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iQIYI: The Numbers Don't Add Up

With cinemas, museums, restaurants and bars all shut down along with much of the rest of the real economy, consumers have had far fewer options for entertainment. With more people staying in, streaming video platforms are getting a considerable boost in viewers. Yet, while Netflix Inc. (NFLX) may be enjoying the lockdown life, a prominent Chinese streaming company, iQIYI Inc. (IQ), has taken a serious hit. Specifically, some accusations have appeared claiming that the company has been exaggerating its numbers. Thus, investors should approach this name with extreme caution.


China's Netflix

Established in 2010 by Baidu Inc. (BIDU), China's largest search engine company, iQIYI, has established itself as the leading player in the domestic streaming content market. The company has been dubbed the "Chinese Netflix" by numerous U.S. market analysts and commentators, and it has enjoyed considerable growth. In 2018, iQIYI listed on the Nasdaq, raising $2.25 billion through the initial public offering.

While the Chinese streaming giant has seen considerable top-line growth, it has not posted a single annual profit in its decade-long history. This is partly by design. Like Netflix, iQIYI has eschewed profitability in favor of user growth and content development.

With more than 500 million claimed total users, including more than 100 million paid subscribers spending about 6 billion combined hours on its platform each month, iQIYI is unquestionably one of the largest online video sites in the world. Some analysts believe it may even become a rival to Netflix's global streaming content dominance. Looking past this rosy outlook, however, I find several reasons for concern lurking beneath the surface.

Questionable growth trajectory

On Feb. 27, iQIYI released its fourth-quarter earnings update. The company reported beats on both top and bottom lines, with $1.1 billion in revenue and an operating loss of $363.2 million. Revenue was up 7% from the same period in 2018, while the operating loss margin shrank from 47% to 34%. For the full year, iQIYI reported $4.2 billion in revenue. The full-year operating loss came in at $1.3 billion.

While iQIYI enjoyed considerable top line growth overall in 2019, this failed to translate to significant improvement to its bottom line. While revenue was up 16% for the year, operating loss margin barely improved, falling from 33% to 32%. That is not an encouraging result for the bull case, which maintains that volume (i.e., top line growth) will solve iQIYI's profitability problems in the long-run.

Paid subscriber growth also stalled in 2019, with iQIYI reporting just 0.7% growth in the fourth quarter, the lowest in its history. The company's advertising revenue was in even worse shape, down 15% from the year prior and still delivering negative gross margins.

Fudging the numbers

Things may be worse than they seem at iQIYI. Indeed, if the company's latest reported numbers are not terribly encouraging for the bull thesis, recent investigations from Wolfpack Research, a short-biased activist research and due diligence firm, is even worse. On April 7, Wolfpack Research published a scathing report on iQIYI based on extensive on-the-ground primary research, including 1,563 in-person surveys. According to Wolfpack's findings, iQIYI has seriously inflated its revenue and user numbers:


"We estimate IQ inflated its 2019 revenue by approximately RMB 8-13 billion, or 27%-44%...IQ does this by overstating its user numbers by approximately 42%-60%. Then, IQ inflates its expenses, the prices it pays for content, other assets, and acquisitions...We also obtained Chinese credit reports for all of IQ's VIEs and WFOEs since 2015. When compared to IQ's prospectus, we found that the deferred revenues reported to the SEC were inflated by 261.7%, 165.5% and 86.2% in 2015, 2016 and 2017... Based on the highest-end estimated value per non-exclusive episode provided by a former IQ employee involved in content acquisition, IQ would have needed to barter the licenses for ~3.9x and ~3.2x the total number of TV series episodes produced by all Chinese production companies to legitimately reach its reported barter revenues in 2018 and 2019, respectively."



The research behind Wolfpack's report was supported by Muddy Waters Research, a highly respected short-side market research organization. Muddy Waters concurred with Wolfpack's findings, concluding that iQIYI "fraudulently and materially overstates its users, revenues, acquisition consideration, and value of its 'barter' content."

Verdict

If the accusations leveled by Wolfpack Research and Muddy Waters Research prove to be even partly true, iQIYI's share price will likely suffer a severe correction. The stock dropped about 4% in the immediate wake of the research report, but soon recovered.

At time of writing, the share price stood at $15.80, which translates to a market capitalization of $11.6 billion. Clearly, there are significant growth expectations priced into this stock. Yet, even if Wolfpack's claims prove false, I believe there is substantial reason for investors to be concerned about iQIYI. Stalling user growth, falling advertising revenue and lugubrious bottom line improvement all serve to question the growth narrative fueling positive investor sentiment and buoying iQIYI's valuation. My recommendation to investors is to approach this name only with extreme caution.

Disclosure: Author is short Netflix.

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This article first appeared on GuruFocus.