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Baidu.com Inc. (NASDAQ:BIDU)

Q1 2006 Earnings Conference Call

May 9, 2006 8:00 p.m. EST

Executives

Cynthia He - Investor Relations Manager

Robin Li - Chief Executive Officer

Shawn Wang - Chief Financial Officer

Analysts

Anthony Noto - Goldman Sachs

Wallace Cheung - CSFB

Jason Brueschke - Citigroup

Matt Schindler - Piper Jaffray

Lillian for Robert Peck - Bear Stearns

Dick Ji - Morgan Stanley

James Mitchell - Goldman Sachs

Andrew Collier - New York Global Securities

Steve Winston - Pacific Crest Securities

Tony Tang - Lucite Research

Chang Qi - Foreign Technology Research

Ray Bing - Deutsche Bank

Ari [Schwagg] - Set Capital

Presentation

Operator

Good evening and thank you for standing by for Baidu first quarter 2006 earnings conference call. (Operator instructions) I would now like to turn the meeting over to your host for today’s conference, Ms. Cynthia He, Baidu’s Investor Relations Manager. Please proceed.

Cynthia He

Thank you. Hello, everyone and welcome to Baidu’s first quarter 2006 earnings conference call. This is Cynthia He, Baidu’s IR Manager. We announced our first quarter earnings earlier today. You may find a copy of the press release on the Company’s website as well as on Newswire services.

Today, you will hear from Robin Li, our Chief Executive Officer; and Shawn Wang, our Chief Financial Officer. After their prepared remarks, Robin and Shawn will be available to answer your questions.

Before we continue, please note that the discussion today will contain forward-looking statements made under the Safe Harbor Provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risks and uncertainties. As such, our results may be materially different from the views expressed today.

A number of potential risks and uncertainties are online in our public filings with the SEC. Baidu does not undertake any obligation to update any forward-looking statements, except as required under applicable law.

As a reminder, this conference is being recorded. In addition, a webcast of this conference call will be available on Baidu’s corporate website at ir.baidu.com. I will now turn the call over to Baidu’s CEO, Mr. Robin Li.

Robin Li

Hello everyone, thank you for joining us. Baidu posted strong performance in the first quarter of 2006. We exceeded the top end of our previously announced revenue guidance. We are particularly pleased with our results, given that the first quarter is generally the slowest for our business because of the long Chinese New Year holiday.

Our traffic growth remained strong again this quarter as we continued to improve our search experience. Already this year, we have rolled out a number of new products and features, all tailored to the specific tests and preferences of Chinese users, including Ancient Chinese literature search, government search, postal code search, and Baidupedia.

We noted more and more users are relying on search engines as the gateway to information and their information needs are becoming more and more diverse. We studied user needs and focused on providing products and features to address them.

We recently launched Baidupedia, together with Baidu Post Bar and Baidu Knows to form a trio of knowledge-based search products that draw from the minds of users, while offering a strong sense of community. Baidu Knows was launched in June of 2005 and is already the number one knowledge search site in China.

Our deep connection to Chinese users and our focus on providing the services and products most desired by them is the real differentiator for Baidu and has helped us become the number one Chinese search engine. We are confident that as long as we continue to provide the best user experience, we will be able o maintain and extend our current leadership position.

Our customer base also shows healthy growth in the first quarter. We served over 74,000 active online marketing customers; that is 11,000 more than what we did in the previous quarter.

There were two key drivers of our customer expansions. First, more Chinese companies are realizing the benefit of Baidu pay-for-performance marketing platforms. Secondly, we improved the sales efficiency of both our direct sales offices and distribution network. We did this through a combination of sales force training, customer education and additional head count, particularly in our direct sales offices. We are very pleased with the pace of our customer expansion, in which we believe will continue to provide strong support for our future growth.

We also rolled out new strategic partnerships that strengthens our focus on providing the most convenient way for people to find information. In March, we announced a partnership with Nokia to make mobile search easier in Chinese. A selection of Nokia high-end phones will offer Baidu search services via a user-friendly search icon on the screen interface. Four of Baidu's most popular services will be installed on the mobile phone: web search, news search, image search and Baidu Post Bar.

We also recently signed an MOU with Intel to cooperate on Internet search and related applications in China. This cooperation will combine Intel's total solution platform with Baidu's leading search application to make search more convenient outside of a traditional computer environment. This is a long-term collaboration and it is intended to bring opportunities for the future.

As a Company focused on search, the goal of both the partnerships is to make search more widely available through non-traditional devices such as mobile phones and digital home appliances. As well as to broaden the role of Internet in people's lives.

