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Baidu, Inc. (NASDAQ:BIDU)

Q2 2010 Earnings Call

July 21, 2010 8:00 pm ET

Executives

Victor Tseng - IR Director

Robin Li - Chairman and CEO

Jennifer Li - CFO

Haoyu Shen - SVP of Business Operations

Analysts

Alan Hellawell - Deutsche Bank

James Mitchell - Goldman Sachs

Richard Ji - Morgan Stanley

Alicia Yap - Citi

Dick Wei - JPMorgan

Yu Jin - CICC

Andrey Glukhov - Brean Murray

Eddie Leung - Bank of America

Stephen Ju - RBC

Aaron Kessler - ThinkEquity

Wallace Cheung - Credit Suisse

Mayuresh Masurekar - Kaufman Brothers

Jake Li - Guotai Junan

Wendy Huang - RBS

Welin Li - UBS

Operator

Hello and thank you for standing by for Baidu's second quarter 2010 earnings conference call. (Operator Instructions) I would now like to turn the meeting over to your host for today's conference, Victor Tseng, Baidu's Investor Relations Director.

Victor Tseng

Hello, everyone, and welcome to Baidu's second quarter 2010 earnings conference call. We issued Baidu's second quarter 2010 earnings release earlier today. You can find a copy of the earnings release on the company's website as well as on newswire services.

Today, you will hear from Robin Li, Baidu's Chairman and Chief Executive Officer, and Jennifer Li, Baidu's Chief Financial Officer. After their prepared remarks, Robin and Jennifer will be joined by Haoyu Shen, Senior Vice President of Business Operations, to answer your questions.

Before we carry on, 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 statement 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 Chairman and CEO, Robin Li.

Robin Li

Hello, everyone, and thank you for joining us today. I'm pleased to report another quarter of strong performance. Successful customer acquisition was the main driver of our top-line growth. We saw a record number of customer additions, a total of 33,000 during the quarter. This was driven largely by our successful nationwide marketing campaign and the favorable macroenvironment.

As part of the marketing campaign, our teams visited over 100 cities across China and attracted a significant number of new customers by educating the market about Baidu and the power of search engine marketing.

The rollout of our CRM systems helped increase sales productivity. Today, our current base of 254,000 customers is still just a tiny fraction of the total addressable market of millions of SMEs in China. As the market leader, we will continue to educate companies about Baidu's cost-effective marketing platform.

During the second quarter, we continued to implement enhancements to our online marketing platform. We were able to monetize more effectively and large companies and SMEs are spending more with us. The strength should continue as customers become more familiar with the platform's functions and see potentially higher ROI.

Phoenix Nest implementation is largely complete, but consider it as version 1.0. There is still much more room for further improvement on an ongoing basis.

Q2 also marked a big step over for our mission of Box Computing. We continue to add more applications in our search engine results page. In other words, our box can do more, especially for time-sensitive queries.

The World Cup event is a great testimony of this technology. During that time, we answered more than 100 million related queries with eight different apps on game schedule, match scores, live broadcasting and recorded videos, et cetera. And the social game we developed during the World Cup on Post Bar attracted millions of people to participate.

As a result, we have seen good traffic patterns since the game started. Typically, our web search traffic is negatively impacted during large and newsworthy events. This time, it was an exception. And in part because of the better-than-expected search traffic during the World Cup, we were able to deliver Q2 revenue higher than previously guided.

Our close connection to our users has been a central factor in establishing Baidu's leadership. As the new technologies are emerging all the time, the market remains a very competitive place. Over time, success depends on investing in long term to anticipate industry trends and keep up the technological development.

That's why we're putting top talent, especially in R&D remains a focus for us. As you may have heard, we were in Silicon Valley just now, looking for top software engineers to expand our R&D team. We are excited about the talented people we met and look forward to making some great hires.

