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Baidu, Inc. (NASDAQ:BIDU)

Q4 2008 Earnings Call Transcript

February 18, 2009 8:00 pm ET

Executives

Linda Sun – IR

Robin Li – Chairman and CEO

Jennifer Li – CFO

Haoyu Shen – VP, Business Operations

Peng Ye – COO

Analysts

Eddie Leung – Banc of America

Ming Zhao – Susquehanna International

Dick Wei – JP Morgan

Wallace Cheung – Credit Suisse

Eric Wen – MainFirst

Jeffrey Lindsay – Sanford Bernstein

James Lee – Sterne Agee Capital Markets

Paul Wuh – Nomura International

Wendy Huang – RBS

Elinor Leung – CLSA

Stephen Ju – RBC Capital Markets

James Mitchell – Goldman Sachs

Jason Brueschke – Citigroup

Richard Ji – Morgan Stanley

Steve Weinstein – Pacific Crest

Tian Hou – Pali Capital

Kar Kwong – Needham & Company

Paul Keung – Oppenheimer

Operator

Good day, ladies and gentlemen, and welcome to Baidu's Fourth Quarter and Full Year 2008 Earnings Conference Call. My name is Michelle and I will be your coordinator for today. At this time, all participants are in listen only mode. We will be conducting a question and answer session toward the end of this conference. (Operator instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today’s call, Ms. Linda Sun from Baidu Investor Relations. Please proceed.

Linda Sun

Hello, everyone, and welcome to Baidu's fourth quarter and full year 2008 earnings conference call. We distributed Baidu's fourth quarter and fiscal year 2008 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, Baidu's Chief Executive Officer, and Jennifer Li, Baidu's Chief Financial Officer. After their prepared remarks, Robin and Jennifer will be joined by Peng Ye, our Chief Operating Officer, and Haoyu Shen, Vice President of Business Operations 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. 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 web cast 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, Robin Li.

Robin Li

Hello, everyone, and thank you for joining us today.

2008 was a year of strong growth for us with total revenues up over 80% from 2007. That said, the fourth quarter was a very special quarter for us. In particular, Chinese economy experienced a sudden slowdown and many businesses, including our customers, became more cautious in their marketing spending. Also during Q4, we removed questionable paid search listing from several sectors. Despite this factor, we still delivered a 58% revenue increase from Q4 of 2007. This result underscores our strong ability to execute. And coming off of this quarter, the quality of our customer base is now higher and our operational controls are now tighter.

Going into Q1, we expect any of our customers will continue to be affected by weak macro conditions and the typical seasonality around Chinese New Year. However, we have already observed some positive trends during Q1, which I would like to share with you. First, our advertising campaign has generated positive feedbacks from our users, customers and employees. During the Chinese New Year period, we launched an advertising campaign that included prominent placements, the CCTV New Year’s eve gala. Over 90% of Chinese household viewed this program. Second, I am pleased to note that in the weeks following Chinese New Year, we have seen significant traffic growth in the customer spending.

Moving on, I would like to discuss our main focuses for 2009. First, on the customer front, one of our primary effort in the near term is to educate the market. We want to let more people know that the best way to get revenue during a difficult time is to market their products and services on Baidu. Our addressable customer market is huge. Of the approximately 40 million SMEs in China, currently about 200,000 are Baidu customers. And we are confident that with our increased sales efficiency and marketing efforts, we will successfully educate an increasing number of Chinese businesses about the advantages of our performance based platform. Furthermore, our sales model, a combination of direct sales and local distributors is unique in its ability to reach out to SMEs nationwide.

Another significant effort we're undergoing in this area is the new online marketing system codenamed Phoenix Next that has been in beta phase since Q4 of last year. The objectives of Phoenix Nest are to improve relevancy in paid search and increase value for customers, thus driving monetization efficiency. Phoenix Nest achieved the objective through an enhanced algorithm that searched more relevant marketing messages. It also provides customers additional tools and information to help them better manage their spending to achieve higher ROI. We have been receiving positive feedback from customers so far, and we plan to make Phoenix Nest broadly available in the second quarter of 2009. With the rollout of Phoenix Nest, we expect Baidu’s monetization capabilities to rise to a new level.

Moving on to the user side, a key new innovation that was announced in December is Aladdin. Aladdin is an ongoing R&D effort aimed at uncovering useful parts of the hidden web in order to enrich such results for our users. The core of Baidu's search experience is offering constant improvements to the abundant, timeliness and the relevance of such results. Aladdin will do just that, improve user experienced gradually but surely.

Another ongoing user focused project that many of you are familiar with is our C2C be to be platform, Baidu Youa. We launched Youa in the fourth quarter of 2008. We believe in the synergies between search and e-commerce and our enormous user base gives us a unique advantage in this space. Baidu Youa has been met with lot of excitement. As of the end of 2008, a short two months after its beta launch, we have almost 140,000 sellers and over 15 million commodities listed on Baidu Youa. We will continue to grow Youa in the quarters to come and we'll keep you updated on the progress. To briefly update you on Baidu Japan, which we officially launched in January 2008, the focus in 2009 continues to be on products development. And also in 2009, we anticipate starting to drive overall traffic. We will keep you updated on our progress too.

