Robin Li , (Chairman, CEO)
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Baidu, Inc. incorporated on 18 January 2000, is a Chinese web services company headquartered at the Baidu Campus in Beijing‘s Haidian District. It is one of the largest internet companies, and one of the premier AI leaders in the world. The holding company of the group was incorporated in the Cayman Islands. Baidu was established in 2000 by Robin Li and Eric Xu. Both of the co-founders are Chinese nationals who studied in Peking University and worked overseas before returning to China. In December 2016, Baidu ranked 4th overall in the Alexa Internet rankings.According to the annual ranking of China’s top 100 internet companies which release by Ministry of Industry and Information Technology of the Chinese government, Baidu occupied the third place in 2016’s ranking.
Baidu’s Global Business Unit, formed under the name of DU Group or DU Apps Studio, is an app developer with a wide variety of popular award-winning apps and services, accumulating over 2 billion users worldwide. It aims to provide innovative products, as well as new and exciting business models and ways to interact with technology, through AI and mobile devices. It has also established offices around the world including Brazil, India, Indonesia, Thailand, Egypt, Japan and the United States, with the goal of becoming the core player in shaping how technology works, in every continent. Its award-winning products include DU Battery Saver, DU Speed Booster, MoboMarket, DU Browser, Facemoji Keyboard, DU Flashlight, DU Security, DU Cleaner, DU Privacy Vault, DU Antivirus, Photo Wonder, DU Caller, DU Recorder, ES File Explorer, Simeji, and more. Baidu also provides an official international and Chinese version of its widely popular online digital distribution services Baidu App Store and Shouji Baidu respectively, both hosting a vast amount of downloadable content and applications from all over the world.
Baidu has the 2nd largest search engine in the world, and held a 76.05% market share in China’s search engines market, the largest in the world, as of April 2017. In December 2007, Baidu became the first Chinese company to be included in the NASDAQ-100index.
As of 2017, Baidu Search released Spider 3.0 which is capable of indexing over trillions of web pages. Baidu offers multimedia content including MP3 music, and movies, and is the first in China to offer Wireless Application Protocol (WAP) and personal digital assistant (PDA)-based mobile search.
Baidu Brain, the company’s AI-based artificial neural network has achieved a remarkable 97% accuracy rate in voice recognition and 99.7% rate in facial recognition, confirming the success of its AI development.
Baidu Cloud, the company’s cloud arm has received recognition from many industries due to its unique offerings, it adopts an integrated approach that combines capabilities and resources in AI, Big Data and Cloud Computing, providing customers with not only storage and computing but also complete solutions and services that are ready to deploy. Numerous companies and organisations have been using Baidu Cloud to increase the accuracy and efficiency of their products and services, as well as developing new technologies. The customer base of Baidu Cloud has increased 10 fold year-over-year, with traffic increasing eight fold and revenue increasing four fold. Recently, it has released the ABC – STACK, a hybrid cloud platform that provides enterprise customers with powerful and flexible solutions to effectively integrate and deploy AI into their businesses.
Baidu Baike is similar to Wikipedia as an online encyclopedia; however, unlike Wikipedia, only registered users can edit the articles due to Chinese laws. While access to Wikipedia has been intermittently blocked or certain articles filtered in China since June 2004, there is some controversy about the degree to which Baidu cooperates with Chinese government censorship.
The company also hosts a music service Baidu Music that has more than 200 million monthly active users, news service Baidu News Feed that has more than 100 million daily active users, and food delivery service Baidu Waimai that has more than 100 million monthly active users. On 4 December 2015, Baidu announced plans to merge with Taihe Entertainment Group to help the service compete with Apple Inc.‘s Apple Music.
