- Baidu investment returns are tied heavily to Chinese macro/sentiment.
- With various indicators pointing to a recovery and a value accretive Ctrip transaction, the narrative favors the bulls.
- Diminished visibility on costs makse it hard to anticipate earnings, but analysts seem conservative on margins.
Baidu (NASDAQ:BIDU) is set to report Q1 results on April 28th. The valuation has recovered quite significantly since the beginning of the year. The stock is still below its 52-week high of $223.95, which was set last year on April 27th 2015 i.e. prior to the Chinese market panic. However, Chinese investors have been piling back into the equity market, re-igniting the momentum trade in Chinese listed companies. Since Baidu’s stock isn’t actually listed on any Chinese exchange some would incorrectly mention the lack of causal linkage. However, Chinese-based ETFs still own Baidu ADRs, so whenever there’s contagion in Asia the weakness in Chinese-specific equities still impacts the stock.
Baidu is 93.67% above its 52-week low, so a good chunk of the value recovery trade has already occurred. So, the focus then shifts to emerging market/Chinese sentiment and core fundamentals.
Source: Bank of America Merrill Lynch
Chinese monetary conditions are sharply improving, and residential real estate prices are recovering quite swiftly. Since much of China’s wealth is concentrated in real estate, the prevailing wealth effect cascades from real estate into other assets (like equities). Therefore, if real estate continues to recover, investors can get more confident and will buy more shares via pooled asset management products.
Since active managers in China rely on fund inflows to buy shares, it goes without saying that Baidu’s share price is heavily contingent on Chinese macro conditions. This is despite digital advertising growth detaching from broad macro fundamentals. Even if earnings don’t improve on a y/y basis, as implied by the consensus estimate for Q1’16, the stock will get a lift from the re-emerging risk appetite of China-specific asset managers. As such, I still have an upwards bias on Baidu despite a slowing growth trajectory for digital advertising, and declining margins.
Growth rates are still robust, but the trajectory of growth is expected to slow quite considerably over the next five-years. Needless to say, the adoption of mobile broadband/baseband in China remains the limiting factor as Robin Li alluded to on the Q4’15 call. As it currently stands, there’s plenty of ad-unit demand, so the issue isn’t on the demand side, but rather the available supply of ad-inventory. Given Baidu’s recently received offer for iQiyi, speculation continues to linger over Baidu’s presence in mobile video. iQiyi still exceeds the market share of Youku Tudou, but it’s presence in video also comes with heightened content costs, which deflated margins in the prior quarter. Robin Li didn’t provide expense guidance in the prior quarter, but he does anticipate costs to remain elevated in FY’16.
Furthermore, the company recently acquired a 25% stake in Ctrip (NASDAQ:CTRP) by swapping its Qunar stake. Baidu earned a 36% premium to Qunar’s valuation. Baidu’s position in Ctrip.com doesn’t give it a majority stake, but it gives investors exposure to the rapidly growing Chinese travel market. Priceline (NASDAQ:PCLN) experienced massive growth in Chinese listings on its platform as a result of its 15% (approximate) ownership of Ctrip.com. The deal with Priceline expanded the market for international travel. Ctrip.com can expect to split with Priceline a 15% to 25% take rate on outbound travel into the United States. My figure on Hotel take rates are from conversations I have had with industry insiders. The volume of Chinese property listings increased from 5,000 to 35,000 on Priceline.com, which positions Ctrip.com considerably better. I’m fairly confident that Baidu’s deal is long-term accretive to shareholders despite the massive premium Ctrip.com trades at (11.6x sales).
The number of analysts actively covering Baidu is small when compared to other internet/media plays. The Thomson Reuters database only compiled 12 estimates for Q1’16. Many of these analysts aren’t in the United States, but rather the Asian operating subsidiaries of the major investment banks. I receive research from the investment banks that do cover Baidu, but only the U.S. equity coverage, so I have less visibility on sell-side commentary with regards to Baidu.
Source: Yahoo Finance
Going into the quarter, analysts are anticipating revenue of 15.74 billion RMB/CNY, which compared to management guidance of 15.41 billion RMB to 15.97 billion RMB. The consensus estimate is slightly above the midpoint of management outlook of 15.69 billion RMB. I’m not anticipating Baidu to beat top line estimates too significantly given the historical accuracy of management guidance, but could see some upside to non-GAAP diluted EPS as Baidu didn’t specify margins on the prior earnings conference call.
Analysts are anticipating non-GAAP earnings to decline by roughly 5.8% in Q1’16, which seems conservative despite the lack of cost visibility. While the management did allude to rising costs, I can’t imagine unit economics deteriorating that significantly. Therefore, investors should be closely eyeing margins as opposed to revenue in the upcoming quarter. Unlike the vast majority of other web companies, Baidu’s Q1’16 report hinges on its bottom line, as analysts are having difficulty with comparing prior-year cost drivers to current year, as the management team mentioned “moderating” content costs. To what extent costs will come down in the iQiyi video streaming segment is up for debate, and isn’t likely to be captured accurately in analyst models.
I’m initiating my coverage on Baidu with a buy recommendation, and will assign a price target following the Q1’16 earnings announcement. I’m recommending Baidu due to its heavy exposure to Chinese digital advertising, value accretion from Ctrip.com, and recovering Chinese equity markets. Even if earnings growth decelerates, the stock’s valuation multiple will likely expand given the better macro backdrop. As such, investors can get a little more aggressive prior to the earnings announcement.