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Question:

Can you identify Baidu's core business and describe the strategy that Baidu has followed within this business. What avenues for growth and innovation is Baidu currently pursuing?

CASE 2 CMR Baidu's Business Model and Its Evolution In the second quarter of 2016 ended July, Baidu, Inc., quarters. This period of uncertainty will pass," said Robin the leading Chinese language Internet search engine, Li Yanhong, Chairman and CEO of Baidu. reported a 34% fall in its quarterly net income- Co-founded by Li and his friend Eric Xu in 2000, its biggest quarterly decline since going public in Baidu was China's first home-grown search engine and August 2005. The company's net income fell to RMB was created with the mission of providing the best way 2.41 billion (US$362 million) in the quarter from RMB for people to find information. The company offered a 3.66 billion a year earlier. The poor performance of the broad range of products and services including search company was attributed to curbs on online advertising in services, Online-to-Offline (020) services, and an China following the death of a 21-year-old Chinese stu- online video platform. Baidu's investments in technol- dent in April 2016 who had tried an experimental cancer ogy along with its focus on local content helped it main- therapy advertised on Baidu's website. "The challenges tain a dominant position in the rapidly growing search Baidu faced in the second quarter served as a healthy engine market in China. In order to establish a global reminder to stay focused on the key drivers of growth, footprint, Baidu forayed into emerging markets such sustainability and leadership: delivering the best user expe as Brazil, Indonesia, Japan, Egypt, India, and Thailand rience and staying at the forefront of technology. The imple- where Internet usage continued to climb. As of July 2016, mentation of new regulations and the stricter standards Baidu commanded over 80% of the Chinese search mar- that we proactively imposed to make our platform more ket, and was among the world's top five search engines in robust will likely suppress revenue for the next two to three terms of market share (see Exhibit I). Exhibit I Market Share of Top Search Engines in the World and in China World China (Mobile + Tablet) AOL, Qihoo 360, 0.15% 0.31% Ask, Excite, 0.01% Sogou, Google, 0.22% Others, 2.05% 0.43% Baidu, 1.82% Shenma 7.14% 9.26% Yahoo, 7.78% Bing, 10.39% Google, 72.48% Baidu, 87.37%12-30 In May 2016, Baidu planned to overhaul its business model from a searchoriented model to one based on Articial Intelligence (AI) due to a slowing revenue growth in its core search business. The company planned to focus on developing products in areas such as auto matic translation, voice search, and driverless vehicles. Li also planned to emphasiZe user experience over income and set up a department to root out any behavior that might hurt user experience. Analysts said that the move would affect Baidu's shortterm profitability, which in turn would make it more challenging for the compa ny's new business model to gain momentum. Moreover, they felt that Baidu's standing as the top Internet giant in China was on shaky ground as the company battled slowing sales growth due to lack of protability in non core divisions like 020 services, regulatory uncertainty, an ongoing cash burn from diversication, intense competition, loss of user trust, and rapid shift toward mobile Internet usage in China. However, some analysts were confident that Baidu would bounce back. \"There's naturally going to be a fair deal of skepticism about Baidu, but it's not going to change its role as the undisputed top clog in the world's most populous nation. Everyone will have to play by the same rules, and this may actually make it even harder ir smaller rivals to grow and diversify the way that Baidu can. Baidu has overcome similar hirsups in the past, and it's a more diversied company these days in terms of businesses as well as regions {....] It's no longer merely China's largest search engine provider: Baidu will bounce back. It's just what it does,\"2 noted Motley Fool's" Rick Munarriz. Li had a tough task on his hands and analysts were waiting to see how he would navigate the challenges faced by Baidu. Background Note Baidu was cofounded by Li and his friend Xu in 2000. Ln 1991, Li, a native of the Shanxi province of China, went to the US for higher studies. After completing his studies, Part 4: Case Studies he worked with IDD Information ServicesC between 1994 and 1997, and as a staff engineer at InfoseekEl between 1997 and 1999. Right from the beginning, Li had a pas- sion for Internetbased search and while working at Infoseek he developed a search mechanism called 'Link Analysis'.c After this, he was given an assignment to supervise search engine development. But in 1999, 1Walt Disney Co. acquired a stake in Infoseek after which the company's focus shifted from search to content. In order to further his interests in search engines, Li decided to start his own search engine along with Xu, a Chinese national working in the US, who had a PhD in biochem istry and good contacts in Silicon Valley.f Li analyzed the Internet search industry and sensed that there was a big business opportunity in a search engine in Chinese as the number of people who used the Internet for search in China was growing. He noticed that all the major portals including the indig enous Sina Corp? and Sohu.com\" were not able to get a foothold in China despite huge investments mainly because of their failure to understand the local culture and preferences. As both Li and Xu were natives of China, they felt that they had better understanding of Chinese culture and the language and it would help them start a successful search engine in Chinese. With seed money in hand they ew to China and founded Baidu in a hotel room overlooking Beijing University's cam pus. They named it Baidu, which means 'hundreds of times\". The name symbolized a constant search for the ideal and was inspired by a Song Dynastyj poem