Baidu’s Undervalued for the Long Term


Although Baidu’s search revenue and reputation were severely damaged in the Wei Zexi incident in early 2016, we believe that the worst has passed. Following the incident, Chinese authorities launched new regulations for online search and advertising, which clearly defined paid search results as advertising; the new regulations came into effect Sept. 1, 2016. As a result of stricter standards for online advertisers, Baidu’s active online marketing customers decreased 6% and its search revenue declined 0.5% in 2016. In 2017, Baidu’s online marketing service revenue growth recovered to 13% thanks to a low base in 2016.

IQiyi, Baidu’s online video platform, has been a key growth driver in the past three years. Revenue increased 55% in 2017 to CNY 17 billion, although this still represented a CNY 4 billion operating loss. Baidu filed for an initial public offering for iQiyi and is planning to raise $1.5 billion, which could value it at $10 billion. In February 2017, iQiyi issued $1.5 billion in convertible bonds.

We think a potential Baidu breakthrough in AI-based apps or services, including autonomous driving, is the key upside risk for this company. As a technology company, Baidu has been actively investing in AI for many years.

Market Share Leader in Search
Baidu’s wide economic moat, which derives from its network effect and intangible assets, is evident, in our view. As one of the earliest Internet companies in China, Baidu has built an ecosystem around search and has successfully shifted to mobile Internet by releasing various well-received mobile apps, such as Mobile Baidu Search and Baidu Map, both ranked number one in their verticals with monthly active users of 400 million and 288 million, respectively, as of the first quarter of 2017, according to Questmobile. This compares with 21 million monthly active users for the Sogou mobile search app in the same period.

Although different data providers reported different market share data, there is no doubt that Baidu is the market share leader in search. According to Analysys, a data provider, the revenue market share of China’s search engine providers excluding channel revenue was 79.62% for Baidu, 11.11% for Google China, and 5.71% for Sogou in the fourth quarter of 2016. According to iResearch, based on mobile queries, Baidu had a market share of 73.8% in September 2017 versus 17.8% for Sogou and 8% for Shenma. Google is not a threat in mainland China, as it exited the local market in 2010 because of censorship.

Intangible assets and network effect are Baidu’s moat sources. The largest database of user behavior data in China, which Baidu’s search engine has accumulated over the course of almost two decades, is critical in generating the most relevant results for users, which leads to increased usage and more data, and in turn higher advertising efficiency.

Meanwhile, Baidu has built up a network effect and a positive feedback loop in its search business by leveraging its significant search traffic on both PC and mobile devices; this is difficult for its competitors to replicate, as it would take a long time to achieve a user base and marketing customer base of similar size. The larger the user base, the more user data Baidu can collect and analyze, improving the search engine algorithm and relevancy of search results. Users receive better, more tailored recommendations, making it less likely for them to use another search engine. With the large amount of user data, Baidu can provide personalized advertising strategies so that advertisers can generate higher returns on investment on their ads. Given Baidu’s largest user base, advertisers are willing to pay higher prices for search ad purchase as advertisers can reach the largest potential audience. Besides web search, Baidu provides other related content, such as Baidu Post Bar (a social media service), Baidu Knows (a query-based searchable community to share knowledge and experiences), Baidu Encyclopedia, and Baijiahao (a platform for content owners to publish content and manage their fans), which can improve the user experience as well as allocating more ad inventory. At the second quarter of 2017, Baidu had 470,000 active online marketing customers, versus Sogou’s 75,000-plus advertisers. Baidu’s revenue per customer in the search business is estimated to be 165%-186% higher than that for Sogou.

We think that Baidu’s other segment has no moat, given intense competition. IQiyi is Baidu’s online video platform, having merged with PPS in 2013. According to Questmobile, iQiyi was a close second in the video streaming industry in China with 434 million monthly active users (versus 435 million at Tencent Video) in March 2017. As with major online video platforms in other regions, iQiyi’s monetization model has been shifting from advertising to a mix of advertising and subscription, and its paid subscribers had increased to over 20 million as of June 2016. At the same time, iQiyi is an important advertising platform in Baidu’s ecosystem to support advertising campaigns. Although iQiyi is the current leader in online video, we don’t think it has a moat, given the intense competition from Tencent Video and Youku Tudou. IQiyi, Tencent Video, and Youku Tudou (under Alibaba) are also investing heavily in premium and self-produced content to attract and maintain users. Baidu also entered the online-to-offline business by acquiring Nuomi in 2014, and transaction services include Baidu Nuomi (scaled back spending since 2016), Baidu Deliveries (sold in 2017), Baidu Wallet, and Baidu Maps.

Overall, we believe that Baidu has a wide moat mainly coming from its search business. Its return on invested capital has historically been significantly above its weighted average cost of capital of 9.4%. ROIC fell in 2016 because of a medical advertising scandal at Baidu and the resulting government curb on healthcare ads. We note that Baidu’s online marketing services revenue started growing in the midsingle digits in the second quarter of 2017 and accelerated to over 20% year over year in the third and fourth quarters, indicating the adverse impact is over.

Intense Competition a Risk
We think Baidu faces high levels of risk, given intense competition, along with questions as to whether its AI-related investment will generate satisfactory returns.

Though Baidu is the largest search engine in China, it is competing with the other two internet giants, Tencent and Alibaba. Regarding the search engine business, Tencent invested in a joint venture (Sogou) with Sohu, and Alibaba acquired UC Web, which owns a mobile search engine, Shenma. Competition has extended to each key area of mobile Internet usage, such as navigation, O2O services, online video services, and so on. Baidu’s margins have been significantly dragged down by aggressive spending in video content and O2O marketing but recovered to 18.5% in 2017 from 14.2% in 2016 as the company sold margin-dilutive businesses.

The major Internet companies in China have been investing in AI-related business, such as cloud computing, voice and image recognition, and autonomously driven cars. Although Baidu is an early mover in this area, the other players are also investing in AI. At the current stage, it is difficult to predict whether Baidu will be the final winner in AI and whether the returns will reward its investment.

In addition, regulatory risk is a concern. Following the Wei Zexi incident in early 2016, Chinese authorities launched new regulations for online search and advertising, which clearly defined paid search results as advertising. If the local authorities release more policies regarding Internet business, such as online advertising and online finance, Baidu’s revenue could be negatively affected.

Since 2017, Baidu has discontinued the disclosure of monthly active users for its mobile search and mobile maps, which is possibly due to weaker numbers.

Baidu’s balance sheet remains very well capitalized, with more than CNY 100 billion in cash and short-term investments to support CNY 7.9 billion in total debt as of December 2017. Its free cash flow was CNY 28 billion in 2017, which is sufficient to fund operations and maintain its moat through investments or acquisitions in new products. As of fiscal 2017, Baidu has a debt/EBITDA ratio of 0.33 and EBITDA/interest coverage ratio of 18. Given the cash-rich nature of the paid search business, we don’t see any issue in Baidu repaying interest expense and debts when they are due. The company has raised a total of CNY 33 billion in U.S.-dollar-denominated senior notes with a relatively low effective interest rate to beef up its war chest for future domestic and overseas acquisition opportunities. Given the growth opportunities in the sector, we do not include any dividends in our 10-year forecast period.

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