China's leading digital media provider, iQiyi (NASDAQ:IQ), reported first-quarter results this week that seem to suggest the company will be investing heavily in original content to attract new paying subscribers.

Let's take a closer look at the results.

Check out the latest earnings call transcript for iQiyi.

Tiny, toy movie theater seats sit on an open laptop's keyboard.

Image Source: Getty Images.

iQiyi results: The raw numbers

Metric Q1 2019 Q1 2018 Year-Over-Year Change
Revenue $1.04 billion $727 million 43%
Operating income ($302 million) ($158 million) N/A
Earnings per ADS ($2.52) ($13.79) N/A

Data source: iQiyi. Q1 2018 results are presented using the same exchange rate as Q1 2019 results of 6.71 yuan = $1. As such, year-over-year changes here may not match reported results. One American depositary share (ADS) equals 7 ordinary iQiyi shares. Q1 2018 earnings per ADS is based upon a reported loss of $1.97 per ordinary share.

What happened with iQiyi this quarter?

iQiyi's user base is closing in on 100 million members who are contributing an ever-increasing amount of subscription revenue. But the company is also spending heavily on premium content to attract those members. iQiyi's membership segment continues to report an operating loss.

  • Membership services revenue increased 64% to $513 million (3.4 billion yuan). This was driven by an increase in subscribers to 96.8 million, which is up 58% over last year.
  • Content costs were up 38% to $943 million (6.5 billion yuan). The most in-demand shows incur the largest expenses, and the content costs are still nearly twice as large as membership revenue. However, the company showed some financial discipline, and content costs rose much less this quarter than they did in the previous quarter (when they rose 97% year-over-year).
  • iQiyi is still monetizing its premium content library elsewhere, with content distribution revenue -- where others pay royalties for the right to air the company's content -- rising 66% to $76 million (522 million yuan). This is significantly slower growth than the 137% year-over-year growth one quarter ago.

Many investors have referred to iQiyi as "the Netflix of China." However, one thing that sets it apart is its advertising business, which Netflix doesn't have. iQiyi's advertising business continues to generate enough revenue to cover all of the company's total research, sales, and marketing expenses.

  • Online advertising services revenue remained flat compared to last year, bringing in $316 million (2.1 billion yuan). iQiyi works closely with its parent company, Baidu (which still controls greater than 90% of iQiyi's voting power), to use finely tuned artificial intelligence algorithms to attract the attention of web users.
  • Selling, general, and administrative costs increased 62% to $170 million (1.1 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 54% to $89 million (598 million yuan).
  • Other revenue rose 129% to $146 million (982 million yuan), which includes gaming and IP licensing.

What management had to say

iQiyi CFO Xiaodong Wang best describes the company's strategy in this succinct statement:

As 2019 unfolds, we will continue to build and invest in our content ecosystem which is the foundation for us to achieve long-term sustainable growth.

Looking ahead

The foundational content ecosystem that Wang describes seems to be a valuable asset. iQiyi's ad revenue flatlined this quarter and the company guided for it to actually decrease in year-over-year comparisons for the upcoming quarter. 

That means iQiyi is focusing on its membership business, where it is neck-and-neck with Tencent Video as China's most popular streaming subscription. Each service has nearly 100 million paying members in this lucrative market, which is believed to have more than half a billion online video streamers.

As a way to differentiate itself, iQiyi is taking a calculated risk of creating its own content, with CEO Gong Yu recently stating it would focus on creating full-length original movies. Even though content costs grew less significantly in this quarter, financing its own original content is a massive commitment. The company recently raised more than $1 billion through convertible bonds.

As in previous quarters, I always like to keep an eye on the spread between the growth in membership revenue and that of content costs. If revenue grows faster than content costs, it is a sign that iQiyi is scaling as a business and expanding profits for shareholders. Membership revenue grew 64% this quarter and content costs rose by 38% -- which is a positive 26-percentage-point difference.

Over the longer term, this is directionally what investors want to see. But if Yu is serious about his company's original-movie ambitions, investors should expect iQiyi's content costs to grow much more significantly in future quarters.