Demand Media's Long-Term Success Will Depend on Its Operating Expense Ratio

|
Includes: LFGR, WBMD
by: Bill Simpson

This analysis of Demand Media (DMD) was provided to TradingIPOs subscribers in advance of its Tuesday January 25th IPO. The company raised $151 million by offering 8.9 million shares at $17, above its expected range of $14 to $16.

------------------

Demand Media plans on offering 8.6 million shares at a range of $14-$16. Insiders will be selling 3.5 million shares in the deal. Goldman and Morgan Stanley are leading the deal, UBS, Allen, Jefferies, Stifel, RBC, Pacific Crest, Raine and JMP are co-managing. Post-IPO DMD will have 83.7 million shares outstanding for a market cap of $1.256 billion on a pricing of $15.

The bulk of IPO proceeds will be used for investments in website content.

Oak Investment Partners will own 27% of DMD post-IPO, Spectrum Equity 17% and Goldman Sachs 7 1/2%.

CEO Richard Rosenblatt, former Chairman of MySpace, was instrumental in the eventual sale to News Corp (NASDAQ:NWS) in 2006. Mr. Rosenblatt also steered iMall towards a $500-$600 million sale in 1999. Pretty good timing by Mr. Rosenblatt (in both cases) as had he waited just a few years later on each, the selling price would have been massively lower.

From the prospectus:

We are a leader in a new Internet-based model for the professional creation of high-quality, commercially valuable content at scale.

DMD claims that instead of creating content based on anticipated consumer interest, their properties create content that responds to actual demand.

At heart DMD is a large group of freelance online content creators as well as a website registrar. DMD contracts more than 13,000 freelancers to produce articles and videos for its websites and outside online publishers. Revenues are accrued from advertising placed on the content. Demand also runs a domain name registry, eNom, which accounts for 35-40% of revenues.

The two segments:

  • Content & Media - Freelancer fueled content creation studio and a network of websites including eHow.com, Livestrong.com and Cracked.com. Surprisingly DMD's owned and operated websites comprised the 17th largest web property in the US. I've looked at the list and I do not believe I have ever intentionally clicked on one of DMD's websites. 105 million unique visitors worldwide monthly. In addition, DMD places content on 375 third party websites. Bulk of Content & Media revenues are derived from ads placed on their content. **In 2010 DMD's 13,000 freelance content creators generated 2 million online articles and videos. DMD does have a number of big name third party customers including USAToday.com, the NFL's website and various newspapers online sites. This segment accounts for 60%-65% of revenues.
  • Registrar - 10 million domain names under management, worlds second largest registrar overall. 72% 2010 renewal rate for expiring domain registrations. 35%-40% of annual revenues.


Note that 69% of content produced in 2010 was for DMD's eHow.com website. We can almost simplify this iIPO down to this: DMD is ehow.com and a registrar, enom.com.

Two interesting notes: DMD pays just $15-$30 per article on average to their freelancers. However DMD has opted to depreciate some of this expense out over 5+ years as they claim that is the useful revenue generating lifespan. Very unusual as all other public web properties expense content costs in real time in the quarter in which they occur. DMD's method will make them appear more profitable in the short run than actual cash flows. Oddly, while it makes them appear more attractive on the bottom line currently, it could negatively impact them down the road as they are depreciating years of costs that have been long paid. Personally we think the claim that an article placed online has 5+ years of useful revenue generation is a bit of a stretch. Not that huge of a deal however, as the expenses will need to be accounted for at some point whether all at once or over time.

Wholly owned content library currently consists of 3 million articles and 200,000 videos. DMD expects this library will increase dramatically going forward as they continue to aggressively add content to their shelves.

Growth - nicely scalable business here, limited only by the volume of ad revenue generating content DMD can churn out. Really, the question/concern here is how much content can a company churn out that will generate ad revenues? DMD does plan on focusing internationally going forward and sees that as a prime growth spot.

Google (NASDAQ:GOOG) relationship - Google's cost-per-click advertising accounted for 28% of 2010 revenues. DMD eschews direct sales staff for most of their ad generation, instead utilizing Google's ad generation service.

41% of traffic derived from internet search engines with majority coming from Google.

Financials


About $1 per share in cash post-IPO.

Nearly all of DMD's growth is being generated from their Content side as the Registrar segment has been relatively flat the past three years.

23% of 2010 revenues derived from eHow.com.

Revenue growth has been solid. Revenues of $170 million in 2008, $198 million in 2009 and a nice breakout to $252 million in 2010.

DMD has never posted an operational profit in any fiscal year to date.

2010 - $252 million in revenue, a solid 27% increase from 2009. Slightly negative operating margins. Should note that DMD for the first time moved into a slight operating profit in the back half of 2010. Loss of $0.03. Note that cash flows will also be negative in 2010.

DMD to date has not been able to significantly lower their operating expense ratio. In 2008 it was 111%, 109% in 2009 and right around 100% in 2010. Going forward the longer term success of this IPO will be levered to DMD's ability to show more improvement in this metric...to date it has not occurred.

2011 - Looking at trends, I would not be surprised to see DMD book $300 million in revenues. Operating margins have been slowly trending towards positive. 5% positive operating margins in 2011. DMD has extensive tax loss carry-forwards putting the tax rate in just the 10% ballpark. 4.5% net margins, $0.16 EPS. Cash flows should be about break-even in 2011.

Conclusion - 2nd tier internet IPO not generating much in the form of positive cash flows or earnings. Having written that, organic growth here has been solid the past two years and appears to be trending well into 2011. At a $1.256 billion market cap (on a $15 pricing), this appears pretty fully valued here on IPO. May get some play short term due to prior successes of the CEO.

In addition, this IPO looks like an initial step to set a baseline valuation for a future buyout. eHow ranks as the number 37 visited website in the US, well ahead of another niche site such as WedMD (NASDAQ:WBMD). WBMD currently has a $3 billion market cap with about double the expected 2011 revenues of DMD. WBMD is also more profitable, however it was not at time of IPO a few years back. If one wants to make a bull case here based on comparables and buyout potential, I believe it could be made...even though I do see this one fully valued in the $14-$16 range.