Baidu Q2 Earnings Call Impresses; Surprised?

Jul.29.11 | About: Baidu, Inc. (BIDU)
On August 19, 2010, I wrote an article on the seemingly overpriced Chinese internet company Baidu (NASDAQ:BIDU). In February, I revisited the stock and concluded, again, that it was ripe for the buying. Now, its earnings have again beaten estimates and analysts seem confused by the seemingly meteoric ascent of a company that operates in the midst of frauds and cheaters. That misconception can similarly be applied to Sina Corp. (NASDAQ:SINA) and RenRen Inc. (NYSE:RENN), but it doesn’t make it right.
Baidu had another outstanding quarter on the back of its Phoenix Nest platform and declining traffic acquisition costs. It continues to benefit from a maturing internet commerce industry, and seems to be focusing efforts on ecommerce in a coordinated way. CEO Robin Li said in the recent earnings call that:

Baidu is at the center of China's increasingly sophisticated internet market, and our efforts to foster an ecosystem around that are paying off. The results can be seen in many areas like e-commerce where we have been a major beneficiary of the recent group buy spending trend.

Additionally, its open application platform (which I've mentioned in previous articles) has been growing at a good pace. Robin said that:

Our Open Applications platform is progressing well. I am proud to report that there are many developers seeking advantage of this platform. We now generate about 20 million clicks per day in less than one year of the platform's launch.

Additional partnerships with CRIC for real estate information and Qiyi for videos have been boons to Baidu as well. Its investment in Qiyi has paid off with 160 million unique monthly visitors to the space. Additionally, an investment in Qunar that was completed last week gives it capital to spend in the travel space. Robin mentioned this expansion by saying that:

We have more recently expanded to travel search through our investment in Qunar. This will provide users with an even better experience in the sectors that have long been one of our most popular query verticals. For example, shortly we will launch enhanced hotel-related content with Qunar. When users search for hotels, we will serve Qunar information at the top of our results page if it is relevant. After clicking through to Qunar, they will be matched with the same high-quality information on the landing page.

So its travel sphere should look more and more like Bing, which it's recently partnered with for English queries. An integrated travel platform may allow it to offer similar value adding services such as fare predictions and integrating multiple travel sites into search results.
Its growth has been impressive, but the nature of that growth has been questioned by certain analysts. Is BIDU raising prices to garner revenues? Is there a ceiling to that strategy? The truth, as laid out in the call, is that there are simply more clicks going through its revenue-generating space than previously. Robin pointed out in the call that he wanted:

To highlight that our revenue growth in driven more by growth in paid clicks than by click price appreciation.

Active online marketing customers have also been increasing at a blazing pace. Jennifer Li, CFO, mentioned that:

Baidu had around 298,000 active online marketing customers in the second quarter of 2011, a 17% increase from the corresponding period in 2010, and a 9% increase from the previous quarter.

The increase in marketing customers has also been coupled with a decrease in traffic acquisition cost. Jennifer stated that:

Traffic acquisition cost, as a component of cost of revenue was RMB269 million, a 7.9% of total revenues as compared to 9.7% in the corresponding period in 2010 and 8.2% in the first quarter of 2011. This decrease reflects traffic mix, driven by stronger organic traffic growth.

One concern that has been voiced by Morgan Stanley is the increase in bandwidth costs. Jennifer notes this increase in saying that:

Bandwidth costs, as a component of cost of revenue, were RMB147 million, representing 4.3% of total revenue compared to 3.5% in the corresponding period in 2010. This increase mainly reflects increase in server capacity to accommodate traffic growth, new product services and higher computing requirements.

This increase, while substantial, is expected in light of the other increases in the business line. Traffic acquisition cost cannot decrease indefinitely, but neither shall bandwidth costs increase perpetually. It is my belief that while this may harness some of the growth Baidu is experiencing, the impact on the investment is marginal. Focusing on this one metric as a reason not to invest is a mistake.
Non-GAAP net income increased 94% year over year, while guidance offered a 75-79% year over year increase for the third quarter of 2011. Baidu looks positioned to continue its ascent, despite what otherwise would appear to be an inflated P/E. I will delve further into its financials and valuation in later articles.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.