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Baidu.com, Inc. (BIDU)

Q4 2006 Earnings Call

February 14, 2007 8:00 pm ET

Executives

Rory Macpherson - Ogilvy Public Relations Worldwide

Robin Li - Chief Executive Officer

Shawn Wang - Chief Financial Officer

Analysts

Anthony Noto - Goldman Sachs

Jason Brueschke - Citigroup

Robert Peck - Bear Stearns

Paul Keung - CIBC World Markets

Richard Ji - Morgan Stanley

James Mitchell - Goldman Sachs

Wallace Cheung - Credit Suisse

Safa Rashtchy - Piper Jaffray

George Chu - UBS Warburg

James Lee - WR Hambrecht & Co.

Steve Weinstine - Pacific Crest

Ming Zhao - Susquehanna Financial Group

Tony Kim - Artisan Partners

Presentation

Operator

Good evening and thank you for standing by for Baidu's fourth quarter and full year 2006 earnings conference call. At this time, all participants are in a listen-only mode. After management’s prepared remarks, there will be a question-and-answer session. Today’s conference is being recorded. If you have any objections, you may disconnect at this time.

I would now like to turn the meeting over to your host for today’s conference, Rory Macpherson.

Rory Macpherson

Hello, everyone, and welcome to Baidu's fourth quarter and full year 2006 earnings conference call. We distributed Baidu's fourth quarter and fiscal year 2006 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, Baidu's Chief Executive Officer; and Shawn Wang, Baidu's 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.

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Robin Li

Hello, everyone, and thank you for joining us. I am pleased to report strong fourth quarter and full year 2006 results. Our growing brand recognition, combined with our new and existing search and community-based offerings drove market expansion in the fourth quarter.

As the Baidu brand continues to gain recognition, more and more Chinese Internet users are making Baidu their search engine of choice. In fact, according to the independent research firm, iResearch, in October 2006, 53.7% of online users in China chose Baidu as their most favorite search engine.

While traditional web search continues to be the largest traffic contributor, we are also seeing encouraging uptake of our leading community-based offerings. For example, Baidu Space and Baidu Notes have grown significantly in popularity and both products are now featured on Baidu's homepage.

We are always creating new products that improve user experience. In the fourth quarter, we added Baidu Blog Search and Baidu Favorites and most recently, we added a video search service. We have also recently received a news publishing license and we will use this opportunity to broaden our reach and increase the impact of the Baidu news service.

Improving customer service quality is one of our key strategies for building our customer base and increasing average spending per customer. During the quarter, we continued to expand and train our direct sales force in major cities. We are confident this strategy will help to drive future revenue growth.

Focus on our customer service is key in helping our customers to transition to and take advantage of our improved P4P monetization platform. We are pleased with our progress thus far and will continue to improve service and fine-tune our monetization model going forward.

During the quarter, we announced new partnerships with content and Internet industry leaders aimed at expanding our online presence and enhancing user experience. During the fourth quarter, we partnered with MTV Network to distribute video and music content. We recently linked with EMI to stream their music online. We believe that the EMI agreement represents a major milestone for the ad-supported digital music industry in China.

We also just launched an online portal for downloading virus protection software made by a number of leading international and domestic brands, including Trend Micro, Symantec, and McAfee. These collaborations provide users with improved options for legal content download and extend Baidu's reach on the Internet.

On the monetization side, we formed a strategic alliance with Microsoft to display our paid search listings with Microsoft properties as well as the 114 search services offered by China Telecom and its affiliates.

In 2007, we will continue to look out for partnerships that enhance our core user experience and provide revenue-generating opportunities.

Another exciting initiative for Baidu is our upcoming interest into the Japanese search market. We believe that with our proven strength in Chinese language search and our focus on delivering the best user experience, we will be able to provide Japanese users with a quality alternative to existing search engines.

Also, considering that Japan has over 50% Internet penetration and our familiarity with the two leading players, we feel there is a strong long-term market opportunity there. We have been making excellent progress building our Japan team and amassing our Japanese language research technology. We will keep you updated on developments.

Currently, we estimate to incur approximately $15 million in expenditures to developing our Japanese initiatives in 2007.

Also in 2007, we will continue to focus on our strengths and deliver the best online search experience to our users. We continue to be very confident in the long-term growth potential of the Chinese search market and we are also excited about the opportunities in the Japanese search market.