We are focused on providing the best Chinese search experience for our users today as well as over the long term. Given our improvements in performance and the huge potential of China's search market, we will continue to make investments in technology, product innovation, sales and distribution as well as explore strategic partnerships. Whatever we believe it takes to continue providing the best search experience for our users and best online marketing platform for our customers.

I will now turn the call over to our CFO, Shawn Wang, to discuss our financials.

Shawn Wang

Thank you, Robin and hello, everyone. We posted another strong quarter with some very healthy expansion in our revenue, user traffic and customer base. Our strong top line growth drove robust earnings growth, which reflects the scalability in our business model. We also benefited from the seasonality impact of Chinese New Year's being less than anticipated.

I will walk you through our financial highlights using RMB currency unless otherwise indicated. Our first quarter total revenues were RMB136 million. That represents an 18% increase from the previous quarter and 197% increase from the first quarter of 2005. This result exceeded the top end of our earlier guidance of RMB130 million.

Online marketing revenues were RMB132 million; that is 97% of our total revenues. This represents 18% sequential and 2007% year-over-year growth. The growth was primarily driven by a solid 18% sequential increase in the number of active online marketing customers to over 74,000. Average revenue per active online marketing customer remains steady from the last quarter at just under RMB1,800.

Traffic acquisition costs as a component of cost of revenues was RMB12 million, and that is 9% of total revenues. This compares to approximately 8% in the previous quarter. The slight increase is the result of the increase in the number of Union members and continued growth of contextual marketing products on Union websites.

Capital expenditures for the first quarter was RMB12 million, primarily related to a routine upgrade of our networks.

Before I discuss head count related expense, I would like to highlight two related accounting principle changes. First, we adopted FAS 123R, on January 1, 2006. Under this new accounting standard, share-based compensation expenses are measured by applying a fair value metric which caused our aggregate share-based compensation charges for the quarter to increase to RMB13 million from RMB10 million in the previous quarter.

Our second accounting principle change is the adoption of SEC Staff Accounting Bulletin No. 107. Pursuant to the requirements of this new standard, share-based compensation expenses are now presented in the same manner as cash compensation as opposed to as a separate line item on the income statement. For the following discussions related to expenses, all historical periods were restated to conform to this new presentation format.

Now coming back to the headcount related expense, R&D expenses for the quarter were RMB16 million, a 9% increase from the previous quarter and 137% increase from the first quarter of 2005. This increase was primarily due to expansion of R&D headcount.

Income tax, our effective income tax rate for the first quarter of 2006 was 16% versus 4% for the fiscal year of 2005. The increase was primarily due to the expiration of preferential tax holidays for one of our operating subsidiaries, Baidu Online.

I will now turn your attention to earnings measures. Net income on a GAAP basis was RMB35 million, representing a 44% sequential increase and a more than 1,300 person increase year-over-year. Typically, our non-GAAP measures exclude share-based compensation expenses. In this quarter, they also exclude the cumulative effect of changes in accounting principles, which I have mentioned earlier that related to the adoption of FAS 123R.

Non-GAAP net income was RMB43 million, a 24% increase sequentially and a 403% increase from the first quarter of 2005. Basic and diluted EPS as measured using non-GAAP measures were RMB1.31 and RMB1.26 respectively. They both translate roughly to $0.16 in U.S. dollars.

Net margins, measured on a non-GAAP basis for the first quarter were 32%, up from 30% in the previous quarter.

Now moving on to our balance sheet, we ended the first quarter with cash and cash equivalents of RMB976 million. Operating cash flow for the quarter was RMB95 million, representing a 52% sequential increase.

Adjusted EBITDA, again a non-GAAP measure, was RMB52 million for the first quarter, representing a 43% increase from the previous quarter and a 270% increase from the corresponding period in 2005.

Now let me provide you our top line guidance for the second quarter of 2006. We currently expect total revenues to be in the range of RMB186 million to RMB193 million which would represent a year-over-year growth of 167% to 177%; or sequentially, an increase of 37% to 42%.

I do wish to emphasis that this forecast reflects Baidu's current and preliminary view, which is subject to change. I will now turn the call back to Robin for his closing remarks.

Robin Li

At Baidu, we believe that the secret to success in Internet search and online marketing in China consists of three factors:

  1. Technological leadership.
  2. Local impact.
  3. Effective execution.

This doesn't sound complicated, but it is very hard to capture. I believe that Baidu possesses all of these factors for success, and I have great confidence in our ability to serve the market, to create exceptional value for our users, customers and shareholders.