In our Union business, we benefited from our new policies which reward high-quality incremental traffic. This is an initiative we began in the third quarter last year. By focusing on improving Union traffic quality and nurturing organic traffic growth, we saw a significant decline in traffic acquisition costs as the percentage of revenue. We're also working on improving our contextual ad business, although it is still relatively small.

As we approach the fifth anniversary of our IPO, it is worth looking back on how far we've come. Since our NASDAQ listing on August 5, 2005, China's internet population has grown from 100 million in 2005 to 420 million today, Baidu's revenue growth from RMB70 million in Q2 of '05 to RMB1.9 million this past quarter. And we've gone from having 41,000 active online marketing customers to 254,000. Keep in mind that while China already has the largest online population in the world, almost 70% of the country is still offline.

While we are proud of the exceptional shareholder value Baidu has created as a public company, we are just getting started. By keeping our focus on providing the best way for people to find what they're looking for, in the years ahead, I'm confident Baidu will become ever more central to China's internet ecosystem.

Thank you again for joining us today. And if you plan to be in Beijing on September 2, we'd love to see you at our Annual Baidu Award event where you'll get a chance to witness the progress we're making.

And I'll now turn the call over to Jennifer for financial highlights.

Jennifer Li

Thank you, Robin. Hello everyone. We had another great quarter. Both top and the bottom-line results were very strong. Robin explained how top-line growth was driven by effective customer acquisitions, continued improvements in monetization and better-than-expected traffic. At the same time, we also effectively managed our expenses. And as a result, margins scaled to all-time high.

As we said last quarter, 2010 is a year of investment. To ensure we continue to develop and serve our customers and users effectively and provide the best of search experience, we'll keep recruitment for sales and R&D teams as a priority. You will also see aggressive investment in our network infrastructure, which is entering a new investment cycle.

Now let's look at the financial highlights for the quarter. All amounts mentioned are in RMB unless otherwise noted.

Online marketing revenues for the second quarter of 2010 were RMB1.913 billion, a 74.5% increase year-over-year. Baidu had around 254,000 active online marketing customers in the second quarter of 2010, a 25% increase from the corresponding period in 2009 and a 15% increase from the previous quarter. The sequential increase was attributable to our successful marketing campaign and a favorable macroenvironment.

Since we first introduced our new online marketing platform, we have seen strong customer acceptance. This has led to increased customer spending. Revenue for online marketing customer in the second quarter reached approximately RMB7,500, a 39% increase from the corresponding period in 2009 and a 27% increase from the previous quarter.

Traffic acquisition cost as a component of cost of revenue was RMB186 million, a 9.7% of total revenue as compared to 16% in the corresponding period in 2009 and 13.2% in the first quarter of 2010. The substantial decrease in TAC as a percent of total revenue is attributable to improvements in Union traffic quality. We expect TAC to remain at approximately this level with moderate fluctuations.

Bandwidth cost as a component of cost of revenue was RMB68 million, representing 4% of total revenue compared to 5% in the corresponding period in '09. Depreciation costs as a component of cost of revenue were RMB84 million, representing 4% of total revenues compared to 5% in the corresponding period in '09.

The decreases in bandwidth and depreciation cost as percentages of total revenues reflects scalability of the business model. As we invest in infrastructure, depreciation cost will go up.

Selling, general & administrative expenses in Q2 were RMB265 million, an increase of 47% year-on-year primarily due to increased sales headcount and marketing spend. R&D expenses were RMB159 million, a 66% increase from the year-ago period primarily due to increased cost associated with R&D headcount.

Share-based compensations, which were allocated to related operating cost and expense line items, decreased in aggregate to RMB22 million in the second quarter of 2010 from RMB23 million in the corresponding period in '09.

Operating profit was RMB972 million, a 130% increase year-on-year. Total headcount as of June 30, 2010, was about 9,000, roughly 1,100 more than the previous quarter. The increase in headcount comes mainly from sales and R&D. In 2010, we remain focused on investing heavily in sales and R&D to drive growth in our business.

