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Baidu.com Inc. (BIDU)

Q2 2006 Earnings Conference Call

July 26, 2006 8:00 pm ET

Executives

Cynthia He - Investor Relations Manager

Robin Li - Chief Executive Officer

Shawn Wang - Chief Financial Officer

Analysts

Jason Brueschke - Citigroup

Anthony Noto - Goldman Sachs

Andrew Collier - New York Global Securities

Robert Peck – Bear Stearns

Safa Rashtchy – Piper Jaffray

Paul Keung – CIBC World Markets

Steve Winston - Pacific Crest Securities

Richard Ji - Morgan Stanley

Leah Hao – Thomas Weisel Partners

James Mitchell – Goldman Sachs

William Bean – Deutsche Bank

Frank Shi - CLSA

Ming Zhao – Susquehanna Financial Group

Tony Tang - Lucite Research

James Mitchell - Goldman Sachs

Presentation

Operator

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

Cynthia He

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

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

Before we continue, please note that the discussion today will contain forward-looking statements made under the Safe Harbor Provisions of the U.S. Private Securities Litigation Reform Act of 1995. Baidu does not undertake any obligation to update any forward-looking statements, except as required under applicable law.

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

Robin Li

Hello everyone. Thank you for joining us. We had another great quarter by many measures. Our results show user traffic growth, revenue increase, customer base expansion and intense profitability.

More importantly, many events that took place from the beginning of the second quarter to date well position us even better for continuing growth in the future. I am very excited to talk to you about this update.

On the user front, we enjoyed strong traffic growth, even though the week-long national holiday in May and the World Cup soccer game took people away from the computer. It is encouraging to see that our focus on improving search experience continues to be meaningful to our users. We previously launched a series of products that address users’ need to feel connected when they search. These products, including Baidu Post Bar, Baidu Knows and Baidupedia are become increasingly popular.

To create a stronger sense of community for our users, we launched Baidu Space on July 13th. This is a product which allows users to create personalized home pages, consisting of blogs, photo albums and social networking functions. The product also integrates the use of other Baidu products in one place. Baidu Space is another product created to meet our users’ demand. Within the first day of the launch, more than 100,000 users registered on Baidu space. We will gather feedback from these early users and continue to improve Baidu space. We expect this product to take off quickly.

On the customer front, we provided online marketing services to more than 90,000 customers compared to 74,000 in the first quarter. 12 months ago for Q2 of ’05 we only had 41,000 active customers. So during the past 12 months we added more customers than we did for the previous four years.

The extension of our active customers base was mainly due to a strengthened sales network and the increasing appreciation of Baidu’s pay-for-performance services amongst small to medium-sized businesse. Our P4P model, works on the real-time keywords auction system. On June 1st, we removed the original RMB0.30 minimum bid price and adopted a dynamic bidding mechanism for the starting price. We believe by letting the average determine the starting bid, we better rationalize the auction system and ensure that pricing better reflects the true value of different keywords.

As a result, the starting bid for some keywords became higher than RMB0.30 and some lower. We have already seen positive impacts of the average [taking] price in online marketing revenues as a result of this change.

Overall, we believe that there is significant room for growth in the average price of keywords which is still low in China compared to other markets. While the market gradually matures, we will continue to refine our P4P systems in order to best capture additional revenue potential.

On the business development front, we continue to be the partner of choice for companies looking to participate in the growth of the Chinese economy. Building on our strategic alliances with Nokia and Intel, we recently signed agreements with IBM and Hewlett-Packard which we expect will create new opportunities for Baidu search products.

While improving and expanding our search business, we need to focus our resources on the business lines central to our core. In line with this strategy, we recently discontinued our Enterprise Search software business, which was on a separate business model and made only a nominal contribution to our revenue streams.

Before I turn the call over Shawn Wang, I would like to emphasis that our second quarter results are evidence of Baidu’s ability to better connect with search users and better serve the needs of online market customers in China. We will continue to offer a superior search experience and cost-effective ways of online marketing. We look forward to leading the way in Chinese Internet search for many years to come. I will now turn the call over to our CFO, Shawn Wang, to discuss our financials.

Shawn Wang

Thank you, Robin. Hello, everyone. As Robin mentioned earlier, we delivered great revenue and earnings results in Q2. I will walk you through the contributors to these great results and other financial highlights. The numbers I will refer to will be in RMB unless otherwise indicated.

