Baidu Still a Buy

Despite a double-digit runup on the day after third-quarter results were released, Baidu’s BIDU shares are still significantly undervalued relative to our $218 fair value estimate. We have seen substantial sequential improvement in revenue, operating profit, and Baidu core operating profit in the second and third quarters, and the most recent results provide further evidence for our thesis that Baidu will cut back on investment and increase margins if returns on some of its investments are not ideal. Management also sees stabilization in the overall business, with the growth in industry ad supply slowing. We note that rival WeChat Moments still has a lot of room to release inventory, though we believe this will happen gradually.

Third-quarter revenue was CNY 28.1 billion, close to the high end of the guidance range of CNY 26.9 billion-28.5 billion. Management expects fourth-quarter revenue of CNY 27.1 billion-28.7 billion, or down 1% to up 6% year over year, while guidance for Baidu core is 0%-6% year-over-year growth. Operating income in the third quarter was up from CNY 233 million to CNY 2.4 billion thanks to an 11% sequential decline in selling, general, and marketing expenses, operating leverage resulting from the 7% sequential increase in the top line, and a 5% sequential reduction in traffic acquisition costs, which management attributed to stronger mobile ecosystem. On a year-over-year basis, operating income still declined 47%. The net loss was CNY 6.4 billion in the quarter, attributed to an impairment of CNY 8.9 billion on the sale of 7% of Trip.com. Baidu's core revenue and operating income were up 8% and 146% sequentially.

The flagship Baidu app’s daily active users came in at 189 million in September, lower than the 200 million that was leaked from an internal company presentation in August and similar to the 188 million reported for June. This growth has shown some signs of saturation.

The company has not reported the number of daily active users of Haokan, the short video app that Baidu invested in, for two quarters. According to Analysys, Haokan’s daily active users in August numbered 31 million versus 26 million in March, and the month-on-month growth rates between March and August were choppy. Baidu said in the press release that its in-app search gained market share, with in-app search queries growing 25% year over year, and spending was up 16%. We see potential for revenue to catch up with search queries as the oversupply situation and macro environment improve.

Growth in Baijiahao, the newsfeed network, and Smart Mini Programs are important, in our view, as they strengthen Baidu’s mobile ecosystem and increase user stickiness. Baijiahao grew 9% to 2.4 million publisher accounts quarter on quarter. Smart Mini Programs’ monthly active user count was 290 million, up 7% from 270 million in June. DuerOS voice assistant’s monthly voice queries surpassed 4.2 billion in September versus 3.6 billion in June. We think the growth in DuerOS use and its market position in voice search should be monitored to know whether Baidu's huge investment in artificial intelligence is justified. Voice search should be able to leverage Baidu's search technology, and therefore Baidu should have an advantage over peers. DuerOS will be the next monetization driver for Baidu’s AI business, although it will take a long time for the contribution to be significant.

Subscribers to the iQiyi video platform reached 105.8 million, similar to the 100.5 million in June. We expect the subscriber base to increase as content restrictions diminish.