China's leading digital media provider, iQiyi (IQ -2.94%), recently reported fourth-quarter results that gave investors reason to applaud. The business makes money in two ways: from paid subscription memberships and from free content supported by advertising. 

Revenue from both segments rose in the most recent quarter, boosting the company's quarterly sales above $1 billion for the first time in its history. But iQiyi's content costs are also growing rapidly, which pushed its net income further into the red.

Let's grab some popcorn and take a closer look at the results.

Check out the latest earnings call transcript for iQiyi.

Tiny toy movie theater seats sit on a laptop's keyboard.

Image source: Getty Images.

iQiyi results: The raw numbers

Metric Q4 2018 Q4 2017 Year-Over-Year Change
Revenue $1 billion $700 million 43%
Operating income ($483 million) ($125 million) N/A
Earnings per ADS ($4.83) ($1.12) N/A

Data source: iQiyi. Q4 2017 results are presented using the same exchange rate as Q4 2018 results of 6.88 yuan = $1. As such, year-over-year changes here may not match reported results. One American depositary share (ADS) equals 7 ordinary iQiyi shares. Q4 2017 earnings per ADS is based upon a reported loss of $0.16 per ordinary share.

What happened with iQiyi this quarter?

iQiyi's rising user base is helping its subscription business grow quickly. But it is also liberally spending on premium content to attract those members, causing this segment -- as well as the entire business -- to operate at a steeper loss.

  • Membership services revenue increased 76% to $465 million (3.2 billion yuan). This was driven by an increase in subscribers to 87.4 million, which is up 72% over last year.
  • Content costs were up 97% to $943 million (6.5 billion yuan). The most in-demand shows incur the largest expenses, and the content costs are still more than twice as large as membership revenue.
  • One benefit of iQiyi's premium content library is that it can monetize it elsewhere. Content distribution revenue, where others pay royalties for the right to air the company's content, rose 137% to $76 million (522 million yuan).

After falling 4% last quarter, iQiyi's advertising business returned to growth mode this time around. It continues to generate enough revenue to cover all of the company's total research, sales, and marketing expenses.

  • Online advertising services revenue grew 9% to $320 million (2.2 billion yuan). iQiyi works closely with its parent company, Baidu, to use finely tuned artificial intelligence algorithms to attract the attention of web users.
  • Selling, general, and administrative costs increased 58% to $178 million (1.2 billion yuan). iQiyi is paying up-front to have its app pre-installed on new devices as a way to bring in new users.
  • Research and development expenses were up 67% to $88 million (608 million yuan). This includes the costs of personnel related to app development.
  • Other revenue rose 129% to $160 million (1.1 billion yuan). This segment includes gaming and IP licensing.

What management had to say

iQiyi founder and CEO Yu Gong pointed out several of the company's 2018 accomplishments on the conference call. He also noted its interest in developing content of its own:

Our subscriber numbers constantly hit new highs; and our revenues continued to scale and diversify. 2018 was also a transition year for us. As we shifted more resources toward producing original content, we believe it will help us build a stronger platform and IP powerhouse over the long term. 

Looking ahead

iQiyi is doing a great job of partnering with others to attract new subscribers. Premium members of, China Mobile, and Ctrip get privileged access to iQiyi's content free of charge (though the companies still pay per member, and members are included in iQiyi's subscriber count). iQiyi also offers special perks from other service providers to its own paying subscribers. 

Developing original content is more expensive than purchasing rights to existing movies. iQiyi's commitment to creating original material suggests that its content costs will continue to grow significantly and will outpace membership revenue for quite some time. The long-term benefit of having exclusive homegrown content could be worth the up-front cost, as a way to woo subscribers away from large competitors like Tencent and Alibaba, which have deep enough pockets to outbid iQiyi for others' content. 

As in previous quarters, I continue to monitor the spread between the growth rates of membership revenue and content costs. If revenue grows faster than content costs, it is a sign that iQiyi is scaling as a business. Membership revenue grew 76% this quarter and content costs rose by 97% -- a 21-percentage-point difference. This is the opposite of what investors want to see.

However, this is also admittedly just for a single quarter and investors will need to watch how things evolve.