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Baidu, Inc. (NASDAQ:BIDU)

Q1 2009 Earnings Call Transcript

April 27, 2009 8:00 pm ET

Executives

Linda Sun – IR

Robin Li – Co-Founder, Chairman and CEO

Jennifer Li – CFO

Peng Ye – COO

Haoyu Shen – VP of Business Operations

Analysts

Jason Brueschke – Citigroup

Gene Munster – Piper Jaffray

Dick Wei – JP Morgan

James Lee – Sterne Agee Capital Markets

Alan Hellawell – Deutsche Bank

Eric Wen – MainFirst

Jeffrey Lindsay – Sanford Bernstein

Paul Wuh – Nomura

James Mitchell – Goldman Sachs

Richard Ji – Morgan Stanley

Eddie Leung – Merrill Lynch

Stephen Ju – RBC Capital Markets

Henry [ph] – Pacific Crest

Elinor Leung – CLSA

Joe King [ph] – Oppenheimer

Operator

Hello, and thank you for standing by for Baidu's First Quarter 2009 Earnings Conference Call. At this time, all participants are in listen only mode. After management's prepared remarks, there will be a question and answer session. Today's conference is being recorded; if you have any objections, you may disconnect at this time.

I would now like to turn the meeting over to your host for today’s conference, Linda Sun of Baidu.

Linda Sun

Hello, everyone, and welcome to Baidu's first quarter 2009 earnings conference call. We distributed Baidu's first quarter 2009 earnings release 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.

We are pleased to report solid results for the first quarter of 2009 and total revenues increased 41% from the year ago period exceeding our top line guidance. As you know, the first quarter was not an easy one, particularly due to the economic uncertainty. But by focusing relentlessly on execution and things we have control over, we have been able to act quickly and efficiently in a tough environment with our highly energized and effective workforce.

In particular, during the quarter, we took actions to drive sales focus. We implemented programs to elevate customer service. We developed incentives to drive overall results. At the same time, we launched successfully branding and marketing campaigns. This focus on execution and the ability to leverage our accumulated experiences and the scale of our customer base and sales force allowed us to deliver strong results in these challenging times. China's Internet industry is only just emerging. We have and will continue to benefit from user growth and the growing appreciation of performance based search engine marketing.

Now I would like to talk a bit more about a couple of key initiatives we have recently announced. First, this month, we officially launched an enhanced bidding platform for online marketing customers called Baidu online marketing professional edition, also notice Phoenix Nest. This new platform will run concurrently with our original bidding platform or classic edition during a customer transition period. The professional edition is the result of a long process of looking at how to optimize our paid search algorithm for the benefit of customers and users.

Specifically, for online marketing customers, this new platform enables customers to have more choices for key words, more choice to manage their marketing budgets, and more data points to measure and analyze their returns. For search users, we believe it can improve relevancy of paid search results through a more sophisticated keyword matching system. And for Baidu, the professional edition will employ more advanced monetization algorithm, which we expect over time to result in enhanced revenue. While this is still a new initiative, customer reaction has been very positive ever since the beta launch in the fourth quarter of last year. We will keep you updated on the progress here.

Also as you may know, we have been working on an initiative code named Aladdin, which is aimed at improving search experience by uncovering useful parts of the hidden web. As part of this initiative, this month we beta launched an open data sharing platform which allows webmasters and developers to submit data to Baidu in order to generate direct such results from dynamic information such as flight schedules and foreign currency exchange rate tables. With a wide range of potential applications we're confident that project Aladdin will be a long-term driver of user traffic growth.

Branding continues to be a focus for us and leveraging our core competency in search to make positive social contribution is an important part of this. Most recently, we launched a search service specially designed to search the rapidly growing senior age online population in China. Along these lines, we also launched search services dedicated to the blind use in the school of traditional Chinese literature. Even though these are not revenue contributors, we believe that these services yield important dividends in the form of reputation and goodwill.

Looking ahead, we're feeling encouraged on a number of fronts. First, following the Chinese New Year holiday, we have seen a healthy pickup in both user traffic and online marketing activities. With our strong execution capabilities and persistent focus on user and customer needs, we're confident that Baidu's cost-effective performance based model will continue to be the online marketing platform of choice common, particularly in this kind of economy. Of course, we're confidently monitoring market trend to stay ahead of the rapidly evolving needs of our users and customers.

Thank you, again, and I will now turn the call over to Jennifer for financial highlights.

Jennifer Li

Thank you, Robin. Hello, everyone.

Before I go into the financial details, I would like to introduce our new Investor Relations Director Victor Tseng. Victor joins us from Deutsche Bank, where he was an equity research analyst covering the China Internet sector. We're confident that Victor's sector experience and his unique perspective will be beneficial to our IR program. So welcome Victor.

