Baidu: No ability to turn the tide, only a path of "difficulty" ahead

$Baidu(BIDU.US)$BIDU-SW(09888.HK) The third quarter report will be released after the Hong Kong stock market closes on November 21, 2024. Although the overall Q3 performance is not much different from market expectations after institutions collectively lowered their forecasts at the end of October, the real reason for the market's dissatisfaction and sell-off is the company's subsequent guidance at a small meeting indicating a high single-digit decline in core advertising revenue growth for Q4, rather than a slight recovery after policy stimulus, and the lack of a clear repurchase upgrade plan.

(The following text focuses on Baidu's fundamentals, thus only discussing Baidu's core performance.)

Specifically:

1. Advertising pressure, even more so in Q4?: Despite the loud AI slogans, Baidu's current valuation and cash flow mainly rely on advertising, so the performance of advertising directly determines Baidu's stock price performance in the near term.

The pressure on advertising in Q3 was within expectations, and institutions made another round of downward adjustments at the end of October, with some institutions being noticeably more conservative. However, for Q4, institutions expected some recovery driven by recent policies, such as a low single-digit year-on-year decline in revenue.

However, contrary to expectations, management revealed during the conference call that they have not seen any confidence turnaround from advertisers, and during the communication meeting, they directly provided further deteriorating guidance—Q4's decline will increase to a high single-digit, which undoubtedly disappointed the market.

Although traditional search is under pressure, the company still stated that for the new AI business, the current goal is user education, not commercialization. The penetration rate of AI search reached 20% in Q3, up from 18% in the previous quarter, but the pace of increase has slowed.

2. Unexpected slowdown in cloud services?: In Q3, the growth rate of smart cloud was only 11%, a slight decline from 14% in the previous quarter, despite having a lower base in Q3.

Dolphin believes that there are macroeconomic and business adjustment reasons for this (the cloud storage business was moved from the smart cloud department to the mobile ecosystem department in Q3), but we cannot ignore that the demand for Gen-AI cloud may also be experiencing a phase of slowdown:

In Q3, among the 4.9 billion in smart cloud revenue, the revenue driven by generative AI accounted for 11%, an increase of 2 percentage points from the previous quarter. However, the actual scale calculated shows that the quarter-on-quarter growth rate has rapidly decreased from 95% in the previous quarter to 17%.

From the specific API calls, it can also be seen that: after the significant decrease in inference costs, although the API call volume grew rapidly in Q3, with a year-on-year increase of 240% in the last week of September, most of the current API call volume comes from ToC product demand (mainly internal product demand), rather than external enterprise customer demand that can truly bring incremental growth

3. Earnings exceed expectations?: Similar to the previous quarter, the profit beat in the third quarter also stemmed from personnel reductions during the organizational adjustment process, as evidenced by the 19% year-on-year decline in equity incentives.

In the third quarter, Baidu merged its healthcare division HCG into the mobile ecosystem division MEG, while also incorporating Baidu Cloud into MEG. Ultimately, driven by a 13% year-on-year decline in R&D expenses, the operating profit margin increased by 0.5 percentage points compared to the previous quarter.

4. Will autonomous driving UE be operational next year?: Excluding the revenue from smart cloud, the remaining businesses such as Xiaodu, smart transportation, and autonomous driving grew by 14% year-on-year in the third quarter, showing significant acceleration compared to the previous quarter.

In the third quarter, Luobo Kuai Pao received 988,000 orders, a year-on-year increase of 20%, with fully autonomous driving orders accounting for over 70%, which increased to 80% in October.

However, for the autonomous driving business, the market is most concerned about when the UE economic model of Luobo Kuai Pao will be operational. Currently, the largest impact on costs still comes from vehicle costs, and the company has clearly stated that it expects to achieve a profitable model in some cities by the time Apollo RT6 is launched.

5. Higher profits but worse cash flow?: In the third quarter, Baidu's core free cash flow was only 2.4 billion, a year-on-year decline of 59%, which is only higher than the first quarter of 2022. The main reason for such poor cash flow is the decline in operating cash flow, rather than capital expenditures, which have actually contracted against the trend.

