Can AI support Baidu's "new story"?

After the Hong Kong stock market closed on November 21st, $ 百度(BIDU.US) released its third-quarter earnings report for 2023. We noticed that although iQiyi's profits exceeded expectations, it still fell by nearly 10 percentage points. Therefore, in addition to looking at Baidu's core business, we will also discuss iQiyi separately.

Performance of Baidu's core business:

1. Lower revenue but already priced in: From the perspective of revenue, the performance in the third quarter is definitely not good. Advertising revenue declined due to the contraction of budgets on e-commerce platforms during the off-season, and the lack of attractiveness in its traffic ecosystem (monthly active users of the Baidu app decreased compared to the previous quarter). Baidu's growth rate also lagged behind other major players in the industry. In addition, the intelligent transportation business in the cloud business is still within the impact period of government budget cuts, leading to a direct year-on-year decline. However, the preview released a month ago was even more conservative. This is also why, despite the recent global AI hype, Baidu, as a Chinese leader in large-scale models, has not seen any improvement in its stock price.

2. Profits greatly exceeded expectations: However, the surprise in this quarter's earnings report lies in the cost reduction. Costs, marketing expenses, and research and development expenses were all lower than expected. Among them, marketing expenses were 10% lower than in the second quarter. As a result, Baidu's core operating profit exceeded expectations by a significant 30%.

Dolphin Research believes that the relatively exaggerated expectation gap may be attributed to two reasons, in addition to the company's own expectation management. Firstly, the market has pre-confirmed the expenditure on AI. The commercialization of Wenxin Yiyu officially started in November, targeting the consumer market. The previous ToB model was more of a strategic cooperation with a collaborative nature, so the costs incurred in the early stage have not been synchronized with the financial report, but the market has already anticipated the current expenditure. Secondly, it is possible that Baidu has already tasted the benefits of AI efficiency improvement during the application of large-scale models.

The former is not a true positive factor. If the incremental expenditure on AI is confirmed along with subsequent revenue recognition, the profit margin will see some marketing expenses. However, if the latter is the driving force, it will lead to a relatively long-term improvement in profitability.

3. Good guidance, cloud business expected to rebound next quarter: In addition, based on the conference call, the company's guidance for the next quarter and next year is positive. The advertising growth guidance for the fourth quarter is basically in line with current expectations. As for the intelligent cloud business, which experienced negative year-on-year growth this quarter, it is expected to bottom out and achieve double-digit growth next quarter due to the impact of AI demand and a low base.

With the official launch of Wenxin Yiyu's paid services for consumers, the current 70 million users, assuming that 20% of them choose to upgrade to the paid version 4.0 and a small portion upgrade to Wenxin Yige, it means that nearly 9 billion yuan of incremental revenue can be generated in a year, equivalent to 9% of the current revenue.4. Share Repurchase and Cash: Baidu has always had sufficient cash, but the share repurchase efforts have been limited. At the end of the third quarter, Baidu held a total of 202.7 billion yuan in cash assets (cash, cash equivalents, and short-term investments), equivalent to 28 billion US dollars. If we deduct various interest-bearing debts (including loans, notes, and low-yield convertible bonds) both long-term and short-term, the net cash would be 17.5 billion US dollars. Despite the investment in AI, the core business generated over 800 million US dollars (6 billion yuan) in cash flow in a single quarter, resulting in an increase in net cash compared to the previous quarter.

However, despite having abundant cash, the management team was still conservative in share repurchases in the third quarter, only spending 126 million US dollars.

4. iQiyi: Supply Gap and Off-Season. As expected in the previous quarter, iQiyi is experiencing a shortage of content supply due to reduced investment in the previous year. The third quarter is usually the peak season, as long as the content keeps up, there should be no shortage of user retention. However, iQiyi had fewer hit dramas in the third quarter, resulting in a loss of 3.7 million subscribers during the peak season.

In the third quarter, the company further reduced costs and increased efficiency, with the core operating profit margin continuing to improve to 9.3%. However, it seems that the market is not buying into this. Dolphin Research believes that the story of iQiyi's contraction and efficiency improvement has been told for over a year, and there is a "fatigue" in terms of funding. Compared to surviving under contraction, the market would prefer to see a true rebirth of iQiyi.

