Baidu (NASDAQ:BIDU) is the leading online search provider in China. While its top-line continues to grow at a healthy rate, the company’s profitability has suffered in the recent past on account of various factors such as increased competition from new entrants, including Qihoo, and due to investments in mobile strategy. In Q1 2013, Baidu’s revenue grew by 40% annually, however, its operating margin fell to 37% from 49% in Q1 2012.
The drastic decrease in operating margin in Q1 2013 was underscored by 68%, 77% and 83% rise in costs of revenue, SG&A and R&D expenses respectively. The consolidation of ITE (its online video platform) also impacted operating margin in Q1 by 3-4%. We expect operating margin to stay under pressure during 2013 as Baidu continues to invest in infrastructure and mobile strategy. Baidu is aggressively pushing into mobile by focusing its R&D efforts to optimize its mobile search and increasing its marketing efforts to drive greater adoption of its mobile portfolio.
While the short-term decline in profitability seems disappointing, we believe Baidu is taking the right steps by undertaking this strategy. Facing increased competition and a trend towards mobile Internet, the mobile strategy will help Baidu differentiate itself against competitors and enhance its market share in the mobile search market and mobile monetization. Currently, Baidu has a much lower market share on mobile devices (37.5%) compared to desktops (around 80%).  Hence, we think these measures could help boost Baidu’s revenue growth in the long run.
Breakup Of Baidu’s Key Costs
Operating Costs and Expenses
|As a % of Revenue in 2010||As a % of Revenue in 2011||As a % of Revenue in 2012||As a % of Revenue in Q1 2012||As a % of Revenue in Q1 2013||
Annual Growth in Q1 2013
|Cost of Revenue||Sales tax and surcharges||
|Traffic acquisition costs||
|Share-based comp expenses||
|Total Cost of Revenue||
|Selling, General and Administrative||
|Research and Development||
|Total costs and operating expenses||
Increased Spending On Infrastructure And ITE Consolidation Impacts Cost Of Revenue
Traffic acquisition cost (TAC) represents the proportion of online advertising revenues that are shared with Baidu Union members. TAC as a % of revenue rose drastically from 7.8% in Q1 2012 to 10.2% in Q1 2013 due to higher contextual ads contributions and hao123 promotions across Baidu Union network (hao123 is a portal that features a directory of links along with internet search). TAC as a % of revenues is expected to rise in the near future as Baidu continues to leverage the Baidu Union network for enhanced growth.
Bandwidth and depreciation costs rose by 82% and 46% annually in Q1 2013 on account of increased network infrastructure capacity and ITE consolidation. As Baidu continues to invest in infrastructure and cloud capacity, we expect these expenses to stay high in the medium term.
Content costs as a % of revenues stood at 1.6% compared to 0.7% in Q1 2012 primarily due to the ITE business. We expect a slight increase in this ratio in the future with large variations across quarters.
Increased Promotional Activities To Fuel Mobile Product Adoption Is Impacting SG&A Expenses
Increased promotional activities conducted to drive installation and usage of mobile products led to a 77% annual increase in SG&A expenses during the quarter. We expect these expenses to stay high during 2013 as Baidu is expected to continue its promotional activities to drive mobile product adoption.
Increased R&D Costs On Mobile Strategy Will Remain A Major Theme Throughout 2013
R&D costs as a % of revenues rose to 13.6% in Q1 2013 compared to 10.4% in Q1 2012 on account of investments in mobile strategy. The Chinese Internet market is seeing a shift to higher mobile usage and Baidu is focusing on the mobile platform development to leverage this structural shift in the industry. Total headcount rose by around 900 in Q1 2013 compared to the previous quarter primarily due to the addition of R&D staff. In addition, share-based compensation also increased due to higher incentives for R&D personnel.
We expect higher R&D expenses to be the trend throughout 2013 as Baidu will continue to invest in mobile strategy to enhance its mobile search market share.
Our $106 price estimate for Baidu’s stock represents near 15% premium to the market price.Notes: