Company Reports

We keep our fair value estimate for Baidu at USD 174, or HKD 171 per share after it posted first-quarter revenue of CNY 31.1 billion that was in line with our estimate. Core Baidu advertising revenue increased only 3% year on year, underscoring continued weakness in China’s macroeconomy. Advertising headwinds were offset by 12% year-on-year growth for the cloud artificial intelligence business, which should remain a bright spot for Baidu as revenue should continue to rise in the midteens year on year next quarter. Baidu remains highly confident that its generative AI model will be a long-term earnings driver, as it is seeing demand from the application side. Clients are now diversified beyond the industrial and infrastructure sectors, and there is greater demand from domestic internet platforms throughout various industries. Baidu said generative AI revenue was about CNY 1 billion this quarter, of which, CNY 322 million came from AI cloud.

We are lowering our Baidu fair value estimate by 5% to USD 174 (HKD 171) per share from USD 183 (HKD 180), after lowering our annual revenue growth assumptions for Baidu’s advertising business to 4%-5% from 6% in 2025-29 as macroeconomic headwinds continue to mount. Previously, wide-moat Baidu indicated that the slow growth rate in the fourth quarter of 2023 was only temporary, with recovery expected in 2024, but we now believe visibility will be limited this year.

Baidu’s online advertising business accounted for 73% of Core revenue in 2022 and will be the main source of revenue in the medium term given its dominant market share for search engines, but we believe unless it can develop another industry-leading business, it could face long-term challenges for advertising dollars from growing competitors such as Tencent and ByteDance. Baidu is increasingly shifting its focus toward its cloud business and now also artificial intelligence, with its Ernie generative AI model becoming its flagship product. We believe that Baidu is an early mover and should benefit from China's AI development, but whether Ernie will be the long-term leader will depend on execution as we believe other resource-heavy companies have the potential to catch up to Baidu if there are missteps in its generative AI development.

We keep our fair value estimate for Baidu at $183 per share after fourth-quarter revenue of CNY 34.95 billion was in line with our estimates. However, its 15.6% operating margin was about 300 basis points less than consensus, due to lower operating leverage from lackluster advertising revenue growth and increased costs from its new artificial intelligence, or AI, products. Revenue growth was driven by advertising revenue increasing 6% year on year. However, cloud revenue outperformed our expectations, increasing 11% year on year for the quarter. Revenue from generative AI represented 4.8% of cloud revenue, and we believe it will incrementally grow in proportion in 2024 and beyond.

We maintain our fair value estimate of USD 183 (HKD 180) after Baidu posted mixed results—core advertising revenue grew 5% year on year in line with our forecasts but with cloud revenue decline of 2%. This was offset by core operating margin of 25%, which increased by 70 basis points sequentially and alleviated concerns that Baidu’s artificial intelligence, or AI, projects would put major pressure on medium-term profitability. Baidu did not provide specific guidance but indicated that next quarter's ad revenue growth should be better than this quarter's and outpace China’s GDP growth—implying a 5%-10% year-on-year increase. It also mentioned that the cloud revenue decline is only temporary. Operating margin increased due to a reduction in operating expenses. Baidu suggested that a 22%-25% operating margin (stock-based expenses excluded) should be maintainable, but that the fourth quarter's should be lower at 21%, due to further AI investments. Management believes that it still has ample room for efficiency improvement and will strive to maintain the current operating margin for 2024. We remain positive on Baidu, given that it maintains a wide moat and dominant market share in China’s search advertising industry.

