by Chaim Siegel of Elazar Advisors, LLC
Earnings drive stocks. For now Baidu Inc (NASDAQ:BIDU), the Chinese internet search service, is reallocating focus away from their profit driving businesses and increasing expenses elsewhere. Because of that we don’t expect to see much earnings growth in the near term even though the Street does. For that reason we’re on the sidelines.
Long Term Patience Required To Hold The Shares
During its last earnings call on April 27, Baidu made multiple comments about artificial intelligence (AI) being their new focus, but stressed that it was a “long term proposition.” We think they are telling us not to expect strong earnings in the near-term.
The Street, however, is expecting big earnings growth in the back half and we think there are a few reasons upcoming earnings may not meet their forecasts.
AI Shift From Mobile
Baidu had been investing in their core search business. That core business was driving their revenues and profits. Now, however, they are shifting investment to AI. AI does not have the near-term profit payback their core business does.
Below, the shift in spending from their core business (SG&A) to their new business (R&D).
The company is making a massive shift to AI, represented by that R&D line. You can see the growth rate of R&D increasing over the last four quarters. The combination of SGA decreasing (which includes advertising driving core search profits) and R&D expenses (which drive revenues down the road) has a negative impact on current profits. Lower revenues and more expenses will likely drag profits.
The timing of payback on AI is unknown. Baidu sees an opportunity that sometime in the future people will be searching based on voice and searching will become more intuitive using AI.
Because Baidu is shifting investment from near-term profit drivers to long-term profit drivers, it’s fair to assume that profit opportunities get pushed out, hurting near-term results.
Investment In Video
Baidu also sees a big opportunity in video. Video is a huge opportunity for any company that has huge traffic because video drives subscriptions and keeps people online. Baidu is investing here too.
With a Netflix (NASDAQ:NFLX) partnership newly inked in April, this spending could increase further.
Here’s their spending on content so far, which shows up in their cost-of-revenues line, which hits gross margins.
Content costs have been growing by strong double—even triple—digits. There is a risk to earnings if content growth re-accelerates with the Netflix deal.
Revenues May Not Be Enough
As the year-ago revenue growth rates slow each quarter, this year’s revenues get easier, lapping smaller growth numbers. Still, it may not be enough because expenses are growing much faster. That should drag on the bottom line earnings performance.
And when you think about Baidu reducing investment on their core revenue drivers it takes the wind out of the upside in revenues.
Earnings Risk
When running through the model (and even being more conservative by not assuming video and R&D expenses accelerate) we show there is risk to earnings in the back half versus the Street's numbers. For that reason we are on the sidelines.
The combination of revenues running slower than expenses, namely R&D and content spending, causes risk to earnings growth.
We aren’t saying our numbers are spot-on, but directionally there appears to be downside to Street numbers.
Baidu's Chart
Baidu's chart looks like it wants to start moving higher with a potential breakout. We're OK with letting this one go until we get into the back half of this year. We'd either want to see Street numbers come down or more clarity that AI can drive Baidu earnings sooner before we get excited about BIDU's chart.
Conclusion
Baidu has a huge opportunity in China but investors this year may have to face a ramp-up in expenses. That could drag earnings. We wouldn’t want to short Baidu despite the earnings risk this year because the opportunity is huge and their positioning is strong. But the earnings risk to Street numbers could force investors to need patience. This keeps us on the sidelines.
Disclaimer: Securities reported by Elazar Advisors, LLC are guided by our daily, weekly and monthly methodologies. We have a daily overlay which changes more frequently which is reported to our premium members and could differ from the above report.
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