Demand Media (DMD) - Stock Analysis

Introduction:

Demand Media (DMD), launched with $120M in venture capital funding, is an online media company founded in May 2006 by Shawn Colo and Richard Rosenblatt. Colo was a private equity investor while Rosenblatt was chairman of MySpace before launching Demand Media. The business plan revolved around purchasing generic domain names (not trademarked), adding low-cost content, and increasing advertisement revenue. The combination worked wonders with Colo focusing on M&A transactions and Rosenblatt on operations. Globally, parked generic sites whose only content were ads that linked to other sites accounted for between 5 and 10% of search-engine revenue at the time. DMD’s plan was to convert these billboards into content websites that would be capable of generating even more ad-revenue once relevant content is incorporated and updated on a periodic basis. To achieve this objective, DMD made a number of acquisitions early on. Chief among them were:
  1. eHow (5/’06): An online how-to guide with over a million articles and 170,000 videos created by freelancers.
  2. eNom (5/’06): A domain name registrar. Two months later, its competitor BulkRegister was also acquired. The combined entity is second only to GoDaddy.com.
  3. Hillclimb Media (8/’06): Hosted sites such as Trails.com and GolfLink.com.
  4. AnswerBag.com (10/’06): Q&A website driven by user questions and answers.
  5. Non-MySpace assets of Intermix Network LLC (parent of MySpace) from Fox Interactive Media (FIM) (11/’06): Portfolio of 20 sites including grab.com and a perpetual license (royalty free) to use grab.com code-base. Later (12/’09), the grab.com related assets were sold to Grab LLC.
  6. ExpertVillage.com (6/’07): ‘How-to’ professional videos on a large array of topics. ExpertVillage was owned by PageWise.
By March 2008, the company had taken in $355M after four rounds of venture capital funding. Aquistion pattern underwent a makeover around 3/2008 during their effort to morph into a few other areas. Chief among them were:
  1. pluck.com (3/’08): A developer of social media tools. The company’s social media technology platform is used in over 375 leading brands including the NFL, Best Buy, and Kraft.
  2. CoveritLive (3/’11): A live event platform company that allows businesses to interact with customers in real-time by streaming live coverage and social engagement. Since ’09, DMD had held a minority interest in the company.
DMD held its Initial Public Offering (IPO) on Jan 26, 2011 and raised over $150M, bringing the valuation of the company to around $1.5B. However, in the few months since, the shares have performed dismally returning a loss of 40%.

Business Issues:

Demand Media (DMD) has never been profitable. The losses showed an increasing loss trend from 2007 to 2009, where the net loss went from around $6M in ‘07 to around $22M in ’09. This trend was contained to a certain degree in 2010 with a net loss of $5M. In the first quarter following its IPO in 2011, the company reported a net loss of $5.58M. Its IPO was delayed, as the company discussed with the Securities and Exchange Commission on how to clarify to investors its approach for expensing the cost of creating its content. DMD’s S-1 filing stated that the capitalized media content is amortized on a straight-line basis over five years. This is an aggressive type of accounting, as companies in the publishing business generally account for content creation costs as they are incurred. DMD’s defense is that its content is more evergreen – how-to articles have a longer shelf-life compared to news and other mass-media articles from Ad revenue point of view. SEC allowed this after mandating DMD use their algorithmic platform to provide proof of probable economic benefits of the content over the 5-year amortization period. On the other hand, the straight-line accounting method seems an approximation at best as the economic benefit of five-year old content can never equal the economic benefit at the time of publication - search engines invariably rank newer content higher. However the company can most certainly derive economic benefits from older articles (more than 5 years), provided they invest albeit lightly to keep the articles up-to-date and apply SEO techniques on a regular basis.

Demand Media’s Registrar business eNom is a mature entity in spite of the healthy revenue growth rate in recent years. The idea with this acquisition was to derive synergistic benefits with its content and media entity. To realize synergies, DMD has focused on mining proprietary data available from hosted sites and providing access to new sources of traffic. The competitive advantage these carry allows them to offer low pricing on domain registrations. This partly explains its vigorous growth rate in that area recently, as indicated below:



However, as the registrar business has very low barriers to entry, it is considered a very low-margin business. Going forward, it will be harder for DMD to show healthy growth rates in this business unit.

