Baidu (NASDAQ:BIDU) reported its earnings for Q4 and full year 2012 on February 4. The company had a decent quarter as total revenues increased to $1 billion, growing almost 40% year-over-year. Despite the growing revenues, operating profit growth slowed as it increased to $457 million, an increase of only 24% year-over-year.
In our pre-earnings article, we had expressed our concerns regarding Baidu’s EBITDA margins, which fell during the year to approximately 55%. We think that this fall in margins is the start of a downtrend in EBITDA margins over our forecast period. We are revising our margin forecast lower to approximately 50% by 2019, which is the primary reason for a revision to our price estimate to $115 from $125.
Margin Pressures a Concern
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We have maintained that Baidu’s long term margin trends could deteriorate due to increasing competition in the Chinese Internet industry. Baidu has enjoyed three years of strong EBITDA margin growth (from 45% in 2009 to 60% in 2011), primarily because of Google’s troubles in the Chinese market. Baidu’s near monopolistic position in the industry after Google’s exit from the country in 2011, seems to be waning as other competitors such as Qihoo enter the search industry.
We think that this increase in competition will only be one part of the company’s margin troubles. We are also concerned that online ad spending in the Chinese market could grow at a slower rate in the coming years, primarily due to the worsening economic environment in the country. Our concerns have more weight in light of Baidu’s slower growth and Chinese Internet company Tencent’s warning that online ad spending growth in China is slowing. 
The slowdown in ad spending growth and the increasing competition in the Chinese Internet landscape will hit the pricing power that Baidu has enjoyed due to its near monopoly. The company’s ability to pass on cost increases to advertisers will wane and it will likely capture a smaller chunk of ad spending growth compared to the past. Additionally, we think that the Silicon Valley like talent wars could come about in the Chinese Internet landscape as the top firms compete for best engineers, increasing labor costs. This downtrend in margins must be closely watched over the coming years because if Baidu’s EBITDA margin falls to 2009 levels of 46% by 2019, we would see 10% further downside to our price estimate.
Average Revenue per Customer Declines Sequentially
Baidu continues to post strong growth in customers, the numbers increased by 30.5% year-over-year and 4.1% from the previous quarter. However, average revenue per customer (ARPU) declined sequentially by 3.1% during the quarter. According to the firm’s management, the decline was driven by growth in small and medium enterprise (SME) clients, which are concentrated in smaller cities and have less purchasing power than large corporations.
This is a troubling trend for Baidu over the long term because we think that small and medium enterprises will be a key driver of customer growth going forward. If SME client growth outpaces large enterprise client growth in the next few quarters, we could see an extended ARPU decline. Therefore, this could be another factor which provides downside pressure to Baidu’s top line in the coming year.
We’ve revised our price estimate for Baidu to $115, which is approximately 15% above the current market price.Notes: