Riding out the pandemic and ushering in ChatGPT, is Baidu about to enjoy a second spring?

After Hong Kong stock market closed on February 2nd, Baidu (9888.HK;$Baidu(BIDU.US)) released its Q4 2022 financial report. Excluding iQiyi, Baidu's core business performance was slightly better than expected, with the main surprise being a significant reduction in research and development investment. Additionally, the company announced a three-year, $5 billion buyback plan.

$ Key performance of Baidu's US core business includes:

1. Core revenue is mainly constrained by the epidemic, and both advertising and cloud are under temporary pressure - The decline may increase or the growth may slow down significantly. However, because market expectations are conservative, all revenues are better than expected.

If we consider performance alone, Dolphin Analyst believes that:

a. Although advertising revenue decreased by 5.5% year on year, it is still relatively resilient. The information behind this may imply that although the epidemic has greatly affected offline economic activities at the end of last year, due to the continuous adjustment of epidemic prevention policies, advertisers may not be as pessimistic about their prospects.

b. Other businesses mainly focused on cloud and intelligent driving increased by 11% year on year. The pillar of innovative businesses, intelligent cloud, only grew by 4% in Q4, showing a significant decline. In addition to the epidemic factor, the adjustment of its own business (actively stripping low-efficiency projects) also affected the current growth rate.

2. Profit situation basically follows the contribution pillar—advertising business, so the downturn is basically expected. However, in Q4, due to the unexpectedly accelerated reduction in research and development expenses (almost ¥600 million difference from the expectation), the final operating profit was slightly higher than expected.

3. iQiyi is no longer a drag: This quarter, iQiyi also performed well, and the Group's overall revenue was RMB 33.1 billion, which was flat year on year and exceeded the market's expectation of RMB 32.1 billion.

At the same time, iQiyi's profitability continues to improve, and it has contributed nearly ¥800 million in free cash flow in this quarter, exceeding expectations. At least in the short term, iQiyi is no longer a burden that Baidu is eager to get rid of.

4. The hosting page ads with relatively high gross profit contribution accounted for 45% of core advertising revenue in Q4, a decrease from the previous quarter.

5. As of the end of last year, Baidu had a lot of cash, with net cash of nearly $16.5 billion after deducting short-term interest-bearing debt and minority equity. This accounted for 34% of its current market value. In Q4, free cash flow was ¥5.9 billion, and it was ¥5.1 billion excluding iQiyi.

The company also announced a $5 billion repurchase plan, which, under normal operations, is equivalent to using the cash earned in one year for repurchase.

Dolphin Analyst's Point of View

As the slowest rebounding Chinese concept stock, Baidu, with the help of the ChatGPT trend in the past month, has caught up with or even exceeded its peers' gains since the low point. In the Chinese-speaking world, Baidu's large-scale model (Wenxin Yiyuan) has almost no rivals. In terms of the market position of domestic search engines, Baidu is also dominant, and other search platforms' accumulation of AI technology is also difficult to directly compete with Baidu. Therefore, it can be said that there is no such crisis for Baidu in terms of ChatGPT's potential competition impact on Google.

Therefore, for Baidu, the focus needs to be on the problem of the potential erosion of short-term profits due to investment costs (see Dolphin Analyst's cost calculation on ChatGPT in the article "US Stocks Advertising: After TikTok, will ChatGPT start a new "revolution"?").

Compared with the English context, the Chinese context has more complex factors in obtaining and cleaning up data, which increases the difficulty and accuracy of training and may also increase training costs. In addition, the difference in training is reflected in the impact on the end application, that is, the user experience of the Chinese large-scale model is weaker than that of ChatGPT, which may also affect the potential commercial space of "Wenxin Yiyuan".

Currently, Baidu has revealed that it will integrate AI into the current search engine and provide external technical authorization. The business model of directly charging for API interfaces is relatively clear (currently Baidu is free to open to the outside, and OpenAI charges by times/time), but it may be difficult to expect advertisers to participate in covering the cost of AI in the short term. It is unlikely that businesses will immediately increase their budgets without significant improvements in advertising effectiveness.

