2023-11-28 03:05:06 ET
Summary
- Baidu's Q3 report exceeded expectations in terms of both revenues and earnings.
- Baidu is growing its top line, driven by a continual recovery in online ad sales.
- iQIYI is seeing strong subscriber growth and monetization improvements. The streaming platform now makes a significant, positive FCF contribution to Baidu.
- Shares trade at a P/E ratio of 11X and have an attractive risk profile.
China’s Baidu ( BIDU ) presented better than expected earnings for the third-quarter, in part due to progress the company is making in the artificial intelligence segment. Considering that the firm benefits from growing AI adoption, generates a ton of free cash flow (now also including its iQIYI-branded streaming platform), and that shares trade at a near-10% earnings yield (3 reasons), I believe the risk profile remains favorable for long term investors!
Previous rating
My rating on Baidu in September was strong buy because the company benefited from a continual recovery in the online advertising business and because shares were considerably cheaper than Alphabet's ( GOOG ) shares, the closest U.S. competitor. Considering that Baidu has considerable operating income and free cash flow momentum, my strong buy rating for Baidu deserves to be maintained following the company’s third-quarter earnings.
3 reasons to buy Baidu: AI growth, FCF strength and a cheap valuation
Baidu delivered better than expected earnings for the third-quarter and beat on both the top and the bottom line.
Baidu generated 34.5B Chinese Yuan ($4.7B) in revenues in the third-quarter which showed 6% year over year growth. However, the company’s operating income soared 18% year over year to 6.3B Chinese Yuan ($860M), in part because Baidu experiences recovering a recovery in its core advertising business. Online marketing services generated 21.3B Chinese Yuan ($2.9B) in revenues, rising 7% Y/Y.
Besides strength in online advertising, which Baidu’s captures through its dominant position in the Chinese Search market (where the company has an estimated market share of 70% ), the company has said that it is seeing increasing momentum for its ChatGPT rival Ernie 4.0.
The inclusion of AI capabilities into Baidu Search as well as the integration of Ernie API into cloud solutions creates a long run-way for growth for Baidu. Although the company does not break down specifically revenues generated by Ernie, Baidu has said that its developing artificial intelligence focus should “set the stage for sustained multi-year revenue and profit expansion”
AI is the ultimate growth market and Chinese companies, like Baidu, are investing billions of dollars in the pursuit of market dominance. For Baidu, which can use AI to improve Search results, delivery efficiencies for advertisers and integrate AI assistants into its Cloud business, AI is a powerful growth driver going forward. According to Precedence Research, the global AI market is set to grow to $2.6T by FY 2032, implying a near-20% annual average growth rate.
Baidu generated free cash flow of 6.0B Chinese Yuan ($822M), on a consolidated basis, in the third-quarter on revenues of 34.47B Chinese Yuan ($4.72B). This calculates to a free cash flow margin of 17% compared to 20% in the year-earlier period. While Baidu suffered a decline in its free cash flow in its core business, but iQIYI is seeing improved free cash flow prospects, largely due to growth in users and monetization. iQIYI-related free cash flows in Q3'23 increased by a factor of 5.6 year over year to 827M Chinese Yuan ($113M).
iQIYI is a streaming platform that offers mostly Chinese users access to movies, games and anime. The streaming company had 107.5M subscribers (average daily number) in the third-quarter compared to 101.0M in the second-quarter.
iQIYI’s monetization is improving as well. The streaming platform generated average monthly revenue per membership of 15.54 Chinese Yuan ($2.16) in Q3’23, increasing 12% Y/Y. The growth in iQIYI-driven free cash flow is good news for Baidu which has not only finally turned a corner on its loss-making streaming operations, but it has also found a way to offset potential weakness in its core online advertising business.
Deep value in the large-cap Chinese tech/e-Commerce space
Shares of Baidu are currently valued at a P/E ratio of 11X which implies a high earnings yield of 9.1%. For comparison, Alibaba (BABA) is trading at a P/E ratio of 8.0X and an earnings yield of 12.5%. Of course, Baidu and Alibaba are operating in different businesses (Alibaba is focused on e-Commerce while Baidu is focused on online advertising, among other things), however both companies are subject to broad online advertising and consumer spending trends. Alibaba is now also a dividend stock , adding to its appeal for international investors.
Alibaba is expected to see long term EPS growth of 17.5% while Baidu is expected to grow at an ever faster rate in the future, 32.5%. However, Baidu's short term EPS performance will depend more on online advertising sales and in the long term, in my opinion, more on growth in the artificial intelligence market.
Risks with Baidu
Baidu is a China growth play and as such exposed to regulatory headwinds and political uncertainty. Additionally, other macro risk factors, such as new trade tensions between China and the U.S. have the potential to affect Baidu’s valuation, though not necessarily Baidu’s core business operations. The recent U.S. chip ban relating to China has not had a negative impact on Baidu's business. The single biggest commercial risk, as I see it, is a potential growth slowdown in online advertising as this segment continues to generate the majority of Baidu’s revenues, cash flow and earnings.
Final thoughts
China’s Baidu submitted a decent earnings sheet for the third-quarter that showed continual growth in the top line and beat earnings estimates. Management also showed confidence in Baidu’s AI-centric business and product strategy as it rolls out new AI products. Besides the potential for AI-related growth (in both Search and Cloud), I believe the strength of Baidu’s free cash flow, which has been driven in part by streaming platform iQIYI, are reasons to own Baidu shares. What I like the most about Baidu is the company’s extremely attractive valuation based off of earnings and free cash flow. For those reasons, I continue to see Baidu as a strong buy and believe the risk profile remains skewed to the upside!
For further details see:
Baidu: 3 Reasons To Buy This Growth Stock