UNITED STATES Baidu BIDU US Outperform Making progress on AI Price (at 20:50, 18 Oct 2017 GMT) US$270.32 Valuation US$ 305.00 Conclusion - Sum of Parts 12-month target US$ 305.00 . Baidu will report 3Q17 results on October 27 (HKT). We expect strong 12-month TSR % +12.8 revenue and earnings growth of 29% and 119% YoY, respectively. Looking GICS sector Software & ahead, deconsolidation of the O2O business should help lift margins from Services 4Q17 onwards. We believe Baidu’s AI strategy is on track and it aims to start Market cap US$m 95,014 mass producing self-driving buses in 2018. We reiterate Baidu as our top pick 30-day avg turnover US$m 551.2 in the China internet space and are maintaining our TP of US$305. Our Number shares on issue m 351.5 SOTP-based valuation includes 1) US$231 per share for Baidu’s core search Investment fundamentals business, based on a 18x FY18e PE; 2) US$18 per share for iQiyi based on Year end 31 Dec 2016A 2017E 2018E 2019E 2x FY18e EV/sales; 3) the rest (Didi, Eleme, Ctrip, cash, etc.) at US$56 per Revenue bn 70.5 85.3 102.4 116.6 share. We have not included AI into our valuation but the current encouraging EBIT bn 10.0 16.2 21.6 28.8 Reported profit bn 11.6 15.5 20.8 26.3 progress provides upside to our current valuation. Adjusted profit bn 13.4 18.6 24.3 30.2 Gross cashflow bn 21.7 25.7 31.6 30.2 Impact CFPS Rmb 62.50 73.62 90.31 86.01 CFPS growth % 15.0 17.8 22.7 -4.8 PGCFPS x 28.5 24.2 19.7 20.7 . 3Q17 bottom line supported by rejuvenated core business. We expect EPS adj Rmb 38.52 53.37 69.52 86.00 Baidu to report strong revenue growth of 29% YoY to Rmb23.5bn in 3Q, in- EPS adj growth % 2.4 38.6 30.3 23.7 PER adj x 46.3 33.4 25.6 20.7 line with consensus. We expect 3Q17 non-GAAP EPS to soar 119% YoY to Total DPS Rmb 0.00 0.00 0.00 0.00 Rmb14.16 per share, 7.5% ahead of consensus, driven by a recovery in Total div yield % 0.0 0.0 0.0 0.0 ROA % 7.2 9.4 10.5 12.5 search and strong news feed monetization. We expect the core search ROE % 14.7 17.6 19.5 20.2 business (including news feed) to grow 21% YoY in 3Q17, accelerating from EV/EBITDA x 28.9 23.0 18.7 18.9 Net debt/equity % -50.8 -76.8 -80.7 -83.3 11% YoY in 2Q17, due to a higher click-through rate on the search engine. P/BV x 6.3 5.4 4.6 3.9 . Deconsolidate food delivery in 4Q17. Looking into 4Q17, Baidu will BIDU US vs S&P 500, & rec history deconsolidate food delivery and book an investment gain. We reduce our 4Q17 revenue forecast by 2.9% on the spin-off. In 1H17, the margin drag from the food delivery business was 1-2ppts. We estimate the spinoff to save Rmb200-400m opex per quarter for Baidu. Net net, we increase our 4Q17E adjusted non-GAAP EPS by 2.6%. We expected non-GAAP OP margin to recover from 18% in 2016 to 24% in 2017, 26% in 2018 and 30% in 2019. The first mass-produced AI product will come as early as 2018. On Sept 21, Baidu released Apollo 1.5 only two months after the launch of Apollo 1.0. Baidu has partnered with King Long to develop a mass-produced autonomous Note: Recommendation timeline - if not a continuous line, then there was no Macquarie coverage at the time or there was an embargo period. bus in 2018. It has also teamed up with BAIC for self-driving vehicles and Source: FactSet, Macquarie Research, October 2017 targets to produce vehicles with L3 and L4 autonomous features by 2019 and (all figures in Rmb unless noted, TP in USD) 2021, respectively. For DuerOS, Baidu and TCL co-released DuerOS-enabled smart TV in September. In our view, the improving visibility for AI products DuerOS and Apollo will bring in revenue contribution from 2019 onwards and provide upside to its long-term valuation. Earnings and target price revision Analyst(s) Wendy Huang, CFA . We raise our FY17E non-GAAP EPS by 0.8% to reflect margin recovery after +852 3922 3378 [email protected] deconsolidation of the O2O business and keep FY18/19 earnings unchanged. Frank Chen +852 3922 1433 [email protected] Marcus Yang Price catalyst +86 21 24129087 [email protected] Ivy Luo . 