You can't judge a Netflix (NASDAQ:NFLX) rental by its cover. They're all red on the outside. You also can't judge a Netflix quarterly report by its bottom-line results. It's not as rosy as the market-thumping $0.37-per-share profit performance would have you believe.

Yes, it's a lot better than the $0.25 per share that Netflix earned a year ago or the $0.23 that analysts were expecting. However, $4.1 million of the total -- or $0.06 a share -- came from a one-time patent-infringement settlement from Blockbuster (NYSE:BBI).

Then you have the company's poor job of attracting and retaining subscribers. That, too, inflates the bottom line, unfortunately. Netflix spent roughly $44 in marketing for each gross subscriber this past quarter. With the company scaling back its marketing costs, attracting fewer members is a near-term enhancer (and a long-term concern), especially with affiliate programs that pay per signup.

The bad news first
Let's get the bad stuff out of the way first. Clamp a clothespin on your nose for the next few bullet points as we get into some of the really ugly things in last night's report. It's a long list, but it's an important one.

  • Netflix closed out the quarter with 6.7 million subscribers, less than the 6.8 million it started the quarter with. That's the first quarterly dip the company has ever experienced.
  • Revenues of $303.7 million were 27% higher than last year's showing, but it was a sequential dip from the $305.3 million it generated during the first quarter of 2007.
  • The company is lowering its year-end subscriber targets, again, to a range from 6.8 million to 7.3 million members. It's been a rough few months on the prognostication front for CEO Reed Hastings. He originally figured that Netflix could gain as many as 2.1 million net new subscribers this year. (I had my doubts.) In April, that figure was slashed to between 1 million and 1.5 million, and the latest revision cuts things down to just 0.5 million to 1 million. Put in a somberly bleak way, at the low end, Netflix is assuming that it won't gain any net new subscribers over the last nine months of 2007. Ouch.
  • Speaking of "ouch," revenue guidance is also getting knocked down. Sequential dips are now likely to continue in each of the next two quarters.
  • On the earnings front, Netflix is looking to earn between $0.62 and $0.76 a share this year. That may not seem to be too far off the $0.76-$0.83 initial range, but here's the kicker: Netflix has already earned $0.55 a share through the first half of the year. It's now expecting to earn between just $0.07 and $0.21 per share in the second half of 2007.
  • It's encouraging to see Netflix still expecting a profit even with the dollar discounts on its most popular plans to compete against Blockbuster. At the low end of its range, that translates into a $5 million profit. But Netflix will make about $10 million in passive interest income alone. In other words, Netflix may still not post an operating profit even with positive net income for the balance of the year.
  • Signing up fewer subs doesn't mean that they are sticking around longer. Churn rate -- the percentage of free and paying subscribers that quit the service in any given month -- rose to 4.6% this past quarter.
  • Gross margins dipped, in part because of the online streaming costs involved in serving up the Watch Now Internet streams that are included in all paying subscription packages.

Silver linings last
As a born optimist, I hate poking too many holes into any stock, especially one that I have owned since 2002. It's not easy to hold back, though. How can I cherry-pick the good in a report when my inner cynic is raising his hand and going "Oooh, oooh, pick me, pick me"?

When Hastings points to the Watch Now feature as a costly endeavor that is generating "online satisfaction," I have to wonder how bad churn and the subscriber dip could have been if patrons were any less satisfied.

I fear for the investors who will wake up today, find that Netflix has earned $1.00 per adjusted share over the past 12 months and pounce on this tidbit because they think it's a value at 17 times trailing profitability. That kind of rearview-mirror investing can be dangerous. Netflix is already telling you that it may earn as little as $0.07 a share over the next two quarters. If the first half of 2008 mirrors the projected last half of 2007, we're talking about a forward price-to-earnings ratio in the range of 41 to 123.

So I'm a realist. Thankfully, the company's guidance isn't taking into account the likelihood that Blockbuster will raise its own Total Access rates. Hastings thinks Blockbuster is losing $200 million annually, and at least one analyst on the call is expecting Blockbuster to bump its Total Access monthly subscription rate by $3 later this year.

Netflix is a cash-rich company. Blockbuster is a debt-laden player with spooked creditors. The only thing that can save Blockbuster from being a total train wreck is the ability of new CEO Jim Keyes to turn around the company's retail operations. If successful, Total Access can survive as a loss leader if the company is able to more than make it up with merchandising improvements that make spending money inside a Blockbuster store attractive again.

If not, Total Access will have no choice but to run a profitable operation. That means higher subscriber fees and more breathing room for Netflix to not only reverse the recent "buck-back mountain" price reduction, but also possibly raise its subscriptions by a buck or two, depending on how high Blockbuster goes.

An interesting factoid for you: The combined market cap of Netflix and Blockbuster is less than the $2 billion market cap that Netflix alone commanded at its peak seven months ago. Even if you tack on Blockbuster's debt and subtract the greenbacks that Netflix is packing to arrive at a combined enterprise value of $2.5 billion, it's a fair price for an entire sector that is still growing and probably a few months away from either vindication or a pricing-war truce.

Sure, digital delivery is just around the corner, but it's a long, long corner to get around. Analysts love to ask Netflix how it will hold up against digital peddlers such as Apple (NASDAQ:AAPL) and Amazon.com (NASDAQ:AMZN), but the DVD will continue to be the platform of choice for at least a few more years.

Netflix is right to hit Blockbuster where it hurts. Unfortunately, doing so is hurting Netflix investors just where it hurts, too. Remember that Netflix cover that's red on the outside? It's no surprise to see shareholders feeling blue on the inside.

The saga, in a nutshell:

Netflix and Amazon.com are recommendations for Motley Fool Stock Advisor newsletter subscribers. Finding out why is just a 30-day free trial subscription away.

Longtime Fool contributor Rick Munarriz has been a Netflix subscriber -- and shareholder -- since 2002. He is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.