Baidu Margin Expansion Story Intact but Uncertainty Looms Over Its Chatbot; Maintain USD 183 FVE

We maintain our fair value estimate of USD 183 for Baidu 09888 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.

We are optimistic that Ernie can be a long-term catalyst for Baidu, but are uncertain over its long-term cost and monetization plans. Baidu plans to incorporate Ernie into almost every aspect in its company, including autonomous driving and its smart speaker Xiaodu, in addition to basic queries for its search engine. We are cautious on whether Ernie can match the success of ChatGPT so far, given that we have not seen real-time use-cases despite the multifaceted ambitions in its incorporation.