The I/O Fund team believes that Baidu could make for an interesting momentum play. We define a momentum position as one where technicals lead, where we respect the stops, and where the fundamentals may not be perfect for one reason or another. For Baidu, risk from China is too high for the stock to be considered for anything more than momentum. Due to the emphasis on technicals, we only release momentum plays to Advanced Members.
Liquidity and Valuations
By Knox Ridley
China’s property sector accounts for nearly 30% of their GDP. This is far greater than any other developed nation, and exposes them to broad based deflation as their real estate market continues to unwind.
The Chinese property downturn is in its 3rd year, as new housing starts are down 60% compared to pre-COVID levels. This is a shocking slowdown in a short amount of time, yet, due to centralized control of the economy, we have yet to see housing prices fall in accordance with demand. While we have seen eight straight months of house prices decline in China, with recent data showing a 1.4% YoY drop, which is an acceleration to the downside from last month’s 0.7% YoY drop, the Chinese government is providing a wide range of defensive measures to prevent a full scale crash in the housing market.
For example, developers and lenders are allowed to delay recognizing bad loans in an effort to avoid bankruptcies, which is helping overextended banks stay solvent. We are also seeing rules on how listings must be priced in an attempt to prevent price discovery based on an oversupply in the face of decreasing demand.
How these measures will play out is yet to be seen. However, the one measure that is of interest to Chinese risk assets is how the People’s Bank of China (PBOC) has reacted. We have seen a large expansion of their balance sheet, which increases liquidity in the Chinese economy. This matters, as Chinese equities have a high correlation to liquidity expansions and contractions.
This correlation to expanding liquidity in China is one reason why we are interested in a small momentum allocation to Chinese equities. It is apparent that the CCP is adamant about preventing contagion from their struggling real estate markets. Furthermore, they have announced their inflation, growth and employment targets for 2024, which is highly supportive of a continuation of easing liquidity.
The other reason can be seen in the fundamentals. Since topping in February of 2021, the popular Chinese ETF, FXI, is currently down 52%, while the tech focused Chinese ETF, CQQQ, is down nearly 70% from its 2021 highs.
This has created some appealing valuations within Chinese tech. Baidu is trading at a 13.2x trailing PE ratio and a 8.9x forward PE ratio, as well as a 2x PS ratio and a 7.4x price to free cash flow ratio. Compare this to American search and generative AI rival Alphabet, which is trading at a 26.2x trailing PE, a 19.3x forward PE, and a 6.6x PS and 28.2x P/FCF ratio.
Baidu is trading at a significant discount relative to its three-year medians for these valuation metrics, though revenue growth next quarter risks declining and EPS growth is expected to be negative in two quarters this year.
However, as a whole, Chinese stocks have been deeply discounted, and the variegated risks from the economic risks discussed here, along with mounting geopolitical risks, has investors looking elsewhere for gains. This has created some attractive valuations within a market that is not correlated to the US markets.
Technical Outlook
How these risks and reactions from the Chinese government are getting baked into the price is interesting. For one, the Shanghai Composite Index (SSE) has broken a trendline that has been in place since 2006. Price has reclaimed this trendline, which is another reason why we are interested in this sector. When this trendline breaks, and if a retest had failed, then it would be a rather large problem for Chinese equities.
As of now, if SSE can break above the 3315 resistance, then we could see a nice swing higher into 2024/2025. How this pattern can be counted is in two general ways. The most bearish one would have us in a large degree 2nd wave. This count would have us, likely, test the 3315 region before rolling over. The other count I’m tracking would have us in a large degree B wave. This count would have us breaking above 3315, at minimum. Both counts do not look favorable for the Chinese markets on a long-term basis, which is why any plays we initiate will come with stops and targets.
My interpretation of the price action can be best counted in 2 general ways. The red count is the most bearish. It has us completing the A wave of a larger 2nd wave. The green count has us in the start of a new cyclical bull market within a larger secular bear market. Both scenarios can account for the setups we are seeing within the Chinese stock market.
Baidu’s Chart:
There are two counts that I am tracking in BIDU:
- Green – we are about to start the C wave of a Zig-Zag correction. Long-term, this would be a bear market rally; however, the C wave is targeting ~100% gains, from current levels.
- Blue – We have a first and now second wave in place in a large degree 5 wave move higher. This would be wave 5 of a very large 5 wave pattern.
The bounce off of the October 2022 low appears to be a 5 wave move. This has been followed by and overlapping, messy correction that is making a higher low, so far. This favors the two bullish counts listed. If we do see a breakdown below $73.50, it will invalidate these two bullish outcomes. Furthermore, the next breakout bounce must be a 5 wave move higher, and it needs to break over $114. This would likely be our signal to buy, with a stop to sell our position if we then move under $93.
