2023-12-29 10:58:06 ET
Summary
- Fund managers are crowding into Big Tech stocks while shorting Chinese equities due to ongoing pessimism in the Chinese market.
- China's regulatory watchdogs will closely monitor internet platforms, AI stocks, and gaming companies, potentially impacting their growth and profitability.
- Baidu's AI ambitions, particularly its Ernie Bot, show promise, but the company's stock may follow a pattern of sharp upturns followed by large fades.
- Among China's equity universe, Internet platforms like Baidu tend to be the most volatile.
China's Internet Sector - especially its platform names - will perpetually be under the government's watchful eye
Investors are wrapping up 2023 and entering 2024 with several key conclusions: the first being continued optimism in the U.S. Magnificent 7 Big Tech stocks, and the second being ongoing pessimism in Chinese equities.
This is resulting in Fund Manager crowding further into Big Tech while simultaneously shorting China equities, according to the latest Fund Manager survey by Bank of America.
While it is clear that China's economy faces a muddled recovery picture, what isn't so clear is whether investors will be rewarded for pressing short positions in China at swing lows.
My opinion is that China's landscape is ripe for careful company selection based on the government's current line of thinking and public policies.
Among the themes that Investors need to be extremely careful about are internet platforms, AI stocks, and gaming companies. It's highly likely that China's regulatory watchdogs will continue closely monitoring internet companies' new product launches and services to make sure they align with the country's political framework and philosophy.
Baidu is indeed a very promising company and its latest AI ambitions are showing clear progress with its Ernie Bot now having over 100 million active users, serving as a growth catalyst for the company if it is able to monetize its enterprise clients successfully.
The company has a tactical upside in 2024, but upon certain key pressure levels, it may follow the same pattern that it has all throughout the last 18 months - a Sharp Upturn followed by a Large Fade.
The Catalysts for BIDU and Fundamental Outlook
Top of mind when it comes to China stocks is the regulatory risk on pure play internet platform companies, which wield a large influence on its users based on the type of content the government allows disseminating. I view pure internet platform companies like BIDU to include a degree of higher risk than e-commerce names like BABA, JD, and PDD.
In China, the government monitors and censors content and activity all across the internet, which puts Internet companies in a very peculiar situation - the B.A.T companies (Baidu, Alibaba, Tencent) have a significant market leadership position but their ability to monetize their business models is constantly reviewed and scrutinized by policymakers.
The Street's revenue outlook for Baidu over the next two years in 2024-2025 is a stable 10% growth after a 10% sales increase in full year 2023. Roughly 15-20% of Baidu's revenue comes from its growing AI Cloud business, and it recently saw a -2% decline in the last quarter, which exhibited softer demand from government infrastructure projects. The U.S. restrictions surrounding AI Chips and GPUs will most likely push forward the timeline of Generative AI initiatives (like Ernie Bot) that Investors hoped to be additive to Baidu's EBITDA margins in 2024-2025.
Baidu's AI Ernie Bot, which now has more than 100 million users , is gaining favorable momentum as the company looks to integrate it across many enterprises to leverage its language learning models. According to Reuters, looking at the ranking service for AI Chatbots from SuperCLUE, Ernie Bot leads in the Chinese market compared to its local peers, but for now, falls short of ChatGPT's user ratings. AI is a closely scrutinized industry in China, so Investors should expect numerous government "reviews" in the future before the Ernie Bot becomes truly a mass market among China's 1.4B population.
Investors may also want to focus on the continued developments in China's e-commerce sector, as ECOM is the second-largest sector exposure for Baidu's core advertising business (just behind Healthcare). Baidu's core advertising business drives the lions share of its business at 73% of revenue, so in the intermediate term, investors will move the stock price based on the health of its Ads business. This year's 11/11 (Double 11) consumer transaction activity was lighter than expectations, which matches the subdued China retail sales 4% year-over-year increase from Q3 2023. This means that e-commerce will require several more quarters to return to growth, and this will show up as muted figures in Baidu's Ads business for the foreseeable future.
The long-term outlook for advertising in China is stable, but Baidu does have growing competition from Tencent and ByteDance to compete for tighter advertising budgets. As a result, Baidu's long-term share price upside will be driven by its new segments such as Cloud, Generative AI, and Autonomous Driving - which are all sensitive areas that are often subject to government review during commercial releases.
AI Cloud is becoming a more important component of Baidu's business at 19% of revenue as of the latest fiscal year, but it should be noted that emerging competitors are quickly building AI initiatives as well, such as Huawei and Tencent.
Due to this fundamental profile in China's macro context, I believe that Baidu has an upside primarily from modest valuation expansion, but structural share price gains will depend heavily on mass market adoption of its AI, Cloud, and Autonomous Driving segments. If these initiatives do not achieve widespread adoption, Investors will lower the expectations for margin expansion, and this may weigh on the company's future free cash flows.
Lower expectations of operating margins from the combination of continued Capex (Research & Development) without increased top-line revenue to support it will result in lower margins (and therefore suppressed valuations).
Risks, Thoughts on Entry and Valuation
Baidu currently commands about 60-70% of China's Search market and is able to have higher CPM (cost-per-mille) impressions and Cost Per Click relative to its peers because of its network effects. It's estimated that Baidu Search Ads have a higher cost per mille and cost per click than its peers Weibo, Douyin, and Toutiao. However, Baidu has been slowly ceding some market share in Search over time as more users spend time on other platforms such as Bing and Sogou as shown in the two graphs below.
Chart 1: China's Search Market
Chart 2: China's Search Market from early 2022 to early 2023 (year-over-year)
The current Bull case for Baidu depends on the company accomplishing two core objectives: fending off competition in its core Advertising business (which is the cash cow to funnel capital to grow its innovative segments) and having its innovative segments in Cloud, AI, and Autonomous Driving experience commercial success.
Its current valuation at 11X forward P/E implies that Investors do not place much hope that these initiatives will prove to be successful. This lack of enthusiasm and low expectations means that it won't take much for Baidu's share price to drift higher.
At the same time, expectations have to be managed for how sustainable any rally will be, given that all of the business models that Baidu participates in are subject to potential government reviews and scrutiny.
For further details see:
Baidu: Tactical Upside But Internet Platforms Subject To Scrutiny By China's Regulators