Our second quarter total revenues were approximately RMB192 million, a 41% increase from the previous quarter and 175% increase from a year ago. This was towards the top end of our earlier guidance of RMB193 million.

Online marketing revenues were RMB189 million or 99% of total revenues, representing a 43% sequential growth and 183% year-over-year growth. This growth was driven by a number of factors, including traffic growth, a sequential increase in the number of active customers at 22%, as well as the sequential growth in per customer spending, which was 19%.

Traffic acquisition costs as a component of cost of revenues was RMB18 million, or approximately 9% of total revenues. Our TAC remained flat as a percentage of revenues compared with the previous quarter.

Capital expenditures for the second quarter was RMB41 million, up from RMB12 million in the first quarter. CapEx was mostly spent on additional network capacity to support traffic expansion and new product rollouts.

On income tax, our effective income tax rate for the quarter was 15% versus 16% for the first quarter.

Our share-based compensation expenses decreased in aggregate to RMB12 million from RMB13 million in the first quarter.

R&D expenses for the second quarter were RMB18 million. That represents an 18% increase from the previous quarter and 111% increase from the second quarter of 2005. This increase was primarily due to the expansion of R&D headcount.

Now on earnings, net income for the quarter was RMB58 million, representing a 66% sequential increase and a 385% increase year-over-year. This growth reflects the inherent scalability of our business. Net income excluding share-based compensation expenses, a non-GAAP measure, was RMB17 million, representing a 62% increase sequentially and a 285% increase from the second quarter of 2005.

Basic and diluted EPS excluding share-based compensation expenses were RMB2.11 and RMB2.03, translating roughly to $0.26 and $0.25 respectively. Net margins excluding share-based compensation expenses for the second quarter were 37%, up from 32% in the previous quarter.

Now a few highlights on the balance sheet. We ended the second quarter with cash equivalents of slightly over RMB1 billion. Operating cash flow for the quarter was RMB130 million, representing a 37% sequential increase. Adjusted EBITDA, again a non-GAAP measure, was RMB85 million for the second quarter, representing a 63% increase from the previous quarter, and a 243% increase from the corresponding period in 2005.

Now let me provide you with our top line guidance for the third quarter of 2006. We currently expect the total revenues to be between RMB238 million and RMB246 million which would represent an annual growth of 168% to 177%, and a sequential growth of 24% to 28%.

I do wish to emphasis that this forecast reflects Baidu’s current view, which is subject to change.

I will now turn the call back to Robin for his closing remarks.

Robin Li

It has been almost a year since we became a public company in August, 2005. We delivered several quarters of solid results, and we are glad to see that more and more people are beginning to appreociate Baidu’s abilities to serve the search market in China, and to capitalize on its vast potential.

With our dedication to understanding the needs and desires of Chinese search users, and our proven ability to develop the right product mix, we are confident that we will continue to lead the way and enjoy growth well into the future.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Jason Brueschke – Citigroup.

Jason Brueschke – Citigroup

Thank you. Good morning, Robin and Shawn. Congratulations on a very solid quarter. My question concerns the seasonality and the sequential growth of your revenues. It looks like you grew revenues 18% sequentially in Q1, you delivered a monster Q2 at 41% or so sequential growth; and now the guidance for Q3 of a range of 24% to 29% suggests a sizeable deceleration.

Could you maybe address the effects of first of all the timing of the Chinese New Year and how that could have influenced the strength in Q2? As well as the fact that Golden Week and the World Cup probably hurt you in Q2 and they don’t reappear in the third quarter, maybe help us understand what is going on in the sequential growth guidance you gave. Thanks.

Robin Li

I think the business by nature is seasonal. As we mentioned, in the first quarter we had Chinese New Year. Second quarter it is basically a catch-up quarter because we had slower growth in Q1, so comparing to Q1, Q2 sequential growth is much higher.

I would guide you to look more closely at the annual growth rates, the current quarter comparing to four quarters ago. Our growth rate is in the 170% range for just the past quarter, or for the current quarter guidance. So it is very natural for us to look at the business this way.

Jason Brueschke – Citigroup

Great, thanks. I will get back in the queue.

Operator

Our next question comes from Anthony Noto - Goldman Sachs.

Anthony Noto - Goldman Sachs

Thank you very much. Hi Robin and Shawn. I was wondering if you could comment a little bit on trends in CapEx and the impact of the Hewlett-Packard deal as it relates to margins going forward? Thank you.

