Life as a public company has been a roller-coaster ride for Chinese streaming giant iQiyi (NASDAQ:IQ). Often dubbed the Netflix (NASDAQ:NFLX) of China, IQ stock rode that favorable Netflix comparison from an $18 IPO price in March 2018 to a $45-plus price tag by June 2018. Then, investors began to question the merits of the Netflix comparison, the sustainability of the high growth of China’s streaming market, and the profitability of IQ’s business model.
As those questions grew louder and louder, IQ stock dropped. Escalating trade tensions between the U.S. and China didn’t help things. Nor did a major rally of the U.S. dollar or the slowing expansion of the Chinese economy.
IQ stock fell from $45-plus in June 2018 to $14 in early 2019.
iQiyi stock has since rebounded from that big selloff. Today IQ stock trades hands around $20. But investors shouldn’t be fooled by the rebound. Going forward, IQ continues to face huge fundamental challenges. Until those challenges are appropriately addressed, IQ stock will not climb meaningfully.
As a result, the strategy vis-a-vis IQ stock is simple. Don’t buy IQ yet. Instead, wait and see how certain metrics progress. If they progress favorably, buy IQ stock on strength. If they don’t progress favorably, stay away from IQ.
iQiyi Has a Large Growth Opportunity
iQiyi stock is supported by IQ’s strong growth outlook, centered around the explosive growth of China’s streaming market.
Streaming is the future of global content consumption. This trend has already largely played out in America, where streaming penetration rates are north of 60% of households with broadband internet. But this trend is just starting to play out in China, where streaming penetration rates are still just roughly 35% and rapidly climbing. Further, because China has so many households with the internet( it’s closing in on 1 billion internet users), this rapid streaming penetration rate expansion is fueling robust streaming market growth. China’s streaming market has grown from a few million subscribers in 2014 to over 250 million subscribers last year.
This growth is poised to continue, given the relatively low streaming penetration rate, along with the backdrop of continued urbanization and the digitization of China’s consumer economy. Realistically, by 2025, China could have 500 million subscribers to internet video services. That represents roughly 100% growth from 2018’s base.
IQ is the king of this market, exiting 2018 with around 90 million subscribers, translating to roughly 35% market share. Thus, as China’s streaming market continues to grow at a robust rate over the next several years, so will iQiyi’s subscriber base, giving the company a big growth runway over the long run.
IQ Faces Big Challenges
Although iQiyi stock is supported by a strong growth outlook, over the next several years, it has equally powerful challenges which could stunt its long-term profit growth.
First and foremost, China’s streaming market isn’t anything like America’s streaming market. Namely, in America, consumers are willing to pay for content. Chinese consumers aren’t. Netflix charges about $10 per month per subscriber. iQiyi, meanwhile, charges about $1.50 to $2 per month, and that number has been stuck in neutral for several years. Thus, while IQ’s subscriber growth potential is very large at this point , its revenue growth potential is capped by its relatively low prices.
Second, even though streaming prices in China are low, the costs for content makers are not that low. As a result, its margins have been, still are, and will continue to be under intense pressure. Its gross margins have been negative for the past two years, and it’s uncertain whether they will turn positive.
Third, while the company does have a digital advertising business to help boost its revenues and profits, that digital ad business is growing at a sluggish rate, as the digital ad market in China is rapidly slowing. Thus, investors can’t really count on the digital ad business to save the day for IQ stock.
iQiyi Stock Is Appropriately Priced, Considering Its Challenges
Considering that iQiyi has powerful growth potential but some major challenges, the valuation of IQ stock today seems fair.
My best guesses for IQ are as follows. China’s total streaming market will reach 500 million subscribers by 2025. iQiyi’s share will be 40% or roughly 200 million subs. Its average revenue per sub will climb roughly 10% per year to $3 per month, implying around $7.2 billion of sub revenue by 2025.
Its digital ad business will grow at a market-average compounded annual growth rate of about 15% into 2025, implying around $3.8 billion of revenue by 2025. Its other revenue will amount to around $2 billion, bringing its total 2025 revenue to around $13 billion.
Its operating margins will rise towards 10%, roughly where Netflix’s margins are today. Its operating profits will reach around $1.3 billion, which – after taxes – should translate into about $1 billion in net profits. Assuming a multiple of 20-times its forward earnings, which is around average for growth stocks, that equates to a 2024 valuation target for IQ stock of $20 billion. Discounted back by 10% per year, that implies a 2019 valuation target of about $12.4 billion.
Leaving room for 15% error in the projections, that further equates to a 2019 fair valuation range for IQ stock of about $10 billion to about $14 billion. IQ stock today trades roughly in that range. As a result, the valuation of iQiyi seems fair.
The Bottom Line on IQ Stock
Don’t be fooled by the Netflix comparison. iQiyi is a different company, with drastically different average revenue per user, a smaller addressable market, less revenue potential, and lower margins.
Considering these challenges, IQ stock seems fairly priced today. If the company makes progress on its average revenue per user and/or its margins, a few of the aforementioned challenges will go away, and the stock will soar higher. But, until that happens, IQ stock will ultimately be capped by its fundamental challenges.
As of this writing, Luke Lango was long NFLX.
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