Why the Big Rally in iQiyi Stock May Be Overdone

iQiyi's fundamentals are improving, but IQ stock has sprinted to extended valuation levels

Shares of Chinese streaming giant iQiyi (NASDAQ:IQ) have gone parabolic over the past few months, rising from $15 in early October 2019 to $25 by early January 2020. That’s a jaw-dropping 65%-plus rally in IQ stock in just three months.

IQ Stock: The Big Rally in iQiyi May Be Overdone
Source: NYC Russ / Shutterstock.com

What’s behind the recent strength in the company? More importantly, will this rally last?

Answering the first question, a multitude of favorable catalysts have converged for iQiyi over the past few months and sparked this big rally. Namely, U.S.-China trade tensions have cooled off, China’s central bank has eased its monetary policy, China’s economy has turned the corner and the outlook for Chinese internet stocks has dramatically improved. Specific to iQiyi, that means that the slowing growth trends of 2019, could turn into accelerating growth trends in 2020. Investors are reasonably buying in bulk ahead of this turnaround.

Answering the second question, the fundamentals imply that recent strength in IQ stock may be overdone. Put simply, shares have come very far, very fast. They presently trade at extremely extended valuation levels. Those extended valuation levels are not supported by the company’s long-term growth potential. Consequently, it appears the 2020 growth turnaround is already fully priced in. Further potential upside seems limited, while potential downside is sizable in the event of an operational misstep.

All in all, the fundamentals underlying iQiyi are improving, but the risk-reward profile on IQ stock after the recent surge isn’t all that compelling.

iQiyi’s Fundamentals Are Improving

There’s no denying the fact that the fundamentals underlying iQiyi stock have dramatically improved over the past few months.

Specifically, as a streaming platform that generates money from subscribers and digital ads, iQiyi goes as China’s economy goes. When China’s economy is doing well, consumers are more inclined to pay up for iQiyi’s streaming services, while advertisers pump more money into the iQiyi ecosystem. On the flip-side, when China’s economy isn’t doing well, consumers are less inclined to pay up for iQiyi’s streaming services, and advertisers pull spend out of the iQiyi ecosystem.

For most of 2018 and 2019, China’s economy was slowing thanks to escalating U.S.-China trade tensions. Not coincidentally, iQiyi’s growth trends meaningfully decelerated. Subscriber growth dropped from above 60% in 2017 to 30% in the third quarter of 2019 and revenue growth rates dropped from 55% to 7% over the same stretch. As iQiyi’s growth trajectory fell flat, so did IQ stock, which dropped from $50 in mid-2018, to $15 by late 2019.

In 2020, though, China’s economy will rebound in a big way. U.S.-China trade tensions will cool off ahead of the 2020 U.S. Presidential Election. China’s central bank has opened significant lending capacity for 2020, too. This concurrent easing of trade tensions and monetary policy should help re-stimulate growth through China’s economy, which should led to reinvigorated consumer and ad spending trends.

For iQiyi, that means the company’s slowing growth trends of 2018 and 2019, will end, and turn into accelerating growth trends in 2020.

iQiyi Stock Appears Overextended

The problem with IQ stock is that the aforementioned fundamental improvements in the iQiyi growth narrative have already been priced into shares.

Let’s look at the numbers here: iQiyi has 106 million subs. That’s up 31% year-over-year. By my calculations, the addressable market for China streaming by 2030 will measure about 350 million households, assuming 1.5 billion people in China, an 80% internet penetration rate and an average household size of 3.4. Assuming that sub growth rates continues to decelerate (as they have been), then iQiyi could realistically hit 350 million subs by 2030, too.

Average revenue per user (ARPU) rates presently hover around $3.50 per month. That’s not that much, compared to Netflix (NASDAQ:NFLX), which charges $10-plus per month in the U.S. But, differences in household economics between the U.S. and China imply that if iQiyi does grow to hit its entire addressable market by 2030, it won’t do so at $10-plus per month price points. Instead, iQiyi’s ARPU rates will forever remain depressed relative to Netflix’s ARPU rates. My model assumes growth to $4 to $5 monthly ARPU rates by 2030.

My model further assumes that iQiyi’s operating model scales to look a lot like Netflix’s operating model, with 30%-plus gross margins and 10%-plus operating margins. Under all those assumptions, my best-case scenario for where profits end up by 2030 is $2.50 per share.

That’s just not enough earnings power to justify a $25 price tag today. Based on a tech stock average 20-times forward earnings multiple, $2.50 in 2030 EPS implies a 2029 price target for IQ stock of $50. Discounted back by 10% per year, that implies a 2020 price target of just over $21.

Bottom Line on IQ Stock

The company’s fundamentals are improving. But these improvements have been fully priced into IQ stock following a 65%-plus surge over the past three months. Further upside seems limited by valuation friction. Meanwhile, potential downside seems enormous, in the event of an operational misstep over the next few quarters.

That’s not a great risk-reward profile. Consequently, I’d wait for a dip before buying into IQ stock.

As of this writing, Luke Lango was long NFLX.


Article printed from InvestorPlace Media, https://investorplace.com/2020/01/big-rally-in-iq-stock-may-be-overdone/.

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