Baidu Stock Downgraded After Once-in-a-Decade Loss

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Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Shares of Chinese internet specialist Baidu (NASDAQ: BIDU) -- the "Google of China" -- are in free fall, and today's downgrades aren't going to help matters much.

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Yesterday after close of trading, Baidu announced its financial results for Q1 2019. Although earnings ($0.41 per share, pro forma) and sales ($3.59 billion) were in line with analyst estimates, investors are reacting with horror to the slowdown in sales growth, the fact that GAAP results showed a loss for the quarter, and some very disturbing commentary from management regarding future prospects.

Here's what you need to know.

Baidu by the numbers

Reporting results mostly in Chinese yuan (renminbi), but with some figures also provided in U.S. dollars, Baidu said its sales grew only 15% year over year in Q1, being depressed somewhat by the absence of revenue from divested businesses. Worse than that, the company reported its first quarterly loss in nearly 15 years -- $0.15 per American depositary share, when calculated according to GAAP.

But that's just the start of the bad news.

Baidu provides context

Baidu's first reported loss since 2005 was bad enough, but the company's explanation for it was also pretty weak. Management blamed losses attributable to its iQiyi streaming video subsidiary for much of the loss, but also its "investment in CCTV's Chinese New Year Eve Gala marketing campaign."

As management explained, after the Chinese New Year, Baidu "released" a "significant" amount of ad inventory into the market, depressing prices calculated in terms of "cost per thousand impressions" (CPM), such that ad rates did not "rebound" as they usually do.

Even more disturbingly, management warned that "the impact of macro environment" (i.e., Trump's trade war with China, which is adding to domestic headwinds) is starting to hurt results. "Tighter government scrutiny on content, cutbacks from the VC community and so forth" are all adding up to create "a more challenging environment" for Baidu going forward, warned CEO Robin Li. And as a result, "online marketing revenues" -- the bulk of Baidu's business at $2.6 billion in the quarter -- grew a bare 3% year over year, even as research and development costs increased 26%, and selling, general, and administrative costs for the company as a whole nearly doubled, rising 93%.

What it means for investors

And even then, the bad news wasn't over. In the context of all the above, Baidu warned investors that in Q2 2019, they should expect to see little or no sales growth, predicting revenue ranging from $3.7 billion to $4 billion. At the high end of that range, total revenue will grow only 2% this quarter, while at the low end, revenue could fall as much as 3%.

And profits? Baidu said not a word about profits -- which is ominous in and of itself.

And last but not least: The downgrades

Suffice it to say that these are not the kinds of numbers investors were looking for from the biggest online search engine in the supposedly "growth" market of China -- nor the kinds of numbers they've been trained to expect from Baidu, which has averaged nearly 25% annual revenue growth over the past five years, according to data from S&P Global Market Intelligence, and has been consistently profitable.

Responding to this bad news, this morning Deutsche Bank downgraded Baidu stock from buy to hold and cut its price target to $147 a share. Previously considered "a relatively defensive name," Deutsche says the company's latest outlook appears "overarching bearish," and warned that "the oversupplied digital media space is exacting a much more severe toll on Baidu than we had thought," resulting in "no top-line growth expected for Baidu Core for several quarters" -- and a "sharp drop in profits" to boot.

The rest of Wall Street was quick to follow suit, with CLSA and Daiwa Securities adding downgrades of their own, as reported by StreetInsider.com (subscription required), and better-known analysts at Benchmark, Citigroup, and KeyBank all cutting their price targets.

Consensus earnings projections now see Baidu's profits sinking by more than 60% this year before resuming growth in 2020, not returning to 2018 levels of profitability before 2022 at the earliest -- and growing at barely 10% on average over the next five years.

Even with Baidu stock selling for an historically low multiple of less than 15 times earnings (it has averaged a trailing P/E of closer to 29 over the last five years), 10% growth may be too slow to justify the company's current valuation. Much as I hate to say it, Deutsche Bank (and everybody else) may be right to take a pass on Baidu stock right now.

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Rich Smith owns shares of Baidu. The Motley Fool owns shares of and recommends Baidu. The Motley Fool recommends IQ. The Motley Fool has a disclosure policy.