However, before actually obtaining effective and sustained revenue growth, costs have already been invested, and in the short term, there may be some impact on profits as Baidu's focus shifts to AI, but it also depends on Baidu's investment pace. (It is recommended to pay attention to the guidance of management on AI cost investment on the conference call.)

In the medium and long-term commercial prospects, after AI empowerment, the boost to Baidu's existing products in traffic entrance and advertising monetization can be observed by paying attention to the gradual realization of industrial development.

Therefore, Dolphin Analyst believes that with the cooling of the hype in the short term due to the expectation of interest rate hikes leading to non-easy market liquidity, we are more inclined to downplay the short-term speculative sentiment and return to the factors that have a greater impact on Baidu's long-term valuation - the macroeconomic recovery and the pace of exceeding expectations - to look at the existing value-added space.

According to current market expectations, Baidu's core advertising revenue growth is expected to be around 5.5% this year. If combined with this year's GDP expectations and the high elasticity of offline local businesses, especially small and medium-sized merchants who suffered severe losses due to the pandemic, the Dolphin Analyst believes that the market's expectation for 2023 is slightly conservative and that it may not be difficult for Baidu to achieve beyond-expectations results. Combining with Dolphin's previous valuation of Baidu in "Consumption warms up suddenly，Can't stop the spring of Ads", the current stock price is in the reasonable range expected by the market(Dolphin is more optimistic than Bloomberg's consensus expectation). If the pace of domestic consumption recovery exceeds expectations after the second quarter, there is also hope to increase the valuation space.

_It's already February 2023, how is the actual consumption recovery situation? How does the company judge the short-term and medium-term prospects? It is recommended to pay attention to the management conference call for future outlook and guidance, and Dolphin Analyst will first time share the meeting minutes of Baidu to the Longbridge app and user research group. Interested parties can add WeChat "dolphinR123" to obtain. _

Interpretation of this quarter's financial report

Baidu is a rare Internet company that breaks down its performance into:

1. Baidu Core: Includes traditional advertising business (search/information flow advertising) as well as innovative businesses (intelligent cloud/DuerOS Xiaodu speaker/Apollo, etc.);
2. iQiyi Business: Memberships, ads and copyright transfer authorization, etc.

The separation of the two businesses is clear, and with iQiyi as an independently listed company with detailed data, Dolphin's research will also decompose the two businesses in detail. Since the two major businesses have offset items of approximately 1% (between 200-400 million), the sub-data of Baidu Core decomposed by Dolphin Analyst may have a slight difference from the actual reported numbers, but it does not affect the trend judgments.

This financial report mainly focuses on the business performance of Baidu Core. Dolphin Analyst will make additional comments on the performance of iQiyi, which will be released on the Longbridge app at the first time. Interested parties can download the app to read it.

I. The conservative expectations of the advertising market

Due to the countermeasure adjustments in December, the country experienced a wave of infection peaks, and offline travel was affected. Therefore, the advertising performance in the fourth quarter was obviously expected to be worse than the previous quarter. The market has also adjusted the growth expectations for Baidu's advertising revenue in the past two months, giving a negative growth expectation of 7%.

However, because market expectations are low enough and the base of last year is also friendly, the actual advertising revenue of Baidu Core is not so bad. Based on Baidu's financial report, Dolphin Analyst calculated that Baidu Core's advertising revenue was 18.1 billion yuan, a year-on-year decrease of 5.5%, slightly better than the market's expected 7% decline.

Overall, although the national economic activities in the fourth quarter were largely suspended due to the epidemic, Baidu's advertising revenue in the fourth quarter was not as pessimistic as the market expected. The signal that can be discerned from this may be: Although there was an epidemic disturbance in the fourth quarter, due to adjustments in epidemic prevention policies, advertisers were still optimistic about the consumption prospects this year at the end of last year. After passing the infection peak of the New Year's Day, the offline economy has started to recover from the Chinese New Year, tourism and travel are booming for all to see, so what about other industries' marketing prospects for the new year? And will the pace of recovery continue to pick up or slow down after the second quarter? It is recommended that attention be paid to the guidance of the management team during telephone conferences.

