China Information Technology 14 September 2017 China Internet Primer: machine learning, deep learning and AI Powered by machine learning and deep learning, artificial intelligence looks set to be the next blockbuster technology We believe the large Internet companies have natural advantages John Choi over start-ups, as they have exclusive data and ample funding (852) 2773 8730 Reiterating Buy (1) on Alibaba and Tencent; maintaining Hold (3) on [email protected] Baidu given uncertain medium-term search ad revenue outlook Alex Liu (852) 2848 4976 [email protected] See important disclosures, including any required research certifications, beginning on page 79 China Internet: 14 September 2017 Table of contents Decoding artificial intelligence: a primer on machine learning and deep learning . 5 Executive summary .......................................................................................................... 5 AI: first forget the jargon ........................................................................................ 10 Defining learning ..............................................................................................................10 Defining machine learning ...............................................................................................11 Defining deep learning .....................................................................................................12 Deep learning: a deep dive .................................................................................... 13 A mathematical interpretation of machine learning ...........................................................13 Neural Network Learning: why does it work? ...................................................................14 Neural Network Learning 101: building a perceptron .......................................................14 The architecture of neural networks .................................................................................15 The learning process underpinning neural networks ........................................................16 Deep learning: why now? ...................................................................................... 18 Much more data, much more computing power ...............................................................18 The other side of the story: inside AI’s black box ............................................... 22 “We can build these models, but we don’t know how they work” ......................................22 Machine learning application: search and recommendation .............................. 24 In this age of information overload, machine-learning algorithms decide what information users see .....................................................................................................24 Search and recommendation: two sides of the same coin ...............................................24 Application of machine learning: speech and visual recognition ...................... 34 Speech recognition and natural language processing ......................................................34 Visual recognition: cameras and the future of AR ............................................................37 Appendix ................................................................................................................. 40 Appendix 1: company profile on AI initiatives ...................................................................40 Appendix 2: selected management discussions of AI, machine learning and deep learning .................................................................................................................47 Company Section Baidu ...............................................................................................................................55 Alibaba Group ..................................................................................................................63 Tencent Holdings .............................................................................................................69 2 China Information Technology 14 September 2017 China Internet Primer: machine learning, deep learning and AI Powered by machine learning and deep learning, artificial intelligence looks set to be the next blockbuster technology We believe the large Internet companies have natural advantages John Choi over start-ups, as they have exclusive data and ample funding (852) 2773 8730 Reiterating Buy (1) on Alibaba and Tencent; maintaining Hold (3) on [email protected] Baidu given uncertain medium-term search ad revenue outlook Alex Liu (852) 2848 4976 [email protected] What's new: We contend that, after the mobile Internet, artificial Key stock calls intelligence (AI), powered by the