Baidu: The turnaround can only rely on AI

After the Hong Kong stock market on February 28, Beijing time, Baidu (9888. HK AND BIDU.O) announced its financial results for the fourth quarter of 2023.

Fourth-quarter results were mediocre and in line with expectations. A month ago, the company has guided the market, due to macro pressure, the growth rate of advertising and cloud business has been lowered (about 1-2pct), and the market has been almost digested during this time, mainly depending on the company's macro outlook for this year.

The AI revenue that has attracted much attention in the market is still relatively small (accounting for about a low-single-digit proportion of revenue, 500 million+, mainly from the improvement of the advertising system, followed by GPU leasing and large model API calls), so the gross profit margin in Q4 does not reflect too much AI cost increment.

We expect to see more significant incremental cost recognition in 2024 as the scale of AI-related revenues expands (the company expects billions of dollars). In terms of capital expenditure, it can be more clearly seen that the company continues to increase the trend of investment, which began to rise in the second quarter of last year and rose quarter by quarter.

The specific performance of Baidu's core business:

1. The revenue is in line with the "guided" market expectations

Baidu's core revenue grew 7% in the fourth quarter, slightly above the guidance expectation of 5-6%. The profit side also did not change much, and the operating margin was slightly better, mainly due to the company's continued strict control of sales and management expenses, which cost 300 million less than expected.

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

With the seasonal increase in e-commerce in the fourth quarter, coupled with the impact of some epidemics in 2022, the industry has actually recovered significantly compared with Q3, with the year-on-year growth rate increasing from a single-digit growth rate in Q3 to 9.8% (source: Questmobile). However, Baidu's core advertising revenue grew by only 6.4% in the fourth quarter, which is only in line with the company's guidance and has lowered its expectations, and the actual performance is obviously not good.

In addition to the relatively low proportion of e-commerce advertising in the Baidu ecosystem, especially the short video platform, this wave of Internet giants' wall demolition dividends and e-commerce platforms' vicious war dividends are basically over. Next, it is a hard power to compete with each other in terms of user scale, stickiness, and conversion rate, but these Baidu do not have an advantage except for scale.

Therefore, whether AI can bring "substantial" increment is very important. Overseas advertising giants Google and Meta have more or less tasted the sweetness of AI's improvement in advertising conversion efficiency, so the market has more or less high expectations for Baidu.

At present, the revenue increment brought by AI to advertising system optimization (such as AI native marketing applications) in the fourth quarter is not much, accounting for about 1-2%, and the company previously expected to reach more than billions of advertising revenue contributions in 2024. Dolphin Jun roughly estimates the annual AI revenue of 5 billion, which means that it contributes 5% to the revenue growth of Baidu's core business.

After all, the traffic of Wenxin Yiyan has continued to rise during this period (100 million users have registered and used, and MAU has reached 2.5 million in January), and with the update and iteration of AI assistants this year, the cognitive penetration rate has increased, and it is expected to reach and convert more users.

3. Low base + AI contribution, smart cloud has begun to pick up

In the fourth quarter, revenue from other businesses, such as cloud in Baidu's core, increased by 9%, beginning to reverse the slowdown. But it is mainly the impact of the low base, Baidu ACE is from the same period last year, that is, 4Q22 began to have a significant decline.

Of course, AI will also have a certain pull on the API call demand for GPU leasing and large models, but the proportion is still relatively low, about 4.8% (about 270 million) of cloud revenue.

4. Expenses continue to be strictly controlled, and profits slightly exceed expectations

In the fourth quarter, due to the recognition of some AI costs, coupled with the average actual performance of revenue, excluding the seasonal impact, the gross profit margin also declined slightly. However, in the fourth quarter, it still relied on strict expense control (mainly selling and administrative expenses), so that the final operating profit exceeded expectations.

In the early stage of AI monetization where revenue and cost do not match, Dolphin Jun expects that this kind of expense control will continue for a period of time, and its own AI will also help to improve internal operational efficiency, so it may continue to control expenses with actions such as low growth in marketing and personnel optimization.

