn’t resulted in “any significant change in traffic” on its Web site, the company said in an e-mail. Chairman Li declined to be interviewed for this story through Cynthia He, who represents Baidu and public-relations company Brunswick Group Inc.

Hiatus From Baidu

Xu Dong, a 31-year-old marketing executive at a Chinese electronics company, said he stopped using Baidu for a month and began making Web queries through Google after the CCTV report. He said he went back to Baidu after the Chinese company said it would increase scrutiny of its advertisers.

“I got a pretty bad impression of Baidu at first,” Xu said. “But it’s also important to support domestic companies.”

Baidu’s American depositary receipts plunged the most in three years on Monday, Nov. 17, the first trading day after the Nov. 15 and Nov. 16 CCTV reports. Google shares also fell that day, amid a broadly declining market.

Google Rises

Since then, Google’s shares have recovered, unlike Baidu’s. Google has risen 20 percent since Nov. 14, while Baidu has fallen 30 percent.

Google climbed $17.56, or 5 percent, to $371.28 at 4 p.m. New York time in Nasdaq Stock Market trading. Baidu dropped 68 cents to $124.61.

Baidu cut its fourth-quarter revenue forecast about 15 percent on Dec. 11, citing the end of ad sales to unlicensed medical companies and the removal of “questionable” links in other industries.

The company hasn’t said which businesses’ ads were removed or how much revenue was lost because of the withdrawals. Morgan Stanley analysts Richard Ji and Jenny Wu estimated medical companies without proof of licenses accounted for about 10 percent to 15 percent of revenue before the removals.

Google, the world’s biggest search engine, stepped up efforts to win market share in China in the wake of the CCTV report, Wallace Cheung, an analyst at Credit Suisse Group AG, wrote in a Dec. 12 report.

CCTV Report

CCTV reported on Dec. 11 that Google was also showing some illegal ads for pharmaceuticals in the sponsored links next to search results, according to news agency Interfax-China. Google said in a blog posting the same day that it removes ads that don’t meet its policies.

In an e-mail to Bloomberg News, Google distanced itself from the practice of prioritizing paid ads.

“Search engines must not mislead, because if they do that, they will eventually lose the faith and trust users place in them,” Google China President Lee Kai-fu said.

While battling Google in online search, Baidu is also seeking to expand into the electronic-commerce market in China, where Alibaba Group Holding Ltd.’s Taobao site commands a market share of about 75 percent. Baidu started a test version of a retail Web site in October, competing directly with Taobao.

China had 298 million Internet users, close to the total U.S. population, as of the end of last year, the government- backed China Internet Network Information Center said on Jan. 14. China passed the U.S. to become the world’s biggest Web market by users in the first half of last year.

Baidu “has multiple ways to grow outside of search in the future,” said Jeff Papp, senior analyst at Oberweis Asset Management Inc., which owns shares in the Chinese company.

Baidu is likely to learn from the controversy and move on, said Walter Price, who helps oversee $3 billion, including Baidu and Google shares, as managing director at RCM Capital Management in San Francisco.

“I’d look at it more as a bump in the road rather than a change in the trend,” Price said.

To contact the reporters on this story: Mark Lee in Hong Kong at wlee37@bloomberg.net; John Liu in Shanghai at jliu42@bloomberg.net; Joseph Galante in San Francisco at jgalante3@bloomberg.net.

Last Updated: February 6, 2009 20:58 EST