rapid evolution of machine learning and New Prev. deep learning (or neural network learning), is the next revolutionary Alibaba Group (BABA US) Rating Buy Buy technology. As we believe that discussions of AI tend to be long on jargon/ Target 200.00 205.00 short on substance, our aim with this report is to take a deep dive into Upside p 11.8% machine learning and deep learning, covering the theory behind deep Tencent Holdings (700 HK) learning algorithms and the real-world applications for machine learning. Rating Buy Buy Also, we include case studies showing how China’s Internet giants are Target 370.00 360.00 incorporating AI/machine learning into their core products. Upside p 10.8% Baidu (BIDU US) Rating Hold Hold What's the impact: AI: it is here, almost unnoticed. Many investors may Target 215.00 195.00 not realise that machine learning and deep learning already serve as the Downside q 9.1% guiding hand in the Internet services they use daily. From search engines Source: Daiwa forecasts to content recommendations, Internet companies are folding machine- learning technology into their services with the aim of improving information discovery and monetisation efficiency. Proprietary data and disruptive business models: crucial to long-term success. We see proprietary data becoming the moat to defend against competition in the AI era, since it gives the owner exclusive insight into users’ behaviour and hence an opportunity to provide a superior experience. We believe the proliferation of machine learning will give rise to new disruptive economic models. Compared with their global peers, the China Internet players have more comprehensive proprietary data to hand, which we think will allow them to make the most of the emerging business opportunities. What we recommend: In our view, the Internet giants have natural capital and data advantages over start-ups in researching and deploying machine learning to their product lines. We see Baidu (BIDU US, USD236.41, Hold [3]) as the pioneer in AI investment and research in China. Although visibility on commercialisation of Baidu’s autonomous driving project is limited, we expect the initiative to significantly expand Baidu’s addressable market. Meanwhile, we contend that Alibaba (BABA US, USD178.97, Buy [1]) AI status is not fully appreciated, as it has been quietly folding machine learning into such products as the mobile Taobao app and Xiami music. Also, we think its cloud leadership will give it a cost advantage in AI training. Finally, Tencent (700 HK, HKD334.00, Buy [1]) looks to be raising its AI game, and its vast set of user data, allied with machine learning, should greatly enhance its ability to monetise online ads and digital payments, in our view. In this report, we revise our 12-month TPs for all 3 of China’s Internet giants. How we differ: We are more positive than the market on how machine learning will enhance the efficiency of Internet monetisation models. See important disclosures, including any required research certifications, beginning on page 79 China Internet: 14 September 2017 Sector stocks: key indicators EPS (local curr.) Share Rating Target price (local curr.) FY1 FY2 Company Name Stock code Price New Prev. New Prev. % chg New Prev. % chg New Prev. % chg Alibaba Group BABA US 178.97 Buy Buy 200.00 205.00 (2.4%) 31.822 32.899 (3.3%) 41.797 42.640 (2.0%) Baidu BIDU US 236.41 Hold Hold 215.00 195.00 10.3% 45.569 43.853 3.9% 51.415 49.651 3.6% Ctrip.com International CTRP US 52.99 Outperform Outperform 55.00 55.00 0.0% 5.644 5.644 0.0% 9.776 9.776 0.0% JD.com JD US 45.27 Buy Buy 60.00 60.00 0.0% 3.676 3.676 0.0% 7.459 7.459 0.0% NetEase NTES US 270.27 Outperform Outperform 330.00 330.00 0.0% 105.617 105.617 0.0% 123.663 123.663 0.0% Tencent Holdings 700 HK 334.00 Buy Buy 370.00 360.00 2.8% 6.651 6.478 2.7% 9.736 9.499 2.5% Vipshop VIPS US 9.89 Hold Hold 10.00 10.00 0.0% 5.078 5.078 0.0% 5.819 5.819 0.0% Source: Bloomberg, Daiwa forecasts China Internet: comparable valuations Market Market price cap PER (x) P/S (x) EV/EBITDA (x) ROE % Ticker Short Name Ratings (local curr') (USDm) FY1E FY2E FY3E FY1E FY2E FY3E FY1E FY2E FY3E FY1E China Internet 700 HK Equity TENCENT* Buy 334.00 402,011 42.0 28.7 22.8 11.7 7.6 5.7 23.4 19.4 14.5 31.1 BIDU US Equity BAIDU INC-SP ADR* Hold 236.41 82,815 33.9 30.0 21.7 6.6 5.3 4.4 26.8 21.6 14.3 15.3 NTES US Equity NETEASE INC-ADR* Outperform 270.27 35,603 16.7 14.3 12.3 4.6 3.5 2.9 11.5 9.0 7.2 32.1 CTRP US Equity CTRIP.COM-ADR* Outperform 52.99 27,785 61.3 35.4 23.5 7.1 5.5 4.7 34.7 22.0 14.3 5.0 WB US Equity WEIBO CORP-ADR Non-rated 106.10 23,198 66.9 42.1 29.9 17.9 14.8 10.2 55.2 34.2 23.7 24.9 SINA US Equity SINA CORP Non-rated 117.08 8,362 42.2 30.8 23.2 5.1 4.3 3.2 15.4 10.1 6.6 8.9 YY US Equity