Inside Baidu's Horrible Quarter

Online search giant Baidu (NASDAQ: BIDU) has long been considered one of the top three tech giants in China, along with Alibaba (NYSE: BABA), and Tencent (NASDAQOTH: TCEHY). However, in the recently reported quarter, Baidu's results diverged from the other two in a big way, and in the wrong direction. Alibaba recently reported robust top-line growth, though with a decline in profitability. Tencent's growth hit an all-time low, but its profit margins held up rather well. On the other hand, Baidu's revenue growth was worse than either rival's, and its profitability was even worse than that.

Baidu has long been considered the Google of China, with a core search business that generates profits to make further bets on the cloud, self-driving cars, AI, media, and healthcare. However, Baidu's results are diverging not only from its Chinese rivals, but also from its healthier American counterpart.

A plunge in profits

For the quarter, Baidu grew revenue 15%, but 21% when one factors in divestitures such as the partial IPO of streaming service iQiyi (NASDAQ: IQ). That revenue growth was in line with expectations; however, non-GAAP (generally accepted accounting principles) EPS of $0.41 missed analysts' expectations significantly as the company's spending went through the roof, even in a slow quarter. Costs of revenues surged 50%; selling, general, and administrative costs grew 94%; and research and development costs rose 26%.

One culprit was aggressive investment in iQiyi's streaming video content investments; however, more concerning was the fact that Baidu's core business, often thought to be a safe haven of profitability, deteriorated in the first quarter, and looks likely to do so again in the current quarter.

Management pointed to a big surge in marketing around its CCTV New Year Eve Gala, calling the campaign "successful" in that it caused a 28% increase in daily active users to Baidu's family of apps. However, the increase in traffic did not lead to a similar increase in revenue. Baidu's cost-per-click for ads plummeted as the online advertising inventory in China became oversupplied. That led to Baidu's core business growing only 16%, ex-divestitures.

But the story gets worse, as management guided to only 1%-6% growth (ex-divestiture) in the current quarter. In addition, the Baidu "core" is set to grow anywhere from negative 2% to positive 4%. That is certainly not what one expects to see out of the leading search engine in one of the world's highest-growth economies, and after a quarter of heavy marketing no less.

You're no Google

The trend in Baidu's business is especially troubling when you compare it with its American counterpart. Google parent Alphabet also showed decelerating revenue last quarter, but when one factors out currency, the decline was fairly tame, going from 23% a year ago to 19% last quarter. Alphabet's EBITDA margins are a robust 29.7%, even after its investing in lower-margin growth seeds like cloud, hardware, and "other bets." Yet Baidu's EBITDA margins plunged to just 7% last quarter, with "Baidu core" coming in at 19%. Baidu even had negative free cash flow in the quarter of RMB 1.5 billion ($226 million).

Baidu is investing in a lot of new technologies, such as DuerOS smart speakers, Apollo self-driving car technology, cloud computing, and of course lots of video content for iQiyi; however, these are all new ventures, and it's basically impossible to tell what the ultimate margins are for these products, or even if Baidu will be the winner in the end.

Investors were likely counting on core Baidu to achieve economics like Google, but it seems that there may be a divergence between the dominant worldwide search engine and the dominant search engine in China. Chinese advertisers could be moving toward WeChat ads or advertising directly on the country's e-commerce platforms, with search not as competitive there as it is in the U.S. With only so much advertising spend to go around in a slowing Chinese economy, investors may have to think about Baidu's real economics.

Executive resignation is the cherry on top

As a final negative, Baidu also announced the resignation of Hailong Xiang, senior vice president of the search business, who was a 14-year veteran of the company. While management said that his departure was due to personal reasons, it's yet another element of uncertainty, and the struggling core business will now be under a new leader.

It was obviously a very disappointing result for Baidu investors, who have seen the stock plunge nearly 50% over the past 12 months. Based on the current outlook and the lingering U.S.-China trade war, I wouldn't expect the stock to rebound anytime soon.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Billy Duberstein owns shares of Alibaba Group Holding Ltd. and Alphabet (C shares). His clients may own shares of the companies mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Baidu, and Tencent Holdings. The Motley Fool recommends iQiyi. The Motley Fool has a disclosure policy.