We are committed to making the long-term investment in innovation, infrastructure and people that will fuel our growth and create exceptional value for our shareholders.

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 healthy revenue and earnings results in the fourth quarter. I will walk you through some important factors contributing to these results and our financial highlights.

Again, the numbers I refer to will be in RMB unless otherwise indicated. Our fourth quarter total revenues were approximately RMB 271 million. That is within our guidance range and up 136% over the year-ago period.

Online marketing revenues were RMB 270 million, representing a 141% growth year over year. This growth was driven by a number of factors, including traffic growth, a year-over-year increase in the number of active customers of 71%, as well as a year-over-year increase in per customer spending of 41%.

Traffic acquisition costs as a component of cost of revenues were RMB 24 million. That is 9% of total revenues compared to 8% in the year-ago period. The slight increase reflects increased revenue contribution by our union properties.

Share-based compensation expenses decreased to RMB 7 million in the fourth quarter of 2006. That was a decrease from RMB 10 million in the year-ago period. The decrease primarily reflects reduced option grants during the quarter, decelerated amortization of existing options granted before 2006, and changes in actual and estimated options forfeiture rate.

SG&A expenses were RMB 71 million, representing a 44% increase from the fourth quarter in 2005. Excluding share-based compensation expenses, SG&A rose 53% year over year.

Research and development expenses were RMB 21 million, representing a 46% increase from the corresponding period in 2005. Again, excluding share-based compensation, R&D expenses rose 81% year over year. That is mainly due to the expansion of headcount.

In the fourth quarter, one of our PRC subsidiaries qualified for income tax preferential treatment for 2006 and the following two years. As a result, the income tax benefit in the fourth quarter included a reversal of RMB 7 million tax expenses that were provided in the previous quarters.

Our net income for the quarter was RMB 123 million, representing a 400% increase year over year. Net income excluding share-based compensation expenses, a non-GAAP measure, was RMB 130 million, representing a 272% increase from the fourth quarter of 2005.

Basic and diluted EPS excluding share-based compensation expenses were RMB 3.87 and RMB 3.75, translating roughly to $0.50 and $0.48 respectively.

Net margin excluding share-based compensation expenses for the fourth quarter of 2006 was 48%, up from 30% in the year-ago period. The year-over-year increase primarily reflects the scalability of our business and the tax reversal during the quarter.

Now, moving on to the balance sheet: we ended the fourth quarter of 2006 with a cash, cash equivalents, and short-term investments of RMB 1.2 billion. That is roughly $157 million.

Operating cash flow for the quarter was RMB 171 million, or $22 million, representing a year-over-year increase of 175%.

Capital expenditure for the fourth quarter of 2006 was RMB 23 million, up from RMB 21 million in the year-ago period. We expect an increased level of capital expenditures during 2007, however, as we begin construction of our Baidu campus, as we continue to upgrade our network infrastructure and increase our network capacity.

Adjusted EBITDA, again, a non-GAAP measure, was RMB 132 million for the fourth quarter, representing a 261% increase from the corresponding period in 2005.

Now, a few highlights on the fiscal year 2006 results. Total revenue for the year was RMB 838 million, representing a 162.5% increase from the previous year.

Online marketing revenue for the year was RMB 828 million, representing a 170% increase from the previous year.

Traffic acquisition costs were RMB 75 million, representing 9% of total revenues compared to 7% in 2005. Again, that is a reflected increase in the revenues by our union properties.

Selling, general and administrative expenses were RMB 250 million, representing an increase of 86% from 2005, mainly due to the expansion of the direct sales force and the strengthening of our distribution network.

R&D expenses totaled RMB 79 million, representing a 79% increase from 2005, largely due to the headcount expansion.

Net income was RMB 302 million, representing a 534% increase from 2005.

Net income excluding share-based compensation expenses, an accumulated effect of changes in accounting principle, again that is a non-GAAP measure, the number was RMB 345 million, representing a 326% increase from 2005.

Basic and diluted EPS, excluding share-based compensation expenses, an accumulated effect of accounting principle changes, were RMB 10.38 and RMB 10.01, translating roughly to $1.33 and $1.28 respectively.

Net margin excluding share-based compensation expenses, an accumulated effect of the changes in accounting principle for the fiscal year 2006, net margin was 41%, up from 25% for 2005. Again, the margin increase was mainly due to the benefits of the economy of scale for our business.

