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Baidu.com Inc. (NASDAQ:BIDU)

Q3 2006 Earnings Call

October 31, 2006 8:00 pm ET

Executives

Leslie Zhang - Investor Relations

Robin Li - Chief Executive Officer

Shawn Wang - Chief Financial Officer

Analysts

Anthony Noto - Goldman Sachs

Safa Rashtchy - Piper Jaffray

Dick Wei - JP Morgan

Robert Peck - Bear Stearns

Steve Weinstein - Pacific Crest Securities.

Jeffery Zhang - Singular Research

Jason Brueschke - Citigroup

Leah Hao - Thomas Weisel Partners

Chang Tiu - Foreign Technology Research

Dick Wei - JP Morgan

James Lee - WR Hambrecht

Joe Boveril – Suttonbrook

Presentation

Operator

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

Leslie Zhang

Hello, everyone and welcome to Baidu’s third quarter 2006 earnings conference call. We distributed our third 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, Robin Li.

Robin Li

Hello everyone, thank you for joining us today. I am pleased to let you know that we had another good quarter as we strengthened our position as the number one provider of Internet search in China, and continued to grow our revenue.

During the quarter, we expanded and enhanced our product offering, further refined our monetization algorithm, rationalized our distribution network in Beijing, and invested in technology to position Baidu for long-term growth.

With popular community-based search products like Baidu Space, Baidu Knows, Baidu Post Bar and Baidu Encyclopedia, and a growing suite of vertical search products including Legal Search, Baidu Index, University Search, Government Search, and Youth Search, we continue to boost traffic growth and gain market share by making Chinese search more useful and convenient.

In fact, according to an independent survey by China Internet Network Information Center, Baidu’s share of Chinese Internet traffic rose to 62% as of August 2006, compared to 48% as of August 2005. We are excited to see that the gap between Baidu and our competition continues to widen.

During the quarter, we continued to invest in refining our monetization algorithm. As we discussed previously, in June, we optimized our monetization algorithm by introducing a dynamic starting bid business; and in September, we introduced an intelligent ranking system which provides a better user experience and increased customer ROI by incorporating relevancy into the ranking system for sponsored links.

This new initiative may affect our revenue growth in the near term; however, we believe that as users see greater relevance in their search results and our online marketing customers receive higher quality hits from their increased spending, these changes will produce strong revenue growth over the long term.

We believe that the best way to ensure Baidu’s growth for the long term is to continue investing in technologies that give our users the best search experience. By staying focused on improving the overall user experience, we believe we will continuously increase ROI for our customers and build exceptional long-term value for our shareholders.

Another area in which Baidu is pushing technology is in the mobile space as we modify our most popular offerings so that they can be accessed by people on the move. In addition to our traditional web search, we have now adapted a range of our other search functions such as Baidu Knows, Baidu Weather, flight/train information, Baidu Dictionary and Baidu Stock Search for use on mobile phones, wireless devices and other non-traditional means. We are seeing good results from this early effort and expect this to be an area of growth for us in the future.

Leadership in the Chinese search market is not just a matter of gaining unparalleled market share and user traffic. It is also essential to ensure that our online marketing customers receive the dedicated service that they deserve. With this in mind, we began to transition from serving customers by a third-party distributor to direct sales in the Beijing market in July. We are sure that in the long term, our customers will appreciate direct access to our in-house sales and service teams based in Beijing, and we expect that this will be reflected in our future results.

In other cities, we continue to help improve our distributors’ capabilities to serve our customers. Over the quarter, we provided online marketing services to more than 102,000 customers, compared to over 90,000 in the second quarter.

Baidu’s leadership in China’s Internet industry makes us the perfect partner for international content providers, and I am pleased to talk to you about our most recent alliance with MTV Networks that will expand our powerful, online entertainment platform. Through a dedicated MTV zone on Baidu’s website, China’s 123 million Internet users will have access to 15,000 hours of MTV and Nickelodeon’s original video content and music videos licensed from five music companies. We are excited by the opportunity for collaboration with leading content providers, and will continue to keep our eyes open for strategic partners that enhance our user experience.