Thank you again for joining us today. I will now open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Anthony Noto, Goldman Sachs.

Anthony Noto - Goldman Sachs

Thank you very much. Shawn and Robin, congratulations on another strong quarter. I was wondering if you could comment specifically on the growth, either sequentially or year-over-year, in the core Baidu business as opposed to the growth that was contributed from your Union members?

As I look at the TAC and I try to keep it constant, it looks like the TAC dollars have accelerated faster than the year-over-year growth which would imply more of your growth is coming from Union members than the Baidu site. While the Baidu site is growing fast, we're trying to get a sense of what the underlying core growth rate of Baidu is, either sequentially or year-over-year. Thank you.

Robin Li

Hi Anthony, this is Robin. I think we are not an exception in terms of growing our business both from the organic side and from the Union side. As you have seen, that TAC only represents single digits of our total revenue. Depending on the market condition, the market maturity and competitive landscape, we would make our judgment on how aggressively we will expand our Union memberships.

But at this time, the gross revenue and the net revenue -- revenue net of the TAC -- both are growing quite nicely. We don't see anything alarming here.

Anthony Noto - Goldman Sachs

Thank you.

Operator

Your next question comes from the line of Wallace Cheung - CSFB.

Wallace Cheung - CSFB

Hi, Robin and Shawn. Hello?

Robin Li

Yes?

Wallace Cheung - CSFB

Hi, congratulations on a very good quarter. A quick question, can you comment on the direct sales force contribution on the first quarter revenue? And secondly on the guidance for the second quarter. Thank you.

Shawn Wang

The direct sales force contribution continued to remain a small portion of the revenue that we have generated. You notice that we've been making an investment in building our direct sales force over the last two quarters. But given the recurring nature of our business, all of these investments have not brought in immediate revenue contribution change. So in terms of revenue breakdowns, there is not a pattern at this time.

Robin Li

I would add that if you look at the customer acquisition contribution, I think direct sales is contributing more and more.

Shawn Wang

That is right.

Robin Li

In the customer base.

Operator

Our next question comes from Jason Brueschke - Citigroup.

Jason Brueschke - Citigroup

Thank you. My question is about the average revenue per active customer. It seems to have been flat the last two quarters. On the one hand that is good because growth is coming from your new customer acquisitions; and on the other hand it represents a potential accelerator for your growth going forward.

Could you discuss in qualitative terms why that number is flat? Is it a function of the price per keyword? Is it a function of the amount of query traffic for a customer? Or is it something to do with the timing of when you are bringing on new, active customers in the quarter? Thanks.

Shawn Wang

Jason, I think it is mainly due to seasonality, as we mentioned multiple times that during the Chinese New Year holiday our traffic would suffer a decrease and some of the customers would stop their online advertising campaign. So it is purely a factor of seasonality, nothing else.

Operator

Our next question comes from Safa Rashtchy - Piper Jaffray.

Matt Schindler - Piper Jaffray

Hi, this is Matt Schindler calling in for Safa Rashtchy. Congratulations on another good quarter. I wanted to get your take on how well your small and medium enterprise customers are doing with search advertising right now? Specifically the ones that still lack their own web pages and are using the service. Do you have any sense of the ROIs they are getting, and are these ROIs transparent enough to the customer that they are not churning out of the service without knowing whether or not they got their money's worth?

Robin Li

The majority of our small and medium enterprise customers, they really have little alternative when it comes to promote their products and services. Baidu provides a unique opportunity for them to do so. Many of the SME customers do not have a good way to measure the ROI for their promotional efforts. That has two implications for our business. One, it means that the current online marketing world, and search in particular in the situation in China is that it is still in the early stage. Most of the SMEs do not understand how to take advantage of our marketing platform.

Secondly, this also shows good potential because once more and more SME realize how to measure the ROI, they will find that Baidu is the best way to promote their products and services. Lots of the SMEs, many of the SMEs offer a product or service for certain niches. It is really hard for them to find alternatives. They usually spend a small fraction of money on us in order to achieve similar results for performance. So while we have not seen any ceiling on the ROI front for the SMEs at this time.

Operator

Our next question comes from Robert Peck - Bear Stearns.

Lillian for Robert Peck - Bear Stearns

Hi, it is actually Lillian for Bob, congrats on an excellent quarter. My question is actually in light of the recent speculation that we have been hearing about recently about the potential consolidation of Internet players in the Chinese market, is there an opportunity that Baidu might be looking to pursue? Maybe you can give us some directions on where Baidu might be thinking, for example in the wireless direction. Is it possible in that area?

