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Executives

Cynthia He - Investor Relations Manager

Robin Li - Chief Executive Officer

Shawn Wang - Chief Financial Officer

Analysts

Jason Brueschke - Citigroup

Anthony Noto - Goldman Sachs

Safa Rashtchy - Piper Jaffray

Richard Ji - Morgan Stanley

James Mitchell - Goldman Sachs

Leah Hao - Thomas Weisel Partners

Tan Ke - Owens Technology Research

Robert Peck - Bear Stearns

Tony Tang - Lucite Research

Robert King - Peninsula Capital

Wallace Cheung - CSFB

Andrew Collier - New York Global Securities

Presentation

Operator

Good day ladies and gentlemen and welcome to Baidu's fourth quarter and full year 2005 conference call. (Operator instructions) I would now like to turn the meeting over to your host for today's conference, Ms. Cynthia He, Baidu's Investor Relations Manager. Please proceed.

Cynthia He

Thank you. Hello, everyone and welcome to Baidu's fourth quarter and fiscal year 2005 earnings conference call. My name is Cynthia He, Baidu's IR Manager. We announced our fourth quarter and fiscal year earnings earlier today. You may find a copy of the press release on the Company's website as well as on other wire services.

Today, you will hear from Robin Li, our Chief Executive Officer; and Shawn Wang, our Chief Financial Officer. After their prepared remarks, Robin and Shawn will be available to answer your questions.

Before we continue, please note that the discussion today will contain forward-looking statements made under the Safe Harbor Provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risks and uncertainties. As such, our results may be materially different from the results discussed today.

A number of potential risks and uncertainties are online in our public filings with the SEC. 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, Mr. Robin Li.

Robin Li

Thank you, Cynthia. Hello, everyone. Thank you for joining us this morning or evening, as your case may be. I am pleased to report that Baidu has achieved another quarter of strong revenue and earnings growth, as well as solid full year results.

During the fourth quarter of 2005, we generated total revenues of RMB115 million, which significantly exceeded our previous guided top end revenue of RMB106 million. We also saw a strong improvement in our bottom line, which will be discussed in further details by our CFO, Shawn Wang.

We continue to extend our lead as China's number one search engine as demonstrated by [emphatic] growth in the fourth quarter. According to a survey in January 2006, conducted by High Research, an independent research firm in China, Baidu further strengthened our position as the most frequently used search engine in China, with 66.6% of Chinese search users choosing Baidu to conduct Internet searches on a regular basis compared with 44.7% in 2004. The survey estimates that the gap between us and the competition is widening. We believe this trend is a result of our focus on providing the best search experience for our Chinese users.

The Baidu brand continues to grow stronger in China, thanks in part to the effect the IPO had on our brand recognition, the popularity of our product and services, and the growing awareness by Chinese companies that keyword search can bring real gains.

In the fourth quarter, we saw strong performance from our Guangjo direct sales office, which we opened during the third quarter. We also strengthened our distributor network. These initiatives helped to attract new customers and reinforce loyalty for existing customers.

As a result, we saw an increase in the number of our active online marketing customers from 53,000 to 63,000 during the quarter and we saw spending per customer increase by approximately 10%.

We continue to see tremendous potential for China's search market. It is growing faster than the overall online marketing sector, with strong results that this trend will continue.

In order to fully benefit from this growth and ensure our long-term success, we are concentrating our efforts in several areas. Firstly, we continue to focus on providing the best search experience for our Chinese users. We are monitoring consumer trends very carefully in order to stay ahead of our user preferences and develop the product and services most valued by Chinese users. Our deep understanding of the needs and habits of the Chinese Internet user is a key advantage for us in the area of user experience.

Secondly, we are growing our direct sales force as well as our distributor network. Our on the ground sales team allows us to deliver a high level of service to more mature advertisers based in large and more developed cities; while our distributor network reaches the rapidly growing SME customer base with less sophisticated marketing. As our results demonstrate, this strategy is paying off well for us with strong customer base extension and increased spending per customer.

