Description

Baidu is the weakest of the three major Chinese technology firms (known as BAT).  Baidu operates the dominant search engine in China, and this business generates approximately $3.5b in NOPAT while revenues look set to sustain ~10% annual growth for many years.  At Baidu's current EV, this business is being valued at a high-teens EV multiple, which is too cheap for a high-quality business with ample opportunities for investment at high returns.  This opportunity exists because Baidu's reported earnings are depressed by several earlier-stage loss-making businesses.  While some of these businesses will have turned out to be value-destructive and Baidu's capital allocation has been less than perfect, these assets are now worth a positive value thanks to slowing losses at the failed O2O business and continued success with the video business (iQiyi).  Baidu's leadership in AI research gives it an attractive platform through which to deploy further capital, particularly in light of China's recently announced national AI strategy.

Search

Search advertising is a fantastic business.  Google, Yandex, and Naver all highlight how a dominant search engine can sustain prolonged growth and resist fairly intense competition while earning excellent returns on capital.  The Chinese market is somewhat unique - on one hand, protectionist national policies mean that Google cannot enter the market, eliminating the biggest long-term threat.  On the other hand, the strength of Alibaba and Tencent poses major challenges for Baidu, as these competing platforms are able to exclude much of their content from Baidu's search algorithm (thus reducing the usefulness of the service). While Google was able to build much of its platform (most notably, the crucial Android operating system) before Facebook (or Amazon) became truly massive businesses, Baidu did not benefit from a similarly early start.   Given this weaker position, some opportunities are likely permantenly closed to Baidu.  For example, retail product advertising (estimated at maybe ~20% of Google's revenues) in China is captured by Alibaba rather than Baidu.

This environment is not, however, fatal to Baidu's long-term growth prospects.  There remains a very large portion of internet activity outside these two competing platforms, and Baidu search is the best-positioned product to help users navigate these activities.  Just as Google has been able to sustain ~20% revenue growth for many years through the continued shift on consumer activity online, Baidu will benefit from similar developments in China.  In particular, Baidu generates a significant amount of revenues from healthcare related advertising. While this vertical has some challenges (as demonstrated by a recent scandal which dented Baidu's growth for a few quarters), the opportunity is tremendous and Baidu's early lead in this segment is an advantage.

Video

Baidu's iQiyi is the most popular video site in China, very closely followed by Tencent Video.   Alibaba's Youku is a distant third and appears to be struggling to maintain share.  These video sites all feature a mix of professional studio content and user-generated content, making them like Netflix-YouTube hybrids.  Again, these western counterparts highlight how online video is a fantastic business - massive user demand clearly exists, loyalty builds over time, and there are significant network effects that entrench the advantage of market leaders.  Netflix, despite a material challenge from Amazon Video, is retaining subscribers and generating impressive returns.  

One doesn't need to have a view on whether iQiyi or Tencent Video 'win' the Chinese market.  Both are likely to be highly profitable businesses worth a significant amount of money. Baidu management attempted to privatise iQiyi in 2016 for ~$3b but the effort collapsed after resistance from shareholders (who claimed the asset was worth closer to $6b).  Since that time, the market valuation of Netflix has doubled.  The Chinese market is still relatively young, and intense competition means these businesses remain loss-making, but the long-term value is becoming increasingly obvious.

O2O

Baidu's valuation is depressed because it invested huge sums of money in an O2O (online-to-offline) venture.  Competitive intensity in this business turned out to be extremely high, with Alibaba and Tencent supported businesses competing aggressively by offering huge amounts of consumer rebates and discounts.  Baidu's participation in this contest was value-destructive and in any case, Baidu lost the battle for market-share.  As a result, Baidu are withdrawing their subsidies and seeking to monetise what traffic they have through advertising, their core strength.  As disclosed in the most recent quarterly call, the margin drag from this business should soon cease:

As we're moving from mobile-first to AI-first, we work to align our business operations by folding Nuomi into our core business. Nuomi will play a role to serve as part of the core business's content and service ecosystem. We'll continue to scale back spend for Nuomi and shift Nuomi from a take-rate transaction-based business model to an advertising-based business model which leverages our core business. We do not expect Nuomi to be a significant contributor to margin drag going forward.

AI

Baidu has been the most aggressive of the BAT firms in investing in AI.  As a result, Baidu has developed a leadership position in the technology - while Alibaba and Tencent are also investing, Baidu has demonstrated the most technical progress and has attracted some of the best talent in the field.  While the recent departure of Andrew Ng is a loss, the hiring of Qi Lu (from Microsoft) ensures Baidu remains one of the best-staffed AI centres globally.  

Valuing this asset is difficult.  In addition to powering its core search business, Baidu is utilising AI to power Duer (an Alexa-like assistant) and to develop autonomous vehicle technologies. Whether either of these ventures succeed is uncertain at best.  However, what is fairly certain is that AI will enable multiple attractive business opportunities over the coming decade.  Globally, there are a handful of firms with the required technological prowess to invest in these opportunities - Google, Facebook, Microsoft, Amazon, and Baidu are probably the leaders.  This optionality is hugely valuable, and Baidu's relatively low market-cap results in the opportunity being most meaningful for the stock.

This asset may soon become much more appreciated thanks to the Chinese Government's AI plan (see article - https://www.bloomberg.com/news/articles/2017-07-21/china-artificial-intelligence-plan-seeks-59-billion-industry).  China aims to rapidly accelerate progress in the field.  History suggests that when the Chinese government sets an economic priority, there is a fairly significant flow of funding and favourable regulations which rapidly follow.    As a result, I expect this initiative to be a material boost to Baidu's AI efforts.  China is also attempting to generally consolidate its economy into a handful of 'national champions', and in any case AI research is complex and benefits from scale, so it is unlikely this initiative will lead to a sudden intensification of competition in the area.

Catalyst

Continued search business growth

Progress with AI