Robin Li

We constantly monitor the change in the marketplace, in the landscape. We believe that Baidu's core business is still growing at a rate faster than most of the businesses we have seen in the Internet industry in China. However, we will keep our minds open. If there is any opportunity that fits our strategy, we will consider that.

Operator

Our next question comes from Dick Ji - Morgan Stanley.

Dick Ji - Morgan Stanley

Good morning, Robin and Shawn. I have a question, it is more a qualitative question on the competitive landscape. I noticed that a lot of other search engine sites -- Yahoo! and Google -- are increasing their efforts in China. I wonder from your observation on the advertisers? Do they typically put keywords, buying keywords from other search engines because they are not seen enough from links coming up on Baidu? Or do you see that actually reducing their spending with Baidu and putting some of their advertising dollars into other search engines?

Robin Li

We do not see anything like reduced spending on Baidu because of the competitive offerings. As I mentioned before, we think the industry is still in its very, very early stage. The main challenge for us is market maturity, it is that most of the companies in China do not understand hw to pick up money from paid search.

So we think ware not affected by any competitive pressure in terms of customer acquisition and customer spending.

Dick Ji - Morgan Stanley

May I just have a quick follow-up to that? Do you notice most of your customers put advertisements on any of the search engines, or typically just Baidu?

Robin Li

It would depend, we don't have a concrete number on percentage, but we certainly have the largest online marketing customer base among all of the search providers.

Dick Ji - Morgan Stanley

Great, thanks Robin. Congrats on a nice quarter.

Operator

Our next question comes from James Mitchell - Goldman Sachs.

James Mitchell - Goldman Sachs

Good morning. I guess if I look at your business sequentially, quarter on quarter, you grew revenue by around RMB 21 million. Your expenses by just RMB 8 million so obviously you had a substantial operating profit margin expansion. Looking forward, with the sequential cost growth in the first quarter, is that artificially or is that slowed down by seasonality? Do you normally have slower cost growth in the first quarter of the year and then a reacceleration in future quarters?

Robin Li

James, I think first of all what you have observed is right, there is a very strong scalability in that area of our business, and that is inherent. At the same time, with your second observation it is also right in a way that the first quarter, because of the holiday season, some of the investment initiatives were delayed. We will continue to make investments in technology and upgrading our network and building our direct sales. So in the next few quarters we would expect you would see strong increases in some of the investment initiatives.

James Mitchell - Goldman Sachs

Okay, great.

Operator

Our next question comes from Safa Rashtchy - Piper Jaffray.

Matt Schindler - Piper Jaffray

Yes, once again this is Matt Schindler calling in for Safa Rashtchy. Just a macro level question about where you see growth in online advertising in China. You have experts and insiders in the field, what you think is happening to branded advertising growth, image-based advertising growth versus search and the pay-per-click models that you are doing. Where do you think those growth curves go in the next year to two years?

Robin Li

As I mentioned before, we are quite confident on the long-term sustainability of the paid search market in China. We think it will continue to grow at a very fast pace. Branded advertising apparently is growing slower than paid search, and we are aware that some of our portal colleagues announced mid-30s annual growth rate.

Baidu is not very much exposed to image or graphics-based online advertising or branded advertising, so I think maybe those people can provide a better outlook on the overall branded marketing or advertising in China.

Matt Schindler - Piper Jaffray

Do you see -- thank you.

Operator

Our next question comes from Andrew Collier - New York Global Securities.

Andrew Collier - New York Global Securities

Thank you. There was a boycott among about 750 distributors, it was my understanding, for both Baidu and Google earlier in the quarter. I noticed that obviously the expenditure per customer was flat. Did you see any impact from that boycott? Is that over? Was that part of the reason why expenditure was flat, or was that not relevant at all? Thank you.

Robin Li

That boycott has nothing to do with Baidu. None of the 700 distributors belonged to Baidu's distribution network. I think the media misreported that, in part to catch people's attention.

Andrew Collier - New York Global Securities

So you are saying they were completely related to Google?

Robin Li

I am saying we are completely unrelated to the boycott of the distributors.

Andrew Collier - New York Global Securities

Unrelated to the boycott. Thank you.

Operator

Our next question comes from Wallace Cheung - CSFB.

Wallace Cheung - CSFB

Thank you. I just wanted to have an updated headcount number at the end of the first quarter, and any planning at the end of this year or at the end of second quarter. Thank you.

Robin Li

Our headcount at the end of the quarter is around 1,800 that is an increase from the previous quarter which was around 1,300. That increase mostly is due to the expansion of the direct sales effort we are building.

