2023-08-29 10:21:38 ET
Summary
- The exploration of future markets, particularly in AI and autonomous driving, positions Baidu as a significant player in the tech industry with strong potential for growth.
- Baidu's financial results for Q2 2023 underscore its operational strength. The company's foundation, including its dominant search engine and solid balance sheet, provides a stable platform for capitalizing on opportunities.
- Through a comprehensive Discounted Cash Flow valuation, a projected share price indicating remarkable upside potential emerges.
- For me personally, the decision not to invest in Baidu stock extends beyond financial numbers. The share (ADS) structure introduces a layer of complexity, reflecting China's regulatory constraints on foreign ownership.
Introduction
Baidu ( BIDU ), often referred to as the "Google of China," has recently witnessed a surge in its stock price, beginning a recovery from a slump that followed its peak in 2021. While the primary factor behind this decline was the broader trend of tightening financial conditions leading to higher interest rates, impacting the share prices of numerous technology firms with inflated valuations, the valuation adjustment can be explained by foreign investors becoming more careful about investing in China, slowing down the overall momentum in Chinese stocks, and now demanding a premium for investing in China.
However, the recent uptick in Baidu's stock price is not without reason. It mirrors the positive outcomes from Q2 of 2023, the company's noteworthy potential trajectory in AI, and its many other ventures that extend beyond, such as autonomous driving endeavors and Robotaxis, which in total lay out many strong potential catalysts for the company's future performance.
With its established businesses, such as China's leading search engine, which operates as the high-margin cash cow for Baidu, providing the means for the company to invest and fund its ongoing research across different sectors.
I view Baidu as an interesting company with the potential to play a role in future industries. Overall profitability and solid fundamentals serve as a pleasant backpack on this journey.
A discounted cash flow ((DCF)) analysis indicates that Baidu's current numerical valuation shows either strong upside potential for Baidu shares or that the valuation discount is a reflection of Baidu's attachment to China, the resulting political risks, worrying about the Chinese economy, as well as the fact that Baidu is only investible as an ADS structure and not through real physical shares.
While this article intentionally avoids extensively covering the "Risk for China Stocks Discussion," I am going to explain my number one reason why, despite promising operations, I could never sleep well with a substantial investment in a Chinese ADS such as Baidu-ADRs in general-and hence not go to buy Baidu.
The aim here is to present a subjective perspective and offer a balanced article. It's possible that your risk tolerance differs, and if the ADR framework doesn't raise concerns for you, Baidu might align with your investment preferences.
Baidu's Corporate Structure
Baidu consists of two primary segments:
Baidu Core: This segment has been the cornerstone of their revenue, contributing to over 70% of Baidu's earnings over the past three years. Baidu's Core increasingly leverages AI to provide online marketing services and value-added services within their applications, most significantly and prominently featuring, of course, their search engine, Baidu.
iQIYI: Making up the other 30%, comprises an innovative, leading online entertainment platform in China. Their offerings encompass original content, a broad library of professionally produced content, as well as user-generated content and professional user-generated content. Basically, Netflix, YouTube, you name it, squeezed into one platform. The total number of subscribing members reached 101.7 million as of December 31, 2020, excluding trial memberships.
In 2018, iQIYI's ADS commenced trading on the Nasdaq Global Select Market. It remains a consolidated affiliated entity under Baidu. Baidu holds about 50% of all iQIYI shares and has approximately 90% of the voting power in the company. Based on its current share price, Baidu's position is worth $2.7 billion.
Baidu's total offerings reach over a billion devices each month, engaging an ecosystem that includes millions of users, developers, and enterprises.
For a more extensive overview of all Baidu's products, you may refer to this link to Baidu's website.
Second Quarter 2023 Financial Results (unaudited):
In the second quarter of 2023, Baidu achieved notable financial outcomes. The total revenues reached $4.70 billion, marking a 15% increase year over year. Here's a short breakdown of the key figures I find worth mentioning:
Baidu Core Revenue: The revenue from Baidu Core amounted to $3.64 billion, reflecting a 14% increase compared to the previous year. Online marketing revenue contributed $2.71 billion, representing 15% year-over-year growth. Non-online marketing revenue amounted to $937 million, showing a 12% increase year over year.
See, Baidu's online search engine and related products are clearly the rock the company stands on as of today. They are already generating great returns with that, but those returns could potentially become even greater if we take a look in the next sections at their catalysts-future markets.
iQIYI Revenue: Revenue generated from iQIYI stood at $1.08 billion, registering a robust 17% growth compared to the same period last year.
Net Income: Baidu's net income attributable to the company was $718 million per share, or, more precisely, per ADS of $1.95. This represents a net margin of 19%.
Cash and Investments: As of June 30, 2023, Baidu held about $27.79 billion in cash and short-term investments.
What I find particularly remarkable as well is that, at the end of this quarter, Baidu's balance sheet did not carry any significant long-term debt.
This is a rock-solid balance sheet, as I described it earlier, and a great backpack for the company's journey of capitalizing on its catalysts.
Future Catalysts
Looking ahead, my view is that, as of today, Baidu's potential for even more growth revolves around two primary avenues: its advancements in AI and its ventures into the space of intelligent and autonomous driving.
Autonomous Ride-Hailing Services
Baidu's autonomous ride-hailing service, Apollo Go, already exhibited success with remarkable growth, providing around 714,000 rides in the second quarter of 2023 - a 149% increase year over year.
