Baidu: No Longer A Search Engine Play, But An AI Bet
Aug. 09, 2021 6:44 AM ET Baidu, Inc. (BIDU)
Panther Research
SummaryThe Company has been aggressively sold off for arbitrary reasons unrelated to its fundamentals.Baidu is still the Google of China but its search engine business has and will continue to lose market share.The company’s expansion into the AI space is really the main growth factor moving forward.Apollo Go, DuerOS, Xiaodu Speakers, and its AI Cloud business will culminate in Margin Expansion and Higher Valuation Multiples.I still rate this a buy if you are willing to hold for at least 3 years.
 V2images/iStock Unreleased via Getty ImagesInvestment ThesisAs part of the recent regulatory clampdown on the broader China capital markets by the CCP, Baidu ( BIDU) has unfortunately been sold off for reasons largely unrelated to its business model and operations. The stock has also been caught up in the Archegos Capital debacle and has been in a constant downtrend ever since, down from its highs of US$354.82 in February to US$164.26 today, a 53.7% decrease from peak to current levels.
Despite this, the fundamentals of the business are still sound and the company has its intentions set on continuing the rollout and developments of its AI initiatives that I believe will lead the growth of the company moving forward. Baidu is still the Google of China by market share but that is no longer the factor that one should be banking on for future growth.
I have recently posited my thoughts regarding the CCP’s arbitrary and sudden intervention and regulatory scrutiny on what seems to be in a new industry every other week, and you can find them in my Alibaba ( BABA) article here if you are interested. Unfortunately, if you are of the opinion that China is no longer the capitalistic state you once believed it was and have since withdrawn from investing in the region, this article will not be of much value to you.
That being said, I did mention in my previous article that the best way one could hedge oneself from unnecessary risks investing in China should you choose to, would be to initiate positions in companies operating in industries well in line with the government’s goals as stated in the 14th 5-year plan.
I will not say that Baidu is a better buy than Alibaba at these levels but it certainly is a safer bet that guarantees it a higher degree of immunity from scrutiny by the CCP purely because of the industry it operates in. With that in mind, let’s begin!
Business ModelBaidu’s revenue channels can be easily broken down into 2 categories: Baidu Core and iQIYI. Baidu Core encompasses its legacy search engine advertising platform, the Baidu AI Cloud, its autonomous Apollo Driving unit that itself consists of a Robotaxis, commercial vehicles, and a MaaS division that includes Robobuses and the DuerOS system used in the company’s smart Xiaodu speakers and car systems.
iQIYI is famous for being known as the Netflix of China, albeit there has been some significant competition in this space recently. Baidu spun off iQIYI in 2018 but retained a 28% stake in the company, of which contributed about RMB 8 BN to the company’s topline as of Q1’21, representative of 28.4% of Baidu’s overall sales. 
(Source: Panther Research)
Although iQIYI still remains unprofitable to this day, its net losses have reduced from RMB 2.9 BN as of Q1’20 to just RMB 1.3 BN in Q1 this year. That is indicative of a 55% reduction in their net losses from this segment. iQIYI subscribers have also grown to well over a 100M active customers, that has given the firm the support they need to maintain their 50+ in-house studios and continue the production of originals. This portion of sales has also grown from less than 25% of their overall revenues to more than 28% of the firm’s topline as seen in the 1stquarter ER.
Search Engine No Longer The WOW FactorAlthough Baidu used to be famous for its search engine capabilities and market share, the firm is no longer leveraging this portion of its operations to drive further growth and transform the company moving forward. Yet, Baidu is still the largest operator in the search engine market in China with more than 73% of the market share.
(Source: StatCounter)
The firm has been losing market share and its search engine revenues has been stagnating over the past 5 years in terms of nominal value. After reaching a peak in 2018, its search engine revenues have been on a decline ever since, decreasing 8.76% from then till now.
The search engine and advertising business is categorised under the ‘Online Marketing Services’ as part of the firm’s 10-K, and as a portion of Total Revenues, has also declined from 70% in FY18 to just 61.90% as of FY20. Clearly, Baidu being the Google of China is no longer the X factor that sets it apart from its competitors and warrants the firm the same type of hype and valuation it did before. Apart from more competitors entering the space and competing for market share thereby leading to less reliance on Baidu as an advertising platform and thus less pricing power for the firm, heightened regulatory scrutiny has also proven to be an obstacle for the firm in the recent years.