Finally, we are investing in the future, especially in technology, R&D, management infrastructure and in people. We continue to place great emphasis on hiring the best talent in the business. Beyond our reputation as the leading search engine in China, we are building a strong reputation as a great place to work, and I am proud to tell you that Baidu was named one of the top 10 employers of the year in 2005 by China Central Television.

We are very confident that our focus and marketing efforts position us well to take advantage of the vast potential of China's search market. Now I will hand the call over to Shawn Wang, our CFO, to discuss our financials.

Shawn Wang

Thank you, Robin. I will first lead you through our fourth quarter results and then summarize the full year developments. The figures I discuss today are in RMB unless otherwise stated.

Our strong financial results in the fourth quarter and the fiscal year 2005 reflected continued traffic growth, customer base extension and new [scaleable inaudible] in our [frequently visited inaudible].

As Robin said, we exceeded our earlier guidance with a total revenue of RMB106 million for the fourth quarter. This represents a 29% increase from the previous quarter. Online marketing revenues, which account for 97% of the total revenues in the fourth quarter, were RMB112 million, representing a 30% increase.

The growth was due to our solid increase in the number of active online marketing customers and a moderate increase in per customer spending. Baidu had more than 63,000 active online marketing customers during the quarter, representing a 19% increase from the previous quarter. Average revenue per customer increased by 10% from the previous quarter to over RMB1,700.

The number of online marketing customers and spending per customer are very important metrics to measure Baidu's performance, and we are very encouraged by their rate of growth.

On the network operations side, a major data center expansion was largely completed by the end of the third quarter. As a result, in the fourth quarter depreciation expenses and bandwidth costs remained at similar levels as the previous quarter and capital expenditures in fixed assets declined.

The frequency [inaudible] mentioned depends on the growth rate of our traffic. While we will continue to incur capital expenditures, we currently do not expect network-related CapEx increases in the immediate quarters to be at the same pace as Q305.

Selling, general and administrative expenses for the fourth quarter were RMB42 million, representing a 41% increase from the previous quarter. This increase was mostly driven by the head count addition in sales during the quarter, and by incremental expenditures associated with being a public company. SG&A expenses as a component of total revenue were 37% for the quarter, compared to 34% in Q305.

Operating profit on a GAAP basis were RMB14 million, representing a 106% increase from the previous quarter. Operating profits include a share-based compensation expense -- a non-GAAP measure -- which was RMB25 million for the fourth quarter, a 39% increase sequentially.

Now turning to non-operating items. Interest income doubled from RMB4 million in the third quarter to RMB8 million. This increase was due, for the most part, to the increased cash balance from the IPO proceeds. During Q4, we reported a net income tax benefit of RMB2 million as compared to the net income tax expenses of RMB2 million in the third quarter. The Q4 tax benefit included mainly two items: incremental current quarter deferred tax asset of RMB1 million; and the reversal of RMB3 million valuation allowances against deferred assets, which were recorded in the past three quarters.

Turning to our bottom line, our net income, excluding share-based compensation, was RMB35 million. This represents an 81% increase from the previous quarter. EPS, excluding share-based compensation, was RMB1.06, equivalent to US$0.13.

Net margins, excluding share-based compensation for the fourth quarter, were 30% up from 22% in the previous quarter. Operating cash flow for the quarter was at RMB16 million, representing a 16% sequential increase.

Now turning to fiscal year 2005 results, total revenues for the year were RMB319 million, representing 172% increase from 2004. Online marketing revenue was RMB307 million, representing 188% increase from 2004.

We made significant investments in several areas in 2005, namely technology, marketing, distribution infrastructure and human resources, which increased our total operating costs and expenses to [RMB283] million from RMB106 million in 2004. Accordingly, depreciation expenses as a component of cost of revenues increased [inaudible] to RMB25 million and bandwidth costs increased 1% to RMB21 million.

Capital expenditures in 2005 totaled RMB89 million, up 249% from the previous year. SG&A expenses in 2005 were RMB112 million, representing an increase of 187% from the previous year. This is mainly due to our increased investment in branding, the expansion of our direct sales force, strengthening our distribution network as well as incremental expenditures in the third and the fourth quarter associated with being a public company.

