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Baidu.com, Inc. (NASDAQ:BIDU)

Q3 2009 Earnings Call

October 26, 2009 8:00 pm ET

Executives

Victor Tseng - Investor Relations Director

Robin Li - Chairman of the Board, Chief Executive Officer

Jennifer Li - Chief Financial Officer

Haoyu Shen - Vice President of Business Operations

Peng Ye - Chief Operating Officer

Analysts

James Mitchell - Goldman Sachs

Gene Munster - Piper Jaffray

Dick Wei - J.P. Morgan

Catherine Leung - Citigroup

Jeffrey Lindsay - Sanford C. Bernstein

C. Ming Zhao - SIG

Richard Ji - Morgan Stanley

Steve Weinstein - Pacific Crest Securities

Eric Wen - Main First

Wallace Chung - Credit Suisse

Wendy Hung - RBS

Eddie Leung - Banc of America Merrill Lynch

Lu Chen - CICC

Stephen Ju - RBC Capital Markets

Operator

Hello and thank you for standing by for Baidu's third quarter 2009 earnings conference call. (Operator Instructions) I would now like to turn the meeting over to your host for today’s conference, Mr. Victor Tseng of Baidu.

Victor Tseng

Hello, everyone and welcome to Baidu's third quarter 2009 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 be joined by Peng Ye, our Chief Operating Officer, and Haoyu Shen, Vice President of Business Operations, to answer your questions.

Before we continue, please note that the discussion today will contain forward-looking statements made under 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, Robin Li.

Robin Li

Hello, everyone and thank you for joining us today. Throughout the economic challenges in the past year, Baidu has consistently kept our focus on execution and improving monetization and we are seeing results. The third quarter enjoyed solid growth in both revenues and net income. In addition, large customers are performing well and increasingly allocating more of their budgets to our platform.

China’s Internet market is rapidly growing and search engine marketing is increasingly important, and Baidu has been working hard to offer more advanced product and tools for users, customers, and partners.

We delivered a solid result this past quarter. We are in good shape to drive important initiatives in this quarter.

Phoenix Nest was launched six months ago and has been making good progress on migration. Revenues from Phoenix Nest at the end of Q3 contributed to over 20% of our total revenue. Among those customers who have adopted Phoenix Nest, the percentage is much higher. In addition, we have seen key monetization metrics such as coverage and cost per click trending upwards. We are confident that customer acceptance for Phoenix Nest has reached critical mass and we are ready to complete the transition in Q4.

Having a single platform will allow our customers to focus their resources and better realize the superior benefits offered by Phoenix Nest.

Likewise, by having a single bidding platform instead of two, we will be able to free up internal resources and more efficiently drive customer and revenue growth, as well as improve monetization.

While we are confident in our decision and our ability to execute the switch to Phoenix Nest, we do anticipate short-term negative revenue impact as some customers may lag behind in ramping up their spending on Phoenix Nest.

In preparation, we have implemented a customer service outreach program to help ensure a smooth transition. For the duration of the quarter, our internal resources will be fully occupied by the Phoenix Nest migration.

Looking to other developments in the third quarter, in order to better monetize our union traffic, we introduced Baidu union marketing, an upgraded platform for placing contextual links on Baidu union sites. This project was code-named [Basel], which you might have heard of. The new union marketing platform is independent of P4P, meaning a customer can run contextual campaigns separately from their paid search campaign.

We also launched a number of tools recently to assist our customers and union members to more effectively take advantage of the online marketing product we offer.

Baidu statistics is an advanced tool which allows customers to track and analyze site traffic in order to optimize their online marketing campaigns and increase ROI, and site manager is a tool for partners to manage their inventory on their sites.

Our intent is to create a more efficient online marketing ecosystem for our customers and partners, which Baidu will also benefit from over time.

Moving to the user front, Project Aladdin, an ongoing initiative to mine content from the hidden web, is also moving along. The Aladdin open platform has received thousands of applications from webmasters since it was launched and we have established information exchange interfaces with many of them.

Aladdin is part of a larger initiative, box computing, which will increasingly be the backbone of future Baidu initiatives. The box computing concept is based on our belief that as technology becomes increasingly complex, the user interface will move toward simplification. A person types a command into a box, similar to Baidu's search box, on any device screen and the computer will process the command and take an appropriate action. The action could be to return a piece of information, run a software application, or connect the person to online services directly.

In order to achieve the vision of box computing at Baidu, we have been working with third parties to make content applications accessible through our search box. Mobile search is also an area that is increasingly important to us and we are working to extend Baidu's leadership there. You may have heard that we recently announced a partnership with China Unicom which follows our partnership with China Telecom formed in May.

More importantly, we are working hard to develop high quality mobile search products. Using our proprietary transcoder technology and Baidu Palm, which is Baidu's integrated version of mobile search services, mobile phone users can easily access and enjoy the user friendly functions of our PC based services.

We also launched a mobile search service in Japan, where 80% of Internet users also log on wirelessly. We will continue pushing forward innovations and strategic partnerships on this front.

Today more than ever, Baidu is the number one search engine in China and we are seeing progress on all fronts -- technology, user experience, custom offerings, and branding. But we believe there is still room for improvement. Going forward, we will continue to enhance search user experience, customer ROI, as well as monetization. We will continue to attract talented people. There are tremendous opportunities in our market and we want to be well-positioned to seize them through innovation and execution.

Lastly, in anticipation of our 10th year anniversary, we will be moving into our newly completed headquarters in Q4. We welcome your visit.

And now let me turn the call over to Jennifer for the financial highlights.

Jennifer Li

Thank you, Robin. Hello, everyone. During the third quarter, we remained focused on maintaining strong growth and improving profitability through efficiency management and economies of scale. We will continue with our balanced approach to controlling costs while investing in important initiatives and ongoing improvements to our offerings. Specifically for the fourth quarter, we’ll be allocating marketing budget for the celebration of our 10th anniversary, as well as moving into the new Baidu campus.

In addition, expenses associated with new hires in R&D and sales, which we acquired towards the end of Q3 will be reflected in Q4, along with expenses for new hires we plan to make during the fourth quarter.

Now let’s take a look at some of the financial highlights for the quarter. The amounts mentioned are in RMB unless otherwise noted.

For the third quarter, total revenue was RMB1.279 billion, within guidance and represents a 39% increase year over year. Diluted EPS for the third quarter was RMB14.14, or $2.07. This includes two non-recurring benefits in other income and income tax expenses amounting to RMB29.6 million. Without these, the diluted EPS for the quarter would be RMB13.29, or $1.95.

During the quarter, Baidu had approximately 216,000 active online marketing customers, an 11% increase from the corresponding period in 2008, and a 6% increase from the previous quarter.

Revenue per online marketing customer for the third quarter was approximately RMB5,900, a 26% increase from the corresponding period in 2008 and a 9% increase from the previous quarter.

Traffic acquisition cost as a component of cost of revenues was RMB196 million or 15% of total revenues, as compared to 12% in the corresponding period in 2008 and 16% in the second quarter of 2009. The slight sequential decrease over Q2 reflects normal market fluctuations.

Bandwidth costs and depreciation costs as a percent of revenue both continued to decrease in the third quarter on a year-over-year basis. This reflects efficiency improvements as well as increased scalability of investment in capital expenditure. We will continue to invest to ensure we have an efficient infrastructure and sufficient capacity to serve the growing and evolving Internet development.

Selling, general, and administrative expenses in Q3 was $198 million, an increase of 21% year over year. With the ongoing rollout of Phoenix Nest and overall sales expansion, we expect to continue increasing sales headcount.

R&D expenses were RMB117 million, an increase of 49% over the year-ago period, primarily due to increased headcount.

Operating profit for the third quarter was RMB521 million, an increase of 42% over Q3 2008, primarily driven by good management of expenses and platform scalability.

Total headcount as of September 30, 2009, was about 7,000. The increase in headcount mainly comes from sales and marketing and R&D to support our many initiatives, including Phoenix Nest and Aladdin. We expect to continue to increase sales in R&D headcount.

In other income, we received a government grant of RMB14.3 million in this quarter.

Income tax expense was RMB49 million for the third quarter. The effective tax rate for the third quarter was 9.1%, the same with the corresponding period in 2008 and compared to 11.8% in the previous quarter. The sequential decline in tax expense is due to a receipt of tax benefit in this quarter in the amount of RMB15.3 million for the year 2008. We were awarded this refund because we obtained a preferential income tax status for one of our subsidiaries.

Net income was RMB493 million, a 42% increase from the corresponding period in 2008. Basic and diluted EPS for the third quarter of 2009 amounted to RMB14.23 and RMB14.14, respectively.

Net income excluding share-based compensation expenses, a non-GAAP measure, was RMB514 million, a 41% increase year over year. Basic and diluted EPS excluding share based compensation expenses, both non-GAAP measures, were RMB14.84 and RMB14.75 respectively.