As Robin mentioned, we are very pleased with our financial results for the quarter driven by our execution capabilities and the fundamental strength of our platform. During the quarter, our balanced approach to controlling costs while investing in important initiatives also allowed us to maintain healthy margins. Now let us look at some of the financial highlights for the quarter. The amounts mentioned are in RMB unless otherwise noted.

Online marketing revenues for the quarter were 810 million, a 41% increase year over year. For the first quarter, Baidu had more than 185,000 active online marketing customers, a 15% increase from the corresponding period in 2008 and a 6% decrease from the previous quarter. Revenues for online marketing customers for the first quarter was approximately 4,400, a 22% increase from the corresponding period in 2008 and a 4% sequential decrease.

Traffic acquisition cost as a component of costs of revenue was 124 million or 15.3% of total revenue as compared to 13.3% in the corresponding period in 2008 and 14.6% in the fourth quarter of 2008. The increase in TAC as a percent of revenue reflects strong performance of some of our partners continuing to drive fast growth of our Union business. In the near term, the trend may still fluctuate. We will monitor the Union strategy to ensure we continue to manage a healthy balance.

Bandwidth cost and depreciation cost as a percent of revenue both decreased in the first quarter versus a year ago. This demonstrates continued efficiency improvements as well as increased stability of investment in capital expenditure. Selling, general and administrative expenses increased to 39% from the corresponding period in 2008, primary due to the increase in marketing expense as part of our branding efforts. R&D expenses increased 67% over the year ago period, primarily due to increased headcount. We will continue to prudently invest in R&D to ensure we are at the forefront of technological innovation.

Share-based compensation expenses which were allocated to related operating costs and expense line items increased in aggregate by 45% to 23 million in the first quarter from 16 million in the corresponding period in 2008. The increase in share-based compensation expenses primarily reflects increase in grants to employees. Operating profit for the first quarter was 199 million, an increase of 35% over Q1 of 2008. Total headcount as of March 31, 2009, was about 6,200, roughly 200 fewer than at the end of Q4 of 2008. The decrease in headcount mainly comes from sales and marketing. Our business is growing and we will continue to invest prudently in human resources, particularly in R&D while at the same time focusing on improving operational efficiency.

Income tax expense was 27 million for the first quarter. The effective tax rate for the first quarter was 12.9% as compared to 6.9% in the corresponding period in 2008. The increase was primarily due to some Baidu entities migrating out of tax holiday status. Net income was 181 million, a 24% increase from the corresponding period in 2008. Basic and diluted EPS for the first quarter of 2009 amounted to 5.25 and 5.22 respectively. Net income excluding share-based compensation expenses, a non-GAAP measure, was 205 million, a 26% increase from the corresponding period in 2008. Basic and diluted EPS excluding share-based compensation expense, both non-GAAP measures, were RMB 5.93 and 5.89 respectively. As of March 31, 2009, the company had cash, cash equivalents and short-term investments of 2.8 billion. Net operating cash inflow and capital expenditures for the first quarter of 2009 were 247 million and 42 million respectively.

Now let the provide you our top line guidance for the second quarter of 2009. We currently expect total revenue for the second quarter of 2009 to be between 1.07 billion to 1.1 billion in RMB. That would represent 32% to 36% sequential growth. I do wish to emphasize that this forecast reflects Baidu's preliminary view which is subject to change.

I will now open the call to questions.

Question-and-Answer Session

Operator

The question and answer section of this conference call will start in a moment. (Operator instructions) And the first question comes from the line of Mr. Jason Brueschke with Citigroup. Please proceed.

Jason Brueschke – Citigroup

Thank you and good morning everyone and congratulations on the quarter and the guidance. Jennifer, Robin, my one question, I guess, I will limit myself to is about active customers. The number at 185,000 was down pretty significantly Q over Q and I'm wondering if you could give us a little covered upon this? Is this mostly as a result of the web site cleanups that you guys initiated in the fourth quarter, and to what extent is any of this may be due to some diverting of resources from the sales force to learning and getting trained up on Phoenix Nest ahead of the April launch? And within that, could you maybe help us understand whether the number of active customers have stabilized in April, and do you expect this number to grow sequentially in the second quarter? Thanks.

Robin Li

Jason, Peng will answer your question.

Peng Ye

Hi Jason. This is Peng. Let me answer your question. I think there are three factors contributing to this situation. Number one is the seasonality in Q1. Number two is macroeconomic situation. Number three is the ongoing actions we have taken to improve the quality of the customer bases. That's it, thank you.

Jennifer Li

Jason, let me just add a little color. The active number of customers is defined to be active during the quarter. So if you look at Q4, although we did take measures to improve the quality of our customer base, a majority of those customers were still active in that quarter. You know since we have done that and we have taken additional measures as we mentioned towards the end of the last year, all those removed customers that don't come back, the full extent will be felt in Q1. So in Q1, that basically, the number of customers reflected that fact. And in addition, as Peng mentioned, the normal seasonality, you know right before Chinese New Year is typically a slower time to acquire new customers, on top of that the weaker economy, that is the combination of that is the result of the 184,000 customers. At this stage we want to say, as I mentioned in the past, the activities that we have taken to improve the quality of our customer base to a large extent is over, but we will continue to monitor the healthiness of our customer base and continue to take measures appropriately. But we don't foresee any major changes to the customer base going forward.

