Baidu - Earnings Call - Q3 2011

Transcript

Speaker 2

Hello, and thank you for standing by for Baidu's third quarter 2011 earnings conference call. At this time, all participants are in a listen-only mode. After management's prepared remarks, there will be a question and answer session. Today's conference is being recorded. If you have any objections, you may disconnect the line at this time. I would now like to turn the meeting over to our host for today's conference, Mr. Tseng, Baidu's Investor Relations Director.

Hello, everyone, and welcome to Baidu's third quarter 2011 earnings conference call. We distributed Baidu's third quarter 2011 earnings release earlier today. You can find a copy of the press release on the company's IR 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 answer your questions. Before we proceed, please note that the discussion today will contain forward-looking statements made under the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from our current expectations. Potential risks and uncertainties include but are not limited to those outlined in our public filings with the SEC, including our annual report on Form 20-F.

Baidu does not undertake any obligation to update any forward-looking statement except as required under applicable law. Our earnings press release in this call includes discussions of certain unaudited non-GAAP financial measures. Our press release contains a reconciliation of the unaudited non-GAAP measure to the unaudited most directly comparable GAAP measures and is available on our IR website at ir.baidu.com. As a reminder, this conference is being recorded. In addition, a webcast of this conference call will be available on Baidu's corporate website. I will now turn the call over to Baidu's CEO, Robin Li.

Speaker 3

Hello, everyone, and welcome to today's call. I'll start today by reviewing our results for the third quarter and taking a look at the key trends and growth drivers. Then I'll talk about the exciting new initiatives we launched recently. Finally, I'll update you on our strategic investment projects. Looking first at our results, there's been another stellar quarter for Baidu. Its revenues accelerated 85% year-on-year. In particular, we see three main factors underpinning robust revenue growth in Q3. First, traffic growth maintained its strong momentum in the quarter. Second, we made solid progress on monetization. Our full growth had a record high of more than 65% year-on-year. This was largely driven by enhancements to our Phoenix Nest platform. For example, we introduced a new keyword matching option called Advanced Phrase Match.

This is more focused than the traditional broad match but offers more flexibility and higher coverage than the exact match. It better captures user intent and improves click-through rate, improves click-through quality. We are seeing very encouraging adoption rates so far. There are still many other levers in Phoenix Nest that we can pull out to drive further monetization efficiency. The third factor influencing our strong revenue growth was an increase in spending by our large accounts, which has been a priority for Baidu. One source of strong revenue growth was, once again, the e-commerce sector. In particular, the revenues contributed by the online retail sector regained impressive momentum, growing over 100% year-over-year. Separately, classified information websites' spending also maintained a strong upward trend, increasing by over 50% quarter-on-quarter.

You can see that because of our central position in China's internet ecosystem, we can always benefit enormously from emerging growth areas. While it is difficult to predict the future of any single industry category, the overall online marketing spending trajectory for our large accounts remains very positive. Another area of strong revenue growth was in customers from more traditional industries. We benefited as these customers transitioned from offline to online marketing. The auto industry is a good example of this emerging trend. These established offline businesses increasingly recognize the value of Baidu's online marketing platform and are allocating larger percentages of their advertising budget to us. Meanwhile, our top verticals continue to grow healthily as well and remain an important part of Baidu's revenue makeup. In Q3, we continue to optimize our sales process.

The goal is to ensure customer quality and improve sales efficiency for small and medium-sized customers. Complementing this push, we have deepened our commitment to creating a better, cleaner internet ecosystem. Under the banner of "Fresh in Sunshine," Baidu has forged alliances with major stakeholders, including government ministries and agencies, industry associations, and the media. "Fresh in Sunshine" is part of a long-term effort of which the Chinese government has been very supportive. Let's now move on to talk about some of our new initiatives. Baidu's new personalized homepage feature went live in the beginning of September. The personalized homepage represents the next step in the evolution of Baidu, from simple web search to open data to open applications, and now to personalized and direct feeds that instantly meet users' needs.

This new feature gives users who are signed in Baidu a more personalized experience based on their historical search behavior. For example, if a frequent moviegoer tends to search for local cinema times, we'll include that link on his personal homepage. If a user in Beijing often searches for weather, we will include a link on the Baidu homepage to a Beijing weather forecast automatically. The personalized homepage brings not just the general information but personal information as well. This is a great example of how Baidu is integrating search with users' social activities. We will tightly integrate Baidu's own search social products, like Baidu Post and Space, as well as external social platforms to satisfy users' social needs. Another beautiful thing about our personalized homepage is that users don't have to do anything. An intelligent recommendation engine customizes their homepage for them based on their behavior and social interactions.

This means that the success of the homepage does not depend on users being proactive. These features will ensure that Baidu is the logical starting point for more and more internet users and will keep users on our site longer. Turning now to our mobile strategy, where we've also made important progress. First, we are extending our partnerships with mobile phone makers. Baidu is now the default search engine on over 80% of branded handsets using the Android operating system sold in China so far this year. As a result, we've made tremendous progress in ensuring that Baidu is the gateway to the internet for Chinese users, whether they are going online on PCs or on mobile devices. At the same time, last quarter, we announced our new Baidu Yi mobile platform. Baidu Yi is designed to provide Baidu services to users on the go.

