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Baidu.com, Inc. (NASDAQ:BIDU)

Q2 2008 Earnings Call

July 23, 2008 8:00 pm ET

Executives

Helen Zhang - Senior Manager, Investor Relations

Robin Li - Chairman of the Board, Chief Executive Officer

Jennifer Li - Chief Financial Officer

Haoyu Shen - Vice President of Business Operations

Peng Ye - Chief Operating Officer

Analysts

Gene Munster - Piper Jaffray

Dick Wei - J.P. Morgan

Kathleen Nu - Citigroup

Eddie Leung - Merrill Lynch

C. Ming Zhao - SIG

Richard Ji - Morgan Stanley

James Lee - Sterne Agee

Car Kwan - Needham & Company

Eric Wen - Main First

Leah Hao - Goldman Sachs

Stephen Ju - RBC Capital Markets

Jason Helfstein - Oppenheimer

Operator

Good evening and thank you for standing by for Baidu's second quarter 2008 conference call. (Operator Instructions) I would now like to turn the meeting over to your host for today’s conference, Helen Zhang, Senior Manager of Investor Relations at Baidu. Please proceed.

Helen Zhang

Hello, everyone and welcome to Baidu's second quarter 2008 earnings conference call. We distributed Baidu's second quarter 2008 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 Jennifer Li, Baidu's Chief Financial Officer. After their prepared remarks, Robin and Jennifer will be joined by Peng Ye, Baidu's Chief Operating Officer, and Haoyu Shen, Baidu's Vice President of Business Operations, to answer your questions.

Before we continue, please note that the discussion today will contain forward-looking statements made under Safe Harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Baidu does not undertake any obligations 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.

Robin Li

Hello, everyone and thank you for joining us today. We are pleased to report that in the second quarter of 2008, we exceeded the top end of our revenue guidance with 100% year-over-year growth. Operating profit showed even better progress, growing faster than revenue and reflecting the scalability of our business model.

We increased both the number of active online customers and spending per customers. Despite the devastating earthquake in mid-May, we were able to enjoy yet another extremely strong quarter.

Since Baidu's inception, small and medium sized enterprises have been our most loyal customers. Across China, those businesses were the first to understand and appreciate the value of paid search. Over the past few quarters, we have seen more large enterprises beginning to realize the value on paid search marketing.

The entry of large enterprises into our customer mix has created a considerable pool of customers who can enjoy Baidu's bundled product. An expanding reliable customer base contributes to the strength and stability of our business.

Our business has been resilient in the face of market turbulences, such as the snowstorms of Q1 and the earthquake this past May. A new development this quarter has been the launch of My Marketing Center. Over the past few years, we have had requests from our customers for tools that will help them make better marketing decisions. My Marketing Center is a customized online platform that integrates industry information, market trends, and business and industry news.

Every online marketing customer, regardless of size and spending, is given access to this platform. My Market Center combines Baidu's vast resources in online information to enable customers to improve their marketing strategies. So far, our customers have been quite pleased with the service.

We are also always looking for ways to improve our sales and marketing strategies. One change we made in the second quarter was to consolidate three sales offices in Southern China. The set-up of our Shenzhen office is progressing well and we are able to close nearby offices in Zhongshan and Foshan, bringing the accounts served by those offices under the direction of the Shenzhen office. We expect this will bring greater productivity to the region and better service to our customers in that area. We see this as a clear move towards greater operational efficiency.

As always, at Baidu we listen to our users and provide the product and services they demand. We recently created [inaudible] from our homepage to two of our increasingly popular services, video search and Hao123.

Video search directs users to video content through keyword search. Traffic to our video search portal has been growing rapidly. Hao123 is an index of most popular Chinese websites and [inaudible] that allows users to click through navigation to find desired information. To many local Internet users, it is easier to find a desired website by click-through than typing a URL address or keyword. Hao123 is one of the most common used default homepages in China and is gaining traffic quickly. This site is an important supplement to our keyword searches and have contributed to improved user experience and increased traffic.

Turning now to some of our other important initiatives, our C2C platform is moving along as planned and we expect a formal launch before the end of the year. We have hosted some promotional activities in various test regions of China and we expect a successful launch.

