Most companies are brick-and-mortar businesses that rely on physical store location and expansion to drive revenue and profit growth. But such businesses have built-in expenses such as facility leases, maintenance, utilities and other fixed costs. Over the past few decades, such traditional business models have been challenged by disruptive online competitors that seek to bring greater efficiency to the retail supply chain for goods and services. So let’s see how to online giants – Amazon Inc. and Netflix Inc. – stack-up as investment options relative to each other.
Amazon, Inc. (NASDAQ: AMZN) is the 800-lb gorilla in the global online space, and offers merchandise, content and services to retail and enterprise customers through its amazon.com online store and service offerings – either directly by Amazon or through third-parties that sell through Amazon and leverage its brand, online customer traffic, platform and logistics. Amazon’s vendor-partners include established companies, third-party sellers, authors, musicians, film makers and application developers. The company offers Amazon Prime, a membership program that offers free shipping, access to free online entertainment content and other benefits. Additionally, Amazon – through Amazon Web Services (AWS) – is among the world’s largest providers of cloud-based services such as storage and analytics. Amazon also sells Kindle e-book readers and Fire tablets, phones and streaming sticks (USB dongles that enable software delivery and apps). Amazon has steadily grown its active customer accounts from 20 million in 2000 to 244 million in 2014, with 1,120% growth.
Amazon benefits from third-party vendor-partners because it enjoys high gross margins on those transactions and receives sales commissions. Vendors benefit because they get to leverage Amazon’s 109 fulfillment centers. Third-party vendors account for approximately 44% of all goods sold through amazon.com. With all transactions taking place online and no brick-and-mortar stores, Amazon has a significant competitive advantage over competitors such as Best Buy (BBY), Target (TGT) and Wal-Mart (WMT) which have to purchase inventory upfront and maintain physical stores, while Amazon dynamically manages its inventory based on orders placed and does not face the same fixed costs – allowing Amazon to offer a greater selection and sell products at lower cost. Over the years, Amazon has become a force to reckon with and has upended the traditional world of retail shopping, causing existential angst to businesses like Radioshack (RSHCQ), Staples (SPLS) and Sears (SHLD) that have struggled to attract customers and maintain revenues.
Netflix Inc. (NASDAQ: NFLX) was founded in 1997 and is the leading streaming media company in the world. Netflix operates three segments: Domestic Streaming, International Streaming and Domestic DVD. Customers can use desktop, mobile and smart tv application to stream content – television shows, movies, documentaries, etc. – to their devices. As of April 15, 2015, Netflix had members in 50 countries after recent service expansion into Australia, Cuba, Italy, New Zealand, Portugal and Spain. Netflix is also in discussions to enter the Japanese and Chinese online video market. Netflix has grown its customer base from 300,000 members in 2000 to 62 million members in 2014, which represents a whopping 20,567% growth.
Netflix is also a force in itself and is credited with bankrupting traditional video rental stores such as Blockbuster by offering customers the convenience of ordering rentals online, having DVDs delivered straight to the doorstep and offering instant streaming options on a vast library of entertainment content. To view Netflix content, customers pay a tiered monthly subscription fee to access physical DVDs or streaming content. Netflix’ on-demand growth was directly tied to the introduction of faster Internet speeds; Netflix smartly recognized this shift and augmented its traditional DVD rental market with streaming subscription plans.
Over the last year, Amazon shares up 31%, Netflix shares up 54%
Amazon: As of 6/12/2015, Amazon shares closed at $429.92 per share, giving the company a market capitalization of $200.21 billion. Shares are near the high-end of the company’s 52-week range of $284 – $452.65 and above the company’s 50-day moving average of $428.62 and 200-day moving average of $367.65. Amazon shares are up about 31% over the last year and up about 57% over the last 2 years. The company has an average consensus price target of $470 (9% upside off current levels) and a high price target of $600 (40% upside).