Income tax expense was RMB141 million for the second quarter. The effective tax rate for the second quarter was 14.4% compared to 11.8% for the corresponding period in '09. The increase in the effective tax rate was due to a new tax circular issued in the second quarter, resulting in changes to the applicable tax for one of our subsidiaries in China.

Before going into net income and EPS figures, I'd like to remind you that due to the 10-to-1 ADS to ordinary share ratio change in May, earnings per ADS figures now represent one-tenth of the ADS value announced in previous quarters.

Net income was RMB837 million, a 118% increase from the corresponding period in '09. Basic and diluted earnings per ADS for the second quarter of 2010 amounted to RMB2.41 and RMB2.40 respectively.

Net income, excluding share-based compensation, a non-GAAP measure, was RMB859 million, a 111% increase from the corresponding period in 2009. Basic and diluted earnings per ADS, excluding share-based compensation expense, both non-GAAP measures, were RMB2.47 and RMB2.46 respectively.

As of June 30, 2010, the company had cash, cash equivalents and short-term investment of RMB5.9 billion. Net operating cash flow and capital expenditure for the second quarter of 2010 were RMB1.24 billion and RMB182 million respectively.

As we mentioned earlier, we will aggressively invest in infrastructure and equipment in 2010 to drive innovation, enhance monetization and support growth.

Now let me provide you with our top-line guidance for the third quarter of 2010. We currently expect total revenue for the third quarter of 2010 to be between RMB2.2 billion and RMB2.26 billion, which would represent 72% to 77% year-on-year growth. 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

Your first question comes from the line of Alan Hellawell with Deutsche Bank.

Alan Hellawell - Deutsche Bank

Thank you very much and congrats on yet another fantastic quarter. The one thing I wanted to focus on is something that we've been badgering you guys about and still seem to be overly conservative on a net traffic acquisition cost, they just seem to be falling incredibly dramatically. And I'd like to know now that you're a couple of quarters into reviewing your Baidu Union terms, what are the dynamics of that coming down? Can you give us a sense as to how you're changing your revenue share or what the broad restructuring of these agreements is? And going forward, how much do you think we can now expect in terms of further TAC savings?

Haoyu Shen

Yes, we're seeing a significant decline of TAC as a percentage of total revenue this quarter. As Robin mentioned in his prepared remarks and also Jennifer, this is a result of our continued initiatives to improve the quality of our affiliate traffic, which these initiatives started in the second half of last year.

What we're doing or what we did is we want to reward the traffic brought by affiliate partners that are more of incremental nature rather than a cannibalization nature. So we choose to become more selective in partnering with different kind of players. And in some cases, we reduced the payout rate if we believe that traffic is less of an incremental nature to us. In some cases, we choose to not work with some type of partners, because we deem the traffic is too much of cannibalization nature.

So the impact will be not only I think at overall level, the pay pout ratio is probably coming down. And also, some of the affiliate traffic we have before is not reverting to organic traffic. So both of these factors are working to cause a decline of TAC percentage. Going forward, we expect this TAC ratio to stay at relatively low level, but I don't think it will go further down much more.

And I do want to caution you that affiliate search or search in general is still a very competitive business in China. So we need to stay competitive. We need to stay flexible. So going forward, I'm sure we'll continue to see some fluctuation of TAC ratio.

Alan Hellawell - Deutsche Bank

Just a quick follow-up on the same topic. We're obviously seeing the formation of some other unions. And to the best of your knowledge and very generically speaking, are they trying to gain traction by offering a more generous revenue share or do you feel like everyone is clustered around the same revenue share terms as you guys are?

Haoyu Shen

Now, we don't know any details of how they're structuring their deals. But as I mentioned, this is still very competitive. There are other search engines out there who are probably willing to come out and get some traffic. So we will need to stay flexible and stay competitive.

Operator

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

James Mitchell - Goldman Sachs

When I look at the very strong customer adds in the second quarter, do you think there was any pent-up demand from prior quarters when the sales force was busy with Phoenix Nest stuff? And also, did you see any trends in terms of which industries or provinces contributed to the customer growth?

