BIDU: PROVEN SCALABLE BUSINESS MODEL DESPITE SOFT Q1 GUIDANCE
Investment Conclusion: The company reported solid Q4 results, hitting the high-end of revenue guidance. EPS exceeded consensus by a wide margin, demonstrating the scalability of the paid search model. However, Q1:07 revenue guidance came in light, as management cited seasonality (weakest quarter of the year) and a late Chinese New Year (mid-February vs. late January) for a flattish Q1:07. We feel Q1:07 expectations are very achievable given the higher revenue visibility heading into the quarter (52% vs. 47%). In addition, we believe the main drivers of the business remain intact for 2007. Finally, Baidu’s business has demonstrated significant operating leverage, which could continue providing EPS upside in 2007. With that in mind, we reiterate our Buy rating on Baidu shares despite soft Q1 guidance.
• Q4 at High-end of Guidance. Revenues came in at the high-end of the $34-35M guidance, driven by a 9% Q/Q in average customer growth and 5% Q/Q in ASP. EPS outperformed our estimate by ~30% (normalizing the one-time tax benefit) due to strong scalability in the paid search model. During Q4:06, Baidu continued to make significant progress in key areas:
o On the product front, the company launched Baidu Favorites (online bookmarking) and Video Search, which served as nice complements to Baidu Postbar, Baidu Knows, and Baidu Space. These localized products, which were tailor-made for Chinese Internet users, have clearly differentiated Baidu from major competitor Google China, and enhanced user experience and loyalty.
o On the distribution front, the company became the provider of text-based ads on eBay China, MSN China, and China Telecom’s portal, which are three of the most heavily trafficked Chinese websites.
o On the content front, the company signed distribution agreements with MTV Networks and EMI Music to monetize copyrighted music content through advertising-supported download services. These content agreements indicate to us that Baidu has made progress in solving copyright issues related to its popular MP3 service.
o On the market front, the company has entered the Japanese market, which has been the first stop of overseas expansion for many Chinese technology companies. We believe the cultural and linguistic similarities between China and Japan, and the more developed online advertising market environment in Japan, are the key positive factors supporting Baidu’s Japanese initiative. The company plans to spend $15M in 2007 for this initiative.
• Q1 Revenue Guidance Light. Q1 revenue guidance came in light compared with the consensus ($34.5M vs. $38.4M). Management attributed seasonality (weakest quarter of the year) and a late Chinese new year (mid-February vs. late January) as major factors for a flattish quarter. However, CEO Robin Li cited that the company has seen some customers starting to come back to the Baidu platform after being inactive or using other search engines. Revenue visibility heading into Q1 is good, as 52% of the revenue expectations are already booked by customers (see Exhibit 1).
• Promising Opportunities Going Forward. The company has recently received a license to offer news content, and plans on entering into the news portal business, similar to that of Sina (SINA) and Sohu (SOHU) (and has been recruiting news editorial staff). This may possibly open up more inventory for its expanding banner ad programs. As a reminder, news/info is one of the most potentially profitable contents on the web and it typically appears on the home page of major websites like Sina and Sohu. Based on our estimate, the news/home page site contributed ~30% to 40% of revenues for the two largest portals in China. Given Baidu’s, sizable traffic, we believe the company can potentially add more than 25% to its revenue base if the search engine achieves the scale of the major portal players. Separately, the company is already having early success in selling banner ads in its MP3 and Movie channels.
• Estimate Changes. We are lowering our Q1:07 revenue estimate to $34.9M from $41.1M, or down 15%. However, we are increasing our EPS estimate to $0.40 from $0.38 due to better-than-expected operating leverage. We are lowering our 2007 revenues modestly from $211M to $205M, but increasing our EPS estimate by 5% to $2.11. Our estimates reflect investments in infrastructure and Japan.
• We Like the Stock in the Long-term. Despite soft Q1 guidance, we believe the long-term drivers remain intact, as we expect catalysts such as new banner programs for brand advertisers, new inventory in MP3, Movie and News channels, and new affiliate relationships with major portals and vertical sites will drive growth in the remainder of 2007. We remain convinced that Baidu is a core holding in the China Universe, with an expected EPS growth rate of ~60% from 2006 to 2008E. Our PT remains $130, representing 40x 2008E EPS (ex-option expenses) plus cash.
BIDU 1-yr chart: