iQIYI, Inc. Q1 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by, and welcome to the iQIYI First Quarter 2020 Earnings Conference Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker today, Dahlia Wei. Thank you, and please go ahead.

Thank you, operator. Hello, everyone, and thank you all for joining iQIYI's First Quarter 2020 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; Mr. Xiaodong Wang, our CFO; and Mr. Xianghua Yang, SVP of our membership business. 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, Xianghua will join Dr. Gong and Xiaodong in the Q&A session. Before we proceed, please note that discussions today will contain forward-looking statements made under the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from 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 first-quarter 2020 earnings call. We delivered solid results during the first quarter despite a very challenging and complicated environment amid the coronavirus outbreak. Q1 total revenues increased 9% year-over-year to RMB 7.6 billion, while total user time spent and the number of subscribers achieved strong growth during the quarter. I would like to thank all of our employees for their dedication and tireless work throughout the difficult times, as well as our business partners and investors for their continuous support. As a leading entertainment company, we continue to execute our strategy that focuses on original content production and technology innovation and, in the meantime, perform social responsibility and contribute our piece of pandemic containment efforts by introducing numerous targeted entertainment content that cater to the needs of hundreds of millions of users staying at home. I will start my Q1 review with our membership business. We are pleased to see robust growth in both the number of subscribers and membership revenues during the first quarter. Total subscribers reached 118.9 million as of March 31, 2020, an increase of 23% year-over-year and a net addition of 12 million from the previous quarter. Subscription revenues grew 35% year-over-year to RMB 4.6 billion. This was driven by our continued efforts to introduce more premium content as well as the surge in demand for digital entertainment during the Chinese New Year holiday and the coronavirus outbreak. During the first quarter, our premium content continued to drive subscriber growth. Top-rated dramas among subscribers included iPartment Season 5, Ai Qing Gong Yu; Under the Power, Jin Yi Zhi Xia; and Qing Yu Nian, among others. We kicked off the year with iPartment Season 5, a hot drama watched by 38 million subscribers within the first week and over 74 million subscribers by the release of the series finale. The popularity of the blockbuster drama once again demonstrated the strong appeal of our premium content to our audiences across all demographic groups. Subscriber growth was also driven by an increasing variety of content we offer, including relatively low-budget yet exquisite dramas such as Classmate From Far Far Away, Tong Xue Liang Yi Sui; and the Tang Dynasty Tour, Tang Zhuan, as well as popular movies and animations. Over the past years, our membership business has been primarily driven by growth in the number of subscribers. As our subscriber number reaches critical mass, we are now approaching a new phase where both subscriber number and ARPU will serve as growth engines. We further optimized our membership system during the quarter, such as reducing membership discounts and eliminating less-efficient bundled membership. In addition, we also continued to offer subscribers early access to additional episodes for a premium charge, which is becoming the new norm for the industry. So far, early access option has been applied to over 10 major drama series, including iPartment Season 5; The Great Ruler, Da Zhu Zai; The Love Lasts Two Minds, Liang Shì Huan; and Winter Begonia, Bin Bian Bu Shi Hai Tang Hong, which has been well received by subscribers. Overall, the corona outbreak resulted in the wide adoption of shelter-in-place and accelerated the evolution of users’ entertainment behavior and paying habits. We recorded better-than-expected subscriber growth as people were confined at home during the pandemic. Nevertheless, we hope the pandemic could end soon despite the fact that our membership growth may decelerate. With the pandemic largely under control in China and more people coming back to work, our focus now turns to enhancing membership retention. However, due to delayed box-office window, hence online airing window for many theatrical films, which usually play an important role in member stickiness, our retention efforts may be adversely impacted. Meanwhile, many Japanese anime series have suspended releasing new episodes since late April, pending notice of resuming airing. As the coronavirus pandemic is an unprecedented situation, we currently cannot gauge its overall impact, hence cannot provide a future net additions outlook of subscribers. On the other hand, the ARPU increased during the quarter. This was mainly driven by the aforementioned efforts in offering early access to advanced episodes at a premium charge and cutting promotion activities, as well as the fact that our net adds number peaked in the middle of the first quarter. Meanwhile, we plan to launch a more privileged package called S-diamond Membership soon. The S-diamond Membership will entitle members to a wide range of privileges and premium services including: one, early access to advanced drama episodes as we offer and applicable video-on-demand privilege without additional charges; two, accessibility through multiple terminals, including PC, mobile devices, tablets, Internet TV sets, and other smart displays; and three, integrated content offerings of the existing Gold membership, FUN membership, literature membership, VR membership, and Sports membership. Moving on to our advertising business. The advertising industry faced huge headwinds as the pandemic caused setbacks in many industries, which in turn adversely impacted our advertising business. As a result, our overall advertising revenues softened during the first quarter. Looking ahead, given the challenging macro economy and the ongoing coronavirus impact, we expect that Q2 and the full year will still be under pressure. Q2 ad revenues could see slight sequential recovery but will be down year-over-year, especially now that some of our variety shows will likely be pushed out to Q3 or even Q4 as their production process was delayed due to the pandemic. Nevertheless, we remain cautiously optimistic for the advertising business as we saw advertisers gradually restoring their confidence and resuming ad spending. We will continue to strengthen our advertising products with diversified content offerings in innovative advertising solutions and optimized algorithms in preparation for a potential recovery down the road. Now let's turn to the content. During