We have an incredible suite of products, and we want Baidu users to be able to use them anywhere, anytime. Once devices featuring our platform are available in the mass market, Baidu Yi will give mobile users easy access to our search box, let them stream their music through Baidu App, find their destination on Baidu Maps, and use a growing number of web-based apps. This seamless access to Baidu's products across platforms will increase user stickiness and ensure that we remain at the center of the online experience for Chinese users. All of these features will be tightly integrated with Baidu's evolving AI Cloud computing offering, and we have plenty more exciting features in the pipeline. Also, through Baidu Yi, third-party developers will gain access to Baidu's suite of mobile products and services.

Developers will have APIs to keep its search, maps, payments, and more into the apps for the Baidu Yi platform. Lastly, I'd like to update you on our strategic investment. Our online media platform, iQIYI, continues to grow at a very encouraging rate. During Q3, we saw monthly unique visitors jump to 191 million, from 160 million in Q2. Both Comscore and iResearch show that iQIYI is one of the leading video sites in user time spent onsite. One of the key factors setting iQIYI apart from the competition is differentiated high-quality content. To keep its edge, iQIYI has signed licensing agreements with the Big Six, the top-tier movie content providers, including Warner Bros., Paramount, 20th Century Fox, Sony, Disney, and Universal. We are really encouraged by how quickly iQIYI has captured a huge share of this very competitive market.

Baidu is fully committed to supporting iQIYI to grow further, and we'll be backing this up with further investment. As you know, we recently invested in online travel vertical, Qunar. With that deal now completed, high-quality travel-related information from Qunar has been further integrated into Baidu Search in areas like hotels, airlines, and train information. For example, when users search for hotel chains like Home Inns, on the results page, they will see a Baidu Map that automatically picks up the user's location and provides a comprehensive list of Home Inns hotel options in that geography, along with pricing information. A flight search will show you the recent price trend for your desired flight, so you can see if the cost has been falling or increasing. The net effect of this upgrade is broader box computing coverage of travel-related keywords for our users and better click-through rate.

In conclusion, Baidu's strategic investment, combined with our robust organic growth and new innovative products, are solidifying our position at the heart of the Chinese internet ecosystem. We have every reason for confidence in our prospects for the future. With that, let me now turn the call over to Jennifer Li for the next financial highlight.

Speaker 1

Thank you, Robin. Hello, everyone. As Robin mentioned, Q3 was another stellar quarter that exceeded expectations. This was driven by fantastic growth, monetization improvements, and strong spending by large accounts. In order to ensure that Baidu continues to stay ahead of the curve, we maintained investment in critical areas: R&D, infrastructure, and strategic initiatives. Going forward, aggressive investment will remain central to our long-term growth strategy and driving top-line growth. I would like to highlight that starting in Q3, Qunar financials have been consolidated into our financials. The overall impact on Baidu's financials has so far been insignificant. Also, as Robin mentioned, we'll continue to support iQIYI's rapid growth. Our cash investment of $23 million in iQIYI this quarter was recorded as a loss under the equity accounting methods. Our overall EPADS would have been $91.91 without this charge.

We anticipate a similar level of cash investment in iQIYI in this Q4. After that, we'll assess from time to time what are the optimal options available for Baidu in supporting iQIYI. Baidu and its partners will firmly support iQIYI. Now, let's look at the financial highlights for the quarter. All amounts mentioned are RMB, unless otherwise noted. Online marketing revenue for the third quarter of 2011 was RMB 4.2 billion, an 85% increase year-on-year. Baidu had around 304,000 active online marketing customers in the third quarter of 2011, a 12% increase from the corresponding period last year, and a 2% increase from the previous quarter. Revenue per online marketing customer in the third quarter reached approximately RMB 13,700, a 65% increase from the corresponding period in 2010, and a 19% increase from the previous quarter.

Traffic acquisition cost, as a component of cost of revenue, was RMB 334 million, or 8% of total revenues, as compared to 8.9% in the corresponding period in 2010 and 7.9% in the second quarter of 2011. As we noted before, in the longer term, we expect traffic acquisition cost as a percent of revenues to gradually increase based on the extent of contextual advertising growth. Contextual ads are an important initiative for Baidu and require a higher payout ratio to Baidu Union partners. Bandwidth cost, as a component of cost of revenue, was RMB 156 million, representing 4% of total revenue, compared to 3.8% in the corresponding period in 2010. This increase would mainly reflect an increase in server capacity to accommodate traffic growth, new product releases, and higher computing requirements.