As of September 30, 2009, the Company had cash, cash equivalents and short-term investments of RMB4.0 billion. Net operating cash inflow and capital expenditures for the third quarter of 2009 were RMB734 million and RMB130 million respectively.

Now let me provide you our top line guidance for the fourth quarter 2009. As Robin noted, we believe that our customer acceptance for Phoenix Nest has reached a critical mass and we are ready to complete the transition to Phoenix Nest in Q4. Please note that our guidance already takes into consideration the anticipated temporary impact of the switch.

We currently expect total revenue for the fourth quarter of ’09 to be between RMB1.19 billion to RMB1.23 billion, which would represent 32% to 36% year-over-year growth.

I do wish to emphasize that this forecast reflects Baidu's current and preliminary view, which is subject to change.

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question will come from the line of James Mitchell with Goldman Sachs.

James Mitchell - Goldman Sachs

Could you discuss why you decided to accelerate the full conversion from Baidu classic to Baidu professional to complete it during the fourth quarter rather than complete it next year?

Haoyu Shen

[inaudible] the answer into two parts -- one is the revenue part. As Robin mentioned in his prepared remarks, since about six months ago, we launched the Phoenix Nest openly to all customers who are seeing the key monetization metrics all go in the right direction. The coverage, extra coverage provided by Phoenix Nest is definitely increasing and the CPC, cost per click on the click [inaudible] by Phoenix Nest has also been increasing steadily since six months ago.

So monetization metrics, we’re happy with where we are and on the operation metrics, which Robin also alluded to in his remarks, we are seeing on a monthly basis we are seeing over 70% of our customers are already using Phoenix Nest and overall, at the end of Q3, on a run-rate basis, over 20% of our revenue is already coming from Phoenix Nest so both operation metrics and monetization metrics, we are happy with where we are. We feel we are ready.

Then I guess right now, that’s another part of the question, the running two systems puts a lot of pressure and stress on management capacity, on our customers, and also on our customer service staff, so that’s one thing. The other thing is it also puts some stress on our system, running two options is basically sub-optimal because these two systems are artificially separated and segmented, so it would be hard for Phoenix Nest over time to reach its full potential with running two systems. So I think if we move now, we can free up a lot of resources on the management side and customer service side and also on the customer side to focus on the new [secure] system and also for our algorithms, it can improve faster so that we have the chance to reap the full potential of Phoenix Nest faster. And we’ve been saying all along that this is a superior system and in the past six months, it has proved itself, so given all the above reasons, I think we are ready to move now.

James Mitchell - Goldman Sachs

And if it is a superior system and the monetization is improving, where does the temporary hit to revenue come from? Is it because CPCs are lower on Baidu professional than Baidu classic? Or is it because you expect some customers to just stop spending?

Haoyu Shen

[inaudible] monetization improves on a few metrics so coverage, it gives us more coverage, meaning we -- the system can match more relevant pay links than we can before, so coverage will go up so naturally click through rates will go up [inaudible] as you look at the total impression. And also eventually we think CPC will also go up just because it’s a system that -- it’s an auction system that encourages customers to tell the truth so that they can bid truthfully. Eventually it will be better for them to measure their ROI and -- which will lead to more spending from them on [inaudible].

Robin Li

Also because of the transition, we need to prepare for a lot of things, especially for the customer service team. They basically stopped doing improvements in the classic edition, which we expect would affect the revenue in a negative way.

James Mitchell - Goldman Sachs

Thank you.

Operator

Your next question comes from the line of Gene Munster with Piper Jaffray.

Gene Munster - Piper Jaffray

If we could revisit in terms of the impact from the shift over to Phoenix -- if we weren’t going to do that transition all the way over this quarter, do you know what the impact would have been or what you would have guided to for December, if that was the case? And I have one follow-up question.

Haoyu Shen

Roughly we are generally looking at roughly about 10% negative impact on the query basis because of the switch. As Robin mentioned, so there are two parts -- leading into December 1st, our customer service staff will be totally focused working with the moving customers and also at the time of the switch, we would expect that some of the customers may lag behind, either they are not ready to move immediately or even for example, who move because it’s a new system and they like to scale back their spending with us. So in total for this quarter, we think roughly the impact is about 10%, 10 percentage points.

Gene Munster - Piper Jaffray

Okay, when is the actual -- when does the switch flip over to Phoenix Nest? Is it -- you know, when will we be fully indicative gradual throughout the quarter or is it going to be kind of a one day event?

