The "Netflix of China"? A Closer Look at Baidu's Huge iQiyi Opportunity

Baidu (BIDU 1.02%) is China's largest online search engine, with nearly 80% market share of the country's search advertising. Due to its strong revenue growth and dominant competitive position, we've often referred to it as "the Google (GOOGL 1.27%) of China."

But due to its often-overlooked iQiyi segment, perhaps we should also begin referring to Baidu as "the Netflix (NFLX 4.17%) of China."

iQiyi is Baidu's online video platform, which allows users to stream movies, TV shows, and other digital content. The company monetizes its video through a combination of advertising supported content, free-to-watch content, and ad-free paid subscriptions. For those of us stateside, it's kind of a hybrid of Netflix and Amazon.com (AMZN 1.30%) Prime Video.

Plagued with regulatory headwinds that have restricted growth in its search and transaction services businesses, Baidu has been plowing money into iQiyi -- to groom it as one of their predominant growth drivers.

Let's take a closer look at how quickly this division is growing, and what it will mean for investors.

The iQiyi website on Aug. 8, 2017. Photo credit: IQIYI.COM

An intro to iQiyi

Pronounced "eye-CHEE-yee," iQiyi was fully acquired and consolidated by Baidu from Providence Equity Partners in November 2012. It's a website and mobile phone destination where users can find just about anything entertainment-related that they're looking for.

iQiyi attracts plenty of desktop visitors, but Baidu breaks out their mobile metrics in their annual reports. At the end of 2016, iQiyi's mobile app had 125 million daily active users and 480 million monthly active users. To put that number in perspective, Netflix just reached 104 million subscribers in all of the countries they operate in across the globe.

The user base is simply enormous. But to be fair, only a small percentage of the people watching content on iQiyi are actually paying for it right now. It's estimated that 20 million users are ponying up money for the service, which costs roughly 20 RMB per month (around $3). Multiplying those two numbers together, subscribers are contributing around $720 million per year.

On top of that is the advertising, which brings in a similar amount of revenue as the subscribers. For cost accounting purposes, the advertising revenue gets reported as a part of Baidu's "Online Marketing Revenue," while the subscriptions are accounted for as "Other Services Revenue."

One thing that is becoming clear is that iQiyi's contribution to Baidu is increasing significantly. Revenue more than doubled to $1.6 billion in 2016, and is accelerating in its growth rate.

Conversion from RMB to USD based on then-current exchange rates. Growth rate based on RMB. Source: Baidu 20-F annual reports.

We can make a strong case that the accelerated growth rates will continue. China has more than 700 million internet users who are flocking to iQiyi and attracting a lot of attention from advertisers. And as the company adds more movies to its premier content library (only available to paying subscribers), I expect we'll see the subscription revenue grow as well.

Baidu knows it has a winner

Netflix has already demonstrated just how profitable a regional digital streaming monopoly can be. The content costs of this business are largely fixed: paying for rights from others or producing your own original content. Once the fixed costs are covered, a rapidly growing user base can generate incremental revenue that falls quickly to the bottom line.

Following this same dynamic, Baidu is investing heavily in iQiyi's content to continue to attract those paying users. Management has attempted a few different options on how best to handle the increasing bill related to offering highly demanded content.

For several years, Baidu just foot the bill themselves and internally funded iQiyi's content library:

Conversion to USD based on end-of-year exchange rates. Source: Baidu Quarterly Reports

Then in February 2016, CEO Robin Li tried to change course and buy iQiyi outright. Offering $2.8 billion in cash, Li proposed taking the burden of iQiyi's rising content tab off of Baidu's financial statements and promising to keep it as a "strategic partner" to the parent organization. Shareholders wisely dismissed/refused the offer, recognizing that iQiyi's potential value was much greater than the proposed amount.

Finally, iQiyi issued $1.5 billion of convertible notes earlier this year and immediately invested $300 million of the proceeds directly in expanding their library. For the time being, it seems management and shareholders are content with issuing debt and equity as a strategy to fund iQiyi's future growth.

The Foolish bottom line

iQiyi may not be a commonly recognized name yet, even for investors who are already familiar with Baidu. But with an enormous user base and an expanding digital library, Baidu is planting the seeds of success in this winner-take-all market. Watch for iQiyi to play an increasingly important role in Baidu's future.