iQIYI, Inc. (IQ) Q2 2019 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing and welcome to the iQIYI Second Quarter 2019 Earnings Conference Call. [Operator Instructions] I must advise you that this conference is being recorded. I would now like to hand the conference over to your first speaker today, Investor Relations Director of iQIYI, Dahlia Wei. Thank you. Please go ahead.

Thank you, operator. Hello, everyone, and thank you all for joining iQIYI's Second Quarter 2019 Earnings Conference Call. The company's results were released earlier today and are available on the company's investor relations website at ir.iqiyi.com. On the call today are Dr. Yu Gong, our Founder, Director and CEO; and Mr. Xiaodong Wang, our CFO. Dr. Gong will give a brief overview of the company's business operations and highlights, followed by Xiaodong, who will go through the financials and guidance. After their prepared remarks, we will hold a Q&A session. Before we proceed, please note that the discussion today will contain forward-looking statements made under the safe harbor provision of the U.S. Private Securities Litigations Reform Act of 1995. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from our current expectations. Potential risks and uncertainties include but are not limited to those outlined in our public filings with the SEC. iQIYI does not undertake any obligation to update any forward-looking statements, except as required under applicable law. With that, I will now turn the call over to Dr. Gong. Please go ahead.

Hello, everyone, and thank you for joining us for our second quarter 2019 earnings call. I would like to begin by briefly going over some recent industry updates. So far this year, China's macroeconomic environment has been challenging amid international trade tension and other headwinds. Nevertheless, Chinese users are demonstrating more willingness to pay for high-quality content as they increasingly appreciate the value of premium entertainment experience. On June 22, our total subscribers surpassed 100 million, marking a historic milestone for the online [video] (added by company after the call) industry. Also, we noted the issuing of the first batch of official 5G license in China, which we believe will bring enormous new opportunities for the online entertainment industry. As of June 30, 2019, our total subscribers reached 100.5 million, an increase of 50% year-over-year and a net addition of 3.7 million from previous quarter. The growth was driven by high-quality original content, targeted marketing as well as continuous enhancement of membership experience. To take a few examples. During the second quarter, we launched several original dramas such as The Thunder and the Bureau of Transformer. The Thunder was clearly a blockbuster title that attract a massive and broad audience, with the Bureau of Transformer, which incorporates mild science fiction and comic elements, attracted a younger demographic of viewers. Our wide variety of content caters to increasingly diversified user tastes, especially since our subscribers have reached a critical mass. In addition, we further deploy AI technologies to curate personalized content recommendation for our subscribers. In recent months, we have observed some slowdown in subscriber growth, resulting in lower net additions than [we expected]. This was primarily due to the delayed schedules of some major content. However, we remain confident in the future growth potential in our subscription business; and expect the growth to be mainly driven by, one, deeper penetration in lower-tier cities and older demographics age groups where the paying ratio is still significantly -- lower than among younger age groups and in first-tier cities; number two, longer average paying period per subscriber per year. Given the size of China's population and overall demographics, the rapidly developing Internet infrastructure as well as iQIYI's growing brand awareness and reputation for original content quality, we believe our subscription business will continue to grow at a healthy pace and will serve as a major pillar of our revenue streams. Turning next to our advertising business. During the second quarter, ad revenues decreased 16% year-over-year mainly due to the challenging macro environment, delay of content launch and the drag from in-feed advertising. Despite the industry-wide slowdown in advertising market, we continued to roll out new, innovative ad solutions to improve monetization. During the second quarter, we created a virtual idol band called RiCH BOOM for our self-produced musical variety show I'm CZR which allows advertisers to promote products through the virtual avatars dancing along to the original music. We also developed a Tsingtao Brewery and RiCH BOOM co-branded product, which has been popular among younger demographics. Innovative advertising solutions efficiently unlock the value in our original content, and we are now generating more brand ad revenues from self-produced variety shows than from licensed ones. We also introduced a theater-mode advertising product which groups together drama content filtered by types, viewer traffic level or certain AI algorithm. Advertisers can allocate ad placements to various collection of drama content rather than to a single drama. This theater-mode advertising solution reduces the reliance on a single show's performance and also partially offsets the uncertainty of content launch schedules. It has been very well received by brand advertisers, so far, and we look forward to further expanding the options we offer. For in-feed advertising, the overall competitive landscape remains tough. The increasing supply of ad inventory has been putting industry's CPM pricing under pressure, while we are still striving to grow our client base after the cleanup late last year. In the meantime, we are in the process of refining our feed products and are taking proactive initiatives to regain momentum. Our other business continued to grow significantly during the second quarter, up 82% year-over-year, accounting for 14% of total revenues compared to 9% in the same period of last year. Our IP-centered -- diversification strategy is gradually paying off as we constantly expand the scope of value-added service we offer. Now our content strategy. We remain dedicated to content self-production with emphasis upon quality, diversity and innovation. Over