ERNIE Versus ChatGPT: Baidu Quickly Catching Up
By Damien Robbins
Baidu is making strides in generative AI, evidenced via rapid growth in its generative AI offering ERNIE Bot. This rapid growth in consumer adoption of its ERNIE chatbot and strong initial adoption of its enterprise APIs are a positive sign for AI cloud helping drive a revenue acceleration for Baidu. We’re already seeing strong interest from leading consumer firms to integrate ERNIE – Samsung will integrate ERNIE in its S24 smartphones, Apple is in discussions to use ERNIE in devices in China, while Great Wall Motors will use ERNIE for an in-vehicle assistant.
Daily queries on ERNIE rose 190% QoQ to more than 50 million. Baidu noted that queries in the first half of November were 50% higher month-over-month relative to October, while daily queries had reached tens of millions. For context, ChatGPT had 60 million daily queries in August last year with over 1.4 billion monthly visits.
For Baidu, what’s important to watch is the growth trajectory of ERNIE, and if it can continue to show strong growth trends in both enterprises adopting APIs as well as within daily queries, as that suggests usage remains high. Baidu is expecting to see more enterprises build LLMs using ERNIE’s APIs, which will serve as a growth driver for AI cloud revenue as model deployment and usage increases.
OpenAI has shown signs of successfully monetizing ChatGPT via both APIs and a consumer-facing subscription to unlock more advanced features. OpenAI reached $1.3 billion in ARR in October, which then rose to $2.0 billion in December. Baidu’s generative AI and foundation model revenue was just $90 million (RMB656 million) in Q4, so there’s still a lot of catching up needed with OpenAI in terms of revenue.
Apollo Go: Moonshot Project Making Steady Progress
Baidu is quickly establishing itself as one of China’s outright leaders in autonomous driving via Apollo Go, and while the robotaxi services continue to expand, it remains at a small scale.
Apollo Go announced two significant milestones in 2024 alongside the 5 million cumulative rides: it launched a 24/7 driverless service in Wuhan and launched a highway pilot in Beijing to Beijing Daixin Airport, the world’s first robotaxi airport service in a capital city. Expanding service hours, fleet size, testing in new cities and expanding testing zones within cities are all necessary steps for Apollo Go’s expansion; however, fleet sizes do still remain small, and its geographic presence has not yet proliferated rapidly.
Management has signalled a willingness to push forward with a more rapid expansion path once it reaches UE (unit equivalent) breakeven in Wuhan. Robotaxis are operating in only 10 cities at the moment, and Wuhan’s fleet size reached just 300 vehicles in September, so a swift expansion to more cities with larger fleets opens the door for substantial revenue generation; however, given the small current scale, this is more of a moonshoot bet for 2024 (much in the sense that Tesla’s FSD is a moonshoot) rather than a contributor to the near-term thesis.
Baidu’s Revenue
By Royston Roche
Baidu’s Q4 revenue grew by 2.6% YoY to $4.92 billion. Revenue in local currency grew by 6% YoY to RMB 35 billion. Analysts expect revenue to be flat next quarter and is expected to accelerate to 7.3% YoY growth in Q2 and 7.6% in Q3. It’s clear with the chart below that Baidu’s revenue growth will bottom in Q1, barring any unforeseen issues.
- Revenue from Baidu Core grew by 7% YoY to RMB 27.5 billion or $3.87 billion. Baidu Core includes online marketing that grew 6% YoY to RMB 19.2 billion or $2.7 billion and non-online marketing revenue that grew by 9% YoY to RMB 8.3 billion or $1.17 billion, primarily helped by the growth in AI cloud revenue.
- Revenue from streaming service iQIYI, popularly known as ‘Netflix of China’ grew by 2% YoY to RMB 7.7 billion or $1.09 billion.
The company’s investment in AI has started yielding results and is expected to contribute more meaningful to revenue in 2024.
AI cloud revenue grew by 11% YoY to RMB 5.7 billion or $802.8 million, accelerating from a (2%) decline in Q3, helped by the strong demand for large language models.
Robin Li, co-founder and CEO said in the earnings call, “AI Cloud revenue grew by 11% year-over-year to RMB5.7 billion and continue to improve profitability in the fourth quarter. Revenue from Gen AI and foundation model represents 4.8% of our AI Cloud revenue in Q4. The increasing demand for model building played a significant role in this accelerated revenue growth, along with increasing distributions from inference.AI Cloud revenue grew by 11% year-over-year to RMB5.7 billion and continue to improve profitability in the fourth quarter. Revenue from Gen AI and foundation model represents 4.8% of our AI Cloud revenue in Q4. The increasing demand for model building played a significant role in this accelerated revenue growth, along with increasing distributions from inference.