I spoke to you earlier about the important changes made in our monetization algorithm. With these changes, we are going through a transition period for the next couple of quarters, but we believe these changes will have a positive impact on our long-term revenue growth. More importantly, we have never been more confident that the combination of our deep connection to Chinese Internet users and our ability to create products that meet their needs, will allow Baidu to excel for many years to come.

Lastly, many of you will have noticed that our Chief Technology Officer, Jerry Liu, has decided to resign. Jerry has been a good friend and colleague over the years, and played an important role in making Baidu the top search engine in China. He has also helped to establish what we consider one of the best tech teams in the Internet industry. Jerry has decided to leave for personal reasons, and we wish him all the best.

We have built a very strong team with many senior engineers who will be spearheading our ongoing technology initiatives and I am sure we will continue to exceed expectations. Meanwhile, we are considering options for Jerry’s successor.

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 solid revenue and earnings results in the third quarter. I will walk you through the factors contributing to these results and other financial highlights. Again, the numbers I refer to will be in RMB unless otherwise indicated.

On revenues, our third quarter total revenues were approximately RMB 239 million, and that is a 25% increase from the previous quarter and 159% increase from a year ago. That is within the guidance that we provided.

Online marketing revenue was RMB 238 million, or 99% of total revenues. That represents 26% sequential growth and 177% growth year-over-year. The revenue growth was driven by a number of factors, including traffic growth, a sequential increase in the number of active customers of 13%, as well as a sequential increase in per customer spending of 12%.

Traffic acquisition costs as a component of cost of revenues was RMB 22 million, or 9% of total revenues. TAC remained flat as a percentage of revenues compared with the previous quarter.

Capital expenditures for the third quarter were RMB 51 million, up from RMB 41 million in the second quarter. CapEx was mostly spent on additional network capacities to support traffic growth.

Our effective income tax rate for the third quarter was 2% versus 15% for the second quarter. The decrease of our effective tax rate for the quarter was primarily due to tax incentives newly granted to one of our PRC subsidiaries. As a result, the tax expenses in the third quarter equaled a reversal of RNB 6 million that was recognized in previous quarters. Under PRC tax regulations, these tax incentives were typical for the Internet technology companies in China.

Our share-based compensation expenses increased in aggregate to RNB 16 million from RNB 12 million in the second quarter. The sequential increase in share-based compensation expenses primarily reflects a change in accounting estimates of the forfeiture rate. We did not grant a significant amount of options or shares during the quarter.

For the full year 2006, we expect share-based compensation expenses for awards granted to employees prior to October 1, 2006 to be around RNB 47 million, assuming there is no material change in the forfeiture rate estimate.

This amount does not include expenses to be recognized for the remainder of the year related to awards to be granted to employees after October 1, 2006, or awards to non-employees that have been or may be granted.

R&D expenses for the third quarter were RNB 25 million, representing a 34% increase from the previous quarter and a 67% increase from the third quarter of 2005. That increase was primarily due to the expansion of R&D headcount.

Now, on earnings. Our net income for the quarter was RNB 85 million, representing a 46% sequential increase and a 903% increase year over year. The growth reflects the inherent scalability of our business and our reduced tax rate as well.

Net income excluding share-based compensation expenses, a non-GAAP measure, was RNB 102 million, representing a 45% increase sequentially and a 426% increase from the third quarter of 2005.

Basic and diluted EPS, excluding share-based compensation expenses, were RNB 3.03 and RNB 2.94, translating roughly to $0.38 and $0.37, respectively.

Net margin, excluding share-based compensation expenses for the quarter, was 42%, up from 37% in the previous quarter.

Now moving on to balance sheet. We ended the third quarter with a cash, cash equivalents, and short-term investment of RNB 1.1 billion, or $137 million.

Operating cash flow for the quarter was RNB 131 million, or $17 million, representing a slight sequential increase.

