Welcome to the Big Leagues

With a current market capitalization in excess of $9 billion, Netflix (Nasdaq: NFLX) is stepping into the big leagues. All revolutionary companies must make this transition before becoming a true Rule Maker. Unfortunately, the transitionary period is dangerous ground.

Many revolutionary companies (think AOL, Yahoo!, and that pre-Google (Nasdaq: GOOG) search company Inktomi) all passed through here. While Netflix pioneered the DVD by mail market and has become its undisputed leader, it's making a difficult business model switch to online streaming. From a valuation perspective, Netflix has certainly grown up, but investors should be aware that Netflix's future dominance is far from certain. Here are three reasons for current investors to be concerned.

1. Growth doesn't always equal profitr
By some respects, Netflix is firing on all cylinders. It ended the third quarter with 16,933,000 total subscribers, tallying its fourth consecutive quarter of more than 1 million subscriber additions. CEO Reed Hastings proclaimed, "By every measure, we are now primarily a streaming company that also offers DVD by mail."

Unfortunately, growth in the bottom line isn't keeping pace with the growth in subscribers. Assuming no stock buybacks, which I'll talk about later, diluted EPS in Q3 2010 would have been $0.655. That's about 26% higher tha
Q3 2009 diluted EPS of $0.52, but nowhere close to the 52% growth in subscribers. Net income per subscriber actually declined 17% in the past year, from $2.71 in Q3 2009 to $2.24 in Q3 2010. This rapid decline in margins and revenue per subscriber doesn't seem consistent with other dominant Rule Makers like Google,Microsoft (Nasdaq: MSFT), or eBay (Nasdaq: EBAY).

2. Is content or distribution king?
Netflix is rushing to build out its library of online streaming content, but that doesn't come cheap. This year, it signed a deal with Epix that is rumored to cost $1 billion over five years. That's greater than all of its operating income in 2009. Isn't the dominant company supposed be able to dictate favorable terms? This makes Netflix seem less like Wal-Mart (NYSE: WMT)and more like Sirius XM (Nasdaq: SIRI). Remember when Sirius paid hundreds of millions to Howard Ste
as it sought to build out its content offerings?

3. Manage the business, not the stockr
Reed Hastings finds himself in a difficult position right now. He's built a wonderful business that is transitioning from DVD by mail to online streaming. Unfortunately, it has to pay to support both distribution networks, and to build out a costly library of streaming content at the same time. All this is happening while most of its new subscribers are paying a lot less tha
DVD-by-mail customers (usually opting for the one-disc-per-month option for $8.99 per month).

One way to prop up earnings is to buy back stock. In the past year, the share price has increased from $57 to $169. Despite the rise in price, Netflix has continued to buy back stock, spending $289 million on stock repurchases in the last four quarters. This helped increase diluted EPS in Q3 by about $0.05, from $0.65 to $0.70.

I am all for share repurchases, so long as the company has excess capital and is purchasing shares at a discount to its value. In Q3 2010, Netflix actually accelerated its stock purchases, spending $57 million versus $45 million in Q2 2010.