Baidu Inc. (百度) operates the number one search engine in China and is the most visited Chinese web site. Although the company has some international operations, it earned the majority of FY 2010 revenue in China. The company's core business is selling advertising online, and it offers various services to users (content search, news, community-based information sharing, etc.) to create an audience for its paying customers' ads. Web search is the core of the company's online offering; its ability to deliver the most useful and relevant search results drives its ability to sell advertising (online marketing service comprised 100.0% of FY 2010 revenue).
Baidu's market opportunity has grown with the number of internet users in China, but arguably this also makes the market more competitive, attracting both domestic and international competition. The Chinese government heavily regulates online content and advertisers, something which has helped shape the competitive landscape; major competitor Google was forced to exit in 2010 following disagreements on censorship and content control. Baidu's market share in China search grew to 75.5% after Google pulled out.
Founded in the year 2000, Baidu is the leading search engine in China. Its main search operation provides search for websites (740 million web pages), audio files (10 million), and images (80 million). Baidu went public in America with its initial public offering (IPO) on August 5th, 2005.
Baidu's Chinese language search capability is the core of the company's business. The company earns revenue from selling online advertising, and its search technology drives most of the websites where it displays customers' ads. The websites displaying customers' ads include Baidu's own sites (its core search site along with sites targeted for specific audiences or interest areas) and third party sites collectively called Baidu Union. The company's products and services can be divided into two broad categories: Products and Services for Users, and Paid Products and Services for Customers. The company uses both direct sales and a distribution network to sell advertising.
Similar to US-based Google (GOOG), Baidu's business has expanded from a "search-only" model to a plethora of other internet-based services (with offerings focusing on collaboration, entertainment, multimedia, etc.). The aim of this expansion seems straightforward: by offering more services that are attractive to users, the company can offer customers higher-quality audiences for more targeted advertising. Revenues have grown rapidly since listing: from $39.6 million in 2005 to $1.2 billion in 2010. Although the company historically reported revenues in two segments, Online Marketing Services and Other Services, Online Marketing Services comprised 100% of total revenue in FY 2010.
Because China's Internet landscaping is still evolving, Baidu has several opportunities for growth. In the shorter term, increasing average customer spend and increasing customer counts appears to be the solution. The company introduced Phoenix Next (auction-based software that customers use to choose keywords) in 2009 in an effort to improve advertising customers' experience and the quality of paid search results. Considering the ARPU growth from FY 2009 to FY 2010, the new software seems to be increasing customer spend amounts. To increase customer numbers, the company has been increasingly focusing marketing efforts on SME clients. The company traditionally relied on larger clients for the majority of revenues, and a growing focus on the SME segment beings challenges (typically smaller companies lack the marketing expertise to maximize ROI for ad spending). If the company can provide the right amount of hand-holding, the SME customer base could provide a significant revenue boost.
For growth over the longer term, the company needs to maintain its position as the leader in search as Internet penetration in China increases. The company's answer to this challenge appears to be its Box Computing initiative (integrating data, applications, and other kinds of information with search; everything a user could want through a simple homepage search box). As of FY 2010, Box Computing was a work in progress, with unclear monetization targets.
Revenue grew +85.1% YoY to 4.1 billion RMB. The number of active online marketing customers grew about +11.8% YoY to 304,000 and the average spend per customer increased +65.1% YoY to about 13,700 RMB. 
Gross profit grew +82.5% YoY to 3.1 billion RMB. Gross profit margin declined slightly YoY (to 73.5% vs. 74.6% in Q3 FY 2010) despite a lower TAC costs, due to higher bandwidth and depreciation costs. The TAC / sales ratio declined to 8.0% vs 8.9% in Q3 FY 2010. 
Operating profit grew +88.5% YoY to 2.2 billion RMB. Operating profit margin increased to 53.3% vs. 52.4% in Q3 FY 2010. SG&A / sales declined YoY to 11.0% vs 13.1% in Q3 FY 2010. R&D spending grew proportionally to sales.
Net income grew +79.2% YoY to 1.9 billion RMB. Net profit margin declined to 44.9% vs. 46.0% in Q3 FY 2010. The net profit margin decline was due to non-operating losses for equity method investments (related to the investment in QiYi, a website that provides online streaming of movies, TV shows, etc.).
On the balance sheet, the company had 5.9 billion RMB in cash and 5.5 billion RMB in short-term investments.
