COVID-19 Uncertainties Vitiated Earnings Beats

Summary

• While China is now battle-hardened against the coronavirus, others are beginning to panic.
• Companies ranging from Apple to Starbucks, Alibaba's partner, are signaling improved operating conditions in China.
• Despite the doom and gloom, Chinese indices are in the positive. On the contrary, the week's plunge in U.S. stocks sent the relevant indices deep in the red for February.
• Baidu's stellar Q4 2019 results had been overshadowed by a weak forward guidance and a challenging macro environment impacting advertising revenue.
• I explain why I deemed iQIYI's sell-off as undeserving despite an unappealing Q1 2020 guidance.

By ALT Perspective

While China is now battle-hardened against the coronavirus, others are beginning to panic. The past week has seen global stock markets rocked by the coronavirus outbreak. After being largely viewed as a China issue in the past month, the rapid rise in new COVID-19 cases outside of China has led to fears that the epidemic could escalate into a pandemic. South Korea alone reported more new cases on Thursday and Friday than China did and COVID-19 is now present in 50 countries.

The world squandered the ample time to prepare for the spread of COVID-19

China has been much-maligned for being slow and not taking early actions to contain the infections. Many countries have ample warnings (more than a month!) about the possibility of the coronavirus spreading globally but it seems they are still ill-prepared or have been complacent about their ability to contain COVID-19.

The blessing in disguise for China is that it has by now adapted to the impact of lockdowns and logistical challenges, even as other countries are scrambling to come up with contingency measures. Chinese companies have promptly adopted remote working and online services on a wide scale to cope with the problem of staff being stuck at home. There was a ten-fold jump in the number of daily active users for Corporate WeChat, a 'Mini Program' embedded within the ubiquitous all-in-one messaging app operated by Tencent Holdings (OTCPK:TCEHY)(OTCPK:TCTZF).

Source: CICC, Tencent, KraneShares

Furthermore, China is on the path of recovery. Companies ranging from Starbucks (SBUX) and Apple (AAPL) are signaling improved operating conditions. Starbucks CEO Kevin Johnson stated in a letter to employees on Thursday that 85 percent of its retail outlets in China have reopened. The global coffee chain, together with other food and beverage (F&B) operators like Yum China's (YUMC) KFC and Pizza Hut, had to close a large number of stores not just in Hubei province, the epicenter of the outbreak, but across China.

Businesses faced a shortage of workers as Chinese were mostly being held at home under the lockdown directives from the government and public transportation was halted. Those F&B retailers still operating saw orders dwindling since diners were skeptical of the hygiene in the preparation of the food. With the double whammy, it is an outstanding turnaround to hear that the majority of the roughly 4,300 Starbucks cafes in China are back in business. The Reserve Roastery in Shanghai also recently reopened its doors.

The return of Starbucks is good for Alibaba Group (NYSE:BABA). The two companies had in 2018 jointly announced a partnership to "transform the coffee experience in China". Kevin Johnson, president and CEO of Starbucks, described the partnership with Alibaba as "transformational", and that it represented "a significant milestone" in their efforts to exceed the expectations of the Chinese customers.

Alibaba on its part brings to Starbucks the diversity of its group companies. Ele.me provides the delivery service, while the Tmall and Taobao online marketplaces offer the e-commerce platforms. Starbucks Delivery Kitchens are sited in Alibaba-operated Hema supermarkets dedicated to delivery order fulfillment. Transactions are, of course, facilitated by Alipay, the digital payment service operated by Alibaba's financial arm, Ant Financial. The Chinese technology giant also helped Starbucks enable the Shanghai Reserve Roastery to provide an immersive augmented reality ("AR") experience via a custom-designed digital web-app platform on Alibaba's Taobao app.

Another Alibaba partner, CapitaLand (OTCPK:CLLDF) OTCPK:CLLDY), reported Wednesday that there were "massive traffic jams in Shanghai and Guangzhou" and that "life in China is progressively going back to normal". CapitaLand is one of Asia's largest real estate companies based and listed in Singapore but with an out-sized China presence. It is thus regarded as an authoritative and credible source in understanding the local situation. In 2017, CapitaLand was tasked with the pre-opening and management of the shopping podium and one of the four office towers at the Alibaba Shanghai Center.