Haoyu Shen

Practically, it would be gradual over the quarter leading to December 1st. We’ve noticed all of our customers today I think a lot of them will hear about this -- we noticed our staff yesterday and most of our customers will hear from customers search staff today and we will start moving today. So practically, if you move today, you will have [inaudible] Internet spending tomorrow but December 1st is a clear cut-off date. From December 1st, the old system will not be available.

Gene Munster - Piper Jaffray

Okay. So I guess in that case, if we have a full quarter impact on the new system in Q1, should we take that into consideration when we do our March estimates as well?

Haoyu Shen

I think so.

Gene Munster - Piper Jaffray

Great. Thank you.

Operator

Your next question comes from the line of Dick Wei with J.P. Morgan.

Dick Wei - J.P. Morgan

My question is for the Phoenix Nest [inaudible] essentially the location, the display location is concerned, is it going to be different from the current, the top HUD no and the right-hand side panel, or it was on the other left hand main panel as well, if you can to discuss that. That would be great.

Haoyu Shen

We said all along, Dick, that Phoenix Nest is a new option, a new system, it’s a new mechanism and it’s independent of where [inaudible] are displayed. So this switch that we are talking about means Phoenix Nest as the auction system, as the bidding system, as the keyboard management system, will take over all of the inventory we have on our search results page, meaning the main panel will also be powered, if you will, by Phoenix Nest.

Dick Wei - J.P. Morgan

Great, thank you.

Operator

Your next question comes from the line of Catherine Leung with Citigroup.

Catherine Leung - Citigroup

Good morning. My question is also on Phoenix Nest -- given this has been launched for six months, I assume that some of the expected negative impact, is at least in part based on how the existing customers pd have trended when they switch over to the system. Can you elaborate a little bit more on is the initial impact due to the fewer clicks or customers withholding their budget intentionally? And is there much impact due to the lower click through -- sorry, to the lower cost per click because there was a smaller group of keywords that are available for sale or are the customers under-bidding because this is kind of a flying, kind of closed system. And can you also elaborate on how these customers trend using Phoenix Nest over the past few months since the launch. So in other words, have you seen the recovery in their spend kind of towards the later part of these six months? How fast does the spend recover? Thank you.

Robin Li

That’s a lot of questions but I guess it’s just -- I want to give you a [inaudible] what we seeing in the past six months. So we mentioned that on a runway basis, at the end of Q2 20% of revenues coming from [inaudible] connects, so that --

Haoyu Shen

That percentage has been steadily going up since day one and the other metric, which is 70% are on a monthly basis already using Phoenix Nest. That is definitely a metric that keeps going up.

And if you look at these two metrics together and then you ask yourself okay, so what’s the percentage of spending from Phoenix Nest accounting for those customers who are already using Phoenix Nest but as you can imagine is much higher.

As far as clicks and [PPC], because not all the customers are bidding on Phoenix Nest yet and right now the main panel takes priority. The CPC in a sort of general sense is still lower than the classic system but that’s for obvious reasons. But again, we are seeing that metric, CPC, going up pretty healthily in the past six months. And also, the -- in terms of number of clicks, that is growing very fast as well. The CPC is [low] because the [inaudible] -- better capability in matching queries with the [relevant links]. CPC is also going up at a very healthy rate.

Robin Li

Let me just add a few words -- regarding the number of keywords available for sale right now, separated from classic edition and the professional edition. After the flip, there -- the keywords available for sale should be unified and the number of keywords available should not be less -- it should actually be more.

Catherine Leung - Citigroup

Thank you. Can I ask a quick follow-up? Given as you mentioned the inherent monetization potential of the right-hand side of the page is less than the main left-hand side of the results page, how meaningful do you see kind of this read through on your current six months experience with [inaudible] portion of your results page? How meaningful is that [inaudible] translating over to [inaudible] main results page portion? Thank you.

Haoyu Shen

Contribution from the right-hand side is still a small percentage of our total revenue. It will probably continue to be the case for a while although we are working very hard on the right-hand side panel to make sure that we serve very relevant paid search links so that it can give us good user experience and good monetization. We are definitely making progress on that if you -- I don’t know if you noticed in the past six months, if you check out our right-hand side panels, it’s definitely the [appealing] quality is definitely improving. On the other hand, when we talk about Phoenix Nest, when we talk about a 20% revenue contribution, we are really talking about the majority of that is coming from the left top panel of our search results page, which is managed right now by Phoenix Nest.

Catherine Leung - Citigroup

I see. Thank you.

Operator

Your next question comes from the line of Jeffrey Lindsay with Sanford C. Bernstein.