Full year net operating cash flow and capital expenditures in 2006 were RMB 526 million and RMB 128 million respectively.

Adjusted EBITDA was RMB 382 million in 2006, representing a 270% increase from 2005.

Now let me provide you our top line guidance for the first quarter of 2007. As many of you know, our first quarter results tend to be affected by the seasonality from the long Chinese New Year holiday. In the first quarter of 2007, we currently expect total revenues to be between RMB 265 million and RMB 275 million, which would represent an annual growth of 95% to 103% respectively.

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

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

Robin Li

Thank you, Shawn. With our focus on tailoring online products to meet user needs and our commitment to making strategic investments for our future, we are confident that we will continue to lead the Chinese Internet search market and enjoy growth well into the future.

I will now open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Anthony Noto from Baidu [sic]. Please proceed.

Anthony Noto - Goldman Sachs

It’s Anthony Noto from Goldman Sachs. Robin and Shawn, I was wondering if you could comment on the growth of the overall industry and delineate for us potentially what you are seeing for the growth of the industry, vis-à-vis the slowdown that you may still be seeing from the unsophisticated advertisers and their desire to have to continue to increase their knowledge of how to bid under your new system. Thank you.

Robin Li

As you probably know, we are the market leader in the paid search industry in China. We probably have well over 50% in market share, so our growth rate pretty much represents the growth rate for the whole industry.

Having said that, we do not exactly know how much revenue some of our competitors generate. But from all of the regions across China, what we heard is that we continue to be the dominant player in each of the Chinese provinces and cities. We do not think competition is a major threat at this point.

Anthony Noto - Goldman Sachs

Have you noticed an improvement in the ability of your unsophisticated advertisers to deal with the changes that you have made in monetization and minimum bids now versus what you said on the last two calls?

Robin Li

Yes, we did notice that many of the new advertisers or customers do accept and appreciate the new system. As I discussed in the previous conference call, last quarter and in Q4 and this quarter will be a transition period for the company. There will be some churn for the customers. Some of the old customers who did not want to accept the new pricing policy may choose to leave. So far, we have found that we have no problem to attract new customers and new customers can very well accept the new monetization upgrade.

Shawn Wang

Anthony, if I could just add one more point to Robin’s explanation, I think we are also seeing that in markets where there tends to be more of a presence of sophisticated advertisers, whereas we have our customer service teams are being present for a longer period of time, which is providing a better service, we see those areas, the transition is much smoother and is much better. That gave us the confidence. The key is in the customer service. The elevated awareness among the Chinese advertisers, I think that is a function of time.

Operator

Your next question comes from the line of Jason Brueschke from Citigroup. Please proceed.

Jason Brueschke - Citigroup

Thank you, and good morning, Robin and Shawn. My question is pretty much similar, along the thought lines of Anthony’s. You guys only grew your active new customers by about 6,000 in the quarter, which is a deceleration in the rate of those new customers. Is this due to the move away from your distributor network to your direct sales network, such that it might be temporary and you will see a reacceleration in that? Or is it maybe a reflection of the immaturity of the market, and maybe perhaps if you could comment on it, whether there is an early adopt phenomenon that at 100, maybe 120,000, those are the early adopters in China, that you may get to being close to penetrating that and thus we should expect to see, at least over the near-term, maybe a continued either flat line or deceleration in the in the active new customers? Thanks.

Robin Li

Jason, I think it is a combination of both factors and they are inter-related. When we made the change in the monetization upgrade, a weakness in customer service was exposed. At the same time, we converted the Beijing market from distribution to direct sales. That made things a little worse.

So all those factors combined, we saw some customer churn. As I discussed in the prepared remarks, we have been improving the customer service function. We are building a stronger sales team in Beijing, so we see things are improving quite healthily.

As Shawn pointed out earlier, for the more mature markets, we see better reception of our new policy. Even for this holiday season, we can see that those tier-one cities are less affected by the Chinese New Year holiday. That gives us confidence on the healthening of this business and the paid search industry in China.

Operator

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

Robert Peck - Bear Stearns

A couple of big questions first. One, when we talk about the TAC rate, we see it decreased about 30 bps sequentially. Could you talk to us a little bit about what you are seeing there, what the growth rate of the union sites are versus the core?