From Baidu's own perspective, the marketing of managed pages ("marketing + operations" type advertising SaaS solutions) launched in the second half of 2019 has relatively high gross margins and has contributed significantly to the rapid growth in the past two years, especially during the low period of traditional search advertising.

However, in the fourth quarter, managed page marketing revenue accounted for 45% of the overall core advertising revenue (down 6 percentage points), is this because of the epidemic adjustment, which led to a bigger proportion of mid-to-small business customers in traditional search advertisements recovering with greater elasticity, or because of competition within the same industry? For example, WeChat released its search advertising inventory in the fourth quarter of last year. This is likely to be a point that analysts will inquire about during telephone conferences and may pay attention to the management's explanation.

Baidu's average monthly active users for the fourth quarter was 648 million, and with an increase in customer acquisition spending, the net increase of approximately 14 million people was achieved.

Innovation Business: Short-term impact of the epidemic on smart cloud delivery.

All other non-advertising related revenue in Baidu's core is included in Baidu's other income, which contributes to less than 30% of Baidu's core revenue, with intelligent cloud business being the main contributor.

Specifically, it includes integrated software and hardware smart businesses, smart clouds on both ends (B and C), intelligent speakers, Apollo autonomous driving, and non-advertising income from mobile businesses.

In the fourth quarter, not only did the epidemic affect advertising, but also the delivery progress of innovative businesses such as smart clouds. Baidu's other income was approximately 7.6 billion, up nearly 11% YoY but significantly weaker than the first three quarters of 2022. However, the market's adjustment expectations were timely and more conservative, with only 7% growth expected for innovative businesses.

Apart from the impact of the epidemic on smart clouds, there is also the continued action of divesting low-quality businesses.

Under the strong supervision of the internet over the past two years, compared to Tencent Cloud's entertainment-centered customers and Alibaba Cloud's internet-centered customers, Baidu's customers are more evenly distributed across various industries and Baidu's scale is not as high, so the overall slowdown is slightly slower.

As the main support for innovative businesses, smart cloud revenue was approximately 5.4 billion in the fourth quarter, up only 4% YoY, significantly slower compared to the previous quarter. Firstly, there is the impact of the widespread epidemic on business travel and contract delivery. Additionally, because the slowdown compared to the previous quarter was significantly greater, Dolphin Analyst believes that Baidu should continue to divest themselves from low-benefit projects.

The upcoming Baidu version of ChatGPT, "Wenxin Yiyuan," is mainly aimed at helping to expand the influence of Baidu AI Cloud in the medium and long term. Currently, the number of ecological partners involved in the first batch of testing has reached 400 companies, and the number is still growing rapidly.

Although it is currently in the testing phase, Wenxin Yiyuan authorizes the API interface to the outside world for free, focusing on expanding its ecological influence, while also intending to accumulate more high-quality corpus data and enhance model training.

However, it is not ruled out that, like OpenAI, it may be charged by the number of times/time in the future, and it will serve as a breakthrough for enterprise cloud computing, expanding the capabilities of other modules in the Baidu Cloud.

Of course, this is mainly one of the predictions for the future medium- to long-term prospects. Due to the special nature of this technological change, the Dolphin Analyst believes that there is no need to rush to set a price to the estimated value, but to focus on the subsequent productization and the landing of the business model, especially the key node of industrial development.

1. Intelligent Driving

Compared with the cloud business, which has already taken shape, Baidu's intelligent automobile sector is still a long-term story that requires imagination. Although the dream is very ambitious, every step of the implementation is more important.

1. Assisted driving is a product of ANP (road automatic driving), AVP (automatic parking), and high-precision maps that Baidu lays along the way to fully automatic driving and sells to car manufacturers. It has been loaded on several models of brands such as GAC Aion, Great Wall, and Weima last quarter, and the overall business order amount has exceeded 10 billion yuan. The company expects to gradually confirm the revenue in the second half of this year.

