Earnings Call Transcript - IQ Q3 2023

Chang You, Investor Relations Director

Thank you for standing by and welcome to the iQIYI Third Quarter 2023 Earnings Conference Call. All participants are in a listen-only mode. There will be a presentation followed by a question-and-answer session. I would now like to hand the conference over to Chang You, Investor Relations Director of iQIYI. Please go ahead. Thank you, operator. Hello, everyone, and thank you for joining iQIYI third quarter 2023 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 Mr. Yu Gong, our Founder, Director and CEO; Mr. Jun Wang, our CFO; Mr. Xiaohui Wang, our CCO, Chief Content Officer; Mr. Wenfeng Liu, our CTO; Mr. Youqiao Duan, Senior Vice President of our Membership Business and Mr. Xianghua Yang, Senior Vice President of Overseas. Mr. Gong will give a brief overview of the Company's business operations and highlights, followed by Jun, who will go through the financials. After the prepared remarks, the management team will participate in the Q&A session. Before we proceed, please note that the discussion 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 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 statement, except as required under applicable law. I will now pass on to Mr. Gong. Please go ahead.

Yu Gong, CEO

Hello everyone. Thank you for joining us today. Our focus for the quarter remains firmly on generating high-quality growth, achieving strong results in both revenues and profits. Our total revenues grew 7% year-on-year, while profit performance was far more remarkable. Gross profit and non-GAAP operating profit had annual growth of 23% and 71%, respectively. The impressive financial results demonstrate the strength of our robust operating leverage built by exceptional content, which gives us a competitive advantage. iQIYI is the natural brand for our top-tier content. According to Enlighten data, we have been leading the industry in drama viewership share for seven consecutive quarters. Our original dramas remain a key driver for content supply and revenue contribution. Meanwhile, our diverse range of high-quality titles premiered were highly acclaimed by users. Notably, The Lotus Casebook was the 10th drama in our history to break the 10,000 Popularity Index score. During the quarter, membership services revenue grew by 19% annually, mainly driven by a 12% annual increase in ARM (Average Revenue per Member). Two key factors contributed to the revenue growth. Firstly, driven by the high appeal of our inclusive content, we have reduced the discounts provided for membership purchases directly on the channel sales. Our content is compelling enough to drive purchasing decisions on its own. Secondly, we have upgraded our member benefits and alternatives, resulting in increased value perception among our members and a boosted membership retention rate. The enhanced member benefits encompass a wide range of upgrades. For example, we optimized the viewing experience from mobile devices to large-screen TVs. Members can now enjoy content in stunning 4K, 8K, and even indulge in proprietary audio-visual experiences. The audio experience is equally enhanced with a shift from ordinary stereo sound to immersive and captivating industry-leading sound, and our member perks don’t stop there. We go beyond the online realm, extending our offering to exciting offline experiences such as exclusive concerts. These upgrades have transformed entertainment, providing users with diverse, personalized, and immersive experiences. We are very pleased to see users' appreciation for our content and services translates into our growth. Alongside membership services, advertising revenue was our second growth driver during the quarter. Our premium content and enhanced marketing capability drove up advertising revenue by 34% annually and 12% sequentially. Both brand ads and performance ads booked annual and sequential net growth. Entering into Q4, we are cautiously monitoring the macro environment's impact on the advertising market. We will upgrade our marketing capabilities to weather potential challenges as we continue to seek out new growth opportunities in the future. Now, let's dive deeper into the performance of our core business segments, starting with membership services. In the third quarter, Membership services revenue exceeded RMB5 billion for the second time in our history, representing a strong annual increase of 19% driven primarily by ARM growth. We would like to reiterate that the primary goal for our membership services is to drive long-term and sustainable revenue growth. Membership revenue is driven by three components, mainly on subscriber lifetime and subscriber base. Subscriber lifetime is our current key focus in driving the long-term economic value of membership services. In the third quarter, ARM reached RMB15.54, up 12% annually and 5% sequentially. The average daily subscriber increased by 6% annually to 107.5 million. The current ARM level, in our view, is still very affordable compared with the price of other consumer products. We will continue to drive sustainable ARM growth over the long term backed by several factors. First, as we just mentioned, membership purchase decisions are increasingly being made based on content and member benefits rather than on discounts. Very importantly, our ability to consistently deliver high-quality premium content will be further improved. Second, our member experience offers compelling value for the members. We will continue enhancing our offering with new value-added services that increase members' value perception and willingness to pay, such as express packages, exclusive content, and merchandise offers. Finally, we see significant potential to further upgrade existing Gold members to Platinum and Diamond membership tiers, which command a higher price yet offer more privileges. Our member privileges and benefits have proven to be highly attractive, and we expect their appeal to remain strong. For example, the exclusive product packages, one of the content privileges we developed for members, enables subscribers to redeem their points to unlock early access to the latest episodes of hit drama series. This model was applied to two dramas in the third quarter, attracting over 10 million participating members, demonstrating the significant value of perception attached to these benefits, in line with our strategy to foster deeper connections between our loyal members and all premium content from IP derivatives. Cloud concerts are another important component of our membership offering. We have the materials for The Lotus Casebook's theme concert, which created immersive excitement. Lastly, we have developed a dedicated e-commerce platform for merchandise related to our IPs. Members can use their member points to pay for these items, either in full or in part. As discussed repeatedly, our primary focus is on enhancing member loyalty, retention, and lifetime value through our membership privileges and benefits. Our loyalty program is closely tied to the duration of membership, and we strive to improve service experiences and value perception, especially for our long-term members. For instance, users who have auto-renewed two long-term plans or become premium members receive greater benefits, including faster accumulation of member points that can be redeemed for content-related perks and merchandise. As a result, we observed meaningful year-over-year growth in both the quality and proportion of annual plan subscriptions in the third quarter. Moving on to content. Content is our core competitive advantage. iQIYI original dramas continue to be the main driver in terms of content supply and revenue contribution, accounting for over 68% of the key dramas launched in the third quarter. For this year's summer season, our drama line-up covered diverse genres such as Asian customs, reality, and suspense, with the Asian customs detective drama The Lotus Casebook becoming the dark horse hit of the summer. It was our 10th drama to break the 