In 2017, Baidu announced that its ambitious Apollo autonomous driving program (often called the ‘Android of the autonomous driving industry’, an open source platform for self-driving that includes hardware, software and cloud data services for autonomous vehicles) has over 50 partners (automakers, tier 1 suppliers, component producers, startups, academic institutions, government departments, artificial intelligence and technology companies), including FAW Group, one of the major Chinese carmakers that will work with Baidu on commercialization of the technology. Other partners include worldwide auto companies Chery, Volkswagen, General Motors, Hyundai, Daimler AG (Mercedes-Benz), BYD, Ford, Changan Automobile, ZF Friedrichshafen, BAIC, JAC and Great Wall Motors, as well as global organisations Tsinghua University, Intel, ZTE, Bosch, Continental AG, Nvidia, Microsoft, Velodyne, NXP Semiconductors, TomTom, UCAR, Grab, AutonomouStuff, Horizon Robotics and more.
- Customers. Baidu designs and delivers online marketing services on via http://www.baidu.com to P4P (“pay for play”) customers and other customers who require tailored online marketing solutions. The auction-based P4P services enable customers to bid for priority placement of their links in keyword search results. The firm believes it was the first auction-based P4P service provider in China. The online advertising services allow customers to use both query sensitive and non-query sensitive advertising services, including text links, graphical advertisements and other forms of online advertising. The P4P customers are those who primarily use auction-based P4P services, and tailored solutions customers are those to whom the firm provides marketing solutions, which may consist of one or more forms of online advertising services as well as P4P services. In the fourth quarter of 2008, the firm had over 197,000 active online marketing customers. Customers keep a deposit with Baidu and are expected to replenish this amount at a certain level. Tailored online marketing solutions are provided on net terms and result in accounts receivable.
- Baidu Union Members. Baidu Union includes a large number of third-party web content and software providers. Baidu Union members typically incorporate a Baidu search box into their websites. The firm provides high-quality and relevant search to their users, and in return gains the benefit of increased traffic. Baidu has also launched programs through which it displays online advertisements of customers on Baidu Union members’ websites and share the fees generated by these advertisements with the owners of these Baidu Union websites.
- Industry Overview China is widely perceived as one of the world’s most dynamic economies, given its record of, and prospects for, sustained levels of notable growth. It has more Internet users than any other country and rapidly increasing levels of broadband penetration. According to Analysys International, the Chinese Internet market will more than double in size from 2008 to 2011. Search marketing accounted for 45% of the market as of the fourth quarter of 2007, and it is expected to continue to gain share. As of mid-2008, Baidu was the leader in this segment, with a 64% share of its revenues. In second and third place were Google with 26% share and Alibaba.com with 5.5% share. Although history has shown that non-Chinese companies have had limited success in the Chinese Internet segment, formidable competitors are beginning to improve their offerings.There are some ownership issues for internet companies as well. The PRC government restricts foreign investment in the Internet and advertising businesses. Accordingly, Baidu operates their websites and online advertising business in China through Baidu Netcom, a company wholly owned by their chairman, chief executive officer and co-founder Robin Yanhong Li and co-founder Eric Yong Xu, both of whom are PRC citizens. Baidu Netcom holds the licenses and approvals necessary to operate the website and online advertising business in China. They have contractual arrangements with Baidu Netcom and its shareholders that allow them to substantially control Baidu Netcom, but given the structure and regulation by the PRC government, there is no guarantee that they will be able to enforce their contracts despite owning the company.
- Strategic Analysis Competitive Rivalry: High The online marketing industry in China is very competitive, consisting of domestic firms such as Alibaba.com and Sohu.com, and well-capitalized non-Chinese companies including Google, Yahoo and Microsoft. Competition takes place for traffic (aka “eyeballs”) and analytics, demonstrating to potential advertisers that each search engine brings more people with more dollars.
- Buyer Power: Medium While buyers are highly fragmented (216,000 advertising on Baidu alone), switching between online marketing firms is easily done. Contracts are generally short term (one year or less).
- Supplier Power: MediumFor online marketers, the most powerful suppliers are those who control the telecommunications circuits through which traffic flows and the data centers in which a company’s data processing equipment resides. Price tends to increase dramatically from the lower-tier providers to the higher-tier ones with redundancy and capacity. Baidu mitigates this power through its telecom affiliate, Baidu Netcom (also owned by Baidu’s largest shareholder).