Before concluding, I would like to say that we have the right strategies in place to tackle the current economic challenges and at the same time we are well positioned to capture the benefit of our market’s long-term potential. According to CNNIC, the Internet population in China reached 298 million in 2008. This means Internet penetrating grew from 16% to 22.6% in one year, but this level is still far below that of mature markets. And with Baidu's status as the market leader, we have 73.2% of market share according to iResearch.

Our long-term prospects remain tremendous. Combining all of this with our (inaudible) model, experienced management team and strategies to generate growth and profitability, Baidu is uniquely positioned for success.

Now, I will turn the call over to Jennifer for financial highlights.

Jennifer Li

Thank you, Robin. Hello everyone. Good morning and good evening.

First of all, we apologize for the brief delay getting into the call. We had a very unusual snowfall in the city and many of the drivers are re-learning how to drive on the street, so a couple of the key participants were delayed. Getting back to the content of the call, as you know, the economic slowdown in China combined with the removal of certain paid search listings caused us to revise top line expectations for the fourth quarter. We are pleased to have exceeded the revised guidance.

Now let us look at some of the financial highlights for the quarter. The amounts mentioned below in RMB except otherwise noted. Total revenue for the quarter was $902 million, an increase of 58% year-over-year. For Q4, Baidu had more than 197,000 active online marketing customers, representing a 1.5% increase from the previous quarter, and 27.1% increase from the corresponding period in 2007. Revenue per online marketing customer or the fourth quarter decreased slightly from the third quarter, primarily as a result of some of the paid search links. For the full-year 2008, the number of active customers increased 32.7% and revenue per online marketing customer increased 38.3% from the previous year.

Traffic acquisition cost as a component of costs of revenue was 14.6% of revenue versus 11.8% for Q3 and 12.7% a year ago. Included in the Q4 tax numbers was a one-time adjustment, which accounted for 0.7% of revenue. Without this adjustment, tax for the fourth quarter would have been 13.9% of total revenues. 2008 tax as a percent of revenue was 13.1% versus 11.7% in 2007, reflecting growing Baidu Union contribution to revenues. Bandwidth cost and depreciation cost as a percentage of revenue both decreased in the fourth quarter compared to a year ago level, primarily due to increased equipment efficiency and scalability of our network.

Selling, general and administrative expenses increased to 32.6% over Q4 '07, and up 60.5% on an annual basis, mainly due to increased compensation costs and greater marketing expenses. R&D expenses increased 84% over Q4 '07, mainly due to additional headcount. Total R&D expenses for 2008 was $286 million, a 103% increase from 2007, reflecting continued investment in our R&D capabilities. Share-based compensation expense, which were allocated to related operating costs and expense line items increased in aggregate to $21.5 million in the fourth quarter from $13.3 million in the corresponding period in '07. The increase in share-based compensation expenses primarily reflects increased options and share grants.

Operating profit increased to 73% over Q4 '07. For the year, operating profit reached $1.1 billion, double the level of 2007. Total headcount as of December 31, 2008, was about 6400, roughly 400 fewer than at the end of Q3. The net change in headcount includes increases in R&D workforce and decreases in sales and marketing due to efficiency improvement. Income tax expenses was $41.8 million. The effective tax rate increased from 9.1% in the third quarter to 12.7% in the fourth quarter of '08, primarily due to tax rate catch-up for our software enterprise subsidiary based on new local tax interpretations. For the other subsidiaries, we have been informed that under the new tax law, these entities qualify as new high-tech enterprises. As such, they will continue to enjoy the preferred corporate income tax treatment. The effective tax rate for the full year 2008 was 10%. For 2009, we expect our effective tax rate to be in the low teens.

As of December 31, 2008, the company had cash, cash equivalents and short-term investments of 2.7 billion. Net operating cash flow and capital expenditure for the fourth quarter of 2008 were $482 million and $61 million respectively. Full year net operating cash flow and the capital expenditures were $1.6 billion and $480 million respectively. The company's strong cash flow generating ability will allow us to stay on track with our strategies during a weak economic environment.

Now an update on Baidu’s share repurchase program. On December 16th, Baidu’s shareholders approved a $200 million share buyback program. Subsequently Baidu entered into repurchase agreements before the blackout period started. As of now, the company has bought back over 30,000 shares. We will continue to execute the repurchase program based on market opportunities.

Looking into 2009, we will continue to take a disciplined and a strategic approach to costs while we focus on growing the top line and making responsible cost efficient, we will continue to invest in our core R&D capability and strategically important initiatives. Looking into Q1, we typically have higher marketing expenses during this quarter related to annual events such as the boiling point standings, which promotes our products, and services related to entertainment search. This year in particular, we incurred additional marketing spend during the Chinese New Year. Our incremental marketing budget for the first quarter of 2009 is approximately RMB40 million more than that of Q4.

As an update, our Internet TV channel outsourcing agreement with UiTV, which was signed in the third quarter of 2008, entails a total income of $50 million. This income will be gradually recognized as other income. We will inform you when the deal is officially closed and when we have more clarity on the timing for the income. In 2009, we expect to invest approximately $25 million to $30 million in Baidu Japan as compared to $19 million spent in 2008. The incremental expensed will mainly be incurred in R&D where we plan to devote more resources to product and technology development. In 2009, we will make an additional $30 million to $40 million investment into the construction of Baidu campus. The total spend is in line with our previous budget.

