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Baidu is HOLD at Chinavestor

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CAST_09Q2-tumb (Chinavestor) November 2012 CV_BIDU_2012_Q2-1.pdfHold Rating

We suggest our Hold rating on Inc. (NASDAQ:BIDU). BIDU is a leading search engine service provider with largest market share in China. It has strong financial and cash flow positions, with excellent compounded EPS growth rate in the last five years. However, its business is currently being challenged in two areas. First, its PC side business is facing the most severe competition from Qihoo 360 (QIHU), who is a Chinese internet service providing company, since Google had decided to direct the searching requests from Chinese users to Hong Kong. In addition, BIDU is trying to expand its services in mobile market but the revenue from mobile side is still very small according to its CEO, Robin Li. BIDU’s market share, as well as revenue and profit in the next coming quarters should be analysed to determine the influence of QIHU’s new search services on its business.


Strong revenue and earnings growth Inc. (NASDAQ:BIDU) has continued to present good performance in its revenue growth and earning power, and its revenue in Q2 has increased 47% as compared to Q1 this year. Its gross profit margin in Q2 has reached over 80% again after three consecutive quarters below this figure.

Good financial position

Quarterly and annual data indicate Inc. (NASDAQ:BIDU) has improved its financial position in terms of certain liquidity (current and quick ratio) and solvency ratios (debt to asset and debt to equity ratio).

Increased cash spending and business acquisition

BIDU’s cash from operations (CFO) has continuously increased during past years, which is an indication of its success of major business development. However, because of its short term purchase and business acquisition in 2011, BIDU’s cash from investment has increased dramatically on the year-to-year basis.

Business outlook for BIDU

The future possible expansions of BIDU’s business are to maintain its dominant position in China’s search engine industry, tackle the competition from other search services providing companies, and obtain more market share and revenue from mobile industry.

Estimates (June)


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Key Income Statement Data

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Industry Overview

The total revenue of search engine industry in U.S. is expected to be 17 billion in 2012, according to IBIS World. Over the last five years, from 2007 to 2012, the annual growth rate in revenue in this industry of U.S. is 3.4%. The total revenue of search engine industry in China as year of 2011 is 18.78 billion yuan (2.98 billion dollars), and the expected revenue in year 2012, as a year-to-year growth rate of 55%, is 29.11 billion yuan (4.62 billion dollars) (Source: iResearch). Over the last five years, the compounded annual growth rate for search engine industry, in terms of revenue, has been approximately 58.7%.

Apparently, search engine industry in China has been undergoing a very fast development rate these years, compared to more mature markets such as U.S. and U.K. Although the year-to-year growth rate tends to be lower in the next coming years, the search engine market in China is far from mature, and the search companies in China still have big opportunities to increase their revenues and profits through this business.

As of Q2 2012, Google Inc. (NASDAQ:GOOG) reported revenue of $12,214 million with net income of $2,785 million, whereas (BIDU) generated 866 million of revenue and 440 million of net income. As for the yearly scale, in fiscal year 2011, the revenue and net income for Google Inc. (NASDAQ:GOOG) are $37,905 million and $9,737 million, as compared to BIDU’s yearly revenue of 2,302 million and net income of 1,054 million. Through the comparison of both industry and the major company in this search industry, it can be found that there are still huge business potentials for China’s search industry as well as for the development of Inc. (NASDAQ:BIDU). (BIDU) is the leader in Chinese search engine industry and its market share in this industry has been as No.1 for years (67.8% in Q1 2010 to 78.6% in Q1 2012. The market share of (NASDAQ:GOOG) in China has been experienced continuous decrease for the last couple of years (from 29.5% in Q1 2010 to 16.6% in Q1 2012)., which is a subsidiary of (NASDAQ:SOHU), has been taking some part of the market share in search industry in China by utilizing its user base gained by providing Chinese character typing services. As of Q1 2012, Sogou has obtained 2.8% market share in terms of revenue in the search engine industry. Other players in China’s search industry include Soso, a subsidiary of Tencent (HKG:0700), and Youdao, a subsidiary of NetEases (NASDAQ:NTES).

