Baidu: Turnaround Relies Solely on AI

After the Hong Kong stock market closed on February 28th Beijing time, Baidu.US (9888.HK;$Baidu(BIDU.US)) released its fourth-quarter earnings report for 2023.

The performance in the fourth quarter was in line with expectations. The company had already guided the market a month ago that due to macro pressures, the growth rates for advertising and cloud businesses were slightly lowered (by about 1-2 percentage points). The market has largely digested this information, and now the focus is on the company's outlook for the macro environment this year.

The AI revenue, which has attracted much attention from the market, is still relatively small (accounting for a low single-digit percentage of revenue, over 500 million, mainly from improvements in the advertising system, followed by GPU rentals and large model API calls). Therefore, the gross profit margin in Q4 did not reflect significant incremental AI costs.

We expect that in 2024, as the scale of AI-related revenue expands (the company expects tens of billions of yuan), there will be a more noticeable increase in costs. Looking at capital expenditures, we can see a clear trend of continued investment increase. Starting from the second quarter of last year, capital expenditures began to rise and increased quarter by quarter.

Specific performance of BIDU-SW core business:

1. Revenue meets post-guidance market expectations

In the fourth quarter, the core revenue of BIDU-SW grew by 7%, slightly higher than the guided expectation of 5-6%. There was not much change in profitability, with a slightly better operating profit margin, mainly due to the company's continued strict control over sales and management expenses, saving 300 million yuan compared to expectations.

2. Macro pressures + low competitive advantage, weak advertising growth

In the fourth quarter, there was a seasonal increase in e-commerce, coupled with the lingering impact of the epidemic in 2022. In fact, the industry showed a significant rebound from Q3, with year-on-year growth increasing from single digits in Q3 to 9.8% (source: Questmobile). However, the core advertising revenue of BIDU-SW only grew by 6.4% in the fourth quarter, just meeting the lowered expectations set by the company. The actual performance was not satisfactory.

Apart from the relatively low proportion of e-commerce advertising within the BIDU-SW ecosystem compared to its peers, especially short video platforms, the era of internet giants benefiting from the dismantling of walls and the fierce competition in e-commerce platforms is coming to an end. The next phase will focus on factors such as user scale, stickiness, and conversion rates, where BIDU-SW, except for scale, does not hold an advantage.

Therefore, the potential for AI to bring "significant" incremental growth is crucial. Overseas advertising giants Google and Meta have already tasted the benefits of AI in improving advertising conversion efficiency to some extent, so the market has relatively high expectations for BIDU-SW.At present, the revenue increment brought by AI optimization for advertising systems in the fourth quarter (such as AI native marketing applications) is not significant, accounting for about 1-2%. The company previously anticipated that by 2024, the advertising revenue contribution could reach a scale of several billion. Dolphin Research roughly estimates an annual AI revenue of 5 billion, which means a 5% revenue growth contribution to BIDU-SW's core business.

It is worth paying attention to whether the management has any updates on expectations during the conference call, especially as traffic on Wenxin Yiyuan has been continuously increasing (1 billion registered users, 2.5 million MAU in January). With the update and iteration of AI assistants this year, as well as the increase in cognitive penetration rate, it is expected to reach and convert more users.

3. Low base + AI contribution, Smart Cloud starts to recover

In the fourth quarter, other business revenues in BIDU-SW's core, such as cloud, grew by 9%, reversing the trend of slowing growth. However, this is mainly due to the impact of a low base. BIDU-SW ACE only started to decline significantly from the same period last year, which is 4Q22.

Of course, there will be some pull from AI demand for GPU rentals and API calls for large models, but the proportion is still relatively low, accounting for about 4.8% of cloud revenue (about 270 million).

4. Continued strict cost control, slightly exceeding profit expectations

In the fourth quarter, due to the confirmation of some AI costs and the mediocre performance of revenue, excluding seasonal effects, the gross margin also experienced a slight decline. However, strict cost control (mainly sales and administrative expenses) in the fourth quarter still led to slightly exceeding the expected operating profit.

In the initial stage of AI monetization where revenue and costs do not match, Dolphin Research expects this kind of cost control to continue for some time. Coupled with the help of AI in improving internal operational efficiency, there may continue to be actions such as low growth in marketing spending and personnel optimization for cost control.