Now let me provide you our top line guidance for the first quarter 2009. The current economic downturn has proven to be widespread in its impact, affecting all industries to varying degrees. We believe with our focused sales efforts and our cost-effective and flexible marketing platforms, both established online marketers and new SME customers will increasingly seek out the measurable ROI that our platform offers. We expect a moderate year over year growth for the first quarter of 2009, primarily due to two factors. One, a portion of our online marketing customers may scale back their marketing spending given today's market environment. Two, we expect that the removal of certain sponsored links during the fourth quarter of '08 has resulted in a net loss of 5% of revenue which impacts Q1. We currently expect total revenues for the first quarter of '09 to be between RMB780 million and RMB 800 million which will represent annual growth rate of 36% to 39%. I do wish to emphasize that this forecast reflects Baidu's current and preliminary view, which is subject to change.

I will now open the call for questions. Operator, please go ahead.

Question-and-Answer-Session

Operator

(Operator instructions) Your first question comes from the line of Eddie Leung with Banc of America. Please proceed.

Eddie Leung – Banc of America

(inaudible) full rollout of Phoenix Nest, could you guys tell us the difference between the current trial versions and the full versions of Phoenix Nest? And my second question is related to the increase in Phoenix net revenues as a proportion of revenues in the fourth quarter is was it more driven by an increase in partnerships or just directing more advertising links to your partners? Thanks.

Haoyu Shen

Hi, Eddie. It is Haoyu. So Phoenix Next is a new auction system that is different from (inaudible) today, we are testing, starting from Q4, we are testing, but the work started actually early art of 2008, now we are just testing it… hi, sorry. I was on mute, so Eddie, how are you? The question about… so, the phoenix nest is a new auction system we are testing. We started working on this early part of 2008. We started testing it in beta version starting from Q4. Now we have over 600 customers participating in it and it is invitation based only. So the difference right now between – there is a lot of difference between Phoenix Nest and the current system in terms of the different data, the more data that customers can get, the more tools we give them to manage their budgets, and also the setup is different. Now the other difference right now is it is only tested on the right hand side, but the goal is to eventually make this more broadly available to other customers, which we are planning to do within Q2. And also in Q2 potentially, we will open up some space on the left hand side, the top left hand side space to Phoenix Nest as well. As far as the revenue contribution in Q4 from Phoenix Nest, it is very small. Because it is invitation based and it is – we only have a few hundred customers participating in it, and it is very important to note that this system over time will get better. Once we accumulate more data, and the experience from the customers, it'll definitely get better, and monetization will increase.

Eddie Leung – Banc of America

Hey, how are you? Just one quick follow-up, so this new system will run in parallel to the current paid listing mechanism, right?

Haoyu Shen

Right. For a while. We don't know how long it is going to be yet and for a while it will be running in parallel.

Eddie Leung – Banc of America

Okay, thanks.

Operator

Your next question comes from the line of Ming Zhao with Susquehanna International. Please proceed.

Ming Zhao – Susquehanna International

Hello. Good morning. Thank you for taking my question. The question is in terms of the impact from the macro economy, I think last quarter's management mentioned that manufacturing and franchise are the two verticals impacted, heading into 1Q, have you seen other verticals that are negatively impacted such as education and training and maybe the dotcom companies, the Internet companies?

Peng Ye

Hi, this is Peng Ye. I think only very small potential geography of customers (inaudible) it is true that many of our customers are cautious and have scaled back their spending, but we have already seen after the Chinese New Year very strong pickup after Chinese New Year holiday season and also both in terms of customer spending on their marketing budgets and also the new customer accretion that is the current situation. We do not have the visibility on their marketing budget beyond this quarter.

Haoyu Shen

Hi, Ming. This is Haoyu. On the question about education, my sense – our sense is it is impacted, but it appears to be more resilient than many of the other sectors.

Ming Zhao – Susquehanna International

Okay, thank you.

Operator

Your next question comes from the line of Dick Wei with JP Morgan. Please proceed.

Dick Wei – JP Morgan

Hi. Thanks for taking my question. I have a question on TAC, how should we look at the TAC going into 2009, particularly I believe there is more new initiatives associated with content networking that is going into the Baidu Union space, I don't know if that will significantly drive up the TAC cost or it'll still be going up eventually? And also wonder whether you have seen any impact from some of the smaller sites being shut down due to the government tighter control, which began earlier this year? Thanks.

Haoyu Shen

Hi, Dick. It is Haoyu. So TAC as Jennifer mentioned that in Q4 we had some one-time adjustment that made the TAC in Q4 high, but excluding that, we think TAC is growing at a very comfortable range. So if you look at the whole year of 2008, it ranges from 11% to 13%, and it really largely reflects the faster growth of Union contribution to Baidu overall. If you look at our TAC rate – TAC as a percentage of Union revenue, it is very stable. So over time we are not paying a high percentage of our Union revenues to our Union partners. Going forward, I expect it is possible that Union revenues well continue to grow faster, but I don't think it will go grow dramatically faster than our organic revenue. Organic revenue is also growing at a very healthy rate. And you mentioned the content network, so if you look at our Union business, basically two parts. One is search network. Third-party partners bring search traffic to us and we share revenues with them. The other is content network, contextual links. So contextual links in search of in terms of revenues is still a small – a minority in the total Union revenue contribution and we're putting a lot of effort into that in the past. We will continue, we will probably even increase our focus this year as part of that business. That business does tend to have a higher TAC ratio than the search business, but as I said, it is a smaller percentage of our Union revenue and that is something we're putting a lot of focus on, and I think that is one of the biggest growth areas going forward for the company.

