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The Paul Merage School of Business at UC IrvineTeam Project - BaiduTeam Members:Todd Hochheiser, Henry Jenkins, Monika Prasad, Jonathon Tupper, Mark Wells12/3/2009Contents TOC
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Company Snapshot PAGEREF _Toc247631282 2Introduction PAGEREF _Toc247631283 3Products and Services PAGEREF _Toc247631284 3Industry Overview PAGEREF _Toc247631285 4Strategic Analysis PAGEREF _Toc247631286 4SWOT Analysis PAGEREF _Toc247631287 5Financial Analysis PAGEREF _Toc247631288 6Income Statement Analysis PAGEREF _Toc247631289 6Balance Sheet Analysis PAGEREF _Toc247631290 7Ratio Analysis PAGEREF _Toc247631291 7Profitability PAGEREF _Toc247631292 7Liquidity PAGEREF _Toc247631293 8Cash Flow Analysis PAGEREF _Toc247631294 9Comparing Company Strategies to Ratio Analysis PAGEREF _Toc247631295 10Forecasting PAGEREF _Toc247631296 11Income Statement PAGEREF _Toc247631297 11Balance Sheet PAGEREF _Toc247631298 12Cash Flow Statement PAGEREF _Toc247631299 13Valuation PAGEREF _Toc247631300 13Sensitivity Analysis PAGEREF _Toc247631301 14Special Difficulties PAGEREF _Toc247631302 14Sources PAGEREF _Toc247631303 14Appendix PAGEREF _Toc247631304 15Financial Statements PAGEREF _Toc247631305 15Forecasting Sanity Checks PAGEREF _Toc247631306 16Valuation Assumptions PAGEREF _Toc247631307 17Valuation Sensitivity Analysis PAGEREF _Toc247631308 17Valuation using FCFE – Likely Case PAGEREF _Toc247631309 18Valuation using FCFE – Best Case PAGEREF _Toc247631310 19Valuation using FCFE – Worst Case PAGEREF _Toc247631311 20Company SnapshotStock DataCompany DescriptionClosing Price (2009/11/24)435.54Baidu, Inc. (Baidu) is a Chinese-language Internet search provider. The Company conducts its operations in China principally through Baidu Online Network Technology (Beijing) Co., Ltd. (Baidu Online), its wholly owned subsidiary in Beijing, China. It also conducts its operations in China through Baidu Netcom Science Technology Co., Ltd. (Baidu Netcom), which holds the licenses and approvals necessary to operate the Company's Websites and provide online advertising services. In January 2008, the Company launched a Japanese search service at www.baidu.jp, run by Baidu Japan. The Company's Japanese search services enable users to find relevant information online, including Web pages, images, multimedia files and blogs, through links provided on its Websites.Baidu generates revenue primarily through online marketing (i.e., selling advertisements).Key Points:Revenue compound annual growth rate (CAGR) of 128% over three years.Net income CAGR of 196% over three years.According to Web site traffic ranking company Alexa.com, the Baidu’s flagship website was the most visited in China and the ninth most trafficked in the world as of October 2009.Baidu had approximately 216,000 active online marketing customers.52 Week Range100.50 – 442.86Ticker SymbolBIDUExchangeNasdaqGSShares Oustanding (mil)34.69Market Cap (mil)15,110P/E (ttm)76.9EPS (ttm)5.66YieldN/AFiscal Year EndsDecAnnual Revenue (mil)2008A2009E2010E465636899EPS3 Year Price History for BIDU2008A2009E2010EFull Year$4.42$6.15$8.81Q10.76Q21.61Q32.07Q41.65EIntroductionBaidu, Inc. (“Baidu”) was incorporated in the Cayman Islands in January 2000. Since its inception, it has conducted operations in China principally through Baidu Online, a wholly-owned subsidiary in Beijing, China. It has also conducted part of its operations in China through Baidu Netcom, a consolidated affiliated entity in Beijing, China, which holds the licenses and approvals necessary to operate the websites and provide online advertising services. In addition, Baidu has established three PRC subsidiaries and assisted in establishing two PRC consolidated affiliated entities in recent years. It formally launched a Japanese search service in January 2008 and now has three subsidiaries in Japan.Products and ServicesBaidu is the leading Chinese language Internet search provider. As a technology-based media company, the firm aims to provide the best way for people to find information. In addition to serving Internet search users, it provides an effective platform for businesses to reach potential customers. According to a market survey announced by iResearch Consulting Group, a third-party market research firm, processed approximately 1.1 trillion Chinese language web search requests in 2008, accounting for 73.2% of the total Chinese language web search market in China. The company targets three types of online participants:Users. Baidu primarily offers a Chinese language search platform on www.. The firm provides Chinese language Internet search services to enable users to find relevant information online, including web pages, news, images and multimedia files. The firm also offers online community-based products and entertainment platforms such as Baidu Post Bar, Baidu Knows and Baidu Space. In addition, Baidu also offers beta versions of Baidu Hi, its IM service and Baidu Youa, its C2C service.

Customers. Baidu designs and delivers online marketing services on via www. 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 OverviewChina 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 AnalysisCompetitive Rivalry: HighThe 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: MediumWhile 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: LowWhile 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: MediumThere 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 AnalysisStrengthThe 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.WeaknessThe 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.ThreatBiggest 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.OpportunityAt 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 AnalysisIncome Statement Analysis99.9% 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 AnalysisThe 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 AnalysisProfitabilityCurrent 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 AnalysisThe 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 ActivitiesCash 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 ActivitiesAcquisition 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 ActivitiesBaidu 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 AnalysisWhile 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. YahooGoogleBaidu 200720082007200820072008Profitability Ratios Operating (Profit) Margin0.100.100.310.310.310.34(Net) Profit Margin0.090.060.250.190.360.33ROA0.070.040.210.170.300.33ROCE0.070.040.210.170.380.42Profit Margin on ROCE0.090.060.250.190.360.33Fixed Asset Turnover5.735.035.164.704.074.49COGS as % of Sales0.330.320.340.330.370.36Capital Structure Leverage Ratio1.271.251.101.121.281.29SG&A as % of Sales0.480.470.290.300.240.21Liquidity Ratios Current Ratio1.412.788.498.772.733.36Quick Ratio1.332.658.128.032.633.25Cash Ratio0.872.026.986.882.523.14CFO to Current Liabilities1.020.943.463.622.052.43Solvency Ratios Liabilities to Equity Ratio0.280.220.120.120.310.27Liabilities to Assets Ratio0.190.120.100.110.240.22L/T Debt to Equity Ratio0.000.000.000.000.000.00L/T Debt to Assets Ratio0.000.000.000.000.000.00CFO to Total Liabilites Ratio0.710.782.182.232.022.42CFO to Current Liabilities Ratio0.831.102.843.412.052.43ForecastingIncome StatementRevenue 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. In all scenarios, growth is expected to diminish on an almost logarithmic basis.Scenario200920102011201220132014Long TermBest40.2%32.0%24.8%18.7%13.9%10.2%6.0%Likely36.6%25.7%17.2%12.7%9.2%6.6%4.0%Worst30.2%16.3%8.0%7.3%6.6%6.0%2.0%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 SheetFor 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.

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