Video streaming company iQiyi  (NASDAQ:IQ) recently spun off from Baidu (NASDAQ:BIDU), and the market is taking notice. In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Danny Vena explain why iQiyi is so exciting and what investors should know about the company before digging in.

Press play and find out how huge Baidu is already, what their revenue and growth numbers look like, how the company has been so wildly successful so far, the biggest competitive threats in the Chinese video streaming space, how the stock has performed since its IPO, and why the Netflix (NASDAQ:NFLX) of China has the hosts considering an exception to their "no investing in recent IPOs" rule.

A full transcript follows the video.

This video was recorded on May 11, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, May 11th, and we're talking about the Netflix of China. I'm your host, Dylan Lewis, and I'm joined on Skype by Fool.com's Danny Vena. Danny, we both love Netflix -- you as a shareholder, me as a binger. It seems like the streaming subscription model is something a lot of people can get behind. Today, we're going to be talking about a company in China that has taken note. You want to tee up what we're going to be discussing today?

Danny Vena: Absolutely. iQiyi, which was a spin-off from the Chinese Google, Baidu, they started off strictly following the Hulu model. They began as a company that used strictly advertising to generate their revenue, get as many subscribers in the door as they could, but these people were not paying anything. And it was fairly successful. But about 2015 or so, Baidu recognized just how successful Netflix was becoming, and as it has been the case with so many Chinese companies, they saw a model that they liked, and they copied it. So, they generated some new exclusive content, they stuck it behind a paywall, they encouraged users to sign up and pay, in their case, about $3 a month, and they've gone from there. 

Lewis: Yeah. I'm sure that iQiyi appreciates the "Netflix of China" parallels. Certainly, when Matt Argersinger was first talking about this company, that's how I first got wind of it, and he used that as the pitch. I was immediately ears perked up just because, one, the subscription model has been so strong for Netflix, retention has been so good; and two, it's just such a scalable model. You have something that serves people well, and if you do it right and build out your content library, you can really scale your costs pretty quickly and enjoy some nice margins. 

iQiyi is a business that operates somewhat like Netflix, somewhat like Hulu. And this really plays out in how they make their money and in their financials, right?

Vena: It does. iQiyi still generates the majority of their revenue from advertising. When they filed for their IPO, the information that they provided to the SEC essentially was that 47% of their revenue was still generated from advertising. They also earned some money from this subscription revenue. And then, they also have a bucket called Other. Some of that is a product of content distribution. It's not entirely like Netflix or Hulu, because they sell merchandise that are tied to some of their original content. They have video games, they have content distribution. So, they also have another growing bucket of revenue, which is unlike what we're used to seeing.

Lewis: And as for what growth looks like for that revenue base, in the most recent quarter, iQiyi produced revenue in the high $700 million range. There are some fluctuations, depending on the period you're looking at, due to currency, because this is a Chinese business. But, that was up 57% year over year. While that's pretty good growth, this was actually something that the market was a little disappointed in, Danny.

Vena:​ And I think the market got that wrong, personally, because this is on top of 55% growth in the prior year. So, having several years in a row of exceeding 50% growth for any company is pretty laudable.

​Lewis:​ Yeah. I think you have to be pretty thrilled with that kind of growth. This is kind of like the Facebook thing, where it defies logic that a company can continue to put up 40% or 50% growth year over year on top of 40% or 50% year over year growth. But when you have a product that's that attractive, they just manage to do it.

Vena:​ And I think, one of the things that's going to serve them well in the future -- I'm jumping ahead a little bit here -- if you look at the fact that they have more than 400 million monthly active users on PC, they have more than 400 million monthly active users on mobile, and that provides them a big pool of potential paying subscribers.

​Lewis:​ Right. I think the actual subscriber number is somewhere around 60 million. I think, you can look at this business a lot of the same ways that you would look at a Spotify. You have this free product that's available that gets people in the door. It's an introduction. Then, they have this content wall, and you can pay to see all of this exclusive stuff and these originals. That's been a really successful model for a lot of these content companies, and it proves to be really great for customer acquisition.