Peng Ye

And on the tighter control on content by the government, we have not seen any meaningful impact yet.

Dick Wei – JP Morgan

Right. Thank you very much.

Operator

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

Wallace Cheung – Credit Suisse

Hi, good morning. Just wanted to understand a bit more about the C2C business in terms of the cost impact in 2008 and any guidance in terms of 2009. Thank you.

Jennifer Li

Hi, Wally, this is Jennifer. On the C2C investments, you know we have informed everybody in the past how we leverage our R&D capabilities, and the cost related to the platform to date has not amount to a material amount which warrants a separate disclosure. At this point it is still the case. Going forward we will continue to grow the business and we will invest accordingly. When it comes to the material level for a separate disclosure, we will provide more information.

Wallace Cheung – Credit Suisse

Just quickly, I think last time you mentioned that expenses to be substantially lower than Japan business, does it still go on?

Jennifer Li

It is still the case.

Wallace Cheung – Credit Suisse

Thank you.

Operator

Your next question comes from the line of Eric Wen from MainFirst. Please proceed.

Eric Wen – MainFirst

Hi good morning. Thanks for taking my questions. I just want to – Jennifer, can you elaborate a little bit more on other income. You mentioned that – I didn't hear it clearly, the Baidu TV that is being recognized and why it needs to be amortized instead of just equity recognition of income?

Jennifer Li

First of all, the deal, Eric, was signed in Q3 of '08. It is not completely closed deal yet. So we do in the structure of the transaction a $50 million that should be categorized as other income and it depends on the terms of the payment. We believe it should be amortized over time, rather than one time. So it all depends on the final closure of the deal and what we intend to inform everybody is, we will provide more clarity on the timing and we will provide the information on the transaction and when that is going to happen.

Eric Wen – MainFirst

Sure. Can you just add on, going forward, is this going to be equity investments, equity or investment, basically your ratio is more than 20% or less than 20% ?

Jennifer Li

As we disclosed in the initial transaction, Eric, we have 8% of the equity in UiTV.

Eric Wen – MainFirst

Right, okay. So it is going to be an ongoing investment, okay thanks.

Operator

Your next question comes from Jeffrey Lindsay with Sanford Bernstein. Please proceed.

Jeffrey Lindsay – Sanford Bernstein

Thank you for taking my question. Could I ask, why you feel the need for diversification either geographic in the case of Japan or into new business areas like e-commerce in China, does that imply that there is no sufficient growth in the Chinese search business?

Robin Li

We strongly believe that there is a tremendous opportunity for growth in the Chinese search area for many, many years down the road, but our ambitions go beyond Chinese search. That is why we are making the investment in areas like search in Japan and related areas like e-commerce related search services. We really view this kind of initiatives have great synergies with our existing businesses. The Japanese search shares very fundamental core technology with our Chinese search and e-commerce. The C2C initiative share a very great customer or user base with our existing Chinese search services. As a high growth and an innovative company, we will continue to innovate and try different things. These are two of the larger initiatives, we also have many other small projects going on, and I think that is the right strategy for the company.

Jeffrey Lindsay – Sanford Bernstein

Thank you.

Operator

Your next question comes from James Lee with Sterne Agee Capital Markets. Please proceed.

James Lee – Sterne Agee Capital Markets

Good morning. Can you guys give more color about the customer feedback on the Phoenix Nest system, can you give a sense of what do your customers like about the system, any specific thing that they want you to improve that you are going back to the lab and trying to make a better? And do they view that as a core system or do they sort of view that as a complementary system. And also maybe Robin you can talk about this, can you talk about the click through rates of the new system versus the old system, maybe compared to CPC a little bit, and lastly maybe talk about some of the verticals that are most receptive to the new systems so far? Thanks.

Robin Li

I will let Haoyu handle this adding if there is any?

Haoyu Shen

Yes, James, the Phoenix Nest is now invitation based. It is on the right-hand side only, a few hundred customers are participating. So far they like it, we see good participation. They like it for a few reasons. One, we give them more choices of key words, because it’s on the right hand side, we offer broad match, straight match, not just an exact match, because we only do exact match in our old systems. And also we give them more tools to manage their budgets. In the back end, we also give them more data, and we are reporting so that we they can measure their ROI more clearly than before. So right now we have these two systems running in parallel, some of them probably view this as complementary, but we also made it very clear, we will make it very clear to our customers when we broadly available that this is the future. We will make it a success and this will bring a better system for them, this will be a better monetization system for us. So eventually I think Phoenix Nest well just the Baidu’s new auction system. As far as some of the statistics you mentioned, CPC and CPR, CPC because it is still on a small scale, so it is very hard to tell whether the difference with the current system is material, especially because that is only on the right-hand side, so a lot of statistics, may not indicate it is going to happen when we open up more space meaning the left-hand side of Phoenix Nest going forward.

