百度 (BIDU) 2006 Q3 法說會逐字稿

And thank you for standing by for Baidu's third quarter 2006 earnings conference call. [OPERATOR INSTRUCTIONS]. Today's conference is being recorded. If you have any objections, you may disconnect at this time. I would now like to turn the meeting over to your host for today's conference, Ms. Lesley Zhang, Baidu's senior manager for Investor Relations.

Hello everyone and welcome to Baidu's third quarter 2006 earnings conference call. We distributed our third quarter earnings earlier today and you'll find a copy of the press release on the Company's website as well as on newswire services.

Today you will hear from Robin Li, our Chief Executive Officer, and Shawn Wang, our Chief Financial Officer. After their prepared remarks, Robin and Shawn will be available to answer your questions.

Before we continue, please note that in this discussion today it will contain forward-looking statements made as under the Safe Harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Baidu does not take undertake any obligation to update any forward-looking statements. except as required under applicable law.

As a reminder, this conference is being recorded. In addition, a webcast of the conference call will be available on Baidu's corporate website at ir.baidu.com. I will now turn the call over to Baidu's CEO, Robin Li.

Hello everyone. Thank you for joining us today. I am pleased to let you know that we had another good quarter as we strengthened our position as the number-one provider of Internet search in China and continue to grow our revenues.

During the quarter we expanded and enhanced our product offering, further refined our monetization algorithms, rationalized our distribution network in Beijing and invested in technology to position Baidu for long-term growth.

The popular community-based search products, like Baidu Space, Baidu Knows, Baidu Profile and Baidu Encyclopedia, and along with our vertical search products, including Legal Search, Baidu Index, University Search, Government Search and Youth Search will continue to boost traffic growth and gain market share by making Chinese search more useful and convenient.

In fact, according to an independent survey by China Internet Network Information Center, Baidu's share of Chinese Internet traffic rose to 62% as of August 2006, compared to 48% as of August 2005. We are excited to see that the gap between Baidu and our competition continues to widen.

During the quarter we continued to invest in refining our monetization algorithm. As we discussed previously, in June we optimized our monetization algorithm by introducing a dynamic starting bid system. And, in September, we introduced an intelligent ranking system which provides a better user experience and increases the customer ROI by incorporating relevancy into the ranking system for sponsored links.

This new initiative may affect our revenue growth in the near term. However, we believe that for users, the greater relevance in their search results and our online marketing customers receive higher quality hits from their increased spending, those changes will produce strong revenue growth over the long term.

We believe that the best way to ensure Baidu's growth for the long term, is to continue investing in technologies that give our users the best search experience. By staying focused on improving all our user experience, we believe that we will continuously increase our ROI for our customers and give exceptional long-term value for our shareholders.

Another area in which Baidu is pushing technology is in the mobile space, as we modify our most popular offerings so that they can be accessed by people on the move.

In addition to our traditional web search, we have now adapted and ramped up our other search functions such as Baidu Knows, Baidu Weather, Flight, Train Information, Baidu Dictionary and Baidu Stock Search for use on mobile phones, WAP devices and other non-traditional means. We're seeing good results from this early effort and expect it to be an area of growth for us in the future.

Leadership in the Chinese search market is not just a matter of getting unparalleled market share and user traffic. It is also essential to ensure that our online marketing customers receive the dedicated service that they deserve. With this in mind, we begin to transition from serving customers by a third party distributor, to direct sales in the Beijing market in July. We are sure that in the long term our customers will appreciate direct access to our in-house sales and service teams based in Beijing. And we expect that this will be reflected in our future results.

In other cities, we continue to help improve our distributor capability to serve our customers. Over the quarter we provided online marketing services to more than 102,000 customers compared to over 90,000 in the second quarter.

Baidu's leadership in China's Internet industry makes us the perfect partner for international content providers. And I am pleased to talk to you about our most recent alliance with MTV Networks the world's very powerful online entertainment platform.