Cash flow (adjusted EBITDA) generated in Q3 2011 was about 2.5 billion RMB vs. 1.3 billion RMB in Q3 2010. Increased cash flow was mainly the result of increased accounts payable.
The company expected to generate between 4.4 and 4.5 billion RMB in Q4. Assuming the company were to meet its midpoint revenue number (4,473 million RMB) and costs were similar to averages in Q1-Q3 (proportion to sales: 7% business tax, 8% TAC, 4% bandwidth; flat QoQ spending: depreciation, operating costs, share expense), gross profit would be about 3.3 billion RMB (74.3% GPM). Assuming SG&A / sales and R&D / sales ratios are similar to Q1-Q3 averages (11% SG&A / sales and 9% R&D / sales), operating profit would be about 2.4 billion RMB (54.3% OPM). A 54.3% OPM is higher than previous years (OPM grew from 15.7% in 2006 to 50.7% in 2010), but similar to levels in Q1-Q3 FY 2011. Although the company commented that the lower TAC ratio was a short term phenomenon, Google's exit from China combined with the impact of Pheonix Nest could also be factors driving the mix of more organic search traffic, lowering TAC.
With the exception of Q3, the largest non-operating item was interest income. Assuming interest income is flat QoQ (97 million RMB), FX losses are flat QoQ (-2 million RMB), loss from equity investments is similar to Q1-Q2 at 8 million RMB (the loss in Q3 was mostly related to newly-consolidated subsidiary Qiyi), and other income is the Q1-Q3 average, 19.1 billion RMB, net non-operating income would be about 92 million RMB.
If operating profit was 2.4 billion RMB and net non-operating income was 92 million RMB, pre-tax income would be about 2.5 billion RMB, or about 55.9% of sales. Assuming the statutory 15% tax rate for HNTE ("High and New Technology Enterprise", a tax advantaged status in the PRC), net income would be about 2.1 billion RMB (net profit margin of 47.5%, similar to Q2 2011), or 60.17 RMB per share (B class) assuming shares outstanding in Q3 remain unchanged.
Revenue grew +78.4% YoY to 3.4 billion RMB. The number of active marketing customers increased about +17.3% YoY to 298,000 and average spend per customer increased about +53.3% YoY to 11,500 RMB. 
Gross profit grew +81.6%, mainly driven by lower traffic acquisition costs (TAC). The TAC / sales ratio was about 7.9% for Q2 FY 2011 vs. 9.4% in Q2 FY 2010. As a result of lower TAC, gross profit margin increased to 74.2% (vs. 72.9% in Q2 FY 2010). The company commented that the lower TAC was due to changes in traffic mix (more organic vs. paid search traffic), a short term phenomenon.
Operating profit grew +91.2% YoY, driven by higher gross margins and and a decline in the SG&A / sales expense ratio (11.1% in Q2 FY 2011 vs. 13.8% in Q2 FY 2010). Operating profit margin increased to 54.4% (vs. 50.8% in Q2 FY 2010).
Net income grew +95.0% YoY to 1.6 billion RMB, and the net profit margin increased to 47.8% (vs. 43.7% in Q2 FY 2010). The increase in net profit margin was mainly the result of higher interest income YoY.
Revenue grew +88.3% YoY to 2.4 billion RMB. The company reported 274,000 active marketing customers (+24.0% YoY), and the average spend per customer of about 8,900 RMB (+50.8% YoY).
Gross profit grew +93.3% YoY, lead by lower traffic acquisition costs (TAC). The TAC / sales ratio declined to 8.2% vs. 13.2% in Q1 FY 2010. 
Operating profit grew +125.1% YoY due to higher gross margins and reduced SG&A spending (SG&A / sales was 13.7% in Q1 FY 2011 vs. 16.6% in Q1 FY 2010). The operating profit margin was 49.0% (vs. 41.0% in Q1 2010).
Net income grew +122.8% YoY to 1.1 billion RMB, driven by significantly higher interest income YoY.
Baidu provides users an efficient Chinese language search portal for the web. But like Google, Baidu has also expanded beyond basic search to provide a wide range of web services designed to attract Chinese internet users to its site. The accompanying graph illustrates Baidu's dominance of China's search engine market, while Baidu's individual offerings are explained below.
The products and services that Baidu offers its customers include clickable ads and the software applications to manage the advertising plan (if, when, and how to show the ad based on customer-configured settings). Online Marketing Services comprise the majority of the company's products and service for customers.
