Hello and thank you for standing by for the Baidu Second Quarter 2016 Earnings Conference Call. [Operator Instructions]. Today's conference call is being recorded, if you have any objection you may disconnect at this time. I would now like to hand the meeting over to your speaker today, Sharon Ng, Baidu's director of Investor Relations, thank you, please go ahead.

Hello everyone and welcome to Baidu's second quarter 2016 earnings conference call. Baidu's earnings release was distributed earlier today and you can find a copy on our website, as well as on newswire services. Today you will hear from Robin Li, Baidu's Chief Executive Officer and Jennifer Li, Baidu's Chief Financial Officer. After their prepared remarks, Robin and Jennifer will answer your questions. Before we continue, please note that the discussion today will contain forward-looking statements made under the Safe Harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from our current expectations. Potential risks and uncertainties include, but are not limited to, those outlined in our public filings with the SEC, including our annual report on form 20-F. Baidu does not undertake any obligation to update any forward-looking statement, except as required under applicable law. Our earnings press release and this call include discussions of certain unaudited non-GAAP financial measures. Our press release contains a reconciliation of the unaudited non-GAAP measures to the unaudited most directly comparable GAAP measures and is available on our IR website at ir.baidu.com. As a reminder, this conference is being recorded. In addition, a webcast of this conference call will also be available on the Baidu's IR website. I will now turn the call over to Baidu's CEO, Robin Li.

Hello everybody and thank you for joining to this call. Baidu faced a challenging second quarter, with heightened regulation in the healthcare sector and on internet advertising, impacting [indiscernible] and operations. The implementation of new regulations and the stricter standards that we proactively imposed to make our platform more robust, will likely suppress revenue for the next two to three quarters. This period of uncertainty will pass. Baidu's core value proposition, to help our users find whatever it is they are looking for, on a safe and trustworthy platform and to help our customers connect with those users, remains strong. Our users rely on us every day, a role that comes with great social responsibility and we hold ourselves to a very high standard. We're confident that the stricter standards and regulations will enhance the user experience and have a long term positive impact, resulting in a healthier industry involvement. We believe there are two main drivers of growth; sustainability and leadership in the fast-changing internet landscape that we operate in; providing the best user experience and creating innovative, cutting-edge technology. Our users come first. We can only run a truly sustainable business if we put our users above all else, by deeply understanding their needs and delivering great products to them that are underpinned by innovative technology. Baidu will rise to new heights, as long as we maintain the trust and loyalty of our users and continue to be at the forefront of innovation. This may mean doing the hard things, but the right things, for which there is no compromise. We have taken immediate action to improve the user experience -- implementing even stricter customer requirements over the foundation we put in place in 2013 -- reducing the number of sponsored links and further upgrading user feedback and…

Thank you, Robin. Hello everyone. Baidu faced a challenging second quarter. As Robin mentioned, we expect the impact of the new regulations and stricter standards we proactively implemented to last for the next few quarters. I would like to shed some light on the regulations and stricter standards we've been implementing. Following the search engine measures announced in early May, regulatory authorities further outlined an internet advertising law in early July which will be effective starting September 1, whereby healthcare customers are required to apply for advertising examination forms. As Robin mentioned, Baidu also proactively imposed stricter standards that require customers to show ICP licences and verified enterprise accounts. Healthcare was the first vertical where we applied these stricter requirements, an effort which began in May. A portion of our healthcare customers who were not immediately compliant to our requirements, were not able to spend with us, reducing the number of online active customers in the healthcare vertical. This quarter, we have rolled out the ICP licence and verified enterprise accounts requirement to all verticals. The implementation of these higher self-imposed standards will suppress revenue for the next few quarters. We observed two months of revenue impact in the second quarter, as a result of the regulations and higher standard applied to the healthcare vertical. The full rollout of stricter standards to all verticals will impact the third quarter. This is the right thing to do for the long term health and sustainability of our business. Baidu will have a stronger platform with these higher standards in place and our core value proposition is very much intact. As it pertains to the internet advertising law, Baidu's online advertising revenue which is majority of our revenue, will be subject to an additional business tax of 3 percentage points. We expect our…

[Operator Instructions]. We have our very first question from Mr. Eddie Leung from Merrill Lynch. Please ask your question, Eddie.

