Baidu Inc:Buy,Strengthening mobile position with AI on the horizon

Baidu Inc:Buy,Strengthening mobile position with AI on the horizon

Speeding up innovation. Baidu, in our view, is entering a new phase of
rapidinnovation in core search and AI. For example, by combining search
and feed, it isenhancing the user experience, leading to more
engagements, clicks and capturingmore advertising budgets. 100m users
consume its feed content daily, versus 83m inApril, the highest in
China. Feed, and a meaningful improvement in conversion rates,drove
double-digit growth in paid clicks. AI is also developing at a furious
pace, withBaidu’s voice assistant OS (Duer) partnered with 100 branded
consumer appliancemanufacturers. Voice will be the new query input
method and Baidu will monetizeservices and content similar to search
advertising. Project Apollo, open platform forautonomous driving, has
the biggest ecosystem in the world, with 50 partners,including13 OEMS
(amongst them, Ford and Daimler). Baidu Brain is an openplatform to
drive rapid adoption but Baidu will monetize high-value services such
asHD map, navigation and security. Baidu Cloud should differentiate with
“AI as aservice” solutions. In short, after a challenging 2016,
management is delivering fasterinnovation, accelerating revenue growth
and material margin expansion. For 3Q, itexpects revenue to grow 27% to
30% y-o-y, 29% to 33%, excluding the sale of itsmobile game unit.
Consensus was 25% growth.

    Very strong margins drive 53% growth in operating profits. 2Q
revenue grew23.6% to RMB20.9bn, in-line with expectations. Online
marketing revenue grew 5.6%y-o-y and 21.3% q-o-q due to growth in paid
clicks and 20k net customer adds versus2Q. Feed revenue doubled from 2Q.
The key surprise was OPM, which increased600bps y-o-y to 24%. Content
costs grew 83.2% y-o-y, due to iQiyi video, but SGAdeclined 30.1% y-o-y.
We note that iQiyi had an industry-leading 146m DAUS whowatched 383bn
minutes in June. Its 30m paying subscribers also tops its competitors.

    EPS was RMB16 v. consensus of RMB10, helped by margins and a lower
tax base.

    Estimate changes. We raise revenue due to search and feed, and
increase marginsto reflect lower SGA. We raise our 2017/2018 revenue by
0/3 % and EPS by 14/12%.

    We now expect total revenue to grow 24.7/32.6% yoy for 2017/2018. We
now expectOPM of 18/21% for 2017/2018.

    Maintain Buy and raise our PEG-based TP to USD245 from USD223. Baidu
hasbeen our most controversial call but we expect the market to begin to
recogniseimproving operating momentum on revenue and margins, and
attractive valuation.

    Baidu’s search experience is improving, helped by feed, iQiyi is
growing rapidly, witha line of sight to break-even, and the AI business
models are coming into focus. OurTP implies a PE of 22x for 2018e.