Looking at the progress of content investment, iQiyi mainly purchased external copyright assets in the third quarter, while the production of self-made dramas decreased. This indicates that the amortization quantity (broadcasting) is higher than the new production input. Overall, the content investment in the third quarter was relatively cautious, with short-term considerations for cash flow health. However, the negative impact of this approach is that it may slow down the pace of new product cycles.

5. Detailed Financial Data

Dolphin Research's Perspective

Objectively speaking, the performance in the third quarter was not good, but it was within the conservative expectations set by the company. In addition, with the upcoming peak season for e-commerce, the low base effect of cloud business, and the monetization of AI, combined with the guidance provided during the conference call, it seems to indicate a bottoming out and recovery.

However, Dolphin Research is not overly excited about this "earnings greatly exceeding expectations" as we believe there are many factors related to expectation management. However, what we are more concerned about is the impact of AI investment on the company's profitability after it is gradually confirmed. When AI is deeply applied and integrated within Baidu, whether it can help the group achieve operational efficiency remains to be seen, and the exact answer to this question will depend on the situation in the fourth quarter.In the long-term perspective, Dolphin Research has the following views on Baidu and iQiyi:

1）For Baidu,

which missed opportunities in the mobile internet era, Dolphin Research is interested to see if Baidu can continue to take the lead in the AI era. Although Baidu is currently relatively advanced in AI technology, we still have some doubts about its application in specific scenarios and the execution of its business.

However, Baidu's valuation has always been low. Despite its lack of attractiveness in the advertising business due to the traffic ecosystem, it is still a decent cash cow business. Going forward, it remains to be seen whether the commercialization of AI can bring more imagination to Baidu.

2）As for iQiyi,

Dolphin Research believes that further observation is needed. Although several quarters of profitability have temporarily countered doubts about its business model, the reversal story needs to continue, at least until we see a recovery in content investment. Considering the risk of a convertible bond redemption in August 2024, the short-term cash flow pressure will make iQiyi more cautious in its investments, which is not very favorable in the fiercely competitive long video industry. We can continue to pay attention to iQiyi's subsequent pipeline, perhaps another hit like "Fast & Furious" can solve the current dilemma and accelerate the product cycle.

The following is a detailed interpretation of the financial report:

Baidu is a rare internet company that provides a detailed breakdown of its performance:

Baidu Core: This includes traditional advertising business (search/information flow advertising) as well as innovative businesses (intelligent cloud/DuerOS Xiaodu speakers/Apollo, etc.).

iQiyi Business: Membership, advertising, and copyright transfer authorization, among others.

The separation of these two businesses is clear, and with iQiyi as an independently listed company, Dolphin Research will also provide a detailed breakdown of the two businesses. Due to the offsetting items of approximately 1% (between 200-400 million), the detailed breakdown of Baidu Core by Dolphin Research may have slight differences from the actual reported numbers, but it does not affect the trend analysis.

1. E-commerce off-season, advertising under pressure

Baidu's advertising revenue in the third quarter increased by 5% year-on-year, slightly higher than the previously announced growth rate. In the third quarter, there was still a return of offline scenarios, especially in the medical and cultural tourism sectors, which drove the demand for advertising. However, the third quarter is the off-season for e-commerce, and e-commerce platforms have tighter budgets. Baidu's traffic ecosystem itself does not have an advantage, and the number of users decreased by 14 million compared to the previous quarter. Therefore, with the reduction in e-commerce advertising budgets, contrary to the trend in the first half of the year, growth pressure is evident.

Among them, the proportion of high-margin sponsored search ads continued to increase steadily to 53%, an increase of 1 percentage point compared to the previous quarter.

However, in the third quarter, due to the pressure of slowing growth in online retail, the entire online advertising industry was not doing well, and the growth rate fell to the same level as the previous year. Baidu was able to maintain a growth rate of over 5%, one reason being its large user base, and the other being the dividends brought by the return of offline scenes such as healthcare and cultural tourism.

