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Call Start: 20:01

Call End: 21:12

Baidu, Inc. (NASDAQ:BIDU)

Q1 2013 Earnings Conference Call

April 25, 2013 8:00 p.m. ET

Executives

Victor Tseng – IR Director

Robin Li – CEO

Jennifer Li – CFO

Analysts

Dick Wei – JPMorgan

Alicia Yap – Barclays Capital

Alex Yao – Deutsche Bank

Philip Wan – Morgan Stanley

Jiong Shao – Macquarie

Catherine Leung – Arete Research

Ge Qing – HSBC

Eddie Leung – Bank – America-Merrill Lynch

Jin Yoon – Nomura

Ming Zhao – 86Research

Thomas Chong – BOCI

Gene Munster – Piper Jaffray

Cynthia Meng – Jefferies & Co.

Operator

Hello and thank you for standing by for Baidu's first quarter 2013 earnings conference call.

[Operator Instructions]. 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, Victor Tseng, Baidu's Investor Relations Director.

Victor Tseng

Hello everyone and welcome to Baidu's first quarter 2013 earnings conference call. Baidu's earnings release was distributed earlier today and you can find a copy on our 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 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 US Private Securities Litigation Reform Act of 1995. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from our current expectations. Potential risks and uncertainties include but are not limited to those outlined in our public filings with the SEC, including our Annual Report on Form 20-F. Baidu does not undertake any obligation to update any forward-looking statement except as required under applicable law.

Our earnings press release in this call includes discussions of certain unaudited non-GAAP financial measures. Our press release contains a reconciliation of the unaudited non-GAAP measures to the unaudited mostly directly comparable GAAP measures and is available on our IR website at ir.baidu.com.

As a reminder, this conference is being recorded. In addition, a webcast of this conference call will be available on Baidu's IR website.

I will now turn the call over to Baidu's CEO, Robin Li.

Robin Li

Hello everyone and thank you for joining today's call.

We made a good start to the year with solid progress on our suite of mobile products as well as exciting new innovation and investments to existing functions. As we outlined last quarter, our focus for the year ahead is to push forward with aggressive investments in mobile. We are dedicated to providing the best user experience across every device and to every input method, and I'm confident we are on the right path to achieving that.

We've made substantial advances in our market-leading mobile search and map offerings. As far as our comprehensive suite of apps like browser, personal cloud storage and travel, to name a few, w also introduced a new approach to desktop search, harnessing semantic intelligence and advanced submission learning to enhance user experience in ways I'll elaborate on later in the call.

While we've made strides on the user front, traction with key customer accounts have also been very encouraging. The fact that these customers keep coming back to even in this competitive environment is testimony to the breadth and flexibility of the Baidu marketing platform. We've also made good headway with the crucial work of keeping our customers to potential in mobile channels, and customers are now restarting to awaken to the possibilities.

Moving on to highlights for the quarter, Q1 saw a further increase in our leading position in mobile search. Daily active users of Baidu mobile search grew over 25% from the end of 2012 to over 100 million today. It is one of the most frequently used mobile services on the market. The fast growth of our mobile search reflects the efforts we've put into delivering a superior user experience.

Just as speed was critical to our success in PC search in the early days, delivering a faster result is of paramount importance for us on mobile. Related Android version of our mobile search apps version 4.1 now leverages our [DBT 5] engine, supporting HTML5, the kernel of our mobile browser, along with some other technical improvements that we launched this quarter. This means results now load 30% faster than previous versions.

Baidu mobile search has LBS information embedded and is fully supportive of video content and Flash, thus eliminating the need for separate [native] apps. The Baidu search app also supports voice and image-based search. I'll speak more about the advances we've made in these areas in a moment.

Our leading position in mobile search owes a lot to the excellence of Maps and LBS capabilities. Expectations on search results are dramatically different depending on whether you are sitting at your desk or searching on a smartphone while on the go. Our ability to integrate maps and our LBS to deliver a richer, more useful set of results is one important differentiator for Baidu.

Related version of Baidu Maps which we rolled out recently for Android and iOS offers better LBS categorization and a new navigation upgrade. This new version is already very popular and the new features we've added make for more accurate search and faster decision-making and action. For instance, if I want to search for the newest Thai restaurant, I get restaurant's address, a click-through call phone number, user reviews, average price, directions on how to get there, real-time traffic situation, and information on any special offers there may be, and the option to book a table right away.

Our Maps has an open API and we continue to add partners to build up our LBS platform. This platform already includes features like hailing a cab, booking a hotel room, and even finding group buying deals in your immediate area. Useful features like this make Baidu Maps a gateway for local search.

We have also continued to raise the bar on desktop search with the new format of results for many categories on search. We incorporated semantic intelligence into our search [inaudible] to enhance results. We have built a knowledge [ground]. We not only understand exactly what the user is looking for but also [inaudible] relationships between related content, using content integrated from Baidu's [regular searches], Baidu Knows, Baidu Postbar, Baidu Encyclopedia, and third-party content providers.