Jeffrey Lindsay - Sanford C. Bernstein

Can I ask two questions -- first of all, will your move to greater automation using the Phoenix Nest system give you an opportunity to reduce costs or headcount, or will you just be absorbing your additional staff by not hiring at the same rate? And then my second question is, I noticed that there was a significant increase in traffic acquisition costs for Baidu Union -- does that mean partner deals are becoming more competitive to acquire or are there other factors, such as a shift in mix?

Peng Ye

The complete transition to the Phoenix Nest will not increase, directly increase our sales force because we have noticed that with more customers using our platform, they also need to have better services. As you have noticed, the last two quarters, the ARPU has increased a lot. That means the more and more customers can benefit the value of our platform.

Haoyu Shen

The question on whether the automation [inaudible] provided by Phoenix Nest potential -- you know, the potential to reduce headcount, I think that’s conceivable but that’s definitely not the main objective of Phoenix Nest and Phoenix Nest is more -- I would say a more sophisticated system so on the one hand, it’s providing more [tools]; on the other hand, it probably needs customer service people to work more intensively with customers to optimize their campaign to really get the benefit of Phoenix Nest.

And the question on TAC, I think you are referring to the year-over-year growth of TAC percentage. Actually, if you look on a sequential basis, it’s actually coming down a little bit. There’s no question that affiliate business is [inaudible] especially on the search side, is a price competitive business and the -- but if you look at the year-over-year basis, the increase has been driven by and large by the faster growth of our union revenue than our organic revenue. Our pay-out ratio, although as I said it’s a competitive business, our pay-out ratio has been quite steady and [inaudible] actually came down a little bit and that’s explains the sequential decrease of TAC ratio from Q2 and -- from Q2 to Q3 because we implemented a new union TAC pay-out policy at the end of Q2 so a lot of [inaudible] is flowing through our P&L in Q3.

Jeffrey Lindsay - Sanford C. Bernstein

That’s great. Thank you.

Operator

Your next question comes from the line of C. Ming Zhao with SIG.

C. Ming Zhao - SIG

Thank you for taking my question. Good morning. My question is still on the Phoenix Nest system -- so when we look at the impact to your revenue, you know, temporary right now, does that mean that a lot of the efforts will be focused on converting the usage onto the Phoenix Nest system, and then what we will likely see is basically ARPU going, still going up steadily but you will lose some of the customers when you look at your two metrics there? And if so, when do we see the customer edition becoming positive again?

Haoyu Shen

[inaudible], Ming, I think you are probably right to think that the switch will impact both ARPU and [inaudible] customers negatively -- number of customers I think that some will not be willing to move as fast, so that will have impact on [our customers] but if you look on a quarterly basis, probably not as much because the switch date is December the 1st, so I would imagine most of the customers will keep spending in the first two months. And on ARPU, I think after December 1st for the customers who already moved, they might -- some of them might scale back their spending just because they are not familiar with the system yet, either because of skill or because of will, the ARPU might come down a little bit.

So Q4 definitely hit by Phoenix Nest, we would fully expect Q1 will be as well so I think overall we will just probably take a couple of quarters from the date of switch for the situation to settle down and for us to come back to the normal growth trajectory.

Robin Li

So from [inaudible], the [inaudible] before they [advertise] helping customers to migrate the existing system to Phoenix Nest. That will certainly take some bandwidth from new customer acquisitions.

Haoyu Shen

And if you think about the beauty of the marketplace, the more people bidding for the same thing, you actually have better revenue opportunity for monetization capabilities. Therefore, during the transition as customers moving from the classic edition to the professional edition, we do expect to do so some monetization power because less people bidding on certain key words in [any system].

C. Ming Zhao - SIG

Okay, just a follow-up to that -- when you talk to your advertising customers, what is their feedback in terms of the return or the results after using the Phoenix Nest system?

Haoyu Shen

In general, customers are happy with the return they are getting from the Phoenix Nest, although we don’t have scientific proof or no customers to draw their comparisons, the comparisons between Phoenix Nest and classic system to us. On the other hand, because these two systems are running in parallel, there’s no apples-to-apples comparison anyway but I would say in general, they are happy -- they are happy with the ROI, they are happy with the tools and the data, the extra tools and data we are providing in the new system.

C. Ming Zhao - SIG

Okay, thank you.

Operator

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

Richard Ji - Morgan Stanley

Let me start with the first question regarding the large customer, and obviously more large customers have bought your search engine for their branding initiative. Can you give us some color on the roughly revenue contribution from these larger customers and what are the top advertising categories for these customers? And more importantly, have they given you any sense what is their rough ROI for search related initiatives versus their so-called traditional brand advertising?