Adjusted EBITDA, again, a non-GAAP measure, was RNB 112 million for the third quarter, representing a 32% increase from the previous quarter and a 304% increase from the corresponding period in 2005.

Now let me provide you our top-line guidance again for the fourth quarter 2006. We currently expect total revenues to be between RNB 270 million and RNB 280 million, which would represent an annual growth rate of 135% to 143%, and that is a sequential growth of 13% to 17%.

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

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

Robin Li

Thank you again for joining us today. We are very proud of our progress to date, and excited by the opportunity that the world’s second-largest market of Internet users has to offer. We look forward to presenting better results in the years ahead.

Now, I will turn the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Anthony Noto with Goldman Sachs. Please proceed.

Anthony Noto - Goldman Sachs

Thank you very much. Hi, Robin and Shawn. My question, I know your revenue came in within your guidance range, but historically you have been at the high-end, or even above that. So my sense is, from your comments, that there is a transition going on. I was wondering if you could attribute for us potentially the impact on your revenue in the quarter from the transition of distributors in Beijing vis-à-vis the impact of monetization changes. As you talk about monetization changes, typically what we have seen from other companies on a global basis, such as Google, is that if they change their algorithm to be more relevant in terms of their advertisements, they have actually seen an increase or out-performance in revenue, as opposed to potentially a step back in revenue. I was wondering if you could talk about that as well. Thank you.

Robin Li

Let me answer it this way. I think you correctly noted that the Beijing distributors were replaced with this direct sales team and during the same period, we changed our monetization algorithm. The monetization algorithm actually becomes more complicated than before. As you know, the Chinese online advertisers or customers are not as sophisticated as the U.S. equivalent, so it will take some time for them to digest our changes. Therefore, the short-term impact on revenue is netted, but we do believe this positions us very well for long-term revenue growth.

The transition of Beijing’s market from distributor to direct makes things a little worse because we were not able to hire enough number of sales and customer service people to explain the change to our existing and potential customers.

Anthony Noto - Goldman Sachs

I see. You know, I think actually that provides a lot of clarity, which I wanted to play back a little bit of what you said, just to make sure I understand it. Your old ranking methodology allowed advertisers to put in potentially just one bid, and they knew exactly how much they had to bid and how much money they had to spend to get a certain level of performance. Now they may have to put in more than one entry, i.e. they might have to put in a bid and they may actually have to put in other inputs. So they may need more information to get to the same level of volume, and therefore, there is a frictional cost to that lack of knowledge they have today. Maybe a similar case that Yahoo! may find when they switch their algorithm. Is that a fair characterization?

Robin Li

I would say, in fact, it is more psychological than real. The starting bids changed, but it is still very clear when a customer logs in, they will still be given a definitive starting bid for each keyword or query they are bidding on. As the change actually makes the system a little harder to understand, because many of the customers were not so used to the different pricing for the starting bid.

The auction system itself still works like an auction, so additional efforts by the customers or advertisers is not that much.

Operator

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

Safa Rashtchy - Piper Jaffray

Good morning, Robin and Shawn. Thank you. Could you give us some clarification on the level of impact that you are seeing from the changes you are implementing, especially for Q4. The 15% to 17% sequential increase that you gave, could you perhaps give us some qualitative measure of how much that would have been had you been with the old system? I have a quick follow-up with that.

Robin Li

Safa, I think our current guidance did factor in the transition we are going through because of these monetization algorithm changes. There are a lot of factors that affect the revenue growth for the current quarter for Q4. I believe the main reason is the changing algorithm and the changes we need to make accordingly in the internal system, such as customer service and sales. Other than that, I do not see any major issue in the Q4 guidance.

Safa Rashtchy - Piper Jaffray

Okay, and a follow-up. Could you tell us if you feel you have staffed up enough to meet the requirements for basically accommodating the customers, as well as dealing with your customers in Beijing directly, now that you have taken out the distributors, or is there still a process where you need to build up your sales force and marketing force? One final question, unrelated, but I will just give it to you now, is Shawn, if you could give us some ways to think about the tax in 2007, that would be great. Thank you.