the first quarter, we continued to focus on distinctive and original content by enhancing our innovative production capabilities. We launched a series of popular content titles to capture the surge in entertainment demand during the outbreak, which allowed us to maintain our leading market position and begin 2020 on a strong footing. According to Enlightent, our drama series and variety shows both dominated the market during the first quarter in terms of video views, far exceeding peers. For drama series, we launched several blockbuster titles that were either originally produced and aired exclusively on our platform. We kicked off Q1 with the exclusive release of the fifth and final season of iPartment, which was a tremendous success. This highly popular comedy series, perceived as the Friends of China, was built by over 170 million users by the time its finale was aired, among which over 74 million were subscribers. We also launched a number of original drama series during the quarter, including Detective Chinatown, Tang Ren Jie Tan An, a suspense series; The Great Ruler, a youth costume series; The Love Lasts Two Minds, a romance-themed series; and Winter Begonia, a legend series, which are all quite popular among audiences. For variety shows, we continue to lead the industry with our highly innovative self-produced content. Launched in mid-March, our highly anticipated original girl group talent show, Idol Producer Season 3, turned out to be another multi-season hit. It broke the 9,000 mark in our content popularity index and set a new record high for variety shows. Also, for the first time, we added an international flavor to our show by inviting Lisa, a member of the global sensation pop group Blackpink, to be one of the mentors. The show was simultaneously released in China and overseas, where it instantly became a hot topic on various social media. FOURTRY, our fashion-themed reality show, concluded its first season during the quarter where it ranked among the top variety shows throughout its broadcast window. In addition to professionally produced content, we are also leveraging our strong platform and collaborative resources to enhance our content ecosystem. Our content library continues to grow as we empower more content creators and integrate them into our ecosystem. Driven by the holiday season and the widespread shelter-in-place policy in Q1, a number of Internet dramas performed quite well under our revenue-sharing program, for example, I've Fallen For You, an Internet drama adapted from an iQIYI Literature novel, became very popular and broke the 6,000 mark in the popularity index the day after its launch, a historical high in its category. Another Internet drama, The Sweet Girl, also adapted from a hot iQIYI Literature novel, quickly generated over RMB 20 million in revenues under the revenue-sharing scheme. The parallel success of blockbuster and long-tail content demonstrates our strong capabilities of content distribution and monetization that enable all kinds of content to reach targeted audiences and generate good return on our platform. Also, our subscription model is having an increasingly positive impact on upstream content creators and is helping form a virtuous cycle that incentivizes better content production. For the second quarter, we have a very strong content pipeline, including major drama series Happiness Within Our Touch and The Winter is Love; The Eight; and Love A Lifetime, as well as our multi-generational variety shows, I'm CZR Season 2 and the new trendy lifestyle reality show Summer Surf Shop, among others. With content production back up and running since late March, we are gradually recovering towards the normal level, and the short-term uncertainty on future pipeline caused by the pandemic is fading away. On April 15, the China Television Drama Production Industry Association and the Capital Radio & TV program Producers Association jointly issued a statement urging drama and movie content producers to carefully control production costs under the challenging environment caused by the coronavirus pandemic. This follows NRTA's notice for regulating irrational salary levels for actors and actresses issued in 2018. We believe these regulatory enforcements by government authorities as well as industry associations will help facilitate orderly practice of content production industry and further reduce content production costs. Moving on to technology. As a technology-based entertainment company, we are committed to providing users with enriched content and premium viewing experience through new technologies. Advanced technologies such as AI are the driving forces behind our user-centric entertainment service platform, enabling us to explore innovative forms for content creation, distribution, and monetization. We recently introduced a multi-perspective watching mode in our self-produced variety show, Idol Producer Season 3. This new feature powered by iQIYI's AI angle-switching technology allows users to simultaneously watch the performance of over 100 trainees from a view of the whole stage and a separate view that focuses on their favorite trainee. It creates a more personalized and immersive viewing experience and can deliver a smooth streaming performance on all high-, mid-, and low-end devices as we optimized the capabilities of iQIYI video player for better adaptation. Leveraging our long-term exploration and leading expertise in interactive video technology, we also released various branching plot content for our hit drama iPartment Season 5 based on the interactive video guidance we introduced last year. With 16 branch storylines that lead to numerous different endings, the interactive portion of this comedy series has been welcomed by audiences. During its run, over 28 million viewers watched the interactive content with over 140 million interactions taking place in total. The interactive video content was a strong addition to our innovative original content offerings and greatly enhanced user engagement and stickiness. In conclusion, I'm pleased with the solid progress we made during the first quarter despite the challenging environment. On April 22, we celebrated the 10th anniversary of our founding. In the first decade of our history, we have proved ourselves as we started from scratch and grew into a leading entertainment platform among fierce competition. As we unfold our second decade, we will continue to solidify our leadership position in the online entertainment industry by leveraging our unparalleled original content production and technology innovation. With our expanding subscriber base, diversified monetization, better-controlled content costs, and a more rationalized competitive environment, we believe we are well-positioned to capture future growth opportunities and continue to build our entertainment universe for users. With that, I will now pass the call to Xiaodong to go over our financials.