This new structured format will both result the users' initial query directly found on the search and help the user discover new information quickly and easily. For example, if I search for Lakers basketball player Kobe Bryant, in addition to the search results on the left-hand side of the page, I get a box on the right-hand side. It's a summary that includes his bio, photos and links to other basketball players who competed in the London 2012 Olympics, MVPs and other players I might be interested in.

The technology required to deliver a superior user experience on mobile devices is also highly sophisticated. And Baidu has leveraged our R&D capabilities to stay far ahead of the pack. We've made a serious commitment to ensure that our best ideas become reality over the coming years. Part of this is our investment in advanced submission learning. The Institute of Deep Learning is focused on just that.

Deep learning is about using newer networks to create sophisticated machine learning models capable of performing the kinds of tasks that human brains do well but machines [currently don't], understanding spoken language for example or describing and categorizing images or making inferences from examples, like in the search on Kobe Bryant I just mentioned.

While this theory behind deep learning has existed since 1980s, lack of computing power limited efforts to put it into practice. Not only do we have the [raw computational power] today but very obvious applications for both users and customers. Two such applications are in voice and image recognition, these two of the most natural interfaces, and user demand for this input method is increasing [quickly]. Our efforts here have already yielded impressive results. Voice-based search queries are increasing very rapidly, keeping up with the very fast acceleration we saw in 2012 when voice queries grew ten-fold.

Image-based search is quickly -- is growing quickly too and the accuracy of these searches is literally improving day to day as our systems learn. In voice search, we are the market leader in Mandarin recognition accuracy. In image search, our recognition rates are also the highest. And our facial image index is the most comprehensive in the world. Users can now photograph a bar code, a [QR] code, person, a book or a piece of text they want to translate and Baidu's mobile search app will deliver the information they're looking for instantaneously.

Deep learning only help us deliver a better search experience, it benefits monetization too. Deep learning will help our customers select more effective keywords and will drive higher ad relevance through better contextual [environment]. The upshot is that our push into this important area of artificial intelligence will drive business results for our consumers and for us.

Alongside the work we are doing on user functionality, we continue to expand our customer base and deepen the relationships we already have in our existing customers. Baidu is playing an active role in helping our customers to leverage mobile by educating them about the mobile channel and providing them with tools to build and optimize mobile landing pages. We will accelerate this process as we kick off our nationwide search engine marketing campaign in the current quarter, ensuring that our customers are up to speed on the mobile opportunity. This education process will happen over time, but so far the momentum is encouraging.

At the same time, we've been looking at ways to extend our engagement with a select number of our large customers whose broad branch of advertising needs can be served on the Baidu platform. I mentioned last quarter the partnership between us, the leading insurer, and we've now brought out this joint business plan model with other large other customers in important verticals such as auto, online travel and FMCG.

JointBusiness Plan or JBP is a deep collaboration between Baidu and our customers. We collectively formed a joint task force to optimize online marketing campaigns on the Baidu platform. By figuring ways to better utilize the full scope of our products from [inaudible] to branding to contextual ads. We've already gotten great feedback from customers on this and we see good potential.

Besides the JBP model, we have enhanced our system to go deeper and work more closely with some key [Windows 8] e-commerce accounts as well. By leveraging these APIs, they open to us. We can see their discounts and promotions, delivery and payment requirements, and product availability in real time, allowing us to dynamically modify their [text-based paid links] in real time as well.

Baidu's contextual ads have been growing well too. We made a number of upgrades this past quarter. Our most recent version of ad selling platform provides a better customer experience and targeting algorithms. With better monetization capabilities, we've been able to significantly expand the model of high-quality media inventory for our branding advertisers as well.

We're really optimistic about the headway we've made so far this year. The investments we are making in product innovations are having a clear impact on user experience across different devices and input methods. And with the Baidu platform becoming more interactive and integrated by the day, we are equally focused on strengthening relationships with our customers to help them achieve the highest return possible through our platform.

Now I'd like to hand it over to Jennifer for our financial highlights.

Jennifer Li

Thank you, Robin. As Robin laid out in his prepared remarks, we made solid progress and delivered healthy financial results.

In Q1 we ramped up our promotional efforts to drive the installations and increase usage of our own mobile products and continue to invest in R&D. We complete the ITE transaction last December and has consolidated a whole quarter of ITE financials into our P&L. The line items in our P&L reflect this consolidation.

ITE's Q1 consolidation had 3 to 4 points impact in our Q1 operating margin. For the rest of the year, we expect this impact to be largely consistent with the Q1 level.

Looking ahead, we'll continue to invest and position ourselves for the opportunities ahead. We will continue to invest in infrastructure and R&D. We will push marketing and promotional efforts to drive product adoption, particularly in mobile. We'll continue to leverage the Baidu union network. These initiatives will continue to be important investments.