R&D expenses totaled RMB34 million in 2005, representing a 202% increase from the previous year, primarily due to expansion of R&D head count. On non-operating items, we saw a significant increase of interest income from RMB1 million in 2004 to RMB14 million in 2005. This increase is primarily due to the IPO proceeds and accumulation of free cash flows from operations.

Income tax increased to RMB2 million in 2005 from RMB0.5 million in 2004. The increase was mainly due to the significant growth in total revenues and taxable income in 2005. Our effective tax rate in 2005 was around 4% at a similar level to that of 2004.

Net income, excluding share-based compensation for fiscal year 2005 was RMB81 million, representing 185% increase from 2004. EPS, excluding share-based compensation, for 2005 was RMB4.1.

Moving on to our balance sheet, we ended the year with cash and cash equivalents of RMB901 million. Our net operating cash flow for fiscal year 2005 was RMB162 million compared to RMB57 million in 2004. As previously announced, we plan to build a new headquarters in Beijing. The aggregate consideration for acquiring the land use rights is approximately RMB92 million and we have made a prepayment of RMB77 million against our non-current assets.

In summary, we had a very solid quarter, as well as a very solid year. We will continue to invest aggressively and are confident that our focused investments will produce strong future growth.

Now let me provide you our top line guidance for the first quarter of 2006. As you may be well aware, our Q1 results tend to be affected by the seasonality by the long Chinese New Year holiday. In Q105, our revenues grew 6% sequentially from Q404. For the first quarter of 2006, we currently expect total revenues to be in the range of RMB125 million to RMB130 million, which will represent a quarter-on-quarter growth of 9% to 13%.

I do wish to emphasis 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 again for joining us today. We are very proud of the progress we have made in a relatively short time. Going forward, we will continue to execute our winning strategy of listening to our customers and users and providing them the best user experience. Today, we are excited about what is to come in the Chinese Internet industry and we have never been more confident in the future of Baidu. I will now open the floor for questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Your first question comes from Jason Brueschke with Citigroup. Please proceed.

Jason Brueschke - Citigroup

Good morning, Robin and Shawn. First of all, congratulations on a very super quarter. I will limit myself to two questions. The first question is, it looks like the number of new customers flowed in the quarter, both in terms of a percentage basis and an absolute turn. My question is, are we seeing the effects of competition coming in and making it harder for you to add new customers, or is this more a function of say, seasonality at the end of the year?

Robin Li

I would say Q3 is a very special quarter to Baidu where we had our IPO, so the number of new customers added during that quarter was kind of special. Also, we do not expect, percentage-wise, the number of new customers to grow at the constant rate, that is not the realistic target. We are actually very happy about the pace we are adding new customers at the Q4 rate. At the end of the day, two metrics decide our success, initially. The number of active online marketing customers, as well as the per customer spending. I would like you to review both metrics going forward.

Shawn Wang

And if I may just supplement that as well, there is a small factor of [reduced] mass. You see in Q4 that we have China's national holiday, that is roughly a week off from the third quarter. So that is a factor also. I think the primary reasons are what Robin alluded too.

Jason Brueschke - Citigroup

Okay, great. My second question is, there have been some recent reports about music piracy crackdown by the Chinese government, they seem to have closed around 75 or so pirated music sites. Can you describe for us what the impact is on your business, what is going to happen, if this move continues? Because on the one hand, if it becomes harder to find these music sites we could see that people are using Baidu to search out and find them more. But on the other hand, if the government really were to crack down significantly across the board on music, I know that is a material part of some of your traffic with young people, at least. How do you think this plays out?

Shawn Wang

This is Shawn again. First of all, I think it is very important that we all understand that Baidu is the leader in information search, and that certainly includes the information of an entertainment nature. We see that a properly licensed digital entertainment market is fundamentally strong and good for Baidu's future. So I think we are encouraged by some of the ventures the government has taken.