Vena:​ And I think that also gives them a funnel, because they have all these people, like you said, they're trying out the free service. But in the meantime, they're still earning advertising dollars off of those customers, even though they're free. Then, when those customers decide they want in on some of that higher-quality original content, they'll pony up the few dollars a month to be able to view that original content.

​Lewis:​ Perhaps not surprisingly for a high-growth business, this is not a profitable company. And I think, for the foreseeable future, this is going to be a business, much like Netflix was and continues to be, that trades based on what subscriber counts look like. People are going to use that as the baseline for what, long-term, the business can project out to, and so long as they continue to grow that subscriber count and maybe convert some more monthly actives to paid subscribers, then I think they're going to see a lot of success.

Vena:​ That's true, Dylan. Looking at their most recent full fiscal year, and 2017 was probably pretty representative of what you'll see going forward, they generated a loss of $500-600 million, and primarily because they just keep forking over money for more and more new original exclusive content that they're putting behind a paywall. And they've been pretty successful at doing that. They're following the Netflix model in that way, almost to the letter.

Lewis: Yeah, and they've seen a ton of success with this. A lot of their original programming seems to really land with Chinese consumers, very much the same way that a lot of Netflix programming -- your House of Cards, your reboots of Arrested Development, a lot of their movie Originals -- seem to be huge drivers of customer acquisition here in the U.S. and in some of the new territories for Netflix.

Vena: Right. iQiyi, when they started developing this original content, keep in mind that they were still owned by Baidu, which spun them off earlier this year. Now, Baidu has a lot of similarities to Google. They are the major search engine in China. They have a lot of data. They've been at the forefront of artificial intelligence. So, one of the things that iQiyi said in their IPO filing with the SEC is that they view that data and their ability to analyze that data using artificial intelligence as one of their competitive advantages. So, they have used that to generate shows that Chinese consumers just really love. 

And I want to read a bit here about one of their shows. Their most successful show to date has been something called The Rap of China. That show debuted last summer, and it's been called the most profitable TV show in China ever. It was a 12-episode music competition, similar to a lot of the reality shows that you've seen here. It had 2.68 billion viewers on the season finale in September. The total cost to develop that program was right around $38 million. They had earned more money than that in advertising in the last 60 seconds of the final season's show. So, all of the rest of the advertising for the whole rest of the season was on top of that. It already had paid for itself many times over.

Lewis: Those are some wild economics when you break them out that way. 

Vena: It's crazy!

Lewis: I think I've made the point here that the model is very successful. What makes this particularly enticing is, we look at the streaming market in the U.S., and in some ways it's mature, at least on a relative basis. There are still a lot of households that are on the traditional cable model. But, to go over to China, the penetration is so much lower, both from a connectivity standpoint and from an adoption standpoint. So, the growth runway in front of a business like this, I think it's a lot larger than the growth runway in front of a Netflix right now.

Vena: We don't know exactly how many people in China actually use streaming video on demand services, but estimates are somewhere around a 3% penetration rate for paying subscribers to these streaming video on-demand services like iQiyi. So, when you look at it from that perspective, there are just so many more subscribers to be had. I think the runway is incredible.

Lewis: Yeah. I saw an estimate from Statista basically saying that the compound annual growth rate is expected to be somewhere around 16-17% annually over the next five or six years in China, the streaming video market. Of course, numbers that are that big entice a lot of other players into the space, and I think that this is something that people need to keep in mind with iQiyi. You have a business that's backed by the Google of China, but you also have a lot of other deep-pocketed tech companies that are interested in streaming video there.

Vena: There's some big competition. We can talk about two of the other biggest players in China. By now, everybody has heard of Alibaba. They're a combination of so many U.S. companies, but they're most often compared to Amazon. But there's so much more going on there. One of the things that Alibaba has is a video streaming service called Youku Tudou, which is also one of the big players. Then, Tencent Video, from the video game company in China, although they're also into a lot of different areas. 

Those are the two main competitors, and they have very deep pockets. They have a lot of money. And those two companies are second and third in the number of video streaming customers. I think Tencent Video said they have about 450 million monthly active users under an advertising model. Alibaba has about 325 million. Alibaba has about 30 million paying subscribers, and Tencent has about 43 million, compared to iQiyi's 60 million. So, there's a lot of competition there. All three of these companies are trying to develop original content. They're all going after those China consumer dollars pretty hard.