Netflix: As of 6/12/2015, Netflix shares closed at $660.93 per share, giving the company a market capitalization of $40.07 billion. Netflix shares, too, are trading near the high-end of the company’s 52-week range of $315.54 – $692.79 and above the company’s 50-day moving average of $603.83 and 200-day moving average of $462.55. Shares are up about 54% over the last year and up about 209% over the last 2 years. The company has an average consensus share price target of $597 (10% downside) and high price target of $900 (36% upside).
Netflix shareholders approved a proposal to increase the limit of outstanding shares from 170 million to 5 billion shares, and reflect’s the Board’s likely intent to split the stock to make it more affordable to smaller investors. Netflix’ last stock split was in 2004. On news of the increased share-count authorization, shares climbed to their 52-week high as $692.79 after the announcement, ultimately settling up 4.3% at $675.05. Netflix CEO Reed Hastings and CFO David Wells will report second quarter 2015 results and operating outlook on July 15, 2015.
Neither offer dividends.
Revenue Growth: Slowing at Amazon, Steady at Netflix
Amazon has grown its annual revenue from $600 million in 1998 to $88.99 billion in 2014. From 2007 to 2013 revenue grew 405% from $14.8 billion to $74.45 billion. Over this time, the company introduced several new selection stores, launched Amazon MP3, established trade-in programs for books and video games, and introduced the Kindle tablet. Global expansion also contributed to the company’s growth during this period with international revenue up from $6.74 billion in 2007 to $29.94 billion in 2013. However, as the chart below shows, while Amazon’s revenue growth is still healthy in the low double-digits, the pace of growth has been steadily declining over the past few quarters. Management expects this trend to continue in 2Q15, causing angst for some investors who are concerned that management’s investment decisions over the past 2 years did not translate into revenue growth.
Netflix has grown revenues from $36 million in 2000 to $5.5 billion in 2014, growth of 15,178% over 14 years. Netflix experienced strong revenue growth because the company’s subscriber base increased dramatically as it expanded into Canada, Latin America, the Netherlands and the United Kingdom from 2010 to 2013. The company set a new record for itself in 2014 when it added 13 million new members. Management anticipates expanding services from 50 countries to 200 countries by year-end 2016, which should drive membership and revenue growth.
Return on Invested Capital, Weighted Average Cost of Capital show Netflix more profitable than Amazon
Return on invested capital (ROIC) is a performance measure that allows the comparison of capital investment outcomes across companies and industries, and is particularly useful for companies that invest large amounts of capital for operations. Simply put, ROIC measures the relationship between cash being spent by a company and cash coming into a company from those investments.
Amazon has an ROIC of -13% while Netflix has an ROIC of 32.7%, partly because Amazon still has to deal with storage warehouses, logistics, returns, etc., tied to the physical handling of merchandise. This suggests Netflix has more efficient operations than Amazon, and is more profitable for investors.
Additionally, Amazon’s ROIC of -13% comes from a weighted average cost of capital (WACC) of 14.5%. Netflix, on the other hand, delivers an ROIC of 32.71% on a WACC of 9.56%, which increases shareholder value as the company grows.
Amazon Reshapes Shipping Options, Enters Streaming Media Market, Dominates Cloud Services
While Netflix has impressive financial metrics, Amazon and a slew of other major players such as Microsoft (MSFT), Google (GOOG), Apple (AAPL) and Yahoo (YHOO) have painted a target on Netflix and are keen to increase their share of the lucrative streaming market, while finding innovative ways to grow and optimize current operations.
For example, Amazon has decreased shipping times by allowing merchants to directly ship items to customers instead of storing them at Amazon’s warehouse. Merchants associated with Amazon’s Prime membership are now eligible to independently offer 2-day shipping. Amazon Prime currently has over 20 million items listed for sale, and this number will only grow under the expedited shipping option. Amazon also offers free shipping on small and light items, and same-day delivery for select items and 1-hour delivery in select markets. Additionally, Amazon is building a new fulfillment center in Dallas, its fourth in Texas, to help reduce shipping times.
