Article / 04 November 2015 at 1:06 GMT

Big spender Baidu needs a strategy makeover

China Watcher / Shanghai
China
  • Baidu’s Q3 earnings were well received, but its spending looks unsustainable
  • Net margins have tumbled in the past three years, and major changes are needed
  • The Nasdaq-listed search engine firm has no viable rivals in China
  • It should be able to grow revenues without having to spend excessively
By Neil Flynn

Baidu’s third quarter earnings generated a positive response in the share price, rallying from its pre-release price of $168.99 to last night’s close of $195.19. This was understandable given that the firm beat expectations on earnings, revenues were in line, and announced that its billion dollar share repurchase plan had already been complete, and that another major repurchase plan would take place.

However, behind the headline results, there is a concerning trend at Baidu that it is having trouble keeping its costs under control.


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 Like China’s princelings, Nasdaq-listed search engine company Baidu appears to be
recklessly spending money without regard for its value. Photo: iStock



Over the past few years, Baidu’s net revenues have remained relatively stable, despite averaging 10% quarterly revenue growth over the same period. This has seen the net margin fall from 44.2% to just 15.5% in just three and a half years. Yet perhaps the most concerning aspect of this is that Baidu is either unwilling to arrest this decline, or worst, doesn’t know how to.

Baidu's net margins















Source: Baidu Investor Relations. Create your own charts with SaxoTrader; click here to learn more.


Like China’s princelings, Baidu appears to be spending money without regard for its value. Over the past 18 months, the firm has spent heavily on its video platforms iQiyi and PPStream in order to screen the best content.

This is something that I have discussed many times, particularly in regard to Sohu. Content costs are exorbitant in China, and with the largest platforms being backed by the richest firms, this will only continue.

Baidu content costs

















Source: Baidu Investor Relations

Investing in content is all well and good if there is a tangible benefit from doing so. Online marketing and advertising accounts for 96% of Baidu’s total revenues, but as the number of marketing clients grows, the growth in average revenue per client is grinding to a halt.

Therefore in addition growing costs, Baidu is seeing declining pricing power. This is evidence that Baidu’s investment strategy isn’t working.

Baidu pricing power





















Source: Baidu Investor Relations

What makes this declining pricing power issue interesting is that Baidu doesn’t have any viable search engine rivals in China. Its largest rivals Qihoo Search and Sohu’s Sogou attract traffic flows, but in reality it is akin to comparing Google with Bing.

In my opinion, Baidu should be able to leverage its monopolistic position in the search engine market to grow revenues without having to hemorrhage money.  

Cutting Non-Core Expenses

In the second quarter earnings conference call, the firm announced that it would begin to invest heavily in its O2O food delivery business. It was previously very successful in Beijing, but rarely used in Shanghai, but in the three months since the announcement, Baidu Food has become a popular service.

However, this is an overly simplistic assessment. Over the past three months, Baidu has been offering large discounts to customers that use their food delivery service. As an example, when you order food from Baidu’s O2O platform, an order that originally costs 40 yuan would cost just 30 yuan, with the 10 yuan discount simply being due to Baidu trying to build its user base. In addition, once the order has been placed, you get a further 10 yuan discount off future purchases.

On the rival Meituan service, you get no discount for using its platform, and only get a 1 yuan discount off future orders. All the platforms are the same, in the sense that they have the same restaurants offering the same food at the same prices, so the only choice for users to make is to find the platform with the best discount.

Over the past week, Baidu’s large discounts have decreased notably. When you place an order, Baidu has now stopped offering discounts on future purchases. This can be taken in two ways. First, the sheer expense of offering large discounts is unsustainable over a long period of time. This was exhibited with the Kuaidi-Didi taxi hailing battle, until both decided to merge. Second, offering two sets of discounts is actually pointless, because they can’t be used together. The first discount is always fixed, but second discount for future purchases varies. Therefore you would only use it if it exceeds the fixed discount, which it rarely does.

Baidu doesn’t just offer the largest discounts in the O2O food delivery business; they are the largest by a significant margin.

In addition, Baidu has put a ban on non-campus hiring, with any experienced hire requiring the approval of CEO Robin Li. Essentially, unless another Andrew Ng (Baidu's chief scientist) comes available, the firm's workforce will become younger and cheaper. My take on this is that Baidu will continue to invest in units such as its O2O business, but will cut any superfluous costs.

An industry symptom

The three tech giants in China, Baidu, Alibaba and Tencent, collectively known as the BAT trio, have been trying to outspend each other over the past few years. They are so big that they essentially act as the biggest venture capitalists in China, taking stakes in small startups, integrating them into their respective ecosystems and hoping to profit.

The problem is that this investment rivalry is circular in nature, because as Tencent invests in a service that begins to generate money, Alibaba and Baidu will have to spend more on a rival service to compete. It has essentially reached the stage where all three need to continue to spend heavy just to compete with each other, with no firm willing to take the first step and reduce investment expenditure for fear of losing market share.

Investors shouldn’t expect to see a notable decrease in the investment in content and O2O over the coming quarters, but I expect that we will see efforts to halt the decline in net margin.

– Edited by Robert Ryan

Neil Flynn is a China watcher based in Shanghai. Follow Neil or post your comment below to engage with Saxo Bank's social trading platform.

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