Just wondering if you could give us an update on your top 5 advertiser industries after the recent clean-up. And besides the medical factor which other sectors you would expect some impact from the tightened regulation as well as your efforts to -- more stringent policies to check your clients in your coming couple of quarters? Thank you.

Our top 5 sectors largely remain in line with the prior quarters. Mainly these are local services, retail, medical and health care, education and financial services. As we implemented these stricter rules overall to the whole platform, obviously we're very sensitive and having more measures in the medical service sector. In addition, a self-imposed stricter rule is that giving closer reviews for the financial services sector. So those are primarily the main sectors that we can put stricter controls. Overall, as I mentioned earlier, we're having across the platform, all verticals going through the measures for ICP licenses and enterprise accounts. So overall we're putting a much higher standard to our customer qualifications.

Our next question comes from Mr. Alan Hellawell from Deutsche Bank. Please ask your question, Alan.

Could you take a moment to share with us the spending pattern response between the larger key accounts and you SME customers? Many of us have come to know in conducting channel checks the more acceptable large advertisers and so we know what a reduction paid results would have in terms of impact and it's infinite. But the big black box is obviously what the SMEs are doing. I assume they're not bidding for those top spots, so in restructuring paid results wouldn't the impact be deeper? And then finally just a formality, can you just give us a definition of SME and what percent of revenues come from SME? Thank you.

Typically, the healthcare sector is classified as SME, because of the hiccups the percentage is now relatively lower. But in terms of bidding, each industry has its own related key words. So they are -- it's not much competition between the larger accounts and the smaller ones. I don't know if I answered your question.

Well, forgive me and thank you for allowing me to follow up. If I'm a very large account, a multinational, in all likelihood I'm bidding for slots 1 to 3. If I am a much smaller regional franchise with a much more finite budget, I might be settling for slots 4 to 10. Now, when we have -- in restructuring our results page, I would assume the former group is left much less impacted than the latter group. And I'm wondering whether you can give us a sense of magnitude about the impact on large account spending and then the impact on SME spending.

Yes, I think it's not about the size of the account, it's about which industry you are in. The larger accounts do not necessarily compete with the smaller ones with the SME key word.

Yes. To give you an example, for large accounts, let's say the ecommerce aside, like a JV, like the Ali Babas, they belong to the key account. And games, for example, those are key accounts. And for SMEs, these are smaller. Let's say the medical service belongs to SME and also some of the educational players belongs to that and local services belong to that. So between SME and KA, key accounts, these verticals do not necessarily [indiscernible] and the SMEs do not necessarily -- are bidding against the key accounts, if that answers your question?

I guess so. Again, if I'm an SME I definitely don't have enough money to buy slots 1 through 3, so that restructuring must have had a bigger impact. I'm not talking about competing really with the larger channels, I'm just talking about my own budget and ability to buy spots now that they've disappeared.

I think -- you know our customers, their placement is a variety of factors and of course, their bidding price defines the competitive dynamics within their verticals. So if they're not competing with the key accounts for example, these SMEs can still do similar things compared to before and they can afford the top position. So I would very -- we don't see direct correlations there.

The next question comes from Alicia Yap from Citigroup. Please ask your question, Alicia.

So my question is related in terms of both the ARPU and the number of the customer growth. So in terms of just helping us on modelling, considering the impact, looking into the next few quarters, between the numbers of active customer count versus the average spending per customer which one will likely see the bigger impact? Shall we see slower customer add or even declining number of active customer or should we actually see the spending per customer coming down even more? And then on, related to that, can management give us the update on the click-through rate, the CPC, the user traffic and even the ROI from the customer? Thank you.