Now let me go through some of the financial highlights for the first quarter 2013. All amounts mentioned are in RMB unless otherwise noted.

For the first quarter, total revenues was RMB6 billion, representing 40% increase year on year. During the first quarter Baidu had approximately 410,000 active online marketing customers, a 28% increase from the corresponding period in 2012 and a 1% increase from the previous quarter.

Revenue per online marketing customer for the first quarter was approximately RMB14,500, a 9% increase from the corresponding period in 2012 and a decrease of 6% from the previous quarter of 2012.

Traffic acquisition cost as a component of cost of revenue in Q1 was RMB610 million, 10.2% of total revenues, as compared to 7.8% in the corresponding period in 2012 and 9.6% in the fourth quarter of 2012. The increase mainly reflects increased contextual ads contributions and hao123 promotions through our network.

The Baidu Union Network is an important of Baidu's overall revenue growth. We'll continue to leverage our network to further extract more growth. As a result we expect TAC as a percent of revenue to continue increasing over the medium term.

Bandwidth and depreciation costs as a percentage of revenue in Q1 were 6.8% and 5.6%, respectively, compared to 5.2% and 5.4% in the corresponding period of 2012. The increase was mainly due to increase in network infrastructure capacity as well as the consolidation of ITE.

Content costs as a component of cost of revenues were RMB96 million, representing 1.6% of total revenues, comparing to 0.7% in the corresponding period in 2012 and 1.9% in the previous quarter. Content costs are mainly related to the ITE business.

Selling, general and administrative expenses in Q1 were RMB848 million, an increase of 77% year on year, primarily due to an increase in marketing expenses, particularly for mobile related campaigns. As we stated last quarter, 2013 is an important year to aggressively promote Baidu's great products, particularly in mobile, to drive installation and increased usage. We'll continue to invest in marketing spend in Q2 alongside our search engine marketing campaign. These expenses are necessary and will be closely monitored for effectiveness.

R&D expenses in Q1 were RMB811 million, an increase of 83% over the corresponding period in 2012, primarily due to an increase in the number of R&D personnel. Share-based compensation expenses which were allocated to the related operating costs and expense line items increased in aggregate to RMB111 million in the first quarter from RMB35 million in the corresponding period in 2012. The result was a result of more share being granted to employees. Share-based compensation will continue to be an emphasis to attract and incentivize key talents.

Operating profit for Q1 was RMB2.2 billion, an increase of 6% over Q1 2012. Total headcount as of March 31, 2013 was about 22,000, roughly 900 more than the previous quarter, primarily due to the addition of R&D personnel. Income tax expense was RMB389 million for the first quarter. The effective tax rate for the quarter was 16.2% compared to 15.1% in Q1 of 2012.

Net income attributable to Baidu for Q1 was RMB2 billion, an 8% increase from the corresponding period in 2012. Basic and diluted earnings attributable to Baidu per ADS for the first quarter of 2013 amounted to 5.89 and 5.88, respectively.

Net income attributable to Baidu excluding share-based compensation expenses, a non-GAAP measure, for Q1 was RMB2.2 billion, a 12% increase year on year. Basic and diluted earnings attributable to Baidu per ADS excluding share-based compensation expenses, both non-GAAP measures, were 6.20 and 6.20, respectively.

As of March 31, 2013, the company had cash, cash equivalents and short-term investments of RMB33.8 billion. Net operating cash inflow for the first quarter of 2013 was RMB2.2 billion. Capital expenditures for the first quarter of 2013 were RMB468 million.

Now let me provide you with the top line guidance for the second quarter 2013. We currently expect total revenues for the second quarter to be between RMB7.37 billion and RMB7.55 billion, representing a 35.1% to 38.4% year-on-year increase. Please note this forecast reflects Baidu's current and preliminary view and is subject to change.

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

Question-and-Answer Session

Operator

The question-and-answer session of this conference call will start in a moment. In order to be fair to callers who wish to ask questions, we will take one question at a time from each caller. If you have more than one question, please request to join the question queue again after your first question has been addressed.

And your first question comes from the line of Dick Wei of JPMorgan. Please ask your question.

Dick Wei – JPMorgan

Hi. Thank you for taking my question. Can management give more color on some of the major cost items and the outlook as well? For example, in terms of the R&D, how is the headcount trending for Q1 and the rest of the year? And also on the SG&A front, where are we in terms of marketing? Are we just -- ramped it up in Q1, will have much more marketing for installation in the second quarter and rest of the year? And what about maybe the other items since you have [inaudible] costs, are we just [inaudible] has been more of a [step function], so I wonder if you, one of the step function, jumped in the quarter. If you can give more color, it will be great. Thank you.

Jennifer Li

Morning, Dick. In terms of the overall expense picture, we have consistently been investing in the similar -- in the same investment areas, namely in infrastructure and R&D. And we have said very clearly that this year we will put a big emphasis on sales and marketing promotional expenses to push our products through the systems and to make sure that users adopt our great products.