Jason Brueschke – Citigroup

Jennifer, that's an excellent point. If I could maybe just ask you a quick follow-up, could you maybe give us an apples for apples comparisons because your point is well taken that someone who was there in October or November and was removed in December still shows up in Q4 and wouldn't show up in Q1. But to let us kind of understand what – if you were to kind of normalized Q4 for the actions you took at the end of Q4, did we see some sequential growth or was the sequential decline less if you look at it apples for apples when we look at Q1 versus what really happened in the end of Q4?

Jennifer Li

Jason, if you look at last year's trend, I think there was a slight increase of number of customers between Q1 and the end of 2007. So you know I think the normal trend would put us back in line within that range. It is hard to pin down exactly what is in the that, the exact number of customers that is purely a result of the combination of the three factors we just mentioned.

Jason Brueschke – Citigroup

Great, thank you very much.

Jennifer Li

Welcome.

Operator

And the next question comes from the line of Mr. Gene Munster with Piper Jaffray. Please proceed.

Gene Munster – Piper Jaffray

Hi, good morning, all, and my congratulations. Could you talk a little bit about Phoenix Nest and some of the changes in monetization? I'm sure you guys have some data around the impact on monetization when you have been beta testing Phoenix Nest. And second can you talk about some of the potential impact regarding some of the transparency changes in the search results stage from the user side as far as click through rates? Thanks.

Robin Li

Haoyu?

Haoyu Shen

Hi, Gene. As you must know that, we made Phoenix Nest available to all customers Monday of last week. So we are literally talking about a week ago. So it is very early stage but we like what we're seeing. As far as how organically it improves monetization, I think we can look at a few different dimensions. One is potentially coverage. We're opening up the right hand and left top shaded area for phoenix nest. So the coverage of by relative ads I think potentially will increase. And also CTR will also improve b because we are using better fewer mix algorithms, so CTR will actually increase. And also as far as (inaudible) really a more sophisticated algorithm, more sophisticated algorithm will encourage the bidders, our customers, to look at ROI more closely and enable them to look at their ROI more closely, so that potential ACP will also go up. So this is, all these three dimensions will eventually improve leading to better monetization. But right now, it is really early stage, but we like what we're seeing. A lot of customers are already online and the system is running smoothly.

Gene Munster – Piper Jaffray

And in terms of the I guess the search results page as you guys add more transparency so your users can see which ads are sponsored, is there any risk that your click through rates on that left hand side are going to decline given the greater transparency?

Haoyu Shen

No. Gene, I think there is something I need to clarify. Phoenix Nest is not about where we the paid links are displayed, so it is about a new auction, a new bidding mechanism. So users don't really see it. The surfers, the searches, they don't really see it. So what we did now in April is we made – we made Phoenix Nest manage the top left shaded area, the sponsor search area right now. So THE users as far as right now, they won't be able to see it. So we're just talking about left or right, more transparent separation between paid and natural results. That's about how we display a paid link. And as Robin actually mentioned a few calls back that that model will also evolve. So that's a different thing from the auction mechanism we're using which we are launching now, the new auction mechanism to be exact. These two things are now totally independent from each other, but these are two things. They will both evolve over time, so we are (inaudible) to the evolution of display form and auction mechanism there carefully to make sure that we have a smooth user experience.

Gene Munster – Piper Jaffray

Okay. One just follow question just on the change in the search results page, I realize that independent of Phoenix Nest, if you could talk about how long that transition is between having search results that are less transparent to more of a Google like model which is going to be something that is searched today and is going to be a year from now you'll be almost entirely having cheated results in the top left or is it something that will be six months to three months or two years, any sort of timeframe in terms of how long that transition will take?

Robin Li

Okay. Hi. Gene, this is Robin. I think we at this time do not have the definitive schedule for the full transition process. I guess it will depend on how Phoenix Nest will do in the future and what kind of user experience we would like to offer and general competitive landscape of this market. The trend is going to more clearly separate paid and unpaid results but we cannot commit a definitive schedule at this time.

Gene Munster – Piper Jaffray

Great, thank you.

Operator

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

Dick Wei – JP Morgan

Hi. Thanks for taking my question. I guess in Q4 you guys mentioned about there were some one-time issues that's why the cost of acquisition cost was higher. I guess for Q1 if we can get just, if we can just have more color in terms of the share ratio and the changes in terms of TAC, and also is the management still maintaining that the bottom – I guess absolute bottom line is still more important than the gross margin, or is that still meeting that thought, that would be great? Thanks.