Source: CapitaLand

Stocks of Chinese companies (NYSEARCA:CQQQ)(NYSEARCA:FXI)(NASDAQ:MCHI) did not have a good week but they had relatively done better than U.S. ones. I pulled a one-month chart comparing the performance of Chinese benchmarks versus U.S. ones. Despite the doom and gloom in China, Chinese indices are in the positive. On the contrary, the plunge in U.S. stocks sent the relevant indices deep in the red for the month. Chinese stocks could be called an oasis of serenity.

Data by YCharts

That outperformance is impressive, considering that few stocks were spared the downdraft last week. The Chinese Internet sector representative ETF, the KraneShares CSI China Internet ETF (NYSEARCA:KWEB), declined 4.7 percent for the week. Among the key holdings of the KWEB ETF, Trip.com (TCOM) suffered the worst drop down 8.7 percent.

With the plunge, the Chinese online travel agency was yet again dangerously hovering just above the multi-year support level most recently tested in late January. I showed the following chart a month ago in Viral Outbreak A Fortuity For Alibaba, JD.com, And Tencent; A Disaster For Trip.com And TAL.

Source: ALT Perspective (using the charting tool of Yahoo Finance)

TAL Education (TAL) also saw heavy losses, declining 8.7 percent. Nevertheless, the stock of the education services provider was still more than 16 percent higher than the closing on January 24, 2020, the week when the lockdown of Wuhan was announced.

Baidu (NASDAQ:BIDU) and its video-streaming arm, iQIYI (NASDAQ:IQ), together with NetEase (NTES) rounded up the list of major losers after they reported their quarterly results. Their share prices fell 7-8 percent for the week. It's no coincidence that the latter four companies reported their quarterly results last week. I will comment on Baidu and iQIYI's earnings and guidance in the subsequent sections.

As explained in a past issue of the Chinese Internet Weekly, I found the KWEB ETF holding the most representative stocks in the sector. As such, an overview of the week's share price movements of the top few holdings of KWEB as compared with the ETF itself is provided as follows for convenient reference especially for the stocks mentioned in this article.

Data by YCharts

Baidu's stellar Q4 2019 results overshadowed by a weak Q1 2020 guidance

The share price plunge in Baidu in the week that the domestic search engine giant released its results gives the impression that the Q4 2019 earnings disappointed. That is, however, only partly true. Baidu scored Q4 2019 Non-GAAP EPS of $3.81, beating consensus estimates by $0.39 while GAAP EPS of $2.62 surpassed by a smaller $0.03. Revenue of $4.15 billion was 4.8 percent higher year-on-year (Y/Y), narrowly beating analyst estimates by $100 million.

Any quarterly reporting that exceeded expectations is, of course, a positive. Nevertheless, when investors have been pampered by Baidu's rather fine track record of beats both on earnings and revenue, the relatively smaller surprise probably caused some upset - Baidu had achieved much higher surprises and done so rather frequently in the past quarters.

Source: Seeking Alpha Essentials

Even with seemingly insatiable investor expectations, Baidu's operating metrics still have plenty to please. Its operating income, on a GAAP basis, jumped more than three-fold to 4.66 billion yuan (about $669 million) Y/Y, and almost double the prior quarter. Correspondingly, the operating margin rose to 16 percent, up from the year-ago 4 percent. CFO Herman Yu attributed the improvement to the "strengthening of Baidu's mobile ecosystem and our focus on resource investment returns".

Baidu App average daily active users reached 195 million in December, a jump of 21 percent Y/Y while in-app search queries grew almost 30 percent. Note that the average daily active users of the Baidu App during the Lunar New Year break in January this year surged further to 205 million, an increase of over 5 percent from the end-December figure.

The number of daily active users is expected to increase further. Senior Vice President Dou Shen declared during the earnings conference call that they have witnessed a more than 30 percent rise in the growth in search volume due to the coronavirus outbreak. Baidu's CEO, Robin Li, expressed his confidence that the users would be loyal "even after the epidemic":

"Because we have better technology, better user experience, there's more accurate information, people get a better sense that the Baidu services are superior. So we think they will stay with us even after the epidemic outbreak."

