- Baidu is the AI Leader in China by a wide margin.
- While it couldn’t escape the broad selloff that has affected Chinese equities, we discuss why Baidu is set to ride on the coattails of the CCP’s Five-Year Plan.
- We have revised our rating to Buy, and would await for price action resolution to determine an optimal buy range.
The recent regulatory crackdown by the Chinese government has triggered a broad-based selloff in Chinese equities that has spared almost nobody, not even Baidu (BIDU), as the price has dropped almost 20% at the time of writing since our last article in June.
In this article, we discuss some highlights on the actions from Beijing and why we think Baidu is poised to thrive even in a market environment where negative market sentiments overwhelm fundamental logic, as the company’s AI-driven technological pursuits, as well as its autonomous driving projects are well aligned with Beijing’s Five-Year Plan (FYP) which forms the Chinese government’s “grand strategic blueprint for the next half-decade, as well as longer-term goals for 2035.”
In our last article, we rated BIDU at neutral, mainly due to its less competitive position against its BATs rivals, as well as a relatively weak long-term price trend. However, with the indiscriminate selling taking place across Chinese equities, we think the time has come for us to revisit our rating and consider whether investors could capitalize on the panic selling to add exposure to China’s foremost AI leader.
Our Views on the Latest Regulatory Actions
The latest crackdown on the education sector comes hot on the heels of the spate of Tech related regulatory actions that have affected the entire Chinese Tech sector. While the latest policy actions directed at the burgeoning after-school tutoring industry were somewhat expected, its scale was certainly not. The scale of it has also caught us off-guard and caused us to revisit the underlying drivers behind Beijing’s latest actions and whether certain industries may get some reprieve from the government’s increasingly tight oversights on China’s largest companies.
Since earlier this year, education has been in focus when Chinese President Xi Jinping “called disorder in the tutoring industry ‘a stubborn malady’ and vowed to solve the problem in the ‘Two Session’ annual legislative and political meetings. The Chinese government mainly targeted these actions to address the
situation in China’s education: ‘neijuan,’ or involution, which literally means ‘inside rolling,’ a process of incessant competition from which no one benefits. Chinese parents feel intense pressure to provide the best resources to their children, who in turn must work extra hard to keep up in an educational rat race.
We think Beijing’s tough stance on this matter is warranted, as in “a recent survey of 4,000 parents by the state-backed newspaper China Education Paper found that 92% enroll their children in extracurricular classes and that half of the families spent more than 10,000 yuan ($1,500) each year on such classes.”
We think the government has been increasingly concerned with how this would not only be forcing students to cope with unduly heavier workloads but also increasingly raise the economic burden on families to cope with the endless cycle while enriching the tutoring companies and their investors who are keener to be reaping the fat profits off than anything else. So it has become a central part of the Chinese President’s policy directives in making sure that the education industry does not become a tool for capitalistic profit maximization at the expense of the health of China’s students and their families, and we think a great reset in this industry is entirely justified.
So, where does Baidu play a part in China’s online education? Baidu spun off Zuoyebang in 2015, and the Edtech company had continued to grow strongly and even went on to raise $1.6B in a series E+ funding late last year, and was even considering a US IPO earlier this year. Therefore, we think Baidu should be “safe” from this regulatory fallout as it continues to focus its efforts on AI, automated systems, and autonomous driving as the company’s most important growth drivers in the long term as CEO Robin Li emphasized that “the firm will eventually derive the bulk of its revenue from businesses beyond search and advertising, as it sustains record R&D investment into AI technologies.”
This is important as if investors study China’s most recent 14th FYP, one of the key strategic thrusts is to “Build China into a self-reliant technological and manufacturing powerhouse,” one in which CEO Robin Li thinks that the company has been at the forefront leading China’s innovation efforts as he clearly articulated:
[China] has never emphasized Innovation more than they do today. Right. Innovation is at the center of China’s modernization, according to the official documents and I think companies like us, we invest, you know more than 15 percent of our total revenue every year to do R&D, I think the government likes that.
We think this is highly important as staying onside with Beijing is incredibly important. As we have explained in our recent Tencent article, Beijing expects its companies to behave as good corporate citizens, serving in the best interests of the country and the CCP’s policy agendas and working towards maximizing societal benefits instead of profit maximization.