During the conference call, management did not elaborate on the underlying reasons. Dolphin Jun believes that the decline in operating cash flow is mainly due to:

(1) The cash flow from the advertising business has always been good, so when Baidu's advertising is under pressure, cash flow will naturally be affected; (2) At the same time, other businesses (smart cloud, smart hardware, autonomous driving, etc.) may appear to have good revenue growth, but they may not necessarily result in immediate cash collection.

Additionally, the counter-cyclical contraction in capital expenditures in the third quarter may not be a normal situation, mainly benefiting from the prior front-loading of supply investments. As AI demand continues to expand in the future, Baidu may also need to increase investments again. Conversely, does the current contraction in Capex indicate that Baidu is also sensing a cooling of short-term AI demand?

6. Has the buyback decreased again?: In the third quarter, Baidu's buyback scale was lower than in the past, with only $160 million repurchased. Management explained that this was due to the rebound in market value in the third quarter, leading to a reduction in buybacks. Based on the past year's buyback pace of $1 billion, the shareholder return rate is 3.5% (as of the market value at the close on November 21), which is considered low among Chinese concept stocks.

However, Baidu is not short on cash; as of the end of the third quarter, Baidu's core cash + short-term investments amounted to $20 billion, and even after deducting short and long-term loans, the net cash is still $18.4 billion.

During the conference call, management stated that if the market value is low in the fourth quarter, the buyback pace will resume, but no quantitative commitment was given. From the perspective of the proportion of buyback expenditure, management still prefers to retain the earnings for internal use, namely for subsequent operational investments and short- to long-term deposits/investment products (in the third quarter, over 15 billion RMB of short-term funds were shifted to long-term fixed deposits)

Currently, Baidu's net cash accounts for an astonishing 64% of its market value, but it is no wonder that the market chooses to ignore it. A company facing short-term growth bottlenecks and yet to succeed in long-term transformation, if it does not generously reward shareholders, then no amount of cash will matter to shareholders, and why should it be added to the valuation? Among Chinese concept assets, it is not uncommon for companies to have a market value lower than their net cash. If a company does not commit to increasing long-term returns for shareholders, then such a "cash floor" cannot truly become a "valuation floor."

6. Detailed Financial Report Data Overview

Dolphin's Viewpoint

Only after the tide recedes do we know who has been swimming naked, and this phrase describes Baidu over the past few years perfectly. In the process of fully transforming into AI, Baidu's ongoing loss of market share in search has not been resolved. Instead, the current immaturity of AI commercialization has harmed the group's overall revenue. This has caused Baidu's performance to lag behind several leading platforms during a macroeconomic downturn.

Of course, this is determined by the inherent pain points of search engines. On the other side of the ocean, Google is also facing the erosion of AI on search entry points, but the actual experience is worlds apart—Google's search maintained a strong growth of 12% in the third quarter, while cloud revenue accelerated to 35%.

Although the macro environments of the two are different, the greater differences lie within themselves:

Google has at least not lost its search scenarios. This is due to its leading product experience and good user reputation. In contrast, Baidu's search engine has a mediocre reputation, and users often struggle to efficiently obtain information amidst advertising pages. Coupled with the emergence of new information carriers like short videos, it has been continuously diverted by various social platforms and other search engines (Bing, WeChat search).

The rapid improvement of information acquisition efficiency through AI undoubtedly strikes at the aforementioned pain points. After competitors have also launched AI large models, Baidu's search, even with a 20% share of AI search volume, may still see a decline in total traffic. The lack of user usage scenarios is the real fatal flaw, which means that even if Baidu's AI improves advertising effectiveness, it may still be of little value to current advertisers.

Another significant change over the past few quarters is that Baidu is focused on cost reduction and efficiency improvement. However, cost reduction and efficiency improvement have always been a bonus rather than a lifeline; during a period of revenue pressure, relying solely on cost reduction and efficiency improvement is unlikely to support the market's long-term growth confidence in the company.