Dou Shen highlighted the fact that many news outlets, including China's national broadcaster CCTV, quoted or cited Baidu's data or information "a lot" during the past few weeks proved the leading search engine operator has been regarded as an authoritative source of information. This helped dispel the oft-mentioned notion that Baidu has lost its relevance in search.

The revelation in the earnings press release that Tesla China (TSLA) has selected Baidu Maps to provide map cloud services, such as real-time traffic condition reporting, base map display, and point-of-interest search could also have intrigued some investors. Baidu has its own autonomous driving venture dubbed Apollo which I introduced in an article last year titled Baidu's AI Edge. The municipality of Beijing granted Baidu its first batch of 40 manned autonomous driving licenses in December 2019.

Source: CBInsights

With so many bullish developments, why did Baidu's share price still fall so badly? The larger driver of the decline is arguably the financial guidance for the first quarter of 2020 calling for a 5 percent to 13 percent Y/Y reduction in the revenue to between RMB 21.0 billion ($3.0 billion) and RMB 22.9 billion ($3.3 billion). The underlying assumption is that Baidu Core revenue will fall between 10 percent and 18 percent Y/Y.

The actual performance could be better or much worse, given that the forecast is "subject to substantial uncertainty", according to the press release for the results. I hope that the management would take the first quarter to do some kitchen-sinking since no one can fault them for lackluster numbers given the challenging conditions. We could then expect a stellar Q2 and thereafter.

iQIYI's undeserving sell-off despite outstanding metrics

Shareholders dumped Baidu, ignoring its meek earnings beat. You can call it selling-on-news or other explanations stated earlier. What do you call iQIYI's sell-down despite having topped high-end revenue estimates and delivering a better-than-expected loss?

What's more astounding was the revenue rising 7 percent to 7.5 billion yuan (about $1.1 billion) in spite of a serious drag from the online advertising services segment which declined 15 percent Y/Y on macro challenges in China. Contradicting naysayers who were skeptical that Chinese consumers would pay to watch contents, it was the strong growth in core membership services that provided the powerful lift to iQIYI's Q4 2019 revenue.

Total subscriber count reached 106.9 million on December 31, compared to the year-ago figure of 87.4 million; of those subscribers, 98.9% were paying members. Membership services revenue was 14.4 billion yuan (about $2.1 billion), a 36 percent jump from 2018.

I have written a couple of articles highlighting how China has changed and implored readers to revisit their past understanding of the country and its citizens. For instance, Chinese used to have an indisputable reputation for embracing piracy. However, they have in recent years taken to paying for streaming, among other services. It might be hard for some to fathom the behavioral change is happening but knowing the subscription charges in China are a fraction of similar services in the U.S. could help.

Savvy business strategies also encouraged sign-ups. iQIYI continued to introduce value-added services to its members. For instance, for certain dramas, subscribers can enjoy advanced access to additional episodes at a premium level of package or unit expenses. It has also tapped on partners ranging from telecom operators, banks, e-commerce platforms to fast-food franchises and retail chain stores to leverage their strong local presence in hundreds of low-tier cities to broaden its user reach and improve subscriber conversion.

Consequently, iQIYI was able to reduce its operating loss again to 2.5 billion yuan (about $363.2 million) from a prior-year loss of 3.3 billion yuan. On a trailing-twelve-month basis, the leading video-streaming platform has clearly stemmed the growth in operating losses.

Data by YCharts

That was not enough for shareholders. Having been pampered by the strong growth rate in the past, a forecasted 2 percent to 8 percent Y/Y increase in net revenues to 7.1 billion to 7.52 billion yuan ($1.02 billion to $1.08 billion) for the first quarter of 2020 was apparently deemed unsatisfactory as well.

It is conceivable that the management was trying to be conservative. A potential earnings beat for the next results announcement could come when the fear over the coronavirus outbreak has dissipated considerably and provide a strong boost to the share price then.

China's rapid ramp-up in the production of masks and other protective wear could one day lead to sufficient quantities for exports even as heavy usage in the populous country continues unabated. When other countries are scrambling for supplies, China could re-emerge as the global supplier for essential goods. It could either make a killing or garner loads of goodwill if it decides to off them at cost or without charge to countries that need them most. When the world wakes up to the manufacturing prowess of China, confidence in Chinese internet stocks could return.

Analyst’s Disclosure: I am/we are long BABA, BIDU, JD, NTES, TCEHY. 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.