Under multiple pressures, Baidu is struggling to seek change

Just like the previous quarter, in the second quarter, the core performance of Baidu.US once again beat conservative expectations. The highlights mainly lie in the increase in operating profit margin brought about by cost optimization. In addition, for some top institutions, macro pressures led them to lower their growth expectations for advertising revenue before the financial report, but Baidu's revenue performance slightly exceeded some expectations.

However, during the post-results communication, the management expressed expectations that the performance in the third quarter will continue to be under pressure. Despite the proactive impact of accelerating the generation of AI search content (AI search content is currently not commercialized), they also acknowledged the pressure brought about by the current macro environment, which is precisely the fundamental reason for the recent wave of Chinese concept stock scandals.

The following focuses on the fundamentals of Baidu, so only the performance of Baidu's core business will be discussed.

Specifically:

1. Earnings Exceeded Expectations: The second-quarter profit beat mainly stemmed from personnel reduction. The 27% year-on-year decline in equity incentives, coupled with strict control over promotional expenses, offset some of the increased AI expenditures. In the end, Baidu's core research and development expenses decreased by 8% year-on-year, while sales and management expenses decreased by 11% year-on-year.

2. Short-Term "Double" Pressure on Advertising: Core advertising experienced negative growth in the second quarter, with a 2% year-on-year decline. The management explained this as the impact of actively promoting AI. After all, the proportion of search results provided by AI increased from 11% to 18% in the second quarter, but this part has not yet started commercialization directly (expected in the fourth quarter). Excluding the impact of AI, there is still actual positive growth, but the major driver during the 618 period was the e-commerce voucher battle.

However, on the other hand, the management also mentioned macro pressures, once again confirming the market's biggest concerns. In the context of weak consumption, offline small and medium-sized businesses are often the first to tighten their belts, and this is particularly true for a significant proportion of Baidu's advertising clients.

Therefore, it is expected that in the third quarter, under the dual pressure of external macro factors and internal Gen-AI advancement, the decline in revenue will further expand. However, the management believes that in the fourth quarter, with the commercialization of AI search beginning and a lower base, there will be a rebound.

However, Dolphin remains cautious about the expectation of a rebound in the fourth quarter. Because not only is there a macro trend, but from a medium to long-term perspective, Baidu still faces an unavoidable bug - traffic erosion.

On the one hand, short video platforms are still occupying user time, and on the other hand, whether it is competition from peers such as Quark, Kimi, or other traffic platforms, they are all penetrating search traffic, all pointing to the erosion of Baidu's search traffic. The net increase in MAU in the second quarter is more likely to be AI trial users in Dolphin's view, but the trend of DAU disclosed by third-party data is not good, indicating that the stickiness of existing users may still be declining, so the growth of MAU is recommended to be observed for sustainabilityTherefore, Dolphin believes that before AI truly brings significant "net increment" contribution to advertising (rather than the ups and downs between different forms of advertising internally), Baidu's traditional advertising business, after enjoying the benefits of the internet giants' dismantling walls, still relies on macro factors and may find it difficult to achieve independent advantages.

3. Slight acceleration in cloud business: The smart cloud business continued to accelerate along the trend of the previous quarter, with a year-on-year growth of 14%. Compared to the pull of advertising, the demand for enterprise AI applications may contribute more significantly to the revenue growth of the smart cloud (currently, the daily average API calls in August exceeded 600 million times, a rapid increase from the disclosed 200 million times in May).

4. Strong momentum in autonomous driving: Excluding revenue from the smart cloud, the remaining businesses such as Xiaodu, smart transportation, and autonomous driving did not decline in the second quarter, with a 2.8% year-on-year growth. The highlight is the RoboTaxi service, with 400 driverless cars deployed in Wuhan, already serving 9 million users. As the proportion of autonomous vehicles increases, the operating cost per vehicle has decreased by 50%. With the subsequent launch of the low-cost RT6 vehicle into the market, further optimization of the user experience is expected.