If you look at the line items on the P&L, we have said in the past that the bandwidth and depreciation trend has pretty much been established. The sales and marketing expenses is an emphasis. And R&D has been a consistent theme for us to invest.

I think if you want to extrapolate out the Q1 expense picture, when you look at the Q1 year on year, percent of revenue change compared to last Q1, this trend is -- the change in terms of the percent of revenue for each expense line item is pretty indicative of what you should expect for the remainder of the year. So each quarter there'll be variations, things like marketing campaign that could cause for quarterly changes of SG&A percent of revenue. But for the whole year, the tier 1 year on year step-up is pretty indicative for the whole year.

Dick Wei – JPMorgan

Okay, got it. Thank you very much.

Operator

And your next question comes from the line of Alicia Yap of Barclays. Please ask your question.

Alicia Yap – Barclays Capital

Hi, good morning, Robin, Jennifer and Victor. Thanks for taking my questions. I actually have questions on the comment for your mobile search product that you comment 100 million daily active users. Can you elaborate a little bit more detail, are these users coming mainly from your Baidu prompt app and the Baidu search app, if that will include the users coming from the third-party mobile browser and also the default search box on the Android phones? And in relation to that, can you share what type of behavior and what type of keywords are the most common for these active users that you have been monitoring? Thank you.

Robin Li

Alicia, the mobile search comprises of a number of different channels. The fastest growing is Baidu's search app or Baidu Palm which is a previously used name for the Baidu search app. It's the strongest growth driver.

But we also draw traffic from third-party partners including third-party browser products, Android, the operating system's default search when they came out from the manufacturer. And another important source is that [inaudible] search, people going to a browser, either typing the Baidu.com domain name or some kind of -- through some kind of bookmark. They find ways to use Baidu search.

That helped us. It's really a fundamental need for internet users even on the mobile phone. What we learned from the query is that mobile users tend to use longer queries than PC because phone is perceived as some kind of communication device so users tend to use more verbal language to do the search. This poses both a challenge and opportunity for Baidu. Technically it's more difficult for a search engine to understand natural language, but that's also an opportunity because we are obviously the strongest in artificial intelligence and natural language understanding. So we can do a much better job, the mobile search, than adding one now.

And once we do a better and better job -- and I think users as well are increasingly dependent upon Baidu to find information. Right now mobile search or the whole mobile internet is in its early stage and consumers in most cases cannot tell the quality difference of many competing products, and that's why channel and distribution at this time is very important. But as time pass by, I think our product, our search product quality will stand out and consumers will want to come to us actively and more frequently.

Alicia Yap – Barclays Capital

Can I have a follow-up on, so if we just wanted to break down on your Baidu Palm or your Baidu search app, what are the users out of your 100 million active users?

Robin Li

No. This is a very dynamic component and I don’t want to break down each different channel. The industry and the product is evolving very, very quickly. What I can tell you is that the Baidu app, the Baidu native app is the fastest growing at this time.

Alicia Yap – Barclays Capital

Okay.

Robin Li

Also provides the best user experience because we can -- we have better control on the native apps.

Alicia Yap – Barclays Capital

I see, okay. Great. Thank you.

Operator

And your next question comes from the line of Alex Yao of Deutsche Bank. Please ask your question.

Alex Yao – Deutsche Bank

Hi. Good morning everyone and thank you very much for taking my question. My question is, the quality of landing page on mobile internet, how would this differ to the quality of landing page on PC internet? And how does such a difference affect user behaviors such as time spent on the landing page or the traffic to transaction conversions. Thank you.

Robin Li

Well, the reality is that most of our customers do not have a local specific landing page. So when users do a search on the mobile phone, click on an app, and then the customer's website, that site was just a PC site. The fonts are small, you have to constantly zoom in, zoom out, and move around to find information. It's very unfriendly to mobile phone users. That's the situation for majority of our customers.

For those customers who do have a mobile site, it's not optimal either. Sometimes they are just designed for the 2G, for the really, you know, slow internet connection, small screen phones with very limited features.

And for those who are more savvy to mobile internet, they utilize a lot of, you know, mobile-specific functions like click-through call function, like they share, you know, information to other sources, send information to other apps, and some of the -- obviously the font will [be definitely] adapted to different types of mobile phone screens.

Alex Yao – Deutsche Bank

Thank you for the insightful answer. And can I follow up with one question? What's your solution to address this issue and how long do you envision this will be solved so the content on mobile internet users will be as friendly as those on the PC and the user will behave similar to their behavior on PC?

Robin Li

Yeah, that's right. We are working very hard to help the transition from PC to mobile, because when we come to many of our customers, they now start to realize that mobile is really coming and more and more targeted consumers, their targeted consumers use mobile to try to find their products and services. But they don’t know how to do it. They don’t have the technical capability to come up with a really mobile-friendly website.