Shawn Wang

As you can see, we actually significantly increased our CapEx from RMB12 million in Q1 to over RMB41 million in Q2. That is reflective of our investment both to support our significant traffic growth and also our new product development and new product rollouts. We would expect our investment in these areas to continue.

In terms of the impact of the Hewlett-Packard deal, actually that deal was one of the strategic cooperations; we are working with a lot of our partners. Financially, we don’t believe that it has any material impact at this current stage.

Anthony Noto - Goldman Sachs

Great, thank you.

Operator

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

Andrew Collier - New York Global Securities

Could you give me some sort of guidance on the breakdown of your revenue by sector? In particular I was looking for information about hospitals and healthcare, and education and what the change might be QoverQ, Q3 over Q2.

Shawn Wang

Andrew, as you can tell in past conversations, I have said it many times that our revenue streams are very diversified. There is not a sector that represents a significant portion of our revenues. We are not seeing any changes in that pattern, so going forward I would expect the same type of diversified revenues streams that we experienced in the past.

Operator

Our next question comes from Robert Peck – Bear Stearns.

Robert Peck – Bear Stearns

I was curious if you could provide us a little more color around competition? We know Google has been signing up more and more resellers there, and Yahoo! has been putting more of an effort, particularly with the Alibaba partnership. Could you just give us a little more color on what the delta has been over the last three months? What changes you have seen as far as the competitive environment? Thanks.

Robin Li

As far as we are concerned, we did not see any meaningful change during the past quarter. We continue to be in the leadership position both in terms of user traffic as well as customer numbers. We have the strongest distribution network nationwide in almost all of the major markets, the strongest distributors are Baidu and distributors exclusive to us.

We also have direct sales teams in a number of cities, which is growing very rapidly. We believe that we are very well-positioned in terms of the sales effort in the paid search market. Currently we do not feel any impact from the competition.

Operator

Our next question comes from Paul Keung – CIBC World Markets.

Paul Keung – CIBC World Markets

Can you give an update in terms of how does your churn rate look these days as it relates with your advertising network? What mix are you seeing right now in terms of the sales you are doing directly and indirectly?

Robin Li

Paul, can you repeat your question one more time? It wasn’t very clear.

Paul Keung – CIBC World Markets

I was wondering if you could give me an update on the churn rate of your advertisers, if you see any trends there? Also, what kinds of trends are you seeing in mix of your sales you are doing either on an indirect or direct basis?

Shawn Wang

Paul, we actually haven’t seen any changes in the pattern. We continue to see very strong customer loyalty, repeat to our business. We actually have never discussed the churn rate because the measurement of that is somewhat difficult for our business, because once the customer stops the relationship, they may come back to us again at different times, at different intervals. It is hard to measure.

All we know is the majority of our customers are repeat customers, and that change is continuing.

Robin Li

Let me address more on that. I think our customers are, in general, very loyal to us. We find a lot of new customers each quarter and it literally takes one to two years for new customers to fully appreciate the ROI of our paid search services. So actually it is the other way around. We would expect to get more from the customers who signed up in the past.

Paul Keung – CIBC World Markets

Great, thank you.

Operator

Our next question comes from Jason Brueschke – Citigroup.

Jason Brueschke – Citigroup

Shawn, you didn’t give us specific EPS guidance. Could you maybe qualitatively help us think about how we should be considering what you are going to be doing with operational expenses? A previous question talked about really no change in the competitive environment; you already did a pretty big CapEx increase, probably affecting your gross margins. But should we be thinking the same percentage of revenues or is there any specific plans you may have that you can share with us on the operational expenses in Q3? Thanks.

Shawn Wang

I will try to answer that question in a qualitative way. There is one thing that is for certain, that we are guiding a very strong revenue growth going forward. It doesn’t represent, as Robin mentioned previously, it is not a slowdown from the previous years.

On top of that, scale and building our scalability I think inherently we would expect we will unleash our profitability potential in the quarters to come. But in the near quarters, I also want to caution you that we are still making aggressive advancements, certainly in the areas of sales and marketing.

We are in the phase of building a large increase of our direct sales presence in a number of major cities in China, and all of these are likely to have a near-term negative impact on our bottom line. Although these are investments for our long term.

In terms of CapEx, as I mentioned earlier, we will continue to make aggressive investments in our CapEx. I am not going to talk about the exact number, but I think we will continue on our current pace.