Number two, bigger picture, when we think about some of the new stuff you have done, the news license and some of the monetization capabilities there, could we get a little color around that, and talk about: does it affect your tax status at all? Thank you.

Shawn Wang

Let me give it a try. On your first question, how do we see the union development, it is very difficult to give a prediction of how this will evolve in the future. I think we can look back, and what we have seen is both our organic revenue as well as our union revenue has been increasing rapidly, and the form of increase came from different avenues. Sometimes a newer type of property, sometimes a new channel, sometimes it is related to our new products, from the products we talked about in the previous calls where, for example, [target advertisements], which was a behavioral type of advertising, and then also the ProTheme, which is similar to our contextual ad type of advertisement.

So there have been experiments of different products, and there also has been an expansion of the type of properties that we included as our union. We like to keep that flexibility in terms of broadening our reach to more union websites, union properties.

What we have managed to do in the past is grow both organic and union very rapidly. Going forward, we will continue to explore -- if there is opportunity on the union front, we will do it but it is hard to say exactly how. Will that grow faster than the organic, will it be slower? That is very difficult to say, so I am not going to be able to give you a prediction in terms of how the tax ratio to the revenue will fluctuate.

On the second question, if I understand correctly, you are talking about how these new products were doing and the grant of the new license, how is it going to affect our tax rate. Is that the question?

Robert Peck - Bear Stearns

Yes, just the monetization around the news license and then ultimately does it affect your tax status?

Shawn Wang

Let me leave the news license discussion to Robin to come in a little bit, but one thing I can tell you is we do not expect any changes on the tax rate because of all these new initiatives or new products.

Robin Li

Okay, with the news license, we are now able to display news articles on the Baidu.com website instead of only providing search functions. More broadly, I think Baidu is a very large website -- actually, the largest in the Chinese word, and over 50% of the traffic comes from non-web search. We have been studying all kinds of options to better monetize that part of the traffic.

Right now, some of the channels already display contextual ads from our P4P customer base, but we think there is a lot of potential for us to grow the revenue there.

Operator

Your next question comes from the line of Paul Keung from CIBC World Markets. Please proceed.

Paul Keung - CIBC World Markets

Good evening, Robin and Shawn. One quick question: you mentioned that the -- you tried to explain the transition of the advertisers. You mentioned it was smooth in some markets over others. Are you able to maybe give us something different in terms of how that growth has been let’s say between tier-one and tier-two cities, or between Beijing and some of the other cities?

Robin Li

We cannot break down city by city and region by region. I can only discuss the general phenomena that for the more mature markets, we are seeing customer reception and better growth potential for the P4P service.

As you know, we transitioned the Beijing market from channel to direct and that will take some time to re-accelerate the growth in the Beijing market.

Paul Keung - CIBC World Markets

Okay, another question then, if you don’t mind: the R&D spend, if you go back the last couple of years, obviously you tend to spend the most in the third quarter, a little less in the first, and the second and fourth quarters tend to be a little flattish. Should we expect the same types of patterns next year in terms of how you are going to match your R&D spend to ’07?

Shawn Wang

Yes, well, it will be similar. The reason that Q3 will have a higher R&D spending is because we hire mostly fresh graduates out of school and they graduate in the fall. They can only start in the fall.

Operator

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

Richard Ji - Morgan Stanley

Hi, Robin and Shawn, and a question regarding your direct sales force. You said you expanded your direct sales force in key regional markets. Other than Beijing, can you shed a little more color on what other markets you ventured into, and what are your future plans?

Robin Li

In addition to Beijing, we have direct sales forces in the cities of Shanghai, Guangzhou, [inaudible], [Fuzhou], and [Zhongshan]. At this time, we think we have a very good balance of distribution and direct. But going forward, we will continue to strengthen the direct sales force team. If we find any region where the distributors are not doing so well, we may need to take necessary actions.

Richard Ji - Morgan Stanley

My follow-up question is what is the approximate churn rate for your existing customers after you changed your monetization scheme a quarter ago?

Shawn Wang

Robin, let me try to address that. Richard, it is very difficult for us. We do talk about customer churn, but the real fact is that our customers’ spending was somewhat suspended. A part of our effort in increasing our focus on customer service is making sure that our customer service reaches out to these customers who will always have a relationship with us, and to help them to understand our services.