Yes, Alicia, over the past quarter and obviously in this quarter there is a lot of changes on our platform. Our sales people are busy validating and helping our customers either getting themselves qualified or having the advertising examination form filled out. And so a lot of the effort is on the existing customer base, how we revalidate them and make sure that they qualify as we go forward. At the same time, because we're having a higher entry requirement for new customers, I think I would expect that the overall customer count would not be exponentially growing as you would typically see in the past, simply because we're going through these implementation stages. I think during this time, partially related to the Q3 guidance as I mentioned earlier, customers will go through stages of being signed up and also gradually manage their own spending. So I think -- we do not anticipate the customer spend to be down per se in general, but I think first of all it's the quality of the customer base that we're working on. And these customers, once they get on and they're fully qualified, their spending will be more active and will resume. And so as we go out, look out longer term, I think both on the customer count side as well as the spending side longer term, over time, as we go through the stages, they should resume.

Yes and in terms of ROI I think it's significantly better than before because there are less number of customers competing, therefore the CPC is lower. So it is reasonable to assume that their ROI is better than before.

The next question comes from [indiscernible]. Please ask your question.

How much of the slowdown in your implied core search growth in third quarter based on your guidance can be explained by the reduction in sponsored link and how much of it is reduction in ad loads? And if I can add one more question to that, how should we think of the time it would take, in quarters, potentially, for search, the core search business to recover?

I think to your first question, predominantly the changes are self-inflicted on the customer validation side. The sponsored link changes is not the main driver; it was not the main driver in Q2 either. So this is more what we did with the customer base.

Yes, we actually have a very strict rule on the mobile search in terms of number of sponsored links before this incident. So the negative impact of that is limited, but the impact on PC is higher but like Jennifer said, the majority of the impact comes from the customer cancelling, not from the number of sponsored links or ad load.

And how should we think of the time it would take for recovery?

We think it's going to take another two to three quarters.

The next question comes from [indiscernible] from UBS. Please ask your question.

I'm sorry, it's [indiscernible] on behalf of Erica. So I have a question on [indiscernible] Pictures. So we know they said about [indiscernible] recently-announced RMB2 billion investment and you are investing in 30 movies over the next two years. So can management share more color on Baidu's strategy on movie and online media going forward? Especially after the withdrawal of IT NBL so how should we expect the future collaboration and the integration with the IT and Baidu Nuomi Pictures? Thanks.

I don't think there is any change in terms of our strategy for IT content and Nuomi. Nuomi is designed to connecting people with services and IT is part of this ecosystem connecting people with information. And the video content on IT is very valuable to the Baidu ecosystem and Nuomi is trying to serve the users through movie tickets. And some of the content may have certain synergies, but right now I think they belong to different type of ecosystem, one belongs to the content ecosystem and the other belongs to the service ecosystem.

The next question comes from Chi Tsang from HSBC. Please ask your question. Chi Tsang, your line is open to ask a question, please ask.

I have two questions. Firstly, I'm wondering if you can comment on the natural growth rate of your search business. So just to put this into context, last year search revenue grew about 27%; this year your search revenue will be down due to a number of factors. But I'm wondering over the next couple of years is the natural sort of revenue growth rate per search still sort of in this 20% range? That's my first question. And my second question is, if you think about the next chapter of growth for the internet, for Baidu is it more related to AI, as in autonomous driving and finance or is it more related to O2O? Thank you.