Robin Li

When we look at our spending and budgets, we really look at the long term. Two years from now, five years from now, what the Company is going to look like. We make decisions based on that kind of plan, mission. So we don’t really talk about near-term, bottom line guidance. We will spend whatever is needed to ensure the long-term profitability for our business.

Currently with our margin, it is already well ahead of what most analysts were expecting previously.

Jason Brueschke – Citigroup

Great, thanks. That is extremely helpful.

Operator

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

Steve Winston - Pacific Crest Securities

Great, thank you. If I look at the growth in spend per advertiser in the first half of ’06 over what you were doing throughout ’05, it seems as though there is almost some acceleration in that increase. I am wondering, is that just a function of the new advertisers being smaller relative to the overall [pocket] being less dilutive? Or, are new advertisers at this point given that there is just more research on search coming in, and spending more upfront?

Shawn Wang

Let me try to address that first. I think the increase in the per customer spending is not necessarily an indication that the new customers added are spending more. I think it is a combination of the traffic growth, which is generating more clicks, and in the gradual appreciation of our cost-per-click.

The old customers, a lot of the old customers, they are spending also as well as the new customers. If you look at each quarter, the contribution per customer assumption by the new customers actually, because of the new customers added throughout the quarter, so they actually tend to be a dragging effect on the average per customer spending. Robin, do you have anything to add?

Robin Li

I think the ROI for all of the existing customers are still very, very attractive. We just need to make our systems ready to relieve the buying power from the customers, both old customers and newly added customers.

As I mentioned before, it literally takes a year or two for a customer to fully appreciate our system, fully appreciate the value of the service and customers literally spend more and more after they sign up.

Steve Winston - Pacific Crest Securities

Thank you.

Operator

Our next question comes from Richard Ji - Morgan Stanley.

Richard Ji - Morgan Stanley

Hi Robin and Shawn. We just noticed in the share-based compensation, it actually declined roughly 8% QoverQ. Should we expect a fundamental change in the incentive mechanism within your organization?

Shawn Wang

The answer is yes, Richard. After we became a public company, we were increasing our workforce and we are behaving more and more like an established business. In terms of incentivizing our people, we are moving more towards cash-based compensation and less relying on the share-based compensation. That is the reason. I do expect the share-based compensation as a proportion of our entire compensation scheme will continue to decline.

Operator

Our next question comes from Leah Hao – Thomas Weisel Partners.

Leah Hao – Thomas Weisel Partners

Good morning, Robin and Shawn. I have a question regarding your new customer adds. In terms of the number of new accounts, during the past four quarters you are adding about 10,000 accounts per quarter, and this quarter it jumped to 16,000. I was wondering if you can give a little bit of color behind that acceleration and whether you think that is sustainable going forward as well? Thank you.

Shawn Wang

The increase in the number of customers I think is a combination of two factors. One is our increased efforts in our distribution, both through our distributors and then also more so on our direct sales force. We have been increasing our direct sales presence in a number of important markets presently; I think the number reflects that.

Fundamentally, I think there has been an increased recognition of people who see this as a viable promotion for business by Chinese companies. That makes our efforts more effective as well.

Going forward, given our accumulated experience and more established network and distribution capability, we would expect our business to continue to grow and we expect to increase the number of customers who sign up.

Leah Hao – Thomas Weisel Partners

Thank you. Can I ask a follow-up regarding your sales strategy as well?

Shawn Wang

Which strategy?

Leah Hao – Thomas Weisel Partners

The channel strategy, the direct sales force strategy.

Shawn Wang

Again, we will continue the strategy that we have communicated a number of times to you and to the market. The strategies, we have a differentiated strategy for different markets throughout China. We don’t have one nationwide strategy. In some of the markets we work closely with our distributors to give them the best support to help them to sign up new customers to provide products and services. In other markets, we have chosen to opt to a direct sales presence. The latter case tends to be in larger and more competitive markets.

In the past year, we have executed that strategy in Guanjo, in Shanghai and we will continue to do that in those two cities. In the past quarter, we commenced our effort in Beijing as well. We actually just entered into an agreement with one of our distributors in Beijing in the past few days whereby we will be taking over the distribution from one of our distributors in Beijing we will put direct sales, to continue to provide customer support and sales effort in Beijing. Beijing is the only city where we have an overlap between direct sales and distributor.

Leah Hao – Thomas Weisel Partners

Great, thank you. I wasn’t aware of that as well. Thank you very much. Lastly, since for now you have more than six months of sales data from the Guanjo direct sales force, could you give us a little bit of color regarding the matrix in terms of new account adds or spending per customer, or churn rate before and after the direct sales force, please?