We keep our Baidu fair value estimate of USD 183 (HKD 180) despite lowering our near-term estimates for the second half of 2023. Our revised revenue growth is 4%-5% from 9% year on year for the second half of 2023, and our new revenue forecast for third-quarter 2023 is CNY 33.9 billion from CNY 35.1 billion. We lower our core advertising revenue growth forecasts to 4% and 5% year on year from 8% and 10% for the third and fourth quarters, respectively, over macroeconomic weakness in China. While we are still seeing ad demand from travel and healthcare industries, we believe demand for advertising in e-commerce has declined in the third quarter. This is consistent with government-released statistics showing only a 4% year-on-year increase in the retail sector for the third quarter versus a 10%-11% increase in the second quarter. We also expect flat revenue growth year on year for Baidu’s cloud business for the rest of 2023, revised from 9%, as one of its key industries, smart transportation, is slowing down, due to lower government spending. Smart transportation projects from the government are billed as one-time contracts that make revenue generation lumpy and their timing unpredictable. Baidu remains upbeat that these contracts will eventually restart next year and that ad demand recovers in 2024, but also has less visibility into growth forecasts next year. We believe Baidu remains currently undervalued relative to our fair value estimate, but also expect greater share performance volatility, given its current macroeconomic and geopolitical headline risks.

We attended Baidu World 2023 online on Oct. 17, where Baidu showcased the latest version of its artificial intelligence foundation model Ernie 4.0 and provided updates on the uses for its AI-related portfolio. One of the key claims from Baidu during the conference was that Ernie 4.0 had caught up with OpenAI’s GPT-4 and that it was on par with the Western model. The conference highlighted some of the model’s capabilities rather than giving an update on the long-term strategic direction of Baidu's AI business as there was a lack of new guidance for the business. We believe that the market also got minimal incremental news about its AI business despite a more refined presentation as shares declined 1% during trading on Oct. 17. We believe that investors remain concerned over long-term issues such as how Baidu will deal with chip sanctions and other key risks that could impede further development of the firm's AI business, which were never addressed during CEO Robin Li's presentation. However, we previously forecast that if its AI business could generate 50% more revenue growth for online marketing and cloud revenue, this could potentially represent a USD 7-USD 10 valuation increase, according to our earlier AI scenario analysis.

We maintain our fair value estimates of USD 183 and HKD 180 for Baidu after its second-quarter revenue was 7% better than our estimates, but offset by sequential operating margin decline due to greater sales and marketing expenses. The company indicated that core advertising revenue remained resilient, given its 15% year-on-year growth, and should continue to recover in the third quarter, but we estimate that its growth is likely to slow down to 8%-9%. We also forecast cloud growth to be about 9% in second-half 2023 rather than double digits, and that contribution from artificial intelligence-related cloud revenue is still limited. The operating margin decline was due to a 32% year-on-year increase in sales and marketing expenses due to greater promotional costs, but also from margin dilution of the cloud business, as its revenue only grew 5% year on year and recovery has been slower than expected. Furthermore, Baidu is awaiting the licenses for its generative AI products and their commercialization will take time to fully scale, and thus we also expected margin dilution from the increased research and development expenses until they become widely launched. Despite the mixed results this quarter, we still like Baidu as a long-term position as its AI technology, which is a part of its core competency, remains a long-term growth driver and should result in eventual operating margin expansion.

Baidu’s online advertising business accounted for 73% of Core revenue in 2022 and will be the main source of revenue in the medium term given its dominant market share for search engines, but we believe unless it can develop another industry-leading business, it could face long-term challenges for advertising dollars from growing competitors such as Tencent and ByteDance. Baidu is increasingly shifting its focus toward its cloud business and now also artificial intelligence, with its Ernie generative AI model becoming its flagship product. We believe that Baidu is an early mover and should benefit from China's AI development, but whether Ernie will be the long-term leader will depend on execution as we believe other resource-heavy companies have the potential to catch up to Baidu if there are missteps in its generative AI development.

