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Baidu Finds No Room for Shortfalls

Shares of the China-based search engine are edging lower.

Updated from 9:52 a.m. EST


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shares were slipping Wednesday after the China-based search engine disappointed investors with its soft forecast.

In a damaging

after-hours admission, management said the adoption of a new bidding system may leave its growth below the norm for the next two quarters.

The stock slid as much as 9% Tuesday as investors grew jittery leading up to its results, then shed another 4% following the release of the actual quarterly report. However, when the dust settled, selling pressure abated and the stock was lower by only 1.5% at $85.94 as trading got underway.

Still, the pullback isn't a surprise in light of the stock's steep valuation. Baidu has recently traded above 50 times next year's earnings. At those lofty levels, market watchers saw little room for slip-ups.

In recent months, Baidu's stock has been bid higher because, as China's leading search engine -- a title it has managed to wrest from global giant


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-- it's seen as a bet on the growth of the Internet in the world's most populated nation. Already, 123 million users are said to be online in China.

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On a conference call late Tuesday in New York, CEO Robin Li chalked up the weak outlook to a change made during the second quarter to Baidu's paid search algorithm, which encouraged bidders to pay more for better ad placement. The more sophisticated new system is similar to the one used by Google, allowing customers to make multiple bids to improve their placement.

Baidu hopes it will ultimately boost revenue, but the company's customer base of small and medium businesses in China, who aren't familiar with online auctions, will need a little time to get used to the new system, Li explained.

"Some of the older customers may not be so receptive," he acknowledged. "We knew that by hiking up the price, there will be some customer loss, but we think overall in the longer term it should be healthy and beneficial."

Complicating matters, Baidu didn't have enough staff to brief all its customers on the shift. "We were not able to hire enough sales and customer service people to explain the change to existing customers," Li explained, adding that the company is now hiring new service representatives.

"I believe in the next two quarters we'll be under kind of a transition," Li told analysts and investors on the call. "Beginning in Q2 of next year, we should be back on track with the growth we have been able to achieve historically."

Baidu gave fourth-quarter guidance for 13% sequential growth, meaning revenue of $34 million to $35 million, but that's below the consensus expectation for $36.2 million.

In addition, Li's prediction of soft revenue in the next two quarters raises questions as to whether Baidu can meet the first quarter 2007 consensus. Leading up to the quarterly report, consensus estimates had been for quarterly sales to grow 20% from the fourth quarter to the first quarter.

On the call, Baidu CFO Shawn Wang said the company can only offer guidance one quarter at a time, declining to comment on next year's first-quarter outlook.

Sales are still expanding at a breakneck pace, but not quite as investors have been used to seeing. Baidu's outlook calls for year-over-year revenue growth of 135% to 143% in the fourth quarter. That's well below the 169% rate in the third quarter, 175% in the second quarter and 197% in the first. Of course, growth rates tend to slow as companies get larger.

Also, Baidu's third-quarter revenue of $30.3 million was slightly above the consensus estimate of $30.2 million, but at the low end of its own guidance range of $30 million to $31 million. While it might seem like nitpicking, Wall Street has grown accustomed to Baidu delivering quarterly revenue at the high end of or even above its own estimates.

Now that the downbeat news is out, the next question is whether the selloff will prompt bargain hunting.

Worth remembering is that Baidu lost 21% of its value immediately after a poorly received second quarter report. But as of Oct. 30 the stock was up 32% from its late July low.

Ultimately, if Baidu's new bidding system has, in fact, laid the groundwork for higher revenue a few quarters out, the current weakness will, in retrospect, be nothing more than a hiccup.