iQiyi Lost 3.7 Billion Yuan in a Year and Is Now Filing to Go Public — 9 Charts on China's Online Video Business

iQiyi's nearly 100-page prospectus discloses detailed financial and operating data for the first time.

In its eighth year online, iQiyi is finally being spun out of Baidu to go public on its own.

On February 27, iQiyi formally filed its prospectus with the U.S. Securities and Exchange Commission (SEC), planning to list on Nasdaq and raise US$1.5 billion under the ticker "IQ."

iQiyi is generally regarded as China's most successful video site. Behind the country's three largest video platforms — Tencent Video, Youku Tudou, and iQiyi — sits a fight that Tencent, Alibaba, and Baidu have waged from the start.

But the video business in China is much older than iQiyi — it is roughly as old as Taobao. By 2010, when iQiyi had just gone online, the leaders of the earlier generation of video sites had already listed: Ku6 was bought by Shanda in 2009 and taken to Nasdaq; LeTV listed on China's ChiNext board in 2010; two years later Youku and Tudou merged into Youku Tudou Inc. and listed in the United States. Back then nobody was saying "BAT" yet.

None of those listed video sites survived. Dragged down by Ku6's huge losses, Shanda delisted in 2011; Youku Tudou delisted in 2015 and was bought by Alibaba; LeTV today is a joke.

iQiyi is the most successful player in the industry's second attempt. Over the past three years, both original content and the new paid-subscription model at Chinese video sites started with it.

In Quest Mobile's ranking of Chinese internet apps by average monthly use per person, Tencent Video, iQiyi, and Youku place fifth, eighth, and ninth. Video apps, like WeChat and Alipay, have become part of the plumbing of daily life.

But the video business has never made money, and China's three richest companies keep pumping in cash to keep it alive.

That makes iQiyi and the prospectus it filed with the SEC unusually useful reading. The document runs to nearly 100 pages and is the first time iQiyi has disclosed its finances and operations in detail. What it shows is not just how iQiyi runs, but the bind China's whole online video industry is in.

iQiyi's revenue is growing fast, but its cost of revenue is rising almost in step

The prospectus says iQiyi's total revenue in 2017 was 17.378 billion yuan, up 54.65% from the year before. For comparison, Weibo — also US-listed, also dependent on advertising — took in only about 7.3 billion yuan last year.

Revenue grew faster still in 2016, by 111.3%. iQiyi's 2017 revenue was more than three times what it was two years earlier.

But spending grew just as fast. "Cost of revenue" accounts for 80% of total operating expenses, and over the past three years it has even exceeded total revenue. It rose 52% year on year — the same pace as revenue.

That keeps iQiyi permanently in the red, and the hole keeps getting deeper. Total losses in 2017 were 3.736 billion yuan, up 21.54%, faster than the previous year's 19.38%.

As the prospectus explains it, "cost of revenue" is mostly content costs — the money iQiyi spends buying rights to films and TV series and funding its own productions — plus a share for bandwidth.

iQiyi also broke out its content costs: 12.62 billion yuan in 2017, up 67.3% from the year before. In other words, iQiyi has to spend about 70% of its total revenue every year — a share that keeps climbing — just to keep enough new content on the platform to hold on to the users it has and draw in new ones.

Per monthly active user, iQiyi pays nearly 30 yuan in content costs, up from 18.6 yuan a year earlier. For every yuan of revenue a paying user brings in, iQiyi spends 1.93 yuan on content.

iQiyi's total user numbers have stopped growing; revenue growth comes mainly from a rising share of paying users

Broken down by source, iQiyi's main business is online advertising.

Last year advertising brought in 8.16 billion yuan, up 46.9%, or 47% of total revenue. Second was paid membership, which generated 6.536 billion yuan over the year, 37.6% of the total.

Like Baidu, iQiyi launched feed ads in the fourth quarter of 2016, which drove the growth in ad revenue.

But the main business is shifting toward paid membership. Advertising and membership are trading places: two years ago ads were more than 60% of revenue and paid membership less than 20%.

iQiyi's total user count has stalled. Monthly active users grew just 4% from 2016 to 2017 and sat at 400 million. Daily visitors held above 120 million.

What drives iQiyi's revenue growth is turning more of those users into paying ones.

In 2017, iQiyi had 50.8 million paying users, while 126 million people opened iQiyi every day — about 40% as many.

Count in the less frequent users, though, and paying subscribers are only 12% of the 421 million people who open the app in a given month. That ratio is four times what it was in 2015.

