Netflix Defies Gravity

We may be tightening our belts in these uncertain times, but don't you dare take our red mailers away.

Netflix (Nasdaq: NFLX) kept growing during its second quarter. The DVD-rental-by-mail maven tacked on another 168,000 net subscribers over the past three months, for a total of more than 8.4 million members -- a 25% increase over last year's roster.

Revenue growth wasn't so kind, inching just 11% higher to $337.6 million. The gap is partly explained by last summer's price cut, but it's also a clear snapshot of the weakening economy. DVD buffs may be switching over to lower-cost plans, in exchange for receiving fewer discs at any one time.

Margins also took a year-over-year dip, but that's the result of the popularity of the company's movie streaming service, which Netflix offers at no additional cost to existing subscribers. That led earnings to grow by just 4% to $26.6 million. The increase looks rosier on a per-share basis, leaping 14% to $0.42 thanks to the company's ambitious share repurchase efforts.

The end result? While Wall Street nailed the company's top line, Netflix clocked in just ahead of the $0.40-a-share profit that analysts were expecting. That left the market more favorably disposed toward Netflix than it had been three months ago. Shares got slammed as the company simply met Mr. Market's profit target, even as its stock approached fresh highs.

Sole survivor
Netflix is succeeding in an industry that has proven problematic for nearly everyone else. Wal-Mart (NYSE: WMT) pulled out three years ago. Amazon.com (Nasdaq: AMZN) sold its European copycat service earlier this year. Blockbuster (NYSE: BBI) is still hacking away, though its Total Access growth has stagnated now that Blockbuster hiked its mail-delivery service's prices to achieve profitability.

Meanwhile, Netflix keeps on rolling. Even offering up its "free" movie streaming service to paying subscribers on computers -- and making the home-theater migration through deals to offer the service on Roku boxes, LG electronics, and eventually Microsoft (Nasdaq: MSFT) Xbox 360 consoles -- isn't getting in the way of earnings, even with the associated studio royalty and chunky bandwidth tabs. That Watch Now service is becoming a juicy carrot for Netflix, at a time when Amazon, Blockbuster, and Apple (Nasdaq: AAPL) are angling to charge for their digital deliveries. How can they compete, even if the Netflix streaming library has a smaller selection of titles?

Set course for tomorrow
The company's guidance for all of 2008 seems fairly consistent with its last prediction in April. Netflix is keeping its year-end subscriber target between 9.1 million to 9.7 million members, and narrowing its revenue range to between $1.364 billion and $1.379 billion. It's slightly raising its profitability projection to between $1.19 a share and $1.31 a share, but that -- again -- is the handiwork of the company's aggressive share-buyback efforts. Netflix is keeping its net income outlook in line with the $75 million to $83 million it targeted three months ago.

There's really no reason for Netflix to put the brakes on its share-buyback joyride. The company's debt-free balance sheet is padded with nearly $5 a share in cash. Its ability to remain cash flow-positive while rolling out its movie-streaming service during a challenging economy is great. Netflix seems to have more than enough confidence in its ability to continue to innovate without having to fall back on its greenbacks.

So what else can it do with that money, beyond buybacks and possibly instituting a cash dividend as it matures? Netflix could go the consolidation route, but who would it buy? It's ripping the competition to shreds. Gamefly may be a tempting target, but Netflix would have been renting video games already if it believed in that niche.

Its best buys would be popular entertainment content sites, but most of the good ones, like Rotten Tomatoes, IMDB, and Movies.com, are already owned by much larger companies than Netflix. The company could always approach Hollywood Media (Nasdaq: HOLL) to acquire movie hub Hollywood.com, but since Netflix has been reluctant to run other sites, perhaps that money is best used to bankroll indie flicks, which it can then serve up as exclusive Netflix rentals.

Either way, Netflix is a survivor, mastering the art of profitable DVD lending as it positions itself for a post-optical-disc future.

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