written by Xin Qijij in the 12th century. Li thought the name was ideal as it would remind the world of China's rich heritage, besides matching their mission of providing people with correct and accurate information through constant search. Baidu.com Inc. was registered in Cayman Islandsk with its headquarters at Beijing, China. As it was in need of investments, it raised US$12 million5 from ven ture capital firms like Integrity Partners and Peninsula Capital in February 2000. These two firms were the rst Case 2: Baidu's Business Model and Its Evolution outside investors in Baidu. In September 2000,'1 two other venture capital firms, Draper Fisher Iurvetson and IDG Technology Venture, invested US$10 million in Baidu.s In Iune 2004,\" Google, Inc.1 obtained a 2.6% stake in Baidu for US$5 million. However, in 2006, Google sold its stake for more than US$60 million in order to focus on developing its own operations in the country. When Baidu was launched in Ianuary 2000, there were already many Internet portals in China like Sina, Sohu, and Yahoo! China,m offering multiple services like online advertising and online messaging besides search. Initially, Baidu started out by offering search services to these Chinese portals and charged them each time a user conducted a search. Later, it developed its own stand alone search engine. As per Chinese censorship laws, the Chinese government blocked content deemed to be controversial and unethical. Baidu understood local issues like censorship laws and abided by them. It even had teams employed to block such content. On its web page, Baidu allowed advertisers to bid for ad space and then pay it every time a customer clicked on an ad. By the mid2000s, Baidu had grown significantly. Its total net revenues increased from RMB 10.5 million in 2002 to RMB 110.9 million in 2004.? By March 31, 2005, it gener ated net revenues of RMB 42.6 million. Baidu, which had come to be call ed \"China's Go ogle\C-32 Part 4: Case Studies users who searched for information related to their prod- In addition, Baidu also offered performance-based ucts or services. Baidu was the first auction-based P4P online marketing services and time-based online adver- service provider in China. The P4P model helped Baidu tising services, whereby the customers paid Baidu based monitor each click, understand the tastes and prefer- on performance criteria such as the number of telephone ences of Chinese Internet users better, and improve user calls brought to the customers, the number of bookings experiences in order to drive traffic to its sites. of air tickets or hotel rooms, the number of users regis- In October 2009, Baidu switched from its old adver- tered with the customers, or the number of minimum tising system based on price bid ranking to a new online click-throughs. Baidu's online marketing services gen- advertising keyword bidding system called Phoenix erally included text links, images, multimedia files, and Nest system. The new advertising system contributed interactive forms. The advertisements were displayed to a strong revenue growth along with an increase in through both organic Baidu websites and its affiliated the number of Internet users. Between 2010 and 2014, website partners such as Baidu Union." Between 2006 Baidu's average revenue per customer grew at 33% annu- and 2014, Baidu's online marketing customer base was ally, increasing from RMB 19,200 per customer per year growing by 29% annually, and had reached 1,049,000 to RMB 59,600. According to Li, "If an advertiser wants by December 2015. In 2015, search revenues were RMB to pay a lot of money that probably says something. The best 55.7 billion (US$11 billion), about 84% of Baidu's total sales. measure for this is our growth pattern. If users keep coming Total revenues and operating profit was RMB66.4 billion back to our service, we're doing the right thing." and RMB11.7 billion respectively (see Exhibit II.) In the Exhibit II Baidu-Consolidated Statements of Comprehensive Income Data (In thousands of RMB except per share For the year ended December 31 and per ADS data) 2011 2012 2013 2014 2015 Revenues: Search Services 14,500,786 22,306,026 29,590,276 43,727,459 55,667,478 Transaction Services 1,319,187 3,822,456 7,005,941 iQiyi 1,345,042 2,873,552 5,295,760 Inter Segment (310,581) (1,371,149) (1,587,450) Total revenues 14,500,786 22,306,026 31,943,924 49,052,318 66,381,729 Operating Costs and Expenses: Search Services 15,411,424 23,179,666 27,549,641 Transaction Services 2,841,466 9,796,434 20,151,386 iQiyi 2,088,055 3,983,851 7,679,198 Total Operating Costs and Expenses (6,924,127) (11,254,706) (20,752,204) (36,248,554) (54,710,175) Operating profit 7,576,659 11,051,320 11,191,720 12,803,764 11,671,554 Interest income 418,201 866,465 1,308,542 1,992,818 2,362,632 Interest expense (82,551) (107,857) (447,084) (628,571) (1,041,394) Income (loss) from equity method (179,408) (294,229) 22,578 (19,943) 3,867 investments 2011 2012 2013 2014 2015 Other income, net, including exchange 76,278 449,738 140,951 336,338 24,909,964 gains or losses Income before income taxes 7,809,179 11,965,437 12,216,707 14,484,406 37,906,623 Income taxes (1,188,861) (1,574,159) (1,828,930) (2,231,172) (5,474,377) Net income 6,620,318 10,391,278 10,387,777 12,253,234 32,432,246 Less: Net loss attributable to (18,319) (64,750) (162,880) (943,698) (1,231,927) non-controlling interests Net Income Attributable to Baidu, Inc. 6,638,637 10,456,028 10,550,657 13,196,932 33,664,173Case 2: Baidu's Business Model and Its Evolution C-33 first quarter of 2016, Baidu's online marketing reve- Li said, "We think search is not just about technology. It's nues were RMB14.931 billion (US$2.316 billion), a 19.3% also about language. It's also about culture." According increase compared to the corresponding quarter of the to some analysts, Baidu's success could be attributed previous year. to unique products like Baidu Post Bar, the world's first and largest Chinese-language query-based search- Secret of Success able online community platform; Baidu Knows, the world's largest Chinese-language interactive