Smart Money Won’t Do Baidu

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Business Description

Baidu Inc. is a Chinese-based internet search service provider, comparable to the U.S. company Google. It operates internationally and generates revenue through online marketing and other services. Baidu.com is a Chinese language search platform connecting users with whatever relevant information they are searching for. Nuomi.com is the company’s online transaction platform. iQiyi is the company’s online video platform that contains licensed movies, television shows, and other content. The company’s other services include Baidu Connect, Baidu Maps, Baidu Takeout Delivery, and Baidu Wallet.

 

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Investment Rationale

Inherent Chinese Monopoly: Baidu controls approximately 80% of the Chinese advertising market share. This domination over the market has been aided by the Chinese government’s protection of the company, which is likely to continue. Google was expelled from China in 2010 for not complying with its local censorship laws. Other non-Chinese companies, like Netflix and Facebook, have also found it difficult to compete.

Investment in Deep Learning: Baidu’s initial investments and pioneering into deep learning software development set itself apart from its peers. Deep learning is a subfield of artificial intelligence that uses algorithms to mimic thought patterns of humans. It was the first company to build a graphics processing unit (GPU) cluster dedicated to deep learning. This GPU greatly improves search engine results and has the ability to deliver real-time speech recognition across numerous languages. Additionally, it opened the company up to potential applications in autonomous vehicles, cloud services, and the internet of things (IoT).

Diversification Strategies: At the time of our initial investment in Baidu, it was seeking to diversify its products and services portfolio. This included improving its mobile device internet search capabilities. Its jump into mobile search services allowed it to grab 80% of the Chinese mobile search market share and nearly 40% of the mobile ad revenue.

Clean Accounting Record: Since its IPO in 2005, Baidu has not been the subject of any accounting scandals. Accounting fraud has and continues to be a serious concern for investors, especially when talking about Chinese companies. The company’s independent accounting firm, Ernst & Young, has conducted diligent audits of Baidu’s accounting statements since its IPO in accordance with the U.S. Public Company Accounting Oversight Board standards. Their reporting record remains pristine.

Recent Performance

Since our last assessment of Baidu Inc in January of 2016, the stock has returned -4.8%. During the same time period, an industry-equivalent ETF (PNQI) has returned 16.6% while the S&P 500 has returned 16.5%.

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Analyst Downgrades, Govt. Investigations, and Economic Slowdown (Move A): In January, Baidu had its rating downgraded by Nomura Securities. The firm cited issues with its mobile search services as the primary reason for the downgrade. Baidu’s mobile search platform was unable to search for content in mobile apps from third-parties. Third-party mobile apps were generating most of the new content at the time, putting Baidu at a disadvantage to its competitors. Additionally, the Chinese government initiated an investigation into the company based on its advertisements of pornographic material and false medical claims. All of these issues fell under the umbrella of questions regarding China’s economic growth prospects. Investors were skeptical of the government’s claim of 7% GDP growth for the year.

iQiyi Buyout and Positive Earning (Move B): The stock price rebounded sharply at the beginning of February when Baidu’s CEO Robin Li made a $2.8 billion off for the company’s streaming service iQiyi. In late February’s earnings announcement, the company beat top line estimates for FY15. They followed this up by issuing strong guidance for Q1 16 that represented around 30% revenue growth.  This reversed the 25% fall caused by the analyst downgrades and growth concerns.

Unethical Advertising and Govt. Investigations (Move C): Shares plummeted 10% on news that the Chinese government launched an investigation into Baidu after the death of a college student with cancer. The student tried an experimental therapy that was advertised on Baidu’s search engine. The company’s credibility was in question, especially after the investigations earlier in the year. After shares recovered 13%, the government found Baidu guilty of unethical medical advertising and imposed stricter regulations on how the company presents sponsored results. Baidu then slashed its 2Q16 revenue guidance by 10%.

Praised for AI and Speech Recognition Efforts (Move D): The stock price rose 20% after the company announced a slew of deals with major chip and automakers. Additionally, MIT published a research report praising Baidu for its efforts in AI and voice recognition. In China, mobile speech-based apps and searching were on-pace to overtake traditional typing.

Analyst Downgrades (Move E): Deutsche Bank and BofA issued bearish notes on Baidu’s stock. Additionally, previously bullish analysts from Brean Capital, Oppenheimer, Piper Jaffray, and JPMorgan began to cut their price targets by an average of 11%. Reasons cited for the downgrades were low organic growth potential, competition in the mobile search sector, and reduced revenue from healthcare ads. Third quarter earnings results showed that revenue growth was still being impacted by the new regulations. They also showed that iQiyi and the company’s transaction services still continued to rack up heavy losses.

