Article / 29 April 2015 at 5:01 GMT

Earnings Preview: Investors prepare for Baidu's weak Q1

China Watcher / Shanghai
China
  • Baidu is the tech giant behind China's top search engine
  • The Nasdaq-listed company reports its Q1 earnings today, after US markets close
  • Investors expect slowing revenue growth, based on management guidance

By Neil Flynn

In its fourth quarter earnings conference call, Baidu’s management warned investors that because of the late timing of the Chinese New Year holiday, revenue growth will be noticeably lower than the recent average. Since then, the Chinese tech giant has been embroiled in a public spat with private hospital union Putian, which raises concerns about the important healthcare advertising business.

Ahead of the release of the first quarter earnings on Wednesday April 29, after the close of the US markets, these are the five key points that investors should focus on.




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China's New Year festival only lasts a week, but people head to their hometowns two weeks before that, and delay returning to work in the cities to avoid heavy congestion. Photo: iStock

Just how weak was revenue growth?

Baidu’s share price reacted negatively after the release of the fourth quarter earnings in February. But despite earnings beating consensus, and revenues missing by just 70 million yuan, investors were concerned with the weak first quarter revenue guidance that implied year on year growth would fall to just 35.4%, after averaging 54% in the previous four quarters, and 47.7% in the previous eight quarters.

The firm cited that due to the late timing of the Chinese New Year festival, Baidu’s first quarter earnings would be adversely affected. This year, the week long festival began on February 19, which later than last year (January 31) and the year before (February 10). Typically in China, business is very slow between Christmas and Chinese New Year, as western clients return from their holidays just as Chinese firms prepare for theirs. In addition, while the New Year festival only lasts a week, people start returning to their hometowns two weeks before that, and can return to work up to two weeks afterwards in order to avoid the unparalleled traffic congestion seen during the festival.

Therefore, the later the date of Chinese New Year, the longer the period of slow business performance for Baidu in the first quarter, and hence the explanation for the firm's notably low revenue guidance.

Baidu's Revenues















Source: Baidu Investor Relations  

Given that the date of the Chinese New Year is based on the lunar calendar, there is always an ambiguity as to when the festival will occur, and investors are usually able to accept this, as it affects most Chinese companies, not just Baidu. However, the potential upside for the firm is that because they discussed the effect of the late Chinese New Year in the fourth quarter earnings conference call, it has already been fully priced in.

I have concerns about other firms that failed to bring up the issue in their previous conference calls, as online retailers will be especially affected as third party merchants and couriers stopped working during the holiday.

The notably low revenue guidance may also be related to the ongoing concerns surrounding the dispute with private hospital union Putian, which I discuss below. Healthcare advertising is a major component of Baidu’s advertising revenues, and the ongoing contractual dispute may have caused first quarter revenues to fall even further than management initially expected.

Standoff with Putian

Earlier this month discusssed how Baidu has entered into a public spat with the private healthcare union Putian (see No winners from Baidu’s healthcare spat ) over the renewal of advertising contracts that require hospitals to commit to a high minimal annual increase in advertising spending.

As China’s dominant search engine, Baidu has the power to charge higher prices than its rivals, simply because it attracts so much more traffic. Most advertising clients accept this, and with search engines promoting the potential of the healthcare advertising business during their fourth quarter earnings conference call, Baidu has required Putian's hospitals to sign master contracts, in order to guarantee a minimal level of healthcare advertising revenue. However, Putian has rejected these contractual terms, which leaves both firms in a standoff.

Baidu’s market power has seen ad revenues and customer growth rise steadily

Baidu's Advertising Customer Metrics







Source: Baidu Investor Relations  

The reason this is such an important issue is that healthcare advertising is estimated to account for 30% of Baidu’s advertising revenues, with half of that coming from Putian’s hospitals in just the three major cities of Beijing, Shanghai and Guangzhou. Healthcare advertising is an important long-term driver of revenues for search engines, because the private healthcare business in China is growing at a fast pace.

The Chinese government is happy to let market forces reform the fragmented healthcare industry, and this has seen a huge increase of capital inflows into private healthcare. China’s wealthy and ageing population has seen demand for private hospitals grow, and firms are willing to spend more on search engine marketing in order to capture this growth. 

The result of this dispute is likely to see a decline of between 3% and 6% in Baidu’s revenues, and investors will be keen to not only hear the progress of the dispute, but more importantly, how and when it will be resolved. Baidu may be the biggest search engine in China, but Putian is a client that it simply cannot afford to lose.