Shawn Wang

There is not much change. I think with the addition of direct sales, overall there have been plans for customer service directly from Baidu’s customer service function. So overall, I think it is a very positive effect for our customers to experience and also for our financial results.

Setting up any direct sales force is at the beginning stage. To us, it is still an investment. Our business model scaleabilty will show only when the customer base reaches a certain level and certain thresholds. In the direct sales, all the markets that we are operating, particularly in the new markets we are entering into, we are still in the investment phase.

Operator

Our next question comes from James Mitchell – Goldman Sachs.

James Mitchell – Goldman Sachs

My question has been asked. Thank you.

Operator

Our next question comes from William Bean – Deutsche Bank.

William Bean – Deutsche Bank

Could you give us a sense or any update on your services strategy? I know it is getting into the music, blogs, things like that. Thanks.

Robin Li

At this time, our main business model is still pay-for-performance. Most of the revenue comes from web page search. We do not consider those newly added functions an independent product. We are serving our users’ information needs in whatever way they require or they demand. So when we add new services, we really consider that an added function to the overall Baidu search service to our users.

The best monetization method to-date is still pay-for-performance, mostly for web page searches. We of course will keep an eye on the development of other business models or newer business models, but at this time we do not expect any meaningful revenue from non-web page search services we added during the past half a year or year timeframe.

William Bean – Deutsche Bank

Could you just give us an update on your thoughts on online payments and online commerce and where that stands now?

Robin Li

It is still in its very early stage. The payment infrastructure in China is not mature enough. Currently, there are not a lot of users using those kind of services.

Operator

Our next question comes from Frank Shi – CLSA.

Frank Shi – CLSA

Hi guys. Your revenue per customer increased by 19% quarter on quarter. How much of that is due to the increase in number of clicks and how much of that is due to the increasing price per click? Thank you.

Shawn Wang

Frank, we have a practice of not separately looking to the number of clicks, or click-through rate or average click price. I think we believe any one of these measures, just talking about these measures may be a misleading picture of how we will be growing our business. We are still at a very early stage, whereby we are in the process of refining our P4P algorthim or monetization model. Some of these terms may be changing, but overall I think our traffic has been growing fast and our click price has been in a positive direction.

Operator

Our next question comes from Anthony Noto - Goldman Sachs.

Anthony Noto - Goldman Sachs

Great, thank you. Shawn and Robin, I am not sure if you have answered this question so I apologize; some of the people had asked multiple questions and I kind of lost track of what they were asking. Your guidance for the next quarter implies an acceleration of year-over-year revenue growth. I am wondering if you can give us a little bit more clarity on that.

Is that because you have good visibility into the backlog, because a lot of your new advertisers came in right at the end of the quarter? And projecting out, having them for a full quarter as opposed to maybe just one month of the quarter gives you a natural lift in the third quarter results? Or is it some other factor? Because it is on a year-over-year basis, so it is not related to seasonality. Thanks.

Robin Li

Let me clarify the year-over-year growth rate again. For Q2, the growth rate is 175%; for Q3 guidance, the number is between 168% to 177%. So it is roughly the same growth for both Q2 and Q3. I am not sure why you are asking for an explanation for an acceleration.

Anthony Noto - Goldman Sachs

I guess you caught me; I always assume you are just at the high end of the range, so I apologize. If it were to be at the high end of the range, I guess, even though your range doesn’t call for an acceleration on a net revenue basis.

Robin Li

I think as the revenue number gets larger and larger, we are pleased that we are exempt from the law of large numbers.

Operator

Our next question comes from Ming Zhao – Susquehanna Financial Group.

Ming Zhao – Susquehanna Financial Group

Thank you very much. One question, maybe you have already answered one of them. I am just curious about how you make your forward-looking guidance? Because when you make your forward-looking guidance, you are well a month into the quarter, and you have two months left. Although you can look at the number of customers added, the average revenue per customer, to get a prediction.

On the other hand, I think it is also a function of the traffic and click-through rates and the revenue per click. I am just curious, do you have very clear visibility of how these will trend in the next two months when you make the guidance at this point?

Shawn Wang

The short answer is that all of the things that you mentioned, they actually do look into that. It is a pretty complicated process of looking at the pile of statistics that we’ve been accumulating. The good news is that we are the leading search engine in China, and we serve a commanding market share of the search queries, and our customer base is also large enough to be statistically meaningful.