Now at the same time, Baidu is in the business of providing search and we are not related to any of the music download and upload activities. So we have not seen any changes in the way that our users come to search information on our website. We have not seen anything as a result of what you alluded to, affecting the way we operate and how we conduct ourselves.

Jason Brueschke - Citigroup

Great, thanks again. Congratulations again.

Robin Li

Thank you.

Cynthia He

I would like to remind everyone that we are limiting the question-and-answer session to one question per person at one time. If you have more than one question, please go back to the end of the question-and-answer queue and we will give you an opportunity to ask your questions again. Thank you.

Operator

Your next question comes from Anthony Noto with Goldman Sachs. Please proceed.

Anthony Noto - Goldman Sachs

Thank you. Hi Robin and Shawn. I was wondering if you could comment on what the revenue in the quarter was from acquisitions? Then I will ask my second question back in the queue. Thank you.

Robin Li

Anthony, we did not execute any material acquisitions during the past quarter, so there was not a material addition to revenue that was a result of acquisitions.

Anthony Noto - Goldman Sachs

Thank you.

Operator

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

Safa Rashtchy - Piper Jaffray

Good morning, Robin and Shawn, congratulations on a good performance. Could you talk about the level of investment that you are making in R&D in particular, I noticed that dropped down and I realize some it may have to do with the depreciation comments that you had, Shawn.

But given the competitive environment, could you assess for us how you see the competition, especially from Google and some of the other players? What level do you think you need to sustain to effectively compete and improve on your technology? Thank you.

Shawn Wang

Let me take on the first part, Safa, and I will leave the competition part to Robin to talk a bit. With R&D, understand the R&D expenses mostly relate to the head count. Our R&D expense remained at a similar level, where in Q3 there is a pretty significant jump and that coincides with the summer season, our new recruits came to join us. Also, partly because of the half year bonus.

Robin Li

A pretty good bump in August. So there are not any material changes in terms of the R&D efforts, and our R&D team has been strengthened very much during the year and working on projects. They are very excited in the future to come.

Safa Rashtchy - Piper Jaffray

Okay.

Robin Li

Safa, I think in terms of R&D we have been very aggressive during the last part of Q4. We were as aggressive as before. We try to hire as many engineers as possible as quickly as possible. So far, we have a very stable and growing engineering team and we will continue to try to attract more talent, especially technical talent.

Operator

Your next question comes from Richard Ji with Morgan Stanley.

Richard Ji - Morgan Stanley

Hi Robin and Shawn. I just want to find out, what is the retention rate of your existing online marketing customers?

Shawn Wang

We have not discussed that metric in the past and we are not changing that practice at this time. We are very confident that there are increased levels of customer loyalty to our particular business. I think it is really gaining momentum.

Robin Li

Let me add a few more words. Pay for performance, it is a new business model in China and more and more companies are now realizing the benefit, the superb ROI of this business model. So as companies understand more about search promotion, search marketing I think they will be more loyal to our business than any other competing business.

Operator

Your next question comes from James Mitchell with Goldman Sachs. Please proceed.

James Mitchell - Goldman Sachs

I want to talk a little bit about TAC, traffic acquisition costs. It looks like it was up around 50% quarter on quarter, outstripping the growth in revenues. Thank you.

Shawn Wang

There is a slight increase in terms of the ratio to revenue, which reflects our extension of our third party unit traffic, which we are very successful. It doesn't necessarily reflect any changes in the cost-sharing arrangement, rather the incremental traffic.

Robin Li

In addition to growing organic traffic, we do partner with many of the smaller content providers, as many of the content providers are realizing a search could bring them more benefit in terms of revenue generation. We may see more revenue coming from partner sites.

Going forward, we would like to maintain the flexibility of growing the organic traffic and the partner traffic, but right now I don't see anything material going on between the third quarter and fourth quarter.

Operator

And your next question comes from Leah Hao with Thomas Weisel Partners. Please proceed.

Leah Hao - Thomas Weisel Partners

Hi, good morning Robin and Shawn. I have a question regarding your strategy on direct sales force versus using distributors. First of all, in Q4 results your average spending per account, could you give me a breakdown in terms of the benefit from switching from a distributor to direct sales force, versus the pricing increase?