years, we have been able to continually enhance our content production capabilities underpinned by original ideas, creativity, professionalism and high standards of production. For dramas, we launched several original hits during the quarter. The Thunder, an anti-drug police and detective drama, quickly becomes the most popular series in the first half of this year. It was critically acclaimed for its quality and positivity by government authorities and a wide array of public audiences. We also signed licensing deals to distribute it to CCTV, various satellite TV channels and international markets. Bureau of Transformer became a vertical hit among young and urban demographic groups, reflecting the stratification effect that long-tail content can have on various user groups. As we enter the third quarter, we have released a number of hit dramas, including the romance comedy Go Go Squid!; an exclusive costume drama, Love and Destiny; an original survival drama, Last One Standing; an reality-themed drama, A Little Reunion; and a military-themed drama, Arsenal Military Academy, all of which have gained a lot of traction. For variety shows, we have always been a frontrunner. The second quarter was a grand slam for us with the launch of 3 blockbuster shows. I'm CZR, a singer-songwriter show, provides celebrity artists with a platform to perform new songs composed by themselves. The Big Band, the first band music show over the past 15 years, brings together 31 top Chinese bands on stage to compete for the final top 5. The Big Band has been widely credited for reviving band music in China. And lastly, The Rap of China Season 3, the rap music reality show, embodies the youth trendy lifestyle and fashion. Going forward, our production of variety shows will focus on 4 major themes: music power, youth fashion, the fun and joy of life and new Chinese culture. Today, the majority of our variety shows are in-house produced and exclusively aired on our platform, which is creating an economic moat for us. We are exploring multiple ways of monetization, for example, through box office sales of live shows, concert tours as well as talent agency and IP-derivative business. If you'll take a closer look at our content portfolio and pipeline, you will find that many of them have formed serialized multi-season IPs. The Rap of China is in its third season now. Qipa Talk is entering its sixth season soon, and Idol Producer is -- will shortly begin its third season. Our original suspense series Tientsin Mystic and animation show Beyond the Ocean will soon release their second seasons later this year. In addition, we continued to leverage the value of our IPs by adapting them to different forms of contents to build a complete IP value chain. For example, we adapted our original drama series The Thunder into a digital novel which was simultaneously released on our iQIYI Reading app and quickly rocketed to the top of the best seller list. We also extended the monetization life cycle of our original 3D animation Youth Songs by releasing a digital novel and an online game under the same name. Sports content is an important part of our content library. We established a joint venture last year to operate a sports business. iQIYI Sports has licensed numerous global sports contents, including La Liga, PGA and WTA this year; as well as UEFA EURO 2020 and La Liga next year, among others. AI has been integrated into many areas of content production, distribution and monetization. In the second quarter, we applied intelligent transcription technology to the production of various variety shows. Intelligent transcription employs automatic speech recognition technology, which automatically transcribes subtitles to videos while they are being shot. It significantly improves efficiency when compared with the traditional manual transcription process. We have always prided ourselves in pioneering and creating the technological benchmarks for the industry. It was the first of its kind when we announced the interactive video guidelines, IVG, in May, which provide content producers with standards and tools to create interactive video content. We launched our first interactive drama series, Smile Time, with 21 preset storylines and 17 possible endings, leveraging the "branching plot" function of IVG. Audiences watched on average 2.5 different endings of the show, reflecting the immersive viewing experience and more options they can enjoy. During the Mobile World Conference 2019 held in Shanghai in late June, we announced a strategic partnership with China Unicom to establish a joint innovation lab and work on application of video content to 5G terminals. Through this lab, we will jointly explore 5G opportunities, including network slicing, mobile edge computing, big data, mixed reality, augmented reality, virtual reality and 4K/8K ultra-high resolution technologies. China Unicom will provide research facilities and experimental 5G infrastructure which will complement our MR, AR, VR technologies. To date, we have partnered with all 3 telecom giants in China on the R&D of 5G technology. In summary, we pleased -- we are pleased with the solid performance of the quarter and the progress we've made. Despite some recent challenges, we have further strengthened our platform and our market leadership position in terms of total subscribers and various other metrics. Our efforts in content production continue to bear fruit, as we accumulated years of valuable experiences in producing high-quality original content. We are also continually working on AI innovation and application, especially in terms of intelligent content production, distribution and monetization. We have established a comprehensive and integrated product matrix that generates strong synergies across our ecosystem. China government handed out the first batch of 5G commercial licenses on June, unfolding a brand-new era for us. With high bandwidth and low latency, the 5G technology will support more enhanced entertainment experience, making VR and AR more accessible to ordinary user. We believe 5G will create enormous growth potential and emerge as a catalyst for the entertainment industry. We are excited about the prospects for the future. And we look forward to embracing this new technological wave and capturing the enormous opportunities to grow together with our users, partners and investors. With that, Xiaodong, please.