On August, Qihoo 360 (NASDAQ:QIHU) has launched its own general search engine in China. The performance of its general search product is surprisingly good, in terms of search traffic through its website (till now,

approximately 10% of the search share). Although it has not been monetized yet, the President and CEO of QIHU, Hongyi Zhou, said in the Q2 2012 report release press that they will start generating revenue through this service by the end of 2012. It has been said in the industry that QIHU is challenging the major player BIDU in this industry because the market share of BIDU is decreased, to some extent. In addition, the market share of (NASDAQ:GOOG) is further decreased due to QIHU’s entrance into this industry.

Suggest Hold Rating

1. Strong revenue and earnings growth

Quarterly Income Statement Analysis


As to the quarter to quarter result comparison above, the revenue is experiencing an increase trend, despite the fact that there is a decline of revenue in Q1 2012. The net income has almost the same pattern as revenue in that it also declined in Q1 2012 as compared to Q4 2011, and then it increased 47.10% in Q2 2012 as compared to Q1 2012.


The gross profit margins for the quarter data of Inc. (NASDAQ:BIDU) fluctuated to some extent and they are within the range of 72% to 82%. As for the net profit margin, they are within the range of 44% to 50%, which are really high as compared to other internet companies in China, such as Qihoo 360 (NASDAQ:QIHU) and (NASDAQ:SOHU).

Annual Income Statement Analysis


The annual data shows that revenue growths are increasing fast from 2008 to 2011. Revenues increased by 39%, 78%, and 83% in 2009, 2010, and 2011, and the value of revenues increased to $ 706, 1256, and 2302 million, respectively. The last three years’ compounded growth rate of net income for Inc. (NASDAQ:BIDU) is 85%, which is the reflection of BIDU’s dominant position in the search engine industry in China.


The annual data shows that the gross profit margins from 2008 to 2011 have increased, especially for the year 2010 from 64% to 73%. The gross profit margins are 64%, 64%, 73%, and 73% in year 2008, 2009, 2010, and 2011, respectively. The net profit margins also increased from 2008 to 2011, and it showed the similar pattern as the gross profit margin in that it increased most in the year 2010 from 33% to 45%, while remain fairly stable in the rest of three years shown above.

Annual Gross Profit Margin Comparison



Through the comparison of gross profit margin between BIDU and other companies who share part of the same business in Chinese search engine industry, (NASDAQ: GOOG), (NASDAQ: SOHU), and Qihoo 360 (NASDAQ: QIHU), it is found that the gross profit margin of BIDU has become the second largest among the major players in search engine industry. Although QIHU has not started yet to generate revenue and profit through its general search website, it is listed as one of the major competitors with BIDU due to its relatively big share of search traffic in Chinese internet industry. In the most recent fiscal year 2011, the gross profit margin for BIDU is 73%, while it is 89% for QIHU, 72% for SOHU, and 65% for GOOG. If BIDU could take more market share in the search engine industry, then chances are its gross profit margin, as well as its net profit margin, would continue to increase. The declined market share of Google Inc. (NASDAQ:GOOG) in China has been taken by other competitors such as BIDU, QIHU, and SOHU, and the competition in search engine industry has become more and more severe. Although the search engine industry is still increasing at a fast speed, it is possible that the intense competition between these companies would lower the overall gross/profit margins of the industry. How each company would act under this circumstance, how their actions and strategies would affect the experience of the internet users in China, etc, much attention would need to be paid for these issues as they all could impact the market share of these companies and their profit making capabilities.

2. Good Financial Position

Quarterly Comparison of Financial Strength Ratios

The two graphs in the next page depicting the quarterly data of current and quick ratios for BIDU have shown the trend of increase in the quarter-to-quarter basis. In Q2 2012, BIDU’s both ratios become highest in the three companies (BIDU, GOOG, SOHU) that have generated revenue and profits through search engine in China. This is an indication of BIDU’s continuing good liquidity status.  QIHU has been listed above

mainly because it has started launched general search service in China’s search industry, and the comparison shows that this company has obtained strong ratios.