10,000 popularity index score, and the drama's theme concert generated over 230 trending search topics and attracted over 320 million likes. We are happy to see the significant long-lasting impact with sales, as it continues to dominate the Enlighten list even after its series' finale. Other key drivers, such as Asian customs suspense serials, My Journey to You, Intelligent in Perfect Victim, and The Lost 11th Floor were all well received by audiences and reflect the quality and depth of our drama lineup. For various shows, sequels to all classic IPs, such as the 3rd season of The Big Band and Housework Talent made strong impacts. The Big Band 3 achieved outstanding performance in both advertising and membership revenue. We also launched diverse innovative new IPs, including our very first variety show and the drama crossover As You Wish Love You Seven Times. Our cultural variety show Glory is Back Beijing and the engaging show, Let's Barbecue, attract a wide variety of users. On a separate note, we are also making good progress in realizing the commercial potential of our IPs. Notably, sales of The Lotus Casebook merchandise exceeded RMB18 billion. We have also introduced merchandise based on our original children's IPs, spanning the full range of children's products, including daily life and learning for offline entertainment. Turning into Q4 and next year, we are committed to delivering diversified and high-quality content on a continuous basis. We have a highly anticipated slate of dramas aside from the already launched hit titles such as Long Run of Story of Kunning Palace, Zhu Ruibin. We also have a stellar drama pipeline to be released. This includes major Asian customer titles Journey to Love and the Chinese Palatine, as well as modern-day themed dramas like Detective Chinatown Season 2, The Lonely War for variety shows. Our pipeline covers a wide range of themes, including our first original physical competition show, We Never Stop, and our hit show, Hi, Young Farmers. We also have an exciting lineup of children's cartoon animation. For original children's cartoons, we are going to debut the second half of Deer Squad Season 3 and our brand-new title, MEGA Mail. After trading trends, new athletes such as the sci-fi series The 5th game and the upcoming adaptation of Magic and Groceries are set for release. Moving on to the advertising business, we are delighted to see accelerated recovery during the third quarter. Total advertising revenue reached RMB1.7 billion, up 34% annually and 12% sequentially. Revenue from brand ads recorded double-digit growth both annually and sequentially, driven by several factors, notably our premium original content such as Big Bands Season 3 and Love You Seven Times, which attracted stronger advertising demand. Advertising budgets are allocated towards shows that performed well, and the drama increased by 67% and 28% year-on-year, respectively. Breaking it down by sector, we saw increased ad budgets from food and beverage, while sectors like internet services, transportation, and healthcare also recovered. Revenue from performance ads recorded strong annual revenue growth of over 78%, mainly due to two factors. First, targeted and efficient operations gained higher budget share from sectors such as internet services and e-commerce. Second, the effective use of generative AI-enhanced ad creation and ROI. Looking ahead to Q4, we are cautiously monitoring the overall advertising market. We acknowledge that the consumption segment takes time to fully bounce back, operating a lagging effect on brand advertising business. Nevertheless, based on our unparalleled content quality and extensive user profile, we are the go-to platform for advertisers seeking optimal advertising opportunities. For performance ads, we are optimistic about sectors such as internet services, e-commerce, and the show drivers. We will continue to fine-tune our algorithm and leverage generative AI to enhance ad creation and maximize efficiency. Moving on to technology and products. Our commitment is centered around fostering technology innovation to empower the entertainment ecosystem, creating value for our users and content creators. Firstly, we harness the power of technology to elevate the entertainment experience for our users. Secondly, we empower our content creators by equipping them with the latest tools and resources to improve the quality and efficiency of their creations. Our focus on leveraging AI to enhance the user experience has yielded significant progress. Notably, we have pioneered the use of generative AI in three key search categories: character search, AI Search, and actual search. By applying advanced content analysis, we are now capable of automatically generating video clips and drama highlights. This cutting-edge technology has been applied across hundreds of core dramas on our platform, greatly improving accuracy and user engagement. Users directed to a drama from AI-powered search spend an average of 40% more time viewing the content. One more exciting user experience optimization is the introduction of Karaoke mode in The Big Band 3. This innovative and interactive feature seamlessly integrates lyrics into the on-screen display during band performance sessions, allowing viewers to sing along and creating a more immersive experience, with meaningful viewer engagement. The time spent by users activating this feature has increased significantly. In terms of content production and operation, we are promoting the application of generative AI in various use cases during the rapid technological development of the video industry. The role of generative AI is evolving from embedded tools to co-pilot systems in every phase of workflow. By leveraging this transformative technology, we are empowering creators throughout their work, from planning and development to production and promoting content. This approach not only enhances efficiency but also unlocks new potentials. We are seeing great initial results. For example, we use generative AI to produce low-cost, high-quality posters and visuals to showcase our content. We have applied this technology in promoting our key programs, such as testing Chengdu, and The Big Band Season 3 as a platform. Finally, regarding our business performance in regions outside of Mainland China. Our premium content continues to win acclaim from overseas users and drive steady growth in overseas membership revenue. In the third quarter, membership revenue in Japan, Korea, the U.S., and Hong Kong all increased by over 50% annually. The solid performance was driven by the rising influence of our high-quality content powered by a number of popular titles; the total viewing time for Chinese dramas on our overseas platform increased by 23% annually and 33% sequentially in the quarter. My Journey to You achieved the highest revenue on our overseas platform during its broadcasting period. Meanwhile, The Lotus Casebook’s popularity remains strong in Mainland China, and it topped our overseas platform in both total video views and viewing time in the fourth quarter, ranking number one in total video views in the Southeast Asia, East Asia, and North American markets. For the fourth quarter, we will continue to drive high-quality growth in addition to enhancing platform cooperation and channel expansion. We are dedicated to bolstering our content pipeline to capitalize on the strong momentum of Chinese dramas while introducing localized drivers in Thailand, Malaysia, and Taiwan to further expand our influence. In summary, we have accomplished strong results in the third quarter with a strong emphasis on delivering high-quality growth. As we look ahead, our dedication to enhancing user experience, strengthening our competitive edge in original content, maximizing member value, and harnessing the power of advanced AI technology remains steadfast. Going into next year, we will cautiously increase investments in both our core and innovative businesses to establish a solid foundation for sustainable long-term growth.

