Baidu Inc:Buy,Dual engines of revenue growth and margin expansion

Return to growth. Baidu has been a controversial stock over the past 15 months onconcerns over growth and spending. As we enter 4Q17 and into 2018, Baidu, in ourview, has a dual tailwind of revenue acceleration and margin expansion. Whileinvestors have started to revisit the investment case, we see further upside to the stock.

    Near-term, we point to 1) anniversary of new regulations that impacted revenue in2Q16 2) new revenue from AI-driven products, notably, news feed 3) lower marketingcosts due to the de-emphasis of O2O (offline to online Nuomi group-buying andTakeout Delivery). In addition, iQiyi video continues to grow rapidly, with improvingmargins. Further, we view new management as agents of change with a strategy todrive growth in the long term. Group COO Qi Lu is keenly focused on growth in coresearch users and usage, synergies with iQiyi, and disruptive technologies such asautonomous driving AI, cloud, DuerOS, and financial services. New CFO Herman Yuwill focus on operating efficiency. After reporting 6% growth in revenue in 2016, Baidushould re-rate based on improving revenue and earnings growth. All-in, we expectrevenue to grow by 25/33% and adjusted OPM to increase from 21/24% in2017e/2018e, respectively.

    Opportunities in news feed and iQiyi video. Baidu’s news feed product has beengaining momentum. According to Quest Mobile, monthly active users (MAU) formobile Baidu grew 18% y-o-y to 423m in August and daily time spent per user grew53% y-o-y to 43 minutes. It expects news feed to be a meaningful and material newgrowth opportunity, through brand advertising (complementary to search, which ismostly an SME product). We expect RMB5bn in revenue from news feed this yearand RMB17bn in 2018. Separately, we note that iQiyi has been reported as exploringan IPO valued at USD8bn (Bloomberg 26 September 2017), which would representUSD23/share in value. iQiyi is evolving towards a Netflix-type model in China interms of in-house content and a paying subscribers business model.

    Raise TP to USD282 from USD245 and maintain Buy. We continue to use PEG tovalue Baidu but raise our target PEG from 1.0 to its 5-year historical trend of 1.15. Inour view, this is justified because the company is entering a period of higher earningsgrowth driven by accelerating revenues and margin expansion. In particular, whileadjusted EPS declined 62% in 2016, we expect it to grow 35% in 2017e and 52% in2018e. We are 11/32% above consensus for 2017/2018 EPS estimates. Specifically,we apply a 1.15x target PE to our 2017-20e expected EPS CAGR of 33% to our2017e adjusted EPS of USD7.48. This approach yields a target price of USD282,implying a PE of 25x for 2018 and 19x for 2019. The key downside risks centre oncompetition, technology change and regulation.