Need to limit content costs

China’s online video market continues to face rising content costs as growing competition in the market and stricter regulations of foreign content have seen costs soar. Whilst Baidu, along with BAT trio rivals Alibaba and Tencent, are able to compete financially in the market, the exponential growth in content costs isn’t sustainable.

Previous industry leader Sohu Video reported widening net losses, despite screening eight of the top 10 domestic TV dramas during the quarter, and the second highest ranked TV show, entitled Sing My Song.


Baidu's Rising Content Costs















Source: Baidu Investor Relations  

The key strategy for Baidu via its iQiyi and PPS video platforms is to promote user generated and partner generated content, in order to diversify away from the expensive syndicated content. As I discussed in my Sohu earnings preview last week (see Earnings Preview: How long will Sohu remain sustainable?), user and partner generated content is essential for a sustainable and profitable video business because firms can increase monetization through product placements, and they aren’t competing with rivals to screen the content.

Note that iQiyi and PPS are essential business units for Baidu as China’s tech giants grow their ecosystems into homes and cars, and investors will want to see that management is striving to make its online video businesses sustainable.

Car market strategy

The first quarter saw Baidu make investments in several car related firms, including in-car entertainment  and private car hailing (as described in my article entitled  Five Chinese startups every investor should know). This is a strategy that Baidu has focused on over the past year, as the firm expands its mobile ecosystem with e-commerce and travel verticals, as well as integrating its closed loop ecosystem into vehicles.

Ride sharing and taxi hailing has grown notably over the past year, and it is common for users to have several different hailing apps available, in order to find a taxi. After investing in Uber, Baidu has led the Series C funding round for Tiantian Yongche (天天用车 – literally. Everyday use a car), which offers several different services, including private cars, point to point, carpool and ride sharing. The firm is gaining popularity in China, and whilst it currently only covers the major eastern cities, it intends to expand its services to 60 cities by the end of the year.

Private car hailing is an important part of Baidu’s mobile ecosystem, because it allows the users to find and pay for transportation via their smartphone. Perhaps just as importantly, it keeps users away from Alibaba’s and Tencent’s and payment services (for more on this, read Taxi app merger with Tencent to boost Alibaba) . 

I have discussed previously about how China’s tech firms are targeting the car as a key strategy (fore more detail, read China’s tech titans target the auto market), in order to expand their service ecosystems away from smartphones, and also to collect more user behavioral data, in an environment where smartphone usage is understandably low. Baidu has been working with BMW on developing a semi-autonomous car, which will see the firm equip the vehicle with its services ecosystem. This is a strategy that all of China’s tech giants are pursuing, and we should expect to see these internet-connected vehicles come to the market by next year.

The cloud security market

In my previous report on rival Qihoo (for detail, read #TechWeek: Qihoo needs to show shareholders the money), I was bullish on the firm’s presence in online security, and how expansion into the enterprise security market will be a key revenue driver for the firm in the coming years.

Baidu has increased its presence in the market by acquiring online security outsourcing firm Anquanbao (安全宝 – literally "Safety treasure"), which had previously received funding from Alibaba and Tencent, but has now become a fully owned subsidiary of Baidu. Anquanbao is a cloud based program that protects websites from malware and other attacks, and has previously worked with AWS China to offer enterprise firewall services for major clients. It is expected that Baidu will integrate Anquanbao into its Baidu Cloud services, which will give Baidu a strong presence in the enterprise security market.

Given that Qihoo’s management has talked up the potential of the industry for the past 12 months, I would expect Baidu’s management to discuss their presence and strategy for the industry in the first quarter earnings conference call. 

Earnings history

The Baidu May Week 1 $220 straddle, which expires on Friday, closed last night at a mid price of $12.13 on the screen, which implies that the market is expecting a move of 5.5%. Given the recent one-day post earnings history, this is slightly high, but investors will be concerned about the effect of the private hospital dispute on Baidu's revenues.

Analysts are expecting Baidu to post revenues of 12.9 billion yuan and diluted non-GAAP earnings per average diluted share (EPADS) of 6.52 yuan, whilst the company has offered revenue guidance of between 12.645 bn and 13.065 bn yuan.      

Baidu's Earnings History










Sources: Baidu Investor Relations, Yahoo Finance.

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– Edited by Robert Ryan


Neil Flynn is a portfolio manager at Alcuin Asset Management. Follow Neil or post your comment below to engage with Saxo Bank's social trading platform.





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