Yes, I think search itself is still morphing quickly. A couple of years ago it was the transformation from desktop search to mobile search. But now on the mobile platform there are a number of factors that affecting people's search behavior, including some other killer apps that are attracting more of the users' time. And we have implemented this new feed structure in the mobile Baidu which will extend the users' time spent on our search app. So that the growth rate, the natural growth rate for the next few years largely depends on how well we develop our user-oriented product. Right now the hiccup is pretty much on the customer side, but the longer term it will be on the product innovation side, I would say. The growth outside of search is pretty much all AI-based for our Company for Baidu. Even the financial services, like I mentioned, we use our big data to gain insight of those consumers who need credit loan. We also analyze our advertisers or partners on the quality of their trading programs, things like that. We use our image recognition technology to verify users' ID. So there are lots of technologies, AI-related technology we leverage to provide a better or unique financial services and autonomous driving is another big industry that could benefit from our AI technology. And automotive is of course a very large industry and one we believe eventually as well that the majority of the cars become self-driving, we will be able to play a very important role. There are a number of other products in the works that are AI-related, but are at a more -- earlier stage, so we will give you updates when that becomes more significant. The O2O, yes, O2O again like I said belongs to the core product, our BO search as both are connecting people with information and connecting people with services.

[Operator Instructions]. Our next question comes from [indiscernible] from Credit Suisse. Please ask your question.

My question is to Robin, just wondering if you can provide some more color on the reasons and the rationale behind the withdrawal of the IT and BO offer? I remember one of the rationales back then is that I think this kind of online video content business is regarded as a cultural entertainment-related business to be better owned by the domestic investors, from a regulatory point of view. But does that rationale still hold down the road? And will you be making an offer again in the future to consider that impact? Thank you.

I think we've made it clear in the press release on the reason that's why did the buyer group withdraw the privatization offer. But regardless of the status of IT being a part of Baidu or being privatized, we consistently said that IT is an important part of the Baidu ecosystem. We will always have access to the IT content and Baidu will continue to support the growth of IT.

The next question comes from Mr. Robert Lin from Morgan Stanley. Please ask your question, Robert.

The question is related to the financial services. Obviously we've seen the Company make key hires over the course of the last six months and ongoing JVs with different financial institutions. Perhaps we can get some ideas about what we think -- how we're thinking about the overall Centec business over the next three years and how we should think about the potential impact to both P&L and balance sheet, particularly for payment as that's part of one of the biggest business within the Centec for now. Thank you.

Yes, I think financial services is a very large industry and we do not expect it to take off this year, but we think we do have a unique advantage which is our solid foundation in artificial intelligence related technology and our insights and big data or our insight into our hundreds of millions of users every day. So we're at this stage exploring areas like credit loans, wealth management and we have partnerships with companies like Citic Bank, Allianz, in areas like commercial banking and insurance. And Baidu Wallet functions as a foundation for all of these endeavors because we need a strong user account, we need an account that users can deposit money, can borrow money, can pay, can trust us to do transactions. So that's the rationale behind Baidu Wallet. So it's more about a strong user account than about payment to Baidu. It's still too early to tell you in the next three years how much revenue we're going to get but we think this is a very promising, large industry and Baidu is uniquely positioned to take advantage of some of that.

Our next question comes from Juan Lin from 86Research. Please ask your question, Juan.

My question is related to your SG&A expenses. Your total SG&A expense was quite well managed in the second quarter which was only 7% higher than the first quarter. Does it mean that the full year SG&A expense spend could be adjusted and will eventually be lowered from the previously-guided RMB20 billion level? Thank you.

Obviously throughout the year as we continued to work on the transaction services fund, that's where the SG&A expenses mostly go, we continued to really seek value creation and continued to improve our focus to generate good ROIs for the spending. So obviously we have a plan at the beginning of the year and as we execute we have a very clear objective and we manage the expenses very responsibly. Our strategic target and objectives do not change. As we mentioned earlier, transaction services continue to be our strategically important area to build our service ecosystem and we'll continue to invest in that area. We will continue also to have a very disciplined approach to expenses and so I think as we look at it now, we don't anticipate that we're significantly outside the SG&A expenses, but that in itself is not going in line with the top line. That's not how we manage, as you know. So going forward, our approach will be the same and I think we deploy resources for strategically important areas and we execute it responsibly.