Going forward in the next few quarters, we will continue to make investments in the areas that we said we were going to make, but I don't necessarily expect every quarter 400 or 500 at this time.

Wallace Cheung - CSFB

I just wanted to have an update on the R&D headcount as well.

Robin Li

The R&D headcount has also increased the same way as the previous quarters. That is just a static, normal increase.

Wallace Cheung - CSFB

Okay, thank you.

Operator

Our next question comes from Steve Winston - Pacific Crest Securities.

Steve Winston - Pacific Crest Securities

Thank you. I just want to ask Anthony's question a little bit differently. Can we use the growth rate in TAC as a reliable proxy for the growth in the Baidu Union, or is there some change taking place with the TAC rate that would make that a bad assumption?

Robin Li

I think historically yes, but going forward we consider TAC as a form of investment so we would like to maintain the flexibility of the TAC as a percentage of total revenue. So whatever it takes to extend the business to make Baidu the largest online marketing platform and to grow our revenue both in terms of net revenue and gross revenue, we will do that.

Steve Winston - Pacific Crest Securities

And did that apply in the current quarter? You said the TAC rate changed in the current quarter.

Robin Li

I think I already said that the TAC for the current quarter as a percentage of total revenue, a non-capital material change from Q1 of this year.

Steve Winston - Pacific Crest Securities

Thank you.

Our next question comes from Anthony Noto, Goldman Sachs.

Anthony Noto - Goldman Sachs

Thank you very much. Shawn, I definitely appreciate the seasonality in the expenses given the first quarter's holiday impact. We expect expenses to accelerate. But do we expect the expenses to accelerate faster than the rate of growth in revenues, so that the margins probably come down over the next couple of quarters? My guess is you don't want to have margins on the EBITDA level, excluding stock-based comp, in the 40% plus range, given all of the growth opportunities ahead of you; and that was just an outcome of really strong revenue performance against even modest expense because of the holiday. Is that accurate?

Shawn Wang

Let me just re-emphasis again. When we were looking at our business, making investment decisions, we are not necessarily having the most important weight, the only parameter as achieving certain margin levels. We are making an investment in an area where we think we will be able to grow our revenues in the longer term, and we believe this is still very early stage.

This result, the Q1 result was a reflection of the inherent scalability and also stronger than expected top line growth. Going forward, we will continue to make investments.

Robin Li

I think, Anthony, the goal is not to keep the margin low for the current quarter or after; the goal is to set a solid foundation for the long-term growth of this Company. So we will make necessary investments whenever we see opportunities. That is why we haven't given any bottom line guidance for the past three quarters.

Anthony Noto - Goldman Sachs

Great, thank you.

Operator

Our next question comes from Jason Brueschke - Citigroup.

Jason Brueschke - Citigroup

Thank you. My question has to do with the build-out of the direct sales force. You added a lot of headcount in Q1, a lot of that you said was the expansion of the direct sales force. Two questions: Are those all organic hires, or are you acquiring some of your distributors and bringing them in-house and adding to your direct sales force that way?

And to the extent that you are adding organically to your direct sales force, could you maybe discuss about how you are thinking about the potential channel conflict between a direct sales force out calling on potential customers versus your distributors who may be out there calling on the same customers? Thanks.

Robin Li

Our direct sales force, in terms of the adding of the direct sales force, we are not actually doing it -- we are only doing it in our selected markets where we believe there is potential for efficiency gains. If our distributors are not necessarily performing to what we set out for them to do, we will consider to use the direct sales force.

So far there hasn't been any conflicts that would turn out to be an issue for us at this time. The direct sales force addition is mostly organic growth rather than acquisition. We have seen overall, stronger service quality and efficiency in the direct sales force.

Going forward, we will continue to maintain the same strategy we laid out, which is basically having a different strategy in a different market, whereas the more sophisticated, more developed market has the higher demand for customer services, we will provide more direct sales service approach. Whereas in other markets, we will continue to rely and support our distributor network to grow.

So there is no conflict between direct sales and channel sales, because each sales team is dedicated to specific geographic locations.

Jason Brueschke - Citigroup

Thank you.

Operator

Your next question comes from the line of Robert Peck of Bear Stearns.

Lillian for Robert Peck - Bear Stearns

Hi, it is Lillian again for Bob. My second question is a little bit more on the technology innovation side. We have noticed your initiatives recently, user-generated content, especially in light of the recent launch of Baidupedia, Baidu Post Bar, Baidu Knows, Baidu Community. What are your thoughts on the Web 2.0 phenomena such as tagging or social media, social networking going forward? Thanks.

