Baidu: Embracing The New Norm?

| About: Baidu, Inc. (BIDU)

Summary

BIDU will report earnings on Thursday with lower expectations already priced in post the revenue warning.

Focus will be on the guidance. Anything less than consensus could result in another sell-off.

Increased regulatory scrutiny on BIDU’s advertising practice highlights the importance of non-search revenue.

Baidu (NASDAQ:BIDU) will report earnings on Thursday. The company pre-released its Q2 expectations in the wake of the medical scandal and now expects Q2 revenue to be Rmb18.1B to Rmb18.2B vs. the prior guidance of Rmb20.1B to Rmb20.6B. Over the past several months, the regulatory oversight relating to healthcare advertising has increased in that the authorities have implemented stricter criteria on the message behind the advertisement. In addition, there were reports that BIDU search engine was promoting online gambling during late nights, which is a total violation of China's internet law. The two scandals have drawn increased regulatory scrutiny on the search engine and this will likely weigh in on revenue going forward.

The key focus this quarter will be on the guidance. Note that in the wake of the previous two scandals, BIDU will have to reduce the number of sponsored links on its website to cut back on the amount of advertisement so it can improve user experience and appease regulators. Additionally, I believe that the company could increase the advertisement vetting process to ensure all the ads on the search engine comply with the regulatory requirement before being displayed on search pages.

Besides specific vertical clients pulling back their budgets, BIDU is limiting the amount of sponsored ads on its search pages. Although BIDU cited the need to drive a better user experience, I suspect the real rationale is that BIDU may be conducting its internal audit process on advertisers to ensure a better quality client base and I cannot argue against that. Net-net, I believe BIDU could face near-term volatility as investors try to determine whether the regulatory pressure could persist into year-end. Investors can expect shares to see another pullback if guidance turns out to be disappointing. As such, I would remain cautious on the stock but recommend investors to accumulate on weakness given that this is a minor issue. I see this process to be a natural evolution of the internet company and online healthcare standards.

The regulatory risk associated with search highlights the importance for BIDU to ramp up on non-search verticals such as driverless cars, O2O and video advertising. To my surprise, BIDU's integration of Nuomi since its purchase from Renren has turned out better than expected and that BIDU's O2O platform is emerging to be a competitive threat to Tencent (OTCPK:TCEHY) and Alibaba (NYSE:BABA). Additionally, I believe that BIDU's investment in driverless cars could allow the search engine to differentiate from its peers. Worth reminding investors that my bearish view on BIDU has been well documented and historically BIDU has been at the bottom of my pecking order with the top pick being Alibaba, followed by Tencent. However, I want to note that should BIDU be successful in executing driverless cars, location-based services, big data and artificial intelligence, then the company's long-term outlook would be more favourable as it becomes less reliant on the legacy search business. Alphabet's (NASDAQ:GOOG) (NASDAQ:GOOGL) success in payment, online video and Other Bets is a good example for BIDU to follow and management should note that search will ultimately face maturity.

In conclusion, I remain cautious on BIDU's shares in the near term due to the uncertainty involved with regulators. For investors who are pulling money out of BIDU, my preferred pick is BABA.

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