knowledge- Since its inception, Baidu had positioned itself as a sharing platform; and Baidu Encyclopedia, the world's Chinese language search engine which allowed users to largest user-generated Chinese-language encyclopedia find information, products, and services using Chinese. and MP3" search (see Exhibit III). According to industry observers, it was a challenging According to some industry watchers, one of the task for Baidu because of the complexity of the Chinese reasons for Baidu's rapid growth was, ironically enough language. To make search easier for users, it introduced its competitor Google which began operating in China the 'pinyin' search in 2001 that allowed users to type in in September 2000 and offered millions of pages in the Chinese keywords using English alphabets when the Chinese language. By 2002, Google had become the user was not sure of a written form of a keyword. This leading search engine in China and Baidu was relatively gave relevant results and made Baidu's search reliable. unknown to many Chinese Internet users. But slowly, Baidu designed strategies to appeal to the Chinese Google began to face problems in China. The Chinese web user by leveraging on the concept of 'national- government began to intermittently block several web ism' and 'Chinese heritage' in its business model. Its sites through IP filters. However, users of Google still awareness of the Chinese language and culture gave it managed to circumvent government censorship and an advantage over foreign search engines operating browse the content through cached pages." in China. Baidu created a dominant position for itself By late August 2002, ahead of the 16th Communist by providing features that appealed to Chinese users. Party Congress, " users trying to use www.google.com for Exhibit Ill Baidu Products and Services Search Products Web Search, Image Search, Video Search, News, Web Directory, Hao 123.com, Dictionary, Top Searches and Search Index, Open Platform Social Products Post Bar, Space, Album UGC-based Knowledge Products Knows, Encyclopedia, Wenku, Experience Location-based Products and Services Maps, Group Buy Directory, Travel Music Products Baidu Music, Baidu FM, TT Player PC Client Software Browser, Input Method Editor, Toolbar and Baidu Companion, Baidu Hi, Media Player, Reader Mobile-Related Products and Services Mobile Search, Cloud Smart Terminal Platform, Mobile Browser, Palm, Mobile Phone Input Method Editor, Contacts, Netdisk, Photo Wonder, Wallpaper, Desktop, One Click Root, Voice Assistant Products and Services for Developers Developer Center, Personal Cloud Storage, Baidu App Engine, TS browsing engine, Mobile Test Center, LBS Open Platform, Baidu Webmaster Platform, Statistics, Share Other Products and Services Qunar, iQiyi, Baijob, Baidu Pay, Games, Search and Store, Application Store, Ads Manager, Data Research Center, Sky, Senior Citizen Search, Search for Visually Impaired, Patent Search, Translation, Missing Person Search Site Major Products and Services by Associated Leho, Leju or Cooperative Websites(-34 search were redirected to Baidu, which recorded a sud- den rise in popularity. Later on, the access to Google's site was restored, but a search for some particular terms still led to users being directed to websites approved by the government. By early 2004, users in China began considering Google as unreliable and started using Baidu, which was similar to Google in appearance, with a largely uncluttered white page and few colors. By 2005, Google's market share had fallen to below 30%, while Baidu's share in the market had increased to 46%. Google left the country in 2010, after refusing to coop erate with censors. However, Li cited different reasons for Baidu's growth: \"The market has exploded in a very short time. User information needs to change very quickly. Because we were local and focused, we were able to catch the changes quickly. We understand the Chinese language and culture better.\"u Moreover, Baidu worked closely with the Chinese government in blocking content considered inappropri ate by them. Reportedly in 2009, Baidu won an award from the Internet Society of China for practicing Zilu (selfregulation). According to some industry observers, Li's focused and driven attitude with his emphasis on technology and investment in new ideas had led to Baidu becoming the leading search engine in China. \"However much Baidu has beneted from o'ering pirated music, questionable government interference, oreven any conscious Exhibit IV Online-to-Ofine Ecommerce Sales in China {201 12018] 67% 45% 41% Part 4-. Case Studies home-team bias the Chinese market can be accused o no company becomes so successsl without at least some com petency. Market inertia or even market ignorance but no matter what you say, it will never change the basic fact that Baidu has thus far read and played its market more success fully than its competitors,\"L2 commented Kai Pan, a mod erator on the Chinese online forum ChinaSmack. Foray into 020 Services 020 was one of the fastest growing segments in the Chinese ecommerce market and was projected to grow at an annual rate of 25% from US$390 billion in 2014 to US$718 billion in 2017u (see Exhibit IV). A growing pop ulation, an increasing number of Internet users, and the rapid shift toward smartphones from personal computers were driving the 020 trend in China. With the PC search business maturing and the Chinese economy slowing down, Li was looking to diversify as he wanted to reduce Baidu's dependence on the desktop search business. His goal was to transform Baidu from connecting people with information to connecting people with services. He decided to invest in 020 services (online to offline, digital marketing to describe systems enticing consumers within a digital environment to make purchases of goods or services from physical businesses) as he wanted Baidu to capture a substantial market share in 626 1?2 119 ?5 I | - | I | | 2011 2012 2013 2014 2015 2016 201? 