Chinese Company iQIYI Debuts On Nasdaq Exchange

Spencer Platt/Getty Images News

Spencer Platt/Getty Images News
After years of economic losses for shareholders, iQIYI (NASDAQ:IQ) recorded operating profitability in Q1 2022 and the stock jumped more than 10% following the announcement. Given that the profitability was broadly taken as a surprise, many analysts adjusted their EPS expectations for the company and revised their price targets upwards. Investors might ask: Is iQIYI stock, which has lost >80% of its value since February 2021, now a buy? Although I advise to remain cautious with regards to iQIYI, given significant industry competition, I assign a Buy/High risk recommendation. Based on a residual earnings framework I calculate a target price of $6.71/share
iQIYI is a leading online entertainment company based in China. Specifically, iQIYI is focused on online video streaming, producing and offering both original content and licensing third party PPC content. The company claims also to be a technology company, as much of the platform is powered by the combination of big data and artificial intelligence. With regards to the technology claim, it certainly helps iQIYI that China’s leading AI-company Baidu (BIDU) is the majority owner of iQIYI — holding a >55% stake. But in general, I think it is fair to say that iQIYI’s value proposition and business model is very similar to Netflix (NFLX). As of early 2022, the company has more than 428 million monthly active users and more than 100 million daily active users. The company’s primary revenue sources are membership fees, which are as low as $5.5 per month, and advertising revenues.

IQiyi business overview

iQIYI Investor Relation Homepage

iQIYI Investor Relation Homepage
Arguably, Baidu’s stake in iQIYI is a speculative play to build an integrated ecosystem similar to Alphabet’s (GOOG) (GOOGL) “Google plus YouTube”. However, as of early 2022 the strategy has failed to monetize. For a long time, iQIYI has claimed significant recurrent investments in a highly competitive environment. And although operating losses have begun to narrow, speculating on strong profitability has long been farfetched.
The streaming industry in China is highly competitive with numerous businesses (high intra-industry rivalry) competing not only for subscribers (high buyer’s power), but also for streaming rights (high supplier’s power). Competing platforms backed by technology giants such as Tencent and Alibaba drive up content costs through aggressive competitive bidding. In addition, iQIYI competes for user attention with social media companies such as Douyin and Kuaishou (OTCPK:KSHTY) (high potential for substitution). That said, for years it was hard to see how iQIYI can build a sustainable competitive advantage in the video streaming industry and become profitable.
But amidst macro-economic challenges iQIYI’s business operations surprised the street in Q1 2022: Although revenues were only $1.1 billion, decreasing 9% year over year, iQIYI managed to record unexpected operating profitability — an operating income of $14.7 million, compared to an operating loss of $149 million in the same period in 2021. According to the company’s financial statements, the profitability was achieved by cutting all major non-essential costs. First, cost of revenues decreased 16% year over year; second, research and development expenses decreased 29%, and; Third, selling, general and administrative expenses decreased 38% as strongly reduced marketing and personnel-related expenses.

iQIYI earnings report Q1 2022

iQIYI earnings report Q1 2022

iQIYI earnings report Q1 2022
Are the company’s cost-cutting efforts sustainable? That remains to be seen. But if successful, the stock should deserve a significant rebound. Investors should note that iQIYI management did indeed guide expectations of sustained profitability.
Analyst consensus sees the company’s growth and profitability outlook as follows: Revenues in 2022, 2023 and 2024 are expected to be $4.5 billion, $4.8 billion and $5 billion, indicating approximately 4% CAGR: EPS are estimated to be $ $-0.10, $0.08 and $0.28, respectively. (Source: Bloomberg Terminal)
To value iQIYI, I use the Residual Earnings Framework. I believe the Residual Earnings framework is the best tool to value iQIYI, because: firstly, free cash flows are distorted due to growth-investments; secondly, multiples do not reflect business value; thirdly, the company is paying no dividends. My key assumptions are as follows:
Based on the above assumptions, my calculation returns a base-case target price for iQIYI of $6.71/share, implying a >60% upside potential.
Investors might have different assumptions with regards to iQIYI’s required return and terminal business growth. Thus, I also enclose a sensitivity table to test varying assumptions. For reference, red-cells imply an overvaluation as compared to the current market price, and green-cells imply an undervaluation.

IQiyi valuation

Source: Analyst Consensus, Author’s Calculations

Source: Analyst Consensus, Author’s Calculations

IQiyi valuation sensistivity analysis

Analyst Consensus; Author’s calculation

Analyst Consensus; Author’s calculation
I would like to highlight the following downside risks that could cause iQIYI stock to materially differ from my price-target of $6.71/share:
First, the online video streaming market in China is arguably quite mature and highly competitive. Although iQIYI claims a strong market presence, competition has and will continue to pose a risk to iQIYI’s profitability.
Second, as iQIYI is based and operating in China, the company is exposed to heightened political risks as the CCP aims to regulate tech/internet companies.
Third, much of iQIYI’s share price volatility is currently driven by investor sentiment towards Chinese ADRs and risk assets. Thus, iQIYI stock price might show strong price volatility even though the company’s business fundamentals remain unchanged.
Fourth, iQIYI is exposed to IP licensing risks and loss of bargaining power with content producer/ owner.
Finally, the economy in China is currently pressured by multiple headwinds including inflation, real-estate crisis and COVID-19 lockdowns. If the Chinese economy would slow more than what is expected and priced in, investors should adjust expectations for iQIYI’s short/mid-term business monetization accordingly.
Investors looking for a speculative bet on a turnaround stock might like iQIYI. The stock is down >75% from ATH and the recent Q1 2022 earnings surprise definitely gave a strong signal that the stock might be bound to rebound. Given analyst consensus estimates, I base my valuation on a residual earnings framework and set a base-case target price of >$6.5/share, indicating attractive upside potential. However, if the company’s profitability proves resilient, I would not hesitate to call a price appreciation to $10/share.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not financial advise.

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