Baidu Update: A.I Military Controversy Shocks Sentiment But Is Most Likely Overreaction
Investors Likely Go Bottom Fishing in Baidu after its recent rout
I previously covered Baidu in late December 2023 with the conclusion that the firm's business model in China had fundamentally strong positioning but operated in a sensitive sector.
Specifically, I used targeted language to help readers understand my thinking on the "path" of its stock price, which is an important characteristic to fully grasp on top of its "general direction".
At the same time, expectations have to be managed for how sustainable any rally will be, given that all of the business models that Baidu participates in are subject to potential government reviews and scrutiny.
Last week, market participants were jolted in another surprise event from media outlets with sources from an academic institution suggesting that Baidu's Ernie Bots had commercial links to China's military arm - the PLA.
I believe that institutional market participants may have overreacted to this headline narrative and that after Baidu provided clarity on the situation, investors may look to bottom fish the stock in the coming market sessions.
The reason that Baidu’s stock fell sharply over the previous sessions is that if such a rumor were to be true or perceived to be high-probability of being true, then U.S. regulators may begin discussions on further sanctioning and placing investor restrictions on Baidu accessing investor capital in the U.S. markets. This would result in a strong exodus of capital away from BIDU and into other assets in the market, explaining the stock's large -10% decline in both its Hang Seng Listing HK-9888 and its U.S listing BIDU.
That being said, it’s important to keep in mind that the original article from South China Morning Post referenced a university research paper which included speculation on Baidu’s involvement in connecting its A.I. models with China’s PLA forces. This research paper doesn’t have conclusive evidence that can directly prove the link between Baidu’s Ernie Bot supplying PLA A.I. beyond its public platform.
Additional constructive news that we have received is that this morning Baidu has announced an official response to the situation with the following statement from their press release:
Baidu has not engaged in any business collaboration or provided any tailored service to authors of the academic paper or any institutions with which they are affiliated. The South China Morning Post, the first media outlet that reported on this academic paper, has clarified and corrected their original media report.
The Company is committed to operating its AI related products and businesses in compliance with applicable laws and regulations and best corporate practices.
After this Baidu press release was made, according to Bloomberg, South China Morning Post "removed a reference to a physical link between Ernie and the PLA affiliate."
This development for Baidu comes at a time when sentiment on China's economy and the advertising sector is fragile. In conjunction with heightened geopolitical risks between U.S. and China over sensitive technology, traders are adopting a Sell First, Ask Questions later oriented approach.
We saw this type of knee-jerk reaction from traders with jittery sentiment in NetEase (NTES) and Tencent (TCTZF) during the new draft regulation over gaming which sent NTES and Tencent spiraling downward by 10-20% in one trading session. It is important to note that NTES and Tencent both staged strong tactical rallies immediately afterwards as uncertainty faded.
The latest slump in Baidu has brought its valuation under 10X Forward P/E even though their gross margins are expected to be on a modest positive trajectory and their EPS estimates for next fiscal year are rising.
Exhibit 1: Contracting Valuation due to geopolitical uncertainty related to Ernie Bot AI Military Ties
Data by YCharts
Exhibit 2: Yet, the company's EPS estimates are expected to rise in the next fiscal year, indicating firming up of fundamentals.
Data by YCharts
Exhibit 3: Gross Margins are also on the recovery, meaning that Baidu is set to become a more profitable business, which should curtail significant valuation de-rating.
Data by YCharts
Based on the data above where we see Baidu's valuation continually being de-rated while its forward EPS estimates and gross margins are rising, I believe that absent a delisting of the stock, the company is entering a region where a relief rally may occur on clarity over the situation. Rally may be durable or may be temporary, but the point is a recovery could come.
Baidu's Hong Kong Listing (HK-9888) now is currently at a very critical neckline and psychological level at 100/share. These levels were previously visited during corrective phases which occurred in Fall 2023, Fall 2022, and March 2022.
The next level that I believe is going to be critical will be 85-87/share, which represents a region where Baidu broke out of a steep downtrend during the 20th Party Congress event in Fall 2022 that sent the Hang Seng to 14,800 (last seen during great financial crisis in 2008-2009). For now, I view a revisit to all-time lows of 75/share to be a lower-probability event. The fundamentals do not justify a -25% haircut in equity value from here, which would put the forward P/E multiple at 7.5X.
At today's neckline of 100/share, we are now witnessing a first touch of this support region. If the stock is going to bounce, I expect a reactive bounce here and now. It may or may not be durable, but a reaction is coming. I do expect some bottom-fishing activity to take place in the coming sessions.
If a relief rally doesn't happen and we see several Daily closes beneath 100, Baidu HK-9888 could test the waters between 85-100 where consolidation takes place before a recovery back to 100 and higher.
A "look below and fail" type of sequence would be constructive for the stock.
Baidu Structure (TradingView)
In any case, the geopolitical risk surrounding the company has gone higher, raising the discount rate that investors are placing on its shares. At the same time, the low valuation is disconnected from its slowly improving fundamentals.
To me, this means over a longer time frame, I see the stock trading above its current level today. I see a rather low probability that Baidu retests all-time lows last seen in 2022.
I reiterate Hold as I believe that their business model endures this latest bout of volatility. However, that does not mean Baidu's stock -which is highly volatile- is suitable for investors who do not understand the risks with investing in China.
-Larry Cheung, CFA
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