Digital media provider iQiyi (NASDAQ:IQ) reported its third-quarter numbers on Tuesday night, and the market certainly wasn't very impressed. Investors got spooked by the company's growing operating loss, and shares fell 11.5% on Wednesday, though the stock was headed up on Thursday morning.

A deeper look at the results shows that iQiyi is building its business quite methodically. The expensive premium content driving the operating losses today is bringing in a flood of new subscribing members and licensing revenue from others.

Let's take a closer look at the results.

An image of tiny movie theater seats facing a laptop screen

Image source: Getty Images.

iQiyi results: The raw numbers

Metric Q3 2018 Q3 2017 Change (YOY)
Revenue $1.0 billion $721 million 48%
Operating income (loss) ($377 million) ($155 million) N/A
Earnings per ADS ($0.63) ($3.13) N/A

Data source: iQiyi. YOY = year over year. Q3 2018 results are reported in USD and estimated at the exchange rate of 6.868 yuan to $1, which is held constant for the Q3 2017 results. As such, YOY changes may not match reported results. One American depositary share (ADS) = 7 common iQiyi shares. Q3 2017 earnings per ADS does not include costs related to the accretion of redeemable convertible preferred shares.

What happened this quarter?

iQiyi's business continues to perform admirably, with a spike in users and in membership revenue. But the company's heavy investments in premium content are still causing the business to operate at a significant loss.

  • Membership services revenue increased 78% year over year to $415 million (2.85 billion RMB). This was driven by an increase in subscribers to 80.7 million, which is up 89% compared to 42.7 million last year.
  • Content costs were up 66% to $876 million (6 billion RMB). The most-demanded shows incur the largest expenses, and the content costs are still twice as large as overall membership revenue.
  • One benefit of paying up for premium content is that iQiyi can also monetize it elsewhere. Content distribution revenue -- where others pay royalties for the right to air iQiyi's content elsewhere -- rose an incredible 220% to $122 million (835 million RMB). 

iQiyi's advertising business slipped a bit on the top line this quarter, but it is still generating enough revenue to cover all of the company's research, sales, and marketing expenses. That's a good sign, and it allows the membership division to operate -- at least economically -- as a stand-alone entity.

  • Online advertising services revenue fell 4% year over year to $349 million (2.4 billion RMB). iQiyi is working closely with Baidu to use finely tuned artificial intelligence algorithms to attract the attention of web users.
  • Selling, general, and administrative costs rose 66% to $188 million (1.3 billion RMB). iQiyi continues to pay up to have its app pre-installed on new devices as a way to attract users. This expense line item also includes the stock-based compensation that was paid for the recent acquisition of mobile-gaming company Skymoons.
  • Research and development expenses were up 63% to $81 million (558 million RMB). This includes the costs of personnel related to app development.
  • Other revenue, which now includes the sales contribution from Skymoons, rose 157% to $121 million.

What management had to say

iQiyi founder and CEO Yu Gong noted the company's growing content library and distribution network as a drivers of its long-term business success:

Our library of premium content continued to excel, driving robust growth in subscriber number and membership revenue. Our record-breaking drama series Story of Yanxi Palace turned out to be a megahit for the entire summer, demonstrating our strong capabilities and potentials in producing high-quality premium content. Leveraging our extensive content offerings and expanding distribution network, we are also continuously improving and diversifying our business monetization. We remain dedicated to applying advanced technology to further enhance our platform and refine our ecosystem to generate long-term growth for shareholders.

Looking ahead

China's digital streaming market is full of deep-pocketed competitors like Tencent and Alibaba, who are willing to pay up for premium content to attract members. We should fully expect that iQiyi's heavy investments in content will continue for the foreseeable future.

Meanwhile, iQiyi's recent collaboration with JD.com is paying dividends for both parties. Similar to how Amazon offers free movies to its Prime members, JD offers iQiyi's media content to its own Plus e-commerce members. iQiyi has gained more than 1 million new subscribers from JD Plus, while JD benefits from advertising its products on iQiyi's platform. This win-win partnership between two of China's largest internet companies could be a huge advantage as China's digital streaming industry matures.

One metric I continue monitoring 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, where the top line will eventually grow larger than its associated costs. This quarter's difference of 12 percentage points (78% growth in membership revenue minus 66% growth in content costs) could be a good sign for long-term investors, proving that iQiyi's content investments are bearing fruit for the business.

Investors will watch for this growth in iQiyi's membership and subscriber revenue to continue.

Editor's note: An earlier version of this article misstated iQiyi's subscriber count. The article has been updated. 

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Simon Erickson owns shares of Amazon, iQiyi, JD.com, and Tencent Holdings. The Motley Fool owns shares of and recommends Amazon, Baidu, JD.com, and Tencent Holdings. The Motley Fool recommends iQiyi. The Motley Fool has a disclosure policy.