Baidu (BIDU -8.05%) unveiled Kunlun, its artificial intelligence (AI) chip optimized for cloud-to-edge computing tasks, three years ago. At the time, it claimed the 14nm chip provided 1.5 to three times more processing power than NVIDIA's comparable T4 GPU for AI tasks.

Baidu started mass producing Kunlun chips through its eponymous subsidiary in 2020, and it had installed nearly 20,000 of those chips to power its search engine and other applications by last September. It also revealed the Kunlun 2, a 7nm chip that could offer three times more processing power than its predecessor, and its plans to mass produce the new chips in the second half of 2021.

In March, Baidu completed a funding round for Kunlun, led by CITIC Private Equity Funds Management, which valued the chipmaker at $2 billion. Other investors included IDG Capital, Legend Capital, and Oriza Hua. Baidu still held a 76% equity stake in Kunlun after those investments.

Baidu's Kunlun AI chip.

Image source: Baidu.

However, Baidu recently spun off Kunlun as an independent company with a valuation of about $2 billion. Ouyang Jian, the chip's chief architect, will serve as its CEO, and the stand-alone chipmaker could raise more funds on its own, strike new partnerships, and expand in new directions.

Let's see why Baidu spun off its AI chipmaker, how the move relates to the tech war between the U.S. and China, and what this all means for investors.

Why did Baidu spin off Kunlun?

To understand why Baidu spun off Kunlun, we need to understand how it makes money. Baidu generated 68% of its revenue from its online marketing services in fiscal 2020. The remainder mainly came from its streaming video subsidiary iQiyi (IQ) and its cloud infrastructure platform.

Baidu's online marketing business has been buffeted by macro headwinds, tighter regulations for ads, the pandemic, and competition from monolithic apps like Tencent's WeChat over the past two years. However, its online marketing unit still generates higher-margin revenue than iQiyi, which remains unprofitable more than a decade after its initial launch. Baidu Cloud is also likely unprofitable since Alibaba Cloud still can't generate stable profits despite being the dominant market leader.

As Baidu's advertising business floundered, it relied more heavily on iQiyi and Baidu Cloud's lower-margin revenue to drive its top-line growth. This strategy wasn't sustainable, and Baidu reportedly tried to sell iQiyi to Tencent and Alibaba last year after its growth stalled out.

Baidu's online marketing revenue finally rose for the first time in eight quarters in the first quarter of 2021. It expects that growth to continue in the second quarter -- so its highest-margin business is finally stabilizing again.

Therefore, it's the ideal time for Baidu to streamline the rest of its portfolio by divesting more of its lower-margin and non-core businesses. Kunlun, a capital-intensive chipmaker that is trying to challenge established market leaders like NVIDIA, clearly checks both boxes.

How does Kunlun relate to the tech war?

The tech war between the U.S. and China -- which escalated significantly under the Trump administration -- revolves around China's dependence on American technologies. The U.S. wants to cut China off from the world's most advanced chips, while China is ramping up the production of its own homegrown chips to curb its dependence on foreign companies.

Chess pieces placed atop Chinese and American flags.

Image source: Getty Images.

At the center of this conflict is the "process race" to create smaller and more powerful chips. These chips are measured in nanometers; the world's most advanced chips measure 5nm to 7nm.

Taiwan Semiconductor Manufacturing (TSM -0.94%) and Samsung, the world's most advanced chip foundries, manufacture most of the world's 5nm-to-7nm chips. SMIC, China's most advanced chip foundry, still can't mass produce any chips beyond the 14nm node.

Samsung's foundry manufactured the first generation of Kunlun's AI chip, and it will also likely manufacture the second-generation chip later this year. TSMC, which is being cut off from Chinese chipmakers by U.S. blacklists and sanctions, is a far less likely candidate.

But looking further ahead, Samsung could also face pressure to reduce or suspend its production of chips for Chinese chipmakers. When that day comes, Kunlun might need to turn to SMIC -- which remains generations behind TSMC and Samsung -- to continue manufacturing chips.

Baidu probably doesn't want to deal with that dilemma in the future, so it's spinning off Kunlun before it becomes too entangled with its core businesses.

What does the spin-off mean for investors?

Spinning off Kunlun was the right move for Baidu. It doesn't need another capital-intensive business on its balance sheet, and the chipmaker might fare better as a stand-alone company.

Stepping back from Kunlun could also enable Baidu to expand its higher-margin software businesses -- including the Smart Mini Programs on its mobile app, DuerOS virtual assistant, and Apollo platform for driverless cars -- instead of getting bogged down in the tough semiconductor market.