4. Repurchase and cash:

Baidu has always had plenty of cash, but the buyback/dividend has been small. At the end of the fourth quarter, Baidu held cash assets (cash, cash equivalents, short-term investments) totaling 205.4 billion yuan (including iQiyi), or 28.5 billion US dollars.

If we are more prudent, that is, deducting long-term and short-term various interest-bearing debts (including loans, notes and convertible bonds), that is, net cash of US$21.4 billion, although there is AI investment, because the core business generated more than US$880 million (6.3 billion yuan) of free cash inflow in a single quarter, so the net cash scale has increased somewhat compared with the previous quarter.

Baidu's repurchase quota increased to a certain extent in the fourth quarter, from more than $100 million in the third quarter to 318 million, but it is still not much. With $670 million left in the repurchase plan approved in 2023, the company still prefers to retain its own cash for follow-up operating investments and short-term deposits/wealth management products.

5. List of detailed data of financial reports

Dolphin-kun viewpoint

Dolphin's feelings about Baidu's quarterly report are similar to those of the previous quarter: although the AI story in the capital market is hot, from the perspective of the performance itself, Baidu's current valuation still depends more on the macro environment and the competition for traffic duration between platforms. However, because these two trends are not too favorable for Baidu, it has to be admitted that AI is the decisive factor in whether Baidu's valuation can be revitalized.

At present, the market is no longer reacting to companies with high AI content just listening to stories and having no brains to meet expectations, but has begun to demand real monetization. While it's not a requirement to have an immediate pull effect, it is also necessary to at least see the contribution of meaningful. And for Baidu, more increments may be needed to make up for some macro pressures.

The unattractive old business and the low repurchase dividend rate are the key reasons why Baidu's valuation has been undervalued by the market (Dolphin's cautious neutral expectation is $50 billion, which is still 25% more than the current one). Judging from the expectations given by the management, we expect that AI is expected to contribute about 5% of the growth rate of the core business, and the valuation will have a higher recovery momentum when the old business does not pull the crotch obviously.

However, we also believe that Baidu's pace still needs to be accelerated, and referring to the evolution trend among overseas technology giants, domestic giants are likely to step up the update and iteration of self-developed Chinese large models this year. At present, there is still a difference between domestic and foreign markets, which is mainly reflected in user cognition.

Although Baidu's technology is still leading the industry, because the increase in the penetration rate of AI applications in China is significantly slower than that in Europe and the United States, other platforms are not without opportunities to catch up. And if Baidu's lead gap is not large enough for users to clearly perceive, other giants are likely to make up for the technological gap through ecological advantages.

The following is a detailed interpretation of the financial report

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

1. Baidu core: covering traditional advertising business (search/information flow advertising), as well as innovative business (intelligent cloud/DuerOS Xiaodu speaker/Apollo, etc.);

2. iQIYI business: membership, advertising and copyright sublicensing, etc.

The separation of the two businesses is clear, and iQIYI has detailed data as an independent listed company, and Dolphin Investment Research will also dismantle the two businesses in detail here. Since the two major businesses have about 1% (between 2-400 million) of offset, there may be a slight gap between the core segmentation data of Baidu split by Dolphin Jun and the actual number reported, but it does not hinder the trend judgment.

First, the macro pressure + dividend reduction, advertising growth is flat

Baidu's core advertising increased by 6.4% year-on-year in the fourth quarter, which was basically in line with the company's market expectations after guidance (a 2pct reduction from the guidance given after the previous quarter's earnings report). Among them, the proportion of hosted page advertising with high gross margin fell to 51%, -2pct month-on-month.

Although the fourth quarter is the peak season for e-commerce, due to the impact of the macro economy, the marketing efforts of merchants on Double 11 this year are not too strong. However, due to the impact of the epidemic in the fourth quarter of 2022 and the low base, the performance of the overall advertising industry is okay, with a year-on-year increase of 9.8%.