It is very misleading to define those customers who may suspend or reduce some of the spending as churn customers. It is hard for me to give you that statistic.

Operator

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

James Mitchell - Goldman Sachs

Thank you for taking my question. Could you just repeat what you said you would be spending in Japan in 2007, and also break that down between what you will be expensing through the profit statement and what you will be capitalizing on the balance sheet? Thank you.

Shawn Wang

I am sorry, James, are you asking how much we plan to spending 2007?

James Mitchell - Goldman Sachs

I think that in the preamble remarks, you gave a figure for what you intended to spend in Japan in 2007.

Robin Li

15 million.

James Mitchell - Goldman Sachs

Yes, 15 million. That is which currency?

Shawn Wang

It is $15 million U.S. dollars and that is discussed in the context of our estimate expenditure to be incurred in association with the Japanese initiative.

James Mitchell - Goldman Sachs

How much of that will be expensed through the profit statement versus capitalized on the balance sheet?

Shawn Wang

That is discussed mostly in the context of P&L impact.

James Mitchell - Goldman Sachs

Okay, that’s great. That full answers my question. Thank you.

Operator

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

Wallace Cheung - Credit Suisse

Good morning, Shawn and Robin. Two quick questions. First, regarding Japan, the strategies, could you give us more details, or at least can we understand what is the domain name that you have chosen?

Second is regarding your new media strategy, or you new news reporting team. How much will the increase be in terms of headcount or G&A expenses? Thank you.

Robin Li

Regarding Japan, the domain will be baidu.jp. We have started this initiative roughly two or three quarters ago, but Japan is a more mature market and we need some time to do preparation and we need to have patience to wait for the right time to monetize it. So right now, all of our focus is on building the right team to execute investment in technology and infrastructure.

On the news reporting, we actually have not decided what to do on that front. For the past seven years in Baidu's full history, we actually tried not to produce any content by ourselves. We rely on our users and other website owners to create content for us. We understand that news is very important in the Chinese Internet landscape. We already have a news service, largely oriented to search. We are currently evaluating all kinds of options to make our news service better, more user friendly and make more impact in the Chinese online news space.

But right now, we have not decided how much to invest and whether we need to hire reporters and an editor.

Wallace Cheung - Credit Suisse

Okay, thank you very much, and Happy New Year.

Operator

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

Safa Rashtchy - Piper Jaffray

Good morning, Robin and Shawn. Just a couple of quick questions. As the seasonality of Q1 this year is much more pronounced than in the past, and hence your guidance of nearly flat revenues, how much of that do you think will be shifted to second quarter and how much do you think will be lost?

Also…[inaudible]…for margins going forward. Could you just repeat those, please?

Robin Li

Regarding the seasonality, it is hard for us to give any guidance for Q2 at this time, as it is kind of early. But I would say that the current guidance for Q1 reflects the true picture of both Baidu and the online advertising industry in China. If you look at the whole online advertising industry, you probably would reach the conclusion that sequentially it will be a down quarter from Q4 of last year. Shawn, do you have anything to add?

Shawn Wang

No, I agree with you. I think it is difficult to say. We are dealing with over 100,000 small and medium-sized advertisers, or online marketing customers. If you look at some of the existing, those online advertising businesses that have a limited number of large customers, they tend to have a budget concept and they may move around a bit.

For us, it is really a function of a large number of small businesses, and it is hard to use the concept of the pushing budget into the next quarter or not. But always in the past, we have seen the second quarter has a much stronger pick-up compared to the first quarter.

Safa, you did ask a second question but it wasn’t very clear. You were asking a question regarding margins?

Safa Rashtchy - Piper Jaffray

I thought, Shawn, in your opening comments, you gave some color on how we should look at margins going forward. I kind of missed it.

Shawn Wang

I don’t think I gave any color on the margin going forward, other than what we discussed about our Japanese initiative.

Operator

Your next question comes from the line of George Chu from UBS. Please proceed.

George Chu - UBS Warburg

Good morning, Robin and Shawn. Just a question on the expenses side, in particular on the selling, general and administrative costs. The expenses are flat on a Q-on-Q basis. I am just curious, could you give us some color on how that is going to evolving in the future? Is this an indication that you think you have sufficient footprint in China and the growth in this cost will moderate going forward, or do you think at some point in the future we are going to see a real acceleration of growth for this particular expense? Thank you.