Robin Li

Normally we don’t give the breakdown of the customers but as you’ll have noticed, the tier one customers, our big customers, grow faster than the small and medium enterprises last quarter, especially in the following categories enjoyed much faster growth, which are online gaming, e-commerce, and the auto industry as well. So a couple of our customers allocated much more marketing budget in our platform. For example, [inaudible] Perfect World, for e-commerce like Amazon China, E-Trip, E-Long, and also the C-Trip. Also, a couple of big customers joined us using our platform, such as [inaudible] as well. So those segments we grew much more faster than other industries.

A couple of reasons for those tier one customers allocating more budget to Baidu, we noticed that under these tough economic situations, those big customers pay much more focus on the much efficient ROI marketing platform. Also, last two quarters we introduced more marketing tools to them so that they can understand and appreciate much more the benefit of our platform.

Richard Ji - Morgan Stanley

I have a follow-up question and once you have adopted, fully adopted Phoenix Nest system, what kind of impact should we expect for your Baidu union members and also for your large customers?

Haoyu Shen

For large customers, I think they tend to be -- compared with SMEs, anyway, they tend to be more sophisticated keyword buyers, so they definitely even until today we’ve seen good adoption by these customers, so I would think that that growth differential between large customers and SMEs will probably continue after we switch to Phoenix Nest.

As far as union members, that’s a good question. So in -- as Robin mentioned I think in his remarks, we are launching a new product we call Baidu union marketing, which is new, which is a new contextual product which will gradually replace the old contextual product that we have. But the old contextual product is very much coupled with the old classic paid search product so that will -- so in that sense, coupled with the old system, so in that sense on the switch date, the revenue from that product will also get impacted materially.

Richard Ji - Morgan Stanley

Very helpful. Thank you.

Operator

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

Steve Weinstein - Pacific Crest Securities

I just want to make sure I actually heard you correctly -- I think you indicated that the move to Phoenix Nest was going to cost about 10 points of growth for Q4. If I do the math though, that would imply a much lower sequential growth this Q4 than you have historically, so I want to make sure I understand that right and that that’s mathematically correct.

Also, just as you think about that transition, do you think the impact will be greater in Q4 or in Q1? Thanks.

Haoyu Shen

Yes, you heard correctly -- we did say that on a quarterly -- for the entire Q4, the impact of the switch is roughly 10 [inaudible] points.

Steve Weinstein - Pacific Crest Securities

Is that a year over year or a sequential 10%?

Haoyu Shen

Oh, sequential.

Steve Weinstein - Pacific Crest Securities

Okay, great. That explains it, thank you.

Haoyu Shen

Yes, so you heard it correctly. And as far as how big of an impact is on Q4 and Q1, I think when the switch happens, in December we’ll have a much better idea but we do expect in Q1 there will still going to be material impacts from the switch.

Steve Weinstein - Pacific Crest Securities

Okay, thanks a lot.

Operator

Your next question comes from the line of Eric Wen with Main First.

Eric Wen - Main First

I have -- my first question -- I have two questions. My first question is if you can give us a quick comment on the advertising market outlook in fourth quarter and 2009, I guess from -- if I just mentioned that if we remove that 10% hit, we actually have quite a good acceleration on a year-on-year growth on the advertising revenues, or Baidu's revenues in the fourth quarter. Of course I understand the fourth quarter ’08 is an abnormal quarter but just if you can comment on if we remove on these two temporary factors, how do you see the overall market picking up going forward and in 2010? Thanks, and I have a follow-up question. Thanks.

Robin Li

Let me give it a try -- I think we are seeing increasingly a separation of search engine marketing and online branded advertising, where we have seen that search engine marketing has become increasingly important and more and more customers, especially the larger customers, realize that the performance or the return on investment for paid search is much better than any other means of advertising, so we are very happy and we are very confident that the growth prospect for search engine marketing is very good and will be very good for a long time.

For branded advertising, it has been always a very, very small percentage of our total revenue and we have not seen much movement or growth in the past 12 months.

Eric Wen - Main First

Thanks very much for the clarification. And my follow-up question is to Jennifer -- it looks like the scalability of the cost structure continues to be very good, even with the slowing down in revenue growth due to various factors, operating margin has held up and bandwidth and depreciation and TAC has all coming down in terms of revenue. I just wondered, this has been going on for a while -- I just wondered what is the endpoint? How low can we eventually -- how scalable this model eventually is? I know this is an old question but I just wonder if you have any additional color to shed on that. Thanks.