Jun Wang, CFO

Thanks, Mr. Gong, and hello, everyone. We have delivered a strong Q3 result as you can see. The growth of ARM drove the growth of the membership services revenue, profits, and free cash flow, and our operating leverage led to margin expansion on a year-over-year basis. This demonstrates the dependability and scalability of our business model. Now, let me walk you through the key numbers. The total revenue increased by 7% annually to RMB8 billion, driven by growth in both membership service revenue and online advertising service revenue. Membership service revenue exceeded RMB5 billion, up 19% annually, primarily driven by the increase in ARM. Online advertising revenues reached RMB1.7 billion with an annual growth rate of 34%. This was fueled by the growth in both brand and performance ads, with performance ads showing stronger growth momentum. Now moving to the costs. Our quality costs and expenses remained relatively stable year-on-year. Total cost of revenue was RMB5.8 billion, up 2% annually. Content cost as a component of cost of revenue was RMB4.2 billion, down 3% annually. Total operating expenses were RMB1.4 billion, down 2% annually. Turning to profits and cash flow, the non-GAAP operating income reached RMB895 million, up 71% annually, positive for seven consecutive quarters. The free cash flow reached RMB826 million and has been positive for five consecutive quarters, representing our enhanced cash-generating capabilities. At the end of Q3, the company had cash, cash equivalents, restricted cash, short-term investments, and long-term restricted cash included in the prepayments and other assets, totaling RMB7.2 billion. To conclude, our Q3 results reflected a strong execution of our strategy and steady progress in driving high-quality growth. We are dedicated to delivering long-term value to all of our stakeholders. For detailed financials, please refer to our press release on our IR website. Now we will open the floor for Q&A.