Robin Li

First of all, I think we made the right move. The changes will be beneficial to the company in the longer-term. We have to hire lots of customer service people and train them to understand the change better and communicate these changes to the current and potential customers.

What we found is that new customers are very receptive to the changes. We have no problem to sign up more new customers. For the existing customers, it just takes time for us to explain the changes, so they may, at least psychologically, will be more receptive to the new system.

Operator

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

Dick Wei - JP Morgan

Hi, Robin and Shawn. Just a quick question in terms of the customer service strategy. I think a lot of SMBs really needs like hand-holding in organizing their campaign. What kind of customer service employee that you plan to hire going forward? If you could give us some sense on the size. Also, what kind of incentive structure are you giving them? Furthermore, are there any plans for Baidu helping those customers to build websites? Because I think many of the new customers may not even have websites themselves.

Robin Li

Many of our distributors do have the function or have teams to build websites for our customers. In terms of customer service, we generally hire relatively young and junior people and train them. It does not require very high-paid employees to serve the customers. It is just that we need to train -- we need to tell them our rules. We need to explain to them how the system works, and we just need to help our customers understand how we bring value to them.

These things are not very complicated. It does not require even a college degree to do so. In the past, we hired customer service people like this. We just did not hire customer service people quickly enough to digest the changes we are making.

Dick Wei - JP Morgan

Do you have any comment in terms of the size of the customer service team that you will have?

Robin Li

The size is roughly three-to-one -- for every three sales, we have about one customer service.

Dick Wei - JP Morgan

Thanks, Robin.

Operator

Your next question comes from the line of Robert Peck with Bear Stearns. Please proceed.

Robert Peck - Bear Stearns

I just wanted to ask a couple of quick questions. The first is, is there any update on any of the lawsuits or potential lawsuits around keyword advertising practice? Number two, a couple of questions on the direct sales force. Could you tell us a little bit about what percent of the business is coming from direct versus indirect? Could you talk a little bit about the compensation structure for direct? So when you talk about compensation, what percent of that is going towards engineers, what percent of that is going to sales and marketing?

Lastly, could you give us a little bit of color on the pre-tax margins of the direct business versus the agency? Thanks.

Shawn Wang

Bob, that’s quite a bit of questions. In terms of litigation updates, there hasn’t been any changes in the major litigation. People have been asking us for the past few quarters. The MP3-related litigation are still status quo. There has not been any movement in the legal proceedings.

On the other type of litigations, as of today, I know there are some press articles talking about lawsuits on the pay-per-click business, on click fraud. The fact of the matter is, we’ve been checking with the court and as of yesterday, we didn’t receive any notice from the court so, so far it is only a PR matter at this time.

In terms of the second question on the direct versus the non-direct, the proportion, up until the second quarter, the indirect sales, our distribution, have contributed to over 50% of revenue. With the transition in Beijing from indirect to direct, that actually has changed. Now the direct sales are contributing more than 50% of our total revenue.

In terms of the incentive for our direct sales people, it is typical to have a rather modest base pay with incentives tied to their ability to grow customers and generate revenue. It is pretty-much commission-based, although the commission is tied to the initial sign-up of the customers, in most cases.

Your third question, if I recall correctly, you were asking about the margin on the direct sales versus indirect sales. Our business model for direct sales is pretty straightforward. For indirect sales, we do share our revenue with our distributors, and roughly for the $100 paid by the end customer, about 33% of that will be kept by the distributors. It is left to their disposal, to grow their business or to keep that profit.

So on a GAAP basis, the amount that we report, we actually only recognize the revenue on the net basis, which means 67% of what the end customer pays, so if you look at the margin numbers, our direct sales, would bear the expenses, so we will have a lower margin but the absolute dollar amount is higher on the direct sales model. For indirect sales, we share revenue with them but we only recognize revenue net, so the margin is actually higher.

Robert Peck – Bear Stearns

Perfect. Thanks, Shawn.