2018 I 020* e-Commerce sales l 30 Change Sales in billions of EMS Case 2: Baidu's Business Model and Its Evolution C-35 the surging but highly competitive e-commerce space in dominant player in the 020 travelling market in China China. According to Li, the Chinese 020 represented a with an estimated 80% market share. US$1.6 trillion market opportunity. However, some analysts said that Baidu's deepening As part of the diversification, in May 2013, Baidu investment in the 020 sector would drive up its costs rolled out an online food delivery service called Baidu and affect margins in the short term. According to them, Waimai (Baidu Takeout), wherein customers could place breaking into China's competitive 020 market would not food delivery orders with restaurants. As of 2016, Baidu be easy for Baidu as the market was already dominated Waimai had 30 million customers across 140 cities in by two Chinese Internet giants-Tencent, Inc." and China. In August 2013, Baidu acquired a 59% equity inter- Alibaba Group Holding Limited. d "Basically, there's est in a group buying site Nuomi from Renren, Inc." for a land grab going on. It is expensive. But you can't (gain US$160 million. Subsequently, it acquired the remaining dominance) if you don't spend the money to build and pro- shares in January 2014. Baidu Nuomi offered multiple ser- mote," remarked Kevin Carter, founder of The Emerging vices including ticket booking, dining, hotel reservation, Markets Internet & Ecommerce. " Despite such concerns, and health and beauty services. In 2015, Li announced Li said the company planned to increase its spending in that Baidu planned to invest over RMB 20 billion 020 businesses as such initiatives could drive revenues (US$3.2 billion) over a period of three years in Nuomi. in future. He said that the company was ready to forgo In addition, Baidu rolled out other 020 services such as short-term profitability to invest in opportunities that Baidu Wallet (online and mobile payment services), Baidu might result in huge long-term gains. Maps" (desktop and mobile web mapping service), Baidu Connect (third-party login open API), and Baidu Cloud (personal cloud computing service). Baidu consolidated Global Expansion its major 020 reporting segments into a single line item Though Baidu was the biggest search engine in China, called 'Transaction Services' in its financial reports. its presence outside the country was limited. In 2007, In December 2014, Baidu made an undisclosed it entered Japan but eventually succumbed to market investment in US-based car-hailing service Uber pressures and shut down its Japanese search engine in Technologies Inc. in order to leverage its strengths in March 2015. In Japan, Baidu could not compete against mobile search, mobile mapping, and app distribution. Yahoo and Google and eventually reported losses that The integration of the Uber app with Baidu Maps, amounted to RMB 260 million in 2010. Despite the set- Baidu Wallet, and Baidu mobile search was expected back, Li said that he wanted Baidu to become a global to bring more customers to Uber and more traffic- brand with a presence in over half the world's countries. related income to Baidu. In August 2015, Baidu invested Baidu's president, Zhang Yaqin, said the company was US$100 million in the Chinese online laundry com- targeting emerging markets like Brazil, Indonesia, and pany Edaixi, as part of its efforts to position itself in India with their huge populations and rapidly grow- the rapidly growing 020 space in China. Continuing ing mobile usage so that the company could attract its 020 quest, in October 2016, Baidu-backed Chinese a new wave of users who were coming online for the online travel firm Qunar entered into a share swap deal first time on their smartphones. He said that in such with Ctrip.com International Ltd. under which Baidu markets Baidu planned to roll out specific products for would hold a 25% controlling stake in Ctrip, which each country rather than coming out with a generic, in turn would gain a 45% share in Qunar. According across-the-board service offering. "Baidu has more to industry observers, the deal would make Baidu a than 700 million users abroad, with over 250 millionC-36 Part 4: Case Studies active users in a month. Over the past three decades, 80 million customers across Africa. In July 2014, Baidu we have virtualized the physical world, but in the next entered the South American market by launching a local three decades, we will go the reverse process, applying the Portuguese language search engine named Baidu Busca Internet technology and business model to the physical in Brazil. It also opened its local development office world," said Yaqin. in Sao Paulo, Brazil. Li felt that Brazil was a promising According to industry observers, Baidu had been market as it was the fifth largest Internet market in the expanding into foreign markets with a focus on mobile world with 107 million Internet users and 53% Internet phones. Li said that he was looking for underserved mar- penetration that was expected to grow to 59.5% by 2017. kets where globally dominant search engines like Google In October, Baidu acquired the Brazilian daily deals or Yahoo had not made much of a mark. Baidu's global site PeixeUrbano in order to penetrate the e-commerce strategy was to venture into those markets where English market in Brazil. was not the dominant language, build capabilities in that Li was also eyeing the Indian market as he felt that market, and then expand. Commenting on the choice the country had a strong mobile Internet market. In of countries that Baidu was looking out for as part of fact, some of Baidu's mobile apps such as the DU Speed its global expansion plans, Jennifer Li, Chief Financial Booster and Battery Saver were already available in Officer of Baidu, said, "Before we make a decision, obvi- India. Li said that Baidu was planning to expand in India ously we do market research to understand the country's through mergers and acquisitions and other investments. general demographic situation, the Internet situation, the Reportedly, the company was in talks to invest in Indian line connections and the user growth profile, whether there e-commerce start-ups including