For Baidu's Japan operation, we continue to concentrate on product development. We anticipate this will be our focus for the remainder of 2008. Aside from the four products we have already launched in Japan, we are localizing additional products. We are happy with the progress of our Japan operations to date and look forward to further development ahead.

With that, I will now turn the call over to Jennifer to go over this quarter’s financial highlights with you. Jennifer, please go ahead.

Jennifer Li

Good morning and good evening. As you have heard from Robin, it has been an outstanding quarter for Baidu. I will now lead you through our second quarter results, highlighting a few areas with more detailed explanation.

This quarter, despite some negative effect from the earthquake, we were able to generate total revenues of RMB803 million, exceeding our top end guidance and up 100% year over year. We increased our number of active online customers by approximately 41% year over year and increased revenue per active online marketing customer by 42% year over year.

Traffic acquisition cost as a component of cost of revenue in the second quarter were RMB102 million, or 13% of total revenue, a small decrease from Q108 and up from 11% a year ago. The increase over the year-ago level reflects continued growth of our revenue contribution from Baidu union, while the sequential minor decrease reflects normal fluctuations.

Cost of revenue excluding TAC was RMB179 million, representing 22% of total revenue, compared to 25% in the corresponding period in ’07. The decrease is mainly due to a decrease of bandwidth cost, depreciation, and operation costs as a percent of revenue, reflecting improved usage of infrastructure and operational efficiencies. Cost of revenue excluding TAC before share-based compensation was RMB178 million.

Total operating expenses were RMB245 million, a 95% increase from a year ago. Specifically, SG&A expenses increased 86% over a year ago due to the expansion of our direct sales force and increase in customer service staff to serve our growing customer pool.

R&D expenses increased 124%, mainly due to an expansion in headcount. Excluding share-based compensation expenses, SG&A rose 75% year over year and R&D expenses increased 123% year over year.

As Robin mentioned, our Japan operation is progressing well. Baidu Japan incurred operating costs and expenses in the second quarter close to RMB30 million.

Overall, we have seen improved profitability this quarter. Specifically, adjusted EBITDA, a non-GAAP measure, was RMB377 million for the second quarter, a 110% increase a year-ago period, and operating profit was RMB276 million, a 114% increase over the corresponding period in 2007. Both measures grew at a faster rate than revenue.

In the second quarter of ’08, our income tax expense was approximately RMB29 million. The effective tax rate for the quarter was 9.7%. Year-to-date, we have had an effective tax rate of 8.7%. The increase in tax expense over last year is mainly due to higher taxes applied to some PRC based subsidiaries, as their tax holidays either expired or partially elapsed. We estimate that for the remaining quarters of the year, the effective tax rate will likely be in the neighborhood of what we have seen year-to-date.

Net income for the quarter was RMB265 million, an 87% increase year over year. Net income excluding share-based compensation expenses, a non-GAAP measure, was RMB294 million, a 95% increase from a year ago. Basic and diluted EPS excluding share-based compensation expense were RMB8.6 and RMB8.46, translating roughly to $1.25 and $1.23 respectively.

Now, moving on to the balance sheet, we ended the second quarter of ’08 with cash, cash equivalents, and short-term investments of RMB1.9 billion, or $280 million. Operating cash flow for the quarter was RMB403 million, a 46% increase year over year. Capital expenditures for the second quarter was around RMB113 million. A portion of the capital expenditure was associated with the construction of Baidu's new campus facility.

We ended the second quarter with approximately 6800 employees. This reflects a 2% increase over last quarter. Most of the headcount increase during the quarter was in R&D, while sales, marketing, and customer service staff headcount remained relatively flat compared to the prior quarter.

As Robin mentioned, we have consolidated two South China offices into the Shenzhen office to increase efficiencies. The transition to a direct sales model in Shenzhen is progressing well, and we expect the productivity of local direct sales force to gradually improve in the coming quarter.

Now, let me provide you the top line guidance for the third quarter of ’08. We currently expect total revenues to be between RMB905 million and RMB935 million, which would represent year-over-year growth of 82% to 88%, and quarter-over-quarter growth of 13% to 16%.

During the third quarter, Beijing will host the 2008 Summer Olympic Games. It is a big and exciting event for the country. We believe the Olympics will be beneficial in the long run to our business and the Internet industry as a whole. More people will turn to the Internet to find information and more business in particular will come to appreciate the power of search in promoting their business. However, during the game period, we expect that our users may spend comparatively more time watching the games and less time online to search for business related topics. In addition, we expect that some businesses near Beijing will be affected and in some cases temporarily shut down.

Many new regulations have been imposed to lessen traffic congestion, control pollution, and maintain tight security during the Olympics. To the extent business cannot be carried out as usual, we expect some customers will scale back their paid search marketing during the games.

Due to potential user behavior and the possibility of scaled back business operations, we expect modest growth in total revenue in the third quarter. We are confident though that our strong growth trajectory will quickly resume after the Olympics.

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

I will now turn back to the Operator to open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Gene Munster with Piper Jaffray. Please proceed.

Gene Munster - Piper Jaffray

Good morning and congratulations. Obviously you gave upbeat guidance basically maintaining your estimates despite the fact -- or the street estimates despite the fact that the headwind of the Olympics. Can you walk through a little bit more in detail of how you calculate or anticipate that headwind? How you factored that in? Maybe some more specifics into how that actually was calculated? Thanks.

Robin Li

As we mentioned in the prepared remarks, we have never experienced an Olympics hosted in China, so there are some uncertainties. In the long run, I think it’s going to be a huge plus to Baidu because for every major event, lots of people talk about information they get from online, or specifically from Baidu. So that drives more people to come to Baidu in the future.

During the game time, it will probably affect about two months period of time, starting from July 20th to September 20th, where Beijing has traffic control and even before that time, some of the factories in Beijing and the surrounding province, [the cities] will shut down and some customers do not feel the need to do online marketing during that time.

Also, I think during the game period, the two, three weeks of game period, lots of people, consumers will spend more time watching TV and search for game related information, and we expect work related search volume will drop.

By factoring in all of this kind of factors, we believe that Q3 guidance would be the numbers we just talked about.

Operator

Your next question comes from the line of Dick Wei with J.P. Morgan.

Dick Wei - J.P. Morgan

Good morning and congrats on the good quarter. Just a question on the 3Q guidance as well -- I wonder if you have seen any of the, kind of the macro slowdown in China similar to the -- because we keep hearing news about credit tightening and SMBs shutting down, particularly in the Southern China region. I don’t know if you have factored any of those impacts on your guidance and probably just your view longer term in that respect -- any particular industries that you see impacted more? Thanks.

Robin Li

There are some difficulties in the southern region for a certain export and import related businesses, but Baidu paid search platform is suitable for all kinds of industries. We have a very diversified portfolio of customers. Plus the paid search market is still in its infancy as more and more companies realize that Baidu is the best way for them to promote their products and services. They come to us, so our Q3 guidance did not factor in any macroeconomic conditions for China. We believe that the strong growth of paid search in China will outweigh anything related to the macro economy.

Operator

Your next question comes from the line of Catherine [Nu] with Citigroup.

Kathleen Nu - Citigroup

Good morning. Can you please discuss the progress of the development in both Japan and C2C -- I know that you discussed this briefly in your prepared remarks. Can you maybe discuss and elaborate a little bit more what kind of products and what types of products you plan to introduce to Japan, what if any initial feedback has been, and could you also update us on the plan to spend for the second half of ’08? Thank you.

Robin Li

For Japan, I think our top priority is to really improve the quality of the existing four products. We have already gained good traction for our image search and video search for Baidu.jp, and we are diligently working on improving the quality of our web search and blog search. I think it’s going to take some time for us to really come out with a very competitive product in the mainstream Japanese search. We have shifted some of the product marketing assumptions from Tokyo to Beijing so that more people could work on those kind of products and services.

We are going to open a research center in, a research and development center in Shanghai later this year and initially, we will -- the main purpose of that center will be to serve our Japan related search applications.

Our C2C development is on track. As I mentioned, we are going to launch -- do a formal launch before the end of the year.

Jennifer Li

And Kathleen, just to your question on the spend expectation for the rest of the year for Japan, year-to-date we have incurred 8.6 million in total expenses. As Robin mentioned, we anticipate increased activities related to our Japan initiatives and our original estimate of $20 million to $25 million expenditure for the year, we continue to expect the expenses will fall within that range.

Operator

Your next question comes from the line of Eddie Leung with Merrill Lynch.