Robin Li

Haoyu?

Haoyu Shen

Yes. This is Haoyu Shen. We realize that TAC as a percentage of revenue is at an all time high this quarter. As we said before, it still largely reflects the faster growth of revenues from our affiliate networks and from organic, although in Q1 we are also seeing very healthy growth of revenue from organic search. So I think we still maintain our position that we look at this business on revenue net of tax basis but we also are looking we have been and will continue to look at this business both on a strategic level and also a financial level. It is very hard to – the TAC ratio fluctuates quarter over quarter because of many factors. In some quarters we added a few big partners and that's where TAC may go up just because the next quarter starts to perform. So that is actually – and the loss explains our contact ratio this quarter. In Q4 and Q3 also we added a few big partners and we are really working out this quarter. But going forward, it is very hard to predict every quarter what the TAC ratio will be contingent on different partners' performance, mix shifts of the different operating and mix shifts of kinds of partners, and also competitors move. We realize that that is a clear competitor of – this business, it's been a really competitive start. But just to add on, I think when we look at I think contextual partners, we look closely at what partners can bring us incremental revenues, i.e. incremental users or incremental (inaudible) we are more willing to enter into deals with the other partners, so that is what we are doing and we are going to continue to do.

Operator

(Operator instructions) And the next question comes from the line of James Lee with Sterne Agee Capital Markets. Please proceed.

James Lee – Sterne Agee Capital Markets

Thanks for taking my question. I want to follow up on Phoenix Nest a little bit. Robin maybe you can talk about this if you can. For the early adopters and which specific vertical customers you're saying maybe driving this option and is it more the B2B customers who are driving or B2C? And if I can add one more to that, what do we use Phoenix Nest specifically, is it kind of complementary to the old system that you have, or do the new people coming onto the system use that, Phoenix Nest, as the main system going forward? Thank you.

Robin Li

Hi James. I think at this time the professional edition or Phoenix Nest coexists with its classic edition. So customers are using both. I mean those customers who are using Phoenix Nest are also using our classic edition. Most of the users, our customers of Phoenix Nest, are more mature customers. They understand better how search marketing works and they understand better how to measure the ROI. There are lots of customers from all kind of different industries, but overall we would like to encourage more and more customers to shift from the classic edition to professional edition, and I think a lot more mature customers would shift first and they contribute probably majority of our current revenue.

Haoyu Shen

James, just more color to what Robin said, so it is available to anyone. So anyone can participate now. As far as we go out and target the first batch of customers to move quickly into the system, we are talking to those bigger ones. And those tend to be, if you think about on an ARPU basis, it tend to be the B2C type customers. Those are the early adopters. And they are running, the two systems running in parallel. Our desire is definitely to have the customers move their spending more to the professional edition because that is the system that will eventually – that is the one system that we will use eventually. But right now we are not – for people who are on Phoenix Nest, we're not shutting down their classic edition, we will all make sure that the transition is through.

Operator

Our next question comes from the line of Mr. Alan Hellawell with Deutsche Bank. Please proceed.

Alan Hellawell – Deutsche Bank

Yes, thank you very much. Just wanted to congratulate you for the long-term gains on the investor relations front with your new appointment. My only question is really just a broad 2009 question about Baidu Union, how should we be thinking about it in 2009 versus 2008 in terms of contribution, margin profile, et cetera? Thank you.

Haoyu Shen

So everything we sort of gave specific guidance on the revenue front were network or TAC. We can talk in general about the strategy here. So basically there are two types of businesses that Baidu Union has, one is search, the other is contextual. So on search, which is a majority of our Union business in terms of revenue, as I said a few minutes ago, we had different types of partners, and we're looking at the types of, the different types of partners statistically and financially. We want to make sure that the traffic they bring us is as incremental to us as possible, either traffic or users, and we will have different policies as far as TAC policy is concerned for the different types of partners. And payout ratio has been actually stable. So it very hard to make sure that the payout rate is stable. But on the other hand we realize and we should realize that this is a competitive market. On contextual side, historically a smaller part of our Union business, we're putting a lot of effort on this year as far as improving the product, as far as getting better partners, getting better content partners online. So I think that business is all incremental to us because we're monetizing somebody else's traffic. We're working on – most of these on product side and partner side. So I don't know if that answered the question, we don't give guidance on these numbers but in general that's what our strategy is for Baidu Union this year.

Alan Hellawell – Deutsche Bank

Thank you very much. I'm follow-up with your Director of IR.

Operator

And the next question comes from the line of Mr. Eric Wen with MainFirst. Please proceed.

Eric Wen – MainFirst

Hi, good morning. Thanks for taking my call. I have two questions if I may. The first question is I think – well, I'll try to limit to one. Okay, so the first question is, I think in the first quarter, Baidu had some marketing costs and there was even some number being provided. I just wonder if this marketing cost is already behind us, is there any follow on payment in the following quarters? And my second question is I noticed there is a drop in customer deposits, when you have increases in the first quarter of 2008. Is this because of clean up of medical advertisers, if you can give some clarification there, it would be much appreciated? Thanks.

