Shares of Baidu (NASDAQ: BIDU) surged after its second-quarter numbers topped analysts' expectations.
In its Tuesday report, Baidu said revenue rose 1% annually to 26.3 billion RMB ($3.8 billion), or 6% after excluding divestments, beating expectations by $120 million. Its adjusted net income fell 53% to 3.64 billion RMB ($529 million), or $1.47 per ADR, but still topped expectations by $0.55.
For the third quarter, Baidu expects its revenue to decline 1% annually (at the midpoint), or rise about 2% after excluding divestments. It didn't provide any bottom-line guidance, but analysts expect a 57% drop in earnings. Baidu's headline numbers and guidance look anemic compared to its growth in previous quarters, but a deeper dive into its report reveals a few green shoots for China's top search provider.
Baidu's core advertising business is still in trouble
Baidu generated 73% of its revenue from online ads during the quarter. That business was slammed by the U.S.-China trade war, the economic slowdown in China, and competition from rival ad platforms like Tencent's (OTC: TCEHY) WeChat and ByteDance's TikTok and Toutiao.
Those headwinds -- along with soft ad spending across China's healthcare, gaming, financial services, auto, and logistics sectors -- caused Baidu's ad revenue to fall 9% annually to 19.2 billion RMB ($2.8 billion), marking a steep slowdown from its previous quarters:
Online marketing revenue
Source: Baidu quarterly reports.
On the bright side, its ad revenue rose 9% sequentially, indicating that its declines could finally be bottoming out. Moreover, Baidu's traffic acquisition costs (TAC) only accounted for 18% of its ad revenue, a percentage that remained unchanged from the first quarter.
By comparison, Baidu's top rival Sogou (NYSE: SOGO) spent over half of its ad revenue on TAC during the second quarter. Baidu isn't spending that much cash to acquire traffic because it still controls over two-thirds of China's online search market. Sogou, however, ranks a distant second with an 11% share, according to StatCounter.
Baidu's ad revenue should improve again if the trade war ends or China's economic growth improves, but investors should expect this core business to remain a dead weight on the company's top-line growth for the foreseeable future.
Expanding beyond traditional searches
Baidu still dominates traditional online searches, but it faces disruptive competition from "walled garden" challengers like Tencent's WeChat and ByteDance's news app Toutiao, both of which recently launched search engines for their apps.
To counter that disruption, Baidu is mimicking WeChat by expanding its mobile app into an ecosystem of "Smart Mini Programs" for games, payments, purchases, deliveries, ride-hailing, and other services. These programs widen Baidu's moat against Tencent, ByteDance, and other rivals by locking users into its app.
As a result, daily active users (DAUs) on Baidu's mobile app grew 27% annually to 188 million in June and topped 200 million earlier this month. In June, Baidu's in-app search queries rose 20% annually, and 270 million people use its Mini Programs every month -- up 49% over the past three months.
Baidu also stated that its DuerOS voice assistant's installed base grew 4.5 times annually to 400 million devices, while monthly voice queries surged 7.5 times to 3.6 billion. That growing platform, along with Baidu's ongoing expansion into connected cars, expands its search ecosystem beyond PCs and mobile devices.
Collecting more data from those platforms will strengthen its targeted ads, which could support the ad business' recovery when the macro headwinds finally wane.
A troubling dependence on iQiyi
Most of Baidu's revenue growth came from its video streaming platform iQiyi (NASDAQ: IQ). The platform's subscriber base grew 50% annually to 100.5 million in June, which boosted Baidu's "other revenues" (from iQiyi, its cloud business, and smart speakers) 44% annually to 7.1 billion RMB ($1.03 billion), or 27% of Baidu's total revenue.
However, Baidu's increasing dependence on iQiyi, which it spun off in an IPO last year, is troubling because the unit isn't profitable. Baidu's ongoing investments in iQiyi caused its total content costs to rise 12% annually during the quarter and account for 30% of its revenue.
Those higher expenses, along with Baidu's slower overall revenue growth, caused its adjusted operating margin to plunge from 25% a year ago to just 7%. In other words, iQiyi's growth is a double-edged sword -- it boosts Baidu's revenue and offsets the slowdown in its core ad business, but it's a dead weight on its bottom-line growth.
In a tougher position than Tencent and Alibaba
Baidu generates much more revenue from ads than Tencent or Alibaba (NYSE: BABA), and macro headwinds in China are hurting ad-dependent businesses the most.
Tencent demonstrated stable growth in gaming last quarter, while Alibaba's results revealed robust consumer spending on big-ticket items. Baidu lacks those growth engines, and it can only patiently wait for companies to boost their ad budgets again.
For now, investors should sit tight, let Baidu expand its ecosystem, and hope that it gradually reduces its spending on iQiyi. If Baidu stays focused on these goals, its growth should stabilize once the macro headwinds wane.
This article was originally published on Fool.com