Normalized Customer Base (Move E): On a conference call, management said that the company had fully adjusted to the new advertising laws implemented earlier in the year. This brought the stock price up about 6% with the hopes that the company could return to the growth seen in previous years. Additionally, management seemed excited and optimistic about the other segments the company is operating in.

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Exhibit 2: EPS Growth

Financial Performance

Source: Thomson Reuters

Third Quarter 2016 Results: Baidu reported its 3Q16 results at the end of October. The company earned CNY 18.25 billion in revenue, just shy of consensus estimates of CNY 18.31 billion. This represented 70 basis point decrease from the prior year. Despite this, mobile revenue accounted for 64% of total revenue, up year-over-year from 54%. Online marketing revenue and online marketing customers fell approximately 7% and 16% from 3Q15 levels. This was due to the new laws covering online advertisements. Operating profits were CNY 2.787 billion, an 11% increase. However, operating margins were beaten down by nearly 30 percentage points thanks to iQiyi and the company’s transaction services. Net income came in at CNY 3.102 billion, a 9% year-over-year increase. Net profit margins grew 10% thanks to a 50 basis point reduction in operational costs and a 37% decrease in SGA expenses. The company beat bottom line estimates of CNY 7.34 with CNY 8.94.

Exhibit 3: Reduction of Op. Margins
Exhibit 4: Earnings Surprise History
Source: Company 10-Qs

Previous 12 Month Results: Baidu’s previous 12 months have been troublesome. It all started when the company became the target of an investigation on paid medical search ads prompted by the death of a 21-year-old cancer patient. The Chinese government imposed new regulations on internet advertising account verifications as well as the way sponsored ads are displayed, which Baidu has had to adjust to. As a result, revenue growth slowed to around 6%. Meanwhile, their video streaming service, iQiyi, and online-to-offline segments continue to rack up heavy operating losses. The company’s CEO, Robin Li, made a $2.8 billion bid for iQiyi, but cut his pursuits in July, 2016. New York hedge fund Acacia Partners, a major shareholder, claimed the offer was too low and convinced him to drop it. Rumors of an iQiyi IPO circulated late last year, but Baidu claimed they were inaccurate. iQiyi has reported losses since 2012. The company’s strategy has been to invest heavily in segments that produce smaller revenue streams to spur growth. Between iQiyi and the O2O service, costs from content acquisition, bandwidth traffic, and marketing account for over 40% of their cost of revenue. Operating costs have risen quicker than revenue, resulting in over $3 billion in losses over the past two years. These segments are not projected to be profitable until 2018.

Earnings Surprise History: Over the past eight quarters, Baidu has beaten revenue estimates twice with an average beat of 70 basis points. The average miss over six of the last eight quarters is 38 basis points. For earnings, the company has outperformed expectations in five of the past eight quarters with an average surprise of 11.7%. The average miss in three of the last eight quarters is 3.25%. On beats, the average price reaction on the following day was a positive 96 basis points. On misses, the average price reaction the following day was -3.18%. The company gave relatively weak guidance for 4Q16, projecting revenue contraction or miniscule growth under 1%. Currently Zacks Investment Research rates Baidu’s earnings ESP, the likelihood of Baidu beating earnings estimates based on analyst revisions, at -8.6%.

Exhibit 5: Profit Margin/Assets
Source: Bloomberg

2017/18 Outlook: Baidu spent 2016 adjusting to the new regulations concerning online advertising and growth suffered as a result. This will be reflected in 4Q16’s results. In 2017, Baidu will begin operating with a normalized customer base and can focus on growing its internet advertising segment. Though Baidu was able to monetize its in-feed ads, this is only expected to add 4% and 7% to total revenues in 2017 and 2018. This is complicated by the fact that Baidu is facing stiff competition from the likes of Tencent, Alibaba, and Weibo. After implementation of the new ad laws, advertisers will be looking to newer media platforms to engage users. Continuing its shift to new markets, other segments like iQiyi and its transaction services will garner significant focus. For the past few years, there has been an inverse relationship between assets on the balance sheet and profitability. The company’s goal is to turn these segments profitable by 2018. Until then, the company will continue to incur high content and traffic acquisition costs, eroding margins. There is no room for mistakes in the video streaming sector as Tencent and Alibaba have invested heavily in content over the past 18 months. Additionally, the company will continue its efforts in AI development and autonomous vehicles. They’ve stated they will have a small fleet of driverless cars on the road by 2018 and will begin mass production by 2021.

