Baidu Stock: Q3 Earnings Confirm Company's AI Leadership
Nov. 29, 2021
The Stock Dudar
Summary
- Solid 3Q21 sales and income results are exciting against the backdrop of Baidu's AI technological shift.
- Baidu's AI transportation put years of investment in R&D in a range of applications on full display.
- Baidu continuously demonstrates its leadership in consumer facing AI tech, and industrial AI applications are just getting started.
- The Anti-Monopoly fines levied against Baidu and Chinese peers don't actually look like bad news given the low ~$78,000/incident penalty.
- Baidu faces political and regulatory risks, but there are strategies investors can implement to protect themselves from catastrophic loss.
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The headline 3Q21 earnings numbers send a mixed messages, but a deeper analysis suggests that Baidu's ( BIDU) transformation is intact, building on a technological foundation developed over many years. As an aside I'll cover why I think the recent Anti-Monopoly penalties are a non-issue, for BIDU by looking at the original releases.
I have a sum of the parts analysis here, so the purpose of this article to dive into BIDU's 3Q21 earnings release to look for any cracks in my previous ~$175 billion valuation estimate. I'll put the earnings into the broader context of BIDU's artificial intelligence (AI) technology by recapping the demonstrations from the Baidu World conference and looking at the industrial AI breakthroughs since then.
Analysis of Baidu 3Q21 Earnings Results & Anti-Monopoly Fines
Since BIDU's 3Q21 earnings release on Nov 17th, the stock is down from $170 to $150, about 12% at the time of writing on Nov 24rd. In that week, BIDU and several peers were fined for violating China's anti-monopoly law, and the Industry Ministry told Alibaba ( BABA) and BIDU that they needed to better prevent telecom fraud. The collective market reaction was a 12% sell-off, but looking deeper, I don't think that reaction makes sense.
The Gap Between GAAP and Non-GAAP 3Q Earnings
In BIDU's 3Q21 press release the company reported a $2.57 billion generally accepted accounting principles (GAAP) loss in the quarter, but simultaneously a reported a $790 million non-GAAP profit, which was up 27% YoY and 5% sequentially. The earnings release walks through the difference, which I'll summarize here.
| Net income, non-GAAP | $790M | | Other | -$181M | | Tax effects | $454M | | Fair value loss on long-term investments | -$2,945M | | Impairment of long-term investments | -$497M
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Author's Summary of Page 13 Baidu 3Q21 Earnings
BIDU's GAAP results are noisy from quarter to quarter due to the company's investments. There were $3,442 million in losses associated with long-term investments, and a significant portion of the tax benefit is tied to long-term investments as well. I'm not exactly what methodology BIDU uses to compute "fair-value" or the dates used, and given the non-GAAP nature of these adjustments they may not use a standard method, but it looks like the iQIYI ( IQ) stake had a major impact on GAAP earnings in the current quarter. With rough math, I assume BIDU still has a 56% stake in IQ. The drop from $15.58/share, worth $12.4 billion on June 30, to 8.03/share, worth $6.4 billion on Sept 30, would represent a drop of $6 billion and 56% of that is $3.36 billion. The company expects continued noise in GAAP earnings stating in the 3Q release that they saw: "RMB 18.9 billion non-cash, mark-to-market loss in long-term investments. Such quarterly fair-value adjustment may result in further net income volatility in the future. "
The only place I would push back on BIDU's non-GAAP net income is that they added back in share-based compensation. The cost to shareholders is as real as any other cost, so I'm inclined to say a more shareholder-centric estimate for the quarter is closer to $600 million. That said, with the level of investment BIDU is pouring back into the company, a 41% increase in R&D over 3Q20, long-term profitability should be much more dependent on the company's continued innovation.