Shawn Wang

A few more words about the margin in Beijing. Beijing is a special area in our sales system. Previously we had two distributors and we also had a direct sales team. Because of the competition, distributors did deep discounts to our end customer, therefore after the transition from distributor to direct in Beijing, and margins or the additional revenue we took in was not that significant. It took time for us to rationalize the market. The discount rate will be more in line with other markets in China.

Operator

Your next question comes from Steve Weinstein - Pacific Crest Securities.

Steve Weinstein - Pacific Crest Securities

Thank you. I was wondering if I could get a little better explanation about the tax rate going forward. I understand that there was a one-time reversal in the quarter, but even adjusting for that it does look like the rate is lower than we have been looking for. Is that the sustainable rate going forward or should it fall back more towards what the historic trend is?

Shawn Wang

I think in the previous calls people were asking questions about our going forward tax rate. I think I did mention the number of 10% roughly, on a pro forma basis. I think this quarter actually reflects that. If you look at this quarter’s tax expenses, I mentioned that it included about roughly RMB 6 million of reversal tax expenditures. This RMB 6 median were tax expenses record during Q1 and Q2 of this year. If you take that away, we actually are looking at an effective tax rate of roughly about 10%.

As to the sustainability, let me give you a little background as to why we are getting those tax incentives. One of our subsidiaries, Baidu China, actually has been granted software/technology company status, and that is typical of all of the Internet technology companies in China. With that status we were given the tax break, basically two years of exemptions from income tax and the three years following that for half of the standard rate. Basically the next two years there will be zero income tax for that subsidiary, and a 15% tax rate subsequent to that. So I think that gives us a sustainability in the near term.

Steve Weinstein - Pacific Crest Securities

That's terrific , thanks a lot.

Operator

Your next question comes from Jeffery Zhang - Singular Research.

Jeffery Zhang - Singular Research

Good morning, Robin and Shawn. A quick question. On September 12 Baidu announced through Baidu Space in Chinese that their company web site was attacked by hackers and the company had to shut down the service engine for about 30 minutes. What are some effects of these hackers attacks in terms of traffic reduction? Specifically, the possible damage of Baidu's reputation as China's number one search provider? Moreover, what are some steps that Baidu has implemented to prevent this from happening again? Thank you.

Robin Li

First off, the attacks had nothing to do with Baidu Space. Baidu has the largest Chinese web site in the world and we constantly have to fight with hackers and attacks from around the world. We were able to successfully fend off most of the attacks but during the second quarter we had one incident that caused the service to be down for roughly 30 minutes. We immediately identified the cause and took action. So during the next couple of days we experienced a similar attack from what we think is the same hacker or hacker group and we were able to successfully fend off the attack.

I will say that the nature of the attack which caused denial of service is quite common these days. It is not possible for us to guarantee that there will be no attacks or there will be no interruptions in the service. But we think we have a very strong tech team and we will be able to take immediate actions to make our service available to average users in time.

Jeffery Zhang - Singular Research

Thank you very much.

Operator

Your next question comes from Anthony Noto - Goldman Sachs.

Anthony Noto - Goldman Sachs

I wanted to follow up on the cost side of the business. I know that you don't guide us to cost, but is it reasonable to assume that in the near term margins may take somewhat of a hit as it takes a while to scale up the revenue to cover the fixed cost of paying a sales force internally? Where the long term earnings may still have a lot of upset from where you are today?

Robin Li

You clearly and rightly pointed that we do not provide any guidance on earnings on the bottom line. Our business is highly scaleable. We talk about the advancements that we are making in the monetization algorithm, the changes we're making we're expecting somewhat slower growth than what we had before.

But having said that, that doesn't mean that we're going to somehow change or slow down our investment pace and we'll continue to invest in our business and incur the costs that are necessary for the longer term.

There's not going to be any effort in trying to manage that aspect because it would be inconsistent with our strategy of making changes in the algorithm. So I can't give you any specific discussion on the cost itself, but like I said, we're still in the investment mode.