Compared with the industry situation, Baidu's performance in the fourth quarter was weaker than that of its peers. In the fourth quarter, there are generally more e-commerce advertisements, but compared with other peers, Baidu is not an advantage in e-commerce advertising, and the offline advertising (medical, tourism, etc.) that it is good at is also in the off-season, and 4Q22 also has the dividend of e-commerce platform fighting.

Of course, the core is because Baidu's search traffic ecology itself does not have advantages, only the scale is high, but the user stickiness and duration are weak.

In the fourth quarter, the number of monthly users of the mobile Baidu app increased by only 4 million quarter-on-quarter to 667 million.

However, in the third quarter, due to the pressure of the slowdown in online retail growth, the entire online advertising industry did not do well, and the growth rate fell back to the same level year-on-year. Baidu can maintain a growth rate of more than 5%, one is due to the large number of users, and the other is the dividends brought by the return of offline scenarios such as medical care and cultural tourism.

Looking forward to the first quarter of this year, Dolphin Jun believes that Baidu's advertising may be slightly higher than the agency's expectation because of the full offline travel and tourism during the Spring Festival (+5% yoy expected by the head agency).

However, it is also necessary to pay attention to new power platforms such as Xiaohongshu, which also have strong traffic advantages in offline activities such as tourism, and Xiaohongshu has also been on the Spring Festival Gala to harvest a wave of second- and third-tier traffic. The actual Q1 performance still needs to be performed in the second half of the quarter, so Dolphin Jun is optimistic and cautious about the first quarter.

2. Smart cloud picks up as scheduled: low base dividends are the mainstay, supplemented by AI

Nearly 80% of Baidu's core business (non-advertising business) comes from smart cloud, and the remaining 20% is mainly from autonomous driving technology solutions and smart speakers. In the fourth quarter, the revenue of other businesses was 8.3 billion, a year-on-year increase of 8.9%, and the growth rate rebounded.

The main factor in the recovery is due to the low base. In the fourth quarter of 2022, the ACE revenue in the smart cloud declined significantly year-on-year, among which the cooperation of smart transportation solutions for local government departments was reduced due to the tightening of local budgets. And in the fourth quarter of 2023, it will just begin to enjoy the dividend period of a low base

In addition, in the fourth quarter, due to the hot demand for AI applications, there was new revenue from GPU leasing and API interface calls to Wenxin large models, but the scale of this part is still relatively small, about 200 million. By the end of 2023, developers had created 860,000 AI models on PaddlePaddle.

As a result, the cloud business turned from negative growth of 2% in the previous quarter to positive growth of 11%. The remaining other businesses increased by 4%, with a significant decline.

Considering the intelligent driving in the remaining other businesses, it is still progressing steadily, so the rapid decline in growth in the fourth quarter is likely to be brought about by the poor performance of other intelligent hardware businesses such as small speakers.

(1) In the fourth quarter, Carrot Express provided a total of 839,000 rides, a year-on-year increase of 49% (a certain slowdown from the previous quarter) and a quarter-on-quarter increase of 2%, and as of the end of the fourth quarter, the cumulative number of orders exceeded 5 million.

(2) 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.

3. AI cost recognition may begin to have an impact, and the profit margin will be maintained under strict control of expenses

Although there were some confirmations in the fourth quarter of the year (the gross profit margin in the fourth quarter of the previous period generally fell by 3pct compared with the third quarter, but the gross profit margin in 4Q23 fell by 4pct), the impact on the overall gross profit margin was quite controllable.

In the end, Baidu's core operating profit in Q4 was 4.7 billion, with a profit margin of 17%, an improvement of 2.3pct year-on-year, and a seasonal decline from the previous quarter.

However, last year's revenue was affected by the epidemic + government budget tightening, and advertising and cloud revenue were under pressure, so the year-on-year improvement in 23 was expected. From the perspective of capital expenditure, it may be clearer that Baidu has increased capital expenditure quarter by quarter since the second quarter of last year, accelerating investment.

We expect that the absolute value of subsequent R&D investment and cost items will continue to grow, and Baidu may continue to control non-AI operating expenses for a period of time in order to offset the impact of cost changes on profit margins.