Eddie Leung - Merrill Lynch

Good morning, guys. Can you help us to understand more about your customer mix? In particular, the proportions of advertisers that are e-commerce related? Thanks.

Robin Li

Haoyu.

Haoyu Shen

Your question is the percentage of our customers related to e-commerce, right? I think it’s in general, Internet related industry is a big component of our customer mix, not necessarily e-commerce related, be it C2C or B2C. They are -- some of those customers are [the same thing] for us but in general as a percentage of total revenue, they don’t account for a big number.

Operator

Your next question comes from the line of Ming Zhao with SIG.

C. Ming Zhao - SIG

Thanks for taking the question. Good morning. Can you guys update us on how many large advertisers now are in your customer pool, and what kind of changes have you observed after launching that My Marketing Center? Is there any other plan for implementing more products like My Marketing Center in the future? Thanks.

Haoyu Shen

The number of large advertisers, or what we call brand advertisers, is in the hundreds every quarter and we are seeing a stable growth of that number over time.

As far as the My Marketing Center, that product we launched back in June. It does not specifically target large advertisers. We see a lot of value in that product for SMEs, and as far as going forward, we are definitely looking at more new products serving the needs of different kinds of customers.

Robin Li

And more importantly, for every new product launched, we will spend a lot more effort to improve the quality of that service. So any time we launch something, we will take some time to listen to the market and make the necessary improvements going forward.

Operator

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

Richard Ji - Morgan Stanley

Good morning. A question regarding some of your new initiatives, especially your new service, My Marketing Center. That sounds quite encouraging. Can you elaborate a little more on the type of value-added service that is included in My Marketing Center service? And what percentage of your customers are currently using that service and when do you expect such service will contribute material revenue? Thank you.

Haoyu Shen

We launched this product for only a month and a little over a month. It targets the current SME customers. It’s sort of a gateway for the customers. When they sign in, they come to this page, they see information related to their accounts. They also see information related to their own business, information related to their industry, news and news alerts or what have you. It very sort of self-design. It can be designed by the customers themselves.

But as I said, the product is very new. We don’t want to get into the details of how many have adopted these products but as Robin mentioned, we are continuing -- we are going to continue to monitor the progress of the product, keep improving it.

Robin Li

We do not expect any revenue for the My Marketing Center. It’s more like a value-added service to our existing customers and it’s going to serve as a marketing tool for our paid search services.

As you know, Baidu has the dominant market share in Chinese search. We can actually have a very good sense of the industry trend based on the queries our users type in related to certain industries that our advertisers will [grow customers’ are interested].

So one of the most important features of My Marketing Center is that they can have a graph of the search volume based on the keywords they are interested in and the time elapsed, so our customers will have a very good sense on the consumer appetite trends for their targeted customers. That’s one of the very unique things we can offer to our advertisers and customers.

Operator

Your next question comes from the line of Jason Helfstein with Oppenheimer. Jason, your line is open. You may ask your question. Your next question comes from the line of James Lee with Sterne Agee.

James Lee - Sterne Agee

Can you guys talk about, a little bit more color about how you guys are trying to manage sort of headwind uncertainty going into 3Q? Are you guys doing anything different in terms of launching new products, possibly taking advantage of the possible increase in Olympic related keywords? Anything like that along that line would be very helpful. Thank you.

Robin Li

Yes, we have made the necessary preparations for the Olympic Games. As I mentioned before, every big event, nationwide event is a propeller for usage of Baidu because more people will find information on Baidu and they will talk about it among their friends and families, so through word of mouth, we get more users.

This time is no exception. Probably the only difference is that we have enough time to prepare for what’s going to happen during the next couple of months.

We have lots of products and services that are particularly suitable to users who are looking for this kind of information, specifically Baidu [Postbar], our server-based community, anything that arises all of a sudden, people cannot find enough information on the static web, so whenever they type in the same keywords, they are directed to a community or to a message board that they can exchange ideas and communicate with each other. Every time something happens, we saw traffic surge from those related post-bars, and this time I think that during the game time, there will be lots of surprises in who is going to win what medal, and those related people’s bar will become very, very popular.

We also have an Olympic channel, 2008.baidu.com, and we will report news and the related results from that channel.