James Lee – Sterne Agee Capital Markets

Can I ask you a follow-up question, in theory, right, when you have the new auction system or bidding system on the right, and in theory the click through rate should be lower than what you typically face in – experience in the past on the left side, right? Is it kind of fair to say?

Haoyu Shen

Right. It is definitely fair to say. For anyone I think the click through rate on the right-hand side is lower than the left-hand side.

James Lee – Sterne Agee Capital Markets

Okay. And are you able to balance it may be with higher CPC, assuming people click on the right side, they have a greater intention of going to a customer site and doing a transaction? So in theory you can offset that with a higher CPC pricing in the future?

Haoyu Shen

Right. That is conceivable but at the end of the day, we don't set price, it is auction system.

James Lee – Sterne Agee Capital Markets

Okay great. Thank you.

Robin Li

James, let me add a little more about the Phoenix Nest system. A key part of the Phoenix Nest system technology is the relevance ranking technology. It is very much like a miniature search engine. We need to find the best match between user queries and the marketing messages submitted by our online marketing customers. We're working with parts to start with the relevancy could be similar to the existing system page, search system, but going forward, the relevance will improve and we expect click through rates will go up too.

Operator

Your next question comes from Paul Wuh with Nomura International. Please proceed.

Paul Wuh – Nomura International

Hi. Just a quick questions for you, you mentioned the right side, left side, can you give us a sense of what percentage of your revenues is actually coming from the right side versus the left side?

Haoyu Shen

We can’t. We don't want to go into the detailed numbers, the left-hand side contributed to the majority of our revenue today.

Paul Wuh – Nomura International

Okay. And then a follow-up is also I saw that your customers' deposits increased significantly in the fourth quarter to 422 million RMB from 357 million RMB in the third quarter, why do you think that this happened, and do you expect this trend to continue?

Jennifer Li

Typically that would be a good indication leading into your revenue projection, but for Q4, I think this is a special period that we went through. We all know that customers tend to scale back their marketing expenditures in difficult times. So more customers you know tend to set limits. So we have deposits with us, they went up during the Q4 period, I wouldn't have directly interpret this as increase in revenue, but this is kind of customer driven kind of activity.

Paul Wuh – Nomura International

Thank you.

Operator

Your next question comes from Wendy Huang from RBS. Please proceed.

Wendy Huang – RBS

Hi. Just a quick question on R&D, could you give some guidance for 2009 and what kind of incremental R&D expenditures you budget for 2009?

Jennifer Li

We mentioned in the call in the script that we will continue to invest in the core R&D capabilities. I do not anticipate the scale of growth from an expense perspective will be in line with in the past but will be continued growth and probably one of the biggest growth area in terms of expense for us.

Wendy Huang – RBS

Okay, thanks.

Operator

The next question comes from Elinor Leung from CLSA. Please proceed.

Elinor Leung – CLSA

Hi. Thanks of the call and my question is related to the Phoenix Nest, am I correct that you are only going to implement on the right-hand side in the top part of your website, you're not going to incorporate in your left hand side, the free search result, does that mean that you want to gradually migrate your sponsor link to better separate them from the free search results?

Haoyu Shen

So I think I mentioned earlier that was tested on the right-hand side only but in Q2, when we open up for customers, we will potentially also open up the top left space for Phoenix Nest. So that is what we are going to do and also as I mentioned, we think this will be a better monetization platform, better auction system eventually. It will be very broadly used in Baidu systems.

Elinor Leung – CLSA

So you'll not include that among the free search results? The auction system will not – the auction system will not be implemented in the left right bottom on the middle part among the free search result system?

Robin Li

I think eventually it will.

Elinor Leung – CLSA

Okay, thanks.

Robin Li

It is a new, it is a better auction system. It increases the CPR.

Elinor Leung – CLSA

Thanks.

Operator

The next question comes from Stephen Ju with RBC Capital Markets. Please proceed.

Stephen Ju – RBC Capital Markets

Good morning guys. How much was branded advertising in the fourth quarter and what do you think your conversion rate for the C2C platform stands versus some of your competitors, so in other words, you have the traffic already, do you feel like you offer more efficient platform versus your competitors at this point? Thank you.

Robin Li

So as far as conversion, we don't have a lot of visibility into our customers’ conversion rates because it is a CPC model. It is not a CPA model, but I think past growth in terms of ARPU and also in terms of customers’ shows that they are probably getting a good return on their spending with us.

Peng Ye

Was that the full question?

Stephen Ju – RBC Capital Markets

How much was branded advertising in the fourth quarter?

Haoyu Shen

How much is brand advertising in the fourth quarter? It is still a small percentage of our business and we don’t disclose the exact percentage.

Stephen Ju – RBC Capital Markets

Okay, thank you.

Operator

Your next question comes from James Mitchell with Goldman Sachs. Please proceed.

James Mitchell – Goldman Sachs

Great. Thank you for taking the question. Could you talk a little bit more about your headcount initiatives? It seems like you are taking headcount out of sales and marketing and into research and development.

