Introduction:
The is the first in an ongoing series of research pieces examining Baidu’s (BIDU-NASDAQ) business and share price. The goal of our research is to understand the future direction of BIDU’s share price relative to its peers and the NASDAQ composite.
The main criteria that will determine the future share price of BIDU we believe is:
1) Anticipating the EPS over the next few quarters and
2) Recognizing a change in value on a sum-of-the-parts basis
Sum-of-the parts valuation works best – The primary driver to Baidu’s EPS and stock price is its search service operating margin. This division has generated over 100% of Baidu’s operating profit every year since the company’s diversification into video in 2010. In 2016, Baidu’s non-search services operating losses amounted to ¥15 billion (US$2.24 billion) from Baidu’s other two divisions: iQiyi (a hybrid of Netflix and YouTube) and Transaction services. As a result of the losses in these two growing segments, their real value can best be viewed in a sum-of-the-parts valuation. Another reason why a sum-of-the-parts valuation works well is because Baidu has a track record of selling its non-core assets. These assets should be ascribed some value.
The direction of Baidu’s future share price – In the short-term we believe Baidu’s share price will increase when Q3 and Q4 results are reported. In terms of a trade, we see Baidu increasing relative to the NASDAQ until the end of February 2018. On both a technical and fundamental basis, the share price appears to be headed to $270.
We see a number of reasons why the share price will move higher.
- Eliminating bad players. Baidu’s reputation and trust following its online medical advertising scandal in 2016 has improved materially. This has led to a rebound in online search sales in Q2/17 and this momentum should continue atleast over the next two quarters.
- A.I. is proving to be a differentiator. Baidu is focused on AI as the fundamental driver to enable a better and natural search experience with various inputs such as voice and image, underpinning the growth of daily users.
- iQiyi subscription growth continues to accelerate. While content spending continues at a high rate, 2017 marks the first year they are entering into partnerships with Western media companies such as Netflix to improve their product. Early results have been encouraging.
Exhibit 1- Baidu (BIDU) vs. NASDAQ Composite Performance Over 12 Years
Source: Yahoo Finance
Business Segments
Core search Business – Search services represent 78% of Baidu’s revenue. Baidu is China’s biggest search engine by a wide margin. According to China Internet Watch, Baidu’s 76% market share of China’s search engine market in Q1 includes an 82% share in mobile search. Baidu’s main revenue stream leverages traffic to its site by charging advertisers based on search queries.
News feed short video ads in combination with DAU increases are driving growth – The most important driver in search for Baidu is its launch of a news feed platform in Q2 2016. Within its newsfeed are the inclusion of short video ads. The frequency of ad loads is increasing this year, and this should be material to revenue. In addition, the number of users continues to grow, with Q2/17 Daily Active Users (DAUs) reaching over 100 million (up 400% y/y).
Exhibit 2 – Example of Video Ad
Source: Company reports and Perspectec
Increasing Ad loads revenue not yet seen – Baidu’s core online marketing business declined 1.3% y/y in Q1 before improving to 5.6% growth y/y in Q2. Growth in search services newsfeed revenue in Q1 and Q2 is being masked by lower online marketing sales from the reputational hit Baidu took with its online medical products scandal last year. We expect Q3 and Q4 sales in this segment to increase by 20%+ y/y as both the number of online marketing customers and revenue per online marketing customer continue to increase q/q.
Net result from the medical scandal hit comes with longer-term positives to the business – In April of 2016, 21-year old Chinese student and frequent forum user on Zhizu.com Wei Zexi, died after spending RMB200,000 on a cancer treatment heavily promoted on Baidu. The advertiser (Putian Medical Group) was one of Baidu’s largest customers, and a number of its products have proven to be ineffective. After a China government investigation, Baidu was ordered to take steps to prevent the display of ads posted by unlicensed / unqualified medical providers. It was also ordered to limit ad space to only 30% of a webpage.
Baidu has followed up on these orders with its own self-imposed rules, requiring every advertiser to show its government-issued internet content provider license (mandatory for every Chinese website), and verified business account to prove its identity.
Baidu now allows a maximum of only four sponsored ads per page vs. over ten spots before the crackdown. In addition, with the additional screen space, they are allowing for more clear ad labelling. As a result, we expect cost-per-click (CPC) to be driven higher by at least 2´ to 3x, with the click-through-rate (CTR) reduced with more clear ad labelling. The net result is a Baidu experience that continues to see a 80% market share and higher ad rates for advertisers.
A.I. is increasing the barriers of entry – Baidu is strategically eyeing on A.I. development and implementing the technology to its rich product ecosystem. Users can receive information based on their past searches. Results from A.I. for voice and images searches as well as from continuous improvement of their mobile app has increased its lead versus competitors. Their closest major competitors on the ad revenue side include Alibaba, Tencent, Sohu, Qihoo 360 and others, Baidu consistently upgrades its mobile app.
A.I. is improving the RoI of Baidu’s advertisers – From the perspective of marketing customers, they can be provided with more specific advertising solutions to increase their RoI. In addition, an increasing number of short video spots aids in their improvement. As a result, an increasing number of customers tend to place more of their budget on the platform.
Exhibit 3 – Example of an A.I. influence in the news feed
Source: Company reports
Exhibit 4 – The Upward Trend in the Average Revenue per Advertiser
Source: Company reports and Perspectec
O2O business fades and Baidu is shifting its focus from this part – Baidu is significantly cutting its promotional spending within transaction services over the last few quarters. The drop is due in large part to a move away from online-to-offline business, including the spin-off of their Food Delivery business. Sales and marketing costs were down 30% y/y in Q2. While we are only forecasting a single digit drop in sales and marketing costs over the next four quarters, the potential for double digit y/y cuts remains.