Currently DMD’s content and media business relies heavily on algorithms that analyze the search criteria to identify content topics with a good return on investment (ROI). The concept boils down to spotting “commercially-viable” long-tail searches, and writing optimized content that ranks high in search engines. Those searches with higher specificity generate more Ad revenue compared to less specific searches. A logical conclusion that can be deducted from this model is that the business is sensitive to changes in search engine algorithms. Search engines frequently alter their algorithms, although major ones happen only once every few months. SEO businesses are generally nimble at adapting, but there is no guarantee search-engine rankings will remain consistent over periods of time. The issue is very real as demonstrated by the following graph showing the global percentage reach statistics for the company’s premium site eHow:




The reach went down by close to 15% in the last month following changes to Google’s search algorithm (nicknamed Panda). The initial Panda updates made in February had a short-term positive impact but the final changes in mid-April resulted in an almost immediate negative effect. In the last 45-days, there has not been much improvement to the reach either, begging the question as to whether SEO tricks will facilitate sites holding on to their high rankings.

Demand Media’s content and media business exploits the inefficiencies at both ends of its “supply-chain”. They algorithmically determine the required content based on demand from search data and engage a large author base to provide content at low cost. DMD’s ‘on-demand content generation’ strategy gives them a near-term competitive lead as the majority of content in the Internet is devoid of such techniques. At the supply end are authors who are mostly freelancers used to getting minimal pay for their efforts. With the proliferation of blogs and wikis, the market has a large base of ‘decent’ writers used to contributing content to wikis and/or blogs without remuneration. So, the universal thinking is – any money for such services is good. As with most transformative businesses in the early stages, the processes in place to generate content using freelancers are constantly changing. The promise of DMD is to have a structure in place for this chaotic environment by grading writers objectively whereby pay is commensurate with the quality of the content. Once such a system is established, the limiting factor is the availability of commercially viable content. This is a big unknown, as DMD does not disclose details on the commercially viable content in its pipeline. Demand Media has hundreds of thousands of articles waiting to be written but it is unclear whether they can increase production of new articles while also increasing profitability.

Finances:

The table below summarizes Demand Media’s financial position:


Year200820092010
Revenue170.25M198.45M252.94M
Net Loss(43.11M)(53.32M)(38.58M)
Shares Outstanding8.18M11.16M13.51M
Loss per Share (Normalized – one-time items removed)(5.27)(4.78)(2.86)
YOY Earnings GrowthNA9.30%40.17%
YOY Revenue GrowthNA16.56%27.46%
Net Profit Margin(25.32)%(26.87)%(15.25)%

Although Demand Media shows an accelerating trend in terms of both revenue and earnings growth, they still have quite a distance to cover to attain profitability. The accelerating trend needs to be sustained for a few years for the company’s current enterprise value to be justified.

Quantitative Rating:

The spreadsheet below shows our quantitative rating summary of Demand Media (click for an understanding of the ratings on this spreadsheet):

 

Demand Media scores 0/10 on its ability to beat inflation: Return on Equity, Net Profit Margin, and Free Cash Flow are all negative. PEG ratio, a measure of valuation is very rich at 2.28.

Corporate Abuse rating is 0/10 as their executive compensation is egregious: The CEO makes around $26.8M, around 500 times the average worker.

Income generation and liquidity measure is average at 6.33/10: Demand Media does not pay a dividend. The stock is also optionable. Liquidity is good at 436,473 average in daily volume.

Volatility ranking is below average at 3.33/10: the company has no debt, Beta is not determined, and the company has never been profitable.

Capacity to increase dividends scored 0/10: Demand Media pays no dividends and has never been profitable.

The overall quantitative rating or the ‘OFB Factor’ came in at 1.93/10, which is pretty dismal.

Summary:

Demand Media has an enterprise value of $1.02B and a forward PE of 34.27. Its revenue grew almost 22% on average in the last 3 years. The company plans to achieve revenue growth in the 25% range and is predicted to become profitable as early as the coming quarter. Analysts paint a rosy picture with earnings of 0.27 in the coming year accelerating at a 60% rate in the next year to 0.43. These projections are aggressive and seeing is believing on what the company can actually achieve.

The company has the chance to be a dominant player in the demand-based content creation business. Further, its freelance content creation model has the potential to tap a largely unexploited pool of respectable writers to generate commercially viable content. However it is unclear whether the company can continue to find content topics that are commercially viable while increasing profit margins perpetually.

Demand Media has a PEG ratio of 2.28, which indicates that the valuation is high. Our quantitative analysis showed a dismal rating for the company. As the valuation is high, and growth projections are aggressive, we do not recommend purchasing Demand Media stock at this time.

1 comment:

Anonymous said...

$25/hour should not be considered as minimum pay.

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