Secondly, if you could lay out your progress and your plans for switching over to a direct sales force in Tier 1 cities versus Tier 2 and Tier 3 that would be great. Thank you.

Shawn Wang

Let me first address the point in terms of our increase in customer spending. The direct sales efforts were recent efforts that we committed to mostly do in 2005. To understand our business is a [recurring] business in nature, so a lot of the direct sales effort for the new customer base doesn't necessarily add to the revenue base [inaudible].

Robin Li

From an accounting sense, these are expenses but it is actually an investment in building a customer base for the longer term. So a short answer to your question is, there are not any material changes as we develop the direct sales that are adding to the per customer spending.

Also, we are not switching from the distributor model to a direct sales model. We [aren't just seeing] the mature market, but before the IPO we acquired the Shanghai distributor because the Shanghai market was more mature. Now we are operating a meaningful team in Guangjo because that market is also mature.

China is a big country. There are a lot of places that feel very, very under-penetrated in terms of paid search, and we will continue to rely on our distributors in those areas to bring business to us.

In terms of average spending per customer, at this time it has nothing to do with the balance between direct sales and the distributor network.

Operator

Your next question comes from [Tan Ke] with [Owens] Technology Research. Please proceed.

Tan Ke - Owens Technology Research

Good morning Shawn and Robin. One question, before a Company can become your customer, is it necessary for that Company to have a website?

Shawn Wang

Yes or no. The company needs to have a website in order to use our paid search platform, but a vast majority of our distributors do have a business that constructs websites for companies that do not have one yet. So it is not really a limiting factor.

Tan Ke - Owens Technology Research

Okay.

Operator

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

Robert Peck - Bear Stearns

I was wondering if you could touch a little bit on the ROI. You said ROI has been improving for your advertisers. Could you give us a little more color around some of the certain metrics, where you are seeing the cost per clicks growing, the click through rate and then ultimately conversion rates into sales. If you could just touch, qualitatively, on what you are seeing directionally on those items?

Robin Li

Well I did not say ROI was improving, I just said that the ROI for our paid search is much, much better than any alternatives on the market right now. As we stated previously, we do not disclose the cost per click or click through rate because we don't think it is the right metric to track this business.

In terms of managing ROI, different customers do have different ways of doing that. We are helping some of the larger customers do more data analysis on the click through rate, the lead generation as well as some of the other metrics they prefer to use. But at the end of the day, people are very, very happy about our business and results we can generate for them. They can really measure the results, especially for the small and medium enterprises by the number of orders they tend to make after spending a certain amount of money on our website. I think that is the most important thing to our customers.

Operator

Your next question comes from Tony Tang with Lucite Research. Please proceed.

Tony Tang - Lucite Research

Hi, good morning. My question is regarding your traffic costs. I do recall that number is around 8% of revenues for 2005. However, Google reports this number around 80% of its total network revenues, and around 35% of total revenues. So I just wonder why your number is so low, and then what other components are traffic costs for you? In the future, how should we put that number? Thank you.

Robin Li

Tony, this is Robin. I think we are at different stages of development for the search market. In China, search is still a very young and our organic strategy is growing very, very fast. So a majority of our revenues are generated from our own website's traffic. On the other hand, we are quite often to work with content providers to help them monetize their traffic. We are seeing more and more websites who realize that search can bring them additional revenue. That is why we have a line of business that works with the content partners.

In terms of revenue sharing, we actually can add more value than simple money. We work with those content partners to help them to grow their own traffic to grow their own business. We have a long-term relationship with many of the partners. They believe in us, they have confidence that a partner with Baidu will bring them more and more benefits.

Operator

Your next question comes from Robert King with Peninsula Capital. Please proceed.

Robert King - Peninsula Capital

Hi Robin and Shawn. Bob King here. How are you?

Robin Li

Hi Bob.

Robert King - Peninsula Capital

Congratulations on that year end number, 66.6% is just terrific in terms of execution on your part. Relative to MP3 search, in terms of it being a share of total searches, can you give us some sense as to where we are today and the direction it is moving? Is the sheer MP3 of total number of searches, is it increasing, decreasing? Where are we today on that?