But the challenge is also in a lot of factors: the traffic or click bys, or number of customers that you sign up. All of these are factors that we have to take into consideration. Exactly how, in a guidance judgment, it doesn’t help estimate. It is a pretty challenging task for us as well, but the good news is we have some statistics.

Ming Zhao – Susquehanna Financial Group

So maybe just a follow-on that. What kind of trend do you see on the average revenue per click and the click-through rate?

Robin Li

I don’t think we are ready to disclose the average click price and click-through rate, but let me add more color on this question. I think the number of active customers for the current quarter or the growth rate for that number really represent a combination of our strong position in the market as well as the maturity of the market. I would probably say more towards the maturity of the market. Internally, the revenue really are determined by the related traffic, which is very much like an inventory we can produce for our customers who are advertisers. And also based on pricing and how much we can charge our users.

So internally we plan on the growth of traffic and the capability we can monetize that traffic based on our pay-for-performance rules. Both sectors are changing, or improving. That is how we come up with our quarterly top line guidance. It is an indicator of our position and the market maturity.

Ming Zhao – Susquehanna Financial Group

Thank you.

Operator

Your next question comes from Robert Peck - Bear Stearns.

Lillian Cho - Bear Stearns

Hi, this is [Lillian Cho] for Bob. Robin and Shawn, I would like to get some more details on the newly-launched Baidu Space product. What are the features like integration or even a monetization plan you have in place for this product? How did you differentiate Baidu Space from other social networking sites with similar service offerings, such as MSN Space? Thank you.

Robin Li

We did this because of popular user demand, lots of Baidu users asked for it, they really need it so we came up with a product to satisfy their needs. The functions including, like I said, a blog function and photo album function and some social network functionality.

It is being integrated with other Baidu products, including the Post Bar, the Baidu PDN, the Baidu Notes products. So going forward, we will have more and more information about our users. I think that may help us to better monetize the non-web search traffic in the longer term. But right now, there is no immediate plan to monetize Baidu space.

In terms of competitive offerings, Baidu Space is a new product which launched on July 13th. There is still a lot of room to improve, but with our brand and with the technological advantage we have, Baidu Space is certainly the fastest and most stable service of its kind. We believe over time we will become number one in this category.

Lillian Cho - Bear, Stearns & Co.

Thank you very much.

Operator

Your next question comes from the line of Lu Sun of Lehman Brothers. Please proceed.

Lu Sun - Lehman Brothers

Good morning. I actually just have one question regarding the search experience of your users. We noticed there have been quite a few more ads on the website, i.e. the main search results of your webpage. How do you balance the monetization and also the user experience? Because your competitor is generally increasing their index pages and also providing a better product. Thank you.

Shawn Wang

Lu, I think the best measurement for user satisfaction is page views. If our page views continue to grow at a faster pace than our competitors, than we are serving the users better than them. The criteria is not really how many page search results we display on a certain search results page. It is really how well we can satisfy our users information needs. Based on that, we adjust our search results page layout on a very frequent basis, constant basis because of the early stage nature of the page search business.

Having said that, I do not agree with you that we added a lot more page search links on the left-hand side of our search results. We actually reduced the number of page search links on the left-hand side during the past quarter.

The number of page search links on the search result page is not an indication of how relevant our results are, and it is not an indication of how strong our monetization capability is. Those are not really relevant measures.

Lu Sun - Lehman Brothers

Thank you.

Operator

Your next question comes from Paul Keung - CIBC.

Paul Keung - CIBC World Markets

In the past, you guys have made a point about, in addition to clicks and query growth, you are driving coverage and from the standpoint of going after monetized clicks but also to find more suitable advertisers.

My question is where are we in that strategy, given you have been doing it for some time now? Does that contribution start flowing down into next year?

Robin Li

I think our strategy has always been to continue to find better ways to monetize the traffic. Like I mentioned before, coverage, it is not really a good indicator of our monetization capability. We really look at the quality of the sponsors links and look at the relevancy of the sponsor links. We look at how much value we bring to the advertisers, and based on that, we adjust our bidding process, we adjusted the starting bid. We may add more paid links, sponsor links, we may reduce the number of sponsor links. We may change the matching up between the ads and the user priorities -- there are a lot of things we are playing with. I do believe there is still a lot of room for us to improve.

If you look at the monetization capability, or the clicking price among different search markets, China, Japan, Korea, U.S., or U.K., I believe that the price Chinese advertisers pay is still a fraction of what advertisers in other markets pay.