2. Automatic driving fleet service, Luobu Kuaipao: In the fourth quarter, Luobu Kuaipao provided 561,000 ride-hailing services, a year-on-year increase of 162% and a month-on-month increase of 18.4%. As of January 2023, Luobu Kuaipao has provided a cumulative total of 2 million ride-hailing services to the public.

3. Automatic driving license: Baidu has obtained 718 China automatic driving test licenses, including 571 passenger qualifications and 194 commercial pilot programs.

At the end of last year, Luobu Kuaipao also became the first batch of solution providers approved to conduct unmanned driving tests in Beijing.

1. Ad repair + reduced investment, gross profit margin continues to repair

In the fourth quarter, due to negative growth in high-margin advertising, the overall gross profit margin decreased month-on-month due to the structure of revenue. iQiyi is no longer a drag on overall gross profit margin, and its gross profit margin continued to optimize to 28.8% in the fourth quarter.

But looking at Baidu's core business, the gross profit margin fell by nearly 7% in the fourth quarter, and the core gross profit margin fell by 3 percentage points to 54.3%, which is worse than market expectations. Compared with previous years, during the period of relatively severe epidemic, Baidu's gross profit margin will fall to 53%-54%. Although the proportion of low-margin intelligent cloud and other businesses in the overall revenue is increasing, it is also improving itself after shutting down low-profit projects. Dolphin Analyst believes that if AI's subsequent cost investment is limited or can be commercialized synchronously, the gross profit margin level in the abnormal environment of the fourth quarter should be a relatively low point this year.

4. Intensified Reduction in Research and Development Expenses

In terms of operating expenses, Baidu has already entered a significant cost-reduction and efficiency-increase cycle in 2022, and the sales expense ratio has been continuously shrinking. In the fourth quarter, in addition to the continued year-on-year decline in sales expenses but with a slower pace, the cost of R&D has significantly accelerated to shrink, and after a single-digit decline in the third quarter, the decline rate in this quarter has further expanded to -21.7%.

However, due to ChatGPT's technological innovation since the beginning of the year, Baidu's language seems to have further improved the strategic position of AI, so I'm afraid it may point to the possibility that research and development costs will be re-elevated in the new year.

In the end, due to slightly exceeding revenue (cloud business expectations were slightly too high), R&D investment savings exceeded expectations, and the operating profit of the core business reached 3.8 billion, nearly 200 million more than the market expected.

Operating profit increased by 28% compared with the same period last year. Although it has slowed down, overall, it is in a repairing trend, with an operating profit margin falling to 14.7%, basically in line with expectations.

Historical Articles of Dolphin Investment Research on "Baidu":

Earnings Season (showing the past year)

November 22, 2022, Telephone Conference "Baidu: Advertising resumes upon lifting the ban, and AI will continue to see high investments (minutes)"

November 22, 2022, Earnings Review "Baidu: Valuations are all in 'cash', so why is the market still afraid?"

August 30, 2022, Earnings Review "Advertising relies on the weather, and the reversal still depends on the cloud" 2022 August 31, "Reduce Costs and Increase Efficiency, Pave the Way for AI Cloud and Autonomous Driving" link

2022 May 26, Telephone Meeting "Baidu's Intelligent Cloud and Autonomous Driving Business Return to Market Focus (1Q22 Telephone Meeting Minutes)" link

2022 May 26, Financial Report Review "Is Fortune Finally Smiling on Baidu?" link

2022 March 1, Telephone Meeting "Advertising Now Depends on the Weather, Baidu's Crazy New Business Vision" link

2022 March 1, Financial Report Review "Advertising Still in Purgatory, but Baidu's 'Change of Heart' May Have a Chance" link

In-Depth

2022 December 21, "Consumer Warmth and Coldness? Can't Stop the Spring of Advertising" link

2021 March 17,"Seriously Unpacking Baidu's Assets: How Much Room Does Baidu's HK Shares Have for Re-Evaluation?" link

Risk Disclosure and Statement for This Article: Dolphin Analyst Disclaimer and General Disclosure