Good morning, everyone. Let me go through our financial highlights. For the second quarter of the year 2019, iQIYI's total revenues were RMB 7.1 billion, up 15% year-over-year. Membership service revenue was RMB 3.4 billion, up 38% year-over-year. This was driven by the solid growth of number of subscribing members, which reached 100.5 million at the end of second quarter. This quarter's membership revenue growth was somewhat disproportionate to that of subscribers mainly because of the back-end loaded membership additions. Online advertising service revenue was RMB 2.2 billion, down 16% year-over-year mainly due to the challenging macroeconomic environment in China, delay of certain content launches, as well slower-than-expected recovery of our in-feed advertising. Content distribution revenue was RMB 517.9 million, down 4% year-over-year due to the impact of content delay this quarter. Other revenue was RMB 979.2 million, up 82% year-over-year. This increase was driven by the strong performance across various business lines, especially the robust growth of our game business after the acquisition of Skymoons. Moving to the costs of revenue. Our costs of revenue were RMB 7 billion, up 14% year-over-year. The increase was primarily driven by the higher content costs as well as other cost items. Content costs were RMB 5 billion, up 7% year-over-year. Turning to the operating expenses. SG&A expenses were RMB 1.3 billion, up 42% year-over-year primarily due to the higher marketing spending on games and the increased share-based compensation expenses after the acquisition of Skymoons. Our R&D expenses were RMB 654.6 million, up 48% year-over-year. The increase was primarily due to our continued investment in R&D personnel. Operating loss were RMB 1.9 billion compared with operating loss of RMB 1.3 billion in the same period last year. Operating loss margin was 26% compared to operating loss margin of 22% in the same period last year. Total other expenses was RMB 426.7 million compared with a total other expense of RMB 768.3 million during the same period last year. The year-over-year variance was a combined result of less foreign exchange loss due to the exchange rate fluctuation and increased interest expense associated with our financing activities. Loss before income tax was RMB 2.3 billion compared with a loss of RMB 2.1 billion in the same period last year. Income tax expenses was RMB 5.8 million compared to income tax expenses of RMB 4.9 million in the same period last year. Net loss attributable to iQIYI were RMB 2.3 billion compared with a loss of RMB 2.1 billion during the same period in 2018. Diluted net loss attributable to iQIYI per ADS was RMB 3.22. As of June 30, 2019, the company had cash, cash equivalents and restricted cash and short-term investments of RMB 16.4 billion. Turning to the third quarter 2019 guidance. We expect total revenue to be between RMB 7.21 billion and RMB 7.63 billion, representing an increase of 4% to 10% year-over-year. This forecast reflects iQIYI's current and preliminary view, subject to change. This concludes our prepared remarks. I will now turn the call to the operator and open the floor for Q&A.