Shawn Wang

George, I think SG&A in the course of the past few consecutive quarters, the proportion of SG&A to revenue has certainly been declining, and that is a reflection of the leverage that is inherent in our business.

You mentioned about a bit of a flattish increase this quarter compared to previous quarters. I think that number is excluding share-based compensation. If I recall correctly, I think on a GAAP basis, that number increases less than 2%, SG&A compared to the third quarter. However, if you take away the share-based compensation expense, the increase was much more than that. Cash-based, the expense increase was close to 8%.

So we will continue to expect the absolute dollar amount to increase in the future quarters and also we would expect the percentage of that to total revenue will continue to show the scalability.

George Chu - UBS Warburg

If I may sneak in a quick follow-up question: on the TAC, the percentage declined slowly, or is down on a sequential basis. Could we take that as a sign the competition is using that as a way to buy traffic in China and thus affecting your number, or that is affecting the percentage of revenue sharing?

Robin Li

For the TAC rate, it does fluctuate from quarter to quarter. In our view, there is no material change in the percentage of revenue for TAC. We continue believe that we have the strongest union system or alliance program in China’s paid search industry. We are able to retain all of the key partners, content partners we have. As I mentioned previously we signed a deal with Microsoft, including their affiliates with China Telecom on the syndication deal.

We do not see any increased pressure or threat from competition.

Shawn Wang

Just to add to that, I think our TAC ratio as a percentage of total revenue has bee pretty much the same in the past few quarters. This quarter was 8.7, the quarter before was 9. That is just a very small fluctuation.

Operator

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

James Lee - WR Hambrecht & Co.

Good morning. Robin, can you talk about guidance into Q107, maybe give us a little more clarification? What do you think about the underlying changes to your customer counts versus ASP that you implied by your guidance?

Robin Li

The ASP?

James Lee - WR Hambrecht & Co.

Yes, I was thinking with your guidance pretty much flattish quarter over quarter, what should we read into in terms of customer accounts going from 4Q to 1Q versus ASP going from 4Q to 1Q?

Robin Li

It is hard to quantify as a point. During the Chinese New Year, many of the customers choose to pause their advertising initiatives. That will lower the average spending per customer. Right after New Year, we have about one month, actually a little less than one month to attract new customers. We do expect to have a strong March. However, when you combine with January and February the number of active customers could also be flattish, so it is hard for us to say which one contributes more, but I think both factors are affected by the seasonality.

James Lee - WR Hambrecht & Co.

Is it fair to say that you expect the revenue driver continue to be more from your existing customer base versus coming from new customers, given the fact that --

Robin Li

I think both will grow longer term. I think there are probably more potential in terms of average spending per customer, because our understanding is the clicking price, the cost per click in China is much lower than the industry average in other markets. There are very few IT related products or services that are so cheap in China, or so much cheaper in China than in other markets around the world.

James Lee - WR Hambrecht & Co.

Also, Robin, you talk about you are still experiencing churn from smaller customers in smaller cities in 4Q. Have you seen any activities in 1Q, maybe some of the customers that churn away in 4Q coming back onto your platform because they experience inferior results from other search platforms?

Robin Li

Yes, we see a lot of customers coming back to us. That is very -- usually, when some of the customers decide not to advertise with us, they may not even go to a competitor. They just stop doing paid search. That is because of the immaturity of the market. They just psychologically would not accept the new pricing policy. But they really cannot find any better alternative in this market.

Operator

As a reminder, ladies and gentlemen, could you please limit your questions to one. Your next question comes from the line of Steve Weinstine from Pacific Crest. Please proceed.

Steve Weinstine - Pacific Crest

Thank you. Just looking at your guidance, your suggestion that there is potential for the rate of deceleration in the first quarter to actually be greater than it has been over the last several quarters, and understanding seasonal factors and understanding transitional issues with your sales force, do you think that is nearing a bottoming in terms of the rate of deceleration? Is that the point we should be thinking of going forward, or do you think you can get some reacceleration as you get your sales force aligned and you are not going against negative seasonal factors, or would you expect a continued step down in terms of growth as you progress through the year?

Also, I missed the CapEx that was spent in the quarter, if you could repeat that.