5. Repurchase and cash: Free cash flow in the second quarter was 5.9 billion, a 17% year-on-year decrease, mainly due to a decline in operating cash flow.

Although operating profit increased year-on-year, it was mainly due to the reduction of expenses that do not affect cash flow, such as equipment depreciation, content copyright amortization costs, and employee stock incentive expenses. Therefore, operating cash flow decreased by nearly 2 billion compared to last year. Capital expenditures, such as AI servers and chip investments, led to a 22% year-on-year decrease in capital expenditures.

In the second quarter, Baidu's repurchase scale slightly increased compared to the previous quarter, consuming 300 million US dollars, corresponding to an annualized dividend yield of approximately 4%. Including iQIYI (with a net debt of 150 million in 2Q24), the company still has a total of 162 billion RMB in investments + cash. Excluding short-term interest-bearing debt (including loans, notes, and convertible bonds), the net cash corresponds to 149.5 billion RMB, equivalent to 20.7 billion US dollars, which is still relatively abundant. In terms of the proportion of repurchase expenditure, the company still tends to retain cash for future operating investments and short-term and long-term deposits/financial products (in the second quarter, more than 20 billion in short-term funds were transferred to long-term deposits).

6. Overview of financial report details

Dolphin's Viewpoint:

Baidu's second-quarter performance mainly exceeded market expectations due to the low market expectations. In addition, the strength of cost optimization was also relatively strong, ultimately resulting in a significant profit beat.

However, due to the macro environment and the lack of commercialized AI search penetration, the pressure in the second half of the year is also visibly high. In the medium to long term, the issue of traffic erosion that Dolphin has always been concerned about, although there has been a short-term return of monthly active users, has not been fundamentally alleviated. In addition, Douyin has surpassed ERNIE in user penetration on the consumer end, and the growth momentum has also slowed down. In this situation, it is also difficult to reduce doubts about whether AI can bring a net increment to search advertising in the future.**

For the choice of continuing to promote AI search even at the expense of short-term profits, Dolphin believes that from the perspective of traffic defense, Baidu has no choice but to do so. It is just inevitable that some funds that care about EPS will feel uncomfortable.

After the performance release, Baidu's market value further shrank to 30 billion USD. At first glance, the net cash on hand is only 20 billion USD, seemingly undervalued. However, considering that Baidu's buyback scale is too low, and some short-term funds will be transferred to long-term deposits in the second quarter, it means that the management may not intend to expand the buyback intensity in the short term. Therefore, for some relatively cautious investors, the net cash here may not be considered in the valuation, after all, there are many undervalued but highly repurchased companies in the current Chinese concept assets.

If we are more strict and do not consider net cash, but considering the pressure on Topline growth, Dolphin slightly lowers the market's performance expectations for next year. Thus, the current 30 billion USD market value corresponds to 25 years of after-tax Non-GAAP operating profit (15% effective tax rate), overall corresponding to a 9x valuation. This means that if segmented valuation is considered, the current market value may imply that the advertising business is only valued at 7x.

Therefore, if the liquidity improves in the future, Baidu is expected to restore its valuation along with the Chinese concept assets in the short term. However, whether it can maintain the valuation after the restoration still cannot avoid changes in the macro environment.

Below is a detailed interpretation of the financial report

Baidu is a rare internet company that details its performance as follows:

Baidu Core: covering traditional advertising business (search/information flow advertising) and innovative businesses (smart cloud/DuerOS Xiaodu speakers/Apollo, etc.);

iQIYI business: membership, advertising, and copyright transfer authorization, among others.

The division of the two businesses is clear, and with iQIYI as an independently listed company with detailed data, Dolphin Research will also detail the two businesses. Due to the offset of about 1% (between 200-400 million) in the two major businesses, the detailed breakdown of Baidu Core by Dolphin may have slight discrepancies from the actual reported numbers, but it does not affect trend analysis.

