China Technology Internet:Still bullish on Alibaba,Baidu ahead of earnings,MXCN inclusion

3m absolute underperformance suggests expectations are lowWe remain bullish on the outlook for Alibaba and Baidu ahead of theirresults the week of Oct. 26. We believe anticipated softness in earnings hasbeen priced in following the 3months underperformance in absolute termsof the China Internet sector. We view the potential inclusion in the MSCIChina Index (MXCN) of 14Chinese internet ADRs as benefitting Baidu andAlibaba the most of the group given their significant weightings, andexpect details to be announced Nov 12. We also expect both companies togain from easier 2016yoy comps. The risk from new tech (such as adblockers)for platforms appears minimal and at this late stage, disruptionfrom global internet giants entering China seems low.

    Alibaba shares down 10% over 3m, focus on continuing operationsWe model 2Q FY16GMV of Rmb713bn (+28% yoy), monetization rate of2.26% (2.33% a quarter ago), and revenue of Rmb21.6bn (+28% yoy). As themarket begins to factor in 2016earnings, we remain focused on growthrates adj. for lottery/SME lending (GMV 30%). We also expect an update onAnt, Koubei (O2O), Ali Cloud, Ali Health and Ali Pictures/Youku, and coloron the upcoming Singles Day preparations that include a broad “bricks andclicks” strategy deploying ERP-POS Link at 180k stores and distribution ofUS$0.8bn in e-coupons. Alibaba reports Oct 27. We expect MSCI changeswill see Alibaba’s weight in MXCN rise in two steps, first to 5.2% and thento 9.0%, on assumptions of a free float inclusion factor of 25% and 45%respectively. We lower FY16-FY182%-3%, and our 12m TP from US$95toUS$94, still based on 1.2x PEG. Risks: weaker monetization, tighterregulation, more intense competition. Potential upside 24%.

    Baidu shares down 24% over 3m; Core FY16E P/E below 10xBaidu will report 3Q Oct 30. We forecast revenue of Rmb18.5bn (+37% yoy,Bloomberg consensus Rmb18.5bn) with search growth in the high 20%s onmobile click growth, a narrower mobile discount, higher ad relevancy, andO2O (GMV of Rmb45bn). As guided, we expect higher SG&A, intended tostrengthen O2O presence at the early stage of this industry, to dragmargins, and forecast non-GAAP op. margin of 14% vs. 23% in 2Q and EPSof Rmb8.35(-28% yoy, vs. 4% in 2Q15). We see Baidu as the 2nd majorgainer with the MXCN inclusion as we expect its weight to rise to 4.6%. Welower FY15-FY17EPS 1-3% and 12m SOTP based TP to US$212from $216.Risks: Execution, surging opex, search slippage. Potential upside 35%.