Through a dedicated MTV Zone portal on Baidu's website, China's 123m Internet users will have access to 15,000 hours of MTV and Nickelodeon original video content and music videos licensed to some five music companies. We are excited by the opportunity for collaborations with leading content providers and will continue to keep our eyes open for strategic partners that enhance our user experience.

I spoke to you earlier about the important changes made in our monetization algorithm. With these changes, we are going through a transition period for the next couple of quarters. But we believe these changes will have a positive impact on our long-term revenue growth. More importantly, we have never been more confident that the combination of our deep connection to Chinese Internet users and our ability to create products that meet their needs, will allow Baidu to excel in many years to come.

Lastly, many of you will have noted that our Chief Technology Officer, Jerry Liu, has decided to resign. Jerry has been a good friend and colleague over the years and played an important role in making Baidu the top search engine in China. He has also helped to establish what we consider as one of the best tech teams in the Internet industry. Jerry has decided to leave for personal reasons and we wish him all the best.

We have here a very strong team with many engineers who will be spearheading our ongoing initiatives. And I am sure who will continue to exceed expectations. Meanwhile we are considering options for Jerry's successor.

I will now turn to call over to our CFO, Shawn Wang, to discuss our financials.

Thank you Robin. Hello everyone. As Robin mentioned earlier we delivered solid revenue and earnings results in the third quarter. I will walk you through the factors contributing to these results and other financial highlights. Again, the numbers I refer to will be in renminbi, unless otherwise indicated.

The revenue. Our third quarter total revenues were approximately CNY239m. And that is a 25% increase from the previous quarter, and 169% increase from a year ago. That is within the guidance we provided.

Online marketing revenue was CNY238m or 99% of total revenue. That represents 26% sequential growth and 177% growth year over year. The revenue growth was driven by a number of factors, including traffic growth, a sequential increase in the number of active customers of 13%, as well as sequential increase in per-customer spending of 12%.

Traffic acquisition cost as a component of cost of revenue was CNY22m, or 9% of total revenues. TAC remained flat as a percentage of revenue compared to the previous quarter.

Capital Expenditure for the third quarter was CNY51m, up from CNY41m in the second quarter. CapEx was mostly spent on additional network capacities to support traffic growth.

Our effective income tax rate for the third quarter was [12.7%] versus 15% for the second quarter. The decrease of our effective tax rate for the quarter was primarily due to tax incentives newly granted to one of our PRC subsidiaries. As a result, the tax expenses in the third quarter included a reversal of CNY6m that was recognized in previous quarters. And the PRC tax regulation and these tax incentives were typical for Internet technology companies in China.

Our share-based compensation expenses increased in aggregate to CNY16m from CNY12m in the second quarter. The sequential increase in share-based compensation expenses primarily reflects the change in accounting estimates of the forfeiture rate. We did not grant a significant amount of options or shares during the quarter.

For the full year 2006, we expect share-based compensation expenses for awards granted to employees prior to October 1, 2006 to be CNY47m, assuming there is no material change in the forfeiture rate estimate. This amount does not include expenses to be recognized over the remainder of the year related to awards to be granted to employees after October 1, 2006, or awards to non-employees that have been or may be granted.

R&D expenses for the third quarter were CNY25m, representing a 34% increase from the previous quarter and a 67% increase from the third quarter of 2005. That increase is primarily due to the expansion of R&D headcount.

Now our earnings. Our net income was CNY85m representing a 46% sequential increase and a 903% increase year over year. The growth reflects the enhanced [profitability] of our business and our reduced tax rate as well.

Net income excluding share-based compensation expenses, a non-GAAP measure, was CNY102m, representing a 45% increase sequentially, and a 426% increase from the third quarter of 2005.

Basic and diluted EPS, excluding share-based compensation expenses, was CNY3.03 and CNY2.94, translating roughly to U.S.$0.38 and U.S.$0.37 respectively.

Net margin, excluding share-based compensation expenses for the quarter, was 42% up from 37% in the previous quarter.

