iQiyi's Second Quarter: Heavy Spending, but Even Stronger Subscriber Growth

After spinning off from internet search leader Baidu (NASDAQ: BIDU) earlier this year, iQiyi (IQ 5.24%) is solely focused on streaming digital media, and it's showing solid growth in its home country.

The investments it's making today in digital content are sizable, but also necessary to win over subscribers from large competitors. Just as Netflix (NASDAQ: NFLX) has shown us stateside, digital media is a winner-take-most market, so the price of admission is high. iQiyi charges monthly subscription fees for unlimited access to content, and will likely eventually reach a tipping point where its subscription revenue overtakes content costs.

It hasn't reached that point just yet, but the most recent quarterly report quarter brought the company one step closer to profitability. Let's look at iQiyi's second-quarter results:

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iQiyi results: The raw numbers

Data source: iQiyi. Q2 2017 results are estimated at the exchange rate of 6.6 yuan to $1, as in Q1 2018 (as such, YOY changes may not match reported results). One American depositary share (ADS) = 7 common iQiyi shares.

What happened this quarter?

iQiyi's business is split equally between subscriptions and advertising. Paying subscribers get ad-free and exclusive content. Non-paying users get to watch content on the site or in the app, but it's supported/interrupted by advertising. Here are some Q2 highlights:

• Membership services revenue increased 66% year over year to $374 million (2.5 billion yuan), a similar growth rate as last quarter. This division represents iQiyi's subscribers, who now number more than 67 million, up 75% from the year-ago period.
• Online advertising services revenue was up 52% to $396 million (2.6 billion yuan). iQiyi's artificial intelligence algorithms, which were largely developed by Baidu, are becoming fine-tuned and attracting plenty of web browsers.
• Content distribution revenue increased 18% to $82 million (539 million yuan). iQiyi sub-licenses much of its content to others, who pay royalties for the rights to air it elsewhere.
• Content costs were up 47% to $709 million (4.7 billion yuan). This is by far the largest component of the cost of revenue, and the growth rate of iQiyi's content costs declined a bit from last quarter, when it was 54%. But the company is still investing heavily in obtaining the rights to the most-demanded shows.
• Selling, general, and administrative costs rose 51% to $144 million (950 million yuan). iQiyi continues to pay up to have its app pre-installed on new devices as a way to attract users.
• Research and development expenses were up 50% to $67 million (442 million yuan). This includes costs of personnel related to app development.

What management had to say

iQiyi founder and CEO Yu Gong was quoted in the company press release talking about the company's strength during the second quarter and its longer-term ambitions:

Supported by our vast library of premium content, and the premiere of a series of highly popular self-produced content, our membership and advertising businesses both generated robust growth during the quarter, with the total number of subscribing members reaching a new record high. Looking ahead, we will continue to invest in advanced technology, expand the breadth and depth of our content offerings, and nurture our entertainment ecosystem, as we pursue our innovative and diversified monetization model that fully leverages our premium content and [intellectual property] value.

Looking forward

iQiyi is still investing heavily in content and is still reporting heavy operating losses. There is still a lot of risk.

But one metric I really like to track is the difference between the growth rates of membership revenue and of content costs. If revenue grows faster than content costs, then iQiyi is scaling as a business. The larger the difference, the better -- and this quarter's difference of 19 percentage points (66% growth in membership revenue minus 47% growth in content costs) was even greater than the 13-percentage-point difference of last quarter. That's good news for long-term investors, and a sign that iQiyi is getting a nice bang for its buck on its content.

iQiyi's recent collaboration with JD.com (NASDAQ: JD) is also bearing fruit. Similar to how Amazon (NASDAQ: AMZN) offers its Prime members free movies, JD offers iQiyi's media content to its own Plus e-commerce members. In the first week of the partnership, iQiyi brought in an additional 1 million new members.

Investors will continue to watch for growth in iQiyi's membership and advertising revenue. Even though the company is spending aggressively to attract viewership and new members, it is still in the early stages of what is likely to be a very long growth story.