No the ATV2 doesn't have any storage (well it does, but only 8gb for buffering streams etc and you can't use it), it's purely a streamer. I think it's a good piece of kit, use mine for renting films via itunes rather than walking to the video store and steam films/tv series from my pc upstairs.
Airplay is excellent too - if I get halfway through watching something on my iphone while commuting, when I get in I can just push the airplay button and it continues playing on the TV rather than the phone.
I have had issues though - it's reliant upon you having iTunes running on a PC in order to stream content (although you can rent films without having a PC involved) and iTunes is a bit pap as a media server. I found that it would crawl to a halt if you tried to add media from a NAS to your library. Home sharing also seems incapable of handling large amounts of shared photos, so the slideshow aspect is a bit worthless too.
Overall I'd recommend it if you've already invested in other Apple devices, it's cheap, tiny, silent, cool running and the streaming works perfectly.
Like everyone else I use Handbrake for encoding (and DVDfab for ripping - just rip a big batch of disks to my HD and then have a batch script that automates all the encoding) - I just use the iPhone 4 preset in the latest nightly build (then untick the large file option). You shouldn't notice much difference in quality between that and the original source DVD.
Once an untethered JB arrives for 4.3 I might consider going down the XBMC route just to avoid having to use iTunes on the server side.
Edit: if anyone is interested in scripting Handbrake for encoding, this is the command I use to convert existing .avi files to .mp4 - just bung it in a batchfile, change the source and output drives and directories to suit, fire and forget.
Code:
for %%X in (*.avi) do "C:\Program Files (x86)\Handbrake\HandBrakeCLI.exe" -i "c:\source\%%X" -t 1 -c 1 -o "c:\output\%%X.m4v" -f mp4 -w 720 --loose-anamorphic -e x264 -q 20 -r 29.97 --pfr -a 1 -E faac -6 dpl2 -R Auto -B 128 -D 0.0 --verbose=1
