To The Moon

Summary Tencent eyes AI investment, and Baidu expects an online ad rebound with AI-powered chatbots and cloud services. Tencent sees AI as a growth multiplier, with recent industry breakthroughs enhancing product innovation and expanding into new opportunities. Splitting up the company may lead to greater efficiencies. Baidu expects a rebound in online advertising with AI-powered chatbots and cloud services. ERNIE Bot has the potential to reshape information presentation and enhance monetization opportunities for advertisers. TCEHY earns a strong buy rating as it sets up for a positive P/E multiple rerating in the near future, while BIDU earns a buy rating in light of a continuing recovery in the second half of 2023. da-kuk/E+ via Getty Images Investment Thesis China's tech giants are betting on innovation and growth to drive their businesses forward in 2023. The article will explore how these tech giants are poised to lead the charge and cement their positions in the global market. Tencent Holdings Limited (OTCPK:TCEHY) is investing heavily in artificial intelligence to enhance its existing products and expand into new opportunities. The company views recent industry breakthroughs in foundation models and generative AI applications as growth multipliers for its business, which can enhance product innovation, monetization, and operational efficiency of user-to-user services such as social and gaming. Meanwhile, Baidu (NASDAQ:BIDU) is adopting a low-price strategy to expand its user base and enhance its competitiveness in a soft consumption market. As a result, Baidu is optimistic about a recovery in the second half of 2023, and it expects a rebound in online advertising with AI-powered chatbots and cloud services. The China stock bull run early in January was short lived, but both stocks have outperformed the KraneShares CSI China Internet ETF (KWEB) index. TCEHY and BIDU remain undisputed leaders in their category, and the pullback provides a great entry point. However, Tencent stock is the clear winner and earns a strong buy rating due to its undervaluation amidst its shifting focus from cost-cutting to growth. Data by YCharts AI Remains A Growth Opportunity For Tencent Tencent's gross margin improved YoY in 4Q22, reaching 42.6%. This growth was mainly driven by margin improvements across all business segments, with FinTech and Business Services (FBS) showing the most significant improvement. In addition, the company's S&M expenses dropped by 47.4% YoY to RMB 6.1bn in 4Q22, representing only 4.2% of total revenue, compared to 8.1% in the same quarter of the previous year. Tencent's management believes that AI will act as a growth multiplier for the company. AI can empower and benefit several of the company's key business lines, including ads, games, short videos, and the cloud. Tencent's management has been developing foundation models they plan to roll out gradually at the back end while introducing front-end use cases. Tencent views recent industry breakthroughs in foundation models and generative AI applications as a growth multiplier for its business. This new technology can enhance product innovation, monetization, and operational efficiency of user-to-user services such as social and gaming. Additionally, it can help Tencent expand into new opportunities in user-to-machine spaces such as digital assistants and search. Tencent's management views the recent trend towards AIGC and AI chatbots as a growth multiplier for the company. Instead of being disrupted, they believe that many of Tencent's products can be enhanced by generative AI. Furthermore, in areas where Tencent has yet to be dominant, such as digital assistants and search, foundation models can facilitate the introduction of new products that can become new growth areas for the company. Tencent has been developing its foundation models and plans to gradually roll them out at the back end while introducing front-end use cases across its entire product range. In addition, management has announced that they intend to release a ChatGPT-like chatbot. The company identifies AI as one of the most important areas for investment. Tencent's management expects to be disciplined and cost conscious in its investments to minimize the impact on margins while continuing to grow the business. Finally, AI will act as a growth multiplier for the company by enhancing its existing products and introducing new growth opportunities. China's Cloud Market The public cloud market in China is expected to rise, reaching $90 billion by 2025, up from $32 billion in 2021. The Internet has driven the country's cloud industry over the past decade. However, it's expected to slow down its demand for cloud services to 10%-20% in the next few years due to the overall slowdown of the Internet economy. Nevertheless, China's cloud industry is expected to maintain a revenue growth rate of 30%-40% in the medium term. canalys.com Tencent is expected to experience revenue recovery and margin improvement due to the macroeconomic recovery in China. The advertisement segment, led by the Video Account, is expected to drive Tencent's top-line growth as the company expands its client base into more e-commerce-related areas. The game segment, particularly the mobile game segment, is expected to gradually recover in 2023 due to the resumption of Banhao, the launch of new games, and the promotion of in-game activities in existing large games. In addition to revenue recovery, Tencent focuses on improving its margin performance. The company has introduced several cost reduction initiatives, such as monetizing apps like Tencent Meeting and cutting down on loss-making business units. Chart Tencent Could Follow Alibaba's Lead I believe antitrust issues were a major factor in Alibaba Group Holding Limited's (BABA) decision to split its businesses, given the Chinese government's concerns about potential monopolistic practices at the two Internet giants. The effective stranglehold the two companies enjoyed in many sectors of China's technology industry was a barrier to creativity and entrepreneurship. Rather than spur innovation, Tencent's and Alibaba's dominance often stifled competition and squeezed out all but the strongest of firms. Tencent could follow Alibaba's lead and hive off some of its divisions into standalone, separately listed businesses. Although I believe that the motivation for such a move is less compelling than at Alibaba, I think the separation of Tencent's main businesses would deliver advantages to the individual companies, shareholders, and the sector as a whole. For example, Tencent could be split into three businesses: Tencent Cloud, Games, and Messaging. The messaging business would encompass Tencent's core WeChat, e-commerce, fintech, and advertising businesses, which would be hard to separate given their reliance on the messenger super app. A breakup of Tencent's business would help appease concerns that the Internet Goliath has grown too powerful, creating a more level playing