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Morningstar | Baidu Reports Strong 2Q for Its Core Business as Well as iQiyi Customers and Revenue. See Updated Analyst Note from 01 Aug 2018

Baidu reported strong second-quarter results with revenue up 32% and operating income up 29%. The result was highlighted by strong revenue and profit growth from the wide-moat core search and newsfeed business and very strong customer and revenue growth from the video business, iQiyi. Content costs widened the operating loss for iQiyi, with management forecasting continued high content spend over the next few quarters. Baidu management guided to a 23%-30% increase in revenue for the third quarter but did indicate that it expected some margin pressure with margins down 1-2 percentage points compared with the second quarter, owing to increased investment in traffic acquisition and content costs. We make no changes to our USD 322 per share fair value estimate or wide moat rating, with the stock starting to represent good value, in our view, having pulled back a little on the recent general weakness in the sector.

The Baidu Core business (search and newsfeed) reported strong results, with revenue up 24% and non-GAAP operating profit up 32% with the operating profit margin improving from 38% to 39%. Although we have no reliable third-party Chinese search volume statistics to source, Baidu’s own measurements indicate that it has been able to at least hold its search volume market share and probably show some slight increase. This would support the network effect in our wide moat rating. Baidu’s latest version of Baidu app also supports mini-programs launched to help bypass the ever-rising cost of app preinstalls. These mini-programs mimic those in Wechat, and they can really only be attempted by super apps like Baidu. Mini-program designers will get access to Baidu’s artificial intelligence capabilities, and users will be able to run these mini-programs without downloading the apps. Management claimed that it has seen a very high level of interest from app designers.

The Baidu app had 148 million average daily active users over the quarter, up 17% year over year, and total user time spent on the Baidu app was up 30% year on year, implying increased user engagement. Baidu has not been affected by the recent government crackdown on short videos that do not comply with censorship. Video content represents well over half of newsfeed video distribution. It has a sophisticated AI lead system to filter out censored content in both video and text.

While the video business, iQiyi, reported very strong revenue growth of 42%, its non-GAAP operating income loss widened to CNY 1.244 billion from CNY 940 million a year ago and CNY 1.015 billion in the first quarter, mainly due to increased content cost. Revenue growth was also strong sequentially, up 26.5%, and the company guided to increased year-on-year revenue growth in the third quarter of 43%-49%, with continued growth in membership the key driver. IQiyi subscribers were up 75% year on year to 67.1 million, with 66.2 million of those paying subscribers. Membership growth was helped by its program with JD.com and commercial banks, as well as several very popular drama series. Management indicated that content investment will increase in the short term (as a percentage of revenue) in a bid to continue increasing customer numbers. Management also discussed the possibility of the government introducing formal regulations limiting actor and actress compensation, which could help with content costs in the medium term.

Baidu has products addressing the Internet of Things and automated driving markets. Although these are very early-stage markets and neither is likely to significantly affect revenue in the near term, they represent long-term growth prospects for the company. Management believes it is at the forefront of both these nascent markets in China and will likely be the first company to significantly monetize these markets. With regard to IoT, Baidu has released version 3.0 of its operating system, DuerOS, which includes both voiceprint and video recognition, as well as continuous conversation. DuerOS has now been installed in 90 million devices (nearly doubled over the past six months), and voice queries surpassed 400 million in June 2018. The company also has strategic cooperation with over 20 global and domestic auto original equipment manufacturers to provide DuerOS for auto solutions, including entertainment, Internet services, safety features, conversation AI, facial recognition, and augmented reality navigation. OEMs include BMW, Daimler, Ford and Hyundai. Baidu’s autonomous driving platform, Apollo, is also now being used in China’s first fully autonomous L4 minibuses produced by King Long Motor. As of July 4, 2018, 100 units had been produced. Neolix Technology has also launched an L4 micro-car for cargo delivery powered by Apollo. The government’s willingness to invest in autonomous driving in terms of investments in road technology and infrastructure bodes well for the future of these products. With a total of 29 million vehicles sold in China in 2017, this represents a potentially very large market for Baidu once autonomous driving becomes more commonplace.