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Morningstar | Baidu FVE Reduced 19% to $262, but Shares Still Look Undervalued. See Updated Analyst Note from 01 Feb 2019

In light of the weaker economy in China, trade war tensions and weaker demand for advertising, we are reducing our fair value estimate for Baidu by 19% to $262 per share. Wide-moat Baidu’s shares continue to be undervalued for long-term investors. Its monthly active user base of 990 million across Baidu’s family of apps poses a strong network effect and is difficult to displace. We expect revenue growth to reach 26% in 2018 and decelerate to 18% in 2019 and 15% in 2020 due to slowing economy before picking up to 17% in 2021 as the economy recovers. Revenue growth will then decelerate and reach 11% by 2022. Non-GAAP EBIT margin is expected to be 27.2% in 2018 and 20.3% in 2019 and will rise gradually to 22.3% by 2023. We assume investments in marketing, research and development and content amid intense competition will keep margins from significantly improving in the next five years.

The recent weaker economy should have more adverse impact on merchants’ advertising demand and therefore online marketing services segment, and less impact on the subscription of iQiyi, a key component in the others revenue segment. This is also given that paid subscription for content is still in a secular uptrend, whereas search, a key component in the online marketing services segment, is close to saturation. We therefore expect online marketing services revenue growth to display cyclicality but not for the others revenue segment. We forecast online marketing services revenue to grow at 19% in 2018, 8% in 2019, 4% in 2020 before rising to 10% in 2021. By 2022, online marketing services revenue growth will normalize at 8%. Others revenue will decelerate to 16% by 2022 from an estimated 71% in 2018 and 61% in 2019.

We expect content costs as a percentage of sales to be 21.3% in 2018 and maintain at the same level in 2019 as it takes time for the lower salaries of top actors to be reflected. Afterward, we expect to see 100 percentage points decline in 2020 and 2021 and stay flat at 19.3% till 2022 as competition among the top three long form video platforms to produce high quality content will still be fierce. We expect sales and marketing to sales ratio to be 17.3% in 2018 and increase to 18% in the 2019 and stay flat till 2022. In addition to the estimated CNY 1 billion expenses for the 2019 Chinese New Year gala red packet promotions to acquire traffic, we think app pre-installment will continue to be an important way to acquire traffic to promote Baidu’s new APPs (eg the flagship Baidu APP and short video app Haokan in 2019). Research and development as a percentage of sales is expected to be 14.4% in 2018 and increase 20 basis points to 14.6% in 2019 as management is dedicated to invest in artificial intelligence and raise wages of the research staff. This ratio will increase gradually to 15.2% in 2022.