We maintain our fair value estimates of US$ 183 and HK$ 180 for Baidu after its second-quarter revenue was 7% better than our estimates, but offset by sequential operating margin decline due to greater sales and marketing expenses. The company indicated that core advertising revenue remained resilient, given its 15% year-on-year growth, and should continue to recover in the third quarter, but we estimate that its growth is likely to slow down to 8%-9%. We also forecast cloud growth to be about 9% in second-half 2023 rather than double digits, and that contribution from artificial intelligence-related cloud revenue is still limited. The operating margin decline was due to a 32% year-on-year increase in sales and marketing expenses due to greater promotional costs, but also from margin dilution of the cloud business, as its revenue only grew 5% year on year and recovery has been slower than expected. Furthermore, Baidu is awaiting the licenses for its generative AI products and their commercialization will take time to fully scale, and thus we also expected margin dilution from the increased research and development expenses until they become widely launched. Despite the mixed results this quarter, we still like Baidu as a long-term position as its AI technology, which is a part of its core competency, remains a long-term growth driver and should result in eventual operating margin expansion.
We reiterate our view that Baidu maintains a market-leading position in both generative AI and search-based advertising and should capitalize on both industries. Baidu still has a first-mover advantage in its full-stack AI development and is planning to integrate Ernie with its existing services, which should complement its cloud and advertising revenue in the long run. We also expect margin dilution to gradually subside, as the operating margin for cloud should gradually ramp up to its long-term steady state of 20%, similar to advertising margins.