3Q21 Continues Search Diversification Trend
From CEO Li's commentary we learned that non-ad revenue was 21% of Baidu revenue, with AI Cloud growing 73% YoY. Managed page was 43% of core (non-iQIYI) 3Q online marketing revenue, up from 40% last quarter. For readers not familiar with Managed Page, think Shopify/Wix as a starting point with all the tools business owners might need within the Baidu ecosystem to maintain their presence online.
It is worth considering that BIDU's search diversification is a testament to how successful the company has been branching out, not a sign of weakness in BIDU's search leadership. According to StatCounter, BIDU had under 70% of the mobile search market share 3 years ago in Nov 2018, and that share was over 95% in Oct 2021. The results haven't been as positive on desktops, but with an increasingly mobile future, BIDU is well positioned in search. Last year's fears that companies like ByteDance were going to take BIDU's search market share appear to have either not materialized or are progressing very slowly. In fact as we wait for further news on reports that China is weighing making closed app ecosystems like Tencent and ByteDance searchable, the odds of search-related upside are shifting in BIDU's favor.
At the same time, BIDU's main app reached 607 million MAU, up 12% YoY as the company continues to broaden the app's capabilities. I'll talk more about the Baidu World conference and other innovations later, but at the conference, BIDU showed people using the app to make bookings, identify specialty groceries, find reliable healthcare and physicians, livestreaming, education, and more, all while tying into BIDU's assistant and smart speaker system Xiaodu. Once again, the company's smart display was ranked number one globally based on shipment volumes and led the smart speaker market in China according to IDC. The shift to smart displays from speakers adds visually oriented activities like video conferencing, games, and education services.
Overall, in Baidu core, which excludes iQIYI, revenues were up 15% YoY to $3.8 billion in the quarter. When you take out the volatility associated with long-term investments, BIDU had a profitable quarter whether you account for share-based compensation or not. Non-GAAP profitability was down sequentially, primarily on higher SG&A costs, but with a slew of new products in high growth areas, that's not a surprising cost.
43 Tech Anti-Monopoly Penalties Look Like Neutral News at Worst
Directly from the source (Chinese website link, quote translated by Google): "the State Administration for Market Supervision made administrative penalty decisions in accordance with Articles 48 and 49 of the Anti-Monopoly Law of the People's Republic of China, and imposed fines of 500,000 yuan on the enterprises involved in the case. "
Of the 43 notices posted on Nov 20th 2021, I counted 3 naming Baidu, although without cross-checking the names of all of Baidu's subsidiaries, there may have been a few more associated with Baidu. The exact number of fines levied against BIDU isn't too important because each fine carries a penalty of only 500,000 yuan, roughly $78,000 USD. This news made quite a few headlines, with references to previous, much larger fines, and the implication that China is still seriously cracking down on tech companies. Given the insignificant size of the penalties, I don't think that's a fair conclusion.
On one hand, the government demonstrated its power with an ability to go back almost a decade and fine companies for past behavior. The flip side is that $78,000 per incident hardly counts as a penalty for companies like BIDU and BABA. I'm inclined to see this as the Chinese government acknowledging that big tech companies have received and understood the anti-monopoly message, simply reminding them that these fines could have been a lot worse.
Baidu's Technology is Off to the Races
As investors, it's easy to get caught up in political headlines and the near term, quarterly financial results, so much so that we sometimes de-emphasize the underlying company's operations and technology. I'll detail how I protect my portfolio from political and other systematic risks, later on. For now I want to focus on BIDU's stream of technological breakthroughs. I'll recap the demonstrations at BIDU World, before diving into some less showy, but equally interesting innovations that underpin the opportunity BIDU has in industrial AI.