- Threat of Entry: Low While just about anyone can set up a website, online marketing relies heavily on two factors: the network effect to generate large amounts of user traffic and the ability to scale computing power to keep up with that traffic. Both requirements cost significant amounts of money in R&D and capital expenditures to implement and maintain.
- Threat of Substitutes: Medium There are numerous substitutes to online marketing, including newspapers, television, magazines, billboards, and others. However, no medium has the same reach with the same relatively low cost structure. Even highly targeted advertising is available via special-interest websites, although not with the same effectiveness.
- SWOT Analysis
- Strength — The company’s strength lies in its brand recognition and strong R&D expenditures. Baidu has spent heavily on advertising to build up its brand as well as on R&D to constantly come up with innovative, new products. So far the hard work has paid off as Baidu has gained almost three quarters of the Chinese market, compared with its next closest competitor, Google, at almost 20% marketshare.
- Weakness – The company’s weakness lies in its ability to develop the infrastructure quickly to keep up to growing demands. There is a huge Chinese population residing in rural areas where there is no internet available. Also, Baidu’s international expansion to Japan has not provided the same growth as China. Baidu must also weary of government policies in the internet search space as the central government has historically had a heavy hand in not only the content Chinese people are able to view via search engines, but also in determining which companies are able to provide those services.
- Threat -Biggest threat to Baidu is competition. Although Baidu has enjoyed a first mover advantage, the Chinese search market is still relatively untapped as over three quarters of the Chinese population still does not have internet access. This is changing rapidly as increasingly more users come online each month. Several companies, such as Google, Yahoo, Microsoft, Alibaba, Sohu to name but a few, have developed their own Chinese language services and products to attract customers and advertisers.
- Opportunity – At the end of 2008, approximately 22.5% of the Chinese population had internet access, with the rural regions of the country actually growing faster than the urban centers. With many more users expected to come online, China plans on improving its infrastructure by rolling out a faster 3G network with construction set to begin in 2011. China already has more internet users than in the United States, and should this pace continue, Baidu has the potential to be one of the largest search providers in the world. However great these opportunities are, Baidu continue to provide new and differentiating services to the Chinese customers simply to maintain its market share. .
- Financial Analysis.
- Income Statement Analysis — 99.9% of Baidu’s revenue is from online marketing, known as their Pay for Play (P4P) services. The P4P service enables a customer to place its website link and related description on Baidu’s search result list. The customers make bids to determine how much they are willing to pay for each click to their listings in the search results listed on the website. The amount of the customer’s bid will influence the ranking of the customer’s listing in the search results. The customer pays only when a user clicks on one of its website links. Revenue is recognized when a user clicks on one of the customer-sponsored website links. As prescribed by SEC Staff Accounting Bulletin No. 104, or SAB 104, there is persuasive evidence of an arrangement, the fee is fixed or determinable, and collection is reasonably assured at this time. Revenues increased 171%, 123% and 96% in 2006, 2007 and 2008, reflecting extremely strong growth. The cost of revenue consists of business taxes and surcharges, traffic acquisition costs through Baidu Union, bandwidth costs (i.e., data center and telecommunications fees), depreciation of server equipment, and salary & benefits for operating and technical support personnel. The cost of revenue has hovered between 36% and 37%, yielding a gross margin between 63% and 64%.
- The largest components of operating expense are selling, general and administrative (SG&A) and research and development (R&D). Selling and marketing expenses primarily consist of salaries, benefits and commissions for sales and marketing personnel as well as promotional and marketing expenses. The firm expects to incur higher selling and marketing expenses as it intensifies brand-promotion efforts. To the extent that the direct sales force sells a greater proportion of online marketing services, the firm expects that selling expenses will increase as a result of increased sales commissions. General and administrative expenses primarily consist of salaries and benefits for general and administrative personnel and fees and expenses for legal, accounting and other professional services. SG&A accounted for 21% of sales in 2008, down from 30% in 2006. R&D expenses primarily consist of salaries and benefits for research and development personnel. The firm expenses research and development costs as they are incurred, except for capitalized software development costs that fulfill the capitalization criteria under SOP 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” R&D expenses were 9% in 2008, down from 9.5% in 2006. The gradual decrease as a percentage of sales indicate that the firm may have achieved some economies of scale in their administration. However, Baidu does note in their most recent 20-F that sales and marketing expenses are likely to increase because of a shift from primarily word-of-mouth advertising to more traditional marketing.