Anthony Noto - Goldman Sachs

Great, thank you.

Operator

Your next question comes from Jason Brueschke – Citigroup.

Jason Brueschke – Citigroup

Thank you, Robin and Shawn. My question is a follow-up to Anthony's first question about the algorithm. Specifically, I'm interested in more details about what and when. What I mean by that is you have over 100,000 customers, at least active customers in the quarter. I want a little more color on exactly what you are doing to educate your current customers as to the changes to the algorithm and when you started those efforts, and how you're trying to bring your third-party distributors in to educate their customers as well about these changes.

Then the second half is when? When do you expect these efforts to end up having their desired effect such that we no longer see this psychological friction to the new system, and when can we expect these revenues then to return to more hyper growth? Thanks.

Shawn Wang

Let me answer the one question first, as we stated previously in our call we believe during the next two quarters we will be under such a transition, which means that starting from Q2 of next year we should be back on track with the growth we haven't been able to achieve historically.

In terms of what, as I mentioned before we're aggressively hiring customer service people. We ask our customer service and some of the sales to contact existing customers and explain the changes to them. What we found is that when enough communication is done we were able to get back many of the customers. Both in the direct team and the distributor team, we're doing the same thing. Location by location or city by city, there's no difference between direct and the indirect.

Also again what we found is that we have no problems to sign up new customers. The first time they heard about our models, then they don’t have any problem to accept it.

Jason Brueschke – Citigroup

Great, and maybe a quick follow-up. Could you tell us, when did it become apparent to you that this change to the algorithm was having an impact on the behavior of your customers? And maybe help us know when you started these remedial measures to address the question.

Shawn Wang

I would say more or less this was about exactly what we expected when we decided to implement the change. We were prepared for the negative impact on revenue growth when we did the change, specifically in September when we factored in relevance when ranking sponsored links, we knew that the revenue would be negatively affected by the change. We were prepared for that.

For the change we made in June, we also knew that there was going to be some churn of the existing customers, because the average price actually went up. This was as expected. We just need to hire more customer service, and between ourselves and customer service people, to communicate this with the market and with the customers.

There was no surprise at all about the transition.

Operator

Your next question is a follow-up from the line of Safa Rashtchy with Piper Jaffray. Please proceed. Your next question comes from the line of Leah Hao with Thomas Weisel Partners. Please proceed.

Leah Hao - Thomas Weisel Partners

Good morning, Robin and Shawn. I have a question regarding your view on the overall health of the paid search market in China. Looking at the year-over-year revenue growth during the past four quarters, surely you have some transition issues in your operations, but what is your expectation as the traffic share leader, as well as the market share leader, what is your expectation in percentage terms for the overall market growth in ’07 and beyond? Better yet, would you be able to quantify the growth expectations between the volume growth versus the ASP price as well? Thank you.

Robin Li

Let me put it this way. I think the paid search market in China is still very, very small, compared to other markets. China is now the fourth largest economy in the world, but as the paid search market is still much, much smaller than many of the markets we are keeping track of, not only the U.S. but countries like U.K., Japan, and Korea. They all have much larger paid search markets.

What that tells us is that number one, the market maturity in China is still very primitive, and only a very small percentage of the targeted customers are taking advantage of our paid search platform.

Number two is that the paid search price for Chinese customers is still very, very low, probably much lower than any of the markets you can think of at this stage. Our page views have been growing very nicely, and we do expect this trend to continue.

The price customers pay will go up, too. We believe that as the customers realize the promotional power we can bring to them, they will be willing to spend more on our platforms going forward.

Shawn Wang

I just wanted to give you one statistic from our revenue growth history. If you look at a year, two years ago, almost, in Q105, our revenue growth was 154% year over year. This quarter, ours is 170% year over year, and you are thinking in the past few quarters, it has been somewhere between 150% to 190%, so yes, our scale has been growing, but at the same time, the overall growth rate itself continues to be very strong. I think that gives you some flavor how early the market is.