Robin Li

During the second quarter, we had a nationwide marketing campaign to educate the market and do a lot of customer signup. And I guess also the Phoenix Nest transition was a distraction for that in the past few quarters until Q2 of this year.

In terms of customer trends, we are seeing strong customer demand from all kinds of sectors. So we think this is a very healthy trend and will go on for the next few quarters.

Operator

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

Richard Ji - Morgan Stanley

Let me start the first question is regarding the revenue constitution from your big corporate client. Obviously, we are seeing significant pick up in some extending from those phones. Can you elaborate a little more on their relative gross rate versus the small player? And what is the ballpark revenue contribution? And do you also plan to have a dedicated sales force to service these big corporate clients given their big pocket?

Haoyu Shen

This is Haoyu. As we come in to the few times in the past, the large advertisers are spending more with us and they're spend with us has been growing faster than the total standby SMEs. I think that continued to be the case; although when you look at SMEs, you can keep adding many more new customers every quarter. But as far as large advertisers, you only have a few hundred left in a thousand to work with.

We're seeing very healthy growth on their outflow with us. They're buying search for brand building purposes; they're buying search for transaction purposes. A lot of companies are setting up their online stores. So all the key metrics are going in the right direction.

And we always had a dedicated sales force acquiring and serving these large customers. And they are based in Beijing and in Shanghai and in Shenzhen and Guangzhou. So that team is continuing to deliver good results.

Richard Ji - Morgan Stanley

Also highlight your 12 listing categories and especially up the Phoenix Nest road. Have you seen a pick up in any of these areas in terms of growth rate versus your previous stage?

Haoyu Shen

Do you mean the key factors among large customers or overall?

Richard Ji - Morgan Stanley

Overall. Especially, I'm curious about which sector has showed particularly more robust growth after the roll out of Phoenix Nest?

Haoyu Shen

I might not get the orders, Jenifer, you have them?

Jennifer Li

I think particularly the large customers, we set them more mature and they are the early adopters of Phoenix Nest. We have seen sectors such as financial services, real estate really outpace the sector growth in other areas. All sectors are growing very strong. But these sectors that I just named, they were particularly strong.

Operator

Your next question comes from the line of Alicia Yap with Citi, please proceed ma'am.

Alicia Yap - Citi

My question is on your new customer act. How much of that increase would you attribute to the new sales team hire, was this the improved productivity of the assessing sales team? And will most of the increase come from the second and third tier city as a result of your nation wide campaign, or is that increase is more diversified among all the cities?

Robin Li

The new customer, very diversified among all kind of cities including the tier one major cities and the smaller cities. I would say the new customer has mainly attributable to this increase of our sales force, because our productivity improvement just got started although we are seeing great result. But it's not fully in function yet.

Operator

Your next question comes from the line of Dick Wei.

Dick Wei - JPMorgan

Is it possible to update for the mobile search initiative, and any new plans for that and for mobile search approximately how much of the total search volume that accounts for?

Robin Li

During the past couple of years, we have seen a faster growth in mobile search traffic versus pc based search. But it remains to be a small percentage of our total traffic. The mobile landscape is still not settled yet, because a majority of the internet users who access the internet through mobile still using 2G phones. They are expensive and they are slow. There are a small fraction of users who use 3G network that they obviously use it mobile for search on a more frequent basis.

Going forward, we think that smart phone will take over and that the traffic will grow even faster. We have designed a number of mobile relate products and functions to adopt to this kind of user behavior. But I wouldn't see the direction for mobile search is settled yet. So there may be a lot of changes going forward.

Operator

Your next question comes from the line of Yu Jin with CICC.

Yu Jin - CICC

One question is for Jennifer. So Baidu already announced the PE, and the company is already in the operation and will launch Baidu Rakuten. So I think the company should have more accurate understanding of the investment amount. So can Jennifer elaborate a little bit how does (inaudible) and the next year's financials?