Jennifer Li

Yes, James. As we mentioned, we continue to look at ways to improve the efficiency, particularly in the sales and marketing workforce. On the other hand, we continue to invest in the R&D capabilities, and that is why we see the balancing out, you know shifting a little bit more and more R&D capabilities and investment and improve the efficiency as a result reduce the headcount on the sales and marketing front.

James Mitchell – Goldman Sachs

Does that reflect your customers becoming increasingly capable of self-serving rather than relying so much on human being intermediation?

Jennifer Li

Not yet.

James Mitchell – Goldman Sachs

Okay.

Jennifer Li

I think it is more internally efficiency improvement.

James Mitchell – Goldman Sachs

Thank you.

Operator

The next question comes from Jason Brueschke with Citigroup. Please proceed.

Jason Brueschke – Citigroup

Thank you. My question is about linearity of demand in the first quarter. I think there was a previous question on the level of deposits being up significantly. And some of the commentary on the call suggests that post Chinese New Year that we have seen demand pickup, we have also had commentary that the economy is really bad, can you maybe go into a little bit more detail, are people putting the deposits in and just simply not allocating these, or are they bidding less per click, and could you maybe give us a little more color about how much of a change you have seen from maybe before Chinese New Year in the quarter to the period after the Chinese New Year? Thanks.

Jennifer Li

Hi Jason. The trends that we have seen at year-end, I have elaborated on a why we think our customer deposit went up. I think after Chinese New Year, we continued to see the customer making deposits at a faster rate, but this I would interpret the data very differently. Prior to Chinese New Year, I think there is a lot of negative sentiments or cautious sentiments, and people are cautious with their spending. Right after the Chinese New Year, the kind of trend that we have seen as Robin mentioned, is very positive and upbeat and the traffic went up and we have seen the customers really coming back to the platform and more actively engaged in marketing on our platform. So the trend that we have seen over the past month or two or so, I think lessens out a little bit the cautious sentiment that we observed at the year-end.

Jason Brueschke – Citigroup

Right, thank you. Jennifer and maybe as a follow-up to that, I know historically Baidu has done very little offline marketing, you have relied upon your strong brand and word-of-mouth. In light of the tremendous success that you have received or you have obtained from the CCTV Chinese New Year initiative, has that changed in any way your thoughts as to how you will try to grow traffic in Japan, and should we be expecting that because you are actually getting something from those efforts that you might lead more with a formal advertising campaign offline and online in Japan versus just simply relying on word-of-mouth and by your marketing?

Robin Li

Hi, this is Robin, let me try to answer your question. The advertising campaign during Chinese New Year carried offline was indeed something new to the company. We did that in order to find out how effective this kind of advertising campaign would be in terms of educating the market, helping users better realize the benefit of search and helping customers to better understand – better understand about what Baidu can do for them. But after all we believe that the traffic growth for the search service is really dependent on high quality user experience or search service. For Baidu Japan, we are not at that stage yet. We are focused and will continue to be on product and technology. For our Chinese business, this is something new. We're still in the process of evaluating how effective the campaign is and how should we do things like this in the future. So that is the current view of this kind of initiatives.

Jason Brueschke – Citigroup

Great, thank you.

Operator

Your next question comes from Richard Ji with Morgan Stanley. Please proceed.

Richard Ji – Morgan Stanley

Thank you, Robin and Jennifer, how are you? I have two questions. As the first, regarding the clean up measure of your medical listing, is the cleaning up measure largely over, and if so what percentage of your medical listing customer have renewed their service with Baidu, and have they already gotten proper license yet? And then, I have a follow-up.

Jennifer Li

Hi Richard. Yes, we have come through a thorough review of our customer base and as you know in November we removed all of the medical and pharmaceutical sectors customers. Only with proper licenses and documentation will we allow our customers to come back. As we mentioned in the press release, a large portion of the customers have already come back and frankly Baidu has went beyond and taken additional steps to remove additional questionable links. So net net, that is why we have negative revenue impact going into Q1. But at this point we are at the stage that we have gone through the thorough reviews of our customer base. We will continue to monitor the customer base on an ongoing basis. However, I don't expect that any additional action we take will result in this kind of a material revenue impact.

Richard Ji – Morgan Stanley

Thank you. And second question is regarding your margin trend, and obviously 4Q we saw soft margins with margin concession of about six percentage points quarter on quarter, and is your company seeking any cost saving measures for 2009, especially given the micro headwind really looming and are you trying planning scaling back your cost initiatives for your non-core service as C2C, messaging, et cetera? Thank you.

Jennifer Li

Yes, Richard. As I mentioned in my script, our priority is to grow the top line and at the same time maintaining a disciplined and strategic approach to cost. There is a tremendous scalability in this business model as I said many times before, and our margin is very sensitive to the top line. In Q4, and possibly in Q1, you know that we have near term revenues setbacks, but that does not change the business model, it does not result in the structural change of the way we conduct of business. So despite these setbacks and maybe a shorter margin compression, the long-term story holds, and the fundamentals remain strong. So we will not forego important strategic investment opportunities for the sake of shorter margin management. As we have always mentioned there is tremendous scalability in the business model and as China's Internet industry is still emerging, it will be unwise to forego investment opportunities that is right. And frankly, the whole organization takes a very disciplined approach to cost, and we're very, very responsible as we make the cost decisions.