Recap of the BIDU World Conference
I'll do my best to provide a concise overview and commentary, but for anyone interested in more detail than I provide, feel free to check out Baidu's English recap on YouTube. The Baidu World Conference was split into 5 main parts:
- AI Transportation
- AI in Daily Life
- AI Applications
- AI Innovations
- AI to the Future
Part 1: AI Transportation - A Convergence of Baidu's R&D Investments
The headliner, AI Transportation, did so much more than showcase Baidu's autonomous capabilities, robotaxis or Apollo program. It tied together investments and research from BIDU in chip design, cloud, smart cities, speech recognition, robo-assistants, maps, and of course, autonomous vehicles. If you ever wondered what the transition from a full-time driver behind the steering wheel, to a fully autonomous vehicle might look like, BIDU is already there. Their robotaxis are operated remotely by drivers in a centralized location, but BIDU's driverless technology has reached a point where one remote driver is capable of monitoring multiple vehicles, often stepping in only for emergencies or trickier navigation. The reason BIDU's driving demonstration is so impressive is the blend of technologies required to create a smooth user experience.
- Natural Language Processing to communicate with the vehicle
- Smart Cities to reduce traffic and improve predictability
- Baidu Maps as one of the leading map apps in China
- Autonomous Driving, Robotaxi Design, and Apollo allow AI to handle a significant amount of the driving and transportation logistics
- AI Chip Design and AI Cloud form the infrastructure that other features are built upon
The breadth of in-house technology BIDU owns makes it difficult for a company with a more narrow focus, like on that specializes in autonomous driving, to compete without bringing on partners. Even BIDU partners with other companies to manufacture chips, build vehicles, etc., but the company's AI Transportation demonstration put years of investments and research in multiple areas on display.
Part 2: Baidu AI in Daily Life
This segment was the most consumer facing, centralized around the Baidu App and Baidu's Xiaodu smart speaker and assistant, as well as other devices. I wrote about these higher up and in previous articles, so the key takeaway is that Baidu is combining software and hardware to make everyday tasks easier. That could take the form of headphones and "pens" that can automatically translate and transcribe notes, a full featured TV with over 2,000 "skills" that respond to voice commands, or the further expansion of a smart phone as a Swiss army knife for digital tasks. Specifically, BIDU emphasized the inclusive nature of its technology for China's older generations, which has become increasingly important to the government and society as nearly 20% of China's population, around 260 million people are over 60.
Part 3: AI Applications - A Hybrid of Consumer and Industrial Use Cases
The applications are so far reaching that BIDU could only provide the flavor of applications through a few examples.
First up was a 3D video + AI coaching system, which BIDU applied in partnership with China's Olympic diving team. That partnership began in April allowing China's divers to utilize the system in time for the 2021 Olympics, an event they dominated. Outside professional sports applications, you can imagine every amateur golf enthusiast eager to improve their swing once the technology becomes widely available.
Next was a more industrial use case in the city of Quanzhou where BIDU used AI to monitor the city's water system. They leverage the predictive capabilities of AI along with variable data like weather patterns to ensure water treatment plants are operating at peak capacity. BIDU is able to dynamically vary water pressure with a system that never sleeps, ensuring high water quality and less water waste, while cutting electricity usage by 8%.
Finally BIDU showcased its City Brain in applications beyond traffic reduction. In the UNESCO World Heritage Site of Old Town LiJiang, City Brain helps keep the city clean, attractive, and efficient by alerting the responsible parties with anything from improperly parked bicycles to accumulating trash.
If I was to unify these examples under a common theme, I'd say it's that AI is not a one-size fits all solution that can just be sold as a product with immediate benefits to the purchaser. The application has to be analyzed, designed, integrated, and optimized over time. There's a tendency to think of AI software as a product, but it's more of a product/service hybrid where the experience of both the product and service provider improve over time. For these reasons, BIDU has the potential to benefit from initial integrations as well as follow-on service contracts, with lessons learned carrying over from project to project.
Part 4: AI Innovation - Kunlun, Baidu Brain, PaddlePaddle
Baidu's Kunlun II AI chip is the follow-on of China's first AI chip, Kunlun, originally released in 2018. The chip entered mass production this year, and should be anywhere from a 2x-3x improvement over the first generation. AI software tends to benefit from parallel processing, so the chips often have more cores and threading capability. Along with computational improvements, we should expect better energy efficiency like we saw with BABA's new chip.