Moreover, Baidu received permission to provide fully driverless ride-hailing services in four major Chinese cities: Beijing, Shenzhen, Wuhan, and Chongqing.
The Ride-hailing & Taxi market is projected to achieve revenues of US$117.70 billion in 2023.
An annual growth rate (CAGR 2023-2027) of 6.50% is anticipated, leading to a market volume projection of US$151.40 billion by 2027.
Expected users in the Ride-hailing & Taxi market are estimated to reach 0.65 billion by 2027, with user penetration projected at 45.4% by that year.
China is expected to generate the highest revenue (US$117.70 billion) in this market by 2023.
While this segment is still in its early stages of monetization, given the market potential within China and the proof of concept Baidu already demonstrates, I expect the contribution from this segment to become increasingly less insignificant to Baidu's current revenue mix.
AI
The global AI market is projected to surge from about $136 billion in 2022 to an estimated $1.8 trillion by 2030, reflecting a net CAGR of about 37%. This expansion is expected to create fresh avenues for Baidu to extend its AI business reach.
I think Baidu is right when it positions itself as a leading AI company. The company's notable advantages in Generative AI, particularly with this year's launch of Ernie-Bot, have garnered recognition from cloud customers, AI developers, and industry experts alike. This innovation, harnessing Baidu search data and ML, exhibits capabilities comparable to those of ChatGPT. Notably, these advancements could justify a potential narrowing of the valuation gap between Baidu and Alphabet ( GOOGL ), as just one example.
Overall, I believe that Generative AI and the expansive potential of large language models are poised to catalyze transformative shifts across diverse industries, presenting Baidu and its technologies with a substantial market opportunity.
Baidu invests significantly in pioneering AI technologies, particularly in domains like Natural Language Processing ((NLP)) and computer vision. These technologies possess the potential to revolutionize an array of industries, thereby positioning Baidu to further enhance its AI business.
The Chinese government's commitment to AI development, backed by investments in research and development, provides Baidu with access to government funding and resources.
Valuation: Capturing Potential Fair Value for Baidu's Stock
In this segment, I delve into my Discounted Cash Flow ((DCF)) valuation to illuminate a plausible trajectory for Baidu's stock fair value. It's noteworthy that my DCF model accounts for a growth exit ten years into the future (CY33), which, considering Baidu's potential for expanding into emerging markets such as AI, might even be conservatively short-sighted. I employ an 8% Discount Rate and anticipate a Terminal Growth rate beyond CY33 of 3%.
Between CY23 and CY25, I draw from MarketScreener's analyst estimates to inform the data. I find it reasonable to assume a steady top-line growth rate of 10%, which could even be exceeded given the company's dynamic prospects. On the EBIT front, I place my estimate at 17%, an informed conjecture founded on Baidu's observable margin enhancement efforts, both past and projected. Taxation is anticipated to hover around 20%.
I need to point out the company's robust free cash flow conversion, a figure I calculate by adding back Depreciation and Amortization to EBIT, then subtracting Capital Expenditure while accounting for the net change in Working Capital (Assets - Liabilities). Beyond CY25, I presume a sturdy 8% CapEx rate.
Although we're considering the company's substantial cash position and debt-actually, the $21 billion figure reflects total liabilities, short term included-I've included them anyway. It doesn't hurt the calculated upside. Upon this foundation, my valuation yields a share price of $592, suggesting a remarkable upside potential of over 300% for Baidu.
It's important to note that while the DCF model itself boasts sophistication, my assumptions, while simplified and static, might not fully mirror the dynamic reality. Nevertheless, I possess confidence in the reasonableness, if not conservatism, of my assumptions. This conviction suggests that my projections could potentially be exceeded.
Also note that the values are converted from RBM to USD at an exchange rate of 1 Chinese Yuan equals 0.14 United States Dollar.
Personal Decision Not to Invest in Baidu
I want to put some more color on my personal decision not to invest in Baidu, irrespective of its valuation and overall operational outlook. Beyond the prominent geopolitical risks tied to China, there's a tangible factual basis for my stance. It centers around the structure through which Baidu is offered to us foreigners as an investment opportunity.
You might already be familiar with the terms American Depositary Receipt (ADR) and American Depositary Share (ADS).
To put it simply, by buying a Baidu ADS you get to own a certificate that represents an ADR which is essentially a representation of another shell company located somewhere in the Caymans.
This intermediary ADR entity merely holds a profit transfer agreement with the actual Baidu company in China. This structural arrangement is necessitated by the Chinese government's constraints on foreign ownership.
My evaluation of this situation is rather straightforward: I'm not inclined to own shares that essentially aren't genuine ownership of the core company. Investing in what amounts to a shell company raises concerns about the actual value and security of my investment. As someone who opts exclusively for long-term investments, this configuration doesn't align with my investment philosophy.
Conclusion
Baidu emerges as a significant player poised to shape future markets. The recent earnings and the resurgence of its stock price underscore the potential behind its operational successes and pivotal market opportunities.
However, for me personally, the choice to invest in Baidu extends beyond a numerical valuation and the strong upside potential indicated by my model. The company's reliance on an American Depositary Share (ADS) structure raises a red flag to me.
While my personal decision to withhold a substantial investment in Baidu is based on these structural considerations, your risk tolerance and investment preferences might differ. Baidu remains an intriguing contender, backed by profitability, fundamentals, and pioneering AI advancements.
For further details see:
Baidu: Strong Operations - But Here's Why I'm Not Buying