2023-10-23 11:03:07 ET
Summary
- Baidu offers a cyclical sentiment opportunity.
- China's macro recovery could result in margin expansion of the core business.
- Monetization of the company's other ventures could unlock value and attract speculative investment in the stock.
- I believe you get Baidu's core business at intrinsic value, while also getting exposure to hot tech trends for free.
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Thesis Summary
Whilst trying to take a break from what appears to be 'overvalued' US equities, I was recently going over Chinese internet stocks. Baidu (NASDAQ: BIDU ), in particular, caught my eye. According to my analysis, the stock is fairly valued and is worthy of a strong buy, provided the company capitalizes on its promising side ventures. Despite noticeable enhancements in its underlying business, the Baidu stock has witnessed a substantial 37.5% decline over the past five years.
Baidu - Business Overview
Baidu is sometimes referred to as the "Google of China". Due to the large net margins in its search engine business, the company was able to invest and expand rapidly into various sectors. Its business is generally divided into two main segments.
Baidu Core
Baidu Core provides several services, mainly monetized through advertisements and subscriptions. We can divide this segment into three main compartments.
Mobile Ecosystem, main apps
-Baidu: Search Engine app, similar to Google.
-Haokan: Video uploading app, similar to YouTube.
-Quanmin: Short-form video sharing platform, similar to TikTok/Snapchat.
-Baidu Wiki, Baidu Knows, Baidu Experience, Baidu Post: Baidu's several Information-centric products.
There have been attempts in the past for others to build a search engine to take market share, no projects however have yet been successful. So Baidu has been sitting at a 70% market share in China for a while now, solidifying their moat even more. In the meanwhile the market share for advertising in China is projected to keep growing around 9-10%.
Baidu Cloud
-Knowledge-graph Cloud Solutions: Applying computing models on big data.
-Industry Vertical Solutions: Applying PaaS and SaaS in several industries as transportation, finance, manufacturing, utilities, telecom and media.
-Baidu Drive: Store and retrieve documents online, similar to Google Drive.
Cloud services are growing rapidly, the sector is expected to grow over 20% in China over the next five years. However, the environment is very competitive and everyone is competing for market share. Baidu is currently in fourth place in China with a 9% market share. But with such huge tailwinds for the industry, the margin of error is large enough not to worry. Baidu AI Cloud has also restructured its cloud business by cutting low-value customer, which will have a large impact on its short-term growth. This can only prove an advantage in the long-term for patient value-investors.
The newly-formed department will be considered the cradle of “new growth engines,” enabling the company to focus on key technologies.
-Yin Shiming, vice president. ( Baidu restructures to focus on AI and cloud computing · TechNode )
Intelligent Driving & Other Growth Initiatives
-Apollo Self Driving, Robotaxi, intelligent EVs: Baidu is the market leader in autonomous driving in China
-Baidu Health: Providing an online presence for doctors and hospitals.
-DuerOS: Smart assistant for the Chinese language.
-Baidu Maps: Voice-enabled travel-related map, similar to Google Maps.
This business segment is attracting a lot of speculators into the stock by talking about the artificial intelligence opportunities, they are the market leader in AI (most AI patent applications). Growth projections can get pretty wild if you let your imagination go free. Baidu knows this and is attracting a lot of investment into their stock by continuously talking about AI-applications and how to leverage them in the future (there isn’t a paragraph on their website which doesn’t mention AI-technology!). This teaches us a lot about how the stock moves. The Baidu share price - as with many Chinese companies - is almost entirely correlated with either an overly enthusiastic or overly fearful public. Knowing this we should try to determine where find ourselves right now in the sentiment cycle.
iQIYI
Entertainment service, similar to Netflix. Baidu owns a 53% stake in the company, which is also trading on the Nasdaq: (NASDAQ: IQ). It’s currently sitting at a $4.4 billion market cap with a total revenue of $4.3 billion and $0.37 billion in FCF (TTM, also adjusted to USD). Baidu's company structure is very comparable to Alphabet (Google) and Yandex (Russian search engine).
Financials
Baidu’s financials bring with them a large margin of safety. Total shareholders’ equity amounts to $56 billion, with $27.7 billion being pure cash. If we deduct $21 billion of liabilities, we get $6.7 billion of pure cash when we buy Baidu. With the current market cap of $44.5 billion (at 130$ per share), we already arguably have a 15% discount on the share price. Most important of all, their strong balance sheet reduces credit risk and allows for more growth in the future. Baidu’s shares outstanding have been relatively stable over the past years. On February 22, 2023, they even announced a $5 billion share buyback program (11% buyback yield!!!). Their stock-based compensation program however is currently at 5%, taking away from shareholder returns. Moody's rates Baidu CIS-2, presumably because of geo-political risk.