Depreciation cost, as a component of cost of revenue, was RMB 177 million, representing 4.2% of total revenues, compared to 3.7% in the corresponding period in 2010. The increase was mainly due to an increase in network infrastructure capacity. We will continue to aggressively invest in network infrastructure and building more office space. Operational cost was RMB 125 million, representing 3% of total revenue, compared to RMB 85 million and 2.5% in Q2 of 2011. A main part of the sequential increase was due to the pickup of intangible asset amortization related to Qunar transactions. The useful life of these intangible assets ranged from three to ten years, so we expect this will be an ongoing item in the foreseeable future. SG&A expense was RMB 460 million, an increase of 22% quarter over quarter. This increase primarily reflects increased personnel cost, marketing expenses, and, of course, Qunar financial consolidation.

Research and development expenses were RMB 383 million, a 28% increase quarter over quarter. This increase primarily reflects increased headcount and, of course, including Qunar financial consolidation. Share-based compensation expenses, which were allocated to related operating costs and expense line items, increased in aggregate to RMB 39 million in the third quarter of 2011, from RMB 24 million in the corresponding period in 2010. Operating profit was RMB 2.2 billion, an 88% increase year over year. Loss from equity method accounting was RMB 156 million. This increase mainly reflects the cash investment we made in iQIYI this past quarter. Total headcount, as of September 30, 2011, was about 14,700, roughly 1,900 more than the previous quarter. This includes about 800 employees from Qunar, now consolidated in our headcount. Income tax expense was RMB 318 million for the third quarter.

The effective tax rate for the third quarter was 14.5%, as compared to 13.6% for the corresponding period in 2010. The year-on-year increase was due to the expiration of some PRC subsidiaries' preferential tax rate. Net income attributable to Baidu was about RMB 1.9 billion, an 80% increase from the corresponding period in 2010. Basic and diluted earnings attributable to Baidu Inc. per ADS for the third quarter of 2011 amounted to RMB 5.39 and RMB 5.38, respectively. Net income attributable to Baidu Inc., excluding share-based compensation expenses, a non-GAAP measure, was about RMB 1.9 billion, a 79% increase from the corresponding period in 2010. Basic and diluted earnings attributable to Baidu Inc. per ADS, excluding share-based compensation expense, those non-GAAP measures were RMB 5.50 and RMB 5.49, respectively. As of September 30, 2011, the company had cash, cash equivalents, and short-term investments of RMB 11.4 billion.

Net operating cash inflow and capital expenditures for the third quarter of 2011 were RMB 1.8 billion and RMB 490 million, respectively. Now, let me provide you with our top-line guidance for the fourth quarter 2011. We currently expect total revenue for the fourth quarter of 2011 to be between RMB 4.41 billion and RMB 4.54 billion, which would represent a 79.9% to 85% year-over-year growth. This forecast reflects Baidu's current and preliminary view, which is subject to change. I will now open the call to questions. Operator, please go ahead.

Speaker 4

The question and answer session of this conference call will start in a moment. In order to be fair to all callers who wish to ask questions, we will take one question at a time from each caller. If you have more than one question, please request to join the question queue after your first question has been addressed. The first question comes from the line of Dick Wade from JPMorgan. Your line is open.

Speaker 0

Hi, good morning. Congrats on a very strong quarter. My first question is on the revenue contribution from SMEs. Robin mentioned that very strong growth in last customer and classified information websites. I wonder what is the revenue contribution from SME customers, what is the growth rate, and what kind of output for these long-tail customers? If you can share some insight, that would be great. Thanks.

Speaker 1

Hi, Dick. I think this quarter, across the board, all the different customer bases grow very strongly, and they all contributed to, at the end of the day, the revenue growth. The large accounts outperformed the SMEs, but SME has continued to grow very strongly, both on a year-on-year basis as well as on a sequential basis. We have, year-on-year, an 85% increase. You know, both SME and large accounts did well, but large accounts are growing faster than SME for this quarter, and it actually has been the trend for the past few quarters.

Speaker 0

Okay, great. Thank you.

Speaker 4

The next question comes from the line of Jiang Xiao from Macquarie Securities. Your line is open.

Speaker 0

Thank you very much for taking my questions, and congratulations on a very strong result. For Q3, your strong growth of roughly 85% year-over-year, I was wondering, could you please sort of roughly break it down for us in terms of, okay, how much was due to the traffic growth, how much was the monetization improvement, how much is sort of the price appreciation? Any color on those metrics for 2012 would be appreciated. Thank you.

Speaker 3

I think it's a combination of all factors. Traffic continued to grow strongly. The ACP increase was pretty much due to the revenue mix because, in general, large accounts are willing to pay higher prices. We're also seeing a good contribution from existing verticals, as well as new emerging verticals. B2C e-commerce has been very strong. Virtually almost all the larger B2C sites are large customers of ours, and we see very strong momentum of the net trend, the O2O net trend, offline to online.

A lot of the vertical industries are moving their businesses from offline to online, so we are a big beneficiary of that. It is very hard to separate all the sectors and figure out which one contributed more, but what we can tell is that the advertisers are generally very happy about the performance, which tells us we still have a lot of room to grow.

Speaker 4

The next question comes from the line of Catherine Xiong from Goldman Sachs. Your line is open.

