Fitch Affirms Baidu at 'A' with Stable Outlook
KEY RATING DRIVERS
Leading Market Position: The ratings reflect Baidu's dominant internet search engine market position in China. Baidu remains the default choice for advertisers to promote their products on search engines in China. In addition to PC search, Baidu holds leading positions in key mobile entry points in search, maps and applications distribution. Baidu's mobile-search traffic accounted for about two-thirds of its total traffic in 3Q15.
Robust Industry Growth: The ratings also reflect Fitch's expectation of continued robust growth in China's internet search market in the next two to three years, driven by further rise in mobile advertisements and mushrooming e-commerce in China. iResearch forecasts China's total internet search engine revenue to grow at a compound annual growth rate (CAGR) of 29% between 2014 and 2018. Given its dominant market position and technology leadership, we expect Baidu to capture much of this growth.
Margins Under Pressure: Baidu's profitability may remain under pressure in the next one to two years as we expect competition in online-to-offline (O2O) and transaction services to remain intense. We expect Baidu's search services margin to remain robust, at around 50%, but higher selling, general and administrative (SG&A) expenses to promote transaction services may continue to drag on overall profitability. SG&A expenses increased 111% yoy or 47% qoq in 3Q15 to CNY5.7bn. Baidu is prepared to invest CNY20bn to improve its position in the vast local e-commerce market.
High Cash Generation: Given the margin pressure, Baidu's free cash flow (FCF) margin is likely to continue to trend down, although it will still be relatively strong. Fitch expects further improvement in mobile monetization rate to sustain a high cash generation from search services, which will fund the company's transaction service initiatives and help stabilise overall FCF margin at around 20% (2014: 23%). A recovery in Baidu's FCF margin is possible when its transaction services gain critical mass or it starts to cut subsidies to new services.
VIE Weaknesses Mitigated: Baidu generates over 70% of revenues from, and keeps almost all the cash and assets within, its wholly owned subsidiaries in China rather than at the contractually controlled, consolidated and affiliated entities. The alignment of Baidu's and its affiliates' objectives and the company's continued good relationships with the government and regulatory authorities mitigate the risks from the variable interest entity (VIE) arrangements.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Baidu include:
- revenue to rise by more than 30% in 2015 and continue to grow at 20%-25% in 2016 and 2017
- EBITDA margin to fall to 20%-25% in 2015-2016 before rebounding to 25%-30% from 2017
- capex to increase to CNY7.5bn-8.0bn for 2015-2017
- strong liquidity position to be sustained in 2015-2017
RATING SENSITIVITIES
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- evidence of greater government, regulatory or legal intervention leading to an adverse change in the company's operations, profitability or market share
- material loss of market share in key products and services
- significant M&A that negatively affect the operations or the business profile
- sustained decline in operating cash flow
- operating EBIT margin sustained below 10% (2014: 26%)
- a shift to more aggressive financial policies, for example a sustained loss of its net cash position or sustained funds flow from operations (FFO)-adjusted leverage above 2.0x (2014: 2.4x). However, FFO-adjusted leverage rising above this target will not likely lead to a downgrade should the company retain its strong net cash position and high FCF margins.
Positive: For the short to medium term, Baidu's rating is at its ceiling and takes into account Fitch's expectation of profit growth. Fitch may consider an upgrade if the company develops businesses that materially diversify cash generation away from current operations, provided such diversification does not damage the company's financial profile.
LIQUIDITY
Ample Liquidity: We expect Baidu to maintain a conservative capital structure with substantial net cash, even taking into account of continued higher SG&A expenses in the next two to three years. Excluding Qunar Cayman Islands Limited, Baidu had readily available cash plus short-term investments of CNY66bn at end-September 2015, compared with debt of CNY36bn.
FULL LIST OF RATING ACTIONS
Long-Term Foreign-Currency IDR affirmed at 'A'; Outlook Stable
Long-Term Local-Currency IDR affirmed at 'A'; Outlook Stable
Foreign-currency senior unsecured class rating affirmed at 'A'
USD750m 2.250% senior notes due November 2017 affirmed at 'A'
USD1bn 3.250% senior notes due August 2018 affirmed at 'A'
USD1bn 2.750% senior notes due June 2019 affirmed at 'A'
USD750m 3.000% senior notes due June 2020 affirmed at 'A'
USD750m 3.500% senior notes due November 2022 affirmed at 'A'
USD500m 4.125% senior notes due June 2025 affirmed at 'A'
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