Operator

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

Steve Weinstein - Pacific Crest Securities

Thank you. I think you explained some of the issues in the quarter and how they impacted revenue with the changes you were making. I just want to make sure I am putting it in the right context now. When I look at the new advertiser growth, that seemed to slow sequentially, 13%, which is a little less than we were looking for. I think that is a pretty big slowdown from what happened last quarter. Is that where the changes manifest themselves, is your ability to get more advertisers into the system, or did you have advertisers dropping out? Or is there anything else being reflected in that slowdown in advertisers, whether you were trying to clean out your advertiser base or other changes you might be thinking.

Robin Li

I think we are going through our wash after the bid model changed. Some of the older customers may not be as receptive to the new pricing scheme, and mostly because of technological reasons. This is what we expected. We knew that by hiking up the price, there will be some customer loss, but we think overall, in the longer-term, it should be a healthy direction for us to go in. It should be beneficial to the revenue growth longer term.

Operator

Your next question comes from the line of Chang Tiu with Foreign Technology Research. Please proceed.

Chang Tiu - Foreign Technology Research

Good morning, Robin and Shawn. One question, I am not sure if anybody asked yet because I joined the call late. In terms of the advertising revenue growth, for brand advertising, now everybody is kind of thinking, you know, they are debating on [inaudible]. I would like to ask your view in terms of a paid search and a paid listing, what are the effects or the impact to you, and the revenue side too? What is the opportunity you see?

Robin Li

It is still roughly two years away. I think it is kind of too early to tell about the impact on our business. We do not depend on branded advertising in any meaningful way. It is probably more about the market maturity of paid search. If the Beijing Olympics can help open up China so that more advertisers or more small and medium enterprises can understand the promotional power, then we should be a beneficiary of that. If not, it may even hurt our revenue as when we have a major event, not an online event, usually there is traffic for our site while have a temporary dip.

At this time, we do not know yet, but I would like to emphasize that the paid search price in China is still very, very low -- much lower than any other market you could think of.

Chang Tiu - Foreign Technology Research

Right, I know. Another related question is the Internet communication among medium and small enterprises here. Do you have any measure how many of them, or how fast they are adopting Internet?

Robin Li

We do not have any specific numbers. We generally rely on third-party surveys. Some well-known surveys or research firms, like iResearch or CIC. They usually would have numbers on the small and medium enterprises online.

What we found is that it is actually not a very big issue when we try to acquire customers. If the customer does not have a website, we can help to build one for them. It is more about a mentality. If they realize that an online presence will help their business, they will do it.

I think it has to do with the overall maturity of the Internet market about China. It is probably less relevant to whether a customer has a website or not.

Operator

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

Dick Wei - JP Morgan

I just wanted to ask about the CIC survey, that Baidu is gaining market share from some of the competitors. Can you comment on the reason why you are gaining market share away from the competitor? Also, if you can comment on some of your competitors, like Google, Yahoo!, Sohu, et cetera. Thank you.

Robin Li

I think we are not doing anything differently during the past year than what we did for the first six years in the company’s history. We chose to keep a very close eye on our user behavior. We really try to understand the Chinese Internet users and design and modify or improve our product based on the user preference. We care more about user experience. We do not innovate for the sake of innovation. That is the reason we are getting gains in market share.

When two of your friends out of three of your friends tell you that they use Baidu, it is pretty hard for you to use someone else.

Dick Wei - JP Morgan

Robin, if you could comment on what you notice in terms of competitors, like what are they doing recently, differently?

Robin Li

I think a number of the competitors are trying very hard to catch up in the Chinese search market. It is just not that easy. It will take them some time to learn how to operate in this market. At this time, we do not see any meaningful actions that could affect our behavior.

Operator

Your next question comes from the line of James Lee with WR Hambrecht. Please proceed.

James Lee - WR Hambrecht

Hi, Robin and Shawn. Could you guys comment about your customer base a little bit? Specifically about brand advertisers. Have you seen them maybe shifting more spending, online spending, that is, towards paid search? If you could provide some data points on that, that would be helpful.