Video streaming continues to is holding the upward performance – iQiyi is the main video streaming player in China. The video platform has grown by RMB2.4 billion and RMB6 billion over the last two years (a 98% CAGR), supported by the strong performance of subscription payments by its users. The website is poised to spend at the same growth rate in content expenditures in 2017 in order to attract more subscribers. It has signed an exclusive streaming contract with Warner Bros and Netflix during the 1st half of 2017. Despite the aggressive investment in content, we are conservatively forecasting 2017 revenue growth of RMB3.8 billion or 34% revenue growth. Baidu only reports this figure annually. We believe there is significant room to beat estimates here.
Exhibit 5 – Monthly Active Users (MAUs) on China’s main video platforms
Source: BigData research
Exhibit 6 – iQiyi’S Primary Partners in the First Half of 2017
Valuation
On a P/E Basis
We are forecasting an adjusted EPS of ¥53.57 for FY 2017 and ¥65.03 for FY 2018. Their adjusted EPS adds back with a USD to RMB exchange rate of 6.6, this translates to US$8.12 and US$9.85 respectively.
Currently, Alphabet (GOOG) trades at a TTM adjusted P/E of 30x versus Baidu at 33x. While Baidu’s adjustments are more aggressive than Alphabet’s we do not see its trailing P/E ratio being materially out of whack. Therefore a 33x trailing 12-month adjusted EPS appears to be appropriate for Baidu.
Given the expected improvement in adjusted EPS over the next two quarters, we see Baidu share price trading at 33x trailing 12-month adjusted EPS of ¥53.57. The target share price once dividing the RMB figure by the current exchange rate of 6.6 is $268 after Baidu reports its fiscal Q4 2017 results.
In comparing Baidu’s valuation to Alphabet, Baidu has a variable interest entity (VIE) structure in which shareholders do not own the operations of Baidu but rather a contract to pay them the profits of the operating company. Also Alphabet has updated its non-GAAP net income to no longer add back stock-based compensation to its net income starting in Q1/17. While their EPS adjustments now differ materially, there does not appear to be any catalysts that will cause Baidu’s valuation to change relative to Alphabet’s over the next two quarters.
For due-diligence sake, we also look at a sum-of-the-parts valuation.
Our Sum-of-the-Parts Valuation shows a 2018 valuation of $268/share
Key assumptions:
We forecast Baidu’s search services operating income growth to be up 22% in 2017 and up 21% in 2018. We reduce the multiple applied to operating income by 52%. While we could apply a 20x multiple on this figure, we apply a 52% discount to a normal 1.0 PEG in order to get our current sum-of-the-parts valuation to match the current share price.
Exhibit 7 – Search Business Forecast
Source: Company reports and Perspectec
- O2O value of USD 846 million (USD 2.43 per ADS)
- USD 846 million Nuomi value assuming 53% discount to Meituan-Dianping’s valuation of
USD 18 billion as of Jan 2016.
- Baidu would sell its Takeout Delivery business for USD 800 million.
- iQiyi is valued at USD 16.6 billion as of FY 2018 (USD 47.75 per ADS) based on the YouKu-Tudou taken over valuation of USD 5.1 billion and 2018 forward P/S multiple of 6.2x, 15% premium to YouKu-Tudou’s P/S.
- Ctrip value of USD 5.5 billion (USD 15.75per ADS) based on Market Cap of USD 26.77 billion and Baidu’s 20.49% stake
- Net cash of USD 12.08 billion (USD 34.22 per ADS) based on Baidu Q2 2017 cash position plus estimated Takeout Delivery business taken over value of USD 800 million.
Upside Catalyst:
- Baidu’s Q3/17 financial results are on pace to beat management consensus
- Our EPS estimate assumes slowing iQiyi subscription revenue. There is a good chance sales growth could be steady or even growing
- Increasing operating margin after the spinoff of Takeout Delivery business
Risks:
- Slow adding of new online marketing customers
- Worse-than-expected transaction services performance
Exhibit 8 – Business Valuation
Source: Company Reports and Perspectec
Financial Analysis
Gross profit: We currently estimate gross margin to drop from 50% in 2016 to 49% in 2017 and 2018 due to continued heavy investments in content. This hits the cost of revenue line for iQiyi in a similar way as Netflix records costs.
Operating profit: We expect non-GAAP operating margin (%) to increase from 16% to 21% in 2017 and grow to 23% in 2018. The cuts are mainly due to lower SG&A and the divesture of their Food Delivery business. Baidu still expects to invest steadily in R&D, as funds will be increasingly focused on A.I. and autonomous car initiatives.
Net profit: Non-GAAP net profit margin is estimated to be 22% in both 2017 and 2018.
Exhibit 9 – Baidu’s Annual Income Statement and Our Forecast
Source: Company reports and Perspectec
Important Disclosures and Disclaimer
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For the purposes of complying with NYSE, NASDAQ and all Self-Regulatory Organizations, Perspectec Inc. has assigned the following rating system BUY, HOLD/NEUTRAL, SELL for the securities which are the views expressed by an analyst, Independent contractor, and or an employee of Perspectec Inc. The information and opinions in these reports were prepared by Perspectec Inc. or an analyst, independent contractor. Though the information herein is believed to be reliable and has been obtained from public sources believed to be reliable. Perspectec Inc. makes no representation as to its accuracy or completeness.