Richard Ji – Morgan Stanley

Thank you.

Operator

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

Steve Weinstein – Pacific Crest

Great, thanks. Just want to make sure I understand the dynamics impacting the top line here, it looks like Q4 was obviously an anomaly and it is hard to draw any kind of trend from that. But looking at your guidance right now, it looks you are looking for kind of high 30s for revenue growth and if you hadn’t had to remove those links, you would probably be somewhere in the low 40s percent type of growth. That is a pretty big drop off from what you're seeing in the Q3 level. Would you say that the difference in growth is all economically driven, or are there other factors in your business that would make up for such a drop? And are there – are things like Phoenix Nest and other initiatives you might have in the works enough to accelerate the growth as you go forward, or really those are incremental, and the economy is the big headwind and you’ll do kind of whatever the economy allows you to do?

Robin Li

Hi Steve. This is Robin, let me try to answer your question. We’ve already (inaudible) Q1 guidance the moving of certain sponsored links represents like 5% of our revenue. And the rest is pretty much seasonality and the impact of macro conditions. If you look at the sequential growth, it is like 11% to 13%, if you back out 5%, then the rest is pretty much seasonality and the macro conditions. If you look at our Q1 of '08, it was pretty much flat compared to Q4 of 2007. So Q1 is really the weakest quarter of the year. And this is especially so because of natural conditions. And another reason we speculate is that during the past quarter, the past few months, when the Chinese economy experienced a sudden slowdown, everyone was shocked. So we did not do anything for the near term. After the Chinese New Year, I think people realized that they still need to do business and the best way to promote their product and services is to go through Baidu. So we do expect with our execution capability, we are depending our executing capability, that is lot of room for growth in the future.

Steve Weinstein – Pacific Crest

Okay, thank you. Can I ask just one follow question? On the $50 million in other income you're going to recognize, is that – just making sure I understand that, that is going to be recognized over the course of 2009, will there be a continuation of that into 2010 as well?

Jennifer Li

It depends on the starting point. When we started to recognize that we will recognize that amount over about a year period.

Steve Weinstein – Pacific Crest

Okay, so a year from when you start it, not –

Jennifer Li

Yes.

Steve Weinstein – Pacific Crest

Okay, I got it. Thank you.

Operator

Your next question comes from the line of Tian Hou with Pali Capital. Please proceed.

Tian Hou – Pali Capital

Thanks for taking my call. I have two questions, one is regarding your Phoenix system and I just wonder after you officially launch it, are you going to launch it in the right hand, or you are going to also implement that in the left-hand, so where is that going to be?

Haoyu Shen

Okay. So I think I’ve said this a few times, now it is on the right-hand side. In Q2, we will make it broadly available and potentially open it for the left-hand side as well, the left top space.

Tian Hou – Pali Capital

So that will only exist in the top place on the left-hand, is that the case?

Haoyu Shen

That's what we're going to do in Q2. So I also in an answer to another question, we believe if this system becomes successful, it will eventually be the only auction system we have. So it will probably eventually take away the main panel links as well.

Tian Hou – Pali Capital

So eventually as per what you said, you will take the current system, so does it mean eventually on the left-hand, you will only have the top several positions or the Phoenix auction base advertisement and the rest of it will be natural search results?

Haoyu Shen

That could be one scenario but as it evolves, we will adjust our strategy accordingly and it will definitely be a cautious and measured approach.

Tian Hou – Pali Capital

So you don't have a precise answer at this point if that's the case.

Haoyu Shen

No, we don't have a precise timeline right now.

Tian Hou – Pali Capital

Okay, so other question is after the CCTV report in November, in December, I just wonder what is kind of the permanent measures has management put together to prevent those problems from happening again?

Peng Ye

Hi, this is Peng Ye. We, in response to the CCTV reports, we have taken actions to remove not only the medical and the pharma related questionable links, but also other sectors as well. Now we have after that we enhanced our internal control process and tightened internal control better so that to ensure all those customers have appropriate documents with us even though at this stage, there is no regulations require us to do this. In the meantime, we will also provide the training programs to our employees to ensure this as well. Thank you.

Tian Hou – Pali Capital

And have you put this monitoring or training system whatever to other sectors beyond healthcare?

Peng Ye

Yes.

Tian Hou – Pali Capital

Okay, thank you.

Operator

Your next question comes from Kar Kwong with Needham & Company. Please proceed.

Kar Kwong – Needham & Company

Hi guys. Thanks for taking my question. Just a couple of them, I was wondering the 5% reduction in revenues in the first quarter, does that include some of the listings that were removed in 4Q, are all these – all new listings are removed in 1Q, and is that revenue likely to come back, or is that revenue that is more or less expected to be lost on an ongoing basis?

Jennifer Li

Yes. These are the links that is related to the removal activity that we did in Q4 before year-end, and you can consider this as a permanent loss.

Kar Kwong – Needham & Company

Okay. And also maybe you could give us some color on labor costs, what kind of salary increase are we likely to see this year?

Jennifer Li

We haven't mapped out the budget for this year and typically in the past we monitor the CPI situations and implement our increases accordingly. What I want to stress though is if I do value these talent core people and this is an exciting place for many people to start their career and we value our people and we make our compensation packages competitive in the marketplace.