Zomato, BookMyShow, are some main players in there and what are the opportuni- and BigBasket. In the future, Li planned to expand ties. [...J. At the end of the day it is an Internet service and Baidu to the US and Europe as well. As its rival Google the Internet is borderless. If we feel the market has a need was the dominant search engine in both the US and that is not filled and the market has great potential that can Europe, Baidu planned to focus on other channels, such become a very meaningful place, the population is there, it's as finance and its Baidu Maps service, when targeting those kind of factors that make us think we can try these these markets. "I think eventually we will go into Europe, markets." U.S. and then many other places. We are in a number of As part of its expansion plan in the Southeast Asian countries, but we need to find a new battleground. Search market, Baidu launched local services in Thailand, is maturing, and mobile is very different from desktop. We Vietnam, and Indonesia such as a search engine (in need to find ways to access this kind of new market," he Thailand) or security and PC services (Vietnam and said. However, some analysts felt that getting a foot- Indonesia). In 2013, Baidu opened a local development hold in these markets would be tough, particularly on center in Jakarta, Indonesia, as part of a long-term move mobile where Google's Android operating system was to settle down in the region and create long-term rela- the dominant operating system in both the US and tionships with the local merchants, Internet users, and Europe. According to them, it would be difficult for governments. It also launched an Indonesian version of Chinese companies that dealt with content and aimed to its web links portal Haol2. Earlier in July 2012, Baidu become global brands to get anyone to trust them out- opened its research center Baidu-12R Research Centre side of China. "(It is) still early stages for the global efforts, (BIRC), in Singapore in order to develop web products and (there are) a lot of challenges for Chinese companies to for Southeast Asia. Baidu's international products such go beyond their borders-cultural, managerial, familiarity as DU Speed Booster, DU Battery Saver, ES File Explorer, with the local market-but it's worth experimenting"'s said Photo Wonder, MoboMarket, Simeji, Baidu Antivirus, Jennifer Li. Baidu PC Faster were popular in mobile-first nations As part of Baidu's global strategy, CEO Li announced such as Thailand and Indonesia. that the company would launch its mapping services, In 2013, Baidu entered Egypt by launching a local Baidu Map, in more than 150 countries and regions by Arabic site and opening a local office. However, Baidu's the end of 2016 in order to serve more than 100 million expansion into the Middle East was put on hold due Chinese outbound travellers. The internationalization to the political unrest in the region. In January 2013, plan would put Baidu Map in direct competition with Baidu entered in to an agreement with France Telecom the top global mapping service provider, Google Maps. to pre-install Baidu's browser on low-end smartphones As of July 2016, Baidu Map was available in more than to be sold in Africa and the Middle East, by France 18 countries, mostly in the Asia Pacific, such as Japan, Telecom's operators there. France Telecom had about South Korea, Thailand, and Singapore.Case 2: Baidu's Business Model and Its Evolution As of December 2015, Baidu had over 700 million users across 200 Countries and regions globally. Some analysts wondered whether it would be able to with stand competition from technology giants like Google and Amazon.com, Inc.ff which possessed superior tech nology and global work forces as it looked to attract new customers in global markets. They felt that Baidu could face more regulatory and market risks than glob ally diversied competitors. A bigger challenge for Baidu in its global expansion plan was the perceived image of Chinese brands as lowcost copycat brands by some global consumers. Growing Pains Regulatory Challenges Though Baidu dominated the online search engine mar ket in China, its reputation was at stake as the company became involved in some serious medical and healthcare related scandals in China. In April 2016, a 21yearold college student, Wei Zexi, died of cancer after report edly receiving experimental treatment from a hospital in Beijing that advertised on the Baidu search engine. Reportedly, the hospital offering the treatment paid Baidu for the high placement in its search results. Wei contended that the hospital's claims to cure cancer were dishonest and before his death, accused Baidu of pro moting false medical information online, in a post that was widely circulated among Internet users in China. To the question \"Mat do you think is the greatest evil of human nature?\" on Chinese Q&A site Zhihu, Wei replied \"Baidu,\" saying the company was evil and he never should have trusted medical ads on the search engine. The incident sparked a huge outcry on social media in lChina where netizens criticized Baidu for promoting false information in an area as critical as healthcare and putting prots before morals. However, Baidu said the hospital in question was a first tier public hospital licensed by the Beijing municipal government. Following the public outcry, Chinese authori ties including China's Cyberspace Administration Ofce, along with China's Industry and Commerce Administration and National Health and Family Planning Commission, launched an investigation to probe the matter. Thereafter, the Chinese government authorities ordered Baidu to block ads from unlicensed or unqual ified healthcare providers and add risk warnings to (-37 healthrelated paid advertising. The government also announced a new stricter guidance over Internet adver tising effective from September 1, 2016. The new rules required Internet search companies to explicitly identify paid search results as advertisements. All online ads also had to be clearly designated as such to help users differ entiate between sponsored and organic search