Operator

Your next question comes from the line of [Car Kwan] with Needham & Company.

Car Kwan - Needham & Company

Thanks for taking my question. It looks like your gross margins improved a lot this quarter, 500 basis points sequentially, and that seemed to come mainly from bandwidth costs and depreciation. I was wondering just how we should think about these costs going forward, whether this kind of margin is sustainable for the rest of the year, or will we see some softness due to the headwinds in 3Q? And also whether you guys are planning any promotional activities for promoting the Baidu brand during the Olympics? Thanks.

Jennifer Li

Just to address your question, gross margins have indeed improved this quarter. There are two main reasons; one is TAC rate as obviously you can see has been slightly decreased versus last quarter. In addition, you have seen depreciation costs, operations cost, and bandwidth cost as a percent of revenue coming down. As we continue to increase our own monetization methodologies, increasing the revenue base and optimizing our infrastructure usage, I expect there still to be some room from a bandwidth cost and depreciation cost perspective to come down slightly from a total revenue perspective.

Going forward from an Olympics game perspective, I think Robin mentioned during the games, we have our own product lines and the platform that we will attract the users to come in and take advantage of the information hub that we at Baidu currently have.

Just as to exceptional high promotional expenses for the quarter, we currently do not anticipate much.

Operator

Your next question comes from the line of Eric [Wen] with [Main First].

Eric Wen - Main First

Thanks for taking my question. Just continue on the cost side -- your traffic acquisition costs decreased, actually did break [inaudible] trend. May I know that this decrease is due to the lower traffic contribution to your search, or you are decreasing the pay-out ratio to your partners? And further, if I can confirm that, you just said that the bandwidth costs and depreciation costs as a percentage of revenue will further go down in the coming quarters. Thanks.

Jennifer Li

I’ll address the bandwidth and depreciation costs as a percent. What I said is there is still room, we believe, as we can continue to grow our revenue base much faster, we can pool the leverage, the infrastructure base that we have, and therefore to the extent our revenue continues to grow much stronger, there should be room for us to continue to decrease the percentage of revenue from a bandwidth cost and depreciation cost perspective.

In addition, you know we have incurred $30 million also of Japan related expenditures, and much -- a big portion of that expense is related to bandwidth and depreciation cost, to the extent we continue to hold steady that part of the expense and while our main revenue base in the China domain continues to increase much faster, you can see that the total percentage from a bandwidth and depreciation cost perspective as a percent of revenue should continue to have room to improve.

And I’ll get Haoyu to answer the TAC question.

Haoyu Shen

Eric, on TAC, TAC [ratio] has been [inaudible] for a few quarters until last quarter, but this quarter is the first time we saw some slight decline. What I can assure you is it’s not due to slower growth of revenue contribution from our union partners and it’s not due to the decline of [payout] ratio either. It’s a pretty complicated business. In union, we have different kinds of businesses who have different kinds of models. The payout ratios are different so the mix shift will cause the fluctuation of TAC ratio from time to time. As we talked about this many times in previous calls, we looked at our TAC ratio or our unit business on a revenue net of TAC basis. We control TAC ratio very closely but when it makes sense, we do strike deals with partners when it makes strategic sense.

So I think in the long-term, there may be some pressure for TAC ratio to go up but given our leadership position in the market, I don’t see any dramatic increase in the near future.

Having said that, from quarter to quarter, I wouldn’t be surprised to see fluctuations.

Operator

Your next question is a follow-up question from the line of Dick Wei with J.P. Morgan.

Dick Wei - J.P. Morgan

Just a follow-up on [inaudible] -- so I guess in the longer term, we still should expect TAC to continue to increase as a percentage of revenue? Because I think previously, you’ve discussed about driving revenues from more of the union members essentially. I just want to [make sure of that].

Haoyu Shen

Right, yeah, that’s my sense -- long-term, there will be pressure but again, because we are the biggest Internet ad network, we have a lot of leverage. I’d expect the ratio to go up very quickly.

Operator

Your next question comes from the line of Eddie Leung with Merrill Lynch.

Eddie Leung - Merrill Lynch

I just wanted to ask a question about the brand advertising, because I remember a couple of quarters ago, you mentioned that the growth on your brand advertising was slightly faster than your organic [inaudible] growth. How has the situation been changed in the past quarter? Thanks.