field in the end markets. In addition, this could reduce the close regulatory scrutiny of Tencent's business, helping mend relations with the central government. Moreover, a breakup of Tencent's group also could lead to greater operational efficiencies in a business currently run with a highly centralized structure. Allowing each division greater autonomy could lead to better decision making and more efficient use of capital. Being exposed to the scrutiny of the market and external investors also could lead to greater efficiencies in each business. On the flip side, capital-intensive businesses such as Tencent Cloud would become responsible for raising funding externally as they would no longer enjoy cross-subsidies from Tencent's cash cow messaging businesses. That said, the greater accountability this would bring would likely lead to better decision-making and more efficient use of capital, essential factors in a sector known for loss-leading contracts. BIDU - Rebound In Online Advertising Expected In The Second Half Of 2023 Baidu was the No. 1 search engine in China in the last decade in terms of revenue and several users, as well as the number-one "search plus feed app" in China in terms of MAU and DAUs in December 2020. Baidu was also the number-one knowledge-and-information-centric Internet platform in China in terms of online advertising revenue in 2019 and the only company with leading search and feed advertising positions. With the improvement in pandemic control measures in China and the gradual lifting of travel restrictions, Baidu is expected to benefit from the economic recovery trend in 1Q23. In addition, the online marketing performance in verticals such as healthcare, travel, and local life services has improved, likely to translate into increased online marketing revenue for Baidu. Performance-based ads, including search and e-commerce ads, could lead the recovery as advertisers prioritize inventory clearance over new product launches and brand building. The travel and retail/direct consumption-related categories are expected to rebound first, drawing references from re-opening experiences elsewhere. Additionally, as business activities and project delivery resume, Baidu's cloud revenue is expected to recover steadily in the coming quarters. While online penetration in China's online ad space has matured, offline ad spend is expected to increase as physical events resume. As a result, there may not be a drastic ad spend shift from online to offline, but the online share could stall or edge slightly. The recovery of ad spend is likely to vary depending on the nature of ads, i.e., brand vs. performance and the advertiser mix. eMarketer BIDU's ERNIE Bot Has Potential Baidu has also announced the launch of its new chatbot, ERNIE Bot, which has the potential to assist in AIGC scenarios and enrich the search engine experience. However, it may take more time and an initial R&D investment for the new technology to become a game changer for Baidu. Baidu's management is optimistic about the potential of its AI-powered product, ERNIE Bot, and sees significant long-term opportunities. The company plans to integrate the technology into its search business and later expand into other areas, including cloud computing, autonomous driving, and intelligent devices. In addition, by reshaping information generation and presentation, Baidu aims to attract new users, increase user engagement, and enhance monetization opportunities for advertisers. While the launch of the new features is expected to drive user growth, it may not significantly contribute to revenue in the short term. Baidu's management will closely monitor the investment efficiency and may increase research and development spending and capital expenditures if initial user engagement and growth are positive. Baidu Core: Development Of New Initiatives The Baidu Core segment comprises diversified services and products, including various online marketing services, the AI cloud business, the intelligent driving business, and innovative hardware devices. As China's leading online search engine provider, Baidu can offer business customers unique value propositions and help them efficiently run online marketing activities. Even though demand from business clients for online ad demands was temporarily curbed amid macro headwinds, Baidu's high-ROI search ad services can deliver a relatively resilient revenue growth trajectory. The mature online ad business could generate steady profits and cash flows, which could help fund the development of Baidu's other vital new initiatives. I believe Baidu's cloud computing services can leverage leading AI and big data technologies to help resolve pain points in sectors such as intelligent transportation, traditional manufacturing, energy, and utilities. Even though demand for enterprise digitization has been pent-up due to macro headwinds, I remain confident in the value that cloud services can add to enterprises' operations and development and believe cloud migration is an efficient way for enterprises to do business more efficiently and economically. Valuation: Tencent Is The Clear Winner Both Tencent and Baidu are excellent long-term investments in China's growth, and as the nation's economy resumes operations and grows, their ad revenues should increase. Tencent's five-year CAGR in earnings stands at 21.4%, and accounting for a conservative CAGR of 15% for the following years, it suggests a DEPS of $5.6. Tencent stock has a P/E 5-year average of 28.6x but trades at a steep discount of 15.7x. Once the geopolitical environment becomes less intense, the market can regain confidence in Chinese equities, lifting major players. Thus, we can assume a conservative P/E multiple of 20.0x by 2028, suggesting a target price of $112 and a 154% upside from current levels. Although Baidu's stock has crashed from all-time high levels, it still trades at a relatively high multiple, but it has entered the buy zone. Even though Baidu didn't provide any guidance for the year, as soon as the recovery of China is reflected in BIDU's quarterly earnings, the sentiment for the stock will significantly improve. Baidu's stock is still trading at 17 times forward earnings, and the stock might be setting up for a rerating in the second half of the year as the outlook gradually improves. Chart Takeaway The market undervalues the potential for margin expansion as Tencent solidifies a more effective cost structure and the longer-term revenue contribution from video accounts. Finally, BIDU's rising spending on ERNIE might take longer for operating margins to reach pre-pandemic levels. Still, the strong rebound of the advertising market will partially offset the additional costs. Therefore, I expect China's cloud expenditure growth to resume a healthy momentum as the macro environment warms, setting up both Chinese giants for further upside in the year's second half. $Baidu(BIDU)$ $TENCENT(00700)$ $Alibaba(BABA)$ $Alibaba(09988)$ Follow me to learn more about analysis!!