Looking ahead to the fourth quarter, the main factor that put pressure on the third quarter, the e-commerce advertising budget may increase due to the return of Double 11 and Double 12, so the growth pressure on Baidu's core advertising will also be relatively reduced. Dolphin Research expects the growth rate to slightly rebound to around 10%.

2. Cloud will rebound

In terms of other businesses (non-advertising businesses), nearly 80% of the revenue comes from Baidu's smart cloud, while the remaining 20% mainly comes from autonomous driving technology solutions, smart speakers, and other sources of revenue. In the third quarter, revenue from other businesses reached 6.9 billion yuan, a year-on-year growth of 5.6%, significantly slower than the first half of the year.

In Baidu's smart cloud, a significant portion of the revenue comes from smart transportation solutions in cooperation with local governments. In the past three years, due to the difficulty of local governments in borrowing, the scale has shrunk, so this year, this type of "icing on the cake" type of urban infrastructure has also been reduced. This impact still exists in the third quarter, and the cloud business has already turned from positive growth to a 2% year-on-year decline. Other miscellaneous items have also slowed down significantly due to the recovery of the base, but due to the gradual confirmation of revenue from autonomous driving solutions, there is still a nearly 20% year-on-year growth.

However, the management also mentioned that the demand for enterprise cloud in other fields is still recovering healthily, and with the drive of AI empowerment, enterprise customers' interest in Baidu Cloud is also increasing. The management expects that the overall growth rate of the cloud business in the fourth quarter will return to double digits. In addition to the drive of AI demand, the low base of ACE last year, which has been dragging down growth, will also alleviate the growth pressure.

Intelligent driving in other businesses is also a key focus for Baidu. Compared to the cloud business, which has already achieved a certain scale, Baidu's intelligent automotive sector is still in the early stages of development, but it has also accelerated its pace in the past two years.

In the third quarter, the ride-hailing service provided by Robotaxi reached 821,000 orders, a year-on-year increase of 73% and a month-on-month increase of 15%. As of the end of the third quarter, the cumulative number of orders for Robotaxi reached 4.1 million.

3. Profit surprised

As for the market's concerns about the impact of AI investment on profitability, it did not have a significant impact in the third quarter. The operating profit margin of Baidu's core business in Q3 was 20.7%, a 1 percentage point improvement compared to the same period last year, and a seasonal increase compared to the previous quarter.

We believe there are several possible reasons for this:

On one hand, the third quarter has not yet been fully commercialized, so the cost and AI investment recognition are not sufficient. On the other hand, although the advertising pressure in the third quarter is there, compared with the 2% YoY decline in the low-margin smart cloud, it is still slightly better. Therefore, the change in the proportion of business structure will also bring about an increase in comprehensive gross profit margin.

However, Dolphin Research is also concerned about whether AI has helped Baidu Group improve its operations internally. Although AI large models have been popular this year and companies are interested in them, due to economic pressure and lack of confidence in operations, investment in such capital expenditures is relatively cautious. Taking this into consideration, Baidu was the first to launch its own large model, but in practice, it has always been aimed at co-creation testing and strategic cooperation, and has not carried out true commercialization. In addition, Baidu's AI is mostly used internally, with applications such as Baidu Cloud, Baidu Wenku, smart speakers, and mobile Baidu all benefiting from large models. Whether this application will lead to the concentrated reuse of internal resources and accelerate internal research and development efficiency is worth paying attention to.

In terms of expenses, the MoM change is mainly reflected in the reduction of marketing expenses. After a sharp increase in R&D expenses in the previous quarter, they have slightly decreased MoM, but still increased by 7.1% YoY, compared to the previous quarter's acceleration.

We continue our forecast from the previous quarter. With the official commercialization of Ernie Bot, more expenses in AI will be recognized. We expect that the absolute value of subsequent R&D investment and cost items will continue to increase. The specific impact on profit margins will depend on the market's demand feedback for Ernie Bot.