Analyst Recommendations: Analysts have a mainly neutral outlook on Baidu. According to Thomson Reuters, the company’s mean recommendation currently sits at 2.4 with 6 strong buys, 8 buys, 12 holds, 2 sells, and 1 strong sell. The most bullish firm, Stifel Nicolaus and Company, has a price target of $220. The most bearish firm, Bernstein, set a price target of $150. The mean price target is $189.96. Ratings are mainly based on the analysts’ assessments of the future of ad revenue and O2O service growth. Interestingly, the average recommendation and price target has been on a consistent decline for the past 12 months. It started the year with a mean recommendation of 2 and a mean price target of $218. This reflects recommendation downgrades and bearish revisions.

 

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Growth Drivers

Exhibit 7: Chinese Ad Market Share

 

Source: Bloomberg

Digital Advertisements: Baidu was hit harder than most when the Chinese government implemented its new advertising laws. The company was in the spotlight of both the Chinese government and the public long before Wei Zexi, the 21-year-old cancer patient, died from an experimental treatment advertised online. Baidu was accused of selling management rights to unlicensed and fake medical groups as well as turning support and informative forums into free-for-all marketing arenas. The company’s credibility was suffering. Since it was one of the largest ad platforms at the time and had been doing it for so long, it is understandable that it may take longer to adjust to new laws. The company said the final effect of these laws would be felt in Q4 results. From there, the segment can focus on recovery. However, competitors like Weibo, Wechat, and Alibaba are coming up with new ways to engage users. Baidu’s new feed platform was a success when launched late last year but was unable to outweigh the amount of lost advertisers and daily users from the new laws. Baidu will focus on growing profitability with a normalized customer base and is convinced that a higher quality platform with higher quality, loyal customers will drive demand. Management expects the segment to return to its normal levels of growth by 2Q17.

Exhibit 8: Video Streaming Mkt. Share
Source: Talking Data

Video Streaming: After the company acquired its stake in iQiyi, it committed to pursuing the fast growing Chinese video streaming market. Though it’s more than tripled its user base over the past few years, costs have risen even quicker. Licensing, acquisition, and production costs for new content are causing the segment to hemorrhage money. These costs are necessary if iQiyi is to have a fighting chance. Competitors like Alibaba’s Youku and Tencent Video are continuing to add new content to their lineup. Despite the company brushing off an iQiyi IPO as simply a rumor, this could be a very advantageous and strategic move. Spinning off iQiyi into its own entity would allow individual focus on growing both their internet search and video streaming services. It would also stop iQiyi’s currently erosive operations from eating away at core business profitability. Plus, Robin Li’s $2.8 billion offer was turned down in part because it was too small. Shareholders thought an IPO or different buyer would generate closer to $5 billion. Whether the company decides to do this or not is unknown. However, it is not an impossibility.

Exhibit 9: O2O GMV/Market Scope
Exhibit 10: AI Funding and Deals
Source: Bloomberg

Online-to-Offline: These transactions services refer to segments separated from Baidu’s internet search business. Segments like Nuomi, Baidu Wallet, Baidu Connect, and Baidu Takeout and Delivery seek to identify customers online but then, through a variety of different methods, entice them to complete transactions at a physical location. It’s basically online marketing for transactions that will take place offline. These segments have not been profitable since they were initially launched. However, CEO Robin Li said in the 3Q conference call that the marketing expenses associated with these segments would shrink and that revenue streams would normalize. Whether this is true or not, these segments have a long way to go as they contributed to the $2 billion operating loss last year. Plus, the merger of Tencent’s Dianping and Alibaba’s Meituan group deals and purchasing platforms in 2015 gave them control of over 80% of the O2O market. In 2016, Meituan-Dianping raised over $3 billion in investment compared to Nuomi’s $170 million, making it the favorite and seemingly more promising of the two. Likewise, the merger of Tencent and Alibabi’s ride and taxi hailing services give them more strength in the space. Baidu lost out when it backed Uber China as Uber sold out to Tencent.

