February 03, 2019 - 5:01pm EST by
2019 2020
Price: 20.12 EPS 0 0
Shares Out. (in M): 723 P/E 0 0
Market Cap (in $M): 14,560 P/FCF 0 0
Net Debt (in $M): -1,200 EBIT 0 0
TEV (in $M): 13,360 TEV/EBIT 0 0

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Iqiyi is a fast growing Chinese Internet video streaming company with 80+ million subscribers and market cap of $14.5 billion. The stock is 50% off its peak June price and currently is trading at 3.6 times run-rate sales, a bargain considering the growth in subscribers and revenue. The potential is huge.

Iqiyi was  founded in 2010 by Baidu which is its largest owner and controlling shareholder with 93% of total voting power. The best way I can think of to describe the company is as Youtube, Hulu and Netflix combined. Its most important competitors are Tencent Video and Alibaba's Youku. Iqiyi is the market leader in terms of monthly active users with 553 million vs Tencent 463m and Youku 407m. It also leads in terms of average annual subscribers spending and has roughly the same number of paying subscribers as Tencent. Things are moving so fast that any number quickly becomes outdated.

Earlier last year, Baidu launched  IPO in US to raise $2.4 billion so it could stay ahead of its deep-pocketed rivals. About half of the IPO proceeds was said to be spent on content and 10% on technology improvement. After the successful IPO, in  less than three months of trading the stock more than doubled but returned to the initial IPO price in the market sell-off that followed in the second half of the year. The drop in the price should mostly be attributed to the changing macro environment like  poor macro data coming out of China as well as Fed tightening but also due to the end of 180 days lock-up period. Futhermore, some investors and analysts were disappointed with huge losses in Q3.

Iqiyi's run-rate revenue is approximatelly $4bn and derives from:  1) membership services, 2) online advertising services, 3) content distribution and 4) other stuff. The membership services amount to roughly 40% of the total revenue. The last quarter was a turning point as the first quarter in which  the subscription revenue surpassed the advertising revenue. As the CFO explained prior to the IPO, shifting from the pure advertising based model to a more  balanced one which  includes subscription was always planned, but they first had to build the base willing to pay for a content which didn't exist in China like in Western countries. So they offered a lot of free and, I suppose, illegal content to attract consumers. Currently they are in this Youtube/Hulu/Netflix hybrid phase where their platform includes user-uploaded content, licensed content and the increasing share of original content. Moving from licenced-based content to original one brings additional advantage – better margins as the original content costs Iqiyi as half as much as licensing something similar. Ultimately, the goal is to become  Netflix+ or  “Online Disney“ as  CEO Tim Gong Yu often calls it. “Online Disney” is going to be much more vertically integrated company than Netflix, owning the whole entertainment ecosystem, although without theme parks. In his view, that is the only way to build a permanent moat. So besides videos the ecosystem should include online games as well as graphic novels and other merchandise all developed out of their original movies and TV series.

The ad business was growing very fast until 3rd quarter when it dipped as was expected due to World Cup which diverted advertising to traditional TV and some regulatory headwinds related mostly to the online gaming industry which the management does not expect to be translated to the following quarters.

The content distribution is growing strongly and is based on a sub-licensing of the licensed content to other video streaming platforms as well as distributing original content outside China and to Chinese TV stations. The Q3 was particularly strong in the content distribution segment. It tripled over the same period last year primarily as a result of the original content distribution.

I believe that of the three competitors so far Iqiyi showed the most willingness to transit  to  a more Netflix-based model. That should become even more evident in the following quarters. At this point only the number of subscribers matter, which is a result of the quality and quantity of the offered content. The management is perfectly aware of that fact which led to 66% increase in programming costs in Q3. Ballooning costs should not be a cause of concern, but rather the sign that Iqiyi is heading toward a more value added business, by building exclusive, original and  numerous content. They've spent $100 million on the Story of Yanxi Palace, a 70-episode  drama that broke all historical viewing records for dramas in China and was the world's most googled series of 2018 ( which tells a lot about its popularity abroad given the Google status in China and explains huge increase in content distribution) . That is how you attract subscribers and build scale. At the end of 2015 Iqiyi had 11 million subscribers, in 2016 the number  rose to 30 million, in 2017 to 50 million, in the 3d quarter of 2018  to 81 million of which 98% are paying for the service. In the first quarter of this year Iqiyi should surpass 100 million subscribers. The management expects that in 2019 the number will increase at the rate at least as high as in 2018. In other words, 2019 should end with at least 130 paying subscribers. If  such a strong growth in membership numbers continues, the management might even increase the membership fee. Of the Big Three, subscribers on average spend the most on Iqiyi content. Content costs as percentage of revenue were 78% in the third quarter of 2018. Close to $0.9 billion just in one quarter! Iqiyi is scaling up at much faster rate than Netflix did in that stage. To stay ahead they decided to raise even more capital, $750 million, this time in the form of convertible senior notes. The company doesn't have a lot of debt so new debt offerings that would be used for financing more content  are very likely in the following quarters. Ultimately, incremental revenue coming  from more subscribers, higher membership fees and increased ad spending is going to surpass fixed costs resulting in a sharp bottom line improvement.