4. iQiyi: After the surge, a return to silence

The process of iQiyi's survival by cutting off its arm and downsizing to save itself has been analyzed by Dolphin Research in previous earnings reports. In the third quarter, iQiyi continued to improve its profitability, but after the success of "The Bad Kids," the shortage of hit content made it difficult to achieve a true reversal by simply contracting its business model. As Dolphin Research mentioned in the previous quarter, iQiyi can only truly enter an upward trajectory when content investment returns to normal.

However, considering that there is a high probability of early redemption of a substantial convertible bond in August 2024, iQiyi's short-term investments may continue to be cautious due to cash flow pressure.For investors, in the short term, it is important to continue to focus on its pipeline. Of course, if it can hit the next "Fast & Furious" and accelerate its investment cycle, that would be great.

Specifically:

1）Overall impression of the earnings report: Performance is basically in line with expectations, nothing surprising.

In the third quarter, there was still a lack of content, missing the window of opportunity to acquire customers during the summer. The average daily number of subscribed members was 107.5 million, with a MoM loss of 3.7 million, but still a 6% YoY growth. Average revenue per member (ARM) increased by 12% due to a price increase at the end of last year. Ultimately, the combination of volume and price led to a 19% growth in subscription revenue.

While raising prices, iQiyi has also followed the policy of focusing on high-quality and selected projects in content investment over the past year. In the third quarter, the coverage of subscription revenue to content costs remained at 119%, similar to the second quarter. However, in order to continue to improve, it needs a "The Knockout（狂飙）" like in the first quarter to support it.

In the third quarter, iQiyi's advertising revenue continued to rebound on a very low base, reaching 1.67 billion, a YoY growth of 34%.

The lack of content not only affects its own subscription business, but also reduces revenue from external distribution. In the third quarter, content distribution revenue was only 530 million, a significant YoY decline of 28%.

In the end, the gross profit margin was increased by 1 percentage point through the optimization of bandwidth and server costs. In the third quarter, iQiyi achieved a GAAP net profit of 480 million yuan, an operating profit of 750 million yuan, and a Non-GAAP operating profit of 900 million yuan after adding back stock incentives and amortization of intangible assets. The profit margin was 11%, a MoM increase of 1 percentage point.

Third-quarter free cash flow net income was 826 million, slightly down QoQ, mainly due to the lack of high-quality content and failure to seize the peak season, resulting in overall growth pressure. As of the end of the third quarter, the cash balance was 5.26 billion, with a net increase of over 600 million QoQ.

2）Under the pressure of early redemption of convertible bonds, the return of content investment still needs to wait

In the previous quarter's earnings report review, Dolphin Research pointed out that the true reversal of iQiyi's return can be seen from the acceleration of the content investment cycle, which is the quarterly change in content assets.

In the third quarter, there was a net increase of about 300 million in content assets MoM, but the overall pace still leaned towards caution. Self-produced content continued to decrease MoM, which means that iQiyi's investment in the third quarter was mainly in the procurement of external copyrights.

Currently, iQiyi's content investment has not yet started to accelerate, and the content inventory continues to be consumed. Therefore, in the short term, there will still be a situation where a quarter hits a hot-selling hit, but the next quarter will be relatively quiet. To continue producing high-quality dramas like Netflix, we still need to wait.

Of course, based on past performance, Dolphin Research is slightly optimistic about iQiyi's team's "vision" in selecting high-quality and high-yield content, but this is more of a long-term logic, and it is hard to say whether the market still has long-term faith in iQiyi.

Therefore, Dolphin Research is more cautious and optimistic about iQiyi, either as a gamble on the rebound opportunity of absolute undervaluation, or as a wait for the arrival of the content investment cycle. However, iQiyi is no longer a drag on Baidu, so whether iQiyi has long-term value has little impact on the current valuation of Baidu.

Dolphin Research "Baidu" historical articles:

Earnings Season (showing the past year)

August 23, 2023 conference call "AI investment is amortized over multiple years, with little short-term financial impact (Baidu 2Q23 conference call summary)"August 23, 2023 Earnings Report Review: "Baidu: Cloud Rests, Advertising Supports"

On August 23, 2023, Dolphin Research published an analysis report titled "Baidu: Cloud Rests, Advertising Supports" (link: 百度: 云歇了，广告撑门面).