One of the key impetus behind Beijing’s interventions in the Tech sector has got to do with the increasing influence and size of its Tech behemoths such as Tencent and Alibaba and also DiDi Global, especially so when BABA and DIDI have been brazen in their approach with Beijing, demonstrating the need for Beijing to sufficiently tame these companies, to make sure they toe the line of the party.
Beijing has learned its lessons for being highly permissive in its Tech giants’ unfettered growth. It may, in some cases, have led to undesirable outcomes as these companies continue to expand, not for the betterment of the country or China’s society, but mainly to fuel their greed and decimate their smaller rivals. On this matter, CEO Robin Li succinctly explained why he thought Beijing’s Tech crackdown is good for the industry as a whole: “And in the meanwhile, I think antitrust is also good for innovation. You cannot imagine, you know, the number one [company] all of a sudden, merge and gaining more than 90 percent of market share in the US. But that happened quite a few times in China before. So that’s not good for Innovation.”
Baidu’s R&D Spending
Nevertheless, while we think the company has a huge budget for its R&D in AI and autonomous driving, we wish to remind investors that even with a much higher R&D margin, its actual R&D spend still trailed its BATs rivals by a mile. In fact, BABA outspent BIDU by almost 3x (see chart above). So while we think that Baidu’s AI leadership among Chinese companies is impressive, we don’t think the argument is so straightforward regarding the impact of the spending.
Intel (INTC) R&D metrics. Data source: S&P Capital IQ
We can elucidate a classic case in point from Intel’s R&D spending. Investors should be able to glean that while it has spent consistently close to 20% of its annual revenue in R&D in the last 5 years, we think we can reasonably argue that AMD (AMD) and Taiwan Semiconductor (TSM) have been clearly defying this R&D spending logic by outperforming INTC consistently in their technological leadership. If we look closely at INTC’s LTM R&D expenses of $19B, it’s more than twice what BABA spent and more than 6x of what BIDU spent in the recent quarter. So clearly, the size of Baidu’s spend may not necessarily improve its chances of success in AI and autonomous driving.
Despite that, we think Baidu’s relentless focus on AI for the last decade has certainly put them in a great leadership position to help lead China’s innovation around AI, which is one of the key agendas in China’s quest to achieve self-reliant technological leadership and manufacturing prowess.
It was clearly emphasized in the FYP, as indicated earlier by CEO Robin Li that
innovation remains at the heart of China’s modernization drive. The government vowed to focus on achieving major breakthroughs in core technologies, including next-generation artificial intelligence, semiconductors, cloud computing, and other key areas…The significant commitments for elevated R&D spending and plans for a reinvigorated manufacturing drive underscored Beijing’s determination to continue expanding the role of innovation as a major growth engine for the Chinese economy.
Therefore, while we think that a high R&D spend ratio may not necessarily translate to success eventually, it is still largely in line with the government’s thinking to help speed up China’s modernization drive and become a technological superpower.
Hence, we think Baidu’s leadership in AI would have a huge impact in helping China in its quest and help keep Baidu onside with the regulators. Moreover, as we shall explain in the sections below, AI and automated systems are likely to impact industries beyond automobiles and, importantly, into manufacturing. Therefore, it’s in China’s vested interests to see AI leaders like Baidu succeed over time, as long as Baidu doesn’t start buying up companies “indiscriminately” to consolidate their power, of which Baidu was quick to assure investors that the company would surely seek approval first before making any future acquisitions, in response to its recent fine by the regulators where CEO Robin Li pointed out that while they were penalized for not seeking prior approval before making the acquisition, but the penalty wasn’t for monopolistic practices.
China’s Burgeoning AI Market
China’s key policy initiatives to continue developing its AI capabilities are not new. Back in 2017, Bloomberg reported that
[China] Policymakers want to be global leaders, with the AI industry generating more than 400 billion yuan ($59 billion) of output per year by 2025, according to an announcement from the cabinet…Key development areas include AI software and hardware, intelligent robotics and vehicles, virtual reality and augmented reality…[The report also mentioned:] Artificial intelligence has become the new focus of international competition. [China] must take the initiative to firmly grasp the next stage of AI development to create a new competitive advantage, open the development of new industries and improve the protection of national security.
China AI market forecast. Data source: Intel and Deloitte
Based on research by Intel and Deloitte, China’s AI market is expected to reach 546B yuan (equivalent to about $83.9B) by 2025, from just 70.9B yuan in 2017. Importantly this exceeds Beijing’s expectations of 400B yuan by 2025, which we think would set up China nicely for global AI technological leadership.