We believe we still have a lot of things to do, and we have a lot of room to improve.

Does that answer your question?

Paul Keung - CIBC World Markets

Close enough, thanks.

Operator

Your next question comes from Steve Weinstein - Pacific Crest.

Steve Weinstein - Pacific Crest Securities

Thank you. Just a question on the growth in CapEx in the quarter. I think in the script you talked about that really trying to keep up with the demand there was in the quarter, but I am wondering if there was some additional spending in the quarter to prepare for growth in the second half of the year?

Or if you really match the spending with the current demands of the business, how we should think about CapEx, having it grow more in line with just the overall top-line growth going forward?

Shawn Wang

The CapEx growth is not, for the most part, it is not related to any specific project. I think it is more in line with the overall strategy for growing our business. This CapEx is money spent buying servers and network equipment, which have an average life of somewhere between three to seven years, that we could use.

It just reflects the confidence we have in the future growth of the business, and we will continue to make investment in the future quarters to come.

Steve Weinstein - Pacific Crest Securities

Thank you.

Operator

Your next question comes from Andrew Collier - New York Global Securities. Please proceed.

Andrew Collier - New York Global Securities

Thank you. Could you give some indications of what your hiring has been thus far in the quarter, and what you expect it will be for the remainder of the quarter, given that you are taking over distribution in Beijing from [Guanjo] and you are also, you mentioned earlier that you are going to be expanding some of your sales and marketing efforts elsewhere in the country.

Shawn Wang

We will continue to grow our direct sales. I think our headcount increase in the past quarter, in the near quarters to come will continue to be the addition of direct sales headcount. I think the taking over of the general customers would require us to expand our customer service support, and also expanding our direct sales presence in Beijing.

At the same time, we see growth opportunities in Shanghai and Guanjo continue to be unleashed, and we will be adding manpower in those markets as well.

Andrew Collier - New York Global Securities

A month ago when I was in Beijing, the Company said that they added I believe 600 people since the beginning of the year. Where does that figure stand now, since January, and where do you expect it to be by the end of the quarter?

Shawn Wang

At the end of the quarter, at the end of Q2, we have roughly about 2,300 people, and that is really about a 500 or 600 headcount increase from the previous quarter. I think most of the addition came from direct sales. We will continue to be adding more and more direct sales. I cannot give you an exact number, how many we will be adding.

Andrew Collier - New York Global Securities

Thank you.

Operator

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

Nat Schindler - Piper Jaffray & Co.

Hi, this is Nat Schindler calling in for Safa. What percentage of your sales are now coming through distributors? How has that changed over the last quarter? I know you have talked about bringing more of your sales in-house. What effect will that expansion of the in-house sales force, as opposed to the distributor sales force, have on your margins in the long-term? Thank you.

Shawn Wang

The majority of our sales at this stage continue to be -- still the majority of our revenue came from our third party distributors. Over the course of the past few quarters, as we have been making less in direct sales, that proportion has been gradually declining, but it is still over 50%.

In longer-term, we would see the increase in direct sales contribution will accelerate, because the direct sales forces that are put in place will not have immediate incremental sales effect in the near quarter. As we build our customer base gradually, and it is a recurring customer base, the effect of our direct sales and the contribution in terms of revenue will accelerate.

At some point in time, the majority of our sales will be generated by direct sales.

Robin Li

In terms of margin, I think direct sales inherently have slightly lower margin because we have to hire the sales force, but it will have a better impact on top-line. Currently for the distributors, we only record net revenue, not our distributors commission.

Shawn Wang

Direct sales will have a better both top line and bottom line. It is just the margin itself, because you will be picking up these additional experiences, they may be affected.

Nat Schindler - Piper Jaffray & Co.

Thank you.

Operator

Your next question comes from the line of Frank Shi of CLSA. Please proceed.

Frank Shi - CLSA

How much of your traffic growth is coming from the community-based product? Because those traffic probably won’t generate much revenue for you, and do we need to worry about the deterioration of your traffic, not only for you but probably for the whole industry, because everyone else will probably do the same thing. Thank you.

Robin Li

If you look at the third-party data, Baidu is the number one website among all Chinese users, probably the largest website in Asia, or the largest website outside of the U.S., in terms of reach and traffic.

Not all of the traffic is web page search traffic. We do have traffic from the community RN, search services or search-related services. I believe those services help increase the traffic of webpage search or the traffic that we can better monetize.