Robin Li

From my point of view, Baidu was a Web 2.0 company since day one because we never generated any content by ourselves; we don't have any editors to edit the content. Originally we provided a search function to all people to find information that is being created by somebody else, other web sites.

Later on we found that given that we had a large user base, we could enable our user base to communicate with each other and help each other to solve their problems and to find information for them. That is why in 2003 we launched the Baidu Post Bar which is a community, and now it is probably one of the most popular online community in China.

Later on, last year we launched Baidu Knows, a knowledge-based search service and last fall we launched Baidupedia to allow our users to edit the official definition for certain content in the queries. We believe, given our trends in our user base, we are very well-positioned to take advantage of the trend and users will have better ways to participate in the creation of content.

Having said that, I emphasize that Baidu view is that a search engine company, for whatever we do, those functions surround the search end, and the purpose is to enable people to find information in better ways.

Lillian for Robert Peck - Bear Stearns

Just quickly, in terms of priority, how does your initiative in user-generated content compare to other technology innovations, such as local or wireless? Is there a difference in priority, or are they pretty much all priorities for you guys?

Robin Li

Well, the goal or our mission is to provide the best way for people to find information. We will sort out the priority based on how a product can help achieve this goal.

Lillian for Robert Peck - Bear Stearns

Thanks.

Operator

Your next question comes from the line of James Mitchell of Goldman Sachs. Please proceed.

James Mitchell - Goldman Sachs

Hi, this is a quick question. Can you provide guidance on the tax rate for ’06?

Shawn Wang

As I mentioned earlier, our tax rate for this quarter was 16% effective tax rate, and that is due to the fact that one of our main operating subsidiaries, Baidu Online, the tax holiday has expired last year, so it went into a new phase.

We are in the process of negotiating this with the government authorities in both Beijing and in Shanghai. In Shanghai, that relates to our newly set up entity, Baidu China. We are in the process of acquiring certain additional tax benefit. At this time, it is too early to give any specific forward-looking information on that.

Operator

Your next question comes from the line of Chang Qi of Foreign Technology Research. Please proceed.

Chang Qi - Foreign Technology Research

Good morning, and congratulations. Robin, I have one question for you. Earlier in last conference call, you kind of mentioned competition helps in terms of education, the market. Recently, you were quoted as saying in five years, Google will not be around in terms of Chinese search. Can you elaborate a little bit more here?

Robin Li

First of all, I still think that competition helps to educate the market, solely because of the early stage of this business. I think the media kind of misreported on my comment about the competitive landscape in the future. I said in five years, Baidu will be the predominant player in the Internet search base in China. That is true today and I believe that will be true five years down the road.

Chang Qi - Foreign Technology Research

Thank you.

Operator

Your next question comes from the line of Tony Tang of Lucite Research. Please proceed.

Tony Tang - Lucite Research

Hi, thanks for taking my call. My question is related to some legal issues. Recently, Google and some U.S. search engines was involved and accused of fraudulent clicks measured, and then Google agreed to pay, if I remember correctly, it will be $50 million as the compensation.

So I just wonder if Baidu sees anything happen in China in the markets, and if so, what is Baidu's position on this issue? Is Baidu developing any new technology to prevent this happening? Thank you.

Shawn Wang

I’m sorry, Tony, the question relates to fraudulent clicks? Is that your question?

Tony Tang - Lucite Research

Yes, that is right.

Shawn Wang

Baidu was the first search engine in China, so from the very beginning, the measures to prevent fraudulent clicks has always been high on our priorities. We have set up numerous measures, both through an automated technology and also through manual efforts to prevent that from happening, and we have engaged third parties to help us test the system as well.

I think so far it has proved to be very effective, anti-fraudulent click measures, and our customers have been generally happy with the results. We have not received the type of complaints or even a suggestion or the indication of that kind in China.

Also, my understanding of that, I do not think the Chinese legal system has the practice of allowing class actions at this stage, but that is a minor point. Fundamentally, we are investing aggressively in anti-fraudulent click measures, and so far it has been working very well.

Tony Tang - Lucite Research

Okay, thank you. One more thing about your projections for the online market customers. You are really assuming 74,000 customers. Could you provide geographic description for these 74,000 customers? Then, going forward, what kind of rate do you see this customer growth?

Shawn Wang

The 74,000 customers continue to represent a very diverse and scattered representation of industries. Our customer composition was very much -- I think in previous quarters, they were up, roughly about 40 industries represented by the top 80% of our customers, and that trend continues. I think we even see a somewhat even more diversification as our customer base continues to expand.