Now moving on to balance sheet. We ended the third quarter with a cash equivalent in short-term investments of CNY1.1b or U.S.$137m. Operating cash flow for the quarter was CNY131m or U.S.$17m, representing a slight sequential increase.

Adjusted EBITDA, again a non-GAAP measure, was a CNY112m for the third quarter, representing 32% increase from the previous quarter and 304% increase from the corresponding period in 2005.

Now let me provide you our top-line guidance again for the fourth quarter 2006. We currently expect total revenues to be between CNY270 and CNY280m, which will represent an annual growth rate of 135 to 143% and that is a sequential growth of [13 to 17%]. I do wish to emphasize that this forecast reflects Baidu's current and preliminary view. It is subject to change.

Now I will turn the call back to Robin for his closing remarks.

Thank you again for joining us today. We are very proud of our progress to date and excited by the opportunities that the world's second largest market of Internet users has to offer. We look forward to presenting better results in the years ahead. I now open the call to questions.

[OPERATOR INSTRUCTIONS]. Your first question comes from the line of Anthony Noto with Goldman Sachs. Please proceed.

Thank you very much. Hi Robin and Shawn. My question -- I know your revenue came in within your guidance range, but historically has been at the high end region above that. So my sense is from your comments that there is a transition going on. I just wondered if you could attribute for us potentially the impact on your revenue in the quarter from the transition of distributors in Beijing vis a vis the impact of monetization changes.

And as you're talking about monetization changes, just looking at what we've seen from other companies on a global basis such as Google, is that if they changed their algorithm to be more relevant in terms of their advertisements, they've actually seen an increase or out-performance in revenue as opposed to potentially a step back in revenue. So I was wondering if you can just talk about that as well. Thanks.

Hi Anthony. This is Robin. Okay, sorry we had some sound problems. Let me answer it this way. I think you correctly noted that the Beijing distributors was replaced with direct sales team. And during this same period we changed our monetization algorithm. The monetization algorithm has actually become more complicated than before. As you know, the Chinese online advertisers for customers are not as sophisticated as the U.S. equivalent, so it will take some time for them to digest our changes.

And therefore, for the short term impact, our revenue is negative. But we do believe this positions us very well for long-term revenue growth. This transition of Beijing market from distributor to direct just seems a little worse because we were not able to hire enough number of sales and customer service people to explain the change to our existing and potential customers.

I see. I think actually that provides a lot of clarity, which I want to play back a little bit of what you've said, just to make sure I understand it. Your old ranking methodology allowed advertisers to put in potentially just one bid. And they knew exactly how much they had to bid and how much money they had to spend to get a certain level of performance.

Now they may have to put in more than one entry, i.e. they may have to put in a bid and they may actually have to put in other inputs. So they may need more information to get to the same level of volumes. And therefore there is a frictional cost to that lack of knowledge that they have today. Maybe it's a similar case that you having to find when they switch their algorithm. Is that a fair characterization?

Well, I would say it's more psychological than real. The starting bids are changed. But it's still very clear when a customer logs in, they will clearly be given a definitive starting bid for each [inaudible] they are bidding on. But the change actually makes the system a little harder to understand because many of those customers were not so used to the different pricing for the starting bid. The auction system itself still works like an auction, so transitional effort by the customer or advertiser is not that much.

Okay. Thank you very much.

Thank you.

Your next question comes from the line of Safa Rashtchy with Piper Jaffray. Please proceed.

Hi. Good morning Robin and Shawn. Thank you. Could you give us some clarification on the level of impact that you are seeing from the changes you are implementing, especially for Q4, [relating] to 17% sequential increase that you gave. Could you perhaps give us some of the qualitative measure of how much that would have been had you been [still] with the old system. And I have a quick follow up to that.

Safa, I think our current guidance did factor in the transition we are going through because of this monetization algorithm changes. There are a lot of factors that affect the revenue growth for the current quarter of Q4. I believe the main reason is the changing algorithm and the changes we need to make accordingly in the internal systems, such as customer service and sales. Other than that, I don't see any major issue in the Q4 guidance.