Good morning, everyone. Let me go through our financial highlights. For the first quarter of 2020, iQIYI total revenues were RMB 7.6 billion, up 9% year-over-year. Membership services revenue for the first quarter was RMB 4.6 billion, up 35% year-over-year. The increase was primarily attributed to the growth of the number of subscribing members, driven by our premium content and increased entertainment demand during the Chinese New Year and the COVID-19 pandemic. Online advertising services revenue for the first quarter was RMB 1.5 billion, down 27% year-over-year, primarily due to the challenging macroeconomic environment in China related to the virus situation. Content distribution revenue for the first quarter was RMB 602.8 million, up 29% year-over-year, driven by the increase of high-quality content, which fulfilled distribution to several platforms during the quarter. Other revenues for the first quarter were RMB 875.9 million, down 9% year-over-year, primarily due to the soft performance of certain business lines, partially offset by the growth in the game business. Moving on to the cost of revenues. Our cost of revenues for the first quarter was RMB 7.9 billion, up 9% year-over-year, primarily due to the increased content costs this quarter. Content costs for the first quarter were RMB 5.9 billion, up 11% year-over-year. Turning to the operating expenses. SG&A expenses in the first quarter were RMB 1.3 billion, up 15% year-over-year. This was primarily due to higher marketing spending for certain iQIYI apps and increased allowance for doubtful accounts due to the COVID-19 pandemic. Our R&D expenses in the first quarter were RMB 678.1 million, up 13% year-over-year. The increase was primarily due to our continued investment in R&D staff. Operating loss in the first quarter was RMB 2.2 billion compared with an operating loss of RMB 2 billion in the same period of 2019. The operating loss margin for the first quarter was 29% compared to an operating loss margin of 29% in the same period last year. Total other expenses in the first quarter were RMB 628.5 million compared with total other income of RMB 211.1 million during the same period last year. The year-over-year variance was a combined result of exchange rate fluctuation between RMB and the U.S. dollar and an increased interest expense associated with our financing activities. Loss before income taxes for the first quarter was RMB 2.9 billion compared with a loss of RMB 1.8 billion during the same period last year. Income tax expense for the first quarter was RMB 4.8 million compared to income tax expense of RMB 7.4 million in the same period last year. Net loss attributable to iQIYI for the first quarter was RMB 2.9 billion compared with a loss of RMB 1.8 billion during the same period of 2019. Diluted net loss attributable to iQIYI per ADS for the first quarter was RMB 3.92 compared to a diluted net loss attributed to iQIYI per ADS of RMB 2.52 in the same period last year. As of March 31, 2020, the company had cash, cash equivalents, restricted cash, and short-term investment of RMB 9.9 billion. Turning to the second quarter 2020 guidance. We expect total revenue to be between RMB 7.25 billion and RMB 7.67 billion, representing an increase of 2% to 8% year-over-year. This forecast reflects iQIYI's current and preliminary view subject to changes. This concludes our prepared remarks. I will now turn the call to the operator, open to Q&A. Thanks.