12-month price target: US$305.00 based on a Sum of Parts methodology. +852 3922 1507 [email protected] . Catalyst: News feed monetization, AI product commercialization. 19 October 2017 Macquarie Capital Limited Action and recommendation . Reiterate Baidu as our top pick in the internet space. Please refer to page 9 for important disclosures and analyst certification, or on our website www.macquarie.com/research/disclosures. Macquarie Research Baidu 3Q17 results preview . Solid top line and bottom-line growth supported by rejuvenated core business. We estimate Baidu’s 3Q17 revenues at Rmb23,543m, up 29.0% YoY, in-line with the street and in the middle of management’s guided growth range of Rmb23,130-23,750m. We expect non-GAAP EPS to soar 119% YoY to Rmb14.16 per share (vs. 91% YoY growth in 2Q), 7.5% ahead of consensus, driven by a recovery in search and strong news feed monetization. Dial-in detail. Baidu's management will hold an earnings conference call at 8:00 PM on October 26, 2017, U.S. Eastern Time (8:00 AM on October 27, 2017, Beijing/Hong Kong Time). Call-in numbers: 4006208038 (China), +1 8456750437 (US), +852 30186771 (HK), +44 2036214779 (UK); Passcode: 98359218. Fig 1 3Q17 result preview 3Q17 Rmb mn 3Q16 2Q17 3Q17E YoY QoQ Consensus vs consensus Guidance Revenue 18,253 20,874 23,543 29.0% 12.8% 23,456 0.4% RMB 23.13 to 23.75bn Gross profit 9,025 10,340 11,612 28.7% 12.3% Gross margin (%) 49.4% 49.5% 49.3% (12 bps) (21 bps) 47.5% 179 bps S&M -3,479 -2,698 -2,825 -18.8% 4.7% R&D -2,341 -2,636 -2,973 27.0% 12.8% Operating profit 2,787 4,210 4,998 79.3% 18.7% 4,134 20.9% Operating profit margin (%) 15.3% 20.2% 21.2% 596 bps 106 bps 17.6% 360 bps Non-gaap operating profit 3,205 5,006 5,814 81.4% 16.1% Non-gaap operating margin (%) 17.6% 24.0% 24.7% 713 bps 71 bps Net profit 3,102 4,415 4,321 39.3% -2.1% 3,768 14.7% Non-gaap net profit 2,248 4,568 4,937 119.6% 8.1% 4,440 11.2% Non-gaap EPADS 6.47 13.12 14.16 119.0% 8.0% 13.17 7.5% Operating metrics No. of advertisers ('000) 524 470 484 -7.6% 3.0% ARPU per quarter (RMB) 31,470 38,049 42,146 33.9% 10.8% Source: Company data, Bloomberg, Macquarie Research, October 2017 Solid progress on AI strategy . After the announcement of the spinoff of the cash-burning O2O business in August, we believe Baidu will fully focus on AI and we see that is has made meaningful progress on its AI strategy recently, especially in the autonomous vehicle space. Mass-produce self-driving bus in 2018. Baidu cooperated with King Long Automotive, a Chinese bus manufacturer, to jointly develop driverless bus. Baidu aims to start trial operations in July 2018 and targets to mass produce autonomous bus on a small scale in 2018. Launch vehicles with L3 features by 2019. In partnership with BAIC group, a Chinese automaker and Baidu Apollo, the project’s major partner, Baidu plans to produce vehicles with Level 3 autonomous features by 2019 and move on to fully self-driving Level 4 cars by 2021. The two also estimate that by 2019, more than 1 million of BAIC’s vehicles carry Baidu’s Apollo. Released Apollo 1.5. Baidu unveiled Apollo 1.5, the latest generation of its autonomous driving platform only two months after the launch of Apollo 1.0 in July. Baidu’s Apollo project now has over 70 partners up from 50 in July. In addition, Baidu also launched Rmb10bn “Apollo Fund” to invest 100 self-driving projects in the next three years. For DuerOS and intelligent voice-controlled products, Baidu and FIIL introduced smart headphone based on DuerOS in Sept. In addition, Baidu and TCL co-released DuerOS-enabled smart TV recently while Baidu partnered with Haier and Midea on smart voice-controlled refrigerator supported by DuerOS. We have not included AI into our valuation. However, the improving visibility and encouraging progress on AI products DuerOS and Apollo will bring in revenue contribution from 2019 onwards and provide upside to its long-term valuation, in our view. 19 October 2017 2 Macquarie Research Baidu Traffic checks . iQiqyi leads China’s mobile video market. iQiyi’s mobile user traffic is on par with Tencent Video since Aug 2016 and surpasses YoukuTudou by a wide margin.