Haoyu Shen

No, it hasn’t changed in the past quarter. We continue [to see] fast growth of the revenues from brand advertisers, be it in search or display.

Robin Li

Let me clarify -- I think it’s not really a distinction between brand advertising and web search advertising. It’s more of a distinction between larger advertisers or larger companies who do business with us. They spend both on display ads and search ads. And during the past few quarters, we have seen a trend that more and more larger companies spend more on the Baidu platform, be it paid search or display ads.

Operator

Your next question comes from the line of Eric Wen with Main First.

Eric Wen - Main First

I just want to ask a question regarding a regulation -- recently there was a Beijing State Administration of Industry and Commerce has said it planned to require registration of small/medium enterprises, starting from August the 1st. How do you see that impacting your customers or potential customers, especially given that Baidu is actually located in Beijing? Thanks.

Robin Li

I think at this time, almost all of our customers are registered companies, so we do not see any immediate impact for those kinds of things. It probably affects C2C services on a bigger scale, because lots of individual sellers could be asked to register. So in that regard, it’s too early for us to say what kind of impact we will get later on.

Operator

Your next question comes from the line of James Lee with Sterne Agee.

James Lee - Sterne Agee

Just a quick follow-up question regarding uncertainties in 3Q again; is one possible option for you guys to get incremental revenue for the quarter would be maybe tweaking your monetization algorithm a little bit to maybe to improve that, to maybe try additional revenue to offset the weakness? Is that one option that you guys are thinking of, or this is not something you are considering in the meantime?

Robin Li

Well, we are not building the company for the next quarter; we are building the company for the next 10, 15 years, so it doesn’t make sense for us to do some short-term tweaking in order to meet certain preset goals.

I think what’s more important for us is that the Olympic Games is a great opportunity for Baidu to attract new users. If we can provide good services to our existing users, they will spread around the word that Baidu has the best service, Baidu helped them to find the information they want. And then after the Games, we should see a good surge in traffic, in new users, in search volume, that kind of things. That would set a very solid foundation for the future growth of the company.

Having said that, improving the monetization capability and algorithm has been our priority for quite a few quarters. We understand there is still a lot of room for us to grow here because if you look at some of the third party research reports, you will see that our traffic share is much higher than our [macro] share in terms of dollar amount.

Operator

Your next question comes from the line of Leah Hao with Goldman Sachs.

Leah Hao - Goldman Sachs

Good morning. A few questions regarding your headcount -- can you update us on the number in your sales team? And how is the sales efficiency tracking for the new sales person as well as for the old, more experienced ones? And what’s your plan for the rest of -- maybe over the next six to 12 months in terms of increasing your sales team headcount?

Also, related to that, besides your Japan and C2C project, what are your top three strategic focuses for the next several years?

Robin Li

Haoyu, why don’t you talk about the sales force?

Peng Ye

There’s always room for us to make improvement, but on the other hand, I cannot -- I don’t seen any big increase in terms of headcount for sales operation in the near future for the [inaudible] couple of quarters.

Robin Li

Regarding the priorities, I wouldn’t say the new initiatives are our top priorities. I think for Baidu, the number one priority is always web search. We always need to come out with better services for the web search, larger index sites, better relevancy, fresher content, that kind of thing. We are also hiring R&D engineers very aggressively, although we have quite a large team [at this stage], we do feel we are short of engineers. There are lots of things we can improve on the natural search system and I would say the second-highest priority would be our monetization capability or as I mentioned before, we still are not satisfied with the monetization capability we have. Our traffic share is still quite higher than our market share and we see lots of things to do here and we have a very good team working on this. It has gotten senior management attention for quite a while, although we actually kind of started late, much later than our natural search capabilities.

I would say that the third priority would be sales force related, or customer acquisition. You know, we already have a very large customer base, large and loyal customer base but it’s still a very small percentage of the total number of enterprise [just in China]. In our mind, we think that every single [business] in China should use Baidu to promote their services and products and we are still quite far away from that.

So these are the top three priorities for Baidu.

Operator

Your next question comes from the line of Stephen Ju with RBC Capital Markets.

Stephen Ju - RBC Capital Markets

Good morning. What is your CapEx outlook for the balance of the year? And looking at the stock-based compensation, it’s up fairly significantly year over year and sequentially. Should we assume that second quarter amount is the new run-rate? Thanks.

