Netflix Puts on a Good Show

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Netflix (Nasdaq: NFLX) is the little online DVD rental service that could. The company reported a 74% year-over-year rise in subscribers for its third quarter, and a 13% sequential gain from the second quarter, stronger than that quarter's 9% sequential gain over the first quarter. In other words, it increased momentum.

The service ended September with 1.29 million subscribers, ahead of expectations and sending the stock as much as 11% higher this morning. Shares are rising despite general concerns about competition from Blockbuster (NYSE: BBI), Wal-Mart (NYSE: WMT), which launched a movie rental service, and even Disney (NYSE: DIS), which as the Fool reported, is starting a movie set-top rental service.

Surrounded by competition, Netflix has advantages that include novelty (it's the hippest option for young audiences, and the young happen to rent a lot of movies); it pioneered renting DVDs through the mail (it was the "first mover"); and it has an attractive "all-you-can-rent" pricing scheme that's tough to compete against. All this is generating impressive market penetration.

In its native San Francisco Bay area, Netflix claims to reach 5.4% of households, up from 3.5% a year ago. Nationwide, the company cites 1.2% household penetration, up from 1% last year. With these gains, second-quarter sales reported in July rose 74% to $63 million.

The company has big goals. By sometime between 2007 and 2009, it aims to hit $1 billion in annual revenue, 5 million subscribers, and $100 million to $200 million in annual free cash flow. Skeptics abound, making Netflix one of the most shorted stocks on Nasdaq. At $37, it trades at 42 times the $0.88-per-share 2004 consensus earnings estimate. Third-quarter results will be announced Oct. 15.

Netflix was chosen by David Gardner in the June issue of Motley Fool Stock Advisor , in the low $20s.