After the earnings release, Baidu's market value further shrank to $28.6 billion. At first glance, the net cash on hand is $18.4 billion (after deducting short-term and long-term loans), and it seems that the management could privatize the company with a little more effort. But as mentioned, in an inefficient investment environment, net cash that is not used to reward shareholders holds zero value for them. In the third quarter, Baidu reduced its already limited buybacks due to the increase in market value, and instead continued to transfer some short-term funds into long-term deposits. At least from a subjective intention perspective, the management may not plan to significantly increase buyback efforts within a year. **

Therefore, Dolphin Jun's judgment on Baidu remains the same as last quarter. Before AI truly makes a miraculous impact, if subsequent policies are favorable, Baidu will only have the space for overall valuation recovery following the macro marginal improvement in the industry, without the space to develop an independent market.

The following is a detailed interpretation of the financial report.

Baidu is relatively rare among internet companies in breaking down its performance in detail:

Baidu Core: Covers traditional advertising business (search/information flow advertising) and innovative businesses (Intelligent Cloud/DuerOS Xiaodu speakers/Apollo, etc.);
iQIYI Business: Membership, advertising, and copyright transfer, among others.

The separation of these two businesses is clear-cut, and with iQIYI being an independently listed company with detailed data, Dolphin Investment Research will also break down these two businesses in detail. Due to approximately 1% (between 200-400 million) of offsetting items between the two major businesses, the segmented data of Baidu Core that Dolphin Jun splits may differ slightly from the actual reported figures, but it does not hinder trend judgment.

I. Advertising under pressure, worse guidance?

In the third quarter, Baidu's core advertising fell by 4.5% year-on-year, which is basically in line with the revised market expectations. Among them, high-margin managed page ads accounted for 51%, remaining flat quarter-on-quarter.

The macro pressure in the third quarter is needless to say, and the growth rate of the entire industry has rapidly slowed to 5.5%. However, despite some stimulus policies released in October, management's guidance for the fourth quarter has not improved, but rather worsened.

The core reason is that Baidu's search ecosystem itself does not have advantages, only a relatively high scale (in the third quarter, the MAU of Baidu's mobile app increased by 1 million quarter-on-quarter, reaching 704 million), but user stickiness and duration are relatively weak.

This is not enough even in social platforms, and even within the segmented categories of search engines, Baidu's market share is rapidly declining.

The advantages of AI seem to have already been surpassed by Byte's Doubao, widening the gap. Dolphin Jun believes that when AI is still in the stage of being a marginal feature for most ordinary users (user education phase), it is still necessary to look at the hard power of the traffic base camp. Byte's exclusive and extensive penetration relies evidently on the original ecological traffic advantage. Conversely, the weakness of Baidu's traffic base camp may further weaken the ability of Wenxin Yiyan to maintain its lead.

The management's outlook for core advertising revenue in the fourth quarter is a high single-digit decline. In addition to the macro pressures and competitive pressures mentioned above, there are also growing pains during Baidu's AI search transformation process.

In the third quarter, the proportion of AI search results in user experience reached 20% of overall searches, an increase of 2 percentage points quarter-on-quarter. Perhaps due to the slowing pace of improvement and insufficient actual user penetration, Baidu stated that it is still not in a hurry to monetize, which will undoubtedly continue to exert greater pressure on short-term advertising revenue.

II. Slowdown in Smart Cloud Growth: Short-term disturbances but demand pressure is hard to conceal

Among Baidu's core other businesses (non-advertising), nearly 80% of revenue comes from Smart Cloud, while the remaining 20% mainly comes from autonomous driving technology solutions, smart speakers, and other revenues.

In the third quarter, revenue from other businesses was 7.7 billion yuan, a year-on-year increase of 12%, accelerating compared to the previous quarter, mainly driven by a low base and "carrot racing" (with 990,000 orders in the third quarter, a year-on-year increase of 20%, slowing from the previous quarter's 26% growth). The growth rate of Smart Cloud was 11%, down from 14% in the previous quarter, but in fact, the base in the third quarter of last year was lower.

This includes factors from the adjustment of Baidu Cloud services, but HaiTun Jun believes that the rapid drop in the month-on-month growth rate of generative AI cloud from 95% to 17% indicates that, at least in the short term, demand for AI cloud has slowed.

III. Layoffs to improve efficiency, investment continues to slow down

Regarding market concerns about the impact of AI investment on profit margins, although some confirmations occurred in the third quarter, the overall impact on gross margin remains controllable, which may be related to the fact that the current direct and larger calling scenarios—AI search problems—have not yet been directly monetized.