Jennifer Li

From a CapEx standpoint, we obviously make investments to infrastructure, to network equipment whenever there is a need and it makes sense for us to do. So we don’t particularly set out for a certain target as to what CapEx expenditure we want to incur.

On your second question related to SBC, as we mentioned in the earnings release, we did have a higher SBC compared to our prior quarters in this Q2. A big portion of that is an update of forfeiture rate that’s assumed in the SBC calculation. So there is a little bit of a catch-up that we were doing in Q2.

The lower forfeiture rate that we have updated is reflecting lower turnover rate of our employees, so this is more like a one quarter event, so going forward, it’s not -- you can expect the SBC expenses isn’t going to be as high as Q2.

Operator

Your next question comes from the line of Jason Helfstein with Oppenheimer.

Jason Helfstein - Oppenheimer

Thanks. Just two quick questions, one on revenue per customer growth -- how much of that do you think was a function of traffic growth? Or was it -- did you guys do anything to try to increase minimum bids, or as far as you think it was more of a function of market driven demand for keywords?

And then, was there any R&D projects that were planned for second quarter that were pushed out into third quarter? Thanks.

Robin Li

Let me give you some color on that. The revenue growth is driven by both ARPU and the number of customers. I think traffic in general would have a very nice growth from Q1 to Q2, due to the low base of first quarter, where Chinese New Year is located, and people would spend more if we can have more to sell or if we have more inventory, lots of customers feel that Baidu is the best way -- provides the best ROI for their marketing dollar. So if we can provide more traffic, they will spend more on us and as I mentioned before, it also can be attributed to the improvement of our monetization algorithm. We are providing better targeted or more relevant paid search results to the consumers or two our users; therefore, the monetization capability has been improved, so that customers can spend more and more effectively.

And so the third factor is that, and I also mentioned that before, that we are seeing a trend that larger companies come to us to spend both on display and paid search. They will drive up -- they have driven up the ARPU too.

Regarding the R&D projects, I’m not sure why you asked this question. All of our projects are on schedule, on target. I don’t see any changes because of the Olympics or anything like that.

Operator

Your next question comes from the line of Dick Wei with J.P. Morgan. Your line is open. You may proceed. Your next question comes from the line of Ming Zhao with SIG.

C. Ming Zhao - SIG

Robin, I wanted to ask you a big picture question about e-commerce in China -- as you know, the consensus view is that the use of search in China is still to generate sales leads rather than leading to online transactions. So in your assessment, when do you think China’s e-commerce will develop to a stage where search will lead to significant online transactions? And if that day arrives, do you think the top line growth of Baidu will accelerate from currently 90% or 100% to even a higher rate? Thank you.

Robin Li

I think people use Baidu's paid search for three reasons. The primary reason, as you correctly pointed out, is for sales leads. But there are companies that use Baidu to drive online transactions. And the third category of companies is to do some branding work awareness. We’ve seen the trend that larger companies do offline advertisement and pointing their audience to search certain keyword online. So larger advertisers, branded advertisers are doing this to -- have been doing this to drive traffic to search sites so that their targeted audience or customers can have a better understanding of their products and services.

So going forward, I think branding oriented customers and transaction oriented customers will both represent a larger percentage of our product mix. And back to the e-commerce question, we’ve seen the e-commerce market in China grow quite nicely over the past couple of years, and that’s why we are doing a C2C launch this year. But it’s a gradual process. We haven’t seen any sudden surge on that and going forward, I think for our main business, the paid search business, these three types of customers will all contribute a significant percentage of our revenue.

Operator

Your next question comes from the line of Kathleen Nu with Citigroup.

Kathleen Nu - Citigroup

I have a follow-up question on the ARPU; once again we saw the revenue per active online marketing customer increase very healthily and you are largely in line with the increase as well in the active online customers. My question is also related to your previous stated priority of increasing the customers -- how should we think about the revenue per active customer, considering that the company is trying to bring in newer customers who may start out at a lower spend per customer? And also, the increase in the average revenue, has that been driven more by increased number of clicks driven by traffic, or increased amounts paid for each keyword? Thank you.