I. "Double" Pressure on Advertising in the Short Term

In the second quarter, Baidu Core's advertising fell by 2% year-on-year, slightly higher than the market's relatively conservative expectations. Among them, the high-margin sponsored page ads rebounded slightly to 51%, up 1% from the previous quarter.

Although there was the 618 e-commerce festival in the second quarter, consumption was relatively weak, especially for offline small and medium-sized businesses, leading to a significant decrease in advertising willingness. This is not good news for Baidu, which has a relatively high proportion of offline small and medium-sized businesses.

Overall industry growth has rebounded, mainly due to the accelerated advertising on games and e-commerce platforms. However, due to traffic erosion, Baidu has not gained much benefit in this regard.

The core reason is that Baidu's search ecosystem itself lacks advantages, only having a large scale, but weak user stickiness and duration. However, in the second quarter, the monthly user count of the Baidu app on mobile devices rebounded, with a net increase of 27 million. It is speculated that this may be due to the penetration improvement of AI search experience, attracting some users to return.

However, through third-party data comparison, it is actually shown that the DAU of the Baidu app on mobile devices decreased in the second quarter, indicating that the increase in monthly active users may mainly be AI trial users, while the stickiness of existing users is still declining. In addition, although ERNIE's activity is still good, it has been surpassed by Byte's Douyin.

Overall, when AI is still in the stage of being a redundant feature for most ordinary users (user education period), it is still necessary to look at the hard strength of the main traffic source. Byte's large-scale educational penetration method is clearly due to its original traffic advantage. However, does Baidu's weak main traffic source imply that the support for ERNIE will gradually weaken in the future?

Looking ahead to the third quarter, the management has already taken precautions against the pressure of growth, and it is expected to see a larger decline than in the second quarter. However, it is worth mentioning that there is temporary pressure due to multiple factors at play in the short term.

1) The macro environment is the first to be affected. Dolphin Jun does not make predictions about the future direction, maintaining a relatively cautious stance.

2) Actively promoting AI search. In the second quarter, the proportion of AI search results in user experience has reached 18% of the overall search, a 7% increase from the previous period. However, Baidu has not commercialized the content of AI search results yet, so actively promoting AI means that the short-term monetization capability will definitely be affected.

But this is something that Baidu has to do. In the irreversible trend of eroding traffic, promoting AI is the only way to regain user duration. In addition, this round of AI transformation also has a disruptive logic for active search entry, so Baidu, for defensive purposes, also needs to actively change and sacrifice short-term profits.

II. Stable demand for Smart Cloud, with many highlights in autonomous driving

In Baidu's other core businesses (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 revenue sources.

In the second quarter, revenue from other businesses was 7.5 billion, a year-on-year increase of 10%, mainly driven by Smart Cloud with a low base + AI, further increasing growth to 14%. Other businesses outside of Smart Cloud have also resumed positive growth, with Luobo Kuai Pao being a highlightIn the second quarter, revenue from Smart Cloud increased by 14%, driven by the rise in demand for large models and the spillover effect of large model demand on other cloud services.

Looking specifically at the contribution of AI Cloud to Smart Cloud revenue, it increased from 5% in the previous quarter to 9%. Additionally, GPU customers' demand for public cloud services saw a significant increase, with the growth rate of other cloud services excluding AI-related large model revenue rising from 11.8% in the first quarter to 13.9% in this quarter.

In other businesses, progress in autonomous driving is rapid. In the second quarter, Carrot Run provided a total of 899,000 ride-hailing services, a year-on-year increase of 26% (with stable growth compared to the previous quarter). As of July 28th, Carrot Run has accumulated over 7 million orders.

Currently, the 400 vehicles deployed in Wuhan are all autonomous driving vehicles, serving 9 million users. With the increasing proportion of autonomous vehicles, the operating cost per vehicle has decreased by 50%. After the lower-cost RT6 vehicles (priced at 250,000 per vehicle, nearly 50% lower than RT5's 480,000) are introduced to the market, there is potential for further optimization of UE.