We have seen a growing number of enterprises, in particular, tech companies turning to our public cloud to build their models. Additionally, the AI cloud revenue generated by Baidu Core, other business groups, such as the Mobile Ecosystem Group and the Intelligent Driving Group was about RMB2.7 billion in Q4. Within the Q4 internal cloud revenue, Gen AI and foundation model accounted for about 14%. On a combined basis, the total internal and external AI Cloud revenue was RMB8.4 billion in Q4, with Gen AI and foundation model contributing around RMB656 million.” On a combined basis, the total internal and external AI Cloud revenue was RMB8.4 billion in Q4, with Gen AI and foundation model contributing around RMB656 million.” The total from both internal and external AI cloud revenue was $1.18 billion in USD and Gen AI and foundation model contributed around $92.4 million.
Margins
The gross margin and the operating margin have improved on a YoY basis, but sequentially, there is a dip due to the higher costs in the AI cloud business. Management believes that the margins will improve in the long-term in the AI cloud business as revenue increases. The net margin was down mainly due to the equity method investment adjustments, which vary each quarter and there was one-time adjustment related to preference shares. However, we saw an uptick in the adjusted net margin sequentially and on a YoY basis.
The gross margin was 50.2% compared to 48.8% in the same period last year and 52.7% in the September quarter. The gross margin partially benefitted from lower content costs, but the higher costs in the AI cloud business were a drag. Management believes that the AI cloud margins will improve in the long term and replied to an analyst question on the margin trend for 2024.
“We are pretty confident in maintaining profitability for our AI Cloud. For Enterprise Cloud, we should be able to consistently improve gross margins for the legacy cloud businesses. As for Gen AI and LLM businesses, the market is still at a very early stage of development. So we should hold a pretty dynamic pricing strategy to quickly educate the market and expand our penetration into more enterprise customers. So we believe over the long term, the new business should have higher normalized margins than the traditional cloud businesses.”As for Gen AI and LLM businesses, the market is still at a very early stage of development. So we should hold a pretty dynamic pricing strategy to quickly educate the market and expand our penetration into more enterprise customers. So we believe over the long term, the new business should have higher normalized margins than the traditional cloud businesses.”
The operating margin was 15.4% compared to 13.9% in the same period last year and 18.2% in the September quarter. The SG&A expenses remained flat YoY, but R&D expenses increased 11% YoY due to the higher server depreciation expenses and server custody fees related to Gen AI R&D.
The net margin was 7.4% compared to 15% in the same period last year. The net margin was down primarily “due to a pickup of losses from an equity method investment as a result of a modification of certain terms of the underlying preferred shares.” The adjusted net margin was 22.2% compared to 16.2% in the same period last year and 21.1% in the September quarter. GAAP EPS was $0.95 compared to $1.97 in the same period last year. Adjusted EPS was $3.08 compared to $2.21 in the same period last year. The analysts expect adjusted EPS to grow 2.3% YoY in Q1 and decline (6.3%) in Q2.
On an annual basis, Baidu is expected to grow fiscal year EPS (-2%) in FY2024 and then 10% over the next two years before EPS is expected to rapidly accelerate in growth in fiscal year 2027 to +33%. Overall, analysts are not expecting any further negative growth beyond FY2024.
Cash Flow and Balance Sheet
The operating cash flow was $1.5 billion or 30.4% of revenue compared to $1.14 billion or 23.8% of revenue in the same quarter last year. The free cash flow was $980 million or 19.9% of revenue compared to $859 million or 17.9% of revenue in the same quarter last year. Management attributed to “Mobile ecosystem exhibited solid performance across revenue margin and cash flow.” They expect mobile ecosystem (includes Baidu App, Ernie bot, Haokan, and Baidu Post, among others) to continue to generate steady profits and cash flows in 2024.
Cash, restricted cash, and short-term investments were $28.93 billion, and debt was $10.77 billion, compared to $27.78 billion and $10.93 billion at the end of the September quarter. The company repurchased $318 million worth of shares in Q4 and totaled $669 million under the 2023 share repurchase plan.