We have been working on building all kinds of tools to help them to speed that up. We come up with tools for [inaudible] to test a different kind [of screen], to utilize our storage capabilities, our computing power. And we write program tools for them to automatically convert the PC-centric websites to a mobile-friendly website. Then they can, you know, start to optimize the mobile site from the converted version. During this year, you know, nationwide marketing campaign, we emphasize very much that the mobile-friendly site to our customers and potential customers.

I think it will take up to two years for our customers to get up to speed. I talked about this transition at the end of last year and I said, if you come from there, it would be from two years, the whole industry is going on transition and I believe that transition will last about two years.

Alex Yao – Deutsche Bank

Thank you very much.

Operator

And your next question comes from the line of Philip Wan of Morgan Stanley. Please ask your question.

Philip Wan – Morgan Stanley

Thanks, Robin and Jennifer, for taking my question. My question is about your top line guidance which implied a further decline in terms of growth rate, even with the relatively easier comp from last year. Was it due to the change of competitive environment or is there any structural change to the search business overall in China? Thank you.

Jennifer Li

I think, you know, we do have a pretty established pattern in terms of the quarterly growth. Typically sequentially our Q2 is the biggest -- you would see the biggest sequential growth. And given the sequential growth at this level, you're looking at about between 23.5% to 26.5%. I think if we mirror that kind of a trend over last year, this is pretty consistent.

Obviously as Baidu has grown phenomenal over the years, we do have a very large base to operate. But in looking at the rate of growth that we currently predict, I think it's pretty much in line. If you recall, I think last Q2 the sequential growth was about 28%, and given the midrange, about close to 25%. I think this is a reasonable sequential that we're looking at.

Many things are going on. You know, I think in this uncertain macro environment, we continue to be very encouraged by what we're seeing in terms of our customer base growth. We continue to add customers our overall pool of service and we are working very closely and engagingly with the large customers. The customers do appreciate our platform. And it's not only web search. We have a complete set of product offerings to the user that commands tremendous traffic. And we're working with these customers to see how we can better address their needs to their potential customers.

So many things are going in, and I think our customers really believe in us and working with us. And I think given, you know, the current forecasts, it is consistent with prior business trends.

Philip Wan – Morgan Stanley

Thank you. Just a quick follow-up, have you heard any initial feedback from the customers given that your competitor Qihoo is starting to monetize their search traffic. I just want to get a sense in terms of competition. Thank you.

Jennifer Li

What we're seeing is customers, as I just mentioned, continue to work very closely. Search market is a competitive landscape, but search is the best product for our customers because it's performance-based. It delivers the kind of ROI that customers really love. And as long as we generate a positive ROI for our customers, they won't stop coming to us.

And some of the examples that, as we illustrated, close working relationship with the joint business partner kind of players like [Pingon], like players in the automotive, FMCG sector, the e-commerce sectors. These customers, if you look at what they're doing, they're playing their trust to Baidu. They want to be very innovative to drive values and growth for their business. And they're working with us to experiment on new -- all kinds of products. And these products are across different platforms, being PC or mobile, and across different products that we have, whether it be web search or non-web search.

So what we're seeing is the customers do believe in the overall value propositions that Baidu constructs for them, and they're working very closely with us. So we're very encouraged by that. And it is really our job to service them.

Robin Li

Let me just that search business has always been inventory [binding], not demand [binding]. I think customers always want to buy more traffic. And when you buy more traffic, you pay a higher unit price for the traffic you get. So it's -- our focus is really, you know, provide the best user experience, make people more dependent and rely on Baidu to find information. Therefore when we have more inventory, we can provide more value to our advertisers and customers.

Philip Wan – Morgan Stanley

Great. Thanks for the comments. Very helpful.

Operator

And your next question comes from the line of Jiong Shao of Macquarie. Please ask your question.

Jiong Shao – Macquarie

Good morning. Thank you for taking my questions. My question is on the investment and on the margins. You mentioned earlier that the increase in spending in the first quarter for the step function and going forward should be somewhat consistent. I was just wondering just the philosophical of your management strategy with respect to investments and spending is that you want to go after by market regardless of the expenses or you feel like, okay, 37% operating margin, that's the new norm and now seasonality is on your back for the rest of the year, you should see margin expansion and sort of next year even better? Just sort of want to get your overall perspective on your margin trajectory -- sorry -- from here. Thank you.

Jennifer Li

I think, you know, we have stated in the past very consistently, as we manage our business, internet space is exciting. It has a lot of opportunities. And particularly at this juncture, mobile holds tremendous opportunities and it calls for us to invest to position ourselves for the future. So we do not specifically at this stage of the company's life focus on managing towards a specific margin target.

In terms of the investment philosophies that we operate, we target strategically important areas that make sense for us to invest. And once we identify the area, will dedicate and allocate resources accordingly. Along the way we'll make sure that the focus is keen, the execution is tight, and the investment is done with great efficiency and effectiveness. And whatever the -- oftentimes the products that we invest in the internet industry do not directly yield revenue at the same time period. So you would see margin variation.

