Netflix Not Done

How is last night's quarterly report from Netflix (Nasdaq: NFLX  ) like its signature DVD mailing envelopes? They're both red all over. The online movie rental service turned in a quarter that was either bloody brilliant or bloody bloodied depending on how you look at it.

On the positive front, the company grew revenues by 80% to a healthy $100.8 million, and its customer churn rate shrank for a sixth consecutive quarter. Netflix feels so confident about its animal magnetism, in fact, that it plans to raise its monthly subscription by two bucks come June.

However, one factor driving client retention is also spooking gross margins. The company's distribution center network has expanded to the point where overnight delivery is available to 80% of the country's population, something rivals Wal-Mart (NYSE: WMT  ) and Blockbuster (NYSE: BBI  ) just can't match at the moment.

At the same time, speedy turnarounds also prompt film buffs to rent more DVDs each month. Under the Netflix monthly subscription model, that's like opening a buffet just as science discovers a way to speed up the digestion process.

Acquisition costs also rose during the period. Management attributes the spike to a new television ad campaign, but one could as easily argue that this is the kind of "jump the shark" move that occurs when a high-growth company has absorbed the early adopters and has to aim higher to reach the mainstream.

When we singled out Netflix in the Oct. 2002 edition of TMF Select -- which since evolved to Motley Fool Hidden Gems -- it was a memorable call given that the stock was bottoming out at a split-adjusted $5.45 a share. The stock fell nearly 10% to just under $34 after hours last night as investors were banking on perfection.

Netflix is still healthy. The company expects to pass the 2 million subscriber mark early this summer, and while it did post a loss of $5.8 million, it nonetheless generated $9 million in free cash flow. With the company looking to close out the year with as many as 2.7 million subscribers, earnings should come in between $10.5 million and $18.5 million this year on $485 million to $535 million in revenues.

The move to hike the standard monthly subscription to $21.99 in June will bear watching. Will the company's churn rate rise or will happy subscribers realize the value and convenience of the Netflix experience? That will reveal plenty about the viability of the Netflix model and its pricing elasticity.

Longing for the next Netflix? Take Motley Fool Hidden Gems for a spin. Thetrial is free.

Longtime Fool contributor Rick Munarriz has been a satisfied Netflix user since 2002. He also owns shares in the company.

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