Xueqing Zhang, Analyst

Thanks, management, for taking my question, and congratulations on another strong quarter. My question is about ARM and ARM has quite a solid growth for this quarter. So, what's your outlook for ARM in the first half and next year? Also, could you provide more color on how to improve your perceived value and the loyalty of membership? Thank you.

Yu Gong, CEO

Thank you. Youqiao will answer this question.

Youqiao Duan, Senior Vice President of Membership Business

Yes. For Q3, the ARM exceeded RMB15 within our expectations. And this is due to our progress in content quality and membership privileges for the long-term. The result has been promising, and more users have been willing to pay a reasonable price for premium content and quality services. We expect healthy growth in ARM to continue in Q4 with significant room for further improvement in the long-term. Our confidence comes from four aspects. Content quality remains the primary determinant for our members' purchase decisions, and our ability to consistently provide high-quality and diversified content is continuously strengthening. Second, compared to other domestic daily consumer goods and similar products abroad, our current prices are relatively low. Third, with the growing demand for watching content on large TV screens, an increasing number of Gold members are upgrading to Platinum and Diamond membership levels. Fourth, the introduction of more member privileges and benefits, such as loyalty points, express packages, cloud performances, member-exclusive e-commerce items, and IP merchandise, will continuously enhance the attractiveness and long-term value for members. All of the above four items I just mentioned give us confidence that ARM will continue to have healthy growth in the future. Furthermore, due to our relatively low pricing base, the absolute impact of ARM growth on user perception is relatively small. What users care about the most is still the quality of content and the user experience. We have seen rapid increases in member conversions with the launch of recent premium content. This indicates that our strategy of leveraging quality content and user experience to enhance ARM and long-term member value is correct and has gained user recognition, leading to sustainable growth in membership revenue. We will continue to pursue this direction.

Lincoln Kong, Analyst

So, my question is at this time juncture of the year, when we think about the next, what is our overall business plan, strategy, outlook, and focus area for next year? Thank you.

Yu Gong, CEO

For next year, for 2024, based on the current macro environment and our current performance so far, our goal for next year is still aiming for high-quality growth. High-quality growth means that revenues and profits will both grow, and profits will grow at a faster pace. Secondly, we will cautiously appropriate increased investments in our core business to promote long-term growth. Specifically, we will reasonably allocate more investment in top premium content to enhance our core membership business performance in ARM, member lifetime, subscriber base, and also drive performance in advertising business. Thirdly, we will continue to explore the implementation of innovative technologies centered on generative AI. There are two sides that will benefit from this; on the B2B side, we'll increase investments in intelligent production to improve the industrialization and efficiency of the video industry. On the B2C side, we'll explore new services and even new business models to cater to consumer needs. Hopefully, this will become the second or third new growth pillar going forward in the long term. The other two innovative and new growing businesses, such as the overseas business and iQIYI Light, if we can maintain profitability in these segments, we hope to grow revenue performance next year.

Daniel Chen, Analyst

Thanks, management for giving me the opportunity to ask questions. My question is on the content cost and content strategy. Could management please elaborate on what's our content strategy going forward and also the content spend outlook? Thank you.