Lewis: I think another point to note with this business is that the economics are slightly different on a per-user basis. Subscribers for iQiyi pay somewhere in the neighborhood of around $2.50 a month for the service. Or, I think, ultimately, it might boil up to about $30 per year, depending on what they decide to opt in to. But, the value of those users is quite a bit different than the value of a Netflix subscriber, because Netflix subscribers are paying $11-12 a month. So, when you're thinking about valuing those subscribers, that's something to walk back a little bit. We see that they have 60 million paying, Netflix has over 100 million paying at this point, and I think that's an important thing to keep in mind.

Vena: Absolutely. I've seen a couple of commentators who've said, you really can't compare them to Netflix on an apples-to-apples basis for a number of reasons. One of those reasons is related to the fact that they have the hybrid model between Netflix and Hulu, so they're not a pure subscriber-based business. Then, on the other hand, when they do get paid by those subscribers, those dollars don't go nearly as far. I don't know what the economics are for a company in China that's going to a studio and saying, "I want to use this content, how much do I have to pay for it?" But, you can imagine that it's still going to be pretty expensive for them. So, I don't think they're going to get the same economics out of it that a Netflix does.

Lewis: As we mentioned, this property just got spun out of Baidu fairly recently. Shares have not been trading all that long. And in that time, we've seen the usual fluctuations that you might expect from a new issuance hitting the public markets. Some of that is due to some recent developments that are helping the company out.

Vena: Personally, when I see a company IPO, I like to watch it for a little bit, see what's happening, get a feel for how the financials are doing. Everybody puts their best foot forward in their SEC filings, not that they're being dishonest, but they want you to see the metrics that put them in the best light. So, you want to watch them for a couple of quarters and see what's going on. 

But even in the last week alone, there's been a couple of major announcement. There's a company in China called JD.com, which is fairly ubiquitous. It's one of the big e-commerce players in China. JD.com and iQiyi announced a partnership whereby their premium members of each company would be able to use the services of each without paying a separate fee. They put out a press release within the last couple of days that said, in the first week alone, they had generated interest from more than a million new customers.

Lewis: Yeah. Which, we talk about the difference giants in the Chinese tech space, given how competitive that space can be, I think these partnerships are valuable. This is also similar to what we've seen with Netflix and some of the other music streaming options out there. The non-conventional, non-cable companies have done quite a bit to bundle services or offer promotional offers. You see Spotify deciding to team up with Hulu recently to make their offering a little bit more appealing. Netflix has done some work in the past with cable companies. It seems like another situation where iQiyi is borrowing from Netflix's playbook a little bit.

Vena: It does. Netflix, it's going to be hard for any company to duplicate that kind of success, but that certainly doesn't stop them from borrowing from the model. The model is wildly successful, so it makes a lot of sense that they would go that route. 

Now, one other thing I wanted to mention, one of the other recent press releases came about the fact that iQiyi is the first internet streaming service in China to be certified in digital rights management. That has to do with protecting copyrights of the shows that they use. That's something we take for granted here in the United States. It's something that's been going on here for at least a decade. You remember, there was a lot of issues with pirated shows before Netflix started streaming, and the more Netflix got out there with their inexpensive monthly subscriber rates, the more pirating dropped. But pirating in China is still fairly widespread. 

One of the things that iQiyi did was, they went to a company in China that's been certified by Hollywood studios, a lot of worldwide movie producers, and they got themselves certified as being a protector of digital rights. So, with this situation, that now makes them more attractive to these Hollywood studios, because they feel like, when they let iQiyi use their content, it's going to be protected, it's not going to be out there in the hands of pirates, and their investment there is protected.

Lewis: We talked about our inclination to have a couple of quarters of results and see how management handles being a publicly traded company before getting too, too interested in an IPO. These two news items alone, I think, have shares up about 20% this past week. That's kind of a testament to how much things can move around early on when you get a lot of excitement about a new business. 

I have gone on the record in the past in talking about how I do not like buying into recent IPOs. I think, even in the Never Will I Ever week, I said that I'd never buy shares of anything that hadn't been trading for at least six months, just because I like seeing that extended period of results and a longer track record, let some of the hype die down a little bit. 

