The challenges facing Chinese streaming video play iQiyi (NASDAQ:IQ) are myriad, and they’ve pressured IQ stock.
iQiyi stock has rallied so far this year, gaining 21%, but it’s faded of late. Those gains, meanwhile, are coming after the stock hit an all-time low in late 2018.
In recent months, at a cheaper price, I’ve come around to the bull case for IQ stock. In June, I called it the best play for those still bullish on China long-term.
That’s not to say the risks weren’t, and aren’t, significant. The Chinese economy continues to struggle amid a trade war with the U.S. Competition is intense, most notably from Tencent (OTCMKTS:TCEHY) and Alibaba (NYSE:BABA) unit Youku Toudo. iQiyi still is burning cash as it grows. Majority owner Baidu (NASDAQ:BIDU) is struggling, leading to the possibility of further sales of iQiyi stock.
iQiyi’s second-quarter report last month seems to highlight, if not increase, those risks. Investors largely have shrugged off the report, as IQ stock trades above where it did before the release.
But on this site, Luke Lango argued the report wasn’t enough, and I’m inclined to agree. iQiyi still has an intriguing long-term case, but the near-term risk to IQ stock seems to be rising.
Growth Slows, but IQ Stock Holds Up
From a headline standpoint, iQiyi’s second-quarter earnings report looks close to disastrous. Revenue growth decelerated dramatically. In Q1, revenue in yuan increased by 43% year-over-year. Growth in Q2 was just 15%.
To be fair, there’s a key culprit outside of the company’s control: the Chinese macroeconomic environment. Advertising revenue declined 16% year-over-year in the second quarter, after a ~flat performance on the same basis in Q1. CEO Tim Gong Yu noted that “a lot of advertisers constrained their advertising budgets,” on the Q2 conference call.
In the subscription business, iQiyi generated new members toward the end of the quarter thanks to new content. And so membership revenue increased just 38% despite a 50% increase in the quarter-end subscriber count.
Both factors are understandable, and indeed the 15% increase was in line with Street estimates. That said, Q3 guidance for revenue growth of just 4-10% suggests a further decline in the top-line growth rate.
At the same time, iQiyi’s spending isn’t going anywhere. Operating loss widened by over 40% year-over-year. Content costs increased by just 7%, but selling and marketing expenses both rose sharply.
Perhaps surprisingly, investors saw the quarter as reasonably in line: iQiyi stock only fell 1% the following day. It may be that 50% subscriber growth and decent performance in a tough environment was good enough, particularly given the fact that IQ stock had slid heading into the release.
The Risks to iQiyi Stock
That said, there are some concerns in the report upon closer inspection. One, in particular, is the fact that subscriber growth came in toward the end of the quarter. As management noted, that boost came as the content was released, which itself is a bit of a concern.
The worry is that iQiyi essentially can’t stop spending on content, or else subscriber growth slows or stops. It’s an echo of the worry facing Netflix (NASDAQ:NFLX), to which iQiyi is often, and somewhat incorrectly, compared.
The bullish case for both stocks is that building out a content library with upfront spending will result in enormous cash flow down the line, as that content is monetized. If, however, consumers come to expect more and better content in perpetuity, the hamster wheel never stops spinning. The correlation between content spend and subscriber growth thus is somewhat discomfiting, even at this early stage in iQiyi’s growth.
The other concern is on the advertising front. Macro weakness is a headwind, to be sure. But iQiyi management also noted an increase in the supply of online advertising inventory, which is pressuring pricing.
That’s a big risk. Price reductions come off the operating profit line at almost 100%. And the combination of higher inventory and macro concerns suggests ad revenues can be pressured into 2020 at least. Investors hoping for near-term profitability may have to wait longer than they expected.
Dented, but Not Broken
To be sure, Q2 earnings don’t break the case for IQ stock. Investors in U.S. markets seem reasonably content with the idea that Chinese companies may struggle for a few quarters. The long-term opportunity, however, still remains.
That’s true for iQiyi as well. That said, it’s hard not to see near- to mid-term risk rising after the second-quarter report. This still is a company with a market cap of over $13 billion, no profitability, and decelerating growth. That’s usually a recipe for disaster.
Add in the underlying concerns in both the subscription and advertising businesses, and IQ stock at least seems like a candidate for a decline when broad markets stumble. And if Q3 shows further revenue deceleration and wider losses, it may not take a market sell-off for iQiyi stock to start falling again.
As of this writing, Vince Martin has no positions in any securities mentioned.