I see Baidu Brain and PaddlePaddle described interchangeably and mixed up. The quickest way I can clear up that confusion is with a photo from Baidu's blog of Baidu Brain 6.0:
Baidu Brain is now on 7.0, but PaddlePaddle (PArallel Distributed Deep LEarning) still makes up the same part of the foundational layer. Where I think it gets confusing is that PaddlePaddle, which parallels U.S. counterparts, PyTorch and Tensorflow, is an open AI platform, with applications outside Baidu Brain that individual developers can work with and contribute to. At Baidu World, the company stated that "3.6 million developers around the world have developed 400,000 AI models through PaddlePaddle, serving over 130,000 enterprises and institutions across a range of fields and industries." Through its integration with Baidu Brain, the company leveraged development in many of the projects described earlier.
Part 5: AI to the Future - Beyond the Consumer
BIDU discussed how much AI and automation are already integrated into our lives. These include many of the smart devices from Part 2 above, as well as uses in search, shopping, and a whole slew of consumer facing technology. While these applications can provide real value, the opportunity to make more substantive quality of life improvements lies on the industrial side which I'll discuss later.
BIDU left us with the concept that the benefits of any new technology need to be explained. If it wasn't clear before Baidu World, the company is all-in on AI, and for a lot of people that's a scary concept. AI can and will have negative consequences, but can provide solutions to existing problems. For example, we grapple with the fear that AI will reduce the workforce required for some jobs, while making other obsolete. At the same time, the working percentage of the overall population is shrinking as lifespans increase and people spend more time in retirement. For a smaller working population to support the remainder of society, business operations are going to need to become more efficient in every industry, and AI has an important role to play. By making investments in AI and adjacent technology over the last decade, BIDU is positioning itself to provide critical services that society will need in the future.
AI Industrial Technology
AI is prevalent and growing in consumer facing products, but there are far reaching applications in business and government oriented offerings. BIDU's YouTube channel and Twitter page are great resources because the company doesn't make a lot of announcements through press releases on its investor relation website.
In one industrial application, PaddlePaddle helps a diagnostic engineer listen to the sounds of thousands of machines on the factory floor to troubleshoot equipment. With PaddlePaddle's fault warning system, machinery had greater uptimes while increasing overall factory output. This is one of those examples where almost everyone benefits from the incorporation of AI. That includes factory employees that don't have to sit idle when upstream equipment breaks, causing delays in their work. In another example, Baidu's Apollo partnered with Huaneng Yimin Coal Mining Co. demonstrating the results of their autonomous mining vehicle.
I've written about BIDU's healthcare capabilities previously, and on the Nov 22, BIDU entered an agreement with Sanofi ( SNY) to integrate its mRNA design platform, LinearDesign, with Sanofi's product design pipeline. Sanofi will use LinearDesign to optimize mRNA sequences. The collaboration with a major pharmaceutical firm is big news for BIDU because the company primarily does business in China. It's also further evidence that while political saber rattling continues, the global economy benefits from greater interconnection.
AI applications for industrial and government uses are in an early stage, and the examples just cited coupled with the smart city cases higher up highlight the market size. The opportunity is so large that it will require multiple AI companies, possibly specializing in certain industries, to meet the demand. There will be competition, but there should be room for multiple winners, and BIDU has made a strong case that it is one of the leaders in the field.
How I Own Baidu & Why I Structure My Investment This Way
How individual investors choose to own stocks, when to buy and sell, and whether to use options are all dependent on an investor's comfort and awareness of their own behavior. In other words the strategy below is tailored to me and my investment in BIDU. For that reason, this section probably isn't replicable, nor should it be, by most readers, but it may provide a jumping off point for a modified strategy. Mostly, I'm including this section because I promised earlier that I would detail how I protect my portfolio from political and other risks.