Tony Tang - Lucite Research

What about geographical distribution?

Shawn Wang

Geographically, there is not a fundamental change either. It continues to represent basically the economic activities throughout China.

Tony Tang - Lucite Research

Thank you.

Operator

Your next question comes from the line of Wallace Cheung of Credit Suisse. Please proceed.

Wallace Cheung - Credit Suisse

Can you comment on the user experience and advertisers’ experience in the last few months, are they improving or deteriorating? And any specific KPR that you are looking at internally? Thank you.

Robin Li

We have a very large team of people to study the user experience of our product and features on a daily basis. We continue to make changes to our existing product while launching new products.

The basic measurement for user experience is actually page views. We have closely monitored the page views increase of each of our products and features. If our users like it, the page views will likely increase. If our users do not like it, the page views will likely to remain flat or grow slowly. That is how we look at our user experience.

Wallace Cheung - Credit Suisse

And the advertiser’s experience?

Robin Li

The advertisers? In terms of advertisers, I mentioned during our previous conference call, pay-for-performance performance is still very a young business model, and we have been continuously improving the marketing platform, so the experience for our advertisers have been improving, and we are continuing to make improvements on our advertising platform, customer interface, things like that, going forward.

Wallace Cheung - Credit Suisse

Thank you.

Operator

Your next question comes from the line of Ray Bing of Deutsche Bank. Please proceed.

Ray Bing - Deutsche Bank

Yes, just stepping back a little bit, there seems to be an uprising of a lot of new companies and some of the existing players focused on your end-customer base, small, medium businesses. Could you just give us a sense of how you think over the course of this year the environment will change as a lot of companies, both large and small, start to target the small, medium business in China, trying to help the people online trying to reach more customers?

Robin Li

Yes, more players coming into this space actually validates our position that an SME market is a fast-growing and promising space. I think by far Baidu has the largest online advertising network in China, and on one hand, we continue to grow our traffic, both organically and through Union, so that advertisers can reach the broadest audience possible when they come to Baidu.

On the other hand, we also aggressively grow our customer base or advertiser base, so that any traffic can be left to monetize through Baidu’s online marketing platform. That is why we report a number of online active customers each quarter, with is also very important.

Ray Bing - Deutsche Bank

As the space gets more crowded, and as you say, it’s an immature market where a lot of the SMEs do not understand the power of search. Are you going to change the way you approach the market or the way you sell in order to make sure the customer base is educated? I think over the course of this year, it looks like they are going to get bombarded with different opportunities or ways to get online. It seems like there could be a lot more confusion rather than clarity going forward. Could you change your marketing strategy at all?

Robin Li

Yes, you are right that many of our customer base have been approached by some of the other players in this space, but I think time is working for us. As the SMEs get more mature, they understand more about Internet promotion or marketing, they will realize that Baidu is the best way to promote their services and products.

So what we have been doing during past years is to regularly launch nationwide road shows to educate the SME market on how to take advantage of our platform, and the result seem to be very effective, satisfactory. Once the SME’s come to us and try our service, they will realize that we can provide the best results for them.

Ray Bing - Deutsche Bank

Thank you.

Operator

Your next question comes from the line of Steve Winston of Pacific Crest. Please proceed.

Steve Winston - Pacific Crest

Thank you. In the press release, you talked about growth in your contextual advertising products. Could you give us a sense of the scale of that product today and kind of where you are in the development of it, and where you think it is going?

Robin Li

Unlike some of the U.S. search companies, we do not make sudden change of our online marketing platform. We continue to make improvements and changes here and there, to make sure our customers have a smooth transition of the online experience.

So we made some changes in Q1 and we will make more changes in the current quarter. The change has been related to the way we display the page, or the sponsor links, how many links we display, the way advertisers fit against each other, things like that.

We think the result of the change has been very satisfactory, the past result, as well as the Q2 guidance does reflect our judgment, improvement of the pay for performance platform.

Steve Winston - Pacific Crest

Thank you.

Operator

Your next question comes from the line of Robert Peck of Bear Stearns. Please proceed.

Lillian for Robert Peck - Bear Stearns

Hi, it’s Lillian for Bob again. One last question on my side and I will let someone else go. I want to quickly follow-up on the direct sales support effort that you just talked about. Is there any metrics or indicator that we can look at to get a feel as to whether the direct sales expansion is a good financial decision for the Company?

Shawn Wang

Right now, we are still at the very early stages of that. I think what we are looking at is the people we put in place and the quality of the customers they generate and the speed at which they generate. The results we have seen is very encouraging in comparison to our distribution networks in the same market that has performed before.