The next question comes from Natalie Wu from CICC. Natalie, please ask your question.

Your traffic acquisition cost climbed a lot in the second quarter, wondering what's the driver behind and if we should regard the status as ongoing or as just a one-off quarter thing?

Yes, you noted correctly that traffic acquisition cost as a percent of revenue did go higher. You note that we revised Q2's earnings guidance and I mentioned last time as we provided the revision, medical-related revenues are predominantly organic and so it does not really affect the revenue we generate on the union side and as we grow our union business and some of these in Q2, some of the revenues related to medicals are affected, it didn't really affect the traffic acquisition cost side. And as a result, you do see sequentially for Q2 there is a step-up of traffic acquisition cost. Going forward, some part of the future revenue, as we deal with the whole client base validation and enterprise account tracking and all that, it affects all the businesses' verticals, so not just medical. So you now regard I think traffic acquisition cost in some way would behave in line with revenue but at the same time, I think that you know that we're growing our contextual businesses, our search business in mobile continues to be very solid and that's predominantly the driver for traffic acquisition cost. So in short, yes, there has been a step up in Q2. It's predominantly medical related. Going forward you should continue to expect the tax to increase due to contextual ads business growing and but then overall maybe Q2 was slightly more pronounced simply because it's medical related.

The next question comes from Mr. Jason Helfstein from Oppenheimer. Please ask the question Jason.

This is Bue [ph] speaking for speaking for Jason. I basically have two question here. Number one, back to the core search margin, it shows a sequential decline throughout the past couple of quarters. So just trying to understand underlying reasons behind a trend and if it's fair to assume that the margin across this quarter is a result of cleaning up the unqualified healthcare accounts which used to be more profitable than the other verticals. Number two, I noticed that the Company recently for first time rolled out its full suite of cloud services for the enterprise customers. Maybe just want to share more color about the Company's strategy and differentiation on that front and how we should think about the timeline of being financially immaterial to the entire Company. Any color on the current adoption rate on cloud and regular user cases will be appreciated. Thank you.

Yes, for your first question related to the core search margin, obviously Q2 was a very special quarter. We had a revision to the revenue at the same time. Basically all the expense line items are not variable component. Even for tech it was not variable to the medical revenue that we generate. As a result, because of this leased changes in revenue you see the margin sequentially would be lower compared to the normal levels. I think going out for a few quarters we should continue to expect that we're going through these changes and the expense line items in itself is not going to drastically change. But overall core search continues to deliver very solid margins and the business has been run for years. It has the setup, the structure, already in place. It's a scalable business. So when you have drastic changes on the top line, either your margins expand or your market gets affected. But then it doesn't really change the nature of the business model for core search.

On the cloud question, are you referring, especially the self-services for customers, are you referring the Nuomi product offering or are you referring to our open cloud business?

The open cloud business?

Yes, I got you. We just formally launched that a couple of weeks ago and the adoption rate has been very encouraging. We have signed up quite a number of very large established customers to work with us. Because we've been doing the cloud thing now for many, many years, it was just designed to satisfy our internal needs. Now, we have decided to open it up and provide our best technology, including cloud services, big data and AI-related technology, to outside customers. We're very confident that this will become a huge business going forward and customers do trust Baidu as the technology leader in internet-related services.

The next question comes from Karen Chan from Jefferies. Please ask your question Karen.

My first question here is wondering if management can give some color on how the initial ads budget plan from customers is coming along, related to the Olympics, going into the third quarter. My second question is wondering if management can share with us some update on the location-based surge advertising uptake by [indiscernible]. Thank you.