Jennifer Li

On the key investments, we have clarified last quarter, because of the shareholding structure and the managed fund control agreed upon between the parties, the investment is accounted for an equity method basis.

And I did mention last quarter that on a going-forward basis, we do not expect material impact from PE, from the joint venture there, unless there is a shareholder structure change. So if there is a shareholder structure change, we'll update the investment community clearly. So do not expect significant material impact from PE.

On the Rakuten JV, the JV will officially launch in Q4, and we'll start to include their results starting in Q4. Because we own less than 50% of the venture, we will likely account the Rakuten joint venture on equity accounting method as well. We do not anticipate within a year's time the Rakuten joint venture will have material impact to the bottom-line.

We will give you more updates as we move into Q4 and you will get to see the picture.

Yu Jin - CICC

So my question is based on our practice, can you tell us some differences like between wireless and the wired internet. You were taking about (inaudible) product or kind of business where we see difference from the PC internet. And from the company's perspective, what area where we'll focus in the near term beyond the search? That's all from me.

Robin Li

Okay. For wireless, because the mobile phones generally have a much smaller screen. Users tend to flip pages more than the pc based user and we try to design the mobile user experiencing so that each page is simpler and lighter than the pc based ones. And because people carry around their mobile phones all time, they are location based the information and it's more personal. So local results are more useful in general to the wireless internet user than the pc users.

Like I mentioned I think it's the pretty much free and open area for wireless surge going forward, exactly what's going to happen to the user behavior, I mean the search behavior on the mobile side is still an open question. And devices that have access to internet are also getting diversified. You have tablet pc, you have mobile phone, smart phones, feature phones and laptop computers. This kind of terminal all have different kind of user behavior.

And we are still studying this kind of trend and try to come up with necessary products and functions to satisfy our user.

Operator

Your next question comes from the line of Andrey Glukhov with Brean Murray.

Andrey Glukhov - Brean Murray

Two things if I may. first, if I look at the custom with friends, can you guys comment in addition to the strong just new customer acquisition? Are you seeing any improvement or any changes in the potential advertiser churn levels? And then separately, Jennifer, if you can just comment why was the other income a substantial negative amount, that would help as well.

Haoyu Shen

On the first part of question about customer churn, it's stable, the churn rate. We never disclose that number, but the churn has been stable, although as part of the efforts, it's being (inaudible) and putting good CRM in place, we are working hard to improve the attrition front of customer retention.

So hopefully going forward, we will see some improvements. But up till now, it's stable.

Jennifer Lee

On your other question, Andrey, the other income is substantially negative this quarter. We did disclose in our last earnings call, because of the Yushu earthquake, we donated them mostly. You know most of the numbers are because of the donation we made. We donated RMB10 million to the suffered area.

Operator

Your next comes from Eddie Leung from Bank of America.

Eddie Leung - Bank of America

The first question I have is, Robin, you mentioned that the existing customers are spending more throughout the quarter. So in general, was this coming more from expansion of keywords or through some increasing prices?

Robin Li

I am sorry I didn't quite get your question.

Eddie Leung - Bank of America

I am asking about the increasing spending of the old customers. In general, was it coming more from increase in keywords or through some increasing prices?

Haoyu Shen

Yes, Eddie, if you look at the good growth of ARPU, it's really driven by many things; first of all traffic. When traffic goes up, click will go up and definitely you will see customer spending a lot. We are seeing customers' appreciation of the new system. So their budget is going up. So a lot of the times, budget is a binding factor for how much they'll spend. So a lot of customers are increasing their budget as a prerequisite for ARPU growth.

And of course, the other monetization metric such as click-through rate and CPC; so all of these are contributing to the good growth of ARPU this quarter.

Robin Li

Obviously, Phoenix Nest allows our customers to become a lot more keyword. So the cost-per-click is also going up, but slowly, I would say at a slower rate than before. So we are very happy about this trend because our customers are getting better ROI because of that.