Robin Li

Bob, as you know, we do not disclose the traffic breakdown for different types of searches, but as a reference point you can go to Alexa.com and see a relative distribution of our traffic. I believe that number is around 15% of the total traffic.

As we said before, we focus on providing the best user experience for our Chinese search users and as you know, the most important information needs is to do a web page search. We did aggressively move out in areas like [inaudible] or annex search, so far. The [inaudible]-based community has been doing very well and our knowledge search, I do know, is now the number one knowledge search site in China. We launched that in June of 2005 and by November of 2005 we already became the number one knowledge search website.

Operator

Your next question comes from Wallace Cheung with Credit Suisse. Please proceed. Mr. Cheung.

Wallace Cheung - CSFB

Hello.

Robin Li

Hello, Wallace.

Wallace Cheung - CSFB

Hi. Congratulations Robin and Shawn on the great results. I am sorry that I am actually a little bit late to the conference. Has someone actually gone through percent of the costs?

Shawn Wang

Twice already.

Wallace Cheung - CSFB

Okay, sorry. Okay. Let me ask some questions -- how do you see the overall page search market grow in terms of year over year revenue growth in this year? Also, I think the first quarter revenue guidance is pretty encouraging, and even so far as the full quarter gross revenue absolute number. It seems to me before -- I accept there should be some seasonality in 2005 and it seems like -- do we expect similar seasonality that happened to replicate in 2006 and 2007 as well?

So there are two questions. The first is the overall growth in '06 and seasonality in '06. Thank you.

Shawn Wang

That is a lot of questions. In terms of the seasonality, if you look at the quarter on quarter growth, Q4 over Q3 of 2005 was a 29% sequential growth. For Q1 of '06 we are guiding about roughly 9% to 13% of growth. So that shows the seasonality of this business.

However, we do believe that the online search market is growing at a rate much faster than the overall online advertising in China. Baidu has a large market share in China's search market and we are expanding quickly. In addition to the [market] factors such as Internet penetration rates, there is a market maturity of the page search, the SMEs understanding of the Internet business, Baidu's execution will by and large dictate the market growth going forward.

Operator

Your next question comes from Andrew Collier with New York Global Securities. Please proceed.

Andrew Collier - New York Global Securities

Yes, good morning and thank you. Could you comment a bit on Google? What kind of impact are you seeing or if you are not seeing any impact at all at this point, what do you expect there might be some impact of in terms of revenue generation for both your own sales force and your distributors?

Robin Li

We are not the first one to pilot a Chinese search in this market. We were actually later than Google. We quickly caught up and surpassed everyone in this market in terms of traffic. Now we are generating more and more revenues. We believe longer term, as long as we focus on what we do best and we focus on providing the best Chinese user experience, we will be able to maintain and extend our current leadership position.

Sometimes competition will actually do us benefit because the market is so early and more market agitation is bringing more customers for the paid search.

Operator

Your next question is a follow-up from Anthony Noto with Goldman Sachs.

Anthony Noto - Goldman Sachs

Thank you. Robin and Shawn, there have been a lot of questions about acquisition costs and other investment spend. I am just wondering if you can give us some perspective on a band of operating margin, excluding stock-based compensation. Do you think that can be achieved in 2006? And to help you frame it, the margins were down in full year 2005 given the investments that you made in going public and as well as some other employee hires. Do you see significant leverage in 2006 at the operating margin line to get margins back to the 70% range? Or, is it going to be more muted in terms of numbers? Thank you.

Shawn Wang

Anthony, as you know, we are a relatively young company operating a very dynamic and early stage market. Our objective at this point is to provide [top line gains] quarter on quarter. Also as we told you during our presentation, we are very confident in our ability to compete in this market. I think the resource and investment it has [inaudible].

Some of the investment you have seen in 2005, for example the bump in G&A expenses associated with being a public company, that is highly [scaleable]. The bump in interest in 2005, if it [inaudible] area. [inaudible] So say for argument, may be late for some of the other items. I can't give you any more details about it, but we are confident.

