Netflix (NFLX +0.14%) and Google's parent company Alphabet (GOOGL 2.00%)(GOOG 2.25%) are two high-quality companies that should continue to grow for a very long time. Netflix is the global leader in subscription video-on-demand (SVOD), while Alphabet is the global leader in internet search, online advertising, and a variety of other technology initiatives. But which one is the better buy?
The case for Netflix
Netflix had 183 million global subscribers at the end of March, including 70 million in the U.S. and Canada (UCAN) region, 59 million in the Europe, Middle East, and Africa (EMEA) region, 34 million in Latin America (LATAM), and 20 million in Asia-Pacific (APAC). The overall subscriber count grew by almost 16 million just in 2020.
The recent growth acceleration is due, in part, to the global COVID-19 pandemic, which has caused more people to stay home where they tend to watch more Netflix. That 16 million paid net subscriber additions blew away management's prior guidance for 7 million paid net adds.
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Some say this is as good as it gets for Netflix. On the first-quarter conference call, management even acknowledged that subscriber growth in the second half of this year will likely slow compared to last year's second half. After all, it noted in the company's shareholder letter:
Some of the lockdown growth will turn out to be pull-forward from the multi-year organic growth trend, resulting in slower growth after the lockdown is lifted country-by-country. Intuitively, the person who didn't join Netflix during the entire confinement is not likely to join soon after the confinement.
Even if that ends up being true, it doesn't take away from the company's enormous long-term global opportunity. There are 1.7 billion global households, excluding China, where Netflix doesn't operate, which should grow to roughly 2 billion in 20 years. By then, the vast majority of them will have sufficient internet connections to stream Netflix. And Netflix's ambition is to make highly relevant content for every culture and interest group around the world. That means the 183 million subscribers the company has may only be about 10% of its long-term subscriber opportunity.
In addition, Netflix has enormous long-term pricing power as it increasingly acts as an ad-free, on-demand replacement for linear television, which tends to be several times more expensive per month. That suggests tremendous revenue-growth potential over time.
As importantly, Netflix has serious long-term profit margin potential as a result of its scale and fixed cost content deals. Regardless of how many subscribers it has, Netflix still pays a fixed price for a given piece of content. While the company's content spending has ballooned over time, these fixed cost content deals explain why the company's content costs on a per-subscriber basis is up less than 1% over the last three years. At the same time, average revenue per subscriber ("ARPU") is up 26% over the same time period, which is justified by the rapidly improving service quality and amount of new content being released. That everwidening spread between revenue per subscriber and content costs per subscriber explains why Netflix's operating margins march higher by about 3% year after year.
The case for Alphabet
Alphabet's core search and ad business Google is one of the world's best businesses. For one thing, it has dominant market share of search in almost all markets globally. The estimated 88% market share Google has in the U.S. is actually below the estimated 90%-plus market shares it has in Canada, Mexico, Brazil, the U.K., France, Spain, Italy, Germany, Australia, and India.
The remarkable thing is there is nothing to prevent internet users from clicking over to another search engine. Google's dominant market share isn't due to some sort of artificial lock-in, but instead due to having a vastly superior search product. In fact, deep-pocketed competitor Microsoft invested billions of dollars in its search engine, Bing, trying to gain meaningful market share to no avail.
Last year, Alphabet's balance sheet included $135 billion of Google advertising revenue, which includes search, YouTube, and other Google-owned and third-party sites. eMarketer estimates the global digital ad market was about $333 billion last year, which implies Google had about 40% market share of the digital ad market. But eMarketer estimates the digital ad market will grow to $518 billion by 2023, which would almost assure continued strong growth for Google.
In addition, Alphabet has a variety of other promising "moonshot" ventures in its Other Bets segment, including autonomous car technology leader Waymo and life sciences unit Verily, among several others. The problem is these units are far from profitability and have been hemorrhaging cash for several years. As a result, Alphabet brought in third-party investors like Silver Lake Partners to help finance their ambitions. Waymo raised $2.25 billion of capital at an implied valuation of "over $30 billion," which was a massive discount to some of the Waymo valuation numbers that had been thrown around in recent years. For example, Morgan Stanley had previously valued Waymo at over $100 billion.
Lately, Alphabet has been dialing back hiring and discretionary spending as the COVID-19 recession creates tremendous uncertainty about advertising demand. This is accelerating the company's effort to achieve greater cost discipline, which was already under way. Eventually, Alphabet's core ad business will recover along with the economy and it should be a leaner, more profitable business.
The better buy
Both Netflix and Alphabet are great businesses that are almost certain to be much larger and more profitable in the distant future. Investors could buy and hold either business for several years and do well. But Netflix appears to have a larger long-term growth opportunity in its core business, considering its subscriber count is only about 10% of global internet households looking out 20 years and it has huge pricing power as evidenced by its mid-to-high single-digit annual ARPU gains. And Netflix has no peer in subscription video-on-demand ("SVOD") considering its $15-plus billion annual content budget, which dwarfs that of its competitors.
In contrast, Google already represents over 40% of the global digital ad market, which leaves limited opportunities for market share gains. In fact, Google has been losing digital ad market share to Facebook and Amazon.
The company's big push to get more efficient should help boost profitability over the next several years, which may be the right thing for the company to do. But a company's growth trajectory tends to slow when it realizes it has fewer high-return reinvestment opportunities than it previously thought. Netflix has those in spades with its global content reinvestment opportunity.
In addition, Netflix's business is getting stronger during this recession as more people stay home. In contrast, Alphabet's core business will be fine but it faces risks because advertising demand is cyclical. No one knows exactly how long this downturn will last or how deep it will get, and it's certainly better to be facing macroeconomic tailwinds than headwinds. So not only does Netflix have a huge long-term growth opportunity, but its business will probably outperform Alphabet's if the economy remains depressed for longer. That's why investors should consider Netflix the better buy.