That being said, the search engine business will continue to be Baidu’s legacy business and main sales channel for the time-being and for the near future, until the AI segment really starts to pick up and provide more value. As it is, despite losing market share and pricing power in the last few years, the ‘Online Marketing Services’ still represents a heavy 84.2% of the Baidu Core segment (61.90% of the 73.49%).
(Source: Panther Research)
The Fuel To The FireThe real growth, however, will come from the company’s AI developments in the autonomous division and in the growth of the cloud business. Baidu Cloud has a 7.2% market share with the biggest in the industry being Alibaba Cloud with a 39.8% market share. Combined, the top 4 participants have a more than 80% market share rendering the market an oligopoly.
(Source: CIW)
However, it is important to note that the above-mentioned is Baidu’s market share of the broader cloud business in China. In terms of the market for an exclusively AI cloud one, Baidu is the clear leader with the largest market share alongside Alibaba. According to an IDC report Baidu:
Boasts the highest market share and highest number of invocations in China's fast-growing AI public cloud services market”.
(Source: IDC Report)
Baidu Cloud offers the most overall AI products and AI capabilities. Baidu also has the most capabilities in natural language processing ((NLP)) and strong positions in intelligent voice, facial and body recognition, conversational AI, and machine learning”.
The massive growth in the company’s cloud services and the wide margin that they have relative to peers can be seen in the growth in its overall sales. Representative of just 2.94% of Total Revenue for the firm 3 years back in FY18, it has since grown to represent more than 8% of the topline at 8.57% for FY20. The firm continues to grow its AI Cloud capabilities, having “partnered with the online arm of China's largest TV network CCTV to implement Baidu AI PaaS with capabilities to automate video clip creation and tagging from live broadcasting and use smart assistant to quickly locate desired video content”.
In terms of its DuerOS initiatives, the growth has also been impressive. Used in both its smart speakers and with the autonomous car division, “DuerOS monthly voice queries reached 6.6 billion with first-party voice queries reaching 3.9 billion in March 2021”.
Baidu’s also continues to dominate the smart speakers with screen segment followed by Alibaba, with the 2 giants accounting for more than 95% of the market. Smart speaker sales in general did drop by 8.6% in 2020, affected by the pandemic, but has been forecasted to improve 1400 bps in 2021 with shipments topping 42 million units.
The Golden GooseBut perhaps the real growth for the firm will come from their venture into the autonomous vehicle market. In this regard, the firm has had long-lasting operations in developing their Robotaxi network, known as Apollo Go.
(Source: Apollo)
The firm has been testing their Robotaxis with intentions to commercialize them on a mass scale for a long time now, having completed more than 210,000 trials by the end of 2020. The Apollo Go Robotaxi service was officially opened to the public on July 17 in Guangzhou, after successfully launching in Changsha, Cangzhou, and Beijing.
As for the five levels for autonomous test permits ranging from T1 to T5 issued by the Society of Automation Engineers (SAE), Baidu is the first company to have attained a T4 license.
Acquiring the T4 license requires holding to the highest technical standards in the country. Vehicles eligible for the license must be able to legally navigate complex stretches of road -- such as through tunnels and past schools -- and cope with scenarios like careless pedestrians and detours around construction sites.
More impressive is the fact that the firm has started to charge for their service after years of testing and improving. According to the company’s 10-Q, "Apollo Go begins to charge for robotaxi ride hailing in Cangzhou, based on the distance travelled starting with a minimum fare, similar to regular ride hailing."
Now the firm plans to further advance their developments by partnering with “state-owned automaker BAIC Group to build 1,000 driverless cars over the next three years and eventually commercialize a robotaxi service across China.”
Although the Robotaxi segment certainly does look promising and is a push in the right direction which aligns with the government’s own plans and preferences as stated in the 5 year plan, the firm has diversified in this segment also by venturing into commercializing their vehicles as seen through the partnership with Geely, and also with their mobility as a service operations through Robobuses.
The autonomous division for Baidu is starting to finally come together and their efforts as a first mover in this space will start to significantly materialize in the near future. If successful and if the markets do pick this up the way the firm anticipates them to, this could be the real golden goose for the firm to replace and potentially overtake their stagnating ad business.
The firm will no doubt face intense competition from industry rivals such as Didi that has also moved to commercialize their very own robotaxi service, but Baidu’s AI dominance and superiority should enable them to retain their stronghold as more and more people start to utilise and get accustomed to the service.
