2023-06-29 12:05:19 ET
Summary
- Baidu's financial performance looks exceptional and many trends in the company's financials suggest that the management is firmly committed to generating more shareholders value over the long-term.
- Enormous political and geopolitical risks related to investing in Chinese stocks seem to be in the past, as recent news suggest that tensions eased.
- My valuation analysis suggests the stock is massively undervalued.
Investment thesis
Baidu's ( BIDU ) financial performance over the long term suggests the management has a solid strategic vision and a firm commitment to innovate. The company invests vast resources in R&D, and the revenue mix dynamic suggests that those investments are highly efficient. Revenue growth experienced headwinds over multiple quarters but I consider these challenges temporary. Baidu's balance sheet is a fortress meaning the company is strong enough to weather the storm. Moreover, the valuation looks very attractive based on my analysis. All in all, I assign the stock a "Buy" rating.
Company information
Baidu is one of the most significant technological Chinese companies. The company specializes in Internet-related services and artificial intelligence [AI]. Since 2000 the company has offered various products and services, including search engines, online advertising, cloud computing, and smart devices. One of the company's long-term bets includes robotics and autonomous driving.
Baidu's fiscal year-end is December 31. According to the latest annual report , online marketing services represented about 60% of the company's total sales.
Financials
The company's revenue growth over the past decade was impressive, with a 13% CAGR. On the other hand, profitability metrics deteriorated significantly. Gross margin declined from 71% in FY 2013 to 49% in FY 2022. The same trend of massive compression relates to the operating margin and the free cash flow [FCF] margin. On the other hand, the company's profitability metrics seem to have bottomed four years ago and since then demonstrated improvement.
Baidu's revenue growth was fueled by extensive R&D. The company's R&D to revenue ratio was close to an impressive 20% in recent years, indicating the management's firm commitment to innovation and long-term mindset. I also like that the SG&A portion of sales declined substantially over the long term. Though, I think that about 17% is still high, and BIDU has room for improvement here.
I also see one more fundamental reason why Baidu's management mindset is long-term. Over the past years, the company significantly diversified its revenue streams, and the share of online marketing services out of the total decreased significantly.
Let's now look at the quarterly level. The momentum for sales growth looks weak, with weak dynamics over the past five quarters. On the other hand, the company improved operating income significantly, mainly by decreasing SG&A. I like the management's proper actions aimed at cost-effectiveness amid the decelerating revenue growth.
Despite apparent near-term challenges in the quarterly financial performance, I think investors can be calm. Headwinds are temporary and not secular, in my opinion. Still, even if this "temporary" will last for multiple quarters, the company's balance sheet is in great shape. As of the latest reporting date, Baidu had almost $27 billion in cash. The company's liquidity looks very strong, and total debt is about twice lower than the outstanding cash balance. The company does not pay dividends but conducts share buybacks.
Seeking Alpha
Valuation
The stock rallied about 19% year-to-date, significantly outperforming other Chinese giants and the iShares MSCI China ETF ( MCHI ). BIDU even outperformed the broader U.S. market. Seeking Alpha Quant assigns the stock an average "C+" rating, which indicates little upside potential. The company's valuation ratios are mostly higher than the sector median. On the other hand, current multiples are substantially lower than 5-year averages across the whole board.
BIDU does not pay dividends. Therefore, I use discounted cash flow [DCF] approach for valuation. Due to the inherent political risks of investing in Chinese stocks, I use a 15% WACC for discounting purposes. I have revenue consensus estimates available up to FY 2028. For the years beyond, I have implemented a very modest 7% revenue CAGR. Overall, for my DCF the expected revenue CAGR for the next decade is at 10%. My FCF margin assumption is also very modest at 10% for the FY 2023 and expected yearly 150 basis points expansion.
As you can see from the above spreadsheet, the stock is massively undervalued with an 87% upside potential. My assumptions are very modest, but let me implement even more pessimistic input data for the second scenario. I implement a 6% revenue CAGR for the next decade and expect the FCF margin to expand slower, at 100 basis points yearly. Even under very pessimistic assumptions, the DCF suggests about 13% upside potential for the stock.
Overall, I believe the stock is attractively valued at current levels. Let me now discuss the risks of investing in BIDU, so we can compare the upside potential to them and arrive at a final decision.
Risks to consider
Based on the difficult relationships between China's Communist Party and technological giants in recent years, we know that political risks are very high for Chinese companies. At a critical point of these tensions between the government and the business, there were even rumors that Chinese giants could be forced to delist from the U.S. stock exchanges. But, according to Bloomberg , delisting risks eased as Chinese companies switched auditors. Geopolitical tensions between the world's two largest economies were also escalated in recent years which included a trade war and even espionage . But recent geopolitical news also suggests that these risks eased. Both countries are trying to stabilize relationships, according to the latest meeting between the U.S. Secretary of State Antony Blinken and the highest Chinese officials. Therefore, it seems that the peak political and geopolitical risks for Chinese tech giants are in the rearview mirror.
Despite significantly diversifying its revenue mix, Baidu is still heavily dependent on its digital advertising revenue stream, which represents about 60% of the total sales. That said, the company is still vulnerable to cyclicality since the advertising spending of businesses significantly depends on the broader economy's health. The Chinese economy is experiencing a significant growth deceleration and still has post-COVID struggles. Challenges in the broader environment might lead to pressures on the revenue growth for the company for the next quarters. On the other hand, a rapidly increasing portion of other revenues suggests the company is succeeding in unlocking new growth drivers.
Bottom line
Overall, I think that BIDU offers potential investors a very attractive upside potential. Investing in Chinese stocks is highly risky. On the other hand, the upside potential looks too high to ignore. Apart from an attractive valuation, I like positive trends in the company's financial performance. Patterns in financial trends suggest the management's firm long-term mindset and commitment to innovation. I give BIDU a "Buy" rating.
For further details see:
Baidu: Very Attractively Valued