But in terms of the actual dollar contribution, it is yet to come. At this time, since we have not broken down the revenue contribution between the direct sales and network, I guess it is hard for you to tell at this time.

Lillian for Robert Peck - Bear Stearns

Okay, I understand that you did not break down the percentage of revenue generated from direct sales force versus independent resellers, but just directionally, does the percentage increase or decrease compared to the previous period? Is there any color on that?

Shawn Wang

Over the longer term, as I mentioned, in some of the markets, we are expanding the scale of direct sales operations. At the same time, direct sales operations does have a stronger performance than their predecessors, so the share of the contribution will increase, and I think this is on the beginning ramp, the beginning period of increasing contribution.

Lillian for Robert Peck - Bear Stearns

Thank you.

Operator

Your next question comes from the line of Safa Rashtchy of Piper Jaffray. Please proceed.

Matt Schindler - Piper Jaffray

Hi, this is Matt once again with a final question. You mentioned growth in traffic was strong. Are there any metrics you can give us on traffic growth? As you know, there is probably very limited access to information sources for Chinese traffic growth. I was hoping for page views or unique users or something on that order.

Robin Li

For obvious reasons, we do not disclose the page views, but if you look at the third party surveys, as well as some of the online websites, you will see that Baidu traffic continues to grow, and we look at the gap between us and other Chinese websites widening. Internally we have noticed that our traffic continues to grow at a very healthy rate.

Matt Schindler - Piper Jaffray

Okay. I know that giving exact numbers are difficult, but would percentage changes and percentage growth quarter to quarter compromise you competitively?

Robin Li

I think each quarter has its seasonality. It is really hard to say that a 20% growth quarter on quarter is good or bad, if you do not look at the historical numbers for the past few years. So at this time, we prefer not to give any percentage for quarterly change on the traffic.

Matt Schindler - Piper Jaffray

I understand. Thank you.

Operator

Your next question comes from the line of Richard Ji of Morgan Stanley. Please proceed.

Richard Ji - Morgan Stanley

I have a question regarding your initiative on mobile and local search. What is the status right now, and what are your plans? Thank you.

Robin Li

I think local search is still at a very early stage. Nobody has figured out how to do it yet. However, we know that local represents a very large opportunity sometime in the future, so we are closely monitoring the development of local search.

Speaking of mobile, as many of you are aware, China will rollout the 3G mobile network in a year or two, which will enable many cell-phone users to access Internet in a better, faster and cheaper way. We have been working with some of the industry leaders in this space to take position so that whenever the user habit changes or the user preference changes, we will be able to notice that and tailor our services to better serve those mobile internet users.

Operator

Your next question comes from the line of Ari Schwagg of Set Capital. Please proceed.

Ari Schwagg - Set Capital

Just to get a little clarification on the costs. I realize you are not giving specific guidance on the cost, but you guys are talking about, at the midpoint about 40% sequential increase in revenues. How fast do you think you could ramp up the expenses? It does not seem like you can increase the expenses by 40% sequentially.

Robin Li

I think this question also relates to Anthony’s question previously. It is very hard to say a stable margin, or a margin increase or decrease is good or bad to the Company without looking at the fundamentals; the market conditions, the market maturity, and competitive landscape.

We will continue to do whatever we think is the best for the long-term growth of the Company. In the meantime, we cannot really make a short-term prediction of how aggressive we will spend to achieve that goal.

Historically, you see that our business has very good stability and I believe longer term, it will remain so; but we just cannot say whether the current quarter will be a quarter for the rest of the investment.

Ari Schwagg - Set Capital

Can you talk about the areas where you would be spending the money, if you would be, and how fast you think you can ramp those?

Robin Li

Ari, I think I can comment in terms of the areas we would like to make investment. First of all, we will continue to make investment in the network capacity, upgrading our network. Secondarily, in R&D, in rolling out new products and services. We will continue to do that. Thirdly is the continued expansion and improvement of our distribution network, which involves both the strengthening of direct sales as well as providing additional stronger support for our distribution network. I think all these areas we expect to see continued investment.

Ari Schwagg - Set Capital

Sound great. Congratulations, great quarter and great guidance. Thanks.

Operator

We are now approaching the end of the conference call. I will now turn the call over to Baidu’s Chief Executive Officer, Robin Li, for his closing remarks. Please proceed.

Robin Li

Once again, thank you for joining us today and please do not hesitate to contact us if you have any further questions. Thank you.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

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Source: Baidu.com Inc. Q1 2006 Earnings Conference Call Transcript (BIDU)
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