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China's tech heavyweights are spearheading the national AI revolution with staunch government backing.
By Vikram Barhat | 09/05/18

As reported in the New York Times, a key element of the ongoing trade spat between a belligerent U.S. and a defiant China is the Trump administration's demand that the Chinese government put the skids on its US$300-billion push into advanced technology, including artificial intelligence (AI). The Asian economic powerhouse has launched a bold bid to surpass America to become the global leader in AI by 2030.

About the Author
Vikram Barhat is a Toronto-based financial writer specializing in investing, personal finance and small business. His experience working in various editorial capacities in digital and print media spans more than a decade across three continents. He has written for CNBC, BBC, The Globe and Mail, the Toronto Star and other publications. He can be reached on Twitter @vikrambarhath.

While the U.S. currently leads the race, China is fast closing the gap. Beijing's audacious vision for AI dominance, is backed by massive infrastructure spending, which includes building a US$5-billion AI fund and the creation of a US$2.1 billion technology park to spur AI innovation. Money has started flooding into China's thriving start-up industry. The country's AI-focused businesses have attracted a whopping US$4.5 billion between 2012 and 2017, according to a whitepaper produced by Chinese venture capital firm Sinovation Venture.

China's tech heavyweights Baidu, Alibaba and Tencent are spearheading the national AI revolution with staunch government backing. Factors like large amounts of raw data (used to train AI systems), lax regulation, favourable government policies and a population eager to adopt new technologies coalesce to make China a serious contender for the top spot.

These tech leaders are well positioned to be the biggest beneficiaries of China's push for global AI supremacy. Currently trading at a sizeable discount to their Morningstar fair value estimates, these names represent attractive buying opportunities for long-term investors, according to Morningstar equity research.

 

Baidu Inc. ADR
Ticker:BIDU
Current yield:-
Forward P/E:26.1
Price:US$251.22
Fair value:US$322
Value:22% discount
Data as of May 3, 2018

The largest internet search engine in China,  Baidu (BIDU) holds a more than 70% share of mobile traffic in the search market. The technology-driven firm, which generates 86% of revenue from online marketing services, has been investing in AI technology such as autonomous cars.

Baidu is going toe to toe with Google in the autonomous vehicles market, backed by its AI-powered self-driving software, Apollo. Much of Baidu's strong fourth-quarter revenue growth was boosted by mobile and artificial intelligence, which led CEO Robin Li to say the company has "built strong momentum by adopting AI-first in our mobile businesses and investing in new AI businesses."

Baidu is an early mover in the AI-related market and has been actively investing in AI-focused business including cloud computing, voice and image recognition, and autonomously driven cars, says a Morningstar equity report. "It has been evolving from a mobile-first to an artificial-intelligence-first company," says the report, cautioning that the technology leader's near-term margins could be pressured due to aggressive content spending and talent acquisition costs for AI personnel.

Morningstar equity analyst Chelsey Tam says a Baidu breakthrough in AI-based apps or services, including autonomous driving, could lead to outsize gains, referring to it as "the key upside risk."

Over the past two decades, the search company has accumulated the largest user database in China, which is critical for broader AI innovation and better data analysis, leading to higher advertising efficiency. "The larger the user base, the more data Baidu can collect and analyse, improving the search engine algorithm and relevancy of search results," says Tam, whose US$322 per ADR fair value incorporates a price/earnings multiple of 34 and a 4.1% free cash flow yield.

Considering that wide-moat Baidu's large user base can help provide personalized advertising strategies, advertisers are willing to pay higher prices for search ad purchase to reach the largest potential audience, she adds.

 

Alibaba Group Holding Ltd. ADR
Ticker:BABA
Current yield:-
Forward P/E:26.3
Price:US$180.29
Fair value:US$210
Value:14.1% discount
Data as of May 3, 2018

The world's largest online and mobile commerce company,  Alibaba (BABA) operates China's most-visited online marketplaces, which accounted for 76% of revenue in 2017, generated through advertising and other merchant data services. The remainder of revenue primarily came from digital media (9%), international marketplaces (8%) and cloud computing (4%).

Alibaba has been aggressively pouring capital into artificial intelligence as it buys or backs start-ups doing pioneer work in the field. In addition to publishing impressive AI research, the firm recently set up a research institute in Singapore to develop AI applications in a range of areas including health care, smart homes and urban transportation.

"Over the past few years, Alibaba has transitioned from a traditional e-commerce marketplace to a big data-centric conglomerate," says a Morningstar report, adding that "transaction data from its marketplaces, financial services and logistics businesses allow the company to move into cloud computing, media/entertainment and online-to-offline services."

Alibaba's China retail marketplaces generated gross merchandise volume of US$680 billion in 2017, more than Amazon and eBay combined, and accounting for more than 75% of China's online shopping industry, according to data from iResearch.

While e-commerce businesses are Alibaba's core cash providers, "AliCloud is likely to develop into a more significant cash flow contributor over time," says Morningstar sector strategist R.J. Hottovy, whose US$210 per ADR fair value estimate incorporates a revenue growth rate north of 31% from 2018 through 2022.

The Asian tech giant enjoys "early-mover advantages in big data and cloud computing in China -- giving it distinct advantages over [Amazon cloud] AWS and [Microsoft cloud] Azure in China -- and increased demand from corporations and other government groups looking to reduce information technology expenditures," he adds. Management, Hottovy points out, has stressed AliCloud could eventually be as profitable as Amazon Web Services.

 

Tencent Holdings Ltd. ADR
Ticker:TCEHY
Current yield:0.16%
Forward P/E:35.3
Price:US$48.60
Fair value:US$82
Value:40.7% discount
Data as of May 3, 2018

 Tencent (TCEHY) is China's largest internet service platform, connecting users to a variety of web-based services and contents. They include communication and social networking (Weixin/Wechat and QQ), online games, media (news, videos, music and literature) and utilities (app store, mobile security and mobile browser). The firm's infrastructure services include payment, security, cloud and artificial intelligence, which create differentiated offerings for businesses.

The internet behemoth has been aggressively ramping up its AI efforts by setting up dedicated artificial intelligence labs, including a robotics lab in its hometown of Shenzhen, and by luring top AI experts away from American tech titans. The company, which often draws comparisons with Facebook and Amazon, has been boosting monetization by incorporating AI across a wide array of businesses, according to a Goldman Sachs report.

The wide-moat internet giant has the largest social networking platforms in China with active users exceeding 1 billion. "Tencent monetises its social-networking platforms through selling in-game items, virtual items, premium service subscriptions, online advertising, payments, financial products and others," Tam says in a Morningstar report.

The company holds a 52% revenue share in the Chinese online gaming market, versus the nearest rival Netease's 14%, according to iResearch. Tencent Games, which include Weixin/Wechat Game Center and QQ Game Center, represents a lucrative way to monetize the voluminous user behaviour data accumulated through various products and services.

Further, with the second largest mobile payment market share of 40%, Tencent's monetization potential in fintech is substantial.

"Through analyzing the data and applying artificial intelligence, the advertisers can improve the efficiency of advertisements through targeted marketing, which can lead to higher advertising revenue for Tencent," says Tam, who pegs the stocks fair value at US$82, and projects a strong annual top-line growth of 29% for the next 10 years.

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