Kar Kwong – Needham & Company

Excellent. And just wondering, I think you mentioned in 1Q the marketing budget would be 40 million RMB more than in Q4, I was just wondering how does this trend for future quarters, I guess you have had a lot of success with your advertising campaign in the first quarter, will we see similar investments in the future?

Jennifer Li

As Robin mentioned already we are not completely done with this advertising campaign yet. Once it is over, we will carefully evaluate the benefit, the effect of that, and what we have learned from it. But the important matter is we do put branding and marketing initiatives as a priority for us, so we will continue to welcome that activities in this regard. However, I just want to give you some sense, the Chinese New Year is gala is once in a year event, an impactful event like this is only once, is only one time in the whole years program that you can reach to 90% of the Chinese households. So it is unlikely to produce another event like this for the remainder of the year. So I don't anticipate massive spend like the Q1 will re-occur. However, we do want to do more work in the marketing and branding initiatives on those fronts and therefore we want to spend – we will allocate resources accordingly, but maybe not of this magnitude.

Kar Kwong – Needham & Company

Got it. And you mentioned the campaign was up, when do you expect to wrap it up?

Jennifer Li

It is getting closed.

Kar Kwong – Needham & Company

Okay. And just two quick housekeeping questions, I was wondering what the CapEx related to campus construction was in 4Q? And also I think you mentioned earlier the Japan cost in 2009, I missed that number, if you could give that again please? Thanks.

Jennifer Li

The Japan expense budgeted for '09 is between $25 million to $30 million. And for Baidu campus, Baidu campus actually capital expenditure for Q4 amounted to – a larger proportion of the CapEx for the quarter. For the whole year, Baidu campus accounted for about 40% of the CapEx incurred in 2008. And we have spent – as I mentioned, $30 million to $40 million, we will spend US dollars on Baidu campus going into 2009.

Kar Kwong – Needham & Company

Thanks.

Operator

Your next question comes from the line of Dick Wei with JP Morgan. Please proceed.

Dick Wei – JP Morgan

Hi. Thanks for taking my follow-up. Just wonder – I noticed that some paid search displayed format in Baidu, some of the paid search result highlighted in a gray box, I'm not sure if that is some display related with the Phoenix Nest, or it is just related to the core system, if you could comment on kind of the longer term thoughts in terms of the paid results display format, that would be helpful? Thanks.

Haoyu Shen

Hi, Dick. I didn't quite get your question, where did you see those links?

Dick Wei – JP Morgan

In the display box…

Peng Ye

At search result pages.

Haoyu Shen

All right. Yes, we do have those – one thing is brand link that we launched last year right. It is some display on the right-hand side and a little bit display on the left-hand side as well. And we're testing – I think we are also testing display only links on the right-hand side for brand advertisers. So it is in the testing mode and (inaudible) brand advertisers pickup.

Robin Li

Right now we have nothing to do with the Phoenix Nest system.

Dick Wei – JP Morgan

Okay. Kind of final question, I guess I have seen some page search results that are highlighted in like a gray box, I don't think it is related to the brand or is it?

Haoyu Shen

If you see shaded links at the top on the left, those – we had those paid links for quite a long time, and those are not directly managed by the customers, so that's the space we will potentially open up in Q2 for Phoenix Nest.

Dick Wei – JP Morgan

Okay great. Thanks

Operator

Ladies and gentlemen, your final question comes from the line of Paul Keung with Oppenheimer. Please proceed.

Paul Keung – Oppenheimer

Hi. The question has to do with the advertisers. I was wondering if you can tell me when you look at sort of the – it looks like in the fourth quarter, first quarter, did you see any unusual weakness or strength in terms – in which categories was advertisers are coming from, any changes in the churn rate of customers and how many of those customers really are new first trials versus old returning customers?

Haoyu Shen

Right. So in terms of sectors, we just looked at Q4 and then coming into the New Year and Chinese New Year, what we saw is sectors such as machinery and electrical engineering, tools, chemicals impacted more both in terms of ARPU and also in terms of number of active customers.

Paul Keung – Oppenheimer

I mean certainly it’s been impacted and I'm trying to see how many of these customers are actually first time resource? There is a sizable increase in the number of advertisers in your first quarter.

Haoyu Shen

So before Chinese New Year, the customer acquisition is slow, and it is always slow before Chinese New Year, and we are seeing good pickup after the Chinese New Year, both in terms of existing customers spending and also the speed of customer acquisition.

Paul Keung – Oppenheimer

Okay. Because we have heard that it is still – what was churn rates in your mind, historically churn rates, you’ve told us is like (inaudible) has that changed at all?

Robin Li

I don’t think we ever disclosed the churn rate because it is very hard to define. So in some sectors, in some regions, we did see higher attrition in Q4, and coming into Q1, but it is – in terms of our total company portfolio, we didn't see massive increased attrition of customers.

Paul Keung – Oppenheimer

Okay. That makes sense. Thank you.

Operator

Ladies and gentlemen, this concludes our question and answer session. I will now turn the call over to Robin Li, chairman and CEO, for 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.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect and have a wonderful day.

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Source: Baidu, Inc. Q4 2008 Earnings Call Transcript
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