III. profits exceed expectations, continuing with extensive layoffs

Despite concerns in the market about the impact of AI investments on profit margins, the second quarter saw some confirmations, but the overall impact on gross profit margins remained relatively manageable. However, as Gen-AI search gradually commercializes in the second half of the year, corresponding incremental costs are expected to be recognized.

From a capital expenditure perspective, Baidu's investments in AI servers and chips saw a slight decline in capital expenditure in the second quarter, down 22.4% year-on-year, indicating a temporary pause in the aggressive investments of the past year. Of course, specific changes may still depend on industry developments, but for now, if there are no major breakthrough products in downstream applications, with revenue under pressure in the short term, Baidu's motivation to continue increasing capital expenditure may not be too high.

However, compared to operating costs, as AI business develops, expenses such as unavoidable growth in server depreciation will increase. The company's proactive approach is adjusting personnel salary costs, as mentioned in our financial report review from the previous quarter.

Similar to the first quarter, in the second quarter, SBC expenses continued to decrease significantly by 28% year-on-year, indicating that optimization mainly came from layoffs/salary reductions, and advertising expenses also likely decreased. Ultimately, Baidu's core operating profit in the second quarter was 5.6 billion, with a profit margin of 21%, a year-on-year improvement of 4 percentage points, and a quarter-on-quarter increase of 2 percentage points, exceeding market expectations

Dolphin Research on "Baidu" Historical Articles:

Financial Report Season (showing the past year)

May 17, 2024 Conference Call "Baidu: Advertising under short-term pressure, can search rely on AI transformation (1Q24 conference call summary)" Link

May 16, 2024 Financial Report Review "Baidu: Kingdom of Search, Can it defend the city with AI?" Link

February 28, 2024 Conference Call "Baidu: AI brings improvement in eCPM and user engagement (Baidu 4Q23 conference call summary)" Link

February 28, 2024 Financial Report Review "Baidu: Can only rely on AI to turn the tide" Link

November 22, 2023 Conference Call "AI improves advertising conversion, reshaping the cloud market (Baidu 3Q23 conference call summary)" Link

November 22, 2023 Financial Report Review "Can AI support Baidu's 'new story'?" Link

August 23, 2023 Conference Call "AI investment spread over multiple years of amortization, short-term financial impact is not significant (Baidu 2Q23 conference call summary)" Link

August 23, 2023 Financial Report Review "Baidu: Cloud rests, advertising supports the facade" Link2023 年 5 月 16 日电话会《 AI has played a role in advertising (Baidu 1Q23 earnings call summary)》

2023 年 5 月 16 日财报点评《 Baidu: Not just an AI story, advertising also comes to support the market》

2023 年 2 月 23 日电话会《 Advertising relies on the macro, cloud emphasizes quality over quantity, decisively invests in AI (Baidu 4Q22 earnings call summary)》

2023 年 2 月 22 日财报点评《 Surviving the epidemic, welcoming ChatGPT, is Baidu ushering in a second spring?》

2022 年 11 月 22 日电话会《 Baidu: Unsealing advertising leads to recovery, AI will continue to see high investment (summary)》

2022 年 11 月 22 日财报点评《 Baidu: Valuation is all "cash", what is the market still afraid of?》

2022 年 8 月 30 日财报点评《 Advertising relies on the weather, reversal still depends on the cloud》

2022 年 8 月 31 日《 Reducing costs and increasing efficiency, paving the way for AI cloud and autonomous driving》

2022 年 5 月 26 日电话会《 Baidu's intelligent cloud and autonomous driving business back in the market spotlight (1Q22 earnings call summary)》

2022 年 5 月 26 日财报点评《 Turning the tide, Baidu's turnaround is not far away?》March 1, 2022 Conference Call " Advertising now relies on the sky for food, Baidu's wild speculation on new business fantasies"

March 1, 2022 Financial Report Review " Advertising is still in purgatory, but Baidu's "change of heart" may have a plan"

In-depth

December 21, 2022 " Is consumer spending warming up or still cold? Can't stop the spring of advertising"