iQIYI: The Thesis Is Still Intact

Summary

• IQ reported very good earnings on Tuesday.
• The stock price was muted in the aftermath but has recently pulled back more than 10%.
• However, there are some under-appreciated developments that the company is executing on.

Investment Thesis

The “Netflix (NFLX) of China,” iQIYI (NASDAQ:IQ), exceeded expectations in Tuesday's earnings report, and it is still a candidate for market-beating returns. The headline numbers were solid, but there were also some aspects of the call that didn’t get enough attention.

What Happened

The company’s second quarter results were solid. Revenues grew 51% in local currency to $933 million. Membership services sales exploded 66% to $374 million. And advertising revenues grew 45% to $396 million.

One of the more noteworthy items in the quarter was the net additions for subscribers. The company added 5.8 million members for a total of 67.1 million. To put this in context, Netflix added just 5.15 million in its last reported quarter. Naturally, Netflix’s subscriber growth should be slower as it has saturated its core market (the U.S.) but there is still considerable room internationally that it is pursuing.

IQ attributes some of the subscriber growth to its partnership with JD.com (JD). What is interesting is that Tencent (OTCPK:TCEHY) owns a sizable chunk of JD, over 15% in fact. This is notable because Tencent Video is the top competitor with IQ. It makes you wonder if JD’s partnership with IQ reveals it believes more in IQ than Tencent Video, even though Tencent is a huge investor.

Moreover, it will be interesting to see how many subscribers Tencent Video adds. In its latest quarter, that number was almost 63 million, so it will be a good gauge for IQ’s market share.

What It All Means

Another point on the subscriber piece is that the company is not trying to squeeze every last dollar of profit. Check out this quote from the CFO,

“as I've said before, so now ARPU [average revenue per user] is not the primary goal of membership surveys. Because we see the trend - definitely will see the opportunity…revenue is not my primary goal on the membership surveys, which we definitely want as many subscribers as possible now.”

This means that IQ has the potential to raise prices over time. I believe this is a discounted aspect of its business and one that Netflix has taken advantage of since its value proposition is so favorable.

Another concern was the slowdown in advertising growth. 45% is not bad, but it was a deceleration from 52% growth in the last quarter. The head of investor relations made some comments on this during the call,

“the ad challenges we have two components. One is brand ad, the other is infeed ad. Infeed ads are growing very nicely. But for the brand ad side, we will take a cautious, optimistic view for the second half of the year.”

In-feed advertising is pretty much like programmatic advertising, where companies can tailor their ads to members’ profiles and watching habits. This was launched in the fourth quarter of 2016 and is growing, presumably faster than brand advertising which was the incumbent technology. In-feed advertising also results in prepayment for ad dollars giving IQ some more revenue visibility. In-feed’s growth is probably being masked by the slowdown in brand advertising. However, management has made it clear that membership services will be more important going forward. That is to be expected at this stage as the company is nowhere near levels of subscriber saturation.

Another interesting aspect of the earnings call was the ‘other’ operating segment. ‘Other’ revenues grew 62% to $81 million, but that was an acceleration from 51% growth for last quarter. According to the IPO prospectus this segment contains,

“revenues from various other channels, such as live broadcasting, online games and IP licensing. In addition, we also generate revenues from online literature and e-commerce.”

Though management has not commented a whole lot on this operating segment, I expect it to continue strong growth as the company’s $300 million acquisition of online game-maker, Skymoons, should materialize. Plus, the CEO has commented a couple times on the opportunities for licensing IP. And China is certainly a hotbed for live-streaming as evidenced by the incredible growth rates of popular companies like YY (YY), Huya (HUYA) and Momo (MOMO). All in all, it will be interesting to see how this 'other' segment provides a growth tailwind to IQ.

Risks and Valuation

The main risk with IQ is competition. When Tencent reports earnings on August 15th, it will be important to look for the subscriber growth in Tencent Video. I do believe there is room for two big online streaming companies, but mindshare is key.

Another risk is the operating losses for the company. In the past quarter, losses came down 2% to -22% from -24% a year ago. In other terms, the company lost $200 million in the quarter. However, IQ has over $2 billion in cash on the balance sheet, meaning losses shouldn't be too much of an issue for at least the next two years.

Revenue is on track for $4 billion by the end of this year, and the enterprise value of the company is about $18 billion after backing out cash. This means the EV/sales ratio is about 4.5, and less if we were to estimate out a full year. For a company that is growing over 50%, adding more subscribers than Netflix, albeit at a lower price point, just over 4x forward sales seems cheap. Don't let the Chinese tariffs scare you out of this one, look at the facts.

In Summary

IQ’s latest earnings call deserved more attention than it was given. Huge net-additions for subscribers, a transition to in-feed advertising and an acceleration in the ‘other’ operating segment are important pieces of the IQ puzzle. These are the underappreciated portions of what, in my opinion, was a solid quarterly report for the company. Stay long.

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Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long IQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.