Okay. And on the follow up, could you tell us if you feel you have staffed up enough to meet the requirements for basically educating the customers as well as dealing with your customers in Beijing directly, now that you have taken out the distributors? Or is there still a process where you need to build up your sales force and marketing force?

And one final question, unrelated, but I'll give it to you now is, Shawn, if you could give us some way to think about the tax rate in 2007, that would be great. Thank you.

First of all, I think we made the right move. So the changes will be beneficial to the Company in the longer term. We need to have lot of customer service and train them to understand the change better and communicate these changes to the current and potential customers.

What we found is that new customers are very receptive to the changes. We have no problems to sign up more new customers. For the existing customers, this takes time for us to explain the changes, so that they, at least psychologically, will be more receptive to the new system.

Okay.

Your next question comes from the line of Dick Wei with JP Morgan. Please proceed.

Hi Robin and Shawn. Two quick questions in terms of the customer service strategy. I think [inaudible] really needs hand holding and organizing those campaigns. I am thinking what kind of customer service employees that you intend to hire going forward. If you can give us some sense on the size and also what kind of incentive structure are you giving them. And furthermore is there any plans for either helping those customers to build websites in the future, because I think many of the customers have given up their sites and so --?

Many of our distributors do have this function or are keen to build websites for our customers.

In terms of customer service we generally hire relatively young and junior people and train them. It does not require very high-tech employees to serve the customers. It's just that they need training. We need to tell them our rules. We need to explain to them how the system works. And we just need to help our customers understand how we bring value to them.

These things are not very complicated. It does not require even a college degree to do so. In the past, we hired customer service people like this. We just didn't hire customer service people quickly enough to digest the changes we are making.

Do you have any comments concerned with the size of the customer service team that you have?

The size is roughly three to one. For every three sales we have about one customer service.

Okay. Thanks Robin.

Your next question comes from the line of Robert Peck with Bear Stearns. Please proceed.

Yes. Hi everybody. Congratulations. I just wanted to ask a couple of quick questions. First, is there any update on any of the lawsuits or potential lawsuits around keyword advertising practice?

And number two, there's a couple of questions on the direct sales force. Can you tell us a little bit about what percent of the business is coming from direct versus indirect? Could you talk a little bit about the compensation structure for direct sale? When you talk about compensation, what percent of that is going towards engineers, what percentage is going to sales and marketing?

And lastly, could you give us a little bit of color on the pre-tax margin for the direct business versus the indirect? Thanks.

Okay Robert, that's quite a bit of questions. Shawn here. In terms of litigation update there hasn't been any changes in the major litigation. Mainly I think the [inaudible] for the past few quarters. The [MP3] litigations are still status quo. There has not been any movement in the legal proceedings.

Now, on the other type of litigations, as of today, I know that there are some press articles talking about motions on the motions on the [inaudible] business and on [Click Soft]. But the fact of the matter is we've been checking with the Court and, as of yesterday, we didn't receive any notice from the Court. So the [hyperbole] so far is only a PR matter at this time.

In terms of the second question on the direct versus the indirect, the proportions, up until the second quarter the indirect sales or distributions contributed to over 50% of revenue. But with the transition in Beijing from indirect to direct, that actually has changed. Now the direct sales is contributing more than 50% of October revenues,

In terms of the incentive for direct sales people, it's typical to have a rather modest base pay with the incentive high, so the ability to grow customers and generate revenues. So it is pretty much commission-based, although the commission is tied to the initial sign up of the customers in most cases.

The third question, if I recall correctly, you were asking about the margin on the direct sales versus indirect sales. The business model for direct sales is pretty straightforward. For indirect sales we do share our revenue with our distributors. And roughly, for the $100 paid by the end customers, about 33% of that will be attracted by the distributors. That goes to their disposal. [Inaudible] keep that profit.

