Nov 1 (The following statement was released by the rating agency)
Fitch Ratings has affirmed China-based Baidu Inc.'s (Baidu) Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) of 'A' and foreign-currency senior unsecured rating of 'A'. The Outlook is Stable.
Key Rating Drivers
Dominant market position: The ratings reflect Baidu's dominance in the internet search market in China with a revenue market share of over 80%. The company has also achieved a clear leading position in China's mobile search market. The ratings also benefit from the company's strong profitability and balance sheet, reflecting its cash generation ability through a proven performance-based, online marketing service to over half a million advertisers targeting hundreds of millions of Chinese internet users, and its strong pricing power.
Strong competitive advantages: Fitch believes that technological innovation plus high levels of brand recognition and consumer satisfaction have enabled Baidu consistently to defend its high market share in a rapidly growing market. The company continues to invest to improve natural language processing, deep learning, image recognition, voice technology, use of big data, location-based services and mobile application search, further strengthening its technology leadership. It also has managed its relationship with the government and regulatory bodies well.
Solid performance: Baidu's revenue grew robustly, by 42.3% yoy, in Q313 while EBIT margin stayed at 37.7% (H113: 37.8%), which remained above global search engine peers' margins. Mobile search revenue continued to accelerate, outpacing mobile search traffic growth, as more customers embrace the benefits of mobile marketing on Baidu's platform. Recent acquisitions further strengthen Baidu's mobile application distribution capabilities and boost its location-based service (mobile map) offering, complementing its existing advertisement business.
Strong cash generation: Baidu generated free cash flow (FCF)/sales of around 40% for the period of 2008 to 2012. Including short-term investments, where the company parks its surplus cash, Baidu had unrestricted cash of CNY17.8bn and near cash of CNY25.5bn at end-September 2013, together covering 243% of its total debt. Fitch expects Baidu to maintain strong financial flexibility with sound profitability and ample liquidity over the medium term.
Foreign ownership restrictions: Chinese law restricts foreign equity ownership in internet, online advertising and employment agency companies in China. Baidu operates its websites in China through contractually controlled consolidated affiliated Chinese entities. These variable interest equity (VIE) arrangements are the usual mechanism for overseas investors to participate in China's restricted sectors and are a credit weakness as they may not be as effective in providing control as direct ownership or may face legal challenges in the future.
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 affiliated entities.
Fitch is reassured by the alignment of Baidu's and affiliates' objectives and the company's continuing good relationship with the government and regulatory authorities.
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
- decline in operating EBIT margin to below 10% (37.7% in 9M13)
- decline in pre-dividend FCF/sales ratio to below 10% (42.3% in 2012)
- increase in funds flow from operations-adjusted leverage to above 2x (1.3x for 2012)
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 operations which are subject to Chinese government and regulatory risk, provided such diversification does not damage the company's financial profile.