Jennifer Li

The good performance on the P&L margin side is a result of good expense management as well as scalability. We take a very disciplined approach to our cost and we invest prudently for the future benefit.

I’ve mentioned many times in the past the model is inherently, tremendously scaleable and so at this point, it’s not really our focus to target a certain margin percentage. We are still at the very early stage of the Internet development so we want to invest and spend prudently to make sure we continue to remain at the leading position on the search engine space.

Having said that, you know, you do have noticed that our infrastructure and equipment scalability has exhibited for many quarters, as well as the bandwidth side. The team is doing a good job to efficiently utilize our infrastructure and the equipment and to optimize the infrastructure in the way we -- the overall architecture works.

Going forward, we will continue to make investment in CapEx. We’ll continue to make investment in important initiatives, like Aladdin, like Phoenix Nest and those require people investment. So our focus is more long-term. It’s not margin management. It’s focusing on driving the growth and maintaining a disciplined approach to run an efficient company.

Eric Wen - Main First

Thanks.

Operator

Your next question comes from the line of Wallace Chung with Credit Suisse.

Wallace Chung - Credit Suisse

Can you update us on the top five industry groups? And also, can you give us some color on these top five groups regarding their response on the performance of Phoenix Nest? Would there be some of them more favorable whereas some maybe less favorable? Thank you.

Haoyu Shen

The top sectors continues to be the same there -- healthcare, machinery, education, [inaudible], and general travel, in that order. As far as -- I think what we mentioned before was in general, the B2C sectors are growing faster than the B2C sectors and that has continued to be true in Q3 and I think actually the launch or the switch to Phoenix Nest will continue, sort of will push that trend even more just because the B2C -- just by nature of the B2C sectors, they will stand to benefit more from the benefits offered by Phoenix Nest because they will have more choices on keywords, they will have better tools to manage more keywords, because they tend to have more keywords to purchase than the B2B sectors.

Wallace Chung - Credit Suisse

Just one quick follow-up -- so overall, these top five customer groups, are they spending more than 20% or less than 20% of total revenue on Phoenix Nest?

Haoyu Shen

I don’t have exact numbers but I think these are not -- some of these are B2B, some of these are B2C. I would guess the B2C sectors, the customers in that sector, in those sectors are spending more, meaning more than 20% of the revenue on Phoenix Nest in general but again, I don’t have exact numbers.

Wallace Chung - Credit Suisse

Thank you very much.

Operator

Your next question comes from the line of Wendy Hung with RBS.

Wendy Hung - RBS

My first question is regarding the seasonality of Q1. I remember that historically Q1 exhibit weak seasonality and also you just mentioned that Phoenix Nest [inaudible] date is December 1st, so actually in 4Q we are not going to see the full quarter revenue impact but in Q1 we will see the full quarter. So in that case, given the two reasons I just mentioned, should we expect to expect the sequential decline for Q1 2010?

Haoyu Shen

We don’t give guidance two quarters down the road but as we said, Q4 will be --

Wendy Hung - RBS

But do you agree with the two points I just mentioned?

Haoyu Shen

The point being seasonality and Q1 we’ll see full quarter impact, yes, those are true statements.

Wendy Hung - RBS

Okay, and also could you maybe give some color on the new Baidu union marketing? How that will affect the union revenue and also how that will affect the TAC ratio, and how different that is from the historical P4P union marketing tool?

Haoyu Shen

So the new product we offer is [inaudible] product. Within Baidu union, within our affiliate business, we have two types of business -- one is search related, one is search. We basically -- partners bring traffic to us and we share paid search revenue with them. And the other is contextual, so historically contextual has been a smaller, much smaller percentage of our revenue. So this new product is upgrade from the old contextual product that we have existing today, which will be unavailable on December 1st together with the old paid search product because they are very much coupled together.

As far as pay out, the pay out on contextual is in general higher than the pay out on search because it’s not search -- the traffic, the content is owned by the third party publishers. So as we grow [inaudible] going forward, because of the mix in the -- in our affiliates business might change and the TAC ratio on contextual is higher, you can potentially see the growth of TAC ratio but I don’t think that’s going to happen in the short-term because the contextual part will be challenged by the switch and also at the end of the day, it’s a very small percentage of our revenue anyway today.

Wendy Hung - RBS

Okay, great. Thank you.

Operator

Your next question comes from the line of Eddie Leung with Merrill Lynch.

Eddie Leung - Banc of America Merrill Lynch

Just a couple of questions -- the first one is actually on the cost front. I’m wondering if Jennifer can share with us more about the costs related to the new headquarters. For example, would there be any continuous depreciation costs and if so, what that amount could be? Thanks.