Speaker 0

Hi, good morning, and also congratulations on this strong result. I was wondering, in terms of the Phoenix Nest enhancements that you discussed, are you seeing this as contributing already a material proportion of your paid clicks in the third quarter or going forward in the fourth quarter? Thank you.

Speaker 3

Yes, as I mentioned during the prepared remarks, advanced phrase match did contribute quite significantly to the overall revenue growth, in particular the number of paid clicks. In the past, advertisers or customers only had two options: they either choose the exact match or the broad match. Some thought the broad match was too broad, some thought the exact match doesn't match all the user queries with their interest, with the customer's interest. With this new option, more advertisers or customers can become more aggressive in showing their ads or paid links or results. This started in Q3 and will benefit from now on. Q4 will also benefit from this. There are still quite a few things like this we are working on. We'll report that as we achieve those goals.

Speaker 4

The next question comes from a line of Jim Yoon from Demura. Your line is open.

Speaker 0

Hi, good morning, everyone. Just to follow up on the previous question, how much impact in your guidance is really attributable to the new tweak in the Phoenix Nest compared to any material contributions from the new homepage, or are you expecting any greater than expected contributions from Qunar? Thanks.

Speaker 3

Let me answer the first part of the question. The new homepage does not have a positive impact on revenue yet. It even has a slight negative impact because users would search a little less with the new homepage, but the new homepage is obviously stickier, and we hope going forward people will stay longer on Baidu's site and use our site as the starting point more frequently. The improvements we made in the Phoenix Nest contributed the most from a product point of view.

Speaker 1

Any improvement we've done on our monetization front will carry forward, and we will continue to refine and improve the monetization capability, as Robin mentioned. To your question on Qunar contribution, as I mentioned, Qunar's overall impact to the Baidu overall picture is really small, and it doesn't really make sense for us to isolate the Qunar revenue per se just for Q4. As Qunar becomes a more meaningful part of Baidu, we'll certainly separately disclose that, but I think in the near term, it's very minimal.

Speaker 4

The next question comes from the line of Eddie Leung from Merrill Lynch. Your line is open.

Speaker 0

Good morning, guys. Two questions. The first one is about your other revenues. Could you give us more color on the increase of other revenues in the quarter? Could you also give us the top five advertiser categories and where online companies/e-commerce spend within the ranking of your advertiser categories? Thanks.

Speaker 1

You will notice there is a slight other revenue number in our reported financials. Our main revenue is online marketing services, and we have set up some business ventures, as you are aware, like Baidu HR, to provide other services. This more other revenue is basically a reflection of those non-online marketing services that we generate. As to your second question related to the top five sectors, these remain largely the familiar ones: the medical and healthcare sector, education, machinery equipment, travel, and business service. Those were the top five sectors for us in Q3. As we mentioned in our script, online e-commerce continues to be a main driver and continues to grow very strongly. As we mentioned in the past, Eddie, we do not separately identify these because that will distort the way that we actually traditionally track our different sectors.

We are able to tell you the online e-commerce sector continues to outpace the general 85% increase and has been growing by over 100% for Q3 still.

Speaker 4

The next question comes from the line of Paul Wu from Samsung Securities. Your line is open.

Speaker 0

Thank you for taking my question. I have a question related to your personalized homepage. I was wondering if you could give us an idea of how many people have signed up for this service already? Related to that, is this service on your way to do more of an SNS-like features like Google has done with Google+? Thank you.

Speaker 3

Hi, Paul. For Baidu's new personalized homepage, users do not need to separately sign up. As long as they have a regular account, whenever they log in, they will see the personalized homepage as their default homepage. The adoption rate has been healthy. I think users are acceptable to this new homepage setting. The benefit of it is obviously users in a lot of cases do not even need to search to reach the site that they are interested in, and also they can reach the feed they sign up on other social sites. Users will be able to view a lot more information than before on the Baidu homepage that includes the social information based on various Baidu social products like Baidu Post or Baidu Space, as well as social feeds from other sites.

We believe that personalization is a very fundamental need from our users, and it also underscores our efforts that are devoted to this direction instead of developing a single social network site. That's been our strategy.

Speaker 4

The next question comes from the line of Richard Jay from Morgan Stanley. Your line is open.

Speaker 0

Hi, Robin, Jennifer, thanks for taking my call. I have a question regarding iQIYI, and so far, can you just give us a little more color on the advertising spending trend on iQIYI, especially given its robust unique visitor growth as well as traffic growth? Going forward, shall we be able to see more cross-selling for advertising service between Baidu and iQIYI?

Speaker 3

iQIYI is a young venture. We have been pretty much focused on expanding the user base and improved user experience. Because of the nature of online video, I think the business model is quite clear, which is advertising, and we are basically competing for media time on this front. We are not so worried about the revenue opportunities of this venture. We have talked to the iQIYI team on cross-selling, but we have not really done much in the past. Going forward, that's certainly a real possibility.

Speaker 4

The next question comes from the line of Jane Munster from Piper Jaffray. Your line is open.

