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, Inc. : BIDU Recommendation: SELL

Angela Wang and Lily Luo

1 Investment Thesis Recommendation: Baidu, Inc. (NASDAQ: BIDU) has substantial long-term downsides in the market, therefore we recommend a sell.

Rationale: Baidu is unlikely to return to strong organic growth due to headwinds in the company's digital advertising business, a failure to effectively create content in its new in-app services, and inefficient investment in AI.

1 Advertising business slowdown

2 Uncompetitive and low-quality content on Baidu platforms

3 Inefficient investment in AI

Price Target: $103.46 11.9% downside to current price of $117.44

2 Company Overview

Company Profile Historical Stock Chart

§ Baidu, Inc. is a Chinese search company that engages Volume $310.00 60,000,000 in the provision of internet search solutions and online $290.00 marketing solutions $270.00 50,000,000 § Baidu offers an array of products such as Baidu Feed, Quanmin $250.00 $230.00 40,000,000 Karaoke App, , and Baidu $210.00 • It generates the majority of its revenue from online $190.00 30,000,000 marketing and advertising services $170.00 $150.00 § Besides the Baidu Core segment, it also operates through $130.00 20,000,000 Baidu maintains 56.6% ownership of iQiyi shares (March 2019) $110.00 $117.44 • iQiyi, Baidu’s video-streaming subsidiary, which is an $90.00 10,000,000 $70.00 online membership video platform $50.00 0 § The Company also invests in technology including artificial Jul-15 Jul-18 intelligence and autonomous driving Dec-14Mar-15 Oct-15Feb-16Jun-16Sep-16Jan-17Apr-17Aug-17Nov-1Mar-18 7 Oct-18Feb-19May-19Sep-19 2019 Revenue by Segment Revenue Breakdown ($ in millions)

$18,000 40% Other $16,000 Online Marketing 35% 27% $14,000 CAGR: 13.65% Services: $2,724 $3,971 30% advertisements on $12,000 Baidu search and iQiyi $1,462 25% $10,000 $343 $848 20% Online Marketing $8,000 $81 Services 15% Other: revenue $6,000 $11,969 $10,688 $11,474 73% generated from Baidu $9,357 $9,428 $4,000 10% Core and iQiyi $7,086 $2,000 5% $- 0% 2014 2015 2016 2017 2018 2019 Online Marketing Services Other EBITDA Margin

3 Industry Overview

Overview Market Share

§ Baidu remains the leading search engine in China 4% 3% § exited China in 2010, and unlikely to come back to Baidu China due to and rules 7% § Newly emerged search engines penetrate market quickly Haoso • Shenma: only available on mobile 15% • Toutiao: launched by ByteDance, leverage content from 71% popular TikTok video app Others § Shopping searches: support and e-commerce by searching for product information § News searches: trending information and breaking news

Revenue Outlook of Search Engines in China Key Drivers $ billion • 98% of Chinese internet users are mobile users 35. 29.1 Mobile users • Mobile devices is the main source of raw 30. 25.3 searches 25. CAGR: 14.2% 22 18.8 • Marketing is the main revenue source of search 20. 16.1 Advertising engines 15. 11.5 12.4 • Slowdown advertising business due to the trade 10. war • Quality control: select high quality content 5. Artificial 0. Intelligence • Improve user relationship management 2015 2016 2017 2018 2019* 2020* 2021*

4 1 Advertising business slowdown

Declining Search Engine Advertising Market Increase of Advertisement Inventory

Market Shares of Online Advertisements by Format in China (%) § Alibaba e-commerce advertising • Ideal platform for businesses to advertise and sell 14.5 13.5 12.2 11.3 20.2 products through and T-Mall 10.4 9.5 Other 12.6 11.4 § 13.7 ’s Ad Network Brand Display ads • Wechat, QQ, Tencent News, and Tencent Video provide 18.4 23.9 30 35.1 12.5 1bn user base New s Feed ads • Tencent Alliance Ecosystem: 75% of top apps (100,000) 28.2 31.8 31.7 E-Commerce Ads with 500mm users, give budget string as low as $150 30.3 29.2 § iQiyi: advertising business slowdown Search ads • Removed false advertisements due to government 25.4 22.7 19.5 17.1 14.9 regulations • 2016 2017 2018 2019 2020 Lower than expected demand for tech-advanced in-feed advertising platform 2 Uncompetitive and low-quality content on Baidu platforms Unfavorable Content Shrinking Dominant Power

§ Baijiahao: platform for independent writers, bloggers, and journalists to write articles and opinion Popular Baidu § No selections and no constraints Apps Before 2012 Baidu Baidu Baidu Baidu § False information and low-quality contents Map Music Knows Post Bar § Baidu search promotes Baijiahao excessively

§ Mini-programs: apps within Baidu app Public Favored § Wechat launched mini-programs earlier in 2017 Replacements § Wechat has over 1 billion monthly active users in 2019 In 2019 Google Map QQ Music § Baidu has 315 million monthly active users in 2019 Alibaba Tencent

5 3 Inefficient investment in AI

AI Long-term Investment AI Implementation in Baidu’s Core Business

§ Baidu’s AI investment is still at an early stage § Multi-mode interaction § Huge amount of expense goes into the research and development of autonomous driving, which is not a part of the Baidu DuerOS § Pilot driving monitoring core business at all smart devices § Onboard Cyber Security § Integration of AI into search engine improves user relationship § Vehicle Intelligent Program management § The return of the investment can only be seen in the long run § Optimize visual speech processing § Help customers increase productivity Baidu Cloud § Improve operational efficiency § AI-powered video editing solution § AI call center enterprise solution

AI Investment in Apollo

§ In September, Baidu launched Apollo powered pilot program, which leverages Baidu’s V2X solution that improves sensors and traffic efficiency § Unlike Google and its autonomous driving subsidiary Waymo, Baidu did not take part in designing the hardware and collecting the data during the experimental stage, causing safety problems during the test § Disclaimer of Apollo: the platform of Apollo and Baidu are not responsible for any false information, sensor problems, and safety issues § Other big motor companies will soon become Baidu’s competitors, and autonomous driving currently does not apply to people’s need

1Difference in revenue is due to rounding. 6 Possible Upside

Ecosystem of Third-party Content and Service Future Entertainment Spending

$ billion 350 Feed Content 300 Network 250 All-in-one 200 App: search, 150 watch, read 100 Smart 50 Mini 0 Program 2015 2016 2017 2018 2019 2020

Games Movies Anime Music Books iQiyi’s Investment in Original Contents Healthcare Initiatives

Number of Paid Subscribers of iQiyi (million) § in healthcare sector § Donate AI fundus screening integrated machines, 120 106 covering 56 million people at risk of eye disease 100 80.7 § Takes 10 seconds to create a screening report for the 80 user § Reshape healthcare industry with AI 60 50.8 § 40 30.2 Baidu Doctor in 2015: online medical service provider § Allows users to contact local doctors, make 20 10.7 appointments, and ask questions 0 § Conversational bot named Melody that can perform 2015 2016 2017 2018 2019 basic triage on patients in late 2016

1Difference in revenue is due to rounding. 7 Investment Analysis

Why We Bought Baidu? What Has Changed?

Dominate search engine in China with strong Losing its dominant position due to intense barriers to entry domestic competition and declining search engine advertising business

iQiyi revenue growth offset by losses due to declining advertising business and high Growth in video streaming on iQiyi platform investment in original content and premium content

Strong core business enhanced by investment Apollo has safety and function issues and does in AI not meet the need of the current market

Opportunity for initiating portfolio exposure to Tencent and Alibaba are better investment Chinese economy choices

8 Key Risks

Key Risks Mitigants

û Premium content and original content would ü The numbers of subscriber only increased by attract more subscribers in the long run 3.8% from 96.9 million to 100.5 million from Q1 to Q2 in 2019 û The implementation of AI improves users’ experience and Baidu’s user relationship ü Intense competition in the industry and the lack management of marketing make it difficult to build loyal customer base û Creating an ecosystem of third-party content and services through Baijiahao and smart mini ü Low-quality content makes people choose to use programs other alternatives for high-quality information

û The number of daily active users of Baidu app ü Gradual process of user growth turning into and smart mini programs is increasing revenue growth

û China’s first search engine company adopts in- ü Requires large investments in marketing for app app service model installation and user education

û Healthcare medical initiatives pave the way for ü Baidu was historically criticized for displaying its deployment in the AI healthcare sector and false medical advertisements and eliminated its increase brand awareness medical sector in 2017

9 Final Recommendation

Base Case Upside Case

Price Target: $103.46 Price Target: $159.6 Downside: 11.9% Upside: 35.9%

Recommendation: Baidu, Inc. (NASDAQ: BIDU) has substantial long-term downsides in the market, therefore we recommend a sell.

10 Appendix

11 Valuation – Comparable Companies Analysis

12 Valuation – WACC

WACC Calculation Capital Structure Debt-to-Total Capitalization 20.7% Equity-to-Total Capitalization 79.3%

Cost of Debt Cost of Debt 3.6% Tax Rate 20.0% After-tax Cost of Debt 2.88%

Cost of Equity Risk-free Rate(1) 3.0% Market Risk Premium(2) 6.7% Levered Beta 1.3

Cost of Equity 11.45%

WACC 9.68%

13 Valuation – DCF (Base)

14 Valuation – DCF (Base)

15 Valuation – DCF (Upside)

16 Valuation – DCF (Upside)

17