Baidu derives the majority of its revenues from internet advertising through its "pay for performance" (P4P) platform, offering customers cost-effective and targeted marketing solutions. A P4P platform is one where customers only have to pay for actual leads (clicks) from potential customers. Baidu also generates income through the sale of enterprise search software and portal search services.
Baidu's Online Marketing Service offers advertisers multiple channels for displaying ads: with search results, contextual advertising (outbound links in specific page content), behavioral advertising (based on previous search or browsing history), and display placement (ads shown irrespective of any search or contextual relevance). The company uses both a P4P and a time/duration model to sell its advertising. Under the P4P method, advertisers bid on keywords so that links to their sites appear when Baidu users search for those specific keywords (or terms associated with the keywords). Advertisers pay Baidu when web surfers actually click on the links to their sites. The company's ad management software allows customers to define demographic, geographic, and other parameters to determine if their ad is shown or not. Similar to competitors Google and Yahoo, Baidu's P4P pricing structure helps align the interests of Baidu and customers: advertisers can pay lower per-click costs if their target content meets users' search needs (exhibiting lower bounce rates, for example).
Along with the P4P method, Baidu also sells advertising that is not based on search or contextual relevance, an effective alternative to quickly market to a wide audience (instead of users who are searching for a particular term). These content-agnostic ads are displayed both on Baidu web pages and Baidu Union sites.
Features of Baidu's Online Marketing Services:
Online Marketing Customer Base
As of FY 2010, Baidu had about 412,000 active online marketing customers.  Baidu's customers include SMEs throughout China, large domestic corporations, and local subsidiaries of overseas corporations. These customers are broadly spread over all industries, however customers in the top 5 industries accounted for about 50% of FY 2010 revenue. Baidu uses both a direct sales channel and over 200 distributors across China to reach customers for sales or support services (many new internet advertisers in China require education in order to use Baidu's online marketing services).
This is getting a bit more svejbctiue, but I much prefer the Zune Marketplace. The interface is colorful, has more flair, and some cool features like Mixview' that let you quickly see related albums, songs, or other users related to what you're listening to. Clicking on one of those will center on that item, and another set of “neighbors” will come into view, allowing you to navigate around exploring by similar artists, songs, or users. Speaking of users, the Zune “Social” is also great fun, letting you find others with shared tastes and becoming friends with them. You then can listen to a playlist created based on an amalgamation of what all your friends are listening to, which is also enjoyable. Those concerned with privacy will be relieved to know you can prevent the public from seeing your personal listening habits if you so choose.
The company uses an arguably complicated group structure to operate its business in China. The various linkages are necessary because of Chinese laws that govern information, publishing, and advertising businesses in China (preventing foreign interests from owning companies in those industries).
In order to comply with Chinese regulations prohibiting foreign investors from owning companies in the communications and other sensitive industries, another level of companies is used to hold the relevant licenses, permits, etc. necessary to operate the group's multiple websites. These 'operating' companies are Variable Interest Entities (VIEs) and include Baidu Netcom, Beijing Perusal, and Baidu HR. Legally these companies are owned by Chinese individuals (Robin Yanhong Li and Eric Yong Xu), but the connections between the "foreigner-owned" Baidu China and Badiu Times and the local companies are tight. Share capital for the "domestic" firms was indirectly provided by the company through personal loans to the individual shareholders. The shareholders in turn pledge their ownership as collateral for the loans and also assign their voting rights to a person of the company's choosing.
There are contractual agreements in place between Baidu Netcom, Beijing Perusal, Baidu HR and Badiu China and Baidu Times (with Baidu Online acting as an intermediary). These companies (Netcom, Perusal, HR) own and maintain the appropriate licensing, permits, and some intangible assets (domain names for example).
Baidu is a foreign company, from the perspective of government regulators. The ownership structure was a source of some investor concern in 2011 when the media reported that China was re-evaluating VIE structure that Baidu and other Chinese companies used in order to access foreign capital markets.
Because Baidu is technically a foreign company and its business involves a sensitive industry (Internet communications), the company faces regulatory risks stemming from domestic government policy. The Chinese government regulates web content accessible in China, and if Baidu were to run afoul of state censorship guidelines, it could face stiff penalties. Also, as China attempts to adopt international standards of intellectual property right protection, Baidu could face potential lawsuits from Yahoo! (YHOO) over its P4P (pay for performance) platform.