So on GAAP basis, the amount that we report, we actually have the -- we only recognize the revenue on the net basis which means 66%, roughly 67% for the [international case]. So if you look at the margin numbers our direct sales would have to bear the expenses, and so will have a lower margin. But the absolute dollar amount is higher on the direct sales model. For indirect sales we share revenue with them but we only recognize revenue net. So the margin is actually higher.

Alright. Thanks Shawn.

A few more words about the margin in Beijing. Beijing is a special area in our sales system. Previously we had two distributors and we also had a direct sales team. Because of the competition, distributors usually give deep discounts to our end customers. Therefore, after the transition from distributor to direct in Beijing, the margin, or the revenue or additional revenue that we've seen was not that significant. The plan was to rationalize the market so that the discount rate will be more in line with other markets in China.

Your next question comes from the line of Steve Weinstein with Pacific Crest. Please proceed.

Thank you. I just wanted to get a little bit of explanation about the tax rate just going forward. I understand that there was a one-time reversal in the quarter. But even adjusting for that, it does look like the rate is lower than we have been looking for. Is that a sustainable rate going forward or should it fall back more towards what the historic trend has been?

Steve, I think in the previous calls people asked me the question about our going-forward tax rate. I think I did mention the number of 10% roughly on a proforma basis. I think this quarter actually reflects that. If you look at this quarter's tax expenses, I mentioned that it included about roughly CNY6m of reversal tax expenses. This CNY6m were tax expenses recorded during Q1 and Q2 of this year. And if you take that away, we actually are looking at an effective tax rate of roughly about 10%.

As to the sustainability, I'm going to give you a little background as to why are we getting this tax incentive. One of our subsidiaries, Baidu China actually has been granted software company -- technology company status. And that is typical of all the -- the Internet technology companies in China.

With that status we were given the tax breaks. Basically two years of exemption from income tax and for the three years following that, for the half of the standard rate. That means really the next two years there will be no income tax for that subsidiary. And 15% tax rate subsequent to that. So that does give us a sustainability in the near term to come.

That's perfect. Thanks a lot.

[OPERATOR INSTRUCTIONS]. Your next question is a follow-up question from the line of Anthony Noto with Goldman Sachs. Please proceed. I apologize. Your next question comes from the line of Jeffrey Zhang with Singular Research. Please proceed.

Good morning, Robin and Shawn. A few questions. On September 12, Baidu announced through the Baidu Space in Chinese that the Company's website was attacked by hackers. And the Company had to shut down their service engine for about 30 minutes. What are some effects of this hacker attacks in terms of traffic reduction? Specifically, the possible damage of Baidu's reputation as China's number one search provider? Moreover, what are some steps that Baidu has implemented to prevent this happening again?

Sure. First of all, the attacks had nothing to do with Baidu Space. Baidu, as the largest Chinese website in the world, constantly has to fight with hackers and attacks around the world. We were able to successfully fend off most of the attacks.

But during the third quarter, we had one incident that caused the service to be down for roughly 30 minutes. We immediately identified the cause and took action. So during the next couple of days, we experienced a similar attack from what we think is the same hacker or hacker group and we were able to successfully fend off the attack.

I would say that the nature of the attack, which has caused denial of service, is quite common these days. It is not possible for us to guarantee that there will be no attacks or there will be no interruptions in the service. But we think we have a very strong tech team. We will be able to take immediate action to make our service available to average users in time.

Thank you very much.

Your next question is a follow up from Anthony Noto with Goldman Sachs. Please proceed.

Thank you, Robin and Shawn. Sorry about that last question. I want to follow up on the cost side of business. I know that you don't guide as to cost. But is it reasonable to assume that in the near term, margins may take somewhat of a hit as it takes a while to scale up the revenue and to cover the fixed costs of paying your sales force internally, where the long term earnings might still have a lot of up side from where you are today?

Anthony, clearly you rightly pointed out that we do not provide guidance on earnings on the bottom line. In our business we're highly scalable. We talked about the investment we're making in the monetization algorithm and the changes we are making. We are expecting somewhat a slower growth than we had before.

