Iqiyi (IQ) had gained increased investor interest following its IPO in 2018, with the market characterizing the company as the “Netflix” of China. While IQ’s revenue growth during its early quarters as a publicly traded company appeared rather enticing, hovering close to 50%, it quickly started fading away. By Q3 2020, the company had already reported its first revenue decline year-over-year.
Simultaneously, the company’s business model appears unable to produce sustainable profits. IQ suffers from quite thin margins that have unfortunately not managed to scale despite a rather big viewer base. Thus, the company has been consistently unprofitable, resorting to serial share issuances in order to stay afloat and fund its (rather constantly unsuccessful) growth ambitions.
With investors getting continuously diluted, management failing to present a path towards sustainable profits, and elevated risk attached to Chinese equities altogether, shares of IQ have plummeted. The stock is currently trading at just over $4, exhibiting the massive decline from the $18 price point the stock went public at.
In my view, nothing has changed about IQ’s investment case fundamentally. With persisting headwinds when it comes to revenue growth and lack of adequate margins, it appears that shareholders’ equity will continue going down the drain. I will not be shorting the stock, but only avoid it, due to its quite high short interest already, which stands close to 19.6% of its total float. Accordingly, I am neutral on IQ.
Unsustainable Business Model
Chinese companies are able to achieve enormous economies of scale due to the country’s massive population. IQ has managed to accumulate a tremendous subscriber base as a result. However, growth in paid subscribers has not just stagnated over the past few years, but subscribers have been, in fact, leaving the service. In Q1 of 2020, the company numbered 118.9 million members. This figure stood at 105.3 million in Q1 of 2021. In its most recent Q1 of 2022, more members canceled their subscriptions, with the company recording 101.4 million subscribers.
Despite the company recording an increase in monthly average revenue per membership of 8% year-over-year to RMB14.69 ($2.19), revenues declined by 9% to $1.1 billion compared to Q1 2021. This indicates that demand for IQ’s service is highly elastic, with its subscribers being quite sensitive to hikes in pricing.
At first glance, IQ’s margins have been improving lately. Gross margins reached 18% during the quarter, allowing the company to post its first profitable quarter as a publicly traded company. However, there are some critical points to note here.
Firstly, despite reporting a profitable quarter, net margins were as low as 2.32%. The company practically broke even. Secondly, the only reason the company was able to produce profits (after all, its revenues declined) was due to gains from its equity investments and due to its cost of revenues dropping by about 17% year-over-year. Operating cash flows were once again negative, in fact.
But even if we focus on the declining cost of revenues, this is not a sustainable strategy to attain profitably in the streaming industry. Streaming companies must keep spending a whole lot towards enriching their content catalog if they are to grow or at least retain their subscriber base. Profitability is supposed to come with scaling economics, not cutting on the content budget.
Thus, here’s why we believe IQ is set to fail whether or not it reaccelerates content spending:
Scenario 1: IQ Reaccelerates Content Spending
If IQ chooses this avenue to revitalize growth, we already know what its business economics should look like, as this was the strategy up until recently. Amid increased content spending, gross margins can hardly be sustained above 10%, as was the case between 2018 and 2020. This leads to certain net losses, as interest expenses on debt are not covered.
Accordingly, this leads to further share issuances, more shareholder dilution, and further shareholder equity going down the drain. By following this strategy, IQ’s common equity value declined from $3.53 billion in 2018 to $1.08 billion as of its latest results. In the meantime, the share count increased from 707.6 million to 823.4 million during this period.
Scenario 2: Content Spending Stagnates or Declines Further
In this scenario, we believe that the company’s subscriber base will continue to decline rapidly as viewers find the service lacks fresh content. In the short term, the company may report thin profits. Long term, however, with the subscriber base shrinking, the ultra-thin positive net margins should turn negative again.
The company may attempt to raise prices to sustain profits, but as we mentioned earlier, demand for the service has proven to be highly elastic. Thus, more subscribers will likely leave in such a scenario, leading to thinner margins. Eventually, IQ will start reporting losses again as a result.
Wall Street’s Take
Turning to Wall Street, Iqiyi has a Moderate Buy consensus rating based on three Buys, two Holds, and one Sell assigned in the past three months. At $5.77, the average Iqiyi stock forecast suggests 35.76% upside potential, nonetheless.
Takeaway
IQ shareholders have suffered substantial losses since the stock’s IPO, with the company’s business model appearing unsustainable. Despite its massive subscriber base, the company has not been able to leverage it into a profitable streaming platform. At this point, whether IQ chooses to increase or decrease content spending does not seem to matter when it comes to preserving shareholders’ equity. For this reason, I will continue to avoid the stock.
