iQIYI: Anticipating Slower Growth And Profitability Improvement (Rating Downgrade)
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Summary:
- iQIYI’s revenue could grow at a more moderate pace in 2024, considering its Q1 top line performance, a focus on the long term, and competition from short-form videos.
- IQ’s first quarter operating margin beat expectations, and there is potential for further profitability improvement driven by marketing expense optimization and content cost reduction.
- I have chosen to downgrade my rating for iQIYI stock to a Hold, as I view the company’s outlook as mixed.
Robert Way/iStock Editorial via Getty Images
Elevator Pitch
My rating for iQIYI, Inc. (NASDAQ:IQ) stock is a Hold. I previously touched on iQIYI’s pricing strategy and financing activities in my February 5, 2023 article.
This latest write-up is focused on IQ’s future financial performance. The company’s 2024 outlook is mixed, as there are expectations of both revenue growth deceleration and operating margin expansion. Therefore, my decision is to revise my rating for IQ from a Buy to a Hold.
Top Line Growth Deceleration
In the past one month, the sell-side’s consensus FY 2024 top line estimate for iQIYI was cut by -4% from RMB34,057 million to RMB32,807 million as per S&P Capital IQ data. This implies that IQ’s revenue expansion rate is projected to moderate from +10% YoY in the previous year to +3% YoY for the current year.
The company’s top line growth prospects in the short term are likely to be weak as per the analysts’ forecasts, taking into account a number of factors.
Firstly, iQIYI’s most recent Q1 2024 results had unfavorable read-throughs for the company’s top line outlook.
Revenue for IQ decreased by -5% YoY to RMB7,927 million in the first quarter of 2024, and this represented a modest +1% beat (source: S&P Capital IQ). As a comparison, iQIYI had delivered positive sales growth rates of +15% YoY and +2% YoY for Q1 2023 and Q4 2023, respectively. It is fair to say that the company’s recent revenue growth momentum is weak.
Secondly, the latest changes to IQ’s disclosures indicate that the company will place a greater emphasis on success for the long run that could come at the expense of short-term underperformance.
At its Q1 2024 analyst briefing in mid-May, iQIYI revealed that the company will “no longer” report its “subscriber (count) and ARM (Average Revenue Per Member) data.”
IQ explained at its recent quarterly earnings call that “membership revenue” will be the “core indicator” going forward, as the company’s target is to “maximize long-term (my emphasis) membership revenue.” The company also noted at the first quarter results briefing that “extending the lifespan of each membership” is as important as the other top line growth engines like increasing ARM and expanding the subscriber base.
In other words, iQIYI is likely to be willing to accept lower ARM and slower subscriber growth (and a more modest pace of revenue increase) for the near term, if it means attracting and retaining loyal and higher-value subscribers for longer.
Thirdly, the company’s long-form video streaming business is facing competition from short-form video competitors.
Caixin Global published a commentary piece on December 7, 2023 noting that “mini dramas” rolled out by “short-video platforms” have grabbed “users’ attention” away from “long-video platforms” in China. An earlier November 2023 China Daily news article also highlighted that the “Chinese short video users” had already exceeded a billion in 2022. According to the early-December 2023 Caixin Global news report, the total GMV (Gross Merchandise Value) for short-form videos in China is estimated to have increased by +160% in the prior year, which is a reflection of their growing popularity.
In summary, IQ’s revenue outlook for the current year is weak. In the next section, I evaluate the company’s future profitability.
Profit Margin Improvement
IQ’s normalized operating profit margin expanded by +190 basis points QoQ and +160 basis points YoY to 11.9% for Q1 2024. The company’s actual first quarter non-GAAP adjusted operating margin was +260 basis points higher than the market’s consensus forecast of 9.3% (source: S&P Capital IQ). Moving ahead, the analysts see iQIYI’s normalized operating margin improving from 9.4% last year to 12.7% this year.
Strict cost control and the utilization of AI are most probably going to be the major profitability enhancement drivers for iQIYI.
The company’s SG&A (Selling, General & Administrative) costs decreased by -17% YoY from RMB1,106 million in the first quarter of 2023 to RMB922 million for the most recent quarter. This also meant that IQ’s SG&A costs-to-revenue ratio declined by -1.6 percentage points YoY to 11.6% in Q1 2024. “Disciplined marketing spending” was credited as the main reason for iQIYI’s lower SG&A expenses in its Q1 2024 earnings press release.
Separately, iQIYI stressed at the latest Q1 2024 analyst call that the company “has meaningfully enhanced the industrialization of content production and operation”, even though it is at the “initial stages of fully unleashing the potential of generative AI.” As a reference, IQ’s content costs-to-sales ratio decreased from 53% for both Q2 2023 and Q3 2023 to 50% and 48% for Q1 2024 and Q4 2023, respectively. As such, the company’s content costs as a proportion of revenue is likely to continue declining in the future, as it exploits AI for content production in a more significant manner.
In a nutshell, I expect IQ’s profitability to improve going forward with the company’s emphasis on expense management and the presence of AI-related content cost optimization drivers.
Concluding Thoughts
IQ deserves to be rated as a Hold. The company’s prospects in terms of top line expansion and profitability improvement are mixed.
In terms of valuations, iQIYI currently trades at an undemanding consensus next twelve months’ normalized P/E of 8.6 times as per S&P Capital IQ, which I deem to be appropriate. IQ’s modest P/E valuation multiple is a reflection of the company’s lackluster top line growth in absolute and historical terms. The consensus FY 2023-2026 revenue CAGR estimate in RMB terms for iQIYI is +4.5% (source: S&P Capital IQ), or much lower than the company’s historical FY 2017-2023 top line CAGR of +10.6%.
Although iQIYI’s operating profitability outlook is good, IQ needs to record a faster pace of top line expansion at a high-single digit percentage to justify a superior P/E ratio. As such, the stock’s valuations are fair for now and iQIYI warrants a Hold rating.
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