results. The government also imposed a 30% cap on the amount of space on each web page that could be used for adver tising. The new rules also prohibited search engines operating in China from displaying banned information in various formats including links, summaries, cached pages, associative words, related searches, and relevant recommendations. After the incident, Baidu removed 126 million paid results from 2,518 medical institutions from its searches. Li also set up a RMB 1 billion fund for any future damage claims that might arise. Analysts said this was not the rst time the company had fallen foul of regulators and public opinion for its han dling of healthcare ads and blogs. In January 2010, Baidu was accused of selling control of some of its hemophilia related Tieba forumsEE to private hospitals, which allegedly used the platform for self-promotion and pro- vided misleading information to the forum users. As early as 2008, the company was criticized on state televi sion CCTV for allowing medical paid search results for treatments that were not in the best interests of users. Medical advertising was estimated to have contrib uted to 2113096 of Baidu's revenues. Heightened regu- lation in the Chinese healthcare sector took a toll on Baidu's secondquarter results in 2016. Lu the AprilJune 2016 period, Baidu's net prot slumped 34.1% on the year to RMB 2.4] billion (US$362 million), the biggest fall in the company's 11year history as a publicly traded entity (see Exhibit Vand Exhibit VI). Revenue from its core business of online marketing, which included search engine ads, dropped 6.7% to RMB 16.4 billion. The num ber of clients decreased by 15.9% to 524,000 companies as Baidu enhanced scrutiny of ad content in line with the government regulation. Baidu's stock price valued at US$217.97 in November 2015 fell to a 52week low of US$100 in August 2016. \"I feetfor Baia'a here. It is, and always has been, in a difficult position. It needs to generate advertising revenue, and medical ads are a big enough part of that that it cannot simply ban them outright. IfBaidu tries to regulate the ads, it faces angry pashbaclc from its private hospital advertisers, and it also faces the diicalt 12-38 Exhibit V Baidu, Inc. Consolidated Statement of Income (in RMB thousands accept for share, per Part 4: Case Studies share {or/ADS} information} Three Months Ended June 30, September 30, March 30, June 30, September 30, 201 5 2015 2016 2016 2016 Revenues: Online marketing services 16,223,496 13,680,334 14 ,930,530 I 16,938,394 I 16,490,040 Other services 342,242 332,707 393, 042 I 1,324,354 I 1,362,319 Total revenues 1 6,535,238 1 3,333,031 15 ,320,572 I 13,263,643 I 13,252,759 Operating costs and expenses: I I Cost of revenues {6,503,020} (3,439,580) (3,563,184) I {8,333,821} I {9,256,330} Selling, general and administrative (3,889,844) (5,301,859) (3, 945 ,944) I {4,194,489} I {3,595,985} Research and development (2,312,681) (2,689,930) (2,100,307) I {2,464,952} I {2,613,533} Total operating costs and expenses {13,105,545} {1 5,831,409] [13, 609,835} I (15,397,262) I (15,465,928) Operating prot 3,469,693 2,51 1,632 2 ,21o,1l'3iI I 2,366,336 I 2,386,831 Other income: I I Interest income 612,523 616,131 596,120 I 486,853 I 623,308 Interest expense (213,522) {329,332} {268, 389) I {235,081} I {319,899} Foreign exchange income, net 5,396 61,403 (66,166) I 243,911 I 20,361 Loss from equity method investments (2,413) (8,856) (113,092) I {554,533} I {248,460} Other income, net 142,382 200,625 298,1 19 I 423,338 I 1,231,932 Total other Income 544,362 539,925 2I 323,392 I 1,351,242 Income before Income taxes 4,014,055 3,051,643 2,653,329 I 3,195,238 I 4,138,033 Income taxes (362,951) (590,513) {634, 350) I {392,323} I {1,045,184} Net Income 3,251,104 2,461,130 1,938,539 I 2,402,555 I 3,092,889 Less: net loss attributable [410,909] {339,939} {8,252} I [11 ,268} (9,441) to noncontrolling interests Net Income attributable to Baidu 3,662,013 2,841,069 1,986,831 I 2,413,823 I 3,102,330 Adapted from httofr'rrbaiducommhoenorzhtmi question of how; exactly, an Internet search company is supposedI to effectively-1 assess the medical legitimacy of a particular hospital or treatment. There is no easy option here, no way that Baidu could have left its users and its advertisers completebz satisfied,\"2D said C. Custer, editor of Tech in Asia. Li in an internal letter to employees promised to emphasiZe user experience over income and asked employees to put values before prot, even though the decision might have a negative impact on the company's income."The management and employees' obsession with KPI {key performance index) has twisted our values . . . and distanced ourselves from users. if we lose the support of users, we lose hold of our values, andI Baidu will truly go bankrupt in just 30 days,\"2l he wrote. CEO Li said that Baidu's troubles with online medical advertising were a temporary problem, and business would improve once regulations were gured out and clients returned. In order to regain the trust of users, CEO Li planned to set up a department to edge out any behavior that might damage user experience. Rising Competition Baidu's market share on desktop search dropped signi cantly from 80.4% in August 2012 to 54.0% in August 201412 (see Exhibit VII). Though Baidu has been able to retain its market leadership on mobile search, this business could come under increased threat from rivals such as Qihoo 360 and Sohu. The company had been losing market share to search engines such as Socomhh and Case 2: Baidu's Business Model and Its Evolution C-39 Exhibit VI Baidu's Stock Price Chart BIDU 210 200 190 180 170 160 150 140 130 Volume . 30 20 10 0 16 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: http://bigcharts.marketwatch.com Exhibit VII China Search Engine Market Share (PC only) (PC + Mobile) Google, Others, Shenma* Google, 2.81% Others, 7.45% 1.59% 6.22% Bing 1.76% 2.85% Sogou Sogou, 3.15% 5.20% Qihoo 360, 8. 