While we maintain our fair value estimate of $183 (and HKD 180) for Baidu, we anticipate short-term headwinds for Baidu’s advertising revenue for both second-quarter 2023 and the rest of year as recovery begins to taper off. In addition, we are also reducing growth estimates for cloud revenue in 2023 as enterprises are more cautious with their budgeting for the rest of the year. We are reducing our second-quarter year-on-year revenue growth for Baidu core advertising to 9% from 12%, and to 6% from 10% for cloud. As for the second half, we lower our year-on-year revenue growth estimates to 6% from 10% for advertising, and to 10% from 15% for cloud. In addition, we expect Baidu core operating margins (excluding stock-based compensation costs) to decline to 19% from 25% in the second half due to incremental expenses from the buildout of Ernie. While we lower our expectations for the rest of the year, we expect continued recovery for advertising and reacceleration of the cloud business into 2024 and for operating margins to increase again once Baidu scales its Ernie product as our long-term assumptions remain unchanged.

Baidu’s online advertising business accounted for 73% of Core revenue in 2022 and will be the main source of revenue in the medium term given its dominant market share for search engines, but we believe unless it can develop another industry-leading business, it could face long-term challenges for advertising dollars from growing competitors such as Tencent and Bytedance. Baidu is increasingly shifting its focus toward its cloud business and now also artificial intelligence, with its Ernie generative AI model becoming its flagship product. We believe that Baidu is an early mover and should benefit from China's AI development, but whether Ernie will be the long-term leader will depend on execution as we believe other resource-heavy companies have the potential to catch up to Baidu if there are missteps in its generative AI development.

We keep our fair value estimate of USD 183 (HKD 180) for Baidu after the firm reported first-quarter 2023 revenue of CNY 31.1 billion, reflecting a 10% increase year on year, and 3% better than the Refinitiv consensus. Better-than-expected revenue was driven by further recovery in its advertising business, which led to operating margin increase of 650 basis points year on year. Baidu indicated that advertising demand remains strong in industries such as healthcare, e-commerce, travel, and local services—which are benefiting from China’s reopening. While no specific guidance was given for the advertising business, the firm expects it to outpace China's macro gross domestic product growth rate. While we believe that Baidu’s margin expansion story remains intact, it may increase more gradually, given the incremental costs associated with Ernie. We do not anticipate Ernie to provide meaningful incremental revenue until 2024, but our valuation already reflects higher costs. General and administrative expense increased 20% year on year, reflecting increased headcount for its new artificial intelligence products, including Ernie. Despite higher costs, we believe that Baidu still has attractive upside given its dominant positioning in advertising, coupled with high operating leverage, and outperforming long-term growth.

We are lowering our first-quarter 2023 revenue growth estimate to 4% year on year from our previous estimate of 6%, and lowering our second-quarter growth estimate to 10% from 11%, due to the slow recovery of the cloud business. First-quarter results are expected in mid-May. However, our fair value estimate is unchanged at USD 183 (HKD 180) as our long-term thesis remains intact—we expect ad revenue to recover and drive margin expansion in the second quarter to 21%. We anticipate ad revenue to outpace China’s GDP growth in 2023, and the top categories to remain healthcare, e-commerce, and travel. In addition, Baidu indicated that it is also starting to see strength from offline retailers this quarter, as it is growing faster than its e-commerce peers.

We maintain our fair value estimate of USD 183 for Baidu despite the company posting better-than-expected revenue and operating margin for fourth-quarter 2022. Optimism over its encouraging results was offset by uncertainty over its long-term plans and costs for Ernie, Baidu’s version of ChatGPT. Baidu posted revenue of CNY 33.1 billion, which was 3% better than the PitchBook consensus estimate. More importantly, it reported operating margin (with stock-based compensation added) of 19.6%, reflecting an increase of 660 basis points year on year. This reinforces our investment thesis that Baidu will expand its operating margin due to the high operating leverage of its advertising business, which is positioned for recovery. We believe that Baidu’s top verticals, including healthcare, travel, e-commerce, and local services, will continue to recover, with low-tier cities leading the pace. We forecast Core ad revenue to increase 5% year on year in first-quarter 2023, compared with this quarter’s 5% decline. However, we are slowing down the pace of margin expansion due to Baidu’s increasing investment in Ernie and keeping Core operating margin flat in 2023 from 2022. While margins continue to benefit from high operating leverage of the ad business, this may be offset by lower gross margin and higher R&D costs from Ernie. We think that the stock remains attractive as our thesis remains intact—we expect ad revenue to recover and operating margins to expand, albeit at a slower pace.