Jennifer Li

Hi Eric, this is Jennifer. On the marketing costs, whatever the activity that we have taken in Q1, the payment is made and the expense booked, so there is no lingering payments related to the Q1 activity. However, as we mentioned in the past, branding is going to – perhaps been our focus and will be our stronger focus for us this year, and I do anticipate a couple more dollars to be spent on marketing. However, it is unlikely for us to reproduce the magnitude of spend in Q1. So hopefully, that answers your number one question. Number two, on the customer deposit, at the end of Q4, we did have a high level of deposit, and you do see a slight decrease at the end of Q1. I mentioned in our Q4 call, the year end number for 2008 on customer deposit was a little abnormal, so I wouldn't take that as a normal trend and use that information, because we all know at the end of 2008, the economic situation was challenging, and I did mention in the prior call that customers were cautious and were holding back on their spending. So we had a lot of accumulated customer deposits. I wanted to say, the behavior of customer deposit has resumed to the normal level, so what you're seeing in Q1 is kind of a normal customer deposit state that you're seeing.

Eric Wen – MainFirst

Thanks. That helps.

Operator

And your next question comes from the line of Jeffrey Lindsay with Sanford Bernstein. Please proceed.

Jeffrey Lindsay – Sanford Bernstein

Thank you. Good morning. Could I ask two things, first a technical question, the cost of goods sold outside of TAC grew faster than revenues. And given that you've reduced costs on staff, given that you have reduced cost on bandwidth, why was that?

Jennifer Li

Jeffrey, it is Jennifer. I'm not sure which you're comparing to, because Q1 is a seasonally low quarter, so we typically compare Q1 ratio to the prior year period. If you look at the prior year period, if you take out TAC, I think we actually had improvement.

Jeffrey Lindsay – Sanford Bernstein

Were you looking sequentially?

Jennifer Li

Yes. Sequentially Q4 because of the typical seasonality, that is not directly comparable.

Jeffrey Lindsay – Sanford Bernstein

Okay, thank you. And then second, guidance is bullish, are you seeing signs of recovery in the Chinese economy and if so in which sectors?

Robin Li

Jeffrey, this is Robin. The guidance is based on the revenue trend we have seen for the TAC a couple of months especially after the Chinese New Year. As we mentioned during the last earnings call after Chinese New Year, economic activity as well as user traffic have been going up. So based on that trend, we calculated that the 2Q revenue projection. I think so far we have not seen any dramatic change after Chinese New Year period. So that is why we have given our guidance like this.

Jeffrey Lindsay – Sanford Bernstein

Thank you.

Operator

And the next question comes from the line of Mr. Paul Wuh with Nomura. Please proceed.

Paul Wuh – Nomura

Yes. Could you perhaps talk about, just to follow up on the last question, what are the top three industries you are seeing the most growth in? And also medical, perhaps you can talk about how medical is looking after all this clean up as far as percentage of the total?

Haoyu Shen

Hi Paul. This is Haoyu Shen. After Chinese New Year, we saw broad pick up as far as different factors are concerned, so I don't think I have sort of an exact changing point about three sectors that grew the fastest. So given the traditional B2B factors involved, the softness before Chinese New Year, we see pretty good recovery as far as we can see now after Chinese New Year. As far as medical, so I think we mentioned before that that reflected all the hip work [ph] that is needed, a majority of the customers are back, and the majority of the revenue is back. So now it is one of the biggest sectors that we have right now and we think it will continue to grow at a healthy rate.

Paul Wuh – Nomura

Do think it is more like 10% to 12% – 10% to 15% of revenues again?

Haoyu Shen

Less than 20.

Paul Wuh – Nomura

Excuse me?

Haoyu Shen

Less that 20%.

Paul Wuh – Nomura

Less than 20%. Okay, thank you.

Operator

And the next question comes from the line of Mr. James Mitchell with Goldman Sachs. Please proceed.

James Mitchell – Goldman Sachs

Great. Thank you very much for taking my question. Could you talk a little bit about headcount? The recent headcount reductions flow from Baidu restructuring, the sales teams that Baidu acquired in the three years after the IPO, and if so where do you think you are in the headcount sales force restructuring process?

Peng Ye

Jim, this is Peng Ye. Actually starting from actually the second half of last year, we initiated a couple of actions to improve the sales operation efficiency, including the streamlined organization, flattening the organizational structure, and also centralized a couple of functions. As a result of those initiatives, actually the second half of last year, the headcount for the sales organization decreased, that we managed to read in. But on the other hand, we are looking at all opportunities to make the strategic investment in the sales force, especially for the training organization, and also for the development of the (inaudible) as well. So we will take all opportunities to improve.