Gong Yu said in a 2017 interview that "once the model matures, in three or four years," advertising, membership, and other businesses such as gaming will each account for a third of revenue.

iQiyi launched paid subscriptions back in 2011, but in the first four years it won only 5 million paying users. Growth took off in 2015, after iQiyi let paying members watch a whole season of 《盗墓笔记》(The Lost Tomb) in one go. In the single year from 2015 to 2016, the number reached 20 million.

That gave the whole video industry a new place to grow. According to the China Netcasting Services Association's "2017 China Online Audiovisual Development Report," more than 40% of domestic online video users had paid for video content by 2017. They are also paying more: the share of paying members spending over 40 yuan a month rose from 20.2% in 2016 to 26.0% in 2017.

The other 60% of video users have never paid, so for the foreseeable future paid conversion should keep delivering growth for iQiyi and its rivals. Open any video site today without a VIP membership and you are scraping by: you sit through ads, and the popular titles keep nudging you to buy a membership to watch.

By iQiyi's own forecast, paid membership will bring in 73 billion yuan by 2022, more than ten times today's figure.

One less encouraging sign: the marginal return on a paying user has stalled. Each one now contributes 128 yuan a year, only 4 yuan more than last year.

At 128 yuan, that is about half of iQiyi's annual membership price — which suggests a good share of those 50.8 million subscribers do not pay for a full year.

Do the math and each iQiyi paying user watches 1.7 hours of video a day and brings in 0.35 yuan

With a similar streaming model, iQiyi has called itself China's Netflix on various occasions. Some of the two companies' numbers really are close.

The number of people who watch video on iQiyi every day is 126 million; Netflix has more than 110 million people paying monthly. By user count, iQiyi is actually ahead.

The average iQiyi user watches 1.7 hours of video a day; by a figure Netflix has published, its average user watches 1.25 hours a day. On watch time too, iQiyi is ahead of Netflix.

But the two count users differently. iQiyi has free users, with paying users making up around 50% of the total, while Netflix, promotions aside, has nothing to watch for free.

As of the third quarter of 2017, each Netflix user brought in US$22.59 (about 143 yuan); per iQiyi's prospectus, each paying subscriber brought in 124.6 yuan. The difference lies behind the revenue: one company is making money, the other is losing it.

Netflix, now 19 years old, turned a profit on its overseas users in 2017 even while speeding up its global expansion. iQiyi is still in the red.

So iQiyi is worth far less than Netflix. iQiyi is currently valued at US$10 billion, while Netflix's market value has passed US$100 billion — a tenth as much.

Beyond video, iQiyi has tried livestreaming, gaming, web fiction, even a news app — none of it brings in much money

Advertising's share of revenue is shrinking, but it is still the fastest-growing business iQiyi has, and it will remain an important source of income.

Besides the two main businesses, the prospectus lists an assortment of side ventures that together make up 8.6% of revenue. It names livestreaming, gaming, and web fiction; these four businesses are the bulk of "other businesses."

iQiyi has tried more new businesses than that. In April 2015, five years after it was founded, iQiyi said it would go into video e-commerce; in 2016 it put 150 million yuan into Skyworth's Coocaa unit to get into internet TV. Later came a phone, and a news app called iQiyi Toutiao — none of it with much to do with film and television itself.

As late as 2016, Gong Yu was still telling the story of an iQiyi ecosystem built around intellectual property, a "pan-entertainment ecosystem": "In the business model, iQiyi corresponds to Disneyland or Universal Studios. We have video, we have online games, and we have the iQiyi Store, small as it is right now. Together they make a healthy ecosystem."

Netflix — the company Chinese video sites are forever compared with and copying — is nothing like that. It has been profitable ever since it turned to streaming in 2009, and apart from the early DVD-rental business it ran when network infrastructure left it no choice, it has barely touched anything outside video.

Original content has not produced a monopoly, and iQiyi cannot say when it will make money

iQiyi says its losses are growing more slowly than its revenue, which "gives us confidence in our future profitability" — though in the short term the costs are not coming down.

In the section on its outlook, the prospectus says: "We cannot provide an accurate forecast as to when we will achieve gross profit."

Note that this is gross profit, not net profit. Gross profit does not subtract costs a company cannot control, such as day-to-day operations and taxes. For iQiyi to say this of itself means net profit is further off still.

The direct reason is that two well-funded rivals are still in the market — unlike Netflix, which has all but cornered the United States and is now pushing abroad.

Describing its future strategy, iQiyi also says it needs to "enrich and expand our existing content library," which means content spending will keep rising.

