Better Buy: iQiyi (IQ) vs. Spotify (SPOT)

The way we consume media has changed drastically in just twenty years. Back in 1998, Napster hadn't been founded yet, and Netflix was still a baby. If you wanted to watch shows or listen to music, that involved buying DVDs or CDs.

The advent of streaming has changed all of that. While many Americans are familiar with music provider Spotify (SPOT -4.21%), few have likely heard of Chinese video giant iQiyi (IQ -5.94%). Today we'll be exploring both companies -- and determining which is a better buy at today's prices.

Image source: Getty Images

Financial fortitude

The first thing we want to compare is the most straightforward: the strength of the companies' balance sheets. When a company has lots of cash on hand and strong free cash flows, it can not only survive a down-turn, but benefit from it -- by acquiring rivals, buying back shares on the cheap, and taking market share through competitive pricing.

Keeping in mind that Spotify is valued at about 60% more than iQiyi, here's how the two compare.

Data source: Yahoo! Finance. Cash includes long and short-term investments. Free cash flow presented on trailing twelve month basis. Figures for Spotify translated from euros to USD. Figures for iQiyi translated from yuan to USD. *iQiyi has not released quarterly cash flow figures. These are estimated from total cash losses since cash flow statements were last revealed

For both companies it is incredibly important that zero debt exists on the balance sheet. This, combined with healthy cash balances, helps bolster the companies when times get tough.

Spotify, however, is the stronger of the two. First of all, we can't be sure of iQiyi's actual free cash flow numbers, as the company hasn't published them since spinning off from Chinese search giant Baidu earlier this year. While that relationship no doubt provides an important source of funding in tough times, there's far more clarity with Spotify.

Just as important, Spotify's cash balances (including long- and short-term investments) are actually growing, while iQiyi's are shrinking thanks to its build-out of content.

Winner = Spotify

Valuation

Next we have valuation. This is a very tricky subject to tackle. Neither of these companies is profitable, and both are still growing quite rapidly. Taking that into consideration, here are three metrics I think are worth noting when evaluating the price you'll be paying.

Data source: Yahoo! Finance, E*Trade, SEC filings. P/E calculated using non-GAAP earnings where applicable. See note in above chart for FCF estimates for iQiyi.

As you can see, even when we look forward -- instead of back at the trailing twelve months -- we have a problem: Neither company is expected to be profitable. When it comes to price-to-sales (P/S), we have a virtual tie. And in the category of free cash flow, Spotify might have a slight lead, but both of those ratios are very expensive.

As such, I think they're both very expensive, and very difficult to value.

Winner = Tie

Sustainable competitive advantages

Above all, however, the most important thing to evaluate is a company's sustainable competitive advantages, or its moat. Both of these companies benefit from what I refer to as "sneaky" high switching costs.

Here's the gist: Neither iQiyi or Spotify is prohibitively expensive for its users. They are both subscription-based services where users submit credit card information to continue paying on a monthly basis. Once that information is submitted, we users normally get on with our lives and forget about it. It would take a major life event (like losing one's income) or a seriously bad experience with the service to motivate users to go through the trouble of canceling the service.

That's why I call these "sneaky" high switching-costs: They don't take much time to switch, but the services are so cheap that it's rarely worth the effort.

As it is, both services have proven popular. Spotify grew its monthly active user base by 28% last quarter to 191 million. iQiyi, on the other hand, is growing even faster, with subscribers up 98% to 81 million. 

There are some important structural differences between the two when it comes to moats, though -- for one, Spotify doesn't "own" original music content the same way that iQiyi does. Over time, that could become an important differentiator.

But as it stands right now, I'm calling this a tie. Both are fast-growing, subscription-based services that do a good job of locking customers in.

Winner = Tie

And my winner is...

So there you have it: While both companies are expensive and have comparable moats, Spotify gets the edge thanks to its strong balance sheet. That doesn't necessarily mean iQiyi is a bad investment, or that you should back up the truck with Spotify. But hopefully this helps you understand some of the differences -- and similarities -- when you start your own due diligence.