[Operator Instructions] Your first question comes from Ella Ji from China Renaissance.

[Foreign Language] So my first question is could Dr. Gong please explain the impact of the regulatory environment change and how that's going to impact the relationships between upstream and downstream companies in the industry and your purchase -- trend of purchase decisions going forward. And my second question is just to confirm that, for yourself, is average ARPU stable? Or are you seeing any change to the average ARPU?

[Foreign language]

Okay. [Interpreted] Thank you for your question. Actually, the first question is a very good question. Our major upstream partners are content providers, including the licensors and also the customization producers, and outsourced producers for us. In the past year, the supply has been very stable. And actually because of the previous years -- because of the hot money inflow, the inventory and the -- supply is very sufficient. That helped to stabilize the pricing of content procurement. And in addition, as you all know, the later half of last year, because of the capped pay for actors, actually the license pricing is on a downward trend. And on the other hand, for our original content we have seen an increase in a lot of talent supply, including producers, screen copywriters, directors as well as actors and actress. I will give you an example here. For some major top-tier actor and actress, they're paid -- their salaries used to be somewhere between CNY 80 million to CNY 120 million, but now many of them have come down to a range to RMB 40 million to RMB 50 million, with -- which is in line with our [joint declaration] we make with the other partners. So overall, the trend has been very stable and the market has become more mature, so we have gotten more negotiation power or, we'll say, bargaining power. And we will be more in control of our content costs. However, as you know, some of the content we purchased before over the last year will be aired gradually in Q3. And also because of some widely-known reason, some of the content will be delayed. So potentially some of the very expensive content will even be pushed back to Q4 or even Q1 next year. So that will have some impacts on our P&L. Thank you.

Ella, I'll try to answer the second question. I think it's mixed results. And the main reason, as I just said in the earnings, is because of -- backend loaded members. I'll try to give some breakdown of the member addition by month. Actually, at end of April, I think, at that time, the total member is even lower than that of in January, so which gave you some rough idea how the pattern looks like during second quarter's. What I can tell you is actually the true ARPU of the members excludes certain onetime adjustments, and the fluctuation was less than 5%. So it's minor impact from like true ARPU fluctuation. It's mainly because of the mix and how it increased during the second quarter. Thank you.

Your next question comes from Eddie Leung from Bank of America.

[Foreign Language] So my question is more about monetization models. Beyond memberships and advertising, do management think about what other business models could be more significant in the medium to longer term given the fast growth of other revenue segment in recent quarters?

[Foreign Language]

[Interpreted] One of our other revenues come from content distribution. We have made quite some progress there. We have distribute a lot of our original content to other channels and to other overseas market as well as to some OTT terminals. So we are very confident in this line, but we also need to bear in mind that there will be some potential limitation here because we need to -- balancing the accessibility of our content on other platforms to the growth of our own subscribers. And the second one is our online game business in which -- we acquired a game company. And this business has been growing very well, including both domestic and international markets. And we have been trying to make some IP bundled game productions which has bear a lot of fruit. And we -- apart from these two, we have other -- a variety of other revenues as well , for example, IP licensing. Although the scale of this business is very small, you can imagine the gross margin is actually quite good. And we also have some literature subscriptions revenues and other revenues. Accumulatively, these revenues become an increasing chunk of our revenues. Thank you.

Your next question comes from Thomas Chong from Jefferies.

[Foreign Language] I have 2 questions. First is about the paying subscribers' trend in Q3 and 2019; as well as, of course, about the long-term paying subs. And my second question is about content costs. Given that we see content cost as a percentage of revenue is lower than the Street expectations, how should we think about the content costs going into the second half and 2020?