Operator

Your next question is a follow-up from Safa Rashtchy with Piper Jaffray.

Safa Rashtchy - Piper Jaffray

Thanks, my question has been answered.

Operator

Your next question is a follow-up from Jason Brueschke with Citigroup. Please proceed.

Jason Brueschke - Citigroup

My follow-up is a follow-up actually to Anthony's last question and that is, Shawn you said in your prepared remarks that you don't expect in the immediate quarter a need to do another data center expansion or major investments in your infrastructure. Should we be thinking that this is something likely to happen in the second half of the year as your traffic demand continues to grow? Or should we be thinking that really, the rest of 2006 you are really in a good position because of the investments that you made in Q3?

Shawn Wang

I think there are two points worth noting. One is the fact that our pace of data center expansions is a function of our traffic growth. The traffic growth itself, we may be looking to the crystal ball to tell you what [inaudible]. What I can also tell on the second point is, if you notice during Q3, especially in Q3 our CapEx spending was closer to the level of spending that we incurred in Q2. That is a very significant bump.

What I am telling you is we will continue to incur CapEx, we will continue to add servers and upgrade our servers, but we will not be at the level of the increase that we experienced in Q3.

Robin Li

Also I would like to add that data center expansion is a good problem for us to have. The more traffic we can attract the better we position Baidu to benefit from the rapidly growing China Internet market.

Operator

Your next question is a follow-up from Richard Ji - Morgan Stanley.

Richard Ji - Morgan Stanley

Hi, Robin and Shawn. I have a question regarding competition. Especially in the geographic breakdown of the customer base. Maybe you can give me some color about what advantage a customer coming from the [inaudible] space. Thanks.

Shawn Wang

Our customers, there is not a special pattern. I think it is pretty much given that we have a fairly large customer base. Our experience has been that it coincides pretty much with the degree of economic development throughout China.

As we told you during our road show, we have over 60 distributors are scattered throughout China. In some of these economically active regions, we certainly have more presence and we do see our customers spending are coinciding with that pattern.

Robin Li

Also, I think the more mature the market, the more revenue we can generate, even percentage-wise. So for all of the major city areas, we are doing very well. As more companies realize how search works, why search is much better than any alternatives, they will stay with us and spend more and more on our platform.

Operator

Your next question is a follow-up from James Mitchell with Goldman Sachs. Please proceed.

James Mitchell - Goldman Sachs

Thank you. This is a follow-up to Lea's question earlier. I guess if I am a keyword buyer in Guangjo previously I was buying from one of your distribution agents, so that the revenue you would have reported from me would have been two-thirds of what I was actually spending, with the other one-third going to the discount to the distributor.

When you take [inaudible] and the revenues you report from me personally would increase, I guess by up to 50% because you recapture the distribution discount. Was that process of recapturing distribution discounts material in terms of your quarter-on-quarter revenue per customer growth, or was it immaterial?

Shawn Wang

James, this was not material.

Robin Li

The Guangjo sales just started in Q3. The initial [percentage] was more of the increase in terms of number of new customers we can attract. In terms of spending power, it is going to take some time to see the real effect. But percentage-wise, Guangjo still represents a small percentage of the overall China market.

Operator

Your next question is a follow-up from Tony Tang with Lucite Research. Please proceed.

Tony Tang - Lucite Research

My question is about the technology side. Could you comment about what your R&D investment plan is for the next 12 to 18 months? What type of technology are you looking at and developing right now?

Robin Li

As I said before, we are very focused as a Company. We believe that the search marketing in China is growing very, very fast and there is still a lot of potential here. We are probably the only publicly listed company that is focusing exclusively on Chinese search. That has been our strategy and will be our strategy going forward.

Our investments in terms of technology still largely surround the Chinese search problem. Most of our efforts are still on the existing product, especially web page search, as well as some of the community search services. Going forward, we will continue to carefully study consumer trends to find out what new search needs they will have and then we roll out new services to satisfy their needs.