Eddie Leung - Bank of America

And just one housekeeping question. Could you give us a top advertiser industries for the second quarter?

Jennifer Li

The top five factors, they account for about 50% of the total revenue. They are medical, healthcare, machinery equipment, education and travel and franchising for this quarter.

Operator

Your next question comes from the line of Stephen Ju with RBC.

Stephen Ju - RBC

I just wanted to see if you have a mobile operating system in the plans for you at some point. And also, the JV with Rakuten, I'm just wondering what is going to be the incremental value-add or differentiating factor that is going to set the platform apart from the Tudou or (technical difficulty).

Robin Li

We have a number of very exciting products going on internally. Obviously, we are optimistic about mobile internet in the future. But typically we do not preannounce the products. So I cannot give you a yes or no answer on the mobile OS thing.

For Rakuten, like I mentioned in the past few quarters, we think search engine is the biggest beneficiary of e-commerce. So we're trying all kinds of things to nurture the e-commerce market. And the Rakuten JV is just one of the endeavors. So as far as we can help companies like Rakuten to set out platforms to allow more benefits to sell their products and services online, we think we will eventually benefit.

Rakuten owns more than 50% of this joint venture. So they will take the lead and do whatever to make it successful. The value we add is twofold. One is we can drive traffic to them.

The other is that the Baidu brand is much bigger than Rakuten here in China. So carrying the Baidu brand will help them to sign up more businesses, especially the larger businesses. So I think more choices to the Chinese businesses is better. And we are seeing a lot of interest, especially from the larger corporations who want to sell online on our Rakuten platform.

Operator

Your next question comes from the line of Aaron Kessler with ThinkEquity.

Aaron Kessler - ThinkEquity

Hi, guys, a couple of questions. First, given the strength of the advertiser growth in the quarter, do you feel comfortable with kind of a higher level of advertiser growth going forward given some of your recent initiatives in terms of the marketing campaign and added sales?

And also just in terms of the sales and marketing expense, it looked like it was pretty flat sequentially. I would think that would be up a little more given the increase in headcount.

Robin Li

I think the customer acquisition will follow the typical seasonality of the past few years. Q2 generally we have quite strong customer acquisition momentum, but Q3 and Q4, well, we continue to add new customers, and Q1 is typically the slowest one. Regarding the sales and marketing cost, maybe Jennifer can walk you.

Jennifer Li

Yes, I think you're right, Aaron. You did notice that we added about 1,100 headcounts in the quarter, and they come from sales and R&D. Not everybody joins the company on the first day of the quarter. So you only see part of the expense impact of these headcount additions. The full impact will be felt in the next quarter. And on top of that, of course, we continue to aggressively hire sales force in R&D. So that's why we wanted you guys to fully be aware of that.

Aaron Kessler - ThinkEquity

And do you just have a sense on the Phoenix Nest, how much of the monetization improvements you've seen to this point and what inning are you in, in terms of improvements for Phoenix Nest monetization?

Haoyu Shen

Hi, Aaron, this is Haoyu. I think the steep part of the trajectory is largely behind us; although going forward, there is still a lot of room for us to put in other than improvements into Phoenix Nest. But I think the monetization improvement will be more gradual than what you saw in the past two quarters.

Operator

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

Wallace Cheung - Credit Suisse

I wanted to ask about your SNS strategy as Google also wanted to develop some kind of SNS called Me. Is it important for a search engine to get into the SNS? And I also wanted to hear your report about any initiative on the real-time search as well.

Robin Li

We already have an SNS type of service called Baidu Space. It is a good complementary to our search business, but I would say it's not very closely related to search. The business model for SNS is quite different from search. Especially in China, the SNS companies typically charge end user. They run online games and that sort of thing. But for search, we basically satisfy people's information needs.

Users come with something in mind with an agenda when they come to our search services, but users usually log on to SNS services to kill time and stay connected. So I think it's a very different type of user need.