This is Xiaodong. I think we didn't provide a specific guidance for [certain] quarter on subscribers. What I can tell you is a general guidance of the total year's increase this year. I think it will be -- probably would be lower than we previous provided, the guidance we previous provided, but still it will be a robust growth of the total subscribing business. And we are quite confident we are still keeping the leading position of this business in China. Back to your question about the content costs: If you look at the pattern last year, definitely you will see a deterioration in second half of the year because typically we tend to launch more content in second half of the year. And sometimes, [the efficiency] will decrease as more content come online. And so I think we still keep the previous guidance about the total content cost and subscriber revenue this year but probably close to the high end. Thank you.

Your next question comes from Wendy Chen from Goldman Sachs.

[Foreign Language] I have 2 questions. First, regarding our next quarter guidance, which is -- has go into a relatively low growth rate compared to the -- to previous quarters. So just wondering where do we see the major pressure coming from, whether that's from the subscription business or the advertising business. Second question is, amid this content delay cycle that we are seeing, whether we see the user time spend growth have changed trend recently.

[Foreign Language]

[Interpreted] Let me answer your second question first. In terms of user time spent on our platform, actually we -- saw more than 10% year-over-year growth in first half of '19 versus 2018. This is actually higher than last year's user time growth versus the year before last year, so you can see the trend. It's pretty well, really good. And to your first question: The challenging for -- to our Q3 guidance mainly come from, one, our brand advertising. As you all know, the macro environment in China is not so strong and also because the -- a lot of advertisers constrained their advertising budgets. So that have put some pressure on advertising business. And secondly, because of the content delays, especially for our head content. Some of the schedules have been pushed out to later time. And our advertising will majorly come into the dramas and the variety shows, those absorbing most of the advertise placements. But because they are delayed, so that will again have some pressure on our brand advertising business. For in-feed: On the other hand, in-feed advertising is just a small portion of the total advertising revenue, and we expect that will come into a stable growth period. And we will achieve some Q-on-Q growth in Q3. For our subscription business, again this comes -- the driver mainly comes from the exclusive-type content. Again because of the delay of the airing of those exclusive content, the net addition of the subscribers will be lower than we expected in the beginning of the year.

[Foreign Language]

[Interpreted] I will also add some comment on the recent regulation environment in terms of the contents delay. I think the -- in terms of the short-term or, say, the temporary new regulations, that will have an impact on us, for sure, but that will probably last until mid of October, after the national holidays. And in the long term, I think, although some of the -- I think most of the temporary constraints will fade away, but some of the regulations will persist in the mid to long term. But we think the long-term constraints -- or limitation, are very limited because, as you know, the -- our production cycle is very long, 12 to 18 months. So after we absorb and understand the regulation changes, we can be better prepared. Hence the mismatch of new regulations and our production cycle, but after a few quarters preparation, in the future, we will still have a lot of room, plenty of room to create very innovative new content which is in compliance with the developing regulations.

Your next question comes from Alicia Yap from Citigroup.

[Foreign Language] My questions is related to the ARPU for the third quarter. So given we see some of the pressure. And also I think there was some bundling joint venture program, so will that be affecting the ARPU for the third quarter on the membership subscription side? And then for content, do we have any interest into sports content licensing? And lastly, any change on the competitive landscape?

Alicia, this is Xiaodong. I will answer your first question and then let Dr. Gong Yu comment on your second one. I think -- for the ARPU in the third quarter, I don't think there will be any major reason you will see, like, significant deterioration on ARPU that I just explained. All the promotion campaign, they will have only minor impact on the total ARPU or earning of every quarter. And I actually will expect the ARPU in the third quarter will be at least about the same or even better than that of last year. So basically I don't see those joint membership or also the promotion campaign will have like significant negative impacts on ARPU. And I will pass to Dr. Gong to comment on your second question, about the sports content.