But, having said that, that doesn't mean that we're going to somehow change or slow down our investment pace. We will continue to invest in our business, incurring costs that are necessary for the longer term. There is not going to be any effort in trying to managing that aspect because it will be inconsistent with our strategy of going and making changes in the algorithm. So I can't give you any specific -- discuss some colors on the cost itself. But, like I said, we're still in the investment mode.

Great, thank you.

Your next question comes from the line of Jason Brueschke with Citigroup. Please proceed.

Thank you, Robin and Shawn. My question is a follow up to Anthony's first question about the algorithm. Specifically I'm interested in more details about what and when.

And what I mean by that is you have over a 100,000 customers, at least half these customers in the quarter. I want a little more color on exactly what you are doing to educate your current customers as to the changes to the algorithm and when you started those efforts, and how you're trying to bring your third party distributors in to educate their customers as well about these changes.

And then the second half is when. When do you expect these efforts to end up having their desired effect, such that you no longer see this psychological friction to the new system? And when can we expect these revenues then to return to more high progress? Thanks.

Let me answer the when question first. As we stated previously in the call, we believe during the next two quarters we will be under such kind of transition, which means that starting from Q2 of next year, we should be back on track with the growth we have been able to achieve historically.

In terms of what, as I mentioned before, we are aggressively hiring customer service people. We asked our customer service and some of the sales team to contact existing customers and explain this -- the changes to them. What we found is that when enough amount of communication is done, we were able to get back many of the customers.

Both in the direct team and in the distributor team we're doing the same thing. Location by location or city by city. There is no difference between direct and indirect. Also, again, what we found is that we have no problems with signing up new customers. If it is the first time they heard about our [biz] model, then they don't have any problems to accept it.

Great. And maybe a quick follow up. Could you maybe tell us when did it become apparent to you that this change in the algorithm was having an impact on the behavior of your customers?

And maybe help us know when you started to use remedial measures to address the question.

Well, I would say more or less this was about exactly what we expected when we decided to implement the change. We were prepared for the negative impact on revenue growth when we did the change, specifically in September, when we factored in [inaudible] in the [inaudible] sponsored links. We knew that the revenue would be negatively affected by the change, so we were prepared for that.

For the change we made in June, we also knew that there was going to be some churn over the existing customers because the price -- average price actually went up. This was -- it's as expected. We just need to hire more customer service and train our sales and customer service people to communicate with the market and with the customers. There was no surprise at all about the transition.

Great. Thank you, guys.

Your next question is a follow up from the line of Safa Rashtchy with Piper Jaffray. Please proceed. Your next question comes from the line of Leah Hao with Thomas Weisel Partners. Please proceed.

Hi. Good morning, Robin and Shawn. I was wondering, I have a question regarding your view on the overall health of the paid search market in China. Looking at the year-on-year revenue growth during the past four quarters, surely you have some transition recently in your algorithm.

But what's your expectation as the traffic share leader as well as the market share leader, what's your expectation in percentage terms for the overall market growth in '07 and beyond? And better yet, would you be able to quantify the growth expectation between the volume growth versus the ASP growth as well? Thank you.

Let me put it this way, I think that the paid search market is China is still very, very small comparing to other markets. China is now the fourth largest economy in the world. But the paid search market is still much, much smaller than many of the markets we've been keeping track of, not only in the U.S. but countries like U.K., Japan and Korea. They all have much larger paid search markets.

What that tells us is that, number one, the market maturity in China is still very primitive. And only a very small percentage of the targeted customers are taking advantage of our paid search platform.

Number two is that the paid search price for Chinese customers is still very, very low, probably much lower than any of the markets you can think of at this stage. Our [paid view] have been growing very nicely and we do expect this trend to continue. The price the customers pay will go up too. We believe that as the customers realize the promotional power we can bring to them, they will be willing to spend more to our platform, going forward.

Sorry operator. Leah, I just wanted to give you one statistic from our revenue growth history. If you look at a year or two years ago almost, in Q1 '05, our revenue growth was 154% year over year. And this quarter ours is a 170% year over year. And I think in the past few quarters that's been somewhere between 160 to 190.