Robin Li

As I said before, Q4 and Q1 would be our transitional period. After that, we do expect stronger growth for the rest of the year. Not necessarily in absolute growth percentages, but relatively speaking, I would think that we will see a better picture going forward.

Steve Weinstine - Pacific Crest

Thank you, and the CapEx in the quarter?

Shawn Wang

CapEx for Q1?

Steve Weinstine - Pacific Crest

What was it for Q4? You said it in the call.

Shawn Wang

The Q4 was 20-something million. It basically remained on a similar level as the previous quarter, but I did mention that the CapEx for ’07, we would expect a very significant pick-up in ’07 as we will be operating on a network capacity and also building our campuses in ’07.

Operator

Your next question is a follow-up question from the line of Anthony Noto from Goldman Sachs. Please proceed. Mr. Noto, your line is open.

Anthony Noto - Goldman Sachs

Thank you. Shawn, I had a follow-up question on the operating margins. The December quarter operating margin, excluding stock-based compensation, was 40%. I am just trying to get a sense -- I know you are not guiding to margins specifically for 2007, but you did give us a sense for the $15 million that you will spend in Japan that will flow through the P&L.

Is one way to think about the methodology to come up with a forecast aligned with what you said is to think that you are at a 40% margin ending December 2006, and you have been able to really achieve about 200 basis points of margin expansion in each quarter, so as you flow out that trend through 2007 in China, and then layer on top of that a $15 million hit, that you would come up with about the operating margin in the range of what you are expecting, without specific guidance?

Shawn Wang

I think the math is pretty straightforward. That will be the expense, and I think in terms of how the amount will be allocated in each quarter, that is really depending on how we are progressing in some of the detailed operational matters.

It is really hard to see how it is going to affect each quarter, but on a year-over-year basis, that is going to be the expense and it will be actually less in the long-term international strategy.

Anthony Noto - Goldman Sachs

Maybe the better way for me to ask is would you operating margin in ’07 excluding Japan be up on the order of magnitude of 400 to 500 basis points in ’07 for the full year, and then obviously it is offset by that?

Shawn Wang

If we take the Japan factor out of the equation, we have not seen anything that would suggest a change to our pattern in the recent quarters, which has been revenue growth and investment in various aspects of CapEx and sales and distribution network. Obviously it has been fairly aggressive but the scalability in our business has been strong.

I think that scene will continue, if we take the Japanese factor away from the equation.

Operator

Your next question comes from the line of Ming Zhao from Susquehanna International Group. Please proceed.

Ming Zhao - Susquehanna Financial Group

Thank you. Good morning, Robin and Shawn. Just a question on your community products. My question is how are you going to monetize that? When you think about contextual ads and the branded advertising, could you break down your Q4 revenue? How much of that is already coming from the contextual ads and the branded ads? Thank you.

Robin Li

For the community-oriented products and services, the revenue contribution is still very small as a percentage of total revenue, so I do not think we need to break it down in terms of branded ads and contextual ads. As I said before, we are still experimenting all kinds of possibilities to better monetize the traffic. We have lots of traffic related to community and other types of searches and the growth is very nice. We see a lot of growth potential in terms of page views and user reach, but we just need to figure out how to monetize traffic better.

Ming Zhao - Susquehanna Financial Group

But for the past few quarters, do you see the contextual ad becoming a meaningful product in the next couple of quarters?

Robin Li

It is meaningful. It has a very good growth trajectory, but it is small percentage-wise.

Operator

Your next question comes from the line of Tony Kim from Artisan Partners. Please proceed.

Tony Kim - Artisan Partners

Most of my questions are answered, but just on Japan, if I look at the Japan spending, how would you look at that? Is it more back-end loaded? Is it front-end loaded? That is a pretty big number for what you guys are planning on.

Secondly, the CapEx again was -- could you clarify what that number was and what was the depreciation?

Shawn Wang

Tony, I think I mentioned earlier that it is fairly difficult to really allocate the total number into different quarters, as we are still going through the exercise. I will probably --

Tony Kim - Artisan Partners

Can I ask something else on Japan then? You said you started the investment two or three quarters ago. Was that a material amount or was that really just --

Shawn Wang

No, it was not material. It was work was done in the past. I think there was a limited amount of investment, mostly from the people side but it does not really show up in a material amount in terms of dollar amount. But going forward, we will be building our networks. We will be hiring folks on the ground. We will be incurring operation expenditures. That is paying and that is where the dollar amount impact will kick in. That is what we talked about, the $15 million for 2007.