5. Repurchase and Cash:

BIDU-SW has always had sufficient cash, but the intensity of repurchases/dividends has been relatively small. At the end of the fourth quarter, BIDU-SW held cash assets (cash, cash equivalents, short-term investments) totaling 205.4 billion RMB (including iQIYI), equivalent to 28.5 billion USD.

If we are more cautious and deduct various interest-bearing debts (including loans, notes, and convertible bonds), the net cash is about 21.4 billion USD. Despite AI investments, due to the core business generating over 880 million USD (6.3 billion RMB) of free cash flow in a single quarter, the net cash scale increased slightly compared to the previous quarter.

The repurchase amount for BIDU-SW in the fourth quarter increased by a certain amount, rising by 318 million from over 100 million USD in the third quarter, but it is still not considered high. There is still 670 million USD remaining in the repurchase plan approved for 2023, and the company still prefers to retain cash for future operational investments and short-term deposits/financial products.

6. Overview of detailed financial data

Dolphin Research Insights

Dolphin Research's view on BIDU-SW's quarterly report is similar to the previous quarter: although the AI story is hot in the capital market, the valuation of BIDU-SW still largely depends on the macro environment and the competition for platform traffic duration. However, as these two aspects are not particularly favorable for BIDU-SW, it must be acknowledged that AI is a decisive factor in whether BIDU-SW's valuation can revive.

Currently, the market no longer blindly invests in companies with high AI content just by listening to stories; instead, it now demands tangible monetization. While immediate impact is not required, at least meaningful contributions need to be seen. For BIDU-SW, it may need more incremental growth to offset some macro pressures.

The lack of attractiveness in old businesses and a relatively low buyback dividend ratio have been key reasons why BIDU-SW's valuation has been consistently underestimated by the market (Dolphin's cautious neutral expectation is $50 billion, which still has a 25% upside). The key going forward is whether AI can provide the necessary momentum for BIDU-SW's growth. Based on management's expectations, we anticipate that AI is likely to contribute around 5% growth to the core business. With old businesses not showing significant drag, valuation will have higher recovery potential.

However, we also believe that BIDU-SW needs to accelerate its pace, following the trend of evolution among overseas tech giants. Domestic giants are likely to intensify the self-research and development of large Chinese models this year. There are still differences between the domestic and international markets, mainly in user awareness.

Although BIDU-SW's technology currently leads the industry, due to the slower increase in the domestic AI application usage rate compared to Europe and the United States, other platforms do have the opportunity to catch up. If the lead of BIDU-SW is not perceived significantly by users, other giants are likely to compensate for the technological gap through ecological advantages.

Detailed Financial Report Analysis

BIDU-SW is a rare internet company that breaks down its performance in detail:

BIDU-SW Core: Includes traditional advertising business (search/information flow advertising) and innovative businesses (smart cloud/DuerOS Xiaodu speakers/Apollo, etc.);
iQIYI Business: Memberships, advertising, and copyright transfer licensing, among others.

The clear separation of the two businesses, along with iQIYI as an independently listed company with detailed data, allows Dolphin Research to analyze the two businesses in detail. Due to approximately 1% offsetting items (between 2-4 billion), the detailed breakdown of BIDU-SW's core by Dolphin Research may have slight discrepancies from the actual reported numbers, but it does not affect trend analysis.

I. Macro Pressure + Reduced Dividends, Flat Advertising Growth

In the fourth quarter, BIDU-SW's core advertising grew by 6.4% year-on-year, which is in line with the market expectations guided by the company (2 percentage points lower than the guidance given after the previous quarter's financial report). Among them, high-margin hosted page ads accounted for a decrease to 51%, down 2 percentage points quarter-on-quarter.In the fourth quarter, although it is the peak season for e-commerce, the marketing efforts of businesses during this year's Double 11 were not very strong due to the impact of the macro economy. However, due to the low base caused by the epidemic in the fourth quarter of 2022, the overall performance of the advertising industry was still decent, with a year-on-year growth of 9.8%.

Compared with the industry situation, BIDU-SW's performance in the fourth quarter was weaker than its counterparts. While e-commerce advertising is usually more prominent in the fourth quarter, BIDU-SW, compared to other peers, does not have an advantage in e-commerce advertising. Its strengths lie in offline advertising (such as medical and tourism), which are currently in the off-season. Additionally, there is a bonus from the scuffle among e-commerce platforms in 4Q22.

The main reason for BIDU-SW's weaker performance is that its search traffic ecosystem itself lacks advantages, with only a large scale but weak user stickiness and duration.