Once a piracy heaven, China has become a market where consumers are increasingly paying for online video content. This shouldn't come as surprise. The continuous rise in discretionary income has made paying for an online content affordable. The government did their part by launching a piracy crackdown  which led to shutting down thousands of sites that provided pirated streaming or downloading. The number of copyright-related cases is rapidly increasing as the former pipelines for piracy content are becoming creators and buyers of content so they are filing suits and sending takedown notices to websites defending their original or licensed content.  Thus, it is not surprising that government is intensifying piracy crackdown given the increasing influence of large tech companies on the government(or the better word would be interconnection of the two?).  A few years ago paying for a video streaming was a lousy deal to consumers since they could freely choose from the pirate and legal ad video on demand sites but the taste of the rising middle class is changing fast as in the other parts of the world. They now have the money to pay for the newest, the most exclusive programming without being bothered by commercials and can  watch it  at their own pace.

The biggest risk to Iqiyi comes from the fact that it operates in a competitive market where its competitors Youku and Tencent Video potentially have more capital to finance production of the original content. Even though ahead of competitors, Iqiyi is only slightly so. Nothing like Netflix vs. the rest. Just in 2018 Tencent spent billions of dollars buying stakes or fully acquiring production companies. Both Tencent Video and Youku have underscored the importance of bringing a new and original content to their platforms. To compete, these companies offer discounts to attract new customers. Furthermore, Tencent’s advantage is its own ecosystem. On the other hand they have numerous businesses so they certainly won’t be as focused as Iqiyi. I suppose Baidu’s decision to IPO Iqiyi came from the idea that its balance sheet was not its competitive advantage but highly focused management team of a newly formed company might be. They have a clear goal and no distractions which is not something you can say for Alibaba’s and Tencent’s managements.  Also, one cannot escape macro risks. If further deterioration of Chinese economy continues and the bubble bursts, it will hurt IQ as any other company in China. But over the long run IQ is a 20+% compounder.

China is the second largest economy in the world with the population of 1.4 billion, twice the population of the US and EU combined. The video streaming market is going to get markedly larger everywhere, including China. Netflix and other western streaming services won’t even try to enter this market in the foreseeable future so it is basically left to the three players that dominate Chinese streaming market. Another upside to the fact that foreigners are essentially banned to the Chinese market is that they will be forced to offer their content to local streaming services. So, unlike Netflix who could possibly face losing all of Disney's content when Disney decides so, Chinese streamers can count on the stable relationship with foreign content producers. Iqiyi entered a partnership with Netflix which gives it a advantage due to the size and quality of the Netflix’s content pool.  

 I believe that even if Iqiyi doesn’t end up the largest of the Big Three it could still earn nice return from the current price. You won’t find many industries where participants are unhappy with the fact that they operate in the industry with only three competitors. True, one could add  linear TV but more than anywhere else, in China future of entertainment belongs to streaming companies. They have the national presence which is not the case with the most TV stations. TV ads represent much smaller percentage of total ad spending than elsewhere. Of the total ad spending of $90 billion, which has doubled since 2010, digital accounts for 65% and growing while TV share is falling. I don’t think major TV stations are a nemesis the Big Three fear much. In 2017 TV broadcasters in China spent $6.4 billion on programming vs. $4.5 billion spent by online platforms. In 2018 Iqiyi spent close to $1bn just in the third quarter so it’s safe to assume that online platforms will significantly outspend traditional TV in 2019 and beyond if that didn’t already happen in 2018. Additionally, TV ads were never that big  in China in the first place and now ad spending is falling which will make things even more challenging for them to compete with the streamers. Given the size of the market, 450 million households and 1 billion mobile phones potential is huge.

So how to value the company? There are various ways to approach this. P/S is a good start. Currently IQ trades at 3.6 x run-rate sales. Which is low for a high growth tech company. IQ is growing fast as or faster than Tencent, Baidu and Alibaba in China or Hulu, YouTube and Netflix abroad. Looking at things from a different perspective and using oversimplified, back-of-the-envelope calculation also suggests higher valuation.  The company has 553 million MAU. If we assume $160 billion valuation for YouTube for its 1.9 billion or so monthly active users, that would imply valuation of $84 per user. Chinese users are less valuable than YouTube's so let's settle down with $35 per user which brings us to $19bn in value. If we take into account the fact the Iqiyi has less user generated content and relies on more expensive PGC maybe $10bn would be more appropriate? This valuation doesn't take into account more valuable part of the business – paid members. Netflix has a 139 million paying subscribers for a total value of $150 billion. More than a thousands dollars per user. Obviously, market values members who pay for a service more than consumers of advertising, which makes Iqiyi's decision to go this path even more important. Iqiyi has 80 million members and the number is growing faster than Netflix's. But Iqiyi's members are less valuable, they are paying less for the service than Netflix users do. This gap is going to  narrow in the future due to higher Chinese growth but puting that aside let's value a Iqiyi's paying subscriber for a third of a Netflix's one, at $300. So just a membership part of the business is worth $24 billion without taking into account ad side of the business. In total, $34 bn in value or 140% upside. With 130 million subscribers the picture looks even brighter.


I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


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