As we said this year in particular, it is important for us to invest in mobile products. We have developed great products and one of the things that’s a little different compared to prior-year investment patterns is that we will aggressively promote our products, mobile products through the different distribution channels. So this is what we're seeing this year.

For Q1 you would already have felt what the investment, any implications to the overall P&L picture. And this effort is not going to end. We'll continue to invest in infrastructure, in people, primarily R&D, as well as sales and marketing efforts as I noted. So I think I give pretty clear indication of what you should expect for this year and that we're expecting, and this is an important year for us to invest to positions ourselves well for the future.

Jiong Shao – Macquarie

Thank you very much for the comments.

Operator

And your next question comes from the line of Catherine Leung of Arete Research. Please ask your question.

Catherine Leung – Arete Research

Hi, good morning. Just following up on the second quarter guidance, I was wondering if you could provide some detail on how much of ITE revenues are included in the guidance. Thank you.

Jennifer Li

We do not separately, even for the [ARPUs], we do not separately report on the sub-units, that we consolidate into our overall financial results, because it does not really come across as material to the overall picture.

For ITE specifically, back to your question, I think what, you know, it is not driver of the Q2 revenue sequential growth nor the laggard. It is, you know, low material impact to us overall, so I can't separately identify what that contribution is.

Catherine Leung – Arete Research

Sure. And maybe can I ask a follow-up on the ITE related content cost? If we look at the content cost growth trajectory, should we benchmark to, you know, some of the listed video players and how much they're spending on content, or is there some reason that, you know, we should expect very wide divergence in how much you're spending?

Jennifer Li

There will be differences quarter on quarter. ITE, in the video, online video business, it is dependent on its content and depends on the timing of quality content and the timing of when it's aired. It does vary quarter over quarter.

You see a little bit of differences between Q4 and Q1. In Q4, you know, there were some yearend tick-up, you know, for ITE, and Q1 I think, you know, there is just one quarter. Some of the phenomenon you're seeing in the online video sector is quarter over quarter there will be, you know, big variations of content costs. And from our perspective, Q1's content cost represents about 1.6% of revenue that should, you know, overall should slightly trend up.

Catherine Leung – Arete Research

Okay. Thank you.

Operator

And your next question comes from the line of Ge Qing of HSBC. Please ask your question.

Ge Qing – HSBC

Good morning. Thanks for taking my question. I was wondering if you can give us a little bit more color on, in terms of mobile, perhaps sort of the growth of mobile traffic. I'm curious about sort of CPC, how that's sort of tracking and how that's growing. And also sort of inventory and how you feel about sort of your particularly mobile inventory right now. Thank you.

Robin Li

You mean the mobile GPC.

GW:

Yes, mobile GPC.

Robin Li

Yeah. Mobile CPC is growing very nicely. On the mobile front [inaudible] traffic and CPM growing very quickly. So on a combined basis, the revenue contribution from mobile is growing very, very quickly. It just come off a very small base, so right now it's still relatively small as a percentage of total revenue. But we are very confident that this part will continue to grow, and as our customers learn how to, you know, utilize the features provided by mobile phones and mobile internet, you know, be able to get better ROI on mobile. Having said that, the CPC on mobile is still lower than the CPC PC.

And in terms of inventory, still, you know, the mobile traffic contribution is still less than the contribution from PC, but that is again growing very quickly. And relatively because last customer function for mobile internet, the mobile inventory is relatively, you know, easier to get than PC inventory at this time.

Operator

And your next question comes from the line of Eddie Leung of Merrill Lynch. Please ask your question.

Eddie Leung – Bank – America-Merrill Lynch

Thank you for taking my questions. Just two quick follow-up questions. The first one is on some of the cost items in the first quarter. I noticed that there was quite a bit of increase in operational cost and cost of services as well as R&D under operating expenses. So, just wondering if, you know, these two items have something to do with the consolidation of ITE. And if so, any color on how we look at these cost items going forward will be helpful.

And then secondly, just a quick follow-up on Robin's answer about mobile just like a minute before. You seem to mention that right now the CPC growing pretty rapidly. You did not mention much about click-through rate. So, wondering whether the technologies at the moment could give a pretty good click-through rate on the mobile side, you know, similar with on PC, or there's still rooms for improvement. Thanks.

Jennifer Li

Eddie, good morning. For your first question on the two line items, for operation costs within cost of revenues as well as R&D expense line items, the primary driver for these two line items are the Baidu business. Obviously, ITE's consolidation would add up to the overall expense, but they're not the main driver.

For the operations cost, I think, you know, we included in there also some intangible amortization that is related to some of the investments we do. This, you know, I think this line item has a pretty established trend, particularly as, you know, the -- as the overall [ITE] picture is in the picture as well, the expense related to that line item is -- has established a pattern.