Jennifer Li

James, this is Jennifer. Let me just add to that. Q1 you did see the sequential decrease also on headcount. I just wanted to point out, as I mentioned in the prepared remarks, we continue to look for ways to improve operational efficiency, at the same time invest in R&D capabilities. Q1 is a low period for us to recruit R&D resources and typically the hiring goes up in Q2 and Q3. So I think at his pace of headcount management is healthy for us. And on the operations side as Peng mentioned, we're definitely looking at ways to improve the efficiency and there might be some resource shift to manage the kind of system capabilities that we have. So I wouldn't take this one quarter as a trend going forward.

James Mitchell – Goldman Sachs

Great. Then if you look at the sales force in total, is it reasonable to assume that having brought your own sales force into the big cities, you're now roughly where you want to be in terms of sales force and most of headcount in research and development?

Jennifer Li

I think on balance, James, you know we have been executing a slow shift from heavy concentration on additional sales force hire to a more R&D focus. I think on balance, the total organization, you know the kind of state that we're in, going into the Q2, Q3 hiring time, and at that time, you know things will stabilize.

James Mitchell – Goldman Sachs

Great, thank you.

Jennifer Li

Does that help you?

James Mitchell – Goldman Sachs

Yes, thank you.

Operator

And the next question comes from the line of Mr. Richard Ji with Morgan Stanley. Please proceed.

Richard Ji – Morgan Stanley

Thank you for taking my call and I have two questions. And of course starting with some of the new initiatives such as your online commerce initiative as well as your Japanese venture, and you have significantly speed up your R&D force, how much of your new R&D headcount will go into this new initiative, and when should we expect this initiative to be material or meaningful revenue contributor for your confidence?

Robin Li

Hi, Richard, this is Robin. Regarding to the two new initiatives you mentioned, online commerce and Japan, we gave a rough guidance at the beginning of the year on the cost associated with Japan. So this year the cost will be between US$25 m million to US$30 million. For the online commerce, because it is not material enough, we have not disclosed a separate cost for that. This long-term investment opportunity we view as strategically important, so we are not cutting on any revenue for this year and as contextual ads, as product gets more mature, we will have a better idea of when to monetize that.

Richard Ji – Morgan Stanley

Thanks Robin. And my follow-up question is regarding Baidu Union, which obviously remains as the bright spot. And given the fact that your arch rival, Google China has been pretty aggressive in sealing partnership with the third party website and going forward how would you or how would Baidu differentiate from Google and attract more Union members?

Robin Li

Haoyu?

Haoyu Shen

I think of course the number one concern of any partners on the search side, on our content side, is how much revenue share we share with them. So this can only be achieved by better monetization, better monetization capability that we're developing. Phoenix Nest is one of those and we are also launching some new product on the contextual side as well. So money is one thing. On the other hand, we are – we do have pretty dedicated team serving the Union partners, either the search side or the contextual side. I think we have a lot of answers in terms of how we serve the needs of our partners and how we respond to the needs, and how they communicate with us. So it is a combination of many things on one side and also on the server side. So it is competitive but we do believe we have some advantages on many fronts.

Robin Li

Just to add what Haoyu touched is that, Richard, I think when it comes to attract Union members, our partners, two major forces will drive the competitiveness. One is the number of customers or advertisers. The more customers we have, the better we can serve our partners in terms of revenue generation. And the second force is the monetization capability of RPN [ph], so we're working on a better system. Actually we have been continuously improving the monetization capability of the traffic we acquired. So with more customers and better monetization I think going forward our Union will be more attractive to the potential partners.

Richard Ji – Morgan Stanley

Thank you Robin and Haoyu.

Operator

And the next question comes from the line of Mr. Eddie Leung with Merrill Lynch. Please proceed.

Eddie Leung – Merrill Lynch

Good morning everyone. Could you share with us some of your plans regarding online music downloads, especially given some initiatives begun by your competitor Fuson [ph]? Thank you.

Robin Li

Eddie, this is Robin. I think it is important to clarify Baidu is a search company. We provide all kinds of search services, be it text, image, audio file or video files. Baidu in history has been an audio file search, and we try to make everything publicly available online searchable by Baidu. We have never provided any download service and we do not intend to become a content provider for music or whatsoever.

Eddie Leung – Merrill Lynch

Got that, so there would not be any initiative using banner advertising to monetize music right?

Robin Li

We have been using banner advertising to monetize the search service, some of the search services, including MP3 research. At the time of IPO, that's like almost four years ago, more than 3.5 years ago, the revenue from MP3 related services represented roughly 5% of our total revenue. I think then that the percentage has gone down significantly. So although we would very much like to see a good value chain, good b business model for digital music, so far the monetization capability for music has not been a strong as we expected, and the user traffic for MP3 search as a percentage of our total traffic is also dropping.

Eddie Leung – Merrill Lynch

Understood, very well. Thanks.