To take on Netflix and content generators, Amazon is using its might to launch new original shows including six children’s shows and full seasons of The Man in the High Castle, The New Yorker Presents and Mad Dogs. The company is building its television show and film library to gain market share in the streaming media industry. Amazon has also struck-up an exclusive content licensing deal with Time Warner’s (TWX) HBO that lets Amazon customers stream select seasons of HBO shows. Amazon has a similar agreement with Bleecker Street for the development of exclusive original content such as films. Amazon also partnered with airline operator, JetBlue, to offer streaming services and digital books to passengers during flights.
Amazon Web Services plans to develop an 80-megawatt solar farm in Virginia to power its data centers solely with renewable energy. Currently, a laudable 25% of power for data centers comes from clean energy and management aims to increase that to 40% by year-end 2016. This switch to solar is expected to sizably reduce energy costs for Amazon while boosting its image as an environmentally-conscious corporation. AWS is a leading provider of hosted services and generates about $6 billion in revenue each year.
Netflix Dominates Streaming Media Industry with Syndicated and Original Content
Netflix plans to boost its margins through the production of original content. The company has a partnership with Plan B Entertainment (actor Brad Pitt’s production company) to produce a satirical war comedy titled War Machine where Netflix will invest $30 million, its biggest film investment to date. Netflix also signed film development deals with comedian Ricky Gervais, comedian Adam Sandler and actor Leonardo DiCaprio. And comedian Chris Tucker plans to headline his first ever stand-up comedy special on Netflix in July 2015.
Netflix also has major content production in the works for launch in 2016. The company will offer new original kids show including Kulipari: An Army of Frogs, Tarzan and Jane, Puffin Rock and Cirque de Soliel, and a new drama series called Montauk. Netflix has had much success with its 16 original shows including Bloodline, Daredevil, House of Cards, Orange is the New Black and Unbreakable Kimmy Schimdt.
Hotel chain operator Marriot International Inc. and Netflix have a partnership to Netflix streaming capabilities through in-room entertainment systems at Marriott hotels across the U.S. The service is currently offered at seven Marriot hotels and Marriot expects to open this up at 100 additional hotels by the end of 2015. All of Marriot’s 300 hotels will offer Netflix streaming by year-end 2016.
Q1 2015 Results: Netflix Leads on Profit Margins, Growth
Amazon: For Q1 2015, Amazon had total net sales of $22.72 billion (up 15%) as net product sales increased 9% and net services revenue increased 40%. Amazon reported income from operations of $255 million (up 75%), income before income taxes of $21 million (down 83%) and net loss of $57 million (down 153%), or $0.12 per share.
As of March 31, 2015, Amazon had $10.24 billion in cash and cash equivalents, $8.26 billion in long-term debt and $10.87 billion in total stockholders’ equity.
Netflix: For Q1 2015, Netflix had revenues of $1.57 billion (up 24%) as domestic streaming contributed $312.5 million in profit, international streaming contributed a $65 million loss and domestic DVD rentals contributed $84.6 million in profits. Netflix reported operating income of $97.5 million (flat), income before income taxes of $38.4 million (down 57%) and net income of $23.7 million (down 55%), or $0.38 per share.
As of March 31, 2015, Netflix had $2.45 billion in cash and cash equivalents, $2.40 billion in long-term debt and $1.91 billion in total stockholders’ equity.
Based on Q1 2015 results, Amazon had a gross margin of 30%, operating margin of 0.31% and profit margin of -0.44% while Netflix had a gross margin of 32.3%, operating margin of 6.93% and profit margin of 4.09%. Despite Amazon earning $21.15 billion more than Netflix in revenue, Netflix reported higher net income.
Netflix has a profitable, high-growth business, is a leader in media streaming, has successfully developed original content, and established partnerships with airlines and hotels. Amazon, on the other hand, is focused on customer acquisition and strategic new business initiatives, and has yet to turn a profit. However, Netflix has significantly higher valuation multiples and shares have increased at a higher rate over the past two years. Moreover, Netflix’ business model is easier to replicate by the likes on Apple, Amazon, Google, Microsoft and others so Netflix could see significant competition to its core business own the road. Amazon has higher barriers to entry and cannot be easily challenged in its core domains. So, over the long run on strategic competitive advantages and the short run on valuation, Amazon appears to be a more compelling investment for investors.