To The Moon

In its earnings release for Q4 and FY 2023, various line items in Baidu, Inc ($Baidu(BIDU)$, $Baidu, Inc.(BAIDF)$ or $BIDU-SW(09888)$) – ostensibly China's answer to Google – has shown arguably the best performance in recent years. Despite this, the stock is said to have missed expectations resulting in the stock price dropping. Whether these expectations were high merit a closer look. 

Trend Drilldown

Baidu can be considered to have four distinct main businesses:

• "Core" which drives revenues much like Google Search does. "Core" also includes the Baidu App Store (much like Google Play) and Android-based smartphone operating system Yi. 

• "iQIYI" which is more like Netflix than YouTube. 

• "Apollo", a driverless vehicle endeavour much like Waymo.

• "PaddlePaddle" (PArallel Distributed Deep LEarning) which, somewhat similar to Google Cloud's Compute Engine, is an open-source deep learning framework released by Baidu in 2016.

Intuitively, it could be understood that "Core" is the traditional breadwinner for the company while the other divisions likely draw sustenance from and gain inroads on the back of the reach provided by the company's dominant position in China's fragmented search/marketing space. 

Trends in key line item trends for "Core" as a percentage of total line items juxtaposed with first-order trends (representing Year-on-Year or YoY changes) trends as well as second-order trends (representing "rate of change") on total line item trends reveal a rather interesting picture:

Over a six-year window, it's evident that non-"Core" business contributions to top-line revenues have largely remained stagnant. On the other hand, they have been a significant drain on the company's Net and Operating Incomes as well as EBITDA till Fiscal Year (FY) 2021. Only since 2022 have their net contributions to these line items begun to turn positive. FY 2023 represents their strongest year yet; however, total revenue still is around 3% down from the high seen in FY 2021. Total EBITDA and Free Cash Flow have seen fairly strong positive upticks for two years now with a nearly 300% improvement in Diluted Earnings Per ADS.  

Second-order terms are a mixed bag: there are very strong trends in swings for EBITDA, Free Cash Flow, et al in either direction, which suggests that passthroughs into earnings isn't a simple proposition; there is substantial work in progress. 

In the present day, there are several indicators that the company's non-Core businesses are improving: 

1. While iQIYI's average daily number of subscribers has witnessed a 6.7% YoY drop at 100.3 million, monthly average revenue per membership has witnessed a 12.8% YoY increase to RMB 15.98 (about $2.2)

2. As of the end of 2023, Apollo Go (Baidu’s autonomous ride-hailing service) has accumulated over 5 million rides, with fully driverless orders in Wuhan - a city of some world renown since 2020 - being nearly half of all orders.

3. PaddlePaddle now has 10.7 million developers that have deployed over 860,000 models for over 235,000 businesses. 

Baidu's Driverless Taxis

Despite these improvements, there is still a long way to go for the company's massive investment in non-Core businesses to substantially pay off. The bulk of most Wall Street analysts' expectations looking at the ADS - as it represents the company's potential profit ownership at this point of time - was that non-Core businesses would have at least bridged the gap towards returning revenues to 2021 levels or beyond. Given current affordability headwinds in China, there was an expectation of non-Core businesses creating sufficient diversification to giving a substantial prop-up to total revenues. This didn't happen - although there are signs that this seems to have begun.

A second means of consideration is what most Wall Street analysts wouldn't have done, i.e. considering the earnings in light of exposure of the company's earnings through the ADS, which is not the same as a stock. Baidu's work is generally deemed to be of strategic importance to China's economy, which ordinarily would have meant significant restrictions on foreign investments. To address this, exposure to Baidu for foreign investors is made available through "American Depositary Shares" (or ADSs), which are not the same as "American Depositary Receipts" (or ADRs). The ADSs represent a ratio-driven exposure to the company's "Class A" shares listed within China's jurisdiction. Since 2010, ten ADSs represented one Class A ordinary share listed in China. In 2021, this ratio was changed: one ADS now represents 8 Class A ordinary shares.