I think this might be one that I asterisk, Danny. [laughs] I did say never will I ever, but I think there's a lot of really interesting stuff going on here, and I think there are some things that make this somewhat outside of the standard IPO for me. This is something that has been spun out of a large and successful business. If you're a Peter Lynch follower at all and you enjoy his investing philosophy, he loves the idea of a company being spun out, because you allow that company to have their growth and their value realized in a way that maybe it wouldn't be when it's umbrella-ed under a larger business. I also look at that IPO slightly differently than I would a standard one because it's not as much of a cash-out for early investors. You look at Baidu, and they're still maintaining a very large stake in this company, and they're maintaining the controlling interest in this company.

Vena: Right. Baidu is still the majority shareholder. I looked at some numbers yesterday, and if memory serves, they're still somewhere around a 60% owner of iQiyi, and they're also still mentoring them, they're still providing them with the artificial intelligence that they need to decide what their subscribers want to watch. There's a lot to be said about a smaller company having a really large, successful business -- I mean, there's really not many businesses in China that are more successful than Baidu -- but, having that company as a mentor, as a guide, supporting them, providing them data, I think that's a lot different than a company that's just a start-up that's gone out to an IPO.

Lewis: Yeah. They get particularly attractive to me, too, because as it stands, they're roughly a $14-15 billion business. You look at Netflix as a $150 billion business, and it's easy to extrapolate that out. You have to do some puts and takes there, because this is a company that only operates in China, whereas Netflix is in 190 countries at this point. I think it just demonstrates that there's a lot of growth in this space. And, as someone that's kind of a pure-play, it's a super interesting company, certainly one that's on my short-term watch list. A couple of the other names that we talked about today, Tencent in particular is another company that I'm watching. But, the streaming video space in China just seems so poised for growth right now.

Vena: It's crazy. I think the consumers in China are a few years behind us in terms of, Netflix started their streaming video back in 2007. iQiyi started their business in about 2010. And the modeling of Netflix only started in mid-2015. So, they're several years behind, I think there's still a lot of growth there. 

The runway is pretty incredible. It's never going to reach the scale of a Netflix. China has about 1.3 billion people, compared to the seven billion in the world that Netflix has as potential customers. Obviously, there are going to be some places where you're not going to have the availability of fixed broadband, where data rates on cellphones are not going to be conducive to streaming video. But, when you take those out, you take out the consumers that really couldn't afford a service like that, the poverty-level consumers, you still have a really huge runway. 

I've read some estimates that said that potential for the streaming market in China right now is somewhere in the neighborhood of 600 to 700 million. And, it's climbing, as you have a growing middle class in China, you have more urban millennials who are tech-savvy and who are making enough money to afford these services. So, I think the runway is pretty large.

Lewis: That's all to say, there are a lot of megatrends that are pushing this company. It's something that I'm probably going to look to opportunistically start a small position in and maybe add to over the next couple of months. Danny, is this something that you're interested in as a stock to own?

Vena: It's a company that ... again, my inclination at first is to not go at a fresh IPO, having been burned in the past. But looking at this company, there are a lot of outlying factors. There are a lot of asterisks, as you put it. I was actually looking to make an investment in this company in the last week or two. I think that's firmed up in my mind a little bit. I'll probably be doing the same thing as you some time in the coming weeks or months, I'll be looking to establish a position.

Lewis: Credit where credit is due on this-like I said, Matt Argersinger put this company on our radar, so thanks to him for tipping us off. And thanks to you, Danny, for hopping on the show and talking about it with me.

Vena: No problem. Always happy to do it, Dylan!

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions or if you just want to reach out and say hey, you can shoot us an email over at industryfocus@fool.com, or you can tweet us @MFIndustryFocus. If you're looking for more of our stuff, you can subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass. For Danny Vena, I'm Dylan Lewis. Thanks for listening and Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Danny Vena owns shares of Alphabet (A shares), Amazon, Baidu, Facebook, and Netflix. Dylan Lewis owns shares of Alphabet (A shares), Amazon, and Facebook. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Baidu, Facebook, JD.com, and Netflix. The Motley Fool recommends iQiyi. The Motley Fool has a disclosure policy.