- Balance Sheet Analysis.
- The largest assets on the firm’s balance sheet are cash and marketable securities (73% of total assets in 2006 to 68% in 2008) and property, plant & equipment (net) at approximately 18% – 20% of total assets. Most of the firm’s customers do not pay with terms, so accounts receivable are a very small portion of the balance sheet. The firm has also been deliberate with acquisitions, so goodwill and finite intangibles are less than 5% of total assets. Because customers generally have deposits on account with the firm, accounts payable is the largest liability account at approximately 22% of assets. Interestingly enough, this balance sheet item did not seem to grow at the same rate as sales in 2008 (47% growth in accounts payable vs. 96% growth in revenues) but it does appear to hold relatively steady against assets as a whole.
- Ratio Analysis
- Profitability — Current assets comprise 72% of all assets. Cash and equivalents comprise 68% of assets in 2008. This compares favorably with other online marketing companies.
- As with most companies that profit from their intellectual capital, Baidu has relatively high net and operating profit margins, both of which are comfortably over 30%.
- The return on common equity has been very strong at 42% and while costs as a percentage of sales have increased (from 32% in 2005 to 36% in 2008), they are well under control and can be supported by operating cash flows.
- Liquidity – Baidu is a very liquid company and solvency (both long-term and short-term) is not an issue. If anything, the ratios suggest that the firm is having difficulty putting its cash to use effectively.
- The firm’s current and quick ratios are both well above 3. The firm certainly has more than enough cash from operations to support its current and total liabilities.
- The firm has no long-term debt, and consequently no interest expense obligations whatsoever.
- Cash Flow Analyas
- The years 2005 through 2007 were atypical of most startups. While cash flow from financing was positive, so was cash flow from operations (CFO). Cash flow from investing (CFI) was negative, as expected when a technology startup is plowing most of its money into fixed assets (primarily computer equipment). In 2008, the company started repurchasing common shares, making its cash flow from financing (CFF) negative for the first time. Excluding the 2005 IPO, CFF has been near zero for 2006-2008. The quality of earnings has improved over time. The EQ ratio appears to be below 1.0 because of the significant amount of addbacks from depreciation, share-based compensation, customer deposits and accrued expenses. In 2007, Baidu started accounting for gains and losses in trading securities as well. The increase in depreciation and share-based compensation is unsurprising, given the nature of the Internet online marketing industry. Customer deposits for the P4P service are restricted cash and would be expected to increase with revenue. In 2005, these accruals were 285% of net income; by 2008, they had decreased to 73% of net income.
- Cash Flow from.
- Operating Activities Cash from Operations has remained strong and consistent for Baidu with the more recent NI/CFO ratio ranging from .57-.67.
- Strong CFO is a good sign given such a young company, as it has exhibited a quick move towards strong positive cash flows from core operations.
- Strong CFO will allow Baidu to have substantial assets on hand for expansion and further improvement on existing assets and technologies.
- Cash Flow from Investing Activities
- Acquisition of fixed assets is the key driver of CFI and should be expected given Baidu’s rapid expansion and reliance on technology.
- CFI indicates that Baidu is growing rapidly both through organic growth and acquisition.
- Short-term investments make up a large portion of CFI activities. Most of these investments are comprised of fixed-rate securities in commercial banks with original maturities of less than one year and are guaranteed. These should indicate that Baidu is looking to preserve cash on hand to use in emergency situations and is managing its cash conservatively when not being used for other purposes.
