Demand Media: An Attractive Business for Now

| About: Leaf Group (LFGR)

This is part of a longer note on internet content in general and Demand Media (DMD) in particular. The full report can be downloaded with this link: Demand Media Crapification (pdf). Below is the section on DMD along with a link to our Intrinsic Valuation of $30.

The launch of the Demand Media IPO provides a detailed look at the massive machine whose purpose is to make money by serving content with a high affinity for advertisers and clicking consumers. First they figure out what people are searching for, intersect that with what advertisers are interested in, and then use a freelance team of thousands of content creators to write articles that will rank highly in search results and draw clicks on paid advertising links.

Although the company takes pains to demonstrate that they do, in fact, produce some decent content that provides complete and unique answers to some queries (like “how to draw a basket of fruit”), the vast majority is basically a page with a blurb of text surrounded by layers of advertising.

Fundamentally, Demand Media is an upgraded, well-capitalized and professionally managed version of other content farms. The company is not trying to fool anyone with the statement: “Our Mission is to fulfill the world’s demand for commercially valuable content.” Demand Media brings more technology and resources to this enterprise than the myriad “small time spammers” out there but, in the end, exists only to push out content that gets clicks. The content is cursory, sometimes cut and pasted from elsewhere, and all the time buried in piles of advertising. It’s certainly not the rich, high quality content users want.

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Demand Media is a giant sensing and production engine. It collects and analyzes a huge amount of data and then uses its production engine, DemandStudios, to publish 4,000 “articles” per day from over 10,000 writers. The company lists articles like “how to become a stockbroker” or “how to look sexy in a bathing suit” that can be written in exchange for a $15 fee. Combine inane questions with uninformed articles by the masses and you have a recipe for a pile of insipid web pages. The last step inserts ads on top, both sides, the bottom, and weaves them into the text to complete the exercise.

Of course, an elitist view of content can lead to missing some great investments. YouTube had plenty of garbage on it to start with. Many blogs and instant messaging traffic streams can be just as content-light as Demand Media sites. There are also companies like I Can Has Cheezburger, which has been extremely successful by dealing unabashedly with sites that provide silly content. Their sites comprise a vast network of distracting and useless sites like LOLcats. There’s real money to be made online by giving people fun, distracting or entertaining content.

Unlike these other companies, however, Demand Media is not trying to entertain but instead to inform and do so with the sole intent of driving advertising clicks. This creates what can only be called spam.

Uninformed search algorithms like Google’s (NASDAQ:GOOG) will return enough of these results to fill the first page or two of a screen. Most of the time it’s not obvious to users that the results are spam until they click on them. Google sees this as “Another happy user clicks on this link. We’re the best!”

Whether one is happy about what Demand Media is doing is beside the point from an investment perspective. Similar arguments were made concerning QuinStreet [(NASDAQ:QNST) – $23] after its IPO, but in our view a year ago the shares were undervalued at $13. Demand Media has an attractive business even though we think innovations in search technologies may make parts of it harder to monetize. Our Intrinsic Valuation model for DMD (pdf) suggests a $30 stock price.

QuinStreet took time to prove its model to investors. After a solid IPO early in 2010, the shares reached $17, only to fall back to $10 by the summer. Subsequently, however, the company has executed on its strategy and now the stock is more in line with its IV at $23. Last year we saw similar stock dynamics for (NASDAQ:ACOM) and Higher One Holdings (NYSE:ONE).

In order to shed more light on what will help improve information content on the web, our next post will look at Quora, another player in the online content space that has been turning heads within the “tech-noscenti” and is beginning to enter the mainstream.

Disclosure: None