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    Chinese streaming giant iQiyi is planning out an original movie business

    Yu Gong (center), founder and CEO of China-based iQiyi (IQ), rings the Opening Bell at Nasdaq MarketSite in Times Square with employees and investors in celebration of its initial public offering (IPO) on March 29, 2018 in New York City.

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    In a bid to increase revenues, Chinese video streaming platform iQiyi is aiming to focus on movies over the next two to three years.

    Often compared with Netflix, Beijing-based iQiyi became the biggest Chinese company since Alibaba's public offering to list in New York last year. The video streaming company offers both paid and free content — preceded by advertisements that can last nearly a minute or far longer.

    The $15.2 billion company has expanded from being a popular platform for streaming video to a brand known for its own drama series, variety shows and other content. But that development comes at a cost. On a year-over-year basis, iQiyi said it nearly quadrupled operating losses to 3.3 billion yuan ($483.5 million) in the fourth quarter of last year. It said its margin of loss for that period jumped to 47% from 19% for the same time in 2017.

    CEO Gong Yu told CNBC in an interview last week that the company's near-term priorities are producing original content and incorporating artificial intelligence. And in that drive for original material, iQiyi is focusing on movies, he said.

    "We plan to spend the next two to three years to see whether we can innovate in this industry," Gong said in Mandarin, according to CNBC's translation. "In other words, in the future, the leading top movies on iQiyi will be original productions by iQiyi. The first window of opportunity is still to screen them in movie theaters. The second window of opportunity is to show them on iQiyi, so as to maximize the total revenue."

    China has rapidly grown into one of the largest markets for movies in the world, raking in $9 billion last year and placing second only to North America at $11.9 billion, according to the Motion Picture Association of America.

    But just as growth in China's overall economy is slowing and movie theaters face challenges from online entertainment, the country's box office earnings have tapered off. Data from ticketing website Maoyan showed earnings grew 9% to 60.7 billion yuan last year, down from 23% growth a year ago. In the first quarter, Maoyan data showed box office earnings fell 7% from a year ago, despite release of blockbuster film "The Wandering Earth."

    On the other hand, the market for online videos is still growing.

    In the next five years, the so-called over-the-top subscription economy in China will be nearly as big as that of pay TV within the next five years, Wangxing Zhao, associate research analyst, S&P Global Market Intelligence, wrote in a report for 2019 published by the Asia Video Industry Association.

    "By 2022, China's aggregate (subscription video-on-demand) revenue will amount to an estimated 94.8% of its multichannel revenue, indicating an almost evenly divided pie between traditional incumbents and internet heavyweights," Zhao said.

    The bigger question will still be when content costs can fall, and we do not expect that to happen in 2019 as shows purchased last year were still expensive, and costs will be amortized this year

    David Dai

    senior analyst, Bernstein

    iQiyi, which is majority-owned by Baidu, ranks second in China's video streaming market in terms of online video subscriptions, with Tencent's video platform taking first place and Alibaba-backed Youku in third, according to Bernstein analysis of third-party data. As of March, iQiyi's app ranked eighth in China, with a penetration of 44.5%, slightly more than ByteDance's local version of TikTok, Douyin, according to a report from app data company Aurora Mobile.

    Tencent Video and iQiyi have just over 530 million monthly active users each, according to Questmobile data cited by Jefferies analysts Karen Chan and Ken Chong said in a May 10 report. They have a "buy" rating on the stock, and their base case projects iQiyi will break even on an operational level by fiscal year 2021, driven by a "meaningful addition of paying subscribers" — to 153 million next year — and lowered costs from a mix of originals and less spending on licensed content.

    iQiyi unveiled over 270 new projects at its annual conference in Beijing last week.

    Perks of a tech native

    Alibaba and other Chinese corporate giants entered the film industry several years ago. Still, iQiyi's background as a video streaming company gives it an edge, CEO Gong said.

    He said a movie that does well in theaters and online doesn't need costly wide-range shots or special effects, since the value of such features would be less apparent on smaller screens. What is most important for a dual-format movie, according to Gong, is a strong lead actor, who can then make ordinary street and office settings appear more vibrant.

    Using artificial intelligence is another way the company can reduce production costs and improve monetization, the CEO said.

    In addition to raising $2.25 billion at its IPO last March, iQiyi has since held two convertible note offerings, for a total raise of about $4 billion. The company is set to report first-quarter results this Thursday.

    Deep learning allowed AI technology to explode commercially at one go in 2017, so we have just started AI technology. Maybe in the next 8, 10, 15 years, we may enjoy the changes brought by AI technology.

    Gong Yu

    founder and CEO, iQiyi

    Elinor Leung, head of Asia telecom and internet at CLSA, said in a May 6 report that she expects iQiyi's operating losses will fall to 2.3 billion yuan in the first quarter. She also expects the cost of content to decline to 88%, and drop further to 75% this year with a slew of new original content and a cap on celebrity salaries due to regulation.

    She projected that subscription revenue will increase 60% year-on-year to 3.4 billion yuan, and that the company will gain 14 million new paying users, bringing the total count to 96 million.

    For Gong, iQiyi is the fourth internet company he has overseen. During the dotcom boom of the late 1990s and early 2000s, Gong founded and led real estate search engine, which was then sold to search engine Sohu. He held executive roles, including that of chief operating officer, at Sohu until 2008. Gong was also president and chief officer of mobile internet solutions company, before founding iQiyi in 2010.

    The tastes of Chinese consumers haven't changed much over the last 10 years, Gong said. Rather, he emphasized their greater desire for quality entertainment, as exhibited in faster-than-expected growth of paying members in roughly the last 12 months.

    It's still unclear how quickly iQiyi's efforts to build different revenue streams can offset the company's cash burn.

    "The bigger question will still be when content costs can fall, and we do not expect that to happen in 2019 as shows purchased last year were still expensive, and costs will be amortized this year," David Dai, senior analyst at Bernstein, and his team said in a May 6 report. They rate the stock as "underperform."

    Whether in its push into movies or other channels, the biggest challenge for iQiyi in the future will be its ability to produce original content, said Gong, who downplayed piracy as no longer being a major problem. The company is already testing ways to use artificial intelligence, augmented reality and virtual reality to make interactive content – and releasing hardware such as VR headsets.

    But Gong said he expects it will take more than five years in order for the technologies to produce content that is clearly different than what is available today. "Deep learning allowed AI technology to explode commercially at one go in 2017, so we have just started AI technology," he said. "Maybe in the next 8, 10, 15 years, we may enjoy the changes brought by AI technology."

    — CNBC's Michael Bloom contributed to this report.

    Correction: This article has been updated to correctly show that a discussion of iQiyi's operating losses and margins of loss is comparing its results from the fourth quarter of 2018 to those from the same period in 2017.

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