The comparison of quarterly data for debt to asset indicates, which are shown in the two charts below, that both BIDU and SOHU have been utilizing higher leverage than GOOG to develop their business, and it also shows that Google Inc. (NASDAQ:GOOG) has been trying to increase its leverage starting from Q2 2012. As long as BIDU could utilize its financial leverage wisely and keep the ratios in the safe range, the leverage can help Inc. (NASDAQ:BIDU) generate more revenue and profit than otherwise lower leverage situation. The debt to equity comparison generally has the similar pattern as the debt to asset ratios.



Annual Comparison of Financial Strength Ratios

The comparison of annual data for current and quick ratios illustrates that Inc. (NASDAQ:BIDU) are fairly stable on these two ratios, which indicate the liquidity status for Inc. (NASDAQ:BIDU) is relatively stable. Google Inc. (NASDAQ:GOOG) has the highest liquidity ratios (excluding QIHU) among these companies. QIHU has shown gradual growth in these liquidity ratios and it is the sign of the improving capability of meeting its short term financial obligations.

The comparison of annual data for debt to asset and debt to equity shows that Inc. (NASDAQ:BIDU) and (NASDAQ:SOHU) are almost in the same level of financial leverage, whereas Google Inc. (NASDAQ:GOOG) has lower ratios than these two companies. QIHU has steadily declined its leverage year by year. The leverage has become lowest for QIHU in the end of 2011, and this is mainly due to its IPO in year 2011. Again, as long as companies could better leverage assets to generate good revenue and profit under safe financial conditions, it is reasonable for them to do so.

To sum up, BIDU has demonstrated good financial health through these years’ operation, in terms of fairly stable liquidity ratios and reasonable financial leverage. The financial status of BIDU like this has provided it enough financial resource for its future business development.

3. Increased cash spending and business acquisition

Annual Cash Flow Analysis

All three cash flows (cash from operations, CFO, cash from investing activities, CFI, and cash from financing activities, CFF) increased significantly in magnitude. The increase of CFO in both 2010 and 2011 are mainly due to the BIDU’s increase in net income.


In 2011, CFI has increased dramatically from negative $193 million to negative $2,264 million, which is more than 10 times in magnitude. The main reason behind this significant increase in CFI in is the large increase in purchase of short term investments and acquisition of businesses for BIDU during this year. To be more specific, BIDU has spent more than $1.7 billion on short term investment (i.e. fixed rate investment) purchase and $309.2 million on acquisition of business. The target of the acquisition is Qunar, which is a traveling searching company focusing on flight and hotel price comparing and booking services in China. This could be considered as BIDU’s business expansion from general search to vertical search services.

Starting from year 2011, Inc. (NASDAQ:BIDU) began to raise capital through proceeds of short term debt, and it also increased much in its long term borrowings, which caused the CFF for BIDU increased from $19.8 million in 2010 to $385.4 million.


The free cash flows of BIDU are $285.4, $587.4, and 602.8 million in 2009, 2010, and 2011, respectively. It increased 106% and 3% in year 2010 and 2011. The slowed increase of free cash flow for BIDU in 2011 is accountable for, at first, its larger capital investment in the fixed assets, and, second, the large amount of capital paid for the acquisition of businesses and intangible assets at that year.

Cash Flow Comparisons


The comparison of cash from operations (CFO) between Inc. (NASDAQ:BIDU) and the other two Chinese internet companies (NASDAQ:SOHU) and Qihoo 360 Tech. (NASDAQ:QIHU) shows that BIDU has the largest scale of CFO. The CFO of another competitor in China’s search engine industry, GOOG, is not included in this comparison as its magnitude is too big and not in the same scale with these three companies shown above. For example, in 2011, the CFO for GOOG is $14,565 million, whereas BIDU only has $1,299 million reported in its annual report. This big difference in CFO between GOOG and BIDU, on the other hand, has demonstrated BIDU’s potential in the future if the search engine industry is continuous to grow and BIDU can maintain its dominant position in this industry.


The comparison of free cash flow between BIDU and its competitors illustrates a few things. At first, the free cash flow for SOHU has declined in the past two years. This is mainly due to SOHU’s increased capital investment in the online video industry, which is competing with other video companies such Youku Tudou Inc. (NASDAQ: YOKU) in China.

