iQiyi's Content Strategy Faces Regulatory Headwinds

China's leading video streamer, iQiyi (IQ 5.24%), recently reported second-quarter results that suggest it is facing headwinds from new government regulations. It is still growing its subscriber base at a healthy pace, but there are a few important details for investors to consider.

Let's take a closer look.

Image source: Getty Images.

iQiyi results: The raw numbers 

Data source: iQiyi. Figures in yuan. Current exchange rate is 6.87 yuan = $1. One American depositary share (ADS) equals 7 ordinary iQiyi shares.

What happened with iQiyi this quarter?

iQiyi's subscriber base crossed 100 million members in the quarter, which suggests it's having no problem in expanding its paying audience. But the content required to attract those subscribers remains expensive, and iQiyi is still reporting negative operating and net income.

• Membership services revenue increased 39% to 3.4 billion yuan ($497 million), driven by a 50% increase in subscribers to 100.5 million. CFO Xiaodong Wang noted that membership was "back-end loaded" due to new subscribers joining late in the quarter to coincide with when its best new content was released. This explains why the subscriber count grew much more quickly than its associated revenue.
• Content costs increased 7% to 5 billion yuan ($732 million) in the second quarter. Content still costs significantly more than subscription revenue brings in, though its cost is increasing at a slower rate than in previous quarters, as content costs grew 38% year over year in the first quarter and were up 97% year over year in the fourth quarter.
• iQiyi continues to monetize its premium content library elsewhere -- reporting this as content distribution revenue (CDR) -- as others pay royalties for the right to air it. CDR dropped 4% year over year to 518 million yuan ($75.4 million), which is a big change from the 75% year-over-year growth one quarter ago. One bright note is that iQiyi is developing more gaming content and is licensing it to others.
• Many investors have referred to iQiyi as "the Netflix of China," but it has an advertising business that Netflix doesn't have. Though revenue from iQiyi's advertising business fell 16%, it is still fully funding the company's research, sales, and marketing expenses.
• Selling, general, and administrative costs increased 42% to 1.3 billion yuan ($196 million). iQiyi pays up front to have its app pre-installed on new mobile devices, and has overhead to comply with China's regulations.
• Research and development expenses were up 48% to 655 million yuan ($95.4 million).
• Other revenue, which includes gaming and intellectual property licensing, rose 82% to 979 million yuan ($143 million).

What management had to say

CEO Yu Gong focused on the strong subscriber growth and upcoming original content strategy:

We are pleased to report another solid quarter of performance highlighted by our total subscribing members surpassing 100 million, marking a historic milestone for the company. We further solidified our market leadership position across various operating metrics, and strengthened our product matrix that generates strong synergies across our platform. We remain committed to our strategy of enhancing production capabilities of high-quality original content and advancing our AI technology innovation in content production, distribution, and monetization.

Looking ahead

While the top-line growth grabbed the headlines, there were other less-optimistic details that investors should note.

The first is the impact of China's latest censorship regulations, which are very restrictive on what new content can be shown, especially what's created by foreign companies. While iQiyi is based in China, it recently ended its two-year licensing partnership with Netflix due to these regulations, which are now constricting the content available for its digital library. This could make it difficult to attract new subscribers or to keep existing ones. It is also delaying the launch of several original movies, while iQiyi takes the time to fully understand the regulations and what it must do to comply.

China's online advertising market is also becoming incredibly competitive. Between slowing GDP growth and trade tensions with the U.S., advertising budgets are decreasing. This has led to an overabundance of available ad inventory, which is pushing down the cost per click that advertisers will pay since they now have so many options available. It is one of the key reasons iQiyi's advertising revenue declined 16% from last year.

And iQiyi's own advertising expenses could likely increase in the near future as the company goes after people in lower-tier cities and older age groups. Those customers won't come cheap: They're less tech-savvy and will require some marketing to win them over to become paying subscribers. iQiyi also noted an interest in obtaining the rights to sports content, which could be expensive.

Even considering all these headwinds, iQiyi still has plenty of opportunities. It just received its first 5G commercial licenses in June, meaning it can take advantage of high bandwidth and low latency to offer ultra high-definition content, faster downloads, and potentially even virtual reality. The company is also incorporating AI into its recommendation engine to personalize content, which could ensure paying subscribers stay engaged and stick with the platform longer.