Baidu is a volatile stock. If I ignored the stock market for a year, I wouldn't be surprised to come back and find BIDU at $500/share or at $0; well, I'd be a little surprised with $0, but it is possible. That's not to say Baidu, the company, could be worthless in a year, but war, a ban on Chinese stock ownership by U.S. investors like myself, and possibilities I can't imagine, are all situations that could drive the stock to zero, and I want to be prepared.
1. The Income & Long-Term Portion - Covered Calls / StockTo take advantage of Baidu's high implied volatility, I own shares (I'll refer to ADRs as shares) with the intent of selling near-dated, weekly or monthly, calls against portions of the shares to produce income. I choose expirations and strike prices where I expect to be able to roll the calls up and out if the price exceeds my strike near expiration. I'll typically wait for a near term spike in price before I sell the calls. For example, after the recent drop from $170 to $150, I have no calls sold against my shares, but I would sell some if the stock returned to $170. Because I'm a long-term believer in BIDU, the shares allow me to participate in that upside and the calls capture time premium from implied volatility and provide income in lieu of a dividend. Of course, the calls provide very limited downside protection which brings me to the next part of my strategy.
2. The Protection - Asymmetric Put SpreadsThe idea here is to pay for insurance to prevent a catastrophic loss. Once again, I'm not advocating for this strategy or any specific options, but for the sake of an example, if I owned 400 shares with the stock at $150 in Nov 2021, I might buy 5 $100 strike 2024 puts for ~$10 each and sell 1 $250 strike 2024 put for ~$100. Four of the $100 strike puts protect the shares, while the 5th offsets the $250 strike option. I hypothetically risk $10,000, have the possibility to make $5,000, and protect $40,000 worth of losses in shares.
3. The Leveraged Upside - Long Dated CallsWith protection in place, my remaining "risk" is that BIDU shares spike up, and my covered calls force me to sell my shares from portion 1. To avoid missing out, I'll buy long dated calls, as far out as I can, using the income from part 1. All three legs of the strategy complement each other with the goal of limited gain/loss during a flat market, protection from a catastrophic loss, and nearly full upside.
A Few Warnings
As I've said before, this exact strategy probably isn't right for most investors, and while it may serve as a jumping off point, I'm not recommending or advocating for this strategy. Please keep in mind that this strategy:
- Requires active management
- Requires complete comfortability with options
- Requires judgement when rolling forward or letting options expire
- Does not protect against all downside losses
- Can result in losses, even in flat markets
There are a limitless number of possible investment combinations, so please invest using a strategy you understand.
Final Thoughts
In a vacuum, BIDU's 3Q21 earnings showed good sales growth, and a solid non-GAAP earnings increase over last year. Against the backdrop of BIDU's industry leading technology, the results are much more exciting. Years of internal investment in R&D are coming together to create offerings in entirely new markets like AI Transportation. I expect BIDU to continue showcasing its consumer facing AI tech, while an AI fueled industrial revolution is just beginning. The 3Q21 earnings results confirm BIDU's continued expansion beyond search with metrics like 73% sales growth in AI cloud.
As a company, Baidu is poised to be a leader, integrating AI into existing industries, sometimes creating new markets in the process. The biggest risks to BIDU come from political agendas in both China and the U.S. As I've written about in previous articles, I think the current fear surrounding China's stock market is overblown, but investors ignore a potential blow-up at their own risks. There isn't much the company can do to mitigate those risks, but individual investors can develop strategies to mitigate risk based on their personal risk tolerance.
Nothing the 3Q21 earnings release or other recent news has given me a reason to update my previous valuation of a ~$175 billion market cap or ~$500/share. This is my estimate of fair value rather than a 1 year price target, because I honestly have no idea where the price will be one year from now. For some, the volatility and risk may mean avoiding BIDU's stock entirely is the best course of action. I personally choose to utilize the strategy described in this article to capture what I estimate to be a significant undervaluation in BIDU's current stock price, but my implementation isn't right for everyone.
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