Speaker 0

Good morning, and all of my congratulations. I would say an impressive growth and an impressive guidance. Maybe we could talk a little bit about what are some examples of further improvements to your platform that you can still make and perhaps compare that to Google's platforms. In what stage are you in terms of your platform relative to Google? Thank you.

Speaker 3

It's very hard for us to compare this with our competitors. We don't know exactly what they have done and what they are doing. What we have seen is that we have lots of room for improvement in the Phoenix Nest system. Basically, there are two main areas that we can improve upon. One is the mechanisms inside. As I mentioned, advanced phrase match is basically a changing mechanism. The other side is the account management, so to speak, the CRM system. How do we provide tools for our customers to better manage their marketing campaign? We just got started on that front. We believe a better management system or more tools will help a lot of the customers, especially the small and medium customers, to spend more comfortably on our platform.

What I can tell you is that we have a lot of levers here, and we will continue to monitor the ROI for our customers. We believe as we move on, we will be able to release the buying power from both the large customers and the SMEs.

Speaker 4

The next question comes from the line of Ming Zhao from SIG. Your line is open.

Speaker 0

Thank you. Good morning. I have a question on the customer acquisition. It seems like you added about 6,000 customers in the quarter. The year-over-year growth has some deceleration there, but you also, in the meantime, booked strong out-bookers. My question is, is it because you have a lot of large customers with stronger spending power that has threatened some of the SMEs' customers, so the customer acquisition has slowed? Any color on that would be appreciated. Thank you.

Speaker 3

I think it's a number of reasons. First, as you probably realized, our focus was more on the large accounts over the past couple of quarters. The desire to spend and the budget to spend on our platform is really high. Secondly, we also realized that there's a macroeconomic reason for this. China is gradually moving away from the export-oriented economy, so there's a rebalancing of the macroeconomy. Some of our export-oriented customers are not doing so well. Thirdly, the SMEs do not really have the necessary tools to really spend on our platform, and we are working on that too.

Speaker 4

The next question comes from the line of Alex Yao from Deutsche Bank. Your line is open.

Speaker 0

Hey, good morning, everyone, and thank you very much for taking my question. Hi, Robin. Can you talk about the number of paid clicks growth in this quarter, and how would you envision this to continue to grow in the next several quarters? Thank you very much.

Speaker 1

Alex, paid clicks grew very healthily this quarter. As we mentioned, we continue to improve our monetization capability, and that in itself helps to improve the click-through rate and generates the number of clicks that will ultimately deliver the customer's ROI. We continue to have ways to refine our monetization platform, and we anticipate paid clicks, as usual, the trend I've seen increasing and growing healthily for our customers, and there's no reason for us to think why that shouldn't be the case going forward.

Speaker 0

Thank you.

Speaker 4

The next question comes from the line of Alicia Yap from Barclays Capital. Your line is open.

Speaker 1

Good morning, Robin, Jennifer, and Victor. Our question is on, have you seen any increase in attractions on the contextual ads, and how will the TAC be trending in the next few quarters, and what should we expect in terms of the margin trend in the fourth quarter and 2012? Thank you. Yeah, contextual ads is a very important initiative for us, and we have been focused on improving on the technology, the product, and also develop customer understanding to adopt the tool. The business initiative is tracking well. We're pleased to see the progress, and as I've indicated in my script, over the longer term, as we gradually improve and take traction on this business, you should expect the TAC rates to increase accordingly because for this business, it's an important initiative, and we do pay out a higher payout ratio to our union partners.

Over time, gradually, as we gain traction from this business, you should expect TAC to increase.

Speaker 4

The next question comes from the line of Wallace Chung from Credit Suisse. Your line is open.

Speaker 0

Hi, good morning. Thanks for taking my questions. I recently did some soft policy restricting some of the pharmaceutical companies not to spend on the TV advertising in CCV1 after 6:00 P.M. Would that policy actually be positive or negative to Baidu as pharmaceutical is pretty much one of the biggest industry segments for Baidu? Thank you.

Speaker 1

We are aware of that development, but we don't have any indication to see if there's any specific regulations that will actually affect our online marketing services to the medical and healthcare service providers. What we have control over is our own process. We have put a lot of effort as part of our normal business process to ensure that we service our end users with quality contact information, and we're vigilant in terms of developing our advertisers. It is very hard for us to say one way or another how this will affect us, but we are doing things that we have control over.

Speaker 4

The next question comes from the line of Jenny Wu from Baidu. Your line is open.

Speaker 1

Thank you for taking my question. Hi, Robin. Would you please share with us your observation on advertiser spending behavior, such as, is that a general trend that more and more large advertisers will adopt this paid search as a key advertising platform? Currently, what industries are your existing large accounts from? Thank you.

Speaker 3

Yeah, sure. I think it's definitely true that the large accounts are very much aware of the trend. From the companies or customers I have been talking to, they all have a mandate from the higher level that they should allocate more of their budget, more of the advertising budgets to online to search. Among all the advertising forms, search obviously provides the best performance, so it's much easier for them to show to their boss how effective the advertising campaign is on Baidu. For the other advertising platforms, online or offline, it's much harder to demonstrate that. Search has definitely become a key advertising platform for them.