Therefore, Baidu has certainly placed itself in pole position to leverage strongly on the AI industry’s growth momentum, which has seen amazing results so far, as Baidu emphasized in Q1’21:
AI cloud was 2.8 billion, up 55% year-over-year, and we expect our AI cloud growth rate to accelerate in the future. Our cloud growth benefited from customers from the Internet, media, financial services, and other high-tech sectors as well as from the strong adoption of Apollo smart transportation by cities seeking to modernize, digitize transportation, and network vehicles. Intelligent driving and OGI revenue also grew rapidly. Apollo Self Driving or ASD, though a small base, grew over 5x from last year.
China’s Big Tech Investments in AI. Data source: Intel and Deloitte
While Baidu is clearly the leader when it comes to the number of companies it has invested in AI, the industry remains a highly fragmented one as “there are about 5,015 AI-related enterprises in China, including 4484 growth AI enterprises, accounting for about 90% of the total.” Therefore, we think Baidu must continue to spend heavily on its R&D and invest astutely to help protect the lead it has painstakingly built over time.
The number of AI Investments by Leading Segments in 2020. Source: Intel and Deloitte
One area that we think investors often missed out on is the wide-ranging industry verticals that could benefit from Baidu’s AI technology, especially in Manufacturing and Medical, other than in Automobiles which Baidu is more popularly known for.
Baidu has already showcased many of its industrial and medical applications with “PaddlePaddle, the first open-source deep-learning platform in China,” that we think clearly demonstrated the immense potential of Baidu’s AI technology.
Investors must remember that industrial applications, especially in manufacturing, are pivotal to achieving China’s goal of transforming its manufacturing capability, and applications that can support the transformation would be highly instrumental.
The government clearly encapsulated China’s sharp focus in transforming its manufacturing prowess:
The manufacturing industry is the lifeblood of the country’s economy, and the real economy should be further strengthened and improved…China is still a third-tier manufacturing power [while] Germany and the U.S. [are] examples of first-tier manufacturing nations. China’s manufacturing output as a share of its economy has declined in recent years, slipping to just over a quarter of GDP in 2020, this has been occurring too early and too quickly.
Therefore, the opportunities for Baidu to help China transform its AI capabilities in industrial applications are immense as a recent report by renowned AI expert Kai-fu Lee summed it up clearly: “Industrial automation and intelligence will do wonders for China’s manufacturing industry. Chinese factories currently have the world’s largest industrial robots, but their intelligence level is still rather low. In the future, robots will be gradually upgraded with AI and widely used in various scenarios.”
Just early this month, Baidu gave us a treat on yet another potentially transformative development in the construction industry this time. Baidu indicated that the company “has developed an autonomous excavator system that it says could have a huge impact on the construction sector.”
Clearly, we are confident that Baidu’s AI leadership, coupled with China’s focus on achieving technological leadership through AI-led transformation, would undoubtedly benefit companies like Baidu, as long as it continues to stay onside with China’s regulatory authorities.
BIDU EV / Fwd Rev 3Y mean.
Street’s mean target price (based on Baidu’s HK listing). Source: TIKR
As the stock has dropped close to 20% (as of the time of writing) from the time we last published our previous article, we think the time has come to revisit our rating opinion on BIDU.
The stock currently trades at an EV / Fwd Rev of 2.3x, 15% below its 3Y mean of 2.68x. In addition, the Street’s mean target price gives BIDU a potential appreciation of 73%, which also values BIDU at an implied EV / Fwd Rev of 3.98x, which is about 49% above its 3Y mean.
While we think BIDU still has much to prove to justify the valuations placed upon them by the Street, we think the price has now finally fallen enough for us to be interested in taking a speculative bet on its autonomous future.
However, the only caveat is that we would be watching the price action first before pulling the trigger. This is given the stock’s poor long-term trend and potentially negative catalysts from further regulatory actions that may continue to swamp Chinese equities.
Most importantly, we want to follow the smart money and see where they would be keen to support the price to stop the rot as the price has broken down a key support level at $175 and could potentially head down to $130 as the next support level. We will be monitoring Baidu closely to place our entry.
Due to the evolving situation, we do not have any recommended buy range as the price action has not been resolved. However, readers keen to add exposure are advised to follow this article, as we would update when we observe a potential entry point subsequently.
As a result, we move our rating to Buy.
Author: JR Research, Seeking Alpha