Baidu (NASDAQ:BIDU) reported better than expected second fiscal quarter results on August 21, 2024. China’s Google benefited from modest growth in its core business, especially Baidu Cloud, but also experienced some headwinds in its core digital advertising business due to a challenging macro situation in China. Baidu is still generating a ton of free cash flow for the benefit of shareholders, and I believe the Chinese large-cap tech firm has considerable capital return potential in 2024 and beyond. Further, Baidu is very cheaply valued, which reflects on overly negative investor attitude towards the Chinese tech company, in my opinion. I don’t believe this negativity is justified, and I continue to see significant revaluation potential for Baidu’s shares.

Previous rating

I rated shares of Baidu a buy in June due to a strong earnings profile and because the tech firm maintained a potent position in the Chinese digital advertising market: Very Deep Safety Margin. I believe that Baidu is getting increasingly interesting from a valuation and capital return point of view, and I continue to see a highly favorable risk profile for investors here.

Baidu beat Q2 expectations, delivers most growth and massive free cash flows

Baidu managed to surpass both top and bottom line estimates for its second fiscal quarter on August 21, 2024. The tech firm generated $2.94 per-share in adjusted earnings on revenue of $4.75B. The EPS figure beat the consensus estimate by $0.34 per-share, while its top line beat the average prediction by $5.3M.

In total, Baidu’s Q2’24 revenues amounted to 33.9B Chinese Yuan ($4.7B), showing 8% quarter-over-quarter growth. Despite headwinds in the Baidu Core business, which includes its large digital advertising business as well as AI Cloud, the tech company managed to grow its non-GAAP operating income 12% quarter-over-quarter to 7.5B Chinese Yuan ($1.0B). The main reason why I maintain my buy rating for Baidu is that despite a challenging economic setup in China, driven by weak consumer spending, Baidu remained a deeply profitable tech enterprise, both on an operating income and free cash flow basis.

In Baidu Core, which includes online advertising and AI Cloud, online marketing revenues declined 2% year-over-year to 19.2B Chinese Yuan ($2.64B). However, weakness in online marketing was offset by strength in other revenue streams, driven by AI Cloud: non-marketing revenues increased 10% year-over-year to 7.5B Chinese Yuan ($1.03B) in Q2’24.

The real reason why investors may want to consider buying Baidu relates to the company’s strong free cash flow as well as improving capital return potential. Alibaba (BABA), another tech large-cap with considerable free cash flow, doubled down aggressively on the theme of boosting its capital returns in a low-growth Chinese economy lately: earlier this year Alibaba guided for $25B in stock buybacks and the company paid a special dividend as well.

Baidu is not doing too bad either in terms of free cash flow: the tech firm generated 6.3B Chinese Yuan ($862M) in free cash flow in the June quarter. While free cash flow dropped 21% year-over-year due to macro challenges and high operating costs, the tech company is still widely profitable: in the last quarter, Baidu generated a free cash flow margin of 19% compared to 13% in the quarter-earlier period.

Baidu is also returning a considerable amount of this free cash flow to shareholders: in Q2’25, Baidu bought back $301M worth of its own shares. The company announced a $5B stock buyback last year and currently has $3.8B in buybacks remaining.

Baidu’s valuation

Baidu remains significantly undervalued, which is an assessment that also applies to other Chinese large-cap companies, including Alibaba, in my opinion.

Baidu’s shares are currently valued at a price-to-earnings ratio, based off of FY 2025 earnings, of 7.4X, which calculates to an earnings yield of 13.5%. Alibaba is valued at a forward price-to-earnings ratio of 8.4X (implying an earnings yield of 11.9%). Alibaba just had a decent earnings report as well, and I continue to see considerable upside for shares of the e-Commerce/Cloud company.

What I like about Baidu especially is that the company owns the largest search engine in China, with a dominating market share of 52% according to Statcounter. The company is also widely free cash flow profitable and has attractive capital return potential long term. In my opinion, Baidu could revalue to its longer-term forward P/E average ratio of 14.5X if the company managed to grow its core business (online marketing and AI Cloud), remained FCF profitable and returned more cash to shareholders going forward. A 14.5X earnings multiplier implies a fair value in the neighborhood of $166 per-share.

Risks with Baidu

The biggest risks for Baidu likely relate to political and economic risks. Baidu’s tech operations are subject to regulation, and Beijing has proven its willingness to interfere in the corporate sector if it serves China’s national interests. Further, China’s economy is sluggish and growth is broadly slowing. However, Baidu is still navigating the environment well and maintained high free cash flow margins in Q2’24 which is what supports my buy rating. What would change my mind about Baidu is if the company saw a deterioration of its free cash flow margins or suffered a more serious slowdown in its Baidu Core business.

Final thoughts

All things considered, Baidu had a solid second-quarter and Baidu generated higher earnings and revenue as expected. While China’s economy has challenges with regard to consumer spending, Baidu clearly managed to deliver solid operating income and free cash flow results. With Baidu’s free cash flow margins also improving in the last quarter, I believe the tech company could afford to buy back more stock in the coming quarters as well, which would potentially represent a catalyst for shares to reverse their down-trend. Lastly, Baidu’s cheap valuation multiplier is completely inappropriate, in my opinion, considering the underlying free cash flow profitability of the firm. With a P/E ratio of only 7.4X, Baidu is even cheaper than Alibaba, which is a bargain in its own right.