Haoyu Shen

I’ll give you more color on -- if you look at existing customers, what’s driving the ARPU growth. Obviously you have inventory or number of queries and CPC, costs per click, so historically, traffic has been the bigger driver of ARPU growth. And on CPC, it has been growing very nicely as well over the quarters. And the growth of CPC can be driven by either more bids for keywords because more customers come to appreciate the value of ROI, and also it can be indirectly driven by our -- sometimes we do increased minimum bid. From time to time, we do look at different sectors and we adjust minimum bid.

So that’s what’s driving the ARPU growth of existing customers.

Operator

Your next question comes from the line of Leah Hao with Goldman Sachs.

Leah Hao - Goldman Sachs

Thank you. A quick follow-up on some short-term stuff; can you give us a little bit of color about the traffic trends and business trends so far into July? And also, the other one, I think you commented quickly about the margin trends, but I was just wondering if the margin, operating margin trend for R&D and SG&A going forward would be sustainable for the rest of the year, I guess? Thank you.

Robin Li

I’ll talk about the traffic trend and Jennifer will tell you about margin trends. For Baidu's search traffic, as I mentioned before, we are seeing some very nice growth for a certain type of our search related services, such as video search and Hao123 during the past few quarters. Those two have been growing quite rapidly.

In terms of web search, the growth pattern is very predictable in the sense that compared to the same time last year, we can actually do week-by-week comparisons, as that is very consistent with what we have done in the past. Also, going into July we have not seen anything that’s abnormal.

Jennifer.

Jennifer Li

On the margin side, this quarter we did post pretty healthy margins. It does demonstrate the stability of our business model and we believe the model does inherently definitely have is scalability.

Peng mentioned earlier from an SG&A perspective, we do not anticipate to add a whole lot of headcount. We are increasing our productivity and that’s our focus.

On the R&D side, Robin mentioned people is our top priority and we continue to attract talent, and in the summertime over the next couple of quarters is when the school year finishes and we will see new graduates starting to be recruited and they join on board to Baidu.

Overall, as I mentioned, we believe there is an inherent scalability in our model. Our margins should improve longer term. However, we have never in the past set a margin target because we believe in investing in the right opportunity, as we have done in the past, and therefore we believe, as I mentioned, longer term operating margins should have room to improve.

Operator

Your next question comes from the line of Car Kwan with Needham & Company.

Car Kwan - Needham & Company

Thanks for taking my follow-up. Just a quick housekeeping question; I was just wondering if CapEx spending on the campus trended similarly to previous quarter.

Jennifer Li

Yes, we have set out in the past that we have budgeted expenditures between 50 million to 60 million for ’08 and ’09. The construction itself started in Q307. Things are going well and we have steadily incurred capital expenditure. For this past quarter, we have a little over one-third of our CapEx that’s related to Baidu Campus.

Operator

Your final question comes from the line of James Lee with Sterne Agee.

James Lee - Sterne Agee

Thank you. I was hoping to get some feedback about your -- from your larger advertiser relating to API. Can you guys comment about, maybe give some case steady or successful examples, how you drive additional adoptions from the larger advertisers? And I’m just curious, is the API offered to large advertisers on a limited basis or is that open to all advertisers wanting to see the product? Thank you.

Haoyu Shen

We started to offer API 1.0 starting from January, and it’s really open to any customer or agencies who have a need to -- so that they can better spend with Baidu. So as of right now, I think that dozens of customers or agencies that are already working off the API that we offered, and I think in the next quarter, at least by the end of the year, we are going to launch API 2.0 to offer more functionality and better usability. I believe that will further drive the growth of spending from big advertisers with us.

Operator

We are now approaching the end of the conference call. I will now turn the call over to Baidu's Chief Executive Officer, Robin Li, for his closing remarks.

Robin Li

As always, we believe that the best is ahead of us. China’s Internet population continues to grow rapidly, and it has surpassed the U.S. to become the world’s largest Internet market as measured by the number of users. Internet penetration is still lower than the global average [inaudible]. This leaves us huge potential for further development. We look forward to continuing to provide the best online search experience for our users and continuing to execute on our strong growth strategies in the coming quarters and years.

Thank you for joining us today. Please do not hesitate to contact us if you have any further questions.

Operator

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 Q2 2008 Earnings Call Transcript
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