Better Buy for 2016: Amazon Inc. or Netflix Inc?

Which digital leader will fare better next year?

Leo Sun
Leo Sun
Dec 24, 2015 at 12:45PM
Technology and Telecom

Amazon (NASDAQ:AMZN) and Netflix (NASDAQ:NFLX) both doubled their market caps in 2015, despite ongoing concerns that both stocks' valuations were too high. Amazon still trades at nearly 120 times forward earnings, while Netflix has a forward P/E of almost 450.

Yet both first movers still dominate their respective industries of e-commerce and streaming video, and their defensive moats keep widening and luring in new growth-oriented investors. But if you can only invest in one of these stocks today, which one would be a better choice? Let's discuss both companies' strengths, weaknesses, and growth opportunities to decide.

Amazon's Kiva warehouse robots. Image source: Amazon.

The key facts
Amazon has become synonymous with online product searches. Last year, Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) chairman Eric Schmidt admitted that "more than twice" the number of shoppers looking for products start on Amazon instead of Google.

At the end of 2014, Amazon had 270 million active customer accounts -- up from 234 million in 2013. In late June, research company CIRP estimated that Amazon Prime, the company's $99 per year premium plan, had 44 million U.S. subscribers -- up from 40 million at the end of 2014. It also claimed that the average Prime member spends $1,200 annually compared to $700 for the non-members. The stickiness and profitability of this user base lets Amazon introduce new delivery options, services, and platforms to maintain its lead over retail competitors and ecosystem rivals like Google. It also enables Amazon to expand into Netflix's turf with streaming videos.

Netflix controlled 57% of the global streaming video market last year, according to video technology company Qwilt. However, research company MTM estimates that its share of the U.S. market will decline from 85% in 2014 to 50% in 2018, due to the growth of rival services like Amazon Instant Video, Hulu, and stand-alone streaming channels. But despite those potential threats, Netflix's total U.S. subscribers still rose 16% annually to 43.2 million last quarter, while international subscribers surged 64% to 26 million.

Netflix bulls believe those strong international numbers will offset its weaker domestic growth over the long term, and that quality original content like House of Cards and Jessica Jones will lock in its existing subscribers.

Marvel's Jessica Jones. Image source: Netflix.

Rising revenue, rising costs
Amazon and Netflix both generate lots of revenue, but very little trickles down to their bottom lines. Last quarter, Amazon's revenue rose 23% annually to $25.4 billion, but it only squeezed out $79 million in net income -- which was nonetheless an improvement from its net loss of $437 million a year earlier. Amazon is known for spending lots of money on its ecosystem-expanding initiatives, but it also heavily invests in robots and drones to cut its labor costs and boost the efficiency of its warehouses. Its cloud platform, AWS (Amazon Web Services), also evolved into the company's most profitable business and generated $521 million in operating income last quarter.

Netflix's revenue rose 23% annually last quarter to $1.74 billion, but its net income fell 50% to $29.4 million because of rising tech, development, and marketing expenses. To cut costs, Netflix gradually reduced its dependence on pricey licensed content, which was putting it at the mercy of larger media companies, and it produced more original shows and movies. However, the production costs of these shows and movies are rising and becoming a major weight on Netflix's bottom-line growth.

For companies with strong sales growth, aggressive spending, and lackluster bottom-line growth, free cash flow can be considered a better indicator of long-term sustainability. By that metric, Amazon has clearly been doing better than Netflix over the past five years:

AMZN Free Cash Flow (TTM) Chart

Image source: YCharts.

The year ahead
Looking ahead into 2016, Amazon will likely experiment with new ways to expand its ecosystem. These initiatives will likely include strengthening AWS, opening more physical pickup locations, adding new delivery options, expanding its online payments platform, and possibly investing in its fledgling advertising business to compete against Google. Drone deliveries, if approved, could also dramatically streamline its delivery system and cut costs.

Meanwhile, Netflix will probably focus on launching more original shows and movies to defend its market share and expand internationally. Depending on how well Netflix does in overseas markets, concerns about the company losing domestic market share could fade. Its new encoding technology, which will reportedly reduce bandwidth usage by 20%, could improve its streaming quality and cut expenses by reducing its "fast lane" payments to ISPs.

The winner: Amazon
Both Amazon and Netflix have market-leading positions in growing digital industries. But when push comes to shove, Amazon is the better stock to own. The company arguably locks in customers better than Netflix, faces fewer meaningful rivals, and generates stronger earnings and free cash flow growth. And despite all of the bearish critiques of its high valuations, Amazon is still a considerably cheaper stock than Netflix.