Source: CB Insights
Exhibit 11: Partial/Full AV Market

Artificial Intelligence: Artificial intelligence has been a key feature in expanding the usability of Baidu’s search engine as well as diversifying its profit points. Baidu started relatively early in pursuing AI compared to its competitors. The massive amounts of data the company has stored enabled it to become one of the leaders in machine and deep learning. The company will continue its efforts in advancing the field. Artificial intelligence can help the company serve markets for big data, robotics, and autonomous vehicles. They also have plans for AI to reach the consumer. Baidu announced late last year that they were developing “Little Fish,” the company’s answer to Amazon’s Alexa and the rest of the voice-controlled home market. To help them along with this endeavor, they’ve hired former Microsoft AI guru Qi Lu to be the company’s new COO. This was after the company funneled $200 million into emerging AI projects in September and $3 billion into mid and late-stage projects in October. Despite the heavy investment and enthusiasm, monetization of their AI efforts are years down the road.

Source: Boston Consulting

Autonomous Vehicles: With their deep exploration into artificial intelligence, it is a relatively easy jump into the autonomous vehicle market. Baidu has used their work in artificial intelligence to develop LIDAR systems and mapping software. In August, Baidu announced a partnership with Nvidia to develop artificial intelligence-based computing software for autonomous vehicles. At CES ’17 in January, Baidu partnered up with BAIC to bring level three autonomous cars to the Chinese market. Road testing is scheduled to begin this year. Baidu is also actively working with the Chinese government to bring self-driving cars to Chinese roads. Though it is widely believed that the autonomous vehicle market will grow by double digits annually for the next 15 years, serious monetization is at least five years away. Regardless, Baidu is continuing to pour resources into the industry and hoping to capture some of the potential growth.

 

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Economic and Industry Analysis

Exhibit 12: China/U.S. GDP Growth
Exhibit 13: Currency Reserves/Exchange
Source: World Bank

China’s Economic Outlook: China is the world’s largest economy in terms of population and second largest in terms of nominal GDP. The relatively recent slowdown in growth has many investors worried, and rightfully so, especially when considering the Trump administration’s anti-China rhetoric. China saw GDP growth of 6.8% in 4Q16, leading to 6.7% growth for the year. To keep up growth, the Chinese government will maintain its expansionary stance on fiscal policy and continue to spend on infrastructure and cut taxes. The urbanization of the mainland will continue along with the rise of average income and home prices in larger cities. The government is actively working to deplete excess housing inventory in the smaller cities as well as general excess capacity to ease pricing pressures, but claimed it would take years. The government will also lift entry restrictions in several service industries but will increase entry barriers in heavy industries. Something that deserves attention is the nearly doubling of corporate debt over the past 5 years, currently sitting at almost 200% of GDP. Additionally, private investment growth has fallen by nearly 10% in the past two years. This makes for a somewhat questionable outlook. The government needs to monitor corporate debt levels, reduce excess capacity, and ensure that public spending needs (such as social security, transportation, etc.) can be met. Regardless, the challenges facing China will make hitting their long-term growth targets difficult.

Source: OECD Database

Currency Outlook: The Chinese Yuan has long been a carefully managed currency by the country’s central bank. One way it manages its currency valuation is through vast foreign exchange reserves. These reserves have taken a beating over the past few years, falling $41 billion to $3.01 trillion in December alone. The People’s Bank has been dumping their USD reserves to slow the depreciation of the Yuan. If they decide to release more of their currency reserves, the yuan and markets in general will likely see increased volatility. Their currency controls have lost their effectiveness as well as the country saw over $650 billion in capital outflows last year. U.S. rate hikes that are expected this year will only encourage more capital outflows in search of higher yield and strengthen the dollar. Additional depreciation of the Yuan will cause heavily indebted Chinese firms to take out additional loans to avoid higher real debt levels. Chinese banks are already stretched thin and taking on high levels of default risk. To top it all off, President Trump has accused China of currency manipulation and has moved dangerously close to trade-war territory. His unpredictable nature and aggressiveness towards China certainly has Chinese officials worried. The People’s Bank will, at best, only be able to pad the gradual depreciation of the Yuan for another 12-24 months. Unless they make serious structural changes to their economic policy, the central bank will lose the power to effectively manage the Yuan.