In the fourth quarter, the monthly user base of BIDU-SW's mobile APP only increased by 4 million compared to the previous month, reaching 667 million. After the decline of the internet ecosystem's traffic dividend, BIDU-SW's traffic is showing signs of peaking.

However, in the third quarter, due to the pressure from the slowdown in online retail growth, the entire online advertising industry did not perform well, with growth slowing down to be flat year-on-year. BIDU-SW can maintain a growth of over 5%, mainly due to its large user base and the bonus brought by the return flow of offline scenarios like medical and cultural tourism.

Looking ahead to the first quarter of this year, Dolphin Research believes that BIDU-SW's advertising revenue may be slightly higher than institutional expectations due to the crowded offline travel during the Spring Festival period (institutional expectations +5% YoY).

However, it is also important to note that emerging platforms like Xiaohongshu have strong traffic advantages in offline activities such as tourism. Xiaohongshu also gained a wave of traffic from second and third-tier cities by participating in the Spring Festival Gala. The actual performance in Q1 will still depend on the second half of the quarter, so Dolphin Research is cautiously optimistic about the first quarter expectations.

Second, Smart Cloud Warms Up as Scheduled: Mainly Benefiting from Low Base, with AI as a Supplement

In BIDU-SW's core non-advertising businesses, nearly 80% of the revenue comes from Smart Cloud, while the remaining 20% is mainly from autonomous driving technology solutions, smart speakers, and other sources. In the fourth quarter, revenue from other businesses reached 8.3 billion, with a year-on-year growth of 8.9%, showing a rebound in growth rate.The main reason for the rebound in growth is due to the low base. In the fourth quarter of 2022, the ACE revenue in the Smart Cloud experienced a significant year-on-year decline, with the cooperation of smart transportation solutions for local government departments being a core factor due to tightening local budgets. By the fourth quarter of 2023, it coincidentally began to enjoy the dividend period of the low base.

Additionally, in the fourth quarter, there was additional revenue generated from the hot demand for AI applications, GPU rentals, and WENXIN large model API interface calls. However, this part of the revenue is still relatively small, around 2 billion. By the end of 2023, developers had created 860,000 AI models on PaddlePaddle.

Ultimately, the cloud business transformed from a negative growth of 2% in the previous quarter to a positive growth of 11%. The remaining other businesses grew by 4%, showing a significant decline.

Considering the steady progress of intelligent driving in the remaining other businesses, the rapid decline in growth in the fourth quarter is likely due to the poor performance of other smart hardware businesses such as Xiaodu speakers.

In the fourth quarter, Luobo Kuai Pao provided a total of 839,000 ride-hailing services, a year-on-year increase of 49% (slightly slower than the previous quarter) and a month-on-month increase of 2%. By the end of the fourth quarter, Luobo Kuai Pao's cumulative orders exceeded 5 million.
In the fourth quarter, Wuhan's unmanned driving orders accounted for 45% of the overall intelligent driving orders, an increase from 40% in the third quarter.

III. The impact of AI cost recognition is beginning to show, with strict cost control maintaining profit margins

Despite market concerns about the impact of AI investment on profitability, although there were some confirmations in the fourth quarter (historically, the gross profit margin in the fourth quarter generally declined by 3 percentage points compared to the third quarter, but in the fourth quarter of 2023, the gross profit margin declined by 4 percentage points), the overall impact on the gross profit margin is still manageable.

In the end, the operating profit of BIDU-SW's core in Q4 was 4.7 billion, with a profit margin of 17%, an improvement of 2.3 percentage points year-on-year, but a seasonal decline compared to the previous quarter.Last year, the revenue was affected by the epidemic and government budget tightening, with pressure on advertising and cloud revenue. Therefore, the year-on-year improvement in 23 is within expectations. Looking at capital expenditures, it is clearer that BIDU-SW has been increasing capital expenditures quarterly since the second quarter of last year, accelerating investment.

As BIDU-SW's AI applications under BIDU-SW accelerate monetization in 2024, related investment expenditures will also be confirmed accordingly. We expect that future R&D investment and absolute values of cost items will continue to grow. To offset the impact of cost changes on profit margins, BIDU-SW may continue to control non-AI operating expenses for a period of time. Additionally, AI itself helps improve internal operational efficiency to a certain extent. Therefore, BIDU-SW may continue to optimize expenses through actions such as low growth in marketing spending and personnel optimization.

Dolphin Research on "BIDU-SW" Historical Articles:

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