In terms of capital expenditure, Baidu's investment in AI servers and chips saw a significant contraction in capital expenditure in the third quarter, continuing the slowdown trend from the previous quarter

Dolphin believes that this counter-cyclical contraction (while industry leaders are increasing capex) is not a medium to long-term norm, and subsequent changes still need to follow the actual demand changes in the industry. Conversely, does the current contraction in Capex mean that the AI demand felt by Baidu is also cooling down?

However, at present, if there are no more blockbuster products emerging from the downstream application side, the motivation for Baidu to continue increasing capital expenditure under revenue pressure in the short term (1-2 quarters) should not be too high.

Like the previous quarter, SBC expenses in the third quarter continued to decline significantly by 18% year-on-year, indicating that the optimization of expenditures mainly comes from layoffs/reductions in salaries, followed by depreciation and amortization of equipment directly related to R&D. Ultimately, in the third quarter, Baidu's core operating profit was 3.9 billion, with a profit margin of 21%. Under revenue pressure, it actually improved by 1 percentage point year-on-year, exceeding market expectations.

Dolphin Investment Research "Baidu" Historical Articles:

Earnings Season (Showcasing the past year)

August 24, 2024 Conference Call “Baidu: How to Gain Greater Value from AI Search? (2Q24 Minutes)”

August 24, 2024 Earnings Commentary “Under Multiple Pressures, Baidu Struggles to Change”

May 17, 2024 Conference Call “Baidu: Advertising Under Short-term Pressure, Search Relies on AI Transformation (1Q24 Conference Call Minutes)”

May 16, 2024 Earnings Commentary Baidu: Can the Kingdom of Search Be Defended with AI?

February 28, 2024 Conference Call: Baidu: AI Brings Improvement in eCPM and User Engagement (Baidu 4Q23 Conference Call Summary)

February 28, 2024 Earnings Report Review: Baidu: Turning Around Can Only Rely on AI

November 22, 2023 Conference Call: AI Improves Ad Conversion, Reshapes Cloud Market (Baidu 3Q23 Conference Call Summary)

November 22, 2023 Earnings Report Review: Can AI Support Baidu's "New Story"?

August 23, 2023 Conference Call: AI Investment Amortized Over Years, Short-term Financial Impact Not Significant (Baidu 2Q23 Conference Call Summary)

August 23, 2023 Earnings Report Review: Baidu: Cloud Has Rested, Ads Hold Up the Facade

May 16, 2023 Conference Call: AI Has Already Played a Role in Advertising Business (Baidu 1Q23 Earnings Conference Call Summary)

May 16, 2023 Earnings Report Review: Baidu: Not Just an AI Story, Ads Also Provide Support

February 23, 2023 Conference Call: Ads Depend on Macro, Cloud Focuses on Quality Over Quantity, Unhesitatingly Invests in AI (Baidu 4Q22 Conference Call Summary)

February 22, 2023 Earnings Report Review: Survived the Pandemic, Welcoming ChatGPT, Is Baidu Coming to a Second Spring?

November 22, 2022 Conference Call: Baidu: Advertising will resume once unblocked, AI will still require high investment (Minutes)

November 22, 2022 Earnings Report Commentary: Baidu: Valuation is all about "cash," what is the market still afraid of?

August 30, 2022 Earnings Report Commentary: Advertising relies on the weather, reversal depends on the cloud

August 31, 2022: Reducing costs and increasing efficiency, paving the way for AI cloud and autonomous driving

May 26, 2022 Conference Call: Baidu's smart cloud and autonomous driving business back in market focus (1Q22 Conference Call Minutes)

May 26, 2022 Earnings Report Commentary: After the storm, is Baidu's turning point not far away?

March 1, 2022 Conference Call: Advertising now relies on the weather, Baidu wildly composes a new business fantasy

March 1, 2022 Earnings Report Commentary: Advertising is still in purgatory, but Baidu's "heart change" may have a chance

In-depth

December 21, 2022: Is consumption warming up or still cold? The spring of advertising cannot be stopped

March 17, 2021: A serious look at Baidu's assets: How much revaluation space is left for "Hong Kong stock version" Baidu?

Risk Disclosure and Statement of this Article: Dolphin Investment Research Disclaimer and General Disclosure