So yes, our scale has been growing but at the same time the overall growth rate itself continued to be very strong. I think that gives you a flavor how early the market is.

Your next question comes from the line of Steve Weinstein with Pacific Crest. Please proceed.

Thanks. I think you explained some of the issues in the quarter and how they impacted revenue would be with the changes you were making. I just want to make sure I'm putting it in the right context. So when I look at the new advertiser growth, that seemed to grow or slow sequentially, 13%, which is a little less than we're looking for. I think a pretty big slowdown from what happened last quarter.

Is that where the changes manifest themselves in terms of your ability to get more advertisers into the system? Or did you get advertisers dropping out? Or is anything else being reflected in that slowdown in advertisers? Whether you were trying to clean out your -- the advertiser base or other changes you might be making.

I think we are going through a wash after the business model change. Some of our older customers may not be so receptive to the new pricing [inaudible], and mostly because of psychological reasons.

This is what we expected. We knew that by hiking up the price there will be some customer loss. But we think, overall, in the longer term, it should be a healthy direction for us to go. And it should be beneficial to the revenue growth longer term.

Okay, thanks.

Your next question comes from the line of Chang Qiu with Forun Technology Research. Please proceed.

Good morning, Robin and Shawn. One question. I'm not sure if anybody asked it because I joined the call late.

In terms of advertising revenue growth, for brand advertising, now everybody thinking the Beijing Olympics will help a lot. I would like to ask your view in terms of a paid search and a paid listing, what are the effects or the impact to you on the revenue side too. What's the opportunity you see?

It's still roughly two years away. I think it's too early to tell about the impact on our business. We do not depend on branded advertising in any meaningful way.

It's probably more about the market maturity of paid search. If the Beijing Olympics can help to open up China so that more advertisers or more small and medium enterprises can understand the promotional power then we should be a beneficiary of that.

If not, it may even hurt our revenue as when we have a major event, [non online] event, usually the traffic for our site will have a temporary dip. So at this time we don't know yet. But I would like to emphasize that the paid search price in China is still very, very low, much lower than any of the markets you can think of.

Right, I know. Another related question is the Internet penetration amount, medium and small enterprises here. Do you have any metrics how many of them -- how [fast of] them are adopting Internet?

We don't have any specific numbers. We generally rely on third party surveys. There are some well-known surveys or research firms like iResearch or [CNNIC]. They generally would have numbers of the small and medium enterprises online.

What we found is that it's actually not a very big issue when we try to acquire customers. If the customer does not have a website, we can help to build one for them. It's more about the mentality. If they realize that an online presence would help their business, they would do it. So I think it has to do with the overall maturity of the Internet market about China. It's probably less relevant to whether a customer has website or not.

Okay, alright. Thank you.

Your next question comes from the line of Dick Wei with JP Morgan. Please proceed.

Hi. I just wanted to ask about the CNNIC survey that Baidu is getting market share from some of its competitors. Can you comment on the reason why you are getting the market share away from your competitor? And also if you can comment on some of your competitors, like Google, Yahoo, Sohu, etc.

I think we are not doing anything differently during the past year than what we did for the first six years in the Company's history. We just keep a very close eye on our user behavior. We really try to understand the Chinese Internet user and design and modify or improve our product based on the user preference.

And we care more about the user experience. We don't innovate for the sake of innovation. And that's the reason we are getting gains in market share. When two of your friends -- two out of three of your friends tell you that they use Baidu, it's pretty hard for you to use someone else to search.

And I was wondering if you can comment on what you notice in terms of competitors, like what are they doing recently, differently.

I think a number of the competitors are trying very hard to set up in the Chinese search market. It's just not that easy. It will take some time to learn how to operate in this market. At this time we do not see any meaningful actions that could affect our behavior.

Okay, thanks.

Your next question comes from the line of James Lee with WR Hambrecht. Please proceed.