For R&D, it's primarily because of Baidu's investment in our R&D. And as I noted, you know, this has been an investment theme for us for a couple of years, and that trend will continue to carry going forward.

Robin Li

Okay. On the click-through rate, we do not track that very closely because it's not really a problem. On the mobile screen, it's very small, and ad would occupy a lot of space. People kind of not, you know, unfamiliar with the mobile search product. So they would naturally click wherever it's shown on the first screen of the search results. So the click-through rate, should customers go up and down, but when you combine it with the CPC and the ROI for the customer, and the willingness of our customers to place their promotional messages on the mobile traffic is very encouraging. We have seen a lot of improvement on that; that's why, you know, the CPM and the traffic are growing very quickly and customers are adopting the mobile search more and more.

So from this point of view, again the limiting factor is how fast they can come up with a mobile-friendly site or mobile-friendly service. It's not about inventory, it's not about click-through rate or cost per click. It's not that.

Eddie Leung – Bank – America-Merrill Lynch

Got that. Thank you.

Robin Li

Yeah.

Operator

And your next question comes from the line of Jin Yoon of Nomura. Please ask your question.

Jin Yoon – Nomura

Hey, good morning everyone. Just is there -- are you guys forcing advertisers that allocate both money to the desktop as well as mobile? And if so, how much of that is incremental and what should we expect mobile to be a very material percentage of total revenues? And furthermore, what's -- if that's the case, what do you expect is going to happen to the overall CPRs and CPCs? And I guess final question to that is, is the mobile search mature enough where you could do that now or just the timing of it is right now I guess?

And just a quick follow-up question after that is just, what should we expect for SBC or [FCC] going forward? We saw a 3x jump on a quarter-over-quarter basis. Should we expect that to reoccur every first quarter going forward, or how should we be modeling that? Thanks, guys.

Robin Li

We are encouraging all of our customers to allocate a certain amount of budget on mobile because we really believe that is the trend that is being -- where the targeted consumers are moving into. We are not forcing them to do so. They still have the option not to advertise the mobile traffic.

Right now the overall CPC is slower because of, you know, the CPC on mobile is lower than the CPC on PC. But it is the transitioning period that the CPC on mobile keep going up and up, and eventually we think the overall impact would be incremental.

Jennifer Li

And Jin, your second question related to SBC? I didn't hear that clearly.

Jin Yoon – Nomura

Yeah. You know, we saw a 3x jump on a quarter-over-quarter basis I believe, and I'm just wondering if that is a one-time thing or should we expect that, you know, first quarter going forward, and just kind of how we should be modeling for that.

Jennifer Li

Yeah. If you look at the details, you know, published financial reports, you can see the breakout of the SBC expenses. You must have seen R&D talent has been a consistent theme and we are increasingly using share-based compensation as a lever to incentivize our people as well as to keep our top talents. And we will continue to use this as a very important tool. So you should expect, I mean this is not a one-time. You should expect that to keep going up.

Jin Yoon – Nomura

Got it. Great. Thanks, guys.

Operator

And your next question comes from the line of Ming Zhao of 86Research. Please ask your question.

Ming Zhao – 86Research

Hi. Thank you for taking my question. I just have a quick question on ITE. Is there any update you can provide us on it? There's been rumor on news in the market. Thank you.

Robin Li

I didn't quite get the question.

Ming Zhao – 86Research

Okay. So my question is about ITE. I was wondering if you could give us some update about the business in the quarter heading to the second quarter. And is there any other strategic operation around it? Thank you.

Robin Li

Okay. Online video is a very important vertical for us because we see a lot of user come to Baidu to search for video content. ITE is our answer to that. We will continue to support ITE to grow. But right now it's still burning money, but we think that longer term this will become a profitable business. So we will continue to support the video business and a very important direction for Baidu.

We obviously do not comment on any specific rumors. I just can tell you that we like the video and we will continue to invest.

Ming Zhao – 86Research

Okay. Thank you.

Operator

And your next question comes from the line of Thomas Chong of BOCI. Please ask your question.

Thomas Chong – BOCI

Hi, good morning. Thanks for taking my questions. I have a question regarding your mobile strategy. Which area in mobile internet will you consider Baidu is better to invest rather than building on its own? Thank you.

Robin Li

Mobile is in its early stage. There are all kinds of different apps and products, technology coming out on the market. My philosophy is that whenever we can buy, we prefer buy to build because that will save us time. But we have our own core business which is search. It's very hard to buy search from other players, so we have to, you know, invest to grow our own for our search [inaudible] in the system.

If there's anything that can help enhance our position, strategic position in search or how grow the overall ecosystem, like how to, you know, help our customers to come up with more search-friendly, mobile-friendly website, that sort of thing, we'll be happy to take a look.

Thomas Chong – BOCI

I see. Thank you.

Operator

And your next question comes from the line of Gene Munster of Piper Jaffray. Please ask your question.