When accounting for the ratio change backwards into the six-year window, it is seen that the ratio-adjusted diluted earnings Per ADS witnessed a near-total wipeout in 2021 in first-order terms, with second-term terms showing a two-year drag in performance growth. The "current" ADS witnessed a 99.4% drop in earnings performance from the massive highs seen in 2020. Present-day earnings are still a 98.6% drop from 2020.

2020 was a massive year, with a 1145% improvement in earnings per "current ADS" over 2019. Relative to 2019, present-day earnings remain 82.2% down. 2018 was also a massive year, with earnings per "current ADS" in 2019 representing a 93% drop. Relative to 2018, present-day earnings remain 98.7% down. 

If considering what the ADS represents, it should be plain to see that the company has a significantly longer way to go before showing a pathway towards the massive earnings shown in 2018 and 2020 than even Wall Street analysts have estimated. As it stands, CEO and co-founder Robin Li states: "our commitment to Gen-AI and foundation models remains unwavering, paving the way for the gradual creation of a new growth engine."

In other words, Baidu won't primarily be a search/marketing and subscriber content platform; it intends to be a primarily AI-relevant business in the future. If so, significant outlays towards building this next-generation business at the expense of core earnings can be expected to continue for several cycles more. 

A Difference in Investor Sentiment?

Since the ADS represents a certain number of Chinese shares, it stands to reason that the US-listed ADS and the Chinese shares would be exactly similar, given that the two nations' currencies as well as the "ADS Ratio" are effectively pegged. As it turns out, a significant difference in sentiment is apparent. 

Considering data from March 2022 till the 28th of February in 2024, US traded volumes have surpassed those in China on only 22 days; the latter tend to be anywhere from 10% to 706% greater than the former on any given day. Daily price performance upticks in the Chinese stock tend to be higher while downturns tend to lesser than that seen in the U.S. stock. 

Despite the ADS effectively being derived from the Chinese share, the two aren't necessarily fungible; effectively, one would have to separately dispose the ADS and buy the Chinese stock (if an investor was qualified by the Chinese government to do so). In fact, an increasing number of instituitional investors with the wherewithal to establish a commercial relationship within China's jurisdiction have been switching to holding the Chinese stock over the ADS in greater proportions in instances where the company is "dual-listed". In Baidu's case, the benefit of this is clear: the ADS is at 63.4% of its value in March 2022 while the stock is at 71.98%. 

Furthermore, the company repurchased $1.2 billion worth of stock from the public through 2020 and 2021. Given the trajectory of the stock in 2021, this ensured a 242% valuation premium to remaining shareholders who cumulatively received a $2.9 billion bump by the end of the year. In 2022, the company's board announced a new share repurchase program with an upper limit of $5 billion, effective through 2025. As of 2023, the company has spent $669 million of this amount. However, given the stock trajectory, this only returned $318 million (or a 53% deficit) to shareholders. 

Nonetheless, given that up to $4.7 billion is still on the table, this is the second benefit given to shareholders: there is a high likelihood of finding at least one "guaranteed" buyer for the stock: the company itself. 

In Conclusion

Be it ADS or stock, there is a recalibration of sorts, as per the company's messaging which seems to imply that it will soon be less "online marketing" (a mature business segment) and more "AI-relevant" (a business with substantial growth potential, many competitors and unknown regulatory hurdles). It's important for investors to be attuned to what they're buying into: the present or the future. 

If the present, passthrough earnings will likely remain impacted as the company grows towards its desired future. If the latter, there are many hurdles to overcome. In the present, the stock is likely overvalued; in the future, the stock might turn out to be cheap right now. What bridges the present and the future is the depth of investor conviction in the company's leadership being able to do this transition. 

All in all, it's a "wait and see"; Q2 and Q3 earnings will make for interesting reading. 

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