We decided not to use new product launch as a PR strategy, so we don't merely talk about new products before those new products become a significant contributor to our traffic and user base.

Operator

Your next question is a follow-up from Wallace Cheung with CSFB. Please proceed.

Wallace Cheung - CSFB

Can you give us a bit of an update on the new building plan? You have already spent around RMB77 million as a pre-payment for the land usage rights. So what timeline can you launch the new building, and the CapEx to spend in the next few years time?

Also, any update in terms of the marketing plan and spending in 2006? Both regarding the advertising and number of new hires for your sales and marketing people. Thank you.

Shawn Wang

Wallace, let me just give you a quick update on the building plan. We signed a contract to acquire land use rights, and that is really step one. The land use right is over RMB90 million and we paid the first down payment, RMB77 million. We are still waiting for the final number and we are in the process of evaluating our architecture. So it is a very early stage right now.

The timetable for a building of such scale to be completed I think will be roughly two to three years. There are still a lot of approvals it has to go through and we are very excited that we will have a campus. It will take some time to complete.

Operator

Your next question is a follow-up from Andrew Collier with New York Global Securities. Please proceed.

Andrew Collier - New York Global Securities

Yes, thank you. The 10% increase in average spend per customer, did that primarily come from your existing, your older customer base in the Beijing, Shanghai, Guangjo areas? Or are you seeing a fairly even pattern of expenditures between old and new customers?

Shawn Wang

Well the new customers, definitely the new customers as they come in through all the different times in the quarter, the addition of new customers will have a effect on the per customer spending. So the increase actually would come from mostly existing customers in most parts.

The key message, I guess is that this business is not really limited by customer buying power, it is more limited by market maturity, the amount of related traffic we can offer.

Operator

(Operator instructions) Your next question is a follow-up from James Mitchell with Goldman Sachs. Please proceed.

James Mitchell - Goldman Sachs

Thank you again. Sorry for pestering you. I believe that earlier you mentioned that the R&D costs were unusually high in the third quarter because you paid a mid-year bonus. Going forward, would you pay mid-year and full-year bonuses to all of your staff, or just your R&D staff? Does that mean that your operating expenses will be higher every first and third quarter, or will you accrue them evenly through the year?

Shawn Wang

We are actually harmonizing -- the overall compensation is being reviewed now for some time in the recent past. I think that some of the component is that we will try to reward our staff, leading towards more cash components versus in the past, or pre-IPO where there was a decent amount of option or share-based compensation. Going forward, we will focus more on cash and also, there will be a more even, equitable bonus in place.

Operator

Your next question is a follow-up from Wallace Cheung with CSFB. Please proceed.

Wallace Cheung - CSFB

Hi. Can you give some guidance on the effective tax rate in 2006 and 2007? Any reasons why the effective tax rate also appears to be low? Thank you.

Shawn Wang

Well the effective tax rate in '04 and '05, as you know, are actual statutory tax rates during those two years of [7.5%]. With the operations in China, where our net [inaudible] was [23%]. Our effective tax rate was relatively lower due to a number of factors, one was the tax holiday itself, and also there are some deferred tax assets that you can see. The tax asset relates to the fixed asset, the CapEx that we invested in during the year.

Now into 2006 and 2007 there are a number of factors that will make the -- there are a couple of factors that need to be considered. One is that we are growing our Southern China operations significantly. We are contemplating the set-up of a new investment entity in Southern China. This new entity, we are expecting some additional tax holidays to be granted to that entity, but the details are subject to confirmation with the local Chinese government.

Whereas our existing operations in Beijing, the effective tax rate -- our statutory tax rate will increase to 15% so that would be -- that would give us a bit of higher tax for the Beijing operations.

So put that all together, it would be -- the tax rate will be somewhere in-between, and also will be affected by the pace of our investment.

Operator

Ladies and gentlemen, we are approaching the end of the conference. If there are no further questions, I will turn the call back over to Robin Li.

Robin Li

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

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation, you may now disconnect. Good day.

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Source: Baidu.com, Inc. Q4 2005 Earnings Conference Call Transcript (BIDU)
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