- Items within CFI seemed to vary greatly which is to be expected given the variability in the needs of a growing company for expansion and updating of equipment.
- Cash Flow from Financing Activities
- Baidu has no long-term debt and all proceeds from financing are in relation to the 2005 IPO.
- The only other item of note in CFF is the structured share repurchase in 2008 under an existing agreement with a particular financial institution. Similar agreements have been issued for the future and should be expected in future projections.
- Comparing Company Strategies to Ratio Analysis
- While Baidu is a company prudently bent on growth in China and the Asia Pacific region, many aspects of its financial statements give the impression that it is a more mature company. This is more evident when comparing the profitability, liquidity and solvency ratios to its North American based competitors Google and Yahoo! which are also targeting the Chinese and Japanese markets and implementing similar strategies for acquiring new users. In a relatively short period of time, Baidu has managed to handily outpace both Google and Yahoo! on virtually every significant profitability ratio. Certainly, Baidu’s higher capital structure leverage ratio and its ability to keep SG&A cost low help explain some of the discrepancies between its peers. It is evident that both Baidu and Google are able to take advantage of their scale in the markets they compete in. The rapidly growing Chinese internet space has certainly provided significant cash flows to Baidu. It is interesting to note that, Google also struggles to make efficient use of its cash flows. Yahoo! is certainly the weakest firm in this regard, but has started to make improvements over the past twelve month period. All firms have no long-term debt and, except for Yahoo!, any other liabilities are easily covered by operating cash flows.
- Income Statement Revenue is the primary driver for the forecasted financial statements. While the firm’s CAGR is almost 130% in 2008, no company can sustain that level of growth. At this time, 99.9% of sales are derived from online marketing in China. Although the firm is attempting to grow other sources of revenue, the forecast assumes that the firm will continue to see online marketing as its primary source of revenue, much as Google has found it difficult to generate sales apart from its online advertising efforts. The three major drivers of expenses in an online marketing firm are cost of revenues; selling, general & administrative; and research & development. All of these remained relatively constant as a percentage of sales in the past. However, because of competitive pressure and potential diseconomies of scale, the following assumptions were made in forecasting.
- Cost of Revenues: The growth rate for this expense was held steady in all scenarios at 37% of revenues. This expense item consists of business taxes and surcharges, traffic acquisition costs, bandwidth costs, and IT operations and technical support personnel. The group believes that these costs will continue to increase linearly with sales.
- Selling, General and Administrative: These costs will jump in 2009 for all scenarios based on the 20-F forecast that the company is switching from a “word of mouth” model to a more serious marketing effort. The best case scenario assumes economies of scale as SG&A falls from 26% of revenue in 2009 to 23% of revenue of 2014. The likely case assumes 26% of revenue every year. The worst case assumes diseconomies of scale, resulting in an increase from 26% of revenue in 2009 to 29.4% in 2014.
- Research & Development: Research in 2009 is expected to grow as competition heats up. Year over year growth starts at 9.5% and grows 2%, 5% or 8% year over year for the best, likely and worst-case scenarios (respectively). Other income statement items forecasted include:
- Interest Income: Interest income is assumed to be equal to the average cash balance multiplied by the implied interest rate (4.1%).
- Income taxes: According to the 20-F, online marketing corporate taxes are expected to be 15% from 2009 forward. That statutory rate is used going forward, as the forecast assumes that most of the firm’s revenues will remain online marketing. Income statement accounts ignored for lack of data include non-recurring gains and losses, other income / (expense), interest expense, minority interest in earnings and cumulative effect of changes in accounting principles.
- Balance Sheet For balance sheet items, forecasting was affected by three major accounts: fixed assets, cash and accounts payable. The following calculations were generally the same for all scenarios, except fixed assets.