Balance Sheet & ValuationsAs always, growth prospects are all nice and rosy but financials matter at the end of the day and so does balance sheet health. Without them, the growth prospects can’t be funded and we don’t want to be buying into a company with a load of debt.
Baidu’s Gross and EBITDA margins come in the highest relative to their BATs rivals with a close to 51% GM and an impressive EBITDA margin of 48.85%. I prefer the use of EBITDA margins rather than NPM or OM as a measure of profitability.
The company also has the best balance sheet amongst its peers by a wide margin. Its current ratio stands at 2.86 with a 5 year average of 2.46, indicative of its full capabilities in terms of meeting short term liabilities. The quick ratio stands in the same healthy range at 2.55. Although Total Debt has been compounding at a CAGR of 16.86% since FY16, the Net Debt still remains negative at RMB 79.66 BN.
In any case most of the debt is long term in nature and its current obligations can easily be covered.
(Source: Panther Research)
Looking to analyst estimates, the firm is expected to grow its topline the 2ndfastest of the BATs group, at an impressive CAGR of 19.07% 4 years out, behind Alibaba’s 21.93%. Although it’s bottom line isn’t projected to grow as fast, it is still anticipated to do a CAGR of 11.73% looking 3 years out into the future, slowed by an anticipated 5.24% decrease in the normalized EPS for FY21.
(Source: Seeking Alpha)
Looking 3 years out to December 2023 given that the firm ends its fiscal year in December instead of March like Alibaba does, the anticipated revenue for FY23 is US$25.83 BN, up 57.5% from the firms recorded TR as of FY20.
(Source: TIKR)
Assuming a EV/REV valuation model and looking 3 years back, Baidu is clearly trading at a discount relative to its own historical mean multiple of 2.98, last exchanging hands at a multiple of 2.75. Relative to its peers in the BATs group, the firm is also trading at a steep discount.
Due to the fact that this has always been the case, it would be more accurate to assume a multiple in line with the firm’s history instead of one relative to the 2 other internet giants.
However, looking to the past of Baidu and simply assuming a multiple would not be accurate and fair as well as this a changing business model play, and the type of valuation that the firm warranted from the markets in the past isn’t indicative of Cloud, AI, and Autonomous Vehicle growth prospects that the firm now has lined up for themselves.
The fact that Baidu has ventured into cloud and AI which is more similar to Alibaba’s area of operations than it ever has been, given that it only focused on advertising sales 3 years back, could also mean that assuming a multiple similar to that of Alibaba would be more accurate in today’s context.
However, given that the business model isn’t entirely the same if we were to assume an industry mean multiple within the BATs group, I will stick with Baidu’s mean multiple but add a premium to account for the fact that the firm is no longer purely a search engine play.
Factoring in that analyst estimates for the bottom line and topline are well into the double digits 4 years out, and that Baidu inherently poses less risks given that they operate in an industry more in line with the government’s 5 year initiatives compared to its peers, I will assume a EV/REV multiple of 3.5.
At a current EV of US$47.35 BN, this valuation model indicates an upside of 91% and a stock price of US$314. For those that want to account for CCP risks that have been arbitrary and random at best, you can assume a more conservative multiple. Given that I have already commented on my take regarding further regulatory scrutiny in this articleand still believe China to be “capitalistic”, I will maintain my position using the above-mentioned multiple.
Investor TakeawaysBaidu is no longer the search engine play that we were once accustomed to. They have evolved and are in pursuit of new industries with high growth prospects and high TAMs. The rollout and buildout of its DuerOS platform along with its autonomous Apollo and the partnerships it has remains to be observed.
Estimates, balance sheet, and financials all cumulatively paint a solid fundamental play but this is not to be taken as a harbinger of positive stock price action in the near term given the risks associated with the Chinese capital markets.
With that in mind, the current levels are not a screaming buy, especially if you are one without a long term horizon of more than 3 years. Swing trading the stock based on undervaluation from a fundamental perspective may only spell further trouble for you. Since I am not one to trade based on technicals, I can’t offer any input for the perfect entry and buy range.
But if you are one willing to hold, have confidence in China’s capital markets albeit hedging this risk by maintaining a weightage of no more than 10% of AUM for China exposure, and like the idea of Baidu pursuing this AI path, this FCF king (13.69% 21 FCF Yield) is a rather obvious buy. Till next time!
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