For Baidu, we lower our near-term revenue growth for the fourth quarter of 2022 to a 4% decline from our previous estimate of 0% year-on-year growth; and lowering first-quarter 2023 growth to 1% from 13% year on year, due to macroeconomic weakness in advertising spending so far in 2023. However, our fair value estimate is unchanged at USD 183 (HKD 180) as our long-term thesis remains intact and we expect margin expansion in the later half of 2023, driven by a recovery in ad revenues. We believe that ad spending has been slow prior to the Lunar New Year, which should lead to Baidu Core ad revenue declining 8% year on year in the fourth quarter and 1% in the first quarter of 2023. However, we are seeing signs of some recovery from 2023 Lunar New Year data, leading us to believe there will be normalization toward the back half of the year.

We maintain our fair value estimate for Baidu at USD 183 after the firm reported better-than-expected revenue of CNY 32.5 billion, which was 3% greater than our estimates, but was offset by a deceleration of artificial intelligence cloud revenue and sluggish progress in the autonomous driving business. Despite mixed results, we remain bullish on Baidu given the firm's non-GAAP operating margin expanded by 3% to 21.5% compared with our estimate of 17%. While management was noncommittal about whether margins are maintainable in future, Baidu's non-GAAP operating margins were 20%-23% in 2017-18 prior to allocating greater resources to build out its cloud and autonomous driving businesses, which are margin-dilutive. Margin expansion was due to staff cuts, lower channel and promotional spending, and allocation of the budget to higher-margin businesses—none of which appear to be on a one-time basis, which leads us to believe operating margin increases are maintainable in 2023 and beyond.

We maintain our fair value estimate of USD 183 for Baidu as we believe the company’s long-term catalysts and drivers remain intact. Baidu’s share price fell after the company reported second-quarter 2022 revenue of CNY 29.6 billion which was 2% better than our estimate, but represents a 5% decline. The decline was driven by Baidu core’s online marketing revenue, which fell 10% year on year due to lockdown headwinds, which reflects ongoing macro soft demand for advertising in China. In addition, the company did not have visibility into third-quarter advertising revenue and is still seeing softness in the ad industry.

We are lowering our near-term forecasts for Baidu in the second and third quarters of 2022 but keep our fair value estimate at USD 183 (HKD 180) and make no changes to our long-term assumptions. We believe that Baidu could guide toward a double-digit decline for its advertising business in the third quarter that could form a buying opportunity if share prices pull back in the near term. Cloud and robotaxis remain the long-term growth drivers and remain intact as headwinds are limited to near-term advertising revenues.

We virtually attended Baidu World 2022 on July 21 where the forum mainly focused on the rollout of its robotaxi business, Apollo Go, and AI cloud solutions. Management struck a positive tone on the future adoption of Apollo Go to expand its paid services outside of its current 10 so far and expects to roll out the robotaxi service globally by 2025. The company proclaimed that itself and Waymo are the current leaders right now as both are in operational phases. Regarding AI cloud solutions, management shared examples of how Baidu AI cloud empowers industrial institutions to digitally transform their infrastructure. Despite providing a timeline for the global launch of Apollo Go, additional operational details were not announced, and our investment thesis remains unchanged as we view Baidu as a leader in China’s autonomous driving and AI cloud industries. Our fair value estimate remains USD 183, or HKD 180, as the current price suggests that Baidu remains undervalued.

On May 31, 2022, China’s State Council released a set of official measures aimed at the recovery of the economy following recent lockdowns and headwinds from COVID-19. The specific implementation of these policies is left to be determined by local and regional governments, as well as State Council’s ministries and directly affiliated agencies. While the timing is still unclear, these measures are set to become law in the near term. These measures do not cause any material changes to our fair value estimates for now, but we want to highlight which internet names are included and assess the potential benefits in the long run.