Baidu’s Search for New Contexts

By Peter Pham - July 30, 2012 | Tickers: AAPL, BIDU, GOOG | 0 Comments

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Chinese search giant Baidu (NASDAQ: BIDU) reported their earnings on July 24^th and the former darling of the extreme momentum crowd returned to most of its former glory by reporting an impressive set of numbers.  This dispelled the worries engendered after its previous earnings report had investors thinking Baidu’s big story was nearing its conclusion and was just biding its time until the Chinese government allowed Google (NASDAQ: GOOG) to come in and compete with them.

The big news for Baidu is that they have moved successfully into two key markets, contextual and mobile search and cloud storage.  Their revenue beat estimates and their earnings were a full 10% over estimates, coming in at $1.24 per share.  Revenue was up 60% year over year and income rose 70%.  Additionally, they raised their 3^rd quarter revenue guidance above the $1 billion mark. 

At first blush, there looks to be a bit of margin erosion, with margins dropping from 59.8% to 51.5%.  This drop is not from a lack of pricing power but from rising operational costs, as SG&A as a percent of revenue dropped as well.  Baidu plowed a ton of money into R&D during the quarter, hiring staff and raising the budget by more than 82%.  This increase more than accounts for the change in margins this quarter.  Baidu added staff to develop new products and stay ahead of the curve.  They raised their R&D spending as a percentage of revenues from 8.7% to 10% year over year.  This will be necessary as they develop ways to build out their mobile platform Yi and seek to improve monetization on the smaller screens of mobile devices.

New products like Brand-Link create a contextual ad that is both flexible and capable of functioning like a mini-site.  They are targeting this technology towards small businesses and coupling it with their expanding location services. 

While revenues from their mobile business are still small, the number of users more than doubled from 9 million to 20 million quarter to quarter.  So, Baidu has now begun the process of pushing for an integrated ecosystem on their platform, getting excellent adoption of their cloud services.

The shift to mobile services as a percentage of revenues it going to come at the expense of revenue per customer.  The lower barriers to entry for getting a mobile phone or tablet are going to create higher acquisition costs for any company like Baidu.  But in this most recent quarter they have confirmed a reversal in new customer growth rate, adding 18.1% users year over year versus the previous quarter’s 17.2%.  Couple this with a focus on creating services and tools for small businesses like Brand Link mentioned above as well as their tool for converting a website into a mobile one in around 10 minutes (according to Baidu) and it is no wonder that TAC rose this quarter and will likely continue to grow for the next couple while they aggressively push into the mobile arena. 

The bottom line is that Baidu has a huge moat around its business.  The questions lingering after last quarter seem to be dispelled after this one, and their guidance was strong going forward while acknowledging the macro headwinds.   Their presence on Apple’s (NASDAQ: AAPL) iPhone as an installed option will drive a lot of mobile search revenue.  And their increasing spending on R&D to develop an app market within Yi is encouraging.

Trading at 24 times future earnings after a quarter which saw core costs rise but net margins increase after four quarters of margin erosion makes Baidu an intriguing offering at current prices.  

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