Baidu Fends Off China Slowdown

| About: Baidu, Inc. (BIDU)

After the bell on Monday, shares of Chinese internet giant Baidu (BIDU) reported its second quarter earnings. Overall, the numbers were good, and shares were up in after hours. Let's look at what Baidu reported.

Second Quarter Results:

Baidu reported revenues of $858.8 million, a 59.8% increase over the prior year period, which beat analyst estimates for $850.78 million. However, that number was just slightly ahead of the midpoint ($857.1 million) guidance that Baidu gave when it reported Q1 results (a range of $847.2 to $867 million). At that time, analyst estimates were for $860.2 million. So really, although Baidu beat, it only beat because expectations were lowered.

On the bottom line, Baidu crushed estimates, reporting $1.26 versus estimates for $1.12. This was the largest beat in a year, as Baidu had only beat by one penny in each of the past three quarters.

Margin Analysis:

The following table shows Baidu's Q2 primary margins over the past few years.

Q2 Margins 2009 2010 2011 2012
Gross 63.68% 72.92% 74.22% 72.36%
Operating 38.53% 50.76% 54.42% 51.59%
Profit 34.92% 43.74% 47.81% 50.37%
Click to enlarge

Baidu did see gross and operating margins decline a bit this year, but they still remain at healthy levels. Baidu's cost of revenues increased by 71.3% for the period, well above the 59.8% increase in revenues. That accounted for the drop in gross margins. Baidu also saw research and development expenses climb by more than 82.6%, which pressured operating margins.

However, Baidu saw its effective tax rate drop from 14.88% in the prior year period to just 7.89%. That explains why Baidu beat by so much on the bottom line, despite the decreases in both gross and operating margins. Had the tax rate been closer to the recent three year Q2 average of 13.67%, Baidu earnings would have been around $1.16. That would have been just a 4 cent beat, a dime less. According to Baidu, the change in tax rate was due to the following:

"The decrease in effective tax rate was due to a reversal of a tax provision the Company booked in 2011 for one of its subsidiaries at a non-preferential tax rate. This subsidiary has obtained a high and new technology enterprise tax license in the second quarter."

Balance Sheet Update:

Baidu has worked to continually improve its balance sheet over the past few years. Here are some key financial numbers, at the end of the second quarter for each year. The working capital number is in Renminbi thousands. In terms of working capital, Baidu had about $2.5 billion dollars at the end of Q2.

Key Financials 2009 2010 2011 2012
Current Ratio 3.98 3.78 3.67 4.69
Debt Ratio 19.28% 21.34% 22.18% 26.32%
Working Capital 2,682,526 4,588,965 8,141,401 15,980,534
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Baidu nearly doubled its working capital over the past year, which has really strengthened the current ratio. However, the debt (liabilities to assets) ratio has increased in each of the past three years. This isn't a concern at the moment, but if this ratio keeps climbing, it could eventually become one.

Third Quarter Guidance:

For the fiscal third quarter, Baidu guided revenues in a range of $983 million to $1.009 billion, which gives a midpoint of $996 million. Currently, analysts are expecting $988 million. Unlike last quarter, Baidu's guidance is ahead of expectations, which contributed to Baidu's after hours rise on Monday (more on that later).

Looking Forward:

Baidu is looking to strengthen its presence in the Chinese search market, as it competes with global giant Google (GOOG). One positive announced during Q2 was a deal with Apple (AAPL). Under the agreement, Baidu will make revenue sharing payments to Apple, but Baidu states that these payments are similar to deals that use Google's Android operating system. Baidu's search will be available on the iOS 6 operating system for iPhones and iPads. According to reports, Baidu maintains a roughly 50% market share in mobile search. But one analyst believes that while Baidu is the leader in mobile search, it only maintains a 34% market share, despite what the company might say.

Baidu's deal with Apple will only increase its presence in the mobile search market. Baidu is also looking to produce its own phone, but the deal with Apple will suffice for now. Baidu has an 80% market share in PC searches, so it is looking to gain ground in the mobile search area.

Conclusion:

Baidu has recently traded at levels not seen since late October. Baidu was over $150 earlier this year, but the guidance given at the last report helped to pressure shares over time. Fears that China is slowing faster than expected have not helped.

In after-hours trading on Monday, Baidu was trading up about $6 to $113. Today's earnings report was decent, although most of the bottom line number was helped by that tax issue. Baidu's guidance was above expectations, so fears that Baidu is slowing fast like China may be alleviated for now. I would expect today's news to help shares for the short term, but for the longer-term, Baidu will still need to consistently beat estimates.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AAPL over the next 72 hours.