Xiaohui Wang, CCO

Our goal for the future remains to consistently deliver high-quality and diverse content, solidifying our core advantage in drama genre while seeking breakthroughs in other content categories. For 2024, in terms of the drama category, while maintaining a stable overall number of releases, we will focus on increasing investment in top-tier projects, which we normally call S and A+ ratings. Continuing to produce high-quality content is our number one goal. In Q1 of next year, we will launch a new season of Ms. Theater, a highly anticipated S Grade production, strengthening our competitive advantage and making a strong kickoff for the year. Based on iQIYI's Popularity Index Score, we have already seen four dramas this year that have exceeded the significant milestone of 10,000 scores. We anticipate that performance for next year will be better than this year. Regarding variety shows, while keeping content costs relatively stable, we will increase the number of programs and upgrade our production team. In addition to the already market-proven, multi-season variety shows, several innovative projects will be gradually introduced starting from Q4 this year, such as our original physical competition show We Never Stop, which will be launched at the end of November, and we have internally high expectations for that. In terms of business models, we will explore monetization models beyond advertising, membership, and IP derivatives, as well as explore more IP development opportunities throughout their lifecycle. For movies, we will increase investment in films made for online distribution and top-tier content feature films while further optimizing the operating models for online films, theatrical releases, and our cloud cinema. For tourist content, we will appropriately increase investments, strengthen the influence of our multi-season IPs, and increase commercially-oriented original content as well as expand user-generated content. Our primary objective will be increasing revenue growth potential, expanding IP licensing, and exploring additional revenue potential such as toy licensing, etc. As for animation, the third quarter was the best quarter we have had for original animations. We are confident in further increasing investment in original content next year and expect a moderate increase in the number of original titles.

Thomas Chong, Analyst

Thanks management for taking my questions. May I ask about our overseas outlook as well as our strategies? Thank you.

Unidentified Company Representative, Representative

Our overseas business started in 2019 and encountered the outbreak of COVID, which led us to adjust and slow down our progress over these three years. However, through these three years of exploration, we have also achieved fruitful results. Firstly, we have validated our business model. Although our overseas business is still small in scale, in 2023, we forecast to achieve revenue growth and profitability. We have experimented in different markets and identified the methods for growth and profitability that can be gradually replicated in other markets. Secondly, we have validated the influence of iQIYI's original content overseas, establishing our core competitiveness. Our goal is to establish our overseas platform as the home of beloved Asian content, with iQIYI's original Chinese dramas being our most evident advantage. Over the past years, Chinese dramas have witnessed significant growth in viewership in certain markets, and we have seen the potential of this growth. Lastly, we began to build a comprehensive ecosystem in key countries, including cooperation with local regulatory agencies, content partners, and channel partners. Through these collaborations, we have already launched exceptional local drama content. We can bring outstanding content and culture from all over the world to iQIYI users in China and around the world through our global network. These advancements have inspired us significantly. Building on these three achievements, we aim to strengthen collaboration with partners around the world, using content as a medium and leveraging technology platforms to facilitate cultural exchange and explore new commercial opportunities. We will continuously empower and add value to everyone in our ecosystem.

Maggie Ye, Analyst

Thank you, management for taking my question. My question is about the advancements we made in the application of generative AI technologies at iQIYI. I'm particularly interested in understanding the results we have already achieved in terms of improvement in business efficiency as well as cost structure. I also want to learn more about management's perspective on the long-term impact of these technologies. Thank you.

Wenfeng Liu, CTO

We believe that generative AI will have a significant impact on the entire video industry in the next three to five years, bringing significant changes in production methods, cost structure, and personnel structure. Currently, iQIYI has already started implementing generative AI in core areas such as content planning, development, production, and promotion. We have achieved a certain level of productivity in four major application scenarios: text, image, sound, and video. This has helped creators improve quality, optimize efficiency, and reduce costs. For example, regarding content planning, we have used generative AI to compress the time required for feedback on project assessment processes from several hours to a few minutes. In the development phase, the use of generative AI has reduced the time required for manual reading from three to four days to about one hour. The accuracy of scene and character breakdowns exceeded 90%. In the production phase, producers have effectively saved on design and production costs by using generative AI tools to generate character sketches and concept posters. In the promotion phase, high-quality posters and dynamic videos generated by generative AI have been applied in on-platform operations and off-platform advertising for key projects such as The Big Band 3. In addition to content production, we also utilize AI-generated creative tools for effective advertising material production. Some industries have seen a 200% increase in ad spending compared to before the use of AI, while other campaigns using AI-generated materials have also experienced a 60% higher rate of investment compared to non-AI materials. In the future, we will continue to explore more business scenarios and application opportunities, fully leveraging the capabilities of generative AI to create even greater value.

Chang You, Investor Relations Director

Thank you everyone for participating in today's call and please do not hesitate to contact us if you have further questions. Thank you. Bye-bye. We will see you next quarter.

Operator, Operator

Thank you. The conference has now concluded. Thank you for attending today's presentation and you may now disconnect.