- Fixed assets: Internet-based companies require tremendous amounts of computer equipment to handle all of the traffic they receive. With 1.1 trillion searches in 2008, this firm is no different. Fixed assets (net) are expected to grow in some proportion to revenue in all scenarios. As equipment is depreciated over 3-5 years, the expected growth rates must take into consideration replacement costs. Because of this, the fixed asset CAGR for the best case scenario is 27% (+1% over revenues), likely case is 32% CAGR (+5% above revenue) and worst case is 31% CAGR (+21% over revenue). The reason for the tremendous jump from likely to worst case is the accelerated replacement rate.
- Cash: Cash was targeted between 59-64% of total assets. The initial calculation was based on that year’s total assets plus implied dividends.
- Marketable Securities: Marketable securities were held to the average percentage of marketable securities to cash over the prior three years.
- Accounts Receivable: Accounts receivable were held to a constant percentage of sales.
- Other Current Assets: This account includes prepaid expenses, advances to suppliers, interest receivables and other miscellaneous accounts. This was held to a gradually decreasing percentage of total assets based on prior trends.
- All other asset accounts (e.g., deferred tax assets) were forecast as a constant percentage of total assets.
- Accounts Payable: This item consists of several components including customer deposits, accrued expenses, deferred revenue and deferred income. Of these components, customer deposits and accrued expenses comprised approximately 90% of the account, split equally. Based on prior trends, this account does not appear to correlate with revenue and thus was forecast as a percentage of total assets.
- Deferred Revenue: Includes any development contracts paid for by customers but not actually delivered by the firm. This was forecast as a constant (and small) percentage of total assets as there appeared to be no correlation with sales.
- All other liability accounts: The firm has no debt, long- or short-term.
- Additional Paid-In Capital: As the company appears to be cash flow positive going forward, there was no need to project additional capital. Thus, the value of this account was held constant going forward.
- Accumulated Other Comprehensive Income: The firm holds cash and marketable securities in U.S. dollars. Assuming further devaluation of the dollar and/or appreciation of the renminbi, foreign exchange losses will continue to rise. This loss in AOCI is expressed as a constant percentage of total assets.
- All other shareholder’s equity accounts: The firm pays no dividend and has no plans to buy back stock. No changes were assumed in the forecast.
- Cash Flow Statement.Cash flow items were derived from income statement and balance sheet amounts.
- Valuation Industry analysis for online companies typically uses free cash flow, as most Internet-based companies do not yet pay dividends. Using the FCFE model of valuing stock shares based on facts and expectations about the company’s future, company’s business, future cash flows and likely risks three scenarios are being considered – likely, best and worst. The prediction is given in the table below: The weighted average cost of capital was determined to be 9.33% with a market risk premium of 6%, a risk-free rate of 3.21% and an industry beta of 1.02.
- Share price valuation indicates that the firm is significantly overvalued, even in the most optimistic scenario prepared for this analysis. Worse yet, the risk-free rate is currently distorted by the Federal Reserve’s quantitative easing. Should the risk-free rate go up as expected, the valuation gap between the firm’s price today and its present value will deviate even more significantly.
- Sensitivity Analysis – The sensitivity analysis demonstrates that a 1% drop in long-term growth rates will result in an 18% drop in share price. However, the discount rate used for the analysis is even more significant, as a 1% increase in the discount rate results in a 23% drop in share price! This is to be expected from a high-risk, high-growth firm that pays no dividend. The future reward (i.e., the present value of the 2015 perpetuity) is worth 96% of today’s share price valuation.
- Special Difficulties – High growth companies are difficult to model. The team decided on relatively logarithmic growth, which turned out similar to analyst predictions .
- 20-F is still GAAP, so interpreting the financial statements worked better than expected. However, some accounting items were found in unusual places.
- Some balance sheet assets found in strange places. Customer deposits, prepaid expenses, etc.
- ROA decomposition did not seem right because of high cash balances; used Google ratios as a sanity check.
- Worst-case valuation was negative, so the team adjusted cash flow held back for operations to a more reasonable level.BAIDU 20-F (2005, 2006, 2007, 2008) – Securities and Exchange Commission, EDGAR.
- Thank you ………..