Baidu: Back To Growth

| About: Baidu, Inc. (BIDU)

Summary

Baidu reported mixed results in Q4 with an earnings beat and a slight revenue miss.

Shares declined 5% after the news due to revenue guidance for Q1 2017 below consensus.

The effects of ad regulation are starting to fade away, and growth will be back on track soon.

Baidu (NASDAQ:BIDU) has recently reported Q4 results, beating earnings estimates but with a slight miss on revenue. Shares fell 5% after the news mainly due to the relatively weak guidance. The good news is that the effects of new regulation on online advertising is mostly gone and the core search business will soon be growing again, helped by the integration of AI.

Recent Results

Baidu's core search results were actually better than I thought. I expected the biggest impact of the new regulation to have its greatest impact on Q4 results, and I was expecting a bigger contraction. Online marketing revenues for the fourth quarter of 2016 were RMB16.166 billion ($2.328 billion), which means 8.2% lower than in Q4 2015.

The stricter regulation had a strong impact on the number of marketing customers, which declined 18.6% from the corresponding quarter of 2015. Many marketing customers from the healthcare sector were probably not able to meet the new requirements. Nonetheless, a strong rise in revenue per marketing customer (+14.2%) offset most of the weakness.

Good news came from the map business as well, with MAUs at 341 million, an increase of 13% year-over-year.

Non-core divisions are still a significant drag on profitability, although they generated almost twice the revenue of Q4 2015.

Content costs almost doubled from Q4 2015 and now account for 14.1% of total revenues. I think that, despite the our desire to see the iQiyi division turn profitable, we can't be angry with management for the strategy they are implementing. It's obvious that the company wants the segment to grow fast and maintain its leadership in the Chinese market. The high investments in content are delaying profitability, but they are also contributing to create a more attractive service. Management said the company will keep investing in content in order to support ITE's growth, so we should not expect this division to turn profitable in the near future. We have to wait until content costs start to rise slower than subscriptions and advertising revenue, which hasn't happened yet and is probably not going to happen in 2017 either, as the CFO suggested (Seeking Alpha transcript):

In 2017, we expect content cost to step up at a similar pace as 2016. Content cost will be used to invest in high quality, licensed and self-produced content to support ITE and support Search and News Feed products through our platform.

The weak guidance is what sent shares down 5% on Friday Feb. 24, as management is guiding Q1 2017 revenue in $2.374B-$2.453B (+4.2%-7.6% Y/Y) against a $2.47B consensus.

I am disappointed by the results in the Transaction Services division, which keeps reporting huge operating losses, while I understand the company's investment in content for ITE, because I understand that a leading position in this business is the best factor for growth. The reason is that the economics of this business are basically the same of Pay-TV, which has already shown in many countries that the market leader has a clear advantage over the others and usually reports much better margins and a more stable growth than competitors. Trying to create a size advantage is probably the best strategy now.

The future - Betting on AI

I think most of the weakness in the core search business is gone. The company has largely completed the changes that were required by the new regulation, and growth in the core search business starts here, although it will be gradual. The segment remains healthy, with the potential to grow for many years simply as a result of the increasing internet usage in China. Moreover the company is seeing good results with News Feed, which is expected to generate incremental traffic for search.

The core business is not the problem. If we exclude the effects of the recent regulatory changes, which was an unexpected, one-time factor, the business is stable, growing and highly profitable.

I think all the doubts the market has at the moment are related to the company's non-core segments. The transaction services division keeps reporting poor performance, with revenue growth decelerating and operating losses rising. I don't think we will have a catalyst like a sale of the division because management has always said it considers this division an integral and important part of the company's core business. Moreover, Robin Li once said he estimated the Chinese O2O market to be worth $1.6 trillion, which would mean the company is just starting to scratch the surface of this market. The market is estimated to grow 20%-25% a year, and Baidu's performance is in line with these forecasts, although operating losses are growing.

A very important indication on the company's future is coming from what management said about Artificial Intelligence. CFO Jennifer Li said:

Over the past year, we have carefully reviewed our strategy and business portfolio. As Robin mentioned, the mobile transition is behind us and we're at the cusp of an AI revolution. Baidu's strategic focus, organization and resources have shifted increasingly towards AI, and we are excited to execute our vision in this new era.

CEO Robin Li declared:

AI is an enormous opportunity that will revolutionize the Internet and traditional industries. Baidu, in particular, is well positioned to lead the AI wave in China, with our unique combination of technology, data and talent. Our existing platform, including our search and newsfeed products, are enhanced by AI and enriched by our content and services ecosystem. We are thrilled by the opportunities that our existing platform has opened up and are excited to build the next generation of AI-enabled businesses."

Artificial Intelligence is described everywhere as the greatest thing of the next 5-10 years. The term AI actually describes a variety of applications, including face recognition tools, automated cars, connected homes, medical devices and robots. Baidu is active in all of them and looking to expand in other areas as well. The company is integrating AI functions in its core search business, it uses machine learning algorithms for voice and image recognition, natural language processing, in order to improve the search results in its search platform. But the impact of AI is not limited to the search business. For example, Baidu has been working on autonomous cars in China and the U.S. for a while and has recently acquired the smart home start-up Raven Tech.

Baidu is the leader in most of the areas where it competes (core search, online videos, online to offline transactions), but all non-core divisions are losing money, with no signs of improvement on the side of profitability. I just hope the venture in AI doesn't end up being another drag on profits like transaction services and iQiyi.

The positive thing is that the short-term weakness that has affected the search business will not weigh on revenue for long. I will continue to hold BIDU for the strength of its core search business and the numerous growth options the company has at its disposal.

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Disclosure: I am/we are long BIDU.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Tagged: , Internet Information Providers, China, Earnings
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