How to squeeze the most revenue out of that spending? Original content is one answer.

The prospectus says that by the end of 2017 iQiyi had produced 141 original titles. Its in-house dramas date back to 2011, and in 2015 the number it made jumped from 6 to 16.

This has also pulled the whole industry back toward the simplest business model there is: charging users directly. Before original content became the focus, video sites spent their entire content budgets buying rights. Original content became a new weapon — using exclusivity to break out of a passive dependence on advertisers, and earning money directly by selling what no one else has.

Youku Tudou and iQiyi have each said more than once that they want to match or beat Netflix, which charges users a monthly fee on the strength of its own shows, and both say they will make more of their own.

iQiyi also spells out what it counts as original content: programs it produces and airs itself, plus rights it locks up through exclusive deals with partners.

Original content is written into the prospectus as a key strategy, and iQiyi says it makes shows that are "extremely popular and trend-setting." The bigger payoff is traffic: 《中国有嘻哈》(The Rap of China) drew more than 3 billion views, and 《盗墓笔记》(The Lost Tomb) drew 100 million in its first 24 hours and more than 4 billion in all.

Original content opened a second round of fierce competition among video sites, after the rights-buying wars. In the prospectus, iQiyi cites iResearch data to argue it holds more top-tier original programming than its rivals.

But look at more third-party data and iQiyi does not hold most of the top 10 spots for either web variety shows or web dramas by views. Original content has not produced a dominant player yet.

iQiyi is burning cash fast, but its rivals are in worse shape

Feeding its own dramas and its licensed library, iQiyi's cash and cash equivalents have shrunk year after year, down to 733 million yuan at the end of 2017 — half what it held two years earlier.

More of iQiyi's cash comes from fundraising than from operations; in 2017 the former was 1.6 times the latter. Most of what iQiyi spends on content and everything else, in other words, does not come from its own core business.

Burning cash is normal for all three video sites, and by comparison iQiyi is not the worst off.

Alibaba reports the profit and loss of its digital media and entertainment segment separately. That segment, which covers Youku, Damai, UC, music, and literature, lost more than 3 billion yuan in a single quarter, a loss rate of 70% — nearly as much as iQiyi loses in a year.

Sohu Video said in its fourth-quarter results last year that it had spent too much on video content for too little growth and had already written down the value of its video rights. From now on it would produce more of its own content and sharply cut what it buys from TV stations.

Regulatory uncertainty worries iQiyi too — the prospectus spends more than 100 lines on it

When Weibo went public in 2014, its prospectus also disclosed the risk of content censorship. Weibo happened to run into the "Cleaning the Web" campaign, which shut down accounts deemed illegal or noncompliant and fined the company as well.

Over the past year regulators have tightened their grip on online audiovisual content, and iQiyi's prospectus spends a long stretch on the trouble content regulation can cause.

The prospectus says: "Over the past year we have from time to time received phone calls and written notices from regulators requiring us to delete or restrict certain content the government deemed inappropriate or sensitive. The General Administration of Press and Publication, the State Administration of Radio, Film and Television, or the State Administration of Press, Publication, Radio, Film and Television may issue content lists from time to time, and we are required to monitor content uploaded to iQiyi and remove content that falls within the scope of these lists."

iQiyi adds that although it has built a content-monitoring system, an opaque regulatory regime makes the job harder: "Due to the ambiguity or uncertainty of the regulatory regime, such risks may persist. Although we have an internal content-monitoring system, we still face risks including suspension of licenses, contractual misrepresentation provisions, and liabilities associated with video publishers."

Because so little is disclosed, iQiyi is likely to find out it has broken a rule only after the fact, since "under China's legal system, some provisions of government policies and internal rules that are not promulgated in a timely manner, or not promulgated at all, can still have retroactive effect."

The online audiovisual rules issued over the past decade or so include these:

In 2009, the Ministry of Culture issued the "Notice on Strengthening and Improving the Review of Online Audio-Visual Content."

In 2014, the State Administration of Press, Publication, Radio, Film and Television restated that any foreign TV series or film must have approval from the relevant authorities before going live on a domestic platform.

In 2015, online platforms were barred from streaming foreign TV series and films that had not been registered with the relevant authorities.

Online games, too, must be filed with the State Administration of Press, Publication, Radio, Film and Television or the Ministry of Culture.

Last year iQiyi made the runaway web variety hit 《中国有嘻哈》(The Rap of China). After the broadcasting regulator ruled that hip-hop culture "promotes vulgar and unhealthy content," iQiyi never got the chance to turn the show into a brand that could keep earning through later seasons.