Speaker 1

In terms of the large accounts and some of the sector players, our customers, as we mentioned, you're familiar with some of the auto vertical auto players like the manufacturers, the OEMs. We have the game sector that's pretty good. Retail, online services, these are all brand players, and they are large accounts for us.

Speaker 4

The next question comes from the line of Cynthia Ming from Jefferies. Your line is open.

Speaker 1

Thank you for taking my question, and congratulations for a great quarter. I have two questions. From your current business development activities, especially with the SMEs, does management see stronger take-up of search marketing from third-tier and interior of China? Do you anticipate any, or have you observed any weakness from the current credit crunch in some of the places for SME companies? The second question is, can management give any guidance on expected run rate investment in iQIYI and Qunar for 2012? Thank you.

Speaker 3

For the first one, Baidu, since it's largely consumer or domestic consumption-oriented, the large cities still contribute a supermajority of our revenue, and the growth rate is far too high. You can probably imagine the large accounts are growing faster, and the revenue contribution from the major cities is getting larger instead of smaller. From this point of view, the third-tier cities are growing fast, but not as fast as the large cities. Because of our limited exposure to those very, very small cities and very, very small enterprises, we have not got any sense of the impact of the credit crunch you mentioned.

Speaker 1

With regards to support from Baidu towards iQIYI and Qunar, on iQIYI, as I mentioned, we supported iQIYI with cash investment in Q3, and we'll do a similar cash investment injection into iQIYI in Q4. After that, we'll assess from time to time what is the optimal options that we have to support this venture. If, as the time comes, I will let you know if there's any new development. With regards to Qunar, we acquired the majority of the company, and Qunar has sufficient cash. On an ongoing basis, Qunar's own business is growing very healthily, has very little demand for additional cash from our perspective. In the near term, I do not expect that Qunar will call for cash contribution from Baidu.

Speaker 4

The next question comes from the line of Andy Yung from Oppenheimer. Your line is open.

Speaker 0

Hi, good morning. Congratulations on a very strong quarter. I just want to ask a little bit about the mobile space. Can you give us some insight into the mobile search area, how much of your current search volume is coming from mobile devices, and also, is there a difference or any difference between your online and mobile paid clicks behaviors and how you actually monetize those clicks?

Speaker 3

Mobile search is a little bit different from the PC search. It's kind of hard to compare on an app-to-app basis. Each mobile page is generally much shorter than a PC page, so the number of page views on the mobile side is different from the number of page views on the PC side. The industry is in, I think, its very early stage. We're still trying to optimize the mobile search experience. We have not been very aggressive in monetizing the mobile traffic yet. We do plan to optimize the advertising part of mobile too. For example, we would allow our customers to show the phone numbers, and consumers can just click on those numbers and make phone calls. This is not possible on the PC side.

Mobile is growing faster than PC, but it's still a relatively small part from the page view point, digital view point of view, and it's an even smaller part from the revenue point of view.

Speaker 4

The next question comes from the line of Gary Nguyen from UBS. Your line is open.

Speaker 0

Thank you very much for taking my questions. I have a question on competition, especially on vertical searches like Alibaba's retail. In the rest of the world, we haven't really seen a successful vertical search elsewhere, but neither have we seen a country which, you know, 80% of the gross merchandise value is being controlled by one company. I just want to get your sense of how do you see the competition, competitive landscape going forward in this particular vertical search. What do you think is the advantage or disadvantage of Baidu versus your competitor? Thank you.

Speaker 3

Yeah, our fundamental belief is that users, most of the users, they don't want to distinguish their information needs from shopping to cars to lifestyle. Any type of information needs, they naturally come to Baidu and search for it. We have the largest user base, and we have the most sophisticated search technology, so we are quite confident users will be increasingly relying upon Baidu for all types of information needs. This is also true for e-commerce-related information needs. Like I mentioned before, virtually all of the large B2C e-commerce sites advertise on us. That's because we can drive traffic. We can drive very good quality traffic to those sites, and users, it's a trend, as you probably also agree, that more of the shopping activities will happen on those credible, larger e-commerce sites, and we are certainly a big beneficiary of that trend.

Speaker 4

The next question comes from the line of Mizhi Lei from Mizuho Securities. Your line is open.

Speaker 0

Hi, thank you for taking my questions, and congratulations for a great quarter. I would like to ask more insight about your feelings of the slowdown in the e-commerce, like group buying and also some general merchandise e-commerce websites that they closed down their services, and how this industry contraction will affect your fourth quarter's result and going forward into 2012. Thank you very much.