Exhibit 14: Digital Ad Market Size
Source: IMF Database

Digital Advertisement Outlook: 2016 saw the internet market grow by 6.2%, or 43 million users. China now has over 730 million people online. An additional 3% of the population was brought online, bringing total market penetration to 53%. Over 50 million people are expected to become internet users each year for the next five years. 95% of China’s users access the internet primarily through smartphones. Baidu had a late start to the mobile market as their search platform was not able to search for content on third party apps. Smaller competitors like Sogou and Qihoo 360 Technology Co. were able to gain considerable market share from mobile users, especially after the issues Baidu faced with medical advertisements at the beginning of 2016. The Chinese digital ad market raked in over $43 billion in 2016. Retailers led the charge, forking out $16 billion for digital ads. This number is expected to rise by 50% through 2020 with overall industry revenue doubling. Social media is the main driver of increased ad spending. As internet services continue to connect with more and more of the Chinese population, the competition to grab market share will intensify. The outlook for growth in the Chinese digital ad space is so bright that Google, who exited China in 2011, is looking to make a comeback

Exhibit 15: O2O Platform by Popularity
Source: ComScore

Online-to-Offline Analysis: In an effort to transition to an economy driven more by domestic demand, the Chinese government has helped speed up the spread of O2O through focused infrastructure spending. Another growth driver of online-to-offline services has been the rapid increase of smartphone ownership throughout the country. The success of O2O is further compounded by the fact that vehicle ownership in China is not as widespread as in the West, making the delivery of goods more convenient for consumers. As a result, over half of the population with access to the internet utilizes O2O services. These include food delivery, ride-hailing, dining, etc. As a result, Baidu, Alibaba, Tencent and others are looking gain control of the rising market. The strategy here is to attract higher volumes of traffic and transactions to offset the higher operating and marketing costs associated with the industry. This strategy may be working and is helping to boost China’s already booming tourism industry. Projections for growth are optimistic, in part, thanks to a millennial generation that is prone to global travel. Online travel agencies are working with O2O platforms and developers to roll out apps focused on hotel reservations, airplane tickets, car rentals, sight-seeing maps, and tour guides.

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Revenue: This pro forma assumes 6% revenue growth for 2016 and 5% growth in 2017. The impact of the new advertising laws have been seen over the past two quarters. They’ve stunted growth and are here to stay. The company said the difficulties presented by the laws will still be apparent in 1Q17’s earnings. Additionally, the advance of competitors like Alibaba and Tencent in the digital ad and mobile spaces will make it difficult for Baidu to achieve the growth seen in recent years.

Source: Student Estimates

Cost of Revenue/Operating Expenses: Cost of revenue has been on a gradual but steady rise over the past 16 quarters. Assuming this trend continues, cost of revenue is calculated as 51% of revenue. This pro forma accounts for total expenses decreasing steadily in 2016 and 2017. This was partly due to management’s statement about reduced marketing expenses for O2O services as well as an optimistic outlook for iQiyi. Despite decreasing marketing costs, licensing, bandwidth, and traffic acquisition costs are difficult to lower in the short-term, necessary for growth, and will continue to depress earnings.

Exhibit 17: Est. Earnings Growth

Earnings per ADR: Earnings per ADR are expected to decrease 15% in 2016, mainly due to the new advertising laws imposed by the Chinese government. After the first quarter of 2017, which management warned might disappoint, earnings growth will resume, but negligibly. This pro forma estimates 2% bottom line growth for 2017.

Source: Student Estimates

Risks: Though Baidu claims that the new advertising laws effectively cleansed their customer base, the fraudulent and lower quality medical advertisers made up a solid chunk of their advertising segment revenue (16% in Q3). As its competitors gain more market share, particularly in the mobile arena, Baidu will struggle to return to the levels of growth seen in years past. Baidu also needs to get the costs associated with iQiyi under control before the segment can become profitable. Until then, the segment will continue to lose billions. Additionally, the big bets they’ve made in AI and autonomous vehicles, if successful, will not produce cash flow for years to come. The exchange risk associated with an ADR and a depreciating yuan is also concerning. All of these uncertainties make for a bearish thesis on Baidu.

Valuation: To calculate the fair value of Baidu’s ADR, two valuation models were used- a residual income model and a franchise value model. The residual income model gave a fair value of $174 per ADR while the franchise value model gave a fair value of $164 per ADR. Averaging those values together gives a fair value of $169 making Baidu overvalued by 3.7%.

Recommendation: When considering the performance over the holding period, the idiosyncratic risks discussed previously, the concern on China’s economic outlook, and the foreign exchange risk, I recommend that the Roland George Investments Program sell all 230 ADRs of Baidu that it currently owns.

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