So developing other functions or products for Baidu users has helped increase the webpage search traffic for us, that being our strategy so far.

Frank Shi

Thank you.

Operator

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

James Mitchell - Goldman Sachs

Thank you very much. You mentioned just now that you enjoy a revenue pick-up when you bring sales force in-house on a per customer basis, because you switched from reporting revenue net of the sales force payment to gross. Is that revenue pick-up having a material impact on your revenue per customer, or is it an immaterial impact at this stage? Thank you.

Shawn Wang

James, it is an immaterial impact at this stage. New customers really need some time to ramp up to release their buying power, so the customers we obtain through the direct sales force to have full buying power release, it is two years from signing up.

James Mitchell - Goldman Sachs

But if there is a customer who is already working through a third party, and then you have brought the third-party salesforce in house. Wouldn’t you get a 50% step up in the spend from that customer that you report?

Shawn Wang

The fact is, many of the customers working through distributors got discounts from the distributors. It is not really a 50% step up for revenue.

James Mitchell - Goldman Sachs

I wasn’t referring so much to the discount they enjoy, but to the fact that when you report revenue, you report net of the distribution discount if it is through a third party and you gross it back when you take the sales force in house?

Shawn Wang

I am not sure if you are asking me about the customers we took over from the distributors or the customers we developed organically through our direct sales force?

James Mitchell - Goldman Sachs

I was referring to the former.

Shawn Wang

When we take over from the distributors, those customers are already enjoying a discount. We cannot change that immediately. So there is no material impact for the top line.

James Mitchell - Goldman Sachs

I wasn’t referring so much to what the customer spends, but to what Baidu books, because previously I though Baidu would book two-thirds of what they are spending as revenue, whereas post the acquisition of the sales force Baidu would book the full amount as revenue?

Shawn Wang

Yes, but two-thirds of the listing price. The end customer may not pay listing price.

Robin Li

To answer your question, yes there is an incremental with regard to taking over from our distributors, there is an incremental contribution for our top line, to the revenue. However, the incremental is not as high as you imagine a 50% pick up because some of the customers are now paying the full listing price. But there is incremental.

However, the distributors that we are taking over, none of them represented a material or larger share of our overall customer base, so the incremental impact for our financials in the immediate term, is not material.

James Mitchell - Goldman Sachs

That’s great. Thanks.

Operator

Our next question comes from Tony Tang - Lucite Research.

Tony Tang - Lucite Research

Thank you for taking my question. Part of my question has been answered about the [inaudible acquisition]. So looking forward, do you have any more acquisitions or a timeline? How do you see this acquisition contributing to future growth? Actually, are you looking for the strategy to grow your revenues through the acquisition in the future?

Shawn Wang

We have an acquisition strategy, we are looking at either some products or software or websites that would be synergetic to our business. Meaning either adding traffic or adding user experience. In the course of the past quarters, we have entered into some small deals, but none of them were material enough and didn’t have any material impact financially on our business operationally. We will continue to look for opportunities along those lines. There is nothing that I could elaborate on further.

Tony Tang - Lucite Research

My other question involves the taxation. Remember way back, a few quarters before, you actually mentioned you are looking for favourable tax treatment from the government. But in the last few quarters, your effective tax rate has been around 16%.

I am just wondering, is anything going on on that side?

Shawn Wang

There is not any change in the status. We are still paying the statutory tax rate. We also are still in the process of applying for certain tax breaks. The timing of which or whether we could or could not get it, it is still uncertain. I wanted to caution you that these are not to be taken for granted.

Tony Tang - Lucite Research

Thank you.

Operator

Our next question comes from Ming Zhao – Susquehanna Financial Group.

Ming Zhao – Susquehanna Financial Group

Thank you. Just a quick question – can you comment on the traffic and the monetization because of the World Cup?

Robin Li

The traffic and monetization both were hurt by the World Cup game, because a lot of people left their computer desk and went and watched TV. Most of our businesses are not related to brand advertising, so we do not get any benefit from that kind of customer spending.

Ming Zhao – Susquehanna Financial Group

Thank you.

Operator

There are no further questions at this time. We are now approaching the end of the conference calls. I will now turn the call over to Baidu’s Chief Executive Officer, Robin Li, for the 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. Thank you.

Operator

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

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Source: Baidu.com Inc. Q2 2006 Earnings Conference Call Transcript (BIDU)
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