Regarding the real-time search, it's actually not a new phenomenon. More than 10 years ago, search engines started to try to tackle the real-time search problem. But it's not an easy problem to solve, because when it's real-time, it's very easy to be stamped. So we have been cautious on this.

Having said that, we have a lot of ways to integrate real-time information in our search results page. As an example, I mentioned in the prepared remarks the World Cup event. We have real-time information updated through our Box Computing technology or the Aladdin platform. We can integrate the real-time information from trusted sources. So that's our take on real-time search.

Operator

Your next question comes from the line of Mayuresh Masurekar with Kaufman Brothers.

Mayuresh Masurekar - Kaufman Brothers

Baidu revenue growth has been accelerating significantly over the last three quarters from 40% to 60% and now 74%. Could you give us a rough estimate of how much of this growth is from the marketing campaign, how much from Phoenix Nest, how much from easy comps because of the economy and how much from share gains from your leading competitor? And could you rank those factors.

Robin Li

Well, I think there are a few factors that contributed to this phenomenon. In 2009, it was a year of transition for the company. We launched the Phoenix Nest in April of 2009, but the system actually runs parallel is the classical version of our page search system. That got a line of distraction for the overall operation of the company and also it caused some confusion on the market.

We were able to successfully switch over December 1 of last year. Therefore, we were able to resume the normal growth trajectory we deserved for a market with great potential.

Along the way, based on third-party research report, we have been gaining traffic share gradually. But because we already have a traffic share north of 70%, so the share gain is kind of a smaller contributor to the overall picture.

Another fact I would say that internet businesses, small and large business in China increasingly start to appreciate the marketing power search engine can bring to them. China's internet is kind of different from the developed markets in the sense that majority of its internet users are very young. They started to use the internet for entertainment purposes.

Even today, I think the majority of internet related revenues are entertainment our end users consumers pay to play games and to communicate and that kind of thing. But gradually we have seen pickup on the business activities on the internet. And I'm sure going forward, more and more business activity as well becomes active through the internet. And therefore we will continue to benefit from this kind of trend.

Operator

Your next question comes from the line of Jake Li with Guotai Junan.

Jake Li - Guotai Junan

Regarding the TAC in the second quarter, is there any one-time item the decrease of new issue? I know the payout ratio of the contextual ad is relatively higher. So excluding the contextual ad, what the spending will be. This is the first.

And second regarding the contextual ads, I know that revenue contribution is relatively small currently. So what the trend is going forward? And I know you will increase the payout ratio by 10% to 15%. So I think that the contribution will be higher going forward. So hope you will give me more color.

Haoyu Shen

Hi, this is Haoyu. There is no major one-time event related to TAC in Q2. So as I mentioned, TAC will probably continue to stay at this relatively low level as we can see.

Contextual, we mentioned a few times before, we are very excited about the opportunity in contextual ads going forward. So we're putting a lot of product management people and lot of R&D people behind this effort. It's still a relatively small percentage of our total revenue, but as I said, we are very excited that, we're very much looking forward to having more revenue contribution from this product maybe towards the end of this year and next year as well.

If and when contextual becomes a bigger part of our revenue, it will impact TAC, because typically the TAC payout is higher on contextual than our affiliated search. Just because the inventory belongs to somebody else, we need to pay a higher rate.

When that happens, it will probably have an impact on total TAC as a percentage of total revenue. But that's a good thing to have. But that's not going to happen in the short term yet.

Operator

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

Wendy Huang - RBS

Two quick questions. First, Google recently announced to acquire ITA. So I wonder if Baidu will consider acquiring any virtual search engine such as the (inaudible) search engine?

Robin Li

We already have a number of verticals. We have English search. We have Baidu Post Bar. We have Baidu Knows. We have Baidu Encyclopedia. And we have technologies to integrate this kind of information in our web search result page, and we also have an open platform that allows third-party information to be integrated in the related search result pages.