Your first question comes from the line of Wendy Chen from Goldman Sachs.

(foreign language) Congratulation on the solid results. So my question is about the content cost moderation. As we have seen several rounds of regulation from both the national and industry level this year on moderating content costs as well as the compensation for actors and actresses. Can management share some color on whether we have seen the per-episode price of content decreasing this year so far and in particular, which drama we have launched or are about to launch have already benefited from such cost moderation?

(foreign language)

Wendy, thank you for your question. Let me first review the historical development of regulatory changes. Back in late 2018, three platforms including us and six major production companies issued a joint statement, and we have limited the top actor/actress salary to a maximum of RMB 50 million per title. Previously, that could go as high as RMB 150 million per title. So that has helped the per-episode costs to go down. But because of the production cycle, those impacts will gradually be seen in late 2019 and now is already taking place in our content costs. And most recently, the new regulatory enforcement is kind of regulating the further enforcement details not only to the first-tier actors/actresses but also to the second-tier and third-tier actors/actresses, as well as those production companies and all kinds of vendors to ask them to control the costs. We believe this will further help reduce the content costs. But again, because of the production cycle, this new round of regulation may have impacts that we will see maybe next year or even the year after next year. But I also want to highlight another factor—before, the major mix of content was licensed copyright. But now more and more content, especially for the top-rated content, around half or even more than half of the content, comes from our self-produced or originally produced variety shows and drama series. So the license price has played less of a role in our content costs. More and more, the content costs will be impacted by the salary levels of actors/actresses, which, as we discussed, will gradually reduce going forward. Thank you.

Your next question comes from the line of Eddie Leung from Bank of America Merrill Lynch.

(foreign language) So my question is about user time spent as well as the subscriber retention rate trend when we get into the second quarter in April and May.

(foreign language)

Eddie, thank you for your question. Yes, you are correct that entering into April and May, we have seen that the time spent for both free users and members have been on a declining trend, although on an average per capita level, the time spent doesn't decline that much but total time spent is declining. Also for our membership, the retention rate has had some impact as well. As a result, the net number or net adds number also have some negative impact. Thank you.

Your next question comes from the line of Alicia Yap, Citigroup.

(foreign language) My question is given the delay and the shortened school summer holiday this year and overall travel sentiment also negatively impacted by the COVID-19, how has that changed our overall variety shows and TV drama launch timing plans? Any difference this year versus previous summer? Any traction for the advertiser sponsorship on this show?

(foreign language)

Hi Alicia, thank you for your question. As far as we understand, this year's university entrance exam was delayed for a month, delayed to the beginning of July. The practice in China is that for other school students, the summer holiday will come after that. But the next semester will still begin on September 1. So we think the summer holiday will be somewhat shorter than previous year's summer vacations. But as you said, due to the pandemic impact, we estimate that people will spend less time traveling and more time for online entertainment. As a result, we think this year's summer vacation’s performance for the online entertainment industry will be stronger than previous years, but the impact will be short term. Thank you.

Your next question comes from the line of Ella Ji from China Renaissance.

(foreign language) So my first question is relating to the membership growth spike during the virus and then dropped afterward. Just wondering what lesson the company has learned through this opportunity. And going forward, in order to retain more users and increase more members, what are the main strategies or directions that the company would like to follow? And secondly, relating to your ad revenue. Since other companies mentioned that for multinational brands, there's some weakness in sponsorship ads as global pandemic increases, I just wonder if you are seeing the same situation here.

(foreign language)

Hi Ella, thank you for your question. I will answer the question for user time spent and advertising first and I will defer your question for membership to our SVP of Membership Business, Xianghua, who'll discuss later. For all the users, including free users and paid members, we have observed that in the past, around two years, those users’ patterns have stabilized, entering into a very stable development stage. Their behavior is quite stable. So usually, their consumption, their time spent will increase during the Chinese New Year holidays or winter vacations, especially when this pandemic outbreak increased as well. But because this users pattern has been quite steady, we predict those users' patterns will gradually come back to normal after the pandemic was contained. Regarding your second question about advertising, we have observed that recently, the domestic clients' ad sales have quickly been recovering. The sales for advertising, especially sponsorship advertising, have quickly come back to a level that's close to the pre-pandemic level. But for some international clients, because their decision-making process is longer than domestic clients, we estimate their pattern will come back to normal maybe two to three months later than domestic clients. Thank you.