18% Qihoo 360 Baidu, 23.56% 59.35% Baidu, 77.88% *Shenma (Mobile only)C-40 Part 4: Case Studies Sogou.com," who were steadily growing their user base the threat from American Internet companies, Kaiser since 2014. Baidu also faced tough competition from Kuo, Director of international communications at Baidu, Alibaba and Tencent who were vying to attract Chinese said, "We would welcome more competition. It's even fair to customers primarily through smartphones. Tencent's say that in the years immediately following Google's depar- mobile messaging service Weixin/WeChat had about ture, we got a little slack, put on a little weight. It was a 800 million users as of August 2016 while Alibaba owned little too easy. Google is a great company. They invested in us mobile browser UC Browser had over 500 million users early on. They're now talking about coming back. That said, globally. Reportedly, Alibaba was expected to overtake it's not going to be easy for them. It's been a long absence, Baidu in Mobile Internet Ad Revenues in China as Baidu's and people's habits have solidified around other products."23 share in China's digital ad market dropped to 21% in 2016 compared to 28% the previous year (see Exhibit VIII). Rapid Shift Toward Mobile Internet Usage In the second quarter of 2016, Baidu's market capital- Baidu was under pressure as Internet users in China ization fell by about US$9 billion to US$55.7 billion, shifted from PCs to smartphones, increasingly opting leaving it just a quarter of the size of its rivals Tencent for mobile devices and social networking apps rather and Alibaba, which enjoyed a market capitalization of than search engines (see Exhibit IX). Commenting on US$ 227 billion and US$207 billion respectively. how relevant the broader search market would remain Moreover, with other Chinese Internet companies in the face of challenges from social networking apps, rushing to launch their own search engines and the CEO Li said, "We face a new problem. Will search still be company's plans to go global where western rivals were relevant? Going forward people can directly go to WeChat, entrenched, Baidu was set to face more serious compe- go to Facebook. . . . go to a lot of different apps. Do they tition than ever before, said some analysts. There were still need search? And we need to worry about this problem. also reports that Google was planning a comeback in We need to address this kind of new consumer behavior, we China with a new Android app store. Commenting on need to keep innovating, we need to come up with better Exhibit VIII Net Digital Ad Revenues in China (2013-2016) In billions of US Dollars 2013 2014 2015 2016 Baidu 4.56 6.85 9.43 12.63 Alibaba 1.75 5.87 7.59 9.61 Tencent .70 1.10 1.61 2.31 Sohu 0.57 0.80 1.06 1.26 SINA 0.48 0.59 ).70 0.81 Youku Tudou ).44 0.56 0.78 1.05 Total digital ad spending 16.46 23.87 31.03 39.72 Net Mobile Ad Revenues in China (2013-2016) In millions of US Dollars 2013 2014 2015 2016 Alibaba 307.50 2,193.40 4,750.30 7,348.10 Baidu 501.80 2,533.10 4525.10 6,695.00 Tencent 83.50 307.30 513.60 992.80 Sohu 0.00 265.10 474.90 729.60 Youku Tudou 13.10 180.20 271.80 390.10 Total mobile Internet ad spending 919.60 7,356.50 13,977.40 22,140.20Case 2: Baidu's Business Model and Its Evolution (-41 Exhibit IX Mobile Search Engine Users and Penetration in Chinai20102015} 69.4% 62.1% 2010 2011 2012 I Mobile search engine users I 96 of mobile Internet users I $6 Change Adapted from China tnternetNemrktnformotion Center (CNNlCJ,33rd S tatisticai Report on internet Development in China. July 26. 2016. Mobile searrh engine users in millions solutions for our users,\"24 Li said. The rapid shift toward mobile usage in China contributed to a slowdown in annual revenue grewth rates. During Q1 2015, Baidu's revenue per online marketing customer fell by 9.8% on at growth in the customer base. Baidu's mobile search monthly active users (MAUs) were 667 million in the month of Iune 2016, an increase of 6% yearoveryear. In Q1 2016, mobile revenue repre sented 60% of total revenues, compared to 50% for the corresponding period in 2015.25 Though the monthly active users for Baidu's mobile search rose rapidly from 540 million in Q4 2014 to 600 million in Q12015, Baidu was feeling margin pressure as monetization rates on mobile searches were low compared to desktop, and slowed topline growth for Baidu. Some analysts felt that Baidu's mobile search business was at risk consid ering the rate at which it was losing market share to search engines Qihoo 360 and Shenma.jj "So, with nearly $6.5 billion in 12month revenue, the majority of which comes from search, and expected revenue growth of 54% and 40% over the next two years, respectively, expectations are high, and Baidu is yet to prove to investors that it can maintain market share. Therefore, Baidu's future doesn't 422.8 22.1% 211% 2013 2014 2015 look nearlv as promising as its past, and investors might be best suited by avoiding the temptation of investing in the socalled Chinese Google'3 said Brain Nichols, an analyst at Motley Fool. Lack of Profitability in Non-core Divisions Baidu's investment in sectors outside its dominant desktop search business weighed heavily on its prot ability. The company's operating margin fell to 15.3% at the end of September 2016 compared to 17.6% in 2015. Baidu's heavy spending to buy market share in the 020' space had raised concerns among some investors about whether the search giant had what it took to successfully differentiate itself from competitors. \"1 think the decision to launch 020 and video content is on the right track, but their applications and video content are not competitive enough compared with other rivals in the market making them less attractive to users?