Speaker 1

In general, I think we saw a big increase in terms of group buying sites getting promotional activities on our platform, and there has been, in our sector, some level of consolidation on our platform. We continue to see the group buying sites are spending with us. The e-commerce side, as I mentioned, continues to grow very strongly. These sectors over the past few quarters have been growing very nicely. As Robin mentioned, we are really at the center stage in terms of the overall internet activity development and the growing transition of users to take advantage of the internet space to do e-commerce activities. Ultimately, Baidu will be the beneficiary. At this, you know, they do not make up to be the top sectors in terms of revenue contribution, so any slight variations in that sector do not really have a material impact to our bottom line.

Of course, we're very excited to see the e-commerce sector growing nicely, and Baidu is right in the center of all the activity.

Speaker 4

The next question comes from the line of Mayuresh Masurekar from Collins Stewart. Your line is open.

Speaker 0

Thanks for taking my question, and congratulations on a great quarter. Large advertisers are clearly playing a big role here. What percentage of the large advertisers' total marketing budgets and online advertising budgets is currently being spent on search? In your opinion, how high can that number go? I have a follow-up question.

Speaker 3

It really varies from customer to customer and from industry to industry. Some of the more internet-savvy accounts spend virtually all of their budget on the Baidu Search platform, while for the other more offline-oriented businesses, they still only allocate a very small percentage of their total advertising budget to us. It varies from like the 80%, 90% of the budgets for those really online-centric sites to like less than 10% online marketing budget for those more traditional businesses. The trend is that they are allocating more budget to online, and an even larger percentage is allocated on search. Of course, you can tell that a much larger portion of the economy comes from those offline businesses, and in general, they spend around like 10% of the advertising budget online, and then out of online, they spend like 30%, 40% on search.

We definitely have a lot of room for growth there.

Speaker 0

Thanks, and my follow-up question is, travel is one of the major advertising verticals for you. As you integrate Qunar into Baidu, what is the reaction that you're getting from your travel source to advertisers? Does it change your role as a partner, and what is the benefit to monetization that you might be getting from the travel paid per clicks?

Speaker 3

Qunar is essentially a vertical search engine. It satisfies the needs of our users' travel activities. It is very hard to separate the Baidu searches from the Qunar searches. We continue to serve our customers from all kinds of travel-related businesses. They have a choice to run their marketing campaign on the Baidu platform or the Qunar platform. Qunar is more detail-oriented, more specific on a lot of things. For Baidu, we are more generic. In this sense, maybe more of the Baidu users may not have that clear intention of where to go or what to do, that sort of thing. They will come to Baidu, and we try to convert that into the real travel customers.

For Qunar, the users in general have a better idea of what they would like to do and where they would like to go, so they go there and find the right information.

Speaker 1

The objective for us to acquire Qunar is really to ultimately provide our users a better search, a better overall search experience as they're looking for travel-related information. As they get into Baidu and they're looking for travel information, they really land on a premium, high-quality vertical travel search information. In general, we're providing travel search information. As you are looking for travel businesses, there are a whole slew of different players and different stages of activities that the user will carry out, such as transaction, such as commenting. In terms of our relationship with the other travel sector players, we don't see any slowdown in terms of their advertising activities on our platform. In fact, in Q3, sequentially, travel was a very strong sector that sees a strong sequential growth.

The notable travel players that you will have a familiar name, they are all increasing their spending in Q3 with us.

Speaker 4

The next question comes from the line of Wendy Huang from RBS. Your line is open.

Speaker 1

Hi, I have two housekeeping questions. The first is regarding your margin. Gross margin and operating margin both hold up quite well in Q3 in spite of increasing bandwidth costs and also amortization costs of the intangibles. Can you give some color for operating margin and gross margin for Q4, especially sales marketing costs? How would that change up in Q4? My second housekeeping question is regarding Qunar. Just to double-check, is this Qunar's revenue included in the online marketing revenue in your revenue breakdown? If this is the case, has your number of advertiser figure and also apples figure included Qunar's contribution as well? Thank you. Great. On your first question, in terms of margin, margin is really a reflection of the speed of revenue growth and also the speed of our investment. Our top priority is really focused to drive the top-line growth.

As I've mentioned in quite a few quarters and that you have seen, we have aggressively invested in R&D, in infrastructure, and in strategic initiatives. These expenses will add up and flow through our expense line. The operating margin is really a natural fall of what the revenue is and what the expenses are. You have seen in the past quarter the trend in terms of all the line items are expenses, and that should give you a pretty good idea in terms of the speed of our investments that we're actually carrying out. In terms of marketing costs for Q4, we do anticipate a continued increase in SG&A expenses, and particularly marketing per se. You do note a Q3 step up, and we would anticipate a Q4 continued step up in terms of marketing spend.

What actually happens in Q4 is this year marks the 10th anniversary of Baidu's commercial product. We will do a number of celebrations and events to carry out to continue to develop the market and promote search engine marketing. We may even carry out some TV commercials in certain cities. Continue to expect that we will do the marketing efforts to develop the market and promote the brand. Sequentially to your question, you should expect marketing expenses to go up. On your second question with regards to Qunar's revenue, Qunar's financials are completely consolidated into Baidu's financials. Both the revenue as well as each expense lines are added, and Qunar's revenue is included in the online marketing revenue dollar amount. Qunar's customers and their customers' output also contributed to Baidu's overall picture. As I mentioned, Qunar's overall impact is very insignificant.

