Chinese search giant Baidu (click ticker for report: ) reported fantastic second quarter results Wednesday afternoon. We recently identified Baidu as one of the cheapest stocks on the market, after making a bullish call on the name in early April. Revenue surged 39% year-over-year to $1.2 billion, easily exceeding consensus expectations. Earnings per share declined 3% year-over-year to $1.26 on a non-GAAP basis, which is several cents better than consensus estimates. Free cash flow was very solid at $433 million, equivalent to 36% of total revenue.
Baidu’s core search business is growing at rates we saw from Best Idea Newsletter portfolio holding Google (click ticker for report: ) in its earlier days as Chinese internet usage continues to grow. Baidu is doing a fantastic job extracting more revenue from existing marketing customers, as revenue per marketing customer increased 3.9% year-over-year to $2,623, which represented sequential growth of 11%. The market was particularly focused on this metric, after it fell for two consecutive quarters. However, we think customers are realizing the value of the firm’s online advertising platform. This is also evident in customer growth, as Baidu acquired 58,000 online active customers during the second quarter—the highest amount ever in a single quarter.
Traffic acquisition costs (TAC) continue to soar, increasing to $143 million (11.6% of total revenue) compared to $71.4 million (8.3% of total revenue) during the same period of 2012. CFO Jennifer Li explained the increase in TAC, saying on the conference call:
“Majority of the TAC spend and the TAC increases are due to contractual business, and contractual business generates incremental revenue for us and we share a part of that with our union partners. And as I mentioned, also hao123 promotion is a driver for the increase of TAC and that has been going on since the last quarter as well. So overall, as Robin mentioned, the arrangement hasn’t really changed per say. The initiatives are driving specifically are mainly in contractual ads and hao123. As you look into the future for the rest of the year, I think looking at TAC, obviously it’s dynamic and it depends on the mix for the different sources of revenue our union partners help us bring in.”
TAC remains well below the 25% level we see at Google, so we wouldn’t be surprised to see this number expand as a percentage of revenue going forward. It is a necessary part of the online advertising business, and nothing to worry about at this time, in our view.
Baidu is also executing on the mobile front, where mobile advertising revenues now account for 10% of the total mix. Though not as impressive as Facebook’s (click ticker for report: ) advertising revenue, we are pleased to see Baidu capitalizing on the secular trend.
Looking ahead, Baidu provided strong revenue guidance of $1.422 billion to $1.6 billion for the third quarter of 2013, an increase of at least 40% year-over-year. Even though Chinese economic growth is decelerating, we think the prevailing tailwinds are strong enough to prevent macroeconomic issues from preventing top-line expansion at the firm. We’re not worried about the firm’s lack of earnings growth as the company continues to invest heavily to improving its product offerings.
Valuentum’s Take
Although we’re worried about broader economic growth in China, Baidu is doing a fantastic job of riding secular tailwinds to higher revenue. We hold peer Google in our Best Ideas portfolio, but we’ll continue to watch Baidu closely if conditions warrant increased exposure to global search in the portfolio of our Best Ideas Newsletter.