Gene Munster – Piper Jaffray

Good morning. Jennifer, you talked about you've been in this investment phase a little bit and the next year to be an investment phase. Just on a high level, I think the [buy] is concerned that this is just going to continue indefinitely. As you kind of look at your investment plan over the next couple of years, do you see that starting slow down, basically start to see enough benefits in the next year that you won't have to be spending as much in 2014? Thanks.

Jennifer Li

I think as I mentioned already, you know, we are facing significant opportunities in the mobile space, and that's why we're deploying a lot of resources, whether it's talent or infrastructure or marketing efforts, to position ourselves. Obviously, you know, when investors look at the margin, it's a combination of the speed of revenue growth as well as investment. It does not necessarily coincide at the same time when you incur expenses, you generate that kind of revenue. Obviously as we invest, we want to make sure that we position ourselves well, and we will have revenue generation capabilities going forward. So this is, you know, where we are.

If I look at the investment themes of the items that incur significant resource allocation, infrastructure, you know, we are building the cloud capacity and we want to really be the key player to host the content to help users, you know, to storage, to help really manage, you know, the huge database that has, you know, our core technical competency. There are fewer players in the country that can do that. And we're in the early stage to invest in infrastructure.

And when you look at R&D talent, we have been growing, particularly R&D talent, very fast over the past few years. It's hard to imagine that we will continue that pace as fast as it used to be. So, over time I think, you know, as we look at the people-related matters, that hasn't been -- that has been the case for sales and we have slowed down hiring and sales and putting our emphasis on R&D. So we have a very clear focus on where we are going and what we need to do and how to allocate resources towards that.

And sales and marketing is a very special item for us at this juncture because we have products that we need to aggressively push. And it is, you know, I think that we are at an advantageous position because I think all the, you know, all the businesses that we have done very well over the years has built us the capability to aggressively promote our products and position ourselves for the future.

Obviously we are doing this with the objective to generate huge success and revenue growth potential. And therefore return to the shareholders. So that's -- this is basically, you know, the cycle we're running the business. There is -- the industry itself continues to evolve. It's hard to say, you know, this year, next year, you know, when it will be end. And I think, you know, it is a continuing theme. And I think when the time comes that we feel this is, you know, we're well-positioned, I think all parties will be happy to see that.

Robin Li

Yeah. One recap that exactly how aggressive we invest really depend on how much growth potential we see in the future. We will aggressively invest if there's, you know, significant growth opportunities ahead of us. The revenue growth and the investments may not, you know, go head to head quarter by quarter, but we look at a relatively time horizon, and you will see that the investment should pay off if we execute things right.

We've talked about the transition period for like a couple of years. It's really industry-wide a trend. We try not to be, you know, disturbed by this trend of negative shifting. We've tried to do things that's right for the longer term for our users and for our customers.

Gene Munster – Piper Jaffray

That's very helpful. And I agree that's a great strategy. Thank you.

Jennifer Li

Thank you.

Operator

And your final question comes from the line of Eric Wen of China Renaissance Securities. Please ask your question.

The line of Eric Wen is open.

And your next question comes from the line of Cynthia Meng of Jefferies. Please ask your question.

Cynthia Meng – Jefferies & Co.

Thank you for giving me the chance. I have one question. On the investment in mobile, there is a lot of discussion by Jennifer and Robin. I just want to follow where Robin said there are two years of transition since last year. Can we understand that the mobile related investments will also last until 2014 or will that -- do you that will go into 2015? And what are some of the sectors and verticals you are looking into for potential M&A opportunities or strategic moves? Thank you.

Robin Li

Well, let me clarify on that. At the end of last quarter, I mean end of last year, I said we were entering to a two-year transition period. That transition period is not really about investment; it's really about [inaudible] change or revenue opportunities. So we will continue to -- investment, you know, to invest in 2015, 2016. We will continue to invest.

We hope that after the transition, the search business will back on track, you know, the monetization capabilities for mobile traffic will be on par or even better than PC search. That's what I mean by transition.

Cynthia Meng – Jefferies & Co.

Okay. Then follow up on that, when do you see -- what is the like optimal mix of mobile search versus PC-based search? Would that be like 15%, 20% of total revenue from mobile?

Robin Li

During what kind of period?

Cynthia Meng – Jefferies & Co.

Right. That's my question. Is that going to be 15%, 20% in three years or how do you see that? Thank you.

Robin Li

I'm not going to give you, you know, exact guidance on the percentage two years down the road. But like I said, the monetization capabilities for mobile, well, is growing very, very quickly. After the transition period, the monetization capability should be on par with PC.

Cynthia Meng – Jefferies & Co.

Okay. Thank you.

Operator

We are now approaching the end of the conference call. I'll now turn the call over to Baidu's Chief Executive Officer Robin Li for his closing remarks.

Robin Li

Once again, thank you for joining us today. 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 and you may now disconnect. Good day.

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