For Olympics we did get some ad budget from the larger customers, but overall it's not that meaningful for the quarter because during the Olympics the traffic mix will change. So the percentage of traffic that has commercial value actually could decrease during that period, so we do not think Olympics is a significant event for Baidu. In answer to the location based customers for advertised search, we're still exploring that in certain industries the result has been very good, but in other industries maybe that customers are still learning how to use our system or maybe their industry is just not that suitable for advertising on Nuomi and Baidu. So we're working on those industry by industry to find out their ROI and to find out if they need additional help or additional tools to really take advantage of our traffic and user base.

The next question comes from Wendy Huang from Macquarie. Please ask your question.

My question is mainly on the cost side. So you mentioned that you were continue to invest at Analyst Day you said RMB20 million but budget -- however on the R&D side given your recent ramp up on the AI and machine learning, how should we expect that to change? I also want to get some clarification on the business tax rate. You mentioned in the prepared remark, you said it will increase by three percentage points starting 1 September. But given my understanding, that three percentage points charges actually came effectively in 2013. So that does it mean that previously Baidu hasn't paid anything on your revenue about that tax. Thank you.

For SG&A expenses I mentioned that we have -- you typically have a plan at the beginning of the year and as you execute we have another review of whether it makes sense for us to incur those expenses. So we operate that in a very disciplined measure. I also said that we have the first year passed and I do not expect a significant sizable step up for SG&A expenses in the second quarter just given what we have learned in that process. For R&D expenses, I think what we mentioned about artificial intelligence and all the different applications, we're experimenting just from a technology and investment standpoint, we have been consistently investing in R&D resources and talent and that will continue to be the case going forward. For business taxes, yes, the new rule will come into effect 1 September. For the existing revenue portfolio, we do have a portion of the revenue that we pay business tax. The majority of our business is advertising, online advertising business, so we do anticipate that a big majority of our revenue will be subject to this tax. So net roughly I said about 3% because there is a component of VAT in there. The VAT depends upon the netting, the net [indiscernible] component. During the quarter it can vary a bit. So roughly I think our business would be subject to the business tax.

The next question is from Ella Ji from China Ren. Please ask your question Ella.

Yes, back to the search and I'm just curious about your -- where do your customers go in to spend their unused ad budget? Do you think they will spend it elsewhere? Or do you think they will probably save it and spend it later? Also what can Baidu do to continue to save this money within your Baidu realm and keep your market share unchanged?

We do not think the budget spent elsewhere necessarily competes with Baidu advertising budget or Baidu revenue. I have repeatedly said that the search benefits -- it's very much traffic bound. The more traffic you have, the more budget you will be able to attract simply because the ROI for search is so much better than anything else. As long as we can provide the best user experience, as long as our users stay with us, search more on Baidu, we will be able to get back that budget sooner or later. So that's our focus.

The final question for today comes from Mr. Eric Wen from Blue Lotus. Eric Wen, please ask your final question.

My question is although your CTR is being impacted by the reservation, I think your CPC should move up now that those who click on your advertising links are really those hardcore advertising customers. Do you observe such trend of CPC improvement and what is your measure that you will start to improve CPC going forward? My second question is that recent acquisitions by Alibaba, JD and [indiscernible] has shown a consolidation of the take hold business with online grocery and the one logistic system, I just wonder what measures does Baidu Nuomi plan to take to increase its economic skill to quickly reach the breaking point. Thanks.

On the CPC like I mentioned earlier during the call, actually it's lower than before because the pay search model is pretty much based on bidding. When you have less customers the bidding is not that intense so the CPC will be lower than before. But we do expect over time it will come back and may become even higher than before. Takeout Delivery or industry consolidation overall, first of all we will continue to work hard to make sure that our operation is more efficient than others, than the competition and we use a very technology-oriented approach to improve the delivery times, the accuracy, the service quality of Takeout Delivery from wins [ph] point of view is doing very well and from subject point of view it really depends on the varied dynamic landscape. I think right now we're very well positioned to take advantage of the current competitive landscape.

Ladies and gentlemen, thank you for your participation in today's conference call. This concludes the presentation. You may now disconnect. Good day and thank you. Bye.