So at the end of day, we think about satisfying users' information need. If any type of actions can help satisfy our users' information needs better, we will do that. We have our internally user-generated content and we integrate third-party information sites. And if certain type of information is owned by someone who has unique content, we may consider that too.

So going forward, we will look for more type of information content or valuable content. We could generate it by ourselves. We could integrate third party. And we could buy them.

Wendy Huang - RBS

My second question is regarding your investment. You mentioned in the prepared remarks that you will invest aggressively in infrastructure and equipment. So can you give me some idea for your budget for this type of investment in the next one to three years? Are those still apart from this investment in your core search business? What's your budget for the none-core business such as the mobile search and the mobile OS possibly in the next three years?

Jennifer Li

As you can see from the Q2 CapEx number, it's a step-up from the Q1 level. And going out to any out-quarters, we have plans to get into the new investment cycle and therefore significantly step up the spending. So it's pretty material going forward.

The infrastructure investment will be on enhancing the core search capability, to enlarge our index size, to ensure we expend on our computing power and also to build flexibility and competency and capability on the infrastructure side. So there are plenty of things that we do surrounding the core search capability. That's where the main investment comes from.

Robin Li

In terms of resource allocation, we consider that the media platform and anything that can either enhance our platform or take advantage of our platform, we would invest in that. Of course, central to the platform is our web search.

So roughly 70% of our resources will be devoted to web search and pay search, this type of business. And 20% of our resources will be invested in projects that could help drive traffic to our web search. And the rest 10% will be invested in (inaudible) project.

Wendy Huang - RBS

Jennifer, can you actually update your CapEx guidance which is on '10-'11?

Jennifer Li

We don't give out CapEx forecast that long. Just to give you a sense, Q1 the spending was about RMB100 million and Q2 is about RMB180 million. So you can see the math. I think it will step up and continue to expect that kind of a momentum.

Operator

Your next question comes from the line of Welin Li with UBS.

Welin Li - UBS

Can you share with us the last revenue breakdown among the tier-one cities and tier-two and tier-three and also which segment is growing faster and also how much of revenue comes from direct sales versus the agency sales?

Robin Li

We typically do not break out among the tier-one, tier-two, tier-three cities. But what I can tell you is that the growth among these types of cities is roughly at the same pace. We have seen very good growth rates among almost all major cities. And like I mentioned before, probably one year or two years ago, direct sales represent more than 50% of our total revenue.

Operator

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

James Mitchell - Goldman Sachs

You mentioned in the beginning that the World Cup soccer event helped your traffic. Could it also help monetization of your revenue? I think the past events like the World Cup tended to be high traffic, but lower paid lead generation.

Haoyu Shen

Typically these keywords are not very monetizable, although we monetize some of these keywords through different methods. But I think what Robin really meant was during the World Cup, a lot of people came to search engine and they searched for stuff related to World Cup and that overall increased people's appreciation of how much search engine can help them.

So just like after every Chinese New Year, you see a major step-up of overall search volume. So a big event like World Cup this time also had that kind of impact on overall search volume, not so much of the revenue growth, not so much due to the monetization of the specific World Cup related keywords really.

Robin Li

The benefit we get from this World Cup related project is that we really made our users more dependent upon Baidu services.

James Mitchell - Goldman Sachs

The new tax in the second quarter that resulted in a 14% effective tax rate for the company, did you expect the tax rates remain around those levels or this is a one quarter phenomenon?

Jennifer Li

James, we did provide earlier in the year guidance for tax. We said it's going to be mid-to-low teens. We will remain in that guidance and probably more towards the mid-teens than low-teens.

Operator

Your last question comes from the line of Wallace Cheung with Credit Suisse.

Wallace Cheung - Credit Suisse

Regarding the latest PBOC rules on the third-party payment service, because we know Baidu also has applied to paid service. So are you going to apply for the payment license as well?

Haoyu Shen

Yes, Wallace, we are going to apply for that license.

Operator

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

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a good day.

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Source: Baidu, Inc. Q2 2010 Earnings Call Transcript
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