Jennifer Li

The Baidu campus on a net net basis does not impact P&L much. Today, we do rent office spaces and so therefore we pay rent and going forward, we move into Baidu Campus and we will recognize depreciation on the P&L. So with the carrying cost and the depreciation, net net it’s about the same as we are seeing today, so not much cost impact.

Eddie Leung - Banc of America Merrill Lynch

Got that. My second question is just a quick question on click through rates -- I’m wondering if you guys can share with us the trends of click through rate in the first quarter and given the various changes in back end systems, should we expect any material change in the click through rates in the upcoming say few quarters? Thanks.

Haoyu Shen

The click through rates on the top left panel and the right panel have been going up because more and more pay links in those spaces are actually managed by the [inaudible] system, which is a [better search relevant] system. So -- but that -- that growth has been gradual, so I think that will probably continue in the next few quarters but I don’t think you will see a dramatic increase.

Eddie Leung - Banc of America Merrill Lynch

Understood. Thank you very much.

Operator

Your next question comes from the line of Lu Chen with CICC.

Lu Chen - CICC

Good morning. I have two questions and one question is on the marketing side, given the impact of the [inaudible] transition and I heard that we will increase investing in marketing activities in the fourth quarter and going forward, so [inaudible] the gross margin operating margin could possibly come down in the next couple of quarters, at least before the revenue can go up [inaudible] from the new system?

And the second question is rather clear -- after that [inaudible] and Unicom but I read in local news that China Telecom [inaudible] another local third partner to be its strategic partner on the wireless side, so can you please clarify on that? Thank you.

Jennifer Li

On the first question, our margin is very sensitive to revenue so we guided for the Q4 reflecting the temporary impact of Phoenix Nest and we were maintain continuing spending for the long-term benefit, so margin will just naturally be the way it is.

Going into Q1, normally we do have seasonal quarters and Q1 is probably one of the lower quarters within the year, and it has been the case. So you do see margin variations quarter over quarter but as I said, we don’t focus on margin, we focus on long-term revenue growth and running an efficient company. So margin will just naturally be the fall-off of that.

Robin Li

Regarding the mobile search partnerships, I haven’t heard about the deal you mentioned with a third company -- between the third company and China Telecom. What we know is that we had a search partnership with China Telecom that was announced in May that we are served our search results to the China Telecom users, mobile users.

Haoyu Shen

What we mentioned before, establishing a partnership with operators is one thing but developing a very good excellent customer service and also the products is another focus we need to make the effort on.

Lu Chen - CICC

Thank you.

Operator

Our final question comes from the line of Stephen Ju with RBC Capital Markets.

Stephen Ju - RBC Capital Markets

Jennifer, just to clarify in regard to the marketing spend for the fourth quarter you mentioned -- should we expect this to be up on an RMB basis quarter on quarter or are we thinking that the spend you have planned for the new building will anniversary, et cetera, replaces what you spent on the world forum during the third quarter?

And CapEx seems to have ticked up a little bit during the third quarter -- what is your outlook for the balance of the year? Thank you.

Jennifer Li

We do expect a step up of SG&A expenses for Q4, so when you look at it, we’re basically -- two main things are happening. One is we are moving into the Baidu campus. We take a lot of pride in moving into the new building. We’ll do a celebration and it also happens to be Baidu's 10th anniversary, so we’ll do a lot of funding activities surrounding these main events.

So marketing expenses will be higher -- will be higher than Q3 and we are also planning to hire, continue to hire sales and R&D talent going into Q4. I did mention in the script that a lot of the headcount increases occurred towards the end of the quarter, so you will see the full expense impact going into Q4, plus some new hires. So SG&A expenses will have a step up from Q3 levels.

On CapEx, I have mentioned in the past that 2009 should be no less than 2008 and you do see I also said in the past that the CapEx is pretty chunky, so Q3 there is a step up and I anticipate Q4 will be a sizable CapEx expenditure as well.

Stephen Ju - RBC Capital Markets

Thank you.

Operator

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

Robin Li

Well, I understand many of you have concerns regarding to the switch or flip to Phoenix Nest. I want to assure you that this is a strategic decision made by the management. We did careful calculation and we think 12 months from now when we look back, we will be happy we did the switch sooner rather than later. So we believe, we truly believe that Phoenix Nest is a superior monetization system and time will tell that we are making the right decisions and right moves.

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

Operator

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

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Source: Baidu Q3 2009 Earnings Call Transcript
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