Speaker 4

The next question comes from the line of Zheng Xiao of Macquarie Securities. Your line is open.

Speaker 0

Thank you for taking my follow-up question. Just to follow up on the operating margin comments, last quarter you correctly predicted that in the near term because of the massive investment you are making in operating. We

Speaker 2

Can shut Trend down and it did. I was just wondering, going forward, it doesn't have to be this quarter, just generally, like for the next few quarters, the direction of the sort of the operating margin, how should we sort of handicap that? Thank you.

I really wouldn't want to enter specifically into the margin predictions as we don't typically do that. As we mentioned, you know, we will continue to drive the top line growth, and you have already, I think, a graph, a good pattern of the way we invest and the expense line items, how that should form out. I think the Q2 and Q3 expense development gives you an idea in terms of the magnitude and the pace, how that's going. If we're looking longer term, really, search is a beautiful business model and has tremendous scalability. Our focus really is to drive the top line growth at this stage because we're really at the very early stage of letting the market stay, knowing the beauty of search engine marketing, and really continue to spend a lot more with us. We deliver the kind of ROI to our customers.

We don't really focus on the margin, so I can't really give you quarter-on-quarter predictions, but this is a beautiful margin, beautiful business, and we are managing this business with a very disciplined approach. We invest prudently to develop future opportunities to drive long-term growth.

Okay, thanks for the comments.

Speaker 3

The next question comes from the line of Dick Wei of JPMorgan. Your line is open.

Speaker 2

Yeah. Hi. Thanks for taking my follow-up. My first question is a longer-term question. If I looked at Q3, sequential revenue growth around 22%, but if I look at the account residual, it's up by 60%. I assume that was just a 90 impacted the large customers are spending much more in Q3. I guess in the preparing remarks that this directory site is also seeing 50% sequential growth. It seems like the SME growth is very much lower than the 22% revenue growth measure. I wonder, for the next three to five years, how would that kind of mix be changed? If you can shed some light, that would be great. I have a follow-up as well. Thanks.

Speaker 1

Yeah. Like I mentioned, the large accounts grow much faster, actually, faster than we had expected too. The point is really that because of our central position in China's internet ecosystem, we are able to reap the benefits of any emerging sector. Last quarter, classified information websites suddenly emerged. They pumped up their advertising on us, and certain verticals would go up and down. It is always a macro trend that once they are in a position to expand their business, they would advertise on our platform. I also mentioned because of the relatively difficult environment for the export-oriented businesses, some of the SMEs are not doing so well. The overall customer portfolio is very healthy, and we just need to come up with the right products, with the right tools for them to really benefit from our online marketing platform.

Speaker 2

Gotcha. Great. Robin, I think just to follow up on that, what are you seeing in terms of the sentiment for some of the large advertisers or maybe SMEs as well given the macro uncertainties? Any particular sectors where we're seeing stronger sentiment or weaker sentiment, or any delay from expanding as well? Any general macro comment would be great.

Speaker 1

Honestly, we have not seen much sentiment on the macro economy, with the exception of export-oriented businesses in the tougher position. Our top verticals are all doing very well. As you know, we are more domestic consumption-focused, and this sector is growing very, very nicely. We haven't seen any slowdown on this front.

Speaker 3

The next question comes from the line of Wallace Chung from Credit Suisse. Your line is open.

Speaker 2

Hi. Thank you. Some issue-related questions. It seems the customer deposit in the third quarter has substantially jumped a lot, but the deferred revenue actually is coming down. Can you explain? Also, one more is, it seems the minority interest loss is actually going up a bit. Is it more related to China? Thank you.

Yeah. Hi, Wallace. Customer deposit, basically, these are the deposits customers make with us. Primarily, the SMEs, they will do a cash deposit, and then they will incur their spending. When you see a customer deposit increase in the first, that's a good indicator of the strong customer desire in terms of spending with us. Deferred revenue, sometimes, it's more or less related to the large account. Large accounts have payment terms and more complicated contracts. To meet the revenue recognition test, a lot of the criteria need to be met, and all the duties need to be fulfilled. You will see some movements of deferred revenue, but that is not a real indication of revenue going forward.

In terms of minority interest in the P&L line, you're referring in the P&L line, I think for the equity accounting that I have pointed out, those are related to the equity accounting-related entities that we invest, and those accounting treatments are under equity accounting methods. If you are looking at less the income, that's overall loss attributable to non-controlling interest, and those are other ventures that we host that really have very small impact to the overall picture. I think if you are trying to get to what is this minority interest related to China, China's financial is doing pretty healthily. It can stand on its own.

Speaker 3

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.

Speaker 2

Once again, thank you for joining us today, and please do not hesitate to contact us if you have any further questions.

Speaker 3

Thank you for your participation in today's call. This concludes the presentation. You may now disconnect. Good day.