Earnings Call
- The company’s investments in AI are expected to yield several billion RMB revenue in 2024. Robin Li said in the earnings call:
“Since Q2 2023, we have actively utilized ERNIE to revolutionize our products and services, creating AI native experiences. We believe real applications are essential to unleashing the full business potential of ERNIE and ERNIE Bot. Recently, we began to generate incremental revenues from ERNIE and ERNIE Bot. In the fourth quarter, we earned several hundred million RMB primarily from ad technology improvement, and helping enterprises build their own models. I'll provide a more detailed explanation in the business review section.Recently, we began to generate incremental revenues from ERNIE and ERNIE Bot. In the fourth quarter, we earned several hundred million RMB primarily from ad technology improvement, and helping enterprises build their own models. I'll provide a more detailed explanation in the business review section.
Looking into 2024, we believe this incremental revenue will multiply to several billion RMB primarily from advertising and AI cloud building.”Looking into 2024, we believe this incremental revenue will multiply to several billion RMB primarily from advertising and AI cloud building.”
- The company launched a new version of AI model Ernie 4.0 in Q4 2023, which it claims will rival Chat GPT-4. Management mentioned in the earnings call that the Ernie API is used in Samsung S24 and Honor Magic 8.0 (Honor was spun off from Huawei in November 2020).
“As the front runner in AI, Baidu probably became the first public company globally to launch a GPT model with our EP 4.0 standing high as the most powerful foundation model in China. ERNIE continues to gain market recognition, as evidenced by ERNIE API calls from multiple well known companies.
Notably, Samsung uses ERNIE API on its Galaxy S24 5G sales. Honor uses ERNIE API in its Magic 8.0 and Autohome using ERNIE API to power multiple AITC apps.”
The management also highlighted the increasing use of Ernie by enterprises as the CEO stated, “In December about 26,000 enterprises are actively using ERNIE through API on a monthly basis, increasing 150% quarter-over-quarter. And ERNIE is now handling more than 50 million queries every day. That's up 190% quarter-over-quarter is a significant rise in third party quality.”
- The company is using AI to increase revenues in advertising.
“In the fourth quarter Baidu’s core online marketing revenue increased by 6% year-over-year, driven by verticals in travel, healthcare, business services, and others.
In Q4, we generated several hundred million RMB incremental ad revenue due to improvements in ad tech.”
- The company expects to achieve operational break-even in 2024 for Apollo Go.
“Our intelligent driving business continued to focus on achieving new breakeven for Apollo Go. In Wuhan, Apollo Go's largest operation, about 45% of our orders were provided by fully driverless vehicles in Q4. This metric surpassed 50% in January. The increase is because we intensified operations during peak hours in areas with complex traffic conditions and further expanding our operating area in the past few months. This development resulted from our ongoing efforts to improve technology through safety — through safely operating Apollo Go on public doles.
In China, Apollo Go provided about 839,000 ride in the public in Q4, marking up 49% year-over-year increase. In early January, the cumulative rides offered by Apollo Go exceeded 5 million. The substantial data collected from operations will further help us enhance the efficiency of safe operations.
Looking into 2024, we will remain focused on getting closer to Apollo Go's UE breakeven target and managing our costs and expenses to reduce losses in intelligent driving. Upon reaching UE breakeven, we plan to swiftly replicate our successful operations in Wuhan to other regions.”
Other Key Metrics
Baidu’s PaddlePaddle AI developer community has reached 10.7 million developers by the end of 2023. Developers created 860,000 models on PaddlePaddle by the end of last year.
Enterprises actively using ERNIE’s APIs on a monthly basis increased 150% QoQ to 26,000 in Q4. Baidu opened ERNIE APIs to enterprise customers at the end of August after receiving approval to deploy ERNIE on a larger scale.
Daily queries on ERNIE rose 190% QoQ to more than 50 million. ERNIE also reached a 100 million user milestone in December, less than five months after launching in August. OpenAI reported in November that ChatGPT had approximately 100 million weekly active users.
Baidu App’s Monthly Active Users (MAUs) grew by 3% YoY to 667 million in December 2023 and has been slightly lower than 5% growth in September 2023.
In Q4, Apollo Go rides grew by 49% YoY to 839,000. The company achieved 5 million cumulative rides from Apollo Go in January this year, marking a major milestone.
Conclusion:
Given the emphasis on AI in the markets combined with China pushing for its domestic tech to be the predominant tech used by its citizens, we foresee a scenario where Baidu emerges as a strong choice for those who want to participate in lower valuations. China’s population can be a catalyst for ERNIE to exceed Chat-GPT in user adoption. With that said, China is risky, ERNIE’s success is still quite speculative given the low revenue, and this is not a stock we can consider as quality. We will use technical analysis to its fullest as we attempt to participate.
Royston Roche and Damien Robbins, Equity Analysts at the I/O Fund, contributed to this article.
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