[Foreign Language]

Okay. [Interpreted] Thank you for your second question. I think sports content is obviously a very important racetrack for us as well, but it's a very expensive one. And also, this sports content, it's almost impossible for us to self-produce. We can never produce original tournaments or buy our own tournaments to produce sports content. So that's why. Those reasons are why we formed the joint venture last year to operate our sports content, and we even being a minority shareholder of that JV. And whether or not to license or-- what to license is totally in discretion of their own JVs management team. As far as we understand, some of the, sports content, the pricing is coming down compared to 2 years ago. Some of them come up. So I think we will respect to the JV's own management team to make the right decision in terms of which sports content to license.

[Foreign Language]

[Interpreted] For your questions on competitive landscape. I do not think there's much change now compared to 6 months ago. I will suggest some third-party data for you, among others, of course. The first two is iResearch and QuestMobile, which provides the platform matrix, for example, DAU, MAU and total time spent. That give you a sense of the market share situation. And if you want more granularity about content， content genres or, individual, vertical channels, I think you can go to Enlightent, in Chinese, [Foreign Language], to investigate more about the content ranking.

Your next question comes from Tian Hou from T.H. Capital.

[Foreign Language] So 2 questions. One is about the content control. Will the content control be a little bit less in [3Q] (corrected by company after the call)? Or another way to ask the question: The total number of content released in 3Q, will that be higher than 2Q? If so, what's the impact on the content costs? That's the first question. The second one is about the interaction with users. We saw a lot of the short video platform. They have this kind of a function enable user interacting with the short-term videos. And so I wonder. iQIYI, do that have any functions or measures to accomplish user interaction.

[Foreign Language]

[Interpreted] Thank you for your questions. For your first question. Our -- the content volume in Q3 will definitely be higher than in Q2, but if you compare it to the Q3s in previous years, that will be definitely lower than in previous years. That's why our Q3 guidance is kind of soft compared to previous years. And for your second question: Our -- the interaction with video content. One, for our long-form video we did a lot of innovation in our brand advertising. So previously a lot of the display ad is not able to be closed. So we now are gradually moving towards more to the true-view format of brand ads, which means people can choose to close or not close that advertisement. So this kind of ad solution is more based on big data, and that is more targeted and more result oriented. So it's well -- very well received by those [APP] download kind of advertisers which are more performance-based advertisers. And secondly, for our short-form video, although our expertise mostly is in long-form video, we do have a Redian channel in our main app. If you click on that, we have both short-form video and mini videos in there. And in those in-feed ads, a lot of in-feed advertising format is based on interaction. Thank you.

And this is Xiaodong. I just want to clarify Dr. Gong's comments about content costs in the third quarter. And what Dr. Gong said is the volume of the content we are going to release in the third quarter will be lower than last year, not the cost. I think the -- if you're talking about the dollar amount, you see it might be probably slightly increased because of the high unit costs of these drama and other content, but definitely you will see a lower increase rate compared to the previous quarters. Thank you.

We will be taking one final question, and your last question comes from Tina Long from Crédit Suisse.

[Foreign Language] So my question mainly lies on SG&A costs. So from a lot of [real costs] from other Internet companies, it seems like their selling and marketing costs are actually on a downtrend. So I want to know what's actually driving the rise in the selling -- SG&A this quarter.

This is Xiaodong. I think the main driver of the SG&A increase is the sales and marketing expense. You will spend on a lot of things, including game, as we mentioned in the earnings, and other apps and service we try to promote in the -- in recent quarters. Because if you noted, in the other revenue I think increase very fast, which actually means we tried to monetize the traffic and IP through our content offerings, which means we try to provide different service for our users. And in the short period, you will see some promotion investment in this new service. And also, another reason of the increase in SG&A is the acquisition of Skymoons, which result additional about 200 million SBC cost every quarter. So that's another reason why you see increase in the recent quarters. Thank you.

I would now like to hand the conference back to Dahlia. Please continue.

Thank you all for joining our call today. If you have any additional questions, please feel free to contact us later. Thank you.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may all disconnect.