May 16, 2023 Conference Call: "AI's Impact on Advertising Business (Baidu 1Q23 Earnings Conference Call Summary)"

On May 16, 2023, Dolphin Research summarized the 1Q23 earnings conference call of Baidu, titled "AI's Impact on Advertising Business" (link: AI 已在广告业务上发挥作用（百度 1Q23 业绩电话会纪要）).

May 16, 2023 Earnings Report Review: "Baidu: Not Just an AI Story, Advertising Also Supports"

On May 16, 2023, Dolphin Research published an analysis report titled "Baidu: Not Just an AI Story, Advertising Also Supports" (link: 百度：不只有 AI 故事， 广告也来护盘).

February 23, 2023 Conference Call: "Advertising Relies on Macro, Cloud Focuses on Quality, AI Investment without Hesitation (Baidu 4Q22 Conference Call Summary)"

On February 23, 2023, Dolphin Research summarized the 4Q22 conference call of Baidu, titled "Advertising Relies on Macro, Cloud Focuses on Quality, AI Investment without Hesitation" (link: 广告依赖宏观，云重质不重量，毫不犹豫投 AI（百度 4Q22 电话会纪要）).

February 22, 2023 Earnings Report Review: "Surviving the Pandemic, Welcoming ChatGPT, Is Baidu Entering Its Second Spring?"

On February 22, 2023, Dolphin Research published an analysis report titled "Surviving the Pandemic, Welcoming ChatGPT, Is Baidu Entering Its Second Spring?" (link: 挺过疫情、迎来 ChatGPT，百度要来第二春？).

November 22, 2022 Conference Call: "Baidu: Advertising Recovers with Unblocking, AI Continues High Investment (Summary)"

On November 22, 2022, Dolphin Research summarized the conference call of Baidu, titled "Baidu: Advertising Recovers with Unblocking, AI Continues High Investment" (link: 百度：解封广告就恢复，AI 还会高投入（纪要）).

November 22, 2022 Earnings Report Review: "Baidu: 'Cash' in Valuation, What is the Market Afraid of?"

On November 22, 2022, Dolphin Research published an analysis report titled "Baidu: 'Cash' in Valuation, What is the Market Afraid of?" (link: 百度：估值里都是 “现金”， 市场还在怕什么？).

August 30, 2022 Earnings Report Review: "Advertising Relies on the Weather, Reversal Relies on the Cloud"

On August 30, 2022, Dolphin Research published an analysis report titled "Advertising Relies on the Weather, Reversal Relies on the Cloud" (link: 广告靠天吃饭，逆转还得靠云).

August 31, 2022: "Reducing Costs, Increasing Efficiency, Paving the Way for AI Cloud and Autonomous Driving"

On August 31, 2022, Dolphin Research published an article titled "Reducing Costs, Increasing Efficiency, Paving the Way for AI Cloud and Autonomous Driving" (link: 降本增效，铺路 AI 云和自动驾驶).

May 26, 2022 Conference Call: "Baidu's Intelligent Cloud and Autonomous Driving Business Regain Market Focus (1Q22 Conference Call Summary)"

On May 26, 2022, Dolphin Research summarized the 1Q22 conference call of Baidu, titled "Baidu's Intelligent Cloud and Autonomous Driving Business Regain Market Focus" (link: 百度的智能云和自动驾驶业务重回市场焦点（1Q22 电话会纪要）).Analysis Report on May 26, 2022 Earnings: "From Adversity to Prosperity, Baidu's Turnaround is Not Far Away?" Link

March 1, 2022 Conference Call: "Advertising Now Depends on the Weather, Baidu's Bold Vision for New Business" Link

March 1, 2022 Earnings Review: "Advertising Still in Purgatory, But Baidu's "Change of Heart" May Have Potential" Link

In-depth

December 21, 2022: "Is Consumer Spending Warming Up or Cooling Down? The Unstoppable Spring of Advertising" Link

March 17, 2021: "A Serious Look into Baidu's Assets: How Much Room for Revaluation Does the Hong Kong Stock Version of Baidu Have Left?" Link

Risk Disclosure and Statement for this Article: Dolphin Research Disclaimer and General Disclosure