Hi, Robin and Shawn. Can you just comment about your customer base a little bit, specifically about brand advertisers? Have you seen them maybe shifting or spending online spending that is towards paid search? And if you can provide some data points on that, that would be helpful.

And also on the sales compensation. When you brought the sales force in house in Beijing, did you have to change any of the compensation to your sales people within that region or did you -- is that more or less the same? Thank you.

In terms of spending I would like to point out that the customer base or advertiser base for Baidu and for the branded advertising guys are quite different. Most of our customers are SMEs. They generally do not spend a lot of money on branded advertising. So, in terms of spending, it really more relates to market maturity than competition.

In terms of the compensation in Beijing, we do not see any material difference between our direct sales team and the distributors around China. We are essentially doing the same thing. It's just that -- probably the only difference is that we are so close to the Beijing team that we can have better communication with them so that they understand our product better and understand the market better.

James, Shawn here. Just to clarify, I think, the question you have in your mind. We actually did not take over the sales and customer surveys from our two Beijing -- former two Beijing distributors. We only discontinued the right [to grow] new customers and we are going and hiring customer services and sales from scratch. And that's why we are having a bit of hiccup in the Beijing market.

Right. I just want to make sure I understand Robin's answer. Basically you're saying that you haven't seen any specific shift from brand advertiser in terms of their increasing spending on -- in the online spending towards paid search. I just want to make sure you didn't see any material change in 3Q.

Well, let me put it this way, we do have quite a number of large companies using the paid search platform to promote their products or companies. What I was saying is that such spending does not contribute a significant portion of our total revenue which, again, implies that the price of paid search is so low, our larger customers are very willing to spend on paid search. It's just that we cannot spend their money fast enough so that it will contribute a meaningful portion of our revenue.

Okay, great. Thanks.

Your next question comes from the line of [Joe Voberil] with [Suttonbrook]. Please proceed.

Hi, thanks. I'm looking at the guidance for the fourth quarter and it seems like revenue growth decelerated to about 13%. And in the expectation, if I look across the street, it is that it will then reaccelerate again to about 20% in the first quarter. But then I hear about the new algorithm change affecting two quarters. So I'm trying to understand the magnitude of the first quarter '07 and the impact this will have on that.

Joe, Q1 will be, of course due to seasonality, will always be the slowest quarter of our business. But, again, we normally just give out a guidance for the next quarter. It's going to be difficult for us to project further from that.

Okay, thanks.

Your next question comes from the line of Safa Rashtchy with Piper Jaffray. Please proceed.

Hi, can you hear me?

Yes.

Okay, good, because I was just cut off. Just a quick follow up. You might have covered this already in [an answer]. Did you say that you had hired customer support and sales that you need to do this transition or are you still trying to build it up?

And also looking at while this transition is happening and some of the customers were getting used to it, do you feel that you may have lost any market share to Google or other search players who might have had more [inaudible].

Okay, the line was actually not very clear. Let me just to try to address this. If it's not what you asked then you can ask again.

In terms of market share we don't see any sign of loss in market share. In terms of sales, both direct and distribution network, we have the strongest of sales teams and customer service people across China. Almost in every major city, when you do your due diligence, when you ask about distributors or third parties, they will tell you that the strongest sales team comes from Baidu team.

We don't see any change in this. We are the leaders in the paid search market. We pretty much decide the rules for paid search. We are currently not seeing any move by the competitors and in fact in our [decision] and our customer acquisition and our customer service.

And are you still trying to complete the build up of the customer service people or are you now at the level that you wanted?

We haven't finished with that build up yet. When we took over the Beijing distributor customer service function in July, we started to build a larger customer service team in Beijing. And after the two changes in monetization algorithm, we also asked our distributors across China as well as the direct sales teams in cities like Beijing and Guangzhou, to build up our customer service.

It just takes some time. When we hire people, it would typically require about three to six months of training period for them to truly understand our products and our services and effectively communicate this to the existing and potential customers.

Okay, great. Thank you very much.

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.

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

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