Operator

And the next question comes from the line of Mr. Stephen Ju with RBC Capital Markets. Please proceed.

Stephen Ju – RBC Capital Markets

Good morning everybody. So CapEx in the first quarter was a bit low versus what we were expecting? Is this a matter of timing and what is the outlook for the balance of the year? Thank you.

Jennifer Li

Hi Steven. CapEx, yes, was a bit low in Q1. You know CapEx they do come in pretty lumpy, but I wouldn't trend the Q1 act for the rest of the year. I mentioned in the last call, our CapEx for this year should be largely in line with last year.

Stephen Ju – RBC Capital Markets

Okay. On a percentage basis or on a renminbi basis?

Jennifer Li

Renminbi basis.

Stephen Ju – RBC Capital Markets

Okay, thank you.

Operator

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

Henry – Pacific Crest

Hi. Thank you for taking my question. This is Henry [ph] for Steve. So the question we have is regarding the Q2 guidance. So we know that the Q2 guidance is implying a lower year-over-year growth than the Q1 what you guys had announced, so are you guys seeing any lower growth in the Q or in April, or you are just trying to be conservative here?

Robin Li

I guess it really goes back to a couple of quarters because of what happened during the previous quarters and our revenue mix changed, our customer quality improved, and quarter on quarter growth will also make more sense at this time than year-over-year growth.

Jennifer Li

I just want to add to that, you know Q2 last year was a very strong quarter and we all know special things happened in Q3 in Q4. We had the Olympics event and we had a very, very challenging quarter in Q4. And you know so you do have a lower base to work on compared to the last year's strong performance just as Robin mentioned, I think at this point, the sequential ratio is more relevant.

Henry – Pacific Crest

Thank you.

Haoyu Shen

I think the economy is also a big factor here as well year over year.

Operator

Our next question comes from the line of Elinor Leung with CLSA. Please proceed.

Elinor Leung – CLSA

Hi. Thank you for taking my call. My question is regarding the Baidu Union, and what is its contribution in 1Q09 to your total revenue, and do you expect the contribution to increase in 2009 based on your forecast, does it mean that if it does, does it mean that TAC cost as a percentage of revenue will continue to go up in Q2 2009?

Robin Li

Haoyu?

Haoyu Shen

As a practice, we never break out the account revenue on our union business. So we said that the recent increase of TAC ratio is attributed accounts growth at Union revenue. And as far as outlook, we can't predict whether it will continue to grow faster than organic revenue or how much the differential growth will be. So I think we will talk about how we think about TAC and how we think about Union businesses in general. We do have our strategies in place and our policies in place, and you will TAC fluctuating quarter on quarter.

Operator

Our next question comes from the line of Mr. James Lee with Sterne Agee Capital Markets. Please proceed.

James Lee – Sterne Agee Capital Markets

If I could follow-up with that Q2 guidance question and maybe that can help remind us what are the seasonal factors that are driving the quarter that we should be thinking about, what verticals and high season, and maybe besides travel which will be good sector I believe in Q2, what other verticals are you seeing demand? I guess lastly within your guidance assumption, are you guys including any improved monetization from the potential use of the Phoenix system during the quarter? Thanks.

Robin Li

Hi James. This is Robin. Regarding to the Q2, I think it is largely driven by the March performance because of the seasonality of year. Right after Chinese New Year, there is a sudden pickup in consumer activities be it user or advertiser. So based on what we have seen in March, we give out guidance for Q2. One thing I forgot to mention about the year over year comparison is that last year the Chinese New Year was very late. So you have less opportunity to monetize your traffic in Q1, therefore the Q2 versus Q1 growth will be stronger. And this year, the Chinese New Year is a little earlier, so we have seen more revenue in Q1, and that is why we see the Q2 growth like what we guided in the press release and the prepared script.

In terms of monetization, it is an ongoing process. We have been working on better monetization for the past few years and the most significant project has been Phoenix Nest. That being said, Phoenix Nest is a revolutionary bidding system and it just launched like a week ago. The initial effect to revenue is actually nothing, but going forward, in the long run, we believe that this system will give us much better capability to monetize our traffic. In terms of verticals, have you seen any thing different?

Haoyu Shen

No. Hi James. This is Haoyu. So different sectors have definitely have different seasonality. So for example in Q2, around – prior to the May 1 holiday, we see pick in travel for example. So we don't look at it in that kind of granularity, how we give guidance is as well until we really look at the performance of (inaudible) performance of a number of active customer and the new customers acquisitions speed in recent weeks. Then we look at how for example April compared with March last year, how May compared with April last year, so try to account for any differences this year and give out our best forecast. So I think seasonality is definitely there depending on the factors each year, but we will work at it in that kind of environment.