Also, on the sales compensation, when you brought the sales force in-house in Beijing, did you have to change any of the compensation to your sales people within that region, or did you just put them more or less the same? Thank you.

Robin Li

In terms of spending, I would like to point out that the customer base or advertiser base for Baidu and for the branded advertising guys are quite different. Most of our customers are SMEs. They generally do not spend a lot of money on branded advertising.

In terms of spending, it really more relates to market maturity than competition.

In terms of compensation in Beijing, we do not see any material difference between our direct sales team and the distributors around China. We are essentially doing the same thing. Probably the only difference is that we are so close to the Beijing team that we can have better communication with them, so that they understand our product better and understand the market better.

Shawn Wang

Just to clarify the potential question you have in your mind, we actually did not take over sales and customer service from our former two Beijing distributors. We only discontinued their right to grow new customers. We are growing, hiring customer service and sales from scratch. That is why we are having a bit of a hiccup in the Beijing market.

James Lee - WR Hambrecht

Great. I just want to make sure I understand Robin’s answer. Basically you are saying that you have not seen any specific shift on brand advertisers in terms of their increasing spending on the online spending towards paid search. I just want to make sure you did not see any material change in 3Q.

Robin Li

Let me put it this way. We do have quite a number of large companies using the paid search to promote their product or companies. What I was saying is that such spending does not contribute a significant portion of our total revenue, which again implies that as the price for paid search is so low, our larger customers are better willing to spend on paid search. It is just that we cannot spend their money fast enough so that it will contribute a meaningful portion of our revenue.

Operator

Your next question comes from Joe Boveril – Suttonbrook.

Joe Boveril – Suttonbrook

Hi, thanks. I am looking at the guidance for the fourth quarter and it seems like revenue growth decelerates to about 13%, and then the expectation, if I look across The Street is that it will then reaccelerate again to about 20% in the first quarter. But then I hear about the new algorithm change affecting two quarters. I am trying to understand the magnitude of the first quarter ’07 and the impact this will have on that.

Robin Li

Joe, Q1 will be, of course, due to seasonality, will always be the slowest quarter for our business. But then again, we normally just give out our guidance for the next quarter is going to be difficult for us to project further than that.

Joe Boveril – Suttonbrook

Thanks.

Operator

Your next question comes from Safa Rashtchy – Piper Jaffray

Safa Rashtchy – Piper Jaffray

Just a quick follow-up. You might have covered this. Did you say if you had hired customer support that you need to do this transition, or are you still trying to build it up?

Also, while this transition is happening and some of the customers were doing [inaudible] did you feel that you may have lost any market share to Google or other search players who might have had easier to understand traffic models, for example?

Shawn Wang

The line was actually not very clear. Let me try to address this. If it is not what you asked, then you can ask again. In terms of market share, we don’t see any sign of loss in market share. In terms of sales, both direct and the distribution network, we believe we have the strongest sales team and customer service people across China. Almost in every major city, when you do your due diligence, when you ask about distributors or third parties, they will tell you that the strongest sales team comes from the Baidu team. We don’t see any change in this.

We are the leaders in the paid search market. We pretty much designed the rules for paid search. We are currently not seeing any move by the competitors to effect our decision and our customer acquisition and our customer service.

Safa Rashtchy – Piper Jaffray

Are you still trying to complete the build-up of your customer service people, or are you now at the level you want?

Shawn Wang

We haven’t finished that build-out yet. When we took over the Beijing distributor customer service function in July, we started to build a larger customer service team in Beijing, after the two changes in monetization at our distributors across China as well as the direct sales team being in Beijing and Guangzhou to build out customer service. It just takes some time, when we hire people we will typically require about three to six months of training for them to truly understand our business and our product and our services, and effectively communicate this to the existing and potential customers.

Safa Rashtchy – Piper Jaffray

Great, thank you very much.

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

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

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Source: Baidu Q3 2006 Earnings Call Transcript
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