Description

Business Description: -

Baidu is the dominant search engine in China with 80+% search market share. Their dominant position is strengthened by Government censorship of non Chinese search engines, like Google. This means that unlike their Western counterparts, the Chinese internet giants (including Baidu) can achieve dominance of their markets. Though Baidu is the leading search engine in China, its position is not as strong as Google’s is in the United States. This is because, in China most product searches start on Alibaba and JD.com rather than Baidu. In 2008, Alibaba made a decision to block Baidu’s web crawlers from indexing its pages and thereby acting as a middleman for product searches. Baidu leads in search services. The Search business (like Google’s) is very attractive, generating operating margins of about 50% (though segment reporting has changed, Baidu historically disclosed the financials of its Search business in pre 2017 20-Fs).

Today Baidu segments its business into two segments: Baidu Core (76% of revenues) and iQIYI (24% of revenues). The former consists of its traditional Search business as well as a lot of “other bets” that are in the investment phase: AI, Cloud as well as Autonomous driving. Baidu Core reported operating margins of 20-30% in the last four years. These are currently below those of the Search business because the “other bets” are in the investment phase. iQIYI is (per the 20-F), “a leading internet video streaming service in China”. It is like YouTube + Netflix (having user generated as well as scripted content). iQIYI is also currently loss making.

The competitive advantages of search engines are well known to the VIC community, so I will not rehash them here. The market opportunity in China is very big. There are 800 million internet users out of a total population of 1.386 billion (about 57.7%. In contrast, 89% of US adults are online). Therefore there is a long runway for growth as internet penetration increases. The online population in China is about 3x of that in the US, and the online retail penetration is about 20% (compared to 10% in the US) so it is a huge, growing market.  

Management and Capital Allocation: -

We can get an idea of whether these guys know how to run their business by studying past actions.

1. Management has recently initiated two $1 billion stock buybacks - once in 2018 and again in 2019. Baidu has repurchased shares only thrice in its history (November 2008 and twice in 2015) - when prices were severely depressed. Both times were good entry points for outside investors.

2. Baidu has been de-consolidating non core businesses to give investors more clarity on the value of its various segments. For example: - i) the IPO of iQIYI, and ii) the divestment of its financial services business (rebranded as Du Xiaoman Financial), both in 2018.

3. Management has been good at throttling back initiatives when they don’t seem to be working. For example, Baidu disposed of its loss-making food delivery business, Xiaodu, to Ele.me as well as cut subsidies to its loss making online-to-offline (O2O) initiatives once it became clear that they were sinkholes.

4. In the wake of the healthcare scandal of 2016, stricter regulations were imposed by the Chinese government on Baidu. The regulations affected the healthcare segment (among the top five advertising segments) as Baidu temporarily suspended some sponsored ads to fix the issues related to fraudulent advertisers. Though this hit their revenue growth numbers in the short term, this rebasement of their advertisers was necessary. After posting negative growth in 2016 (-3.93%), their online marketing revenues in their “Baidu Core” segment resumed their growth posting positive numbers in 2017 (+10.28%) and 2018 (+13.62%).

5. Baidu’s operating margins are currently being impacted by investments in autonomous driving AI and Cloud. Baidu is a leader in both the former areas in China. A position reinforced by a) Government sponsorship of local giants, b) Access to huge proprietary data sets - fed by the search habits of 800 million internet users in China. In addition, Baidu owns one of the leading map services in China which is an advantage for autonomous driving. Baidu is already using AI to enhance its search (for eg: - Search by Voice or Image) and c) Access to AI talent: Baidu already has access to top AI talent from Chinese Universities. In 2017, the Chinese Government issued a policy that aims to make China a world leader in AI by 2030. With Government permission, Baidu has started a national deep learning AI research lab, which should cement Baidu’s status as a Chinese AI leader and help it to attract talent in the future. The payoff from these initiatives seem to be in the future, though, but we don’t seem to be paying very much for them. In any case, management has demonstrated that if initiatives like these do not work, they are not shy about shutting down or selling off loss making divisions.

Financials: -

Baidu has a number of investments (like its 19% stake in Ctrip) which need to be accounted for to arrive at a sum of the parts value. If I do the math, here is what I get: -

* Baidu consolidates iQiyi in its financials. So I have removed iQiyi’s net cash from this calculation to get at “core” Baidu.

Baidu Core did $2.79 billion of ttm EBIT (and this includes other initiatives like AI, autonomous cars, etc.). The current price therefore allows us to purchase the dominant search engine in China at a price of 5.3x ttm EBIT (actually lower, because Baidu includes loss making subsidiaries in its Search segment). Or 6.4x if I tax effect (@ 20%) the above investments that Baidu carries on its books.

Key Issues: -

We are able to buy Baidu at this cheap valuation because of multiple factors including- a) Negative news flow regarding US-China trade discussions, b) Macro slowdown in China, c) Departure of some top executives like Qi Lu and d) Baidu’s management lowered guidance for the year citing the macro slowdown as well as an increase of ad inventory after the Chinese New Year.

The macro is corroborated by comments from other internet companies like Sogou, Alibaba, etc. Both a) and b) are difficult to predict. The Chinese Government seems to be stimulating their economy and I believe it is in the interests of both China and the United States to resolve the trade dispute. To note that in the Great Recession, Google (and Amazon) continued to grow (like Baidu, they are both secular growth stories). The departure of key executives seems concerning, but this is mitigated by the strength of their core franchise as well as the deep bench of their existing talent. Finally, management seems to be taking steps to address the near term slowdown by working to increase eCPMs as well as decreasing operating costs in the near term (they had planned to increase opex by CNY 1 billion per quarter and they have noted that they will take a hard look at decreasing these costs).

Risks: -

Chinese recession

Inability to resolve ad inventory issues

Catalyst

Return to growth after macro issues are resolved