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Downwardly mobile margins

1 February 2013 By John Foley

China’s online giants are tooling for the mobile ad wars, and profit will be the first casualty. Of 560 million web users, three-quarters are already using smartphones, threatening massive disruption for companies who depend on online advertising revenue. Baidu, the dominant search provider that reports earnings on Feb. 4, has most to prove, and most to lose.

Mobile ad revenue in China is small but fast-growing, and should almost triple by 2015, according to iResearch, to 3.5 billion yuan ($560 million). Advertisers tend to be wary of paying up at first, but encouraging fourth-quarter earnings from U.S. internet groups Google and Facebook suggest that changes as mobile matures.

Baidu is the default search on most of China’s Android-based smartphones, but that’s not enough. Apps like Dianping, a location-based listings service, are drawing users away from traditional search, while small screens can return only a few results at a time. Baidu’s track record of growing annual revenue per user by 38 percent for the past four years may not survive the transition.

For now the priority is to capture the biggest share of users’ time. Tencent has a headstart. Its messaging application, WeChat, has notched up a phenomenal 300 million users in just two years. Baidu, meanwhile, is relying on scale more than ideas. It is investing some 10 billion yuan on a new cloud computing centre and offering users and developers storage.

Baidu’s route looks the costlier one. The cloud demands top-notch security products, which it will probably have to offer users for free. Spread the bill for that new data centre over five years and Baidu’s total costs would increase by 50 percent from 2012’s run rate. A cash pile of $4.5 billion gives Baidu options to buy rather than build, but it may end up overpaying to defend its market position.

The upshot is that Baidu’s operating margins of 53 percent in the last quarter will start to look more like Google’s, which are around half that. While its bottom line probably grew four times as fast as Google’s in 2012, the Chinese search giant trades at just a 15 percent premium to its U.S. rival, based on 2013’s earnings. Investors rightly expect things to get vicious.


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