Equity | $56.0B ($27.7B Cash!) |
Total Liabilities | $21.0B |
Left Over Cash | $6.7B ($19.5 per share!) |
Will Tiktok and WeChat take Baidu's moat?
In their side bets, they also have the competitive advantage of being the first with large capital to back them up (Data Advantage). A third of Baidu’s Gross Profit has been going to Research and Development over the past years, a sixth is going to capital expenditures. They’re currently spending a lot of money to build the infrastructure to maintain their technological advantages and on traffic acquisition. They are also clearly a highly diversified player (see above) with protection from China from foreign competitors.
There are still risks and competition from companies like Tencent (WeChat), Alibaba, ByteDance (TikTok). People are starting to consume news and entertainment through other apps like TikTok and WeChat, over time this can have a large impact on the situation. But once again, the industry tailwinds could act as a guardrail for some of these risks materializing.
Valuation
Now, let's determine Baidu Core's valuation with a discounted model. Since cash flow is reported only annually in China, let's take their recent net income as an estimation. For the first two quarters of the year, Baidu Core had a net profit of 0.754B and 0.685B USD respectively. Looking back at Baidu's net income over the past years, I believe it's reasonable to assume a $2.5B starting net income per year as a base case. Now for growth, let's take 5% annually over the next 10 years for the Baidu Core segment. This is stably under the expected growth rate for the online digital ad space. For the terminal P/E multiple I've conservatively chosen 15, to build in a margin of safety. Expecting a 10% annual return for this investment, I obtain a fair valuation of $42.0B.
Baidu Core Valuation | Base Case | ||
Net Income Estimation 2023 | $2.5 billion | $2.5 billion | $2.5 billion |
Expected Return on Investment | 10% | 10% | 10% |
Terminal Multiple | 15 | 15 | 15 |
Growth Rate | 10% | 5% | 0% |
Intrinsic Value | $59.0 billion | $42.0 billion | $30.0 billion |
As of writing this article, the share price is at $107 per share, or a market cap of $37.5 billion. I've also attached two separate cases with different growth rates, indicating how swiftly this valuation can change. It is important to note that this is just the valuation of the core business as it's most predictable. But their side projects are a lot tougher to value. We know Baidu tried to sell their stake of iQIYI for $7B to Tencent last year, giving us a rough indication of its fair value.
The following is a summary of Baidu's Q2 Results:
China's Rational Economics
In contrary to what the news headlines would make you believe China actually seems to have made very rational decisions in the past years. Focusing on economic growth and becoming more free-market oriented. Nevertheless, there are still obviously additional risks associated with investing in China (otherwise the Hang Seng index P/E ratio wouldn’t be at 8.1 in comparison to the Dow Jones at 21). Since Baidu’s financial structure is a VIE (variable interest entity) based in the Cayman Islands that has a contractual agreement with the Chinese entity, China could at all times seize the contracts and take control. This is probably highly unlikely since this would be self-sabotage, ruining international relations. This wouldn’t be in line with their economical plan and wouldn’t be in line with their trajectory over the last decade. The delisting risk also seems quite irrelevant because you would be able to take control of the Hong Kong shares instead (check with your broker).
Credit crunch incoming
There are however some other very real risks you have to be aware of when investing in China. China’s Debt to GDP ratio has increased rapidly over the past years (77.3% at the moment), increasing risk for a larger economic slowdown. The CCP still has the power to take complete control over the company at all times. The risk of an invasion in Taiwan is also possible and would be detrimental to any Chinese or even worldwide holdings. (look at Yandex if you want an example…)
Justified discount for the included risk
Whilst it is important to understand the entire business with all it components, the conservative investor should seek to focus predominantly on the core business. Baidu’s great margins in the core advertising and service business allows them to venture out into different growth initiatives. I don’t believe these should weigh in heavily on the core valuation of the business. There are many opportunities for growth in AI, but there is also a lot of uncertainty and competition. Baidu is making large investments into AI, but so is its competition. If we discard these “bets” and focus on main business, what would then be the intrinsic value of the company? (free hot sector exposure whilst remaining a value investment).
Investment strategy and Conclusion
If we take into account their valuation, cash position and all the other investments we get for free, Baidu, inc. could be a very strong buy if you believe in their side ventures. Relying solely on the possible monetization of projects like Apollo, DuerOS or other investment holdings possibly attracting speculators doesn’t satisfy the involved Chinese risks in my opinion. This could however fit in a portfolio with around 20 positions, depending on your views on China and the side “bets”. Personally, at current valuation (18x P/E, as of writing again) levels, I see very good upside potential for the stock. However cyclical plays are very hard to time and it's important to understand that operating margins are currently at relatively average levels. When their operating margins bottom and sentiment around Baidu is extremely negative, then a contrarian play could be even more very lucrative.
For further details see:
Baidu: A Strong Buy Considering Its Exposure To Promising Tech Trends