Tony Kim - Artisan Partners

Okay, and what was the full CapEx for the year of ’06?

Shawn Wang

The CapEx total for the full year -- let me give you the full number.

Tony Kim - Artisan Partners

And the D&A as well.

Shawn Wang

It is close to about RMB 130 million for the whole year. That is ’06. For ’07, we do expect a significant increase in that because we are at the moment that we are very confident, and I think it is time to make investment now.

Tony Kim - Artisan Partners

I understand. What do you see as eventually the normalized tax rate? Because you had the tax credit this quarter, but what is a normalized tax level going forward?

Shawn Wang

I think the question was asked before. I think my answer was it will be high single digit or close to 10. That was in the previous quarters. Last quarter, we did receive a qualified status for one of our major subsidiaries. If we take that effect into consideration, we are looking at our effective tax rate in the next few quarters to be in the range between 5 to mid- to high-single digit. That is what we are talking about, somewhere in the middle.

Tony Kim - Artisan Partners

And finally, Japan, the hiring and stuff, is that going to be in China, to build out the database or will it also be on the street in Japan?

Robin Li

We are hiring both in Japan and in China. In terms of operation, I think eventually a lot of the operation will be localized. We do plan to place servers in Japan.

Operator

Your next question comes from the line of Jason Brueschke from Citigroup. Please proceed.

Jason Brueschke - Citigroup

Thank you. Two quick follow-up questions. First of all, could you give us more color on your strategy to differentiate yourself in the market in Japan? Unlike China, where you have been the market leader practically since day one and people have been playing catch-up, those roles seem a little bit reversed in Japan.

Then the second question would be with respect to your push more into the news offering and monetizing some of your community, would you guys consider doing any M&A to beef up either your capabilities there or just your market share in and around the brand advertising area? Thank you.

Robin Li

Regarding Japan, let me tell you this: Baidu was not number one in China from day one. We actually started quite late, later than probably most of the Chinese search players you see on the market right now. So we are familiar with how to play the catch-up game.

We have been doing all kinds of studies for a few quarters, but it is still too early for us to say what exactly we will do better or different from the other players in the Japanese search industry. As time passes by, I think we will have more to talk about.

In terms of news and community, it is the same strategy of our other businesses. We are open to all kinds of possibilities, including investment, acquisition, et cetera. But at this time, there is nothing material we can talk about.

Operator

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

Robert Peck - Bear Stearns

I was wondering if you could give us a little more color around some of your content relationships, particularly with the new deal with EMI. Do you foresee seeing a bunch of those types of deals going forward? How do you view video content rights going forward as well? Thanks.

Robin Li

We believe that the future for digital music is an ad-supported media business. We have been pushing this concept for quite a few quarters. We actually signed up more than 20 record companies to support our initiative, mostly domestic record companies. EMI was the first major international record label to work with us on an ad-supported digital music strategy. And in fact, they have the largest market share in China for Chinese music, so we are quite optimistic about the future of this kind of partnership. Although it may take a few years to really become a significant business, we do believe that is the future.

Video content, even at an earlier stage in China, we do see a lot of interest. We do believe in the future of online video, but in terms of monetization I think it will take longer.

Operator

Your next question comes from the line of Paul Keung from CIBC World Markets. Please proceed.

Paul Keung - CIBC World Markets

Hi, this is [Mayresh] calling for Paul. Google just announced a mobile search database for China Mobile. I was wondering if you could talk about Baidu's mobile search strategy going forward, and if you are looking at any partnerships.

Robin Li

We are also optimistic about the future of mobile search. We have been closely monitoring the progress in this space. We believe we have a very good understanding on the current situation of mobile Internet. We believe in the future, things could change very dramatically, so we have been working on a number of mobile-related products, including the web search, the community product. We have versions for many of our existing services but I think it is too early to say who we would partner with and what kind of arrangement. We just think it will take some time to gear up in the mobile search landscape.

Operator

We are now approaching the end of the conference call. I will turn the call back 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.

Shawn Wang

And Happy Chinese New Year to you all.

Operator

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

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Source: Baidu.com Q4 2006 Earnings Call Transcript
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