Which should you invest in, Google or Netflix?

From Motley Fool US headquarters, May 22, 2019 post

Netflix (ticker: NFLX) and Alphabet (tickers: GOOG, GOOGL) have established dominant positions in their respective markets.

Netflix continues to expand its video streaming content and is attracting millions of new subscribers.

Google, the leader in internet search, offers a wide range of services such as Gmail and YouTube, and according to the research firm Brand Finance, Google is the world’s third most valuable brand.

Today we compare the two companies based on current stock prices.

Netflix: Content is Everything

The allure of Netflix stock may lie in its ability to raise service prices.

The company has raised prices several times over the past decade, yet paying subscribers have continued to grow from 41.43 million in 2013 to 1.4886 hundred million in the latest quarter.

With price increases, Netflix continues to invest in original films and TV dramas, which attracts more paying subscribers and drives revenue growth. Shareholders also reap the benefits.

However, content costs rise with its overseas expansion.

Last year the company paid $13 billion for content-related costs, and it plans to spend a further $15 billion this year.

Thus, Netflix needs to continue raising prices.

Price increases alone are not enough.

In recent years Netflix has raised prices several times, but to fund growth it has taken on an additional $10.3 billion in debt.

Netflix remains profitable, with an operating margin of 10.2% in Q1 and an expected 12.5% in Q2.

However, free cash flow has fallen sharply, posting a $3 billion loss in Q1.

In addition, there is debt burden to manage.

The cash-flow deficit is a stepping stone for overseas expansion, so cash conditions are expected to improve going forward.

And management is gradually prioritizing profit generation.

Still, the stock trades at a trailing P/E of 125x, already pricing in future growth.

Google: Data Is Everything

Google’s services continue to generate substantial cash.

Alphabet generated $25.5 billion in free cash flow over the past year, held $113 billion in cash, and has only minimal debt.

With this financial position, Alphabet has ample room to pay dividends, buy back shares, and invest in new areas.

Alphabet allocates billions of dollars annually to data centers, and data collection acts as an engine to accelerate all businesses.

By leveraging data, maps and photos and other services become more convenient, attracting more users.

And as users generate more data, Google analyzes it to further enhance services.

This virtuous cycle supports rising advertising revenue, which accounted for 85% of Alphabet’s revenue last year.

Google’s core platforms (Android, Chrome, Gmail, Google Drive, Google Maps, Google Play, Search, YouTube) each maintain over one billion monthly active users.

Although growth has slowed in recent quarters, over the past five years revenue more than doubled to reach $142 billion.

Which to Choose?

Netflix’s growth is faster than Alphabet’s, and in the near term the gap is widening.

This year Netflix’s revenue growth is projected to be 28% supported by price increases, while Alphabet’s growth is expected to be 17%, down from 23% last year.

Netflix (blue) vs Alphabet (orange) Revenue Growth (%, trailing 12 months)

Source: YCharts. As of May 21, 2019

Meanwhile, profitability is higher for Alphabet, with current operating margin at 23%, while Netflix is at 9.74%.

However, Alphabet’s operating margin growth is slowing, while Netflix’s margin is improving.

Netflix (blue) vs Alphabet (orange) Operating Margin (%, trailing 12 months)

Source: YCharts. As of May 21, 2019

Note that Alphabet’s margin decline is not necessarily a bad thing.

This suggests that new, lower-margin areas are beginning to emerge.

Alphabet maintains broad competitive advantages through its customer-retaining service models and the strength of the Google brand.

Analysts expect a 15.75% compound annual growth rate in profits over the next five years.

Netflix could accelerate growth, but considering its weaker financial position and the entry of Apple and Walt Disney into the streaming space, investors should question whether the current elevated price justifies the potential returns.

Netflix is currently trading at a forward P/E of 103x, so buying Netflix stock might be reasonable to wait for clearer signals in the streaming industry.

Meanwhile, Alphabet’s forward P/E is 23.7x, and its PEG ratio (P/E divided by earnings growth rate) is 1.50x, lower than Netflix’s 2.26x.

Therefore, at present, Alphabet stock is considered superior.