(foreign language)

Xianghua added that we also observed that some of the members, they are transferring their off-line entertainment consumption, such as their usually going to movies to watch theatrical films. During the pandemic outbreak, they switched to online to watch this content, especially during this outbreak period. We launched actually a lot of online movies and very good online content. I think some of those portions of users may be switching more to online consumption for this type of entertainment content. Thank you.

The next question comes from the line of Binnie Wong from HSBC.

(foreign language) Sorry, let me translate my question. In terms of monetization, we saw that in terms of total revenue growth, it's still a little bit soft. Is that mainly because of the advertising growth slowdown due to COVID-19? Or is there eventually some structural reasons that we should be aware of? And then I think in the press release, you also mentioned about your next decade about the diversification of monetization streams. I just wanted to understand more in terms of how it's positioning that and in terms of given that the subscriber number has also been growing nicely but advertising growth is still a little bit soft. And also, would there be any color in terms of our subscriber target as well?

(foreign language)

Binnie, thank you for your question. I will comment on your question about membership first and also the advertising, and then Xiaodong will add some of his comments. I think it's a normal pattern that during the pandemic outbreak, people watched too much entertainment. So I observed there are some fatigue effects, that people are somewhat tired of too much online entertainment. We observed this also in previous years when there were Olympic Games. After the Games were over, people would see a decline in time spent and watching consumption. So that's the first thing I want to mention. It's normal, especially when people are gradually coming back to work and school; I think it’s really very natural for people to reduce their online time. As a result, our membership has seen some fluctuation in terms of retention. And secondly, regarding advertising, especially for brand advertising, our revenues in Q1 have declined. The major reason is the advertisers' willingness for advertising spending and their budget allocation have been impacted because of the macroeconomy and the pandemic. Another reason is some of our major content pipelines have been pushed out to Q3 to Q4 from Q2, which is understandable due to the pandemic impact. So, because of the content delay, that will also have a negative impact on our advertising business. Thank you.

Xiaodong?

I'll try to answer the question through a different angle. I'm always talking about supply and demand being key to understanding the business trend. For the second quarter, definitely because of the COVID-19 situation, you will see changes or decreasing demand in the second quarter. I think if you're talking about structural issues we are facing in the next few quarters, besides this onetime COVID situation, there will still be some factors we have been talking about for a very long time in the past few quarters, which is the content itself, which actually determines the supply of our platform. Even in the previous question, Ella asked about the profile of the paying subscribers during the decreasing period. More importantly, it’s not the profile of those subscribers; it's because most of the time, the frequency of payment determines the balance of subscribers. The same situation applies here. I think if we continue to invest in our original content, continue to improve the quality and volume of our original content, we will change the pattern here. So, let’s focus on the strategy we have been emphasizing over the past few years. We will continue investing in technology and original content; that’s my view for this what you call structural or onetime case factors.

The final question comes from the line of Thomas Chong from Jefferies.

I have a question regarding the timing on profitability. Given that the content cost, we are seeing the benefits coming from the cap on artist compensation, and in Q1, we have seen that the gross loss is actually less than RMB 300 million given the fact that more and more benefits on the content cost will come in 2021 and 2022, can management give us some color about the gross profit trend or the timing of profitability?

Okay. This is Xiaodong. I think this is not a new question; it's a very frequently asked question. I think the answer will be exactly the same as we provided before because nothing has actually changed for the foundation of this business. If we can— as I just mentioned, we can still improve the quality of our original content and increase the volume of our original content and improve the mix of original content. By doing that, we will definitely attract more paying subscribers on our platform, increasing the margin, increasing the revenue, not even mentioning the diversified monetization model. So basically, what we should focus on is not a timetable, but again, the quality of our original content. But as I mentioned before, by decreasing the content cost as a percentage of revenue to about 50% to 55%, we will see an acceptable profit margin in the next few years. So if you still want to know an exact timetable, what I can tell you is I would still maintain the original expectation of this year's margin level or the operating loss level. To give you some sense, even with the COVID-19 situation, the management is still confident in the original outlook of the long-term development of the business. We are still confident on our path to profitability. Thank you.

There are no further questions at this time. I would now like to hand the conference back to today's presenters. You may continue.

Thank you all again for joining today's call. If you have any further questions, please feel free to contact us later. Thank you.

Thank you. Ladies and gentlemen, that does conclude our conference for today. Thank you for participating. You may all disconnect.