Secondly, BIDU still has the largest scale of free cash flow among Chinese companies who conduct search engine business. Thirdly, the increase of free cash flow for QIHU has increased very fast in the past years, and what’s worth noting is that these increased free cash flow did not include the potential income generated by QIHU’s newly released general search engine services.

As illustrated in the former section, the slower increase of free cash flow for BIDU in 2011 is due to the larger investment in fixed assets and business acquisition and intangible assets. It should be followed to find out if BIDU could make use of these investments and produce larger free cash flow in the upcoming years.

4. Annual Profitability Comparison


Through the comparison of the last three years’ return on asset (ROA) for these four companies, it can be found that BIDU has the highest ROA, which indicates, among all the four enterprises, BIDU could make largest profit using the same amount of asset.


The comparison of return on equity (ROE) also represents that BIDU has the highest ROE among these companies. While the ROEs of all the other three companies had declined in the past three years, the ROE of BIDU has increased from 31% to 43%. This is the indication of BIDU’s strong capability of making profit through its business model.

BIDU has shown both strong ROA and ROE in the past years, especially compared with other competitors in the search industry in China. These strong profitability ratios have demonstrated BIDU’s good business model and dominant position in China’s search engine industry.

4. Business Outlook for BIDU

BIDU has been the largest web search service providing company in China for years. Its products not only in search engine services, but also in Tieba forum, Baidu Answer, Documents, online video, etc, have helped to attract and make the Chinese internet users stay within BIDU’s eco-environment. And these multiple services provided by BIDU are also forming a fosse to compete and prevent other competitors and maintain its biggest market share in the industry. However, the major source of revenue and profit for BIDU is still from its search service provided to its customers both in small/middle sized enterprises and large cap companies. Through these years, BIDU has constructed and maintained solid cooperation with its business partners and those online service distributors.

However, they are still concerns for BIDU’s future business expansion and market share maintaining. First, the company mentioned at the very beginning at the report, QIHU, has really good connection and business partnership with the online service distributors in China’s market, which would possibly bring competition for BIDU’s current cooperation with these business enterprises and lower its gross profit margin. Second, although BIDU has kept maintaining biggest market share in China, there are always disagreements and debates on its price-competition-ranking service (pay higher, rank higher), because chances are those who pay very high price and are able to list their advertisements on top are actually frauds. BIDU has exerted enormous efforts dealing with this type of issue, but the concerns of the public never fade away. Having been seeing this issue for a long time, as a business strategy to gain market share, QIHU declaimed it plans to provide “green” search results, which would not only utilize its professional anti-virus technology to detect fraud websites, but would also distinguish the “natural” search results from the “business” oriented search results, just as what Google has been doing for years.

Another issue that not only Inc. (NASDAQ:BIDU), but perhaps all the internet companies are facing is to attract users to use their mobile terminal services and find good business model to generate high revenue without compromise users’ mobile usage experiences. The number of mobile device users in China has exploded within last couple of years, and the time users spend on mobile terminal using internet services is increasing very fast. It is said that one of the necessary conditions for a successful internet company in the next coming years is to have very large mobile terminal users and a excellent revenue generating strategy. BIDU is spending large amount of money on mobile related products, such as cloud computing, however, the revenue generated from these services is still small compared to its total revenue. And it’s facing other internet companies’ competition in terms of mobile user attraction and services provided.

The main reason why a hold, instead of a buy, for BIDU is recommended for the next one or two quarters is not about the financial results it released in most recent quarter, rather that it is worthwhile to wait and see how BIDU reacts to QIHU’s competition (i.e. firm’s strategy), whether BIDU’s financial results would be affected in this case (i.e. net profit margin, revenue growth rate), and to what extent, or if any, would BIDU’s market share be affected, etc."

What’s worth noting is that, Inc. (NASDAQ:BIDU) had also faced severe challenges and competitions within the industry in the past five years, yet it has proved to the market and the investors with its high revenue and profit growth rate and excellent stock price history. Now Inc. (NASDAQ:BIDU) needs to prove again to the market that it could tackle these problems ahead of it well and come up with business plans to embrace the opportunities in China’s search engine industry, both in the web based and mobile terminal based services.

Analyst Certification

I, Sheng Hu, hereby certify that the views expressed in this research report accurately my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

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