Things like this hit iQiyi's bottom line. A hit drives paying-user growth and creates advertising value, and the only marginal cost to iQiyi is bandwidth. But more and more content now vanishes without warning. 《余罪》(Yu Zui), a hit web drama iQiyi pushed hard, was pulled offline at one point; this February the popular web drama 《河神》(Tientsin Mystic) was suddenly taken down for "policy reasons."

The other regulatory risks iQiyi lists include applying for and renewing licenses, advertising review, and foreign-exchange controls.

Going public eases the pressure of relying on Baidu, but it does not end the war

iQiyi was set up with Baidu money, and Baidu has been its main source of funding ever since. In the prospectus, iQiyi says Baidu gave it steady financial support from 2010 until it began raising outside money in September 2014.

iQiyi's founding is tied to the "intermediate page" strategy Robin Li once proposed. An intermediate page sits between Baidu search and the final service on the path that distributes traffic. Put simply, Baidu wanted to use its grip on the search entry point to prop up its own champion in each industry, so that a user searching on Baidu would land on a Baidu-affiliated site — search for video and you get iQiyi, not Youku or some other rival.

The strategy started to fail when mobile internet took off in 2013 and users spent more and more of their time inside individual apps.

In May 2013, Baidu bought PPStream's video business for US$370 million and folded it into iQiyi. The merger helped iQiyi pass Youku Tudou in users and online views in 2014, making it the industry leader.

In its 2012 annual report, Baidu said that because iQiyi's business was expanding, it would start consolidating iQiyi into its own results. Since then Baidu's content costs have multiplied year after year, and bandwidth costs and depreciation on servers and other equipment have risen faster than before.

As iQiyi's paid-membership business grew, Baidu began charging it for bandwidth and operating costs in 2015 and for cloud services in 2016. The compulsory traffic-referral agreement the two signed in 2011 ended in January 2018. Per the prospectus, iQiyi borrowed 4.7 billion yuan from Baidu in 2016 at 4.35%, close to the market rate.

In February 2016 Baidu announced it would buy all of iQiyi's shares and take it private, with plans to raise money through an A-share listing, but the two sides could not agree because Baidu's offer was too low. Five months later Baidu withdrew the offer.

Instead, in February 2017, iQiyi completed a US$1.53 billion convertible-bond placement, of which Baidu took US$300 million. Other major subscribers included Hillhouse Capital, Boyu Capital, Runliangtai Fund, IDG Capital, the Everbright-IDG Industrial Fund, and Sequoia Capital.

In its fourth-quarter and full-year 2017 results, Baidu said iQiyi cut its profit margin by 11 percentage points for the year. At Baidu's current profit of 18.9 billion yuan and 22% margin, that works out to iQiyi costing Baidu about 9.4 billion yuan in a year.

For Baidu, spinning off its long-running cash burner should lift its own margin in the short run.

Over the past three years iQiyi's cash has shrunk and its debt has grown. Without more money from Baidu, it could not keep up with Tencent and Alibaba.

iQiyi says in the prospectus that it hopes to depend less on Baidu's money once it is public, drawing cash mainly from capital markets and commercial banks instead — though plenty of uncertainty remains.

The prospectus discloses that Baidu holds 69.1% of iQiyi, making it the largest shareholder; Xiaomi holds 8.6%, and founder Gong Yu holds 1.8%.

Nor will Baidu wash its hands of iQiyi after the listing: starting in February 2018 it began providing a five-year, interest-free loan of 650 million yuan.

Xiaomi's venture arm has put money in as well. In November 2014 Xiaomi made a strategic investment of 1.8 billion yuan in iQiyi. It has since sent traffic to iQiyi too — for a fee. In 2017 iQiyi paid Xiaomi 81 million yuan for that traffic.

Burning cash will remain the norm. Once public, iQiyi will have more money to spend fighting Youku and Tencent Video.

iQiyi plans to raise US$1.5 billion. At its 2017 loss of 3.7369 billion yuan, that covers close to three years without money worries. iQiyi says it will put 50% of the proceeds into content, 10% into technology and research, and the remaining 40% into operating expenses.

The problem is that being an independent company also means iQiyi has a few years to prove that the China's-Netflix story holds — that it can become a profitable company, or at least one flush with cash, rather than staying where it is now, spending 21.1 billion yuan to take in 17.4 billion.

With two deep-pocketed giants still in the ring, that will not be easy. Either someone gives up, or everyone keeps burning.

Startup founders like to say, modestly, that going public is not the finish line. For iQiyi that is exactly right.