James Lee – Sterne Agee Capital Markets

Just wanted to follow up on Robin's government about the initial negative impact of the new bidding system on your revenue flow, just want to make sure I get that cleared, the initial impact will be negative and that negativity that you are assuming is factored into Q2 guidance?

Robin Li

Yes, that is.

James Lee – Sterne Agee Capital Markets

Okay. Thank you.

Operator

The next question comes from the line of Joe King [ph] with Oppenheimer. Please proceed.

Joe King – Oppenheimer

Hi. Good morning, everyone. My question is about the long-term direction of your R&D and mainly does Baidu have any aspirations to be a provider of like online tools, beyond basic search results and search monetization? Now Robin, you and I spoke about this a couple of years ago, but I felt compelled to ask it again because in an early answer you said that the (inaudible) and I asked because if you look at the global search platforms out there, the market leaders tend to involve in a direction where they are continuous doing some development on that tool, so in many ways I see you in a competitive sense as much as Google as well, so again your thoughts as to the R&D direction of the company?

Robin Li

Let me put it this way. I think for Baidu, our goal is to become a media platform in the sense that we provide a platform that monetizes traffic for our own and operated properties, as well our Union partners. By doing that, the R&D focus will need to be existing in two fronts. One is the core Web search capabilities, it is very sophisticated; and two involving system. We have lots of efforts put into that, and so far I think on a worldwide basis, the most beautiful model for Internet is paid search, and we need to have our own search traffic in order to drive long-term growth for the company.

And the second front is the monetization capability. That front I think we have been late. Only during the last couple of years, we have started seriously investing in the monetization capability in Phoenix Nest as a result of that. With more and more search traffic or inventory to sell and better and better monetization capability, I think this company will be able to maintain a better high growth rate for the years to come. So in that sense, our R&D long-term focus for the R&D team has always been search related, web search related, be it natural search or paid search. We have a number of vertical searches, images search, news search, MP3 search, video search, those are designed to help drive traffic to web search, not to make money by themselves.

Operator

Our next question comes from the line of Mr. James Mitchell with Goldman Sachs. Please proceed.

James Mitchell – Goldman Sachs

Thanks very much. I think that last quarter you disclosed you spent about 40 million renminbi on the CCTV sponsorship in the first quarter, which I guess you took through your SG&A line. Is it sensible at all to look at SG&A ex that 40 million or should I assume that if you didn't spend the 40 million spent, you would have to 10 or 20 or 30 on something else? So that is one question. And then since it is the back end of the call, separate question, I came across a new story about a confidence plan you have set up to encourage SMEs to experiment with Phoenix Nest where you give them rebates. Could you talk a little bit about being the confidence program for the professional Phoenix Nest?

Jennifer Li

JAMES, it is Jennifer. I will answer your first question. Last quarter we provided guidance that sequential –sequentially we anticipate a 40 million incremental marketing related expense. Yes, CCTV, the majority of that incremental expenditures, we typically also have other annual kind of events that happens in Q1. So Q1, I think if you're guess is right, if I take out the 40 million related to marketing, the rest of that will be kind of the other, the main SG&A expenses primarily related to work force and the normal activity.

Haoyu Shen

Hi James. First about the confidence plan that we announced just in the past few days, so it is really aimed at encouraging customers to adopt Phoenix Nest. So how it works is, if they qualify, if the (inaudible) spending on Phoenix system in May we will provide a rebate to credit the customers account that they will be able to use as (inaudible).

James Mitchell – Goldman Sachs

I'm sorry. I didn't fully catch the last. The rebate will be treated as a contra revenue item or will be an expense item?

Haoyu Shen

It'll be contra revenue, yes.

James Mitchell – Goldman Sachs

Okay, perfect. Thank you.

Operator

And the final question comes from the line of Mr. Dick Wei with JP Morgan. Please proceed.

Dick Wei – JP Morgan

Hi. I just wanted to get an update on in terms of the mobile search, I guess Robin made some comment in the past like about weeks ago, and if you can give us some market share data in terms of Baidu market share in WAP search, that would be great?

Robin Li

Dick, in terms of mobile search, I think there are still a lot of uncertainties going forward. As you know that the 3G network infrastructure wise, just got started. It is too early to place a huge bet on that right now. The most popular form of mobile search is WAP, and we do believe that Baidu has the number one position in terms of mobile search traffic wise, and we have a number of mobile search services, web search (inaudible) and a number of others. But going forward, we expect the format will change. The consumer behavior will change. The rate of wireless Internet access will change and a lot of things will change and we would like to work with the carriers to come up with more innovative solutions for them, for the mobile search users, but at this time, it is kind of too early to tell.

Dick Wei – JP Morgan

Great, thank you.

Robin Li

Thank you.

Operator

We're now approaching the end of this conference call. I will now turn the call over to Baidu's Chief Executive Officer, Robin Li, for closing remarks.

Robin Li

Yes. 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.

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Source: Baidu, Inc. Q1 2009 Earnings Call Transcript
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