OREANDA-NEWS. Fitch Ratings says Baidu, Inc.'s (Baidu, A/Stable) two-legged strategy - to spin off loss-making and cash-intensive operations, and seek outside investors to fund its non-search businesses - should help its profitability to recover. However, its credit profile will hinge on the company's ability to maintain its dominance in China's fast-growing search engine market and remain disciplined in spending on online-to-offline (O2O) services.

Baidu reduced its cash burden in 4Q15 by swapping its stake in online travel agency Qunar Cayman Islands Limited (Qunar) for a 25% stake in Ctrip.com International, Ltd. (Ctrip). Baidu's 4Q15 results benefited from the deconsolidation of Qunar from 26 October 2015. Qunar reported a CNY1.8bn operating loss in 9M15, dragging down Baidu's operating margin by 5 percentage points. Recently, some of China's biggest airlines suspended cooperation with Qunar before the peak Lunar New Year season in February 2016 due to customer complaints over ticketing and refund issues.

In addition, the proposed sale of online video subsidiary, Qiyi.com, Inc. (Qiyi), could remove another drag on Baidu's profitability and cash generation. Baidu says that Qiyi diluted its non-GAAP operating margin (excluding share-based compensation) by 5.5 percentage points in 2015. Content costs have risen faster than online video advertising revenue in the past few years; content costs increased 100% yoy to CNY3.7bn in 2015. Baidu's chairman and chief executive recently offered to buy Baidu's entire stake in Qiyi for USD2.8bn.

The spin-offs should help margins; but in Fitch's view, Baidu's credit profile and ability to weather the economic slowdown in China will be driven by its dominance in China's search engine market and the continued solid industry growth. Core search services accounted for most of Baidu's revenue in 2015. The search services margin has remained robust, at around 50%. According to Analysys International, China's search engine market expanded 35% in 2015, despite slower Chinese economic growth.

Baidu's profitability is likely to recover from the low in 3Q15, but remain relatively weaker in the next one to two years than in 2013 and 2014, as competition in O2O or transaction services may remain intense. Higher selling, general and administrative (SG&A) expenses to promote transaction services may partially offset the boost from the spin-offs. SG&A expenses rose 64% in 2015. Transaction services reduced non-GAAP operating margins in 2015 by 25.1 percentage points. Baidu says it is committed to invest to improve the quality of its O2O services and its market position, and will maintain the 2H15 run rate in spending for 2016.

Fitch may downgrade Baidu if its operating cash flow were to decline substantially, its operating EBIT margin stayed below 10%, M&As significantly affected its operational or business profile, it took a more aggressive financial stance and lost its net cash position, its funds flow from operations (FFO)-adjusted leverage rose above 2.0x, or in the event of adverse government, regulatory or legal intervention.

Fitch is unlikely to consider upgrading Baidu before it develops new business lines that significantly diversify the source of cash generation from current operations, assuming such a move does not affect the company's financial profile.