Baidu to Witness Robust Top Line Growth but Investments will Impact Profitability

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Baidu (NASDAQ:BIDU), the largest Internet search provider in China, with 73% share of the search traffic, is set to release its results for Q2 2014 Thursday, July 24. Until mid-2013, there were concerns surrounding the company’s mobile monetization capabilities. However, the company grew organically as well as inorganically to overcome these problems. It worked towards building a better mobile ecosystem by integrating more services and increasing its app distribution strength. On the back of these developments, Baidu marked a solid start to fiscal year 2014 with 59% growth in Q1 revenues, topping $1.5 billion.

While Baidu has been able to boost its top line, investments in enhancing its mobile capabilities and supporting growth at its newly acquired subsidiaries—91 Wireless, PPS and Nuomi—have weighed on the company’s profits in the last few quarters. EBITDA margins (in percentages) have declined from the 50′s to the 40’s and the company does not expect absolute profit growth this year. Baidu has more new products in its pipeline for mobile, and will therefore continue to invest heavily on driving installations and usage of these mobile products.

We will update our $205 price estimate for Baidu’s stock after the upcoming results announcement.

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See our complete analysis of Baidu here

Growth in Customer Base to Reaccelerate

The number of customers actively availing online marketing services from Baidu has sequentially declined in the last few quarters. Baidu had about 446,000 active online marketing customers in Q1 2014, lower compared to 464,000 in Q3 2013. The drop was the result of the company’s +V verified account program that was rolled out across the majority of customers. The program aims to improve the quality of customers by verifying their legitimacy. Only verified businesses can do business with Baidu. A better quality customer base helps Baidu to increase ARPU (average revenue per user). [1]

We believe that Baidu’s customer base will get back its sequential momentum from this quarter as the +V program has been fully rolled out. Additionally, the company’s new idea of allowing advertisers to bid at city level rather than province level will bring in more marketing customers.

Nuomi Plays an Important Role in Baidu’s Location-based Strategy

Baidu acquired a 59% stake in Nuomi last year for $160 million. It bought out the remaining stake from Renren in January this year. Nuomi is increasingly becoming an important part of Baidu’s location-based service offerings through Baidu Maps because Baidu is focused on providing a comprehensive experience to users from answering search queries to delivering services. Group buying, taxi hailing, movie ticket purchasing and hotel booking transactions on Baidu Maps increased by 80% sequentially in the first quarter. [1]

Nuomi is leveraging Baidu’s web traffic resources and extensive sales force infrastructure to scale up its operations. According to Dataotuan, the group buying site accounts for about 10% of revenues of the local deals market in China. It has been facing huge losses since inception due to intense competition. However, the sector is seeing a consolidation, due to which we expect Nuomi to become profitable after the industry is left with only a few players.

Online Video Business is a Good Long Term Bet

The acquisition of PPS, an online video service, has strengthened Baidu’s position in the online video market. Baidu acquired PPS last year in May and merged it with its online mobile video platform, iQiyi, to become the largest online video platform in China with 358 million monthly users. According to data published by consulting group iResearch, iQiyi overtook Youku as the most popular video service by monthly active users this year. iQiyi had 94 million monthly active users in January as compared to Youku’s 83.5 million. [2] Baidu is planning to raise money for its video unit via an IPO in the next three years.

We are encouraged by these recent developments since the Chinese online video market is forecast to grow at a brisk pace of 30% for the next four years, to become a $6 billion market by 2017. [3] Further, it is a good diversification strategy for Baidu, whose business has been heavily dependent on search offerings to generate revenues. We think that Baidu can win the market with its focus on a strong quality of service, brand recognition and user traffic. However, there are also certain challenges that iQiyi must overcome.

First, advertising accounts for over 75% of the revenues of China’s online video market, as selling content to viewers is difficult due to piracy issues. [3] Monetization through sale of content is an important revenue stream that the industry is not able to capitalize on, more so because licensing content from producers is expensive in China. In 2013, Baidu’s content costs increased to 2.6% of revenues ($5.3 billion) from 1% in the prior year primarily because of iQiyi, the company said in its Q4 earnings call. [4] Second, iQiyi has not yet approached profitability, and we think that it may have to produce more in-house videos to become profitable, despite the strong growth that is expected in the video market. Margins on in-house videos are higher than that on licensed videos. And third, Youku recently received a $1.2 billion bid from Alibaba, which has the financial resource to grow Youku into a leader in online video streaming.

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Notes:
  1. Baidu’s CEO Discusses Q1 2014 Results – Earnings Call Transcript, Seeking Alpha, April 2014 [] []
  2. Baidu’s Iqiyi overtakes Youku as China’s most popular video service, Gigaom, March 10, 2014 []
  3. China Online Video Market Snapshot in Q4 2013, China Internet Watch, March 05, 2014 [] []
  4. Baidu’s CEO Discusses Q4 2013 Results – Earnings Call Transcript, Seeking Alpha, Feb 2014 []