\" said Ricky Lai, an analyst with Hong Kongbased investment holding company Guotai Junan International Holdings. CEO Li said he did not expect Baidu to improve its earnings in the short term because of its heavy spending on the 020 services busi ness. Moreover, in July 2016, he withdrew his proposed C-42 Part 4: Case Studies US$2.8 billion bid to buy Baidu's entire 80.5% stake in for Baidu to scale up. According to Cao He, an analyst iQiyi following objections from a major shareholder. with Minzu Securities in Beijing, "There is a long way In addition, analysts said Baidu had to overcome ahead for Baidu and other companies trying to mass pro- some additional challenges including a slowing Chinese duce and sell autonomous driving cars. Given the wide economy. diversity of road conditions from one place to another, it is unlikely for any company to come up with a sizable industry A New Business Model operation within five years." In order to promote Artificial Intelligence-driven In May 2016, CEO Li announced that Baidu would shift healthcare, in October 2016, Baidu launched Melody, a its business from a search-oriented model to one based chatbot that used Artificial Intelligence to connect with on Artificial Intelligence due to a slowing revenue growth patients, ask questions, compare responses with a data- in its core search business. He said that the shift would base of medical information and suggest diagnoses to allow the company to develop products in areas such as doctors, who could then recommend the treatment. voice search, automatic translation, and driverless vehi- Baidu also planned to expand into other areas cles. Baidu was exploring a sub-field of artificial intelli- such as finance, where Li said that Baidu could poten- gence known as deep learning k which aimed to improve tially offer loans to people. The company had set up a search results by training computers to work more like US$3 billion investment fund called Baidu Capital to the human brain. In September 2016, Baidu launched an invest in start-ups artificial system called the Baidu Brain, featuring state- According to some industry observers, the shift of-the-art technology for recognizing and processing in business model would likely affect the company's speech, images, and words and building user profiles short-term profitability as the investments in non-core based on big data analysis. In 2014, Baidu had opened businesses would take some time to return profits. "It its research facility on Deep Learning in Silicon Valley will take years before the technology is mature enough for and appointed Artificial Intelligence (AI) researcher monetization. So far, there is still a lack of visibility on the Andrew Ng as Chief Scientist of Baidu. Ng was to lead prospects for these initiatives, and the search business should Baidu Research, with labs in Beijing and Silicon Valley. continue to remain the sole pillar for the company in the Reportedly in 2015 Baidu had stepped up its investment next few years," said Alex Yao, an analyst at JPMorgan in research and development by 46% to US$1.6 billion Chase & Co. mm compared to 2014. It had set up a US$200 million ven- ture capital unit to invest in Artificial Intelligence proj- ects. In August 2016, Baidu unveiled an augmented Can Baidu Bounce Back? reality platform called DuSee that would allow mobile China, with about 710 million Internet users as of June users in China to test out smartphone augmented real- 2016, was the world's fastest-growing online market. As ity on their mobile devices. The company planned to of September 2016, Baidu continued to dominate the integrate the technology directly into its flagship Mobile Chinese search engine market with a market share of Baidu search app. 54.3% followed by Qihoo 360 (29.24%) and Sogou 14.71%. As part of its focus on Artificial Intelligence, In the third quarter ended September 2016, Baidu's rev- in September 2016, Baidu partnered with Nvidia enues were RMB, 18.253 billion (US$2.737 billion), a Corporation" to develop a computing platform for 0.7% decrease from the corresponding period in 2015. self-driving cars. Baidu began testing the cars in the US Net income was RMB 3.102 billion (US$465.2 million), a and planned to launch a practical model in the market 9.2% increase compared to the corresponding period of by 2018. It had already tested its autonomous vehicle in the previous year. Revenue from online marketing ser- Beijing in December 2015. Experts felt that Baidu would vices decreased by 6.7% year on year and 2.6% quarter have a competitive advantage over other Chinese auto- on quarter due to a slump in the number of active online makers that tested their Artificial Intelligence in the US marketing customers. due to its local knowledge of road conditions in China. CEO Li said it would take some time before the However, some analysts felt that it might take some time revenue and profits of Baidu, which had endured aCase 2: Baidu's Business Model and Its Evolution number of setbacks in 2016, started returning to their normal pace of growth. He said the negative impact of tightened Internet advertising laws would continue in the fourth quarter of 2016 with revenue predicted to be down up to 2.2% quarter on quarter. However, some analysts feared that in the meantime Baidu's rivals might catch up and develop technologies and services that might blunt the company's competitive edge. "You can get past the regulatory hurdles but then people have to make a decision on whether the adver tising revenue growth by that point is going to be spread amonga lot more players. It's hard to draw a direct line between artificial intelligence and revenue growth out- side of search?\" remarked Kirk Boodry, an analyst at research firm New Street Research. 12-43 Going forward, CEO Li planned to invest heavily in Baidu's two core growth segmentsTransaction Services and Articial Intelligence. He said that despite the lack of protability resulting from high investment, the 020 busi ness would be a good driver of growth in revenue in the future due to a positive trend in the Chinese ecomnierce industry. He said that even though Baidu's growth could continue to slip in the short term, the company was poised for solid longterm growth considering the massive growth potential in the Chinese Internet market and its competitiveness in the market. According to Li, \"Baidu will rise to new heights, as long as we maintain the trust and loyalty of our users and continue to be at the fore- ont of innovation. This may mean doing the hard things, but the right things, for which there is no compromise.\"3'1