As a result of a continued economic boom with GDP growth consistently registering double-digit levels, China has witnessed unprecedented growth in internet usage. The accompanying graph shows the rapid growth of China's internet-using population. Although the number of users is significant, the penetration rate is lower than developed countries (about 30% in mid-2011 vs. over 75% for the US). The difference between China's penetration rates and other more developed countries suggests that as the economy develops, China's Internet penetration rate could increase (along with the market opportunity).
Surprisingly, Chinese internet users show a great deal of economic diversity, and the largest income group earns less than Chinese 500 RMB (US$64) per month. Only 1.6% of users had a monthly income of more than 10,000 RMB (US$12,800). Currently over half of this population state that they use the internet for online searching. Growth from the remaining half will further increase traffic for Baidu's various web services, making online advertising even more attractive for potential customers of Baidu's online marketing services.
The Chinese government has several regulations governing Internet access, news distribution, and other content. Under these regulations, Internet content providers can be charged with breaking the law if they display so-called "illegal content." Baidu Post Bar and several other third-party link services, Baidu could have difficulty controlling the content for which it is deemed responsible. In June of 2002, Baidu was forced to shut its servers for a week and pay a RMB 10,000 fine because its search results contained "socially harmful" material. Baidu could face the risk of having licenses revoked or servers shut down if it fails to comply with certain government regulations.
As 3G services and smartphones become more popular in China, clear leadership remains up for grabs. Although Baidu and Google are two clear rivals for the Chinese mobile search market, other companies are also competing. China has approximately 460 million internet users, but over 900 million Chinese residents have mobile phones, and the mobile search market is expected to grow as new technologies develop (3G, LTE) and data-enabled handsets become more affordable. Mobile is still a developing market, but if Baidu could leverage its leadership in the search market, success could be financially rewarding.
While China is notorious for intellectual property law infringements, the government is being pressured to rise to international standards. With the recent government movement to strengthen IP protection, Baidu faces many potential attacks. Much of Baidu's technology and business methods (namely the pay-for-performance P4P platform) could face claims limiting their use. Yahoo! (YHOO) subsidiary Overture Services Inc. applied for a patent in China for its P4P platform before Baidu applied for its P4P patent. Currently no patents for P4P platforms have been granted in China, but should a patent be granted, determining who is infringing on whom could be complicated. Because intellectual property (IP) case law in China is a work in progress, interpretation and application of Chinese patent laws are evolving. If Overture succeeds in receiving a patent before Baidu, this may place Baidu in the position of having to defend a lawsuit centering on a core component of its business, namely how it sells advertising. To further Baidu's worries, Overture has already been granted patents in the United States for the P4P platform, and has launched patent infringement claims within the USA with websites like Findwhat.com. While Baidu conducts operations outside America, this is no guarantee that holders of such patents will not try to enforce these patents in China as well.
The risk is not limited to Baidu's P4P technology. Baidu also offers a very popular MP3 search application, as well as forums for users to post information. Some of these features could put Baidu at risk for hosting allegedly "illegal" content. Should such lawsuits be filed, Baidu could face potential liabilities which could divert management's attention from growing the business.
With China's continued economic boom and the resulting growth of its internet-using population, the internet search industry in China has become extremely competitive. Baidu faces competition from three sources:
As shown in the accompanying graph, Baidu stacks up rather poorly with international competition in terms of its user profile. Google (GOOG) tends to attract a better user profile by monthly income, age, gender mix, education level, and urban penetration. The results of this contrast appear in the higher ROI experienced by Google (GOOG) advertisers. Google (GOOG)'s Chinese market share has grown to 19% in 2006, as many customers prefer the international appeal of Google as an advertising platform. In fact, Baidu's market share is expected to peak at 56% in 2007, after which it may decline in the face of fierce competition.
Top Chinese internet portals Sina (SINA), Tencent HLDG (HKG:700), Sohu.com (SOHU), and Netease.com (NTES) offer online services like news, wireless value-added services, email, online shopping, chat, and social networks targeting the Chinese internet audience. Thus, these sites directly compete with Baidu for user traffic. Sina (SINA) has a search engine named "iAsk" which competes directly with Baidu for search-based advertising spending. Other emerging Chinese internet search service providers such as Sogou, Yisou, and Zhong Sou could also evolve into major rivals.
Traditional advertising media in the forms of newspapers, yellow pages, magazines, billboards, TV, and radio also compete with internet advertising for advertiser dollars.
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