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Demand Media shares have declined precipitously since we reported steep declines in the company's Google (NASDAQ:GOOG) rankings on April 14, based on our proprietary web analytics. When Sistrix confirmed this result, the company broke its silence, pre-emptively reaffirming 2011 fiscal year guidance ahead of this week’s call.

Despite the company’s reaffirmation of guidance, the stock continued to sell off sharply, in what I believe to be an unusual vote of “no confidence” from the company's shareholder base.

With earnings scheduled for May 5, 2011 after market close, I believe the company will spin results by focusing on lightly impacted (and arguably irrelevant) metrics such as revenue and page views, while hiding behind a lack of disclosure surrounding the true problem -- the demise of traffic from immensely profitable organic search traffic.

Question 1: How much future profit opportunity did you lose from the Google de-ranking? Focusing on page views and revenue is irrelevant.

As the CEO of NerdWallet, a credit card comparison site that generates revenue in much the same manner as Demand Media’s properties, I believe that Page Views and Revenue for FY 2011 were minimally impacted by the Google de-ranking. However, I believe that ongoing profitability was massively impacted.

Why the discrepancy?

Demand Media’s businesses (ex domain registry) generate revenue in 2 key ways: 1) through advertising generated from buying clicks to DMD websites, either from media outlets like Google AdWords and Outbrain or by paying network partners a share of revenue, and 2) through advertising generated from either direct traffic or unpaid Google search traffic to their websites.

I believe that method 1 constitutes a majority of the company’s Media revenue and page views, but method 2 is what accounts for most of the profits.

For example, assume a web page generates an average of $1 per visitor. If you pay 99 cents to acquire the traffic from a media outlet, the incremental visitor generates a $0.01 profit. However, if you get the visitor for free via Google search results, or from direct visitors, the incremental visitor generates a $1 profit. This means that a search visitor in this example generates 100x the profits of a purchased visitor.

Economic theory stipulates that when you are bidding for traffic against competitors, as Demand Media often does, the profits per visitor acquired will quickly approach 0%.

NerdWallet finds it impossible to turn a profit buying keywords, for example, but we could double our traffic tomorrow if we so desired, by buying traffic at zero incremental margin. But these increased page views and increased pro-forma revenues are irrelevant to our profitability, or to our business value.

Larger scale players like DMD may be able to turn a thin margin on purchased traffic, but they are bidding competitively against other revenue sharing experts or keyword buyers, like Quinstreet and AOL.

Demand Media’s page views won’t be affected much because organic search wasn’t a dominant component of its page view base. But you infer that even though the company gets most of its page views from network partnerships or buying traffic, it gets most of its profit from search engine positioning.

Therefore, given Google’s recent de-ranking of their content farms, static pages that generate 100% incremental margin for a very low cost, especially eHow.com, the key question to ask is, “What is the overall impact to profits dollars per year, generated by your average existing article?”

Question 2: Does capitalizing content still make sense? Experts in the industry believe DMD properties flagrantly violated Google’s anti-spam guidelines in order to achieve the company's present search rankings.

One juggernaut in the SEO field, SEO Book, recently made Google the butt of webmaster ridicule, by illustrating how Demand Media used numerous “black hat” techniques to game Google rankings.

One technique involved using its domain registrar, eNom, to snap up expired websites with existing in-links, and redirecting those links to eHow. This is a big no-no according to Google’s web spam chief, Matt Cutts.

The article also points out some of the gems the company had in its intangible assets pool during IPO, such as “How to Get a DUI” and “How to Pick Your Nose” (which were quickly removed after the article was published).

Ultimately, Aaron Wall of SEO Book believes Google de-ranked eHow, because Demand Media “Made Google Look Stupid.” I believe, from a business perspective, Google’s brand reputation is a lot more important to its mangement than one large AdSense partner.

Demand Media has an incentive to make things sound good, in the near term.

The company and its bankers have an incentive to paint a rosy picture, ahead of a targeted secondary stock offering in the coming weeks. I believe the company needs to raise cash to invest in new content. While this need may not be apparent from the income statement, it is apparent from the cash flow statement – the company capitalizes content creation costs over 5 years, so it burns cash even while being marginally “profitable”.

Any admission on the company’s part that the high ROI from content creation reported on its S-1 for generating new content is at risk, would not only potentially derail the company's secondary offering and forward earnings growth logic, but also potentially cause its auditors to re-evaluate the wisdom of amortizing content over 5 years.

Where does that leave us?

It is my suspicion that despite how the company may present itself to investors, Demand Media consists of a lot of low margin businesses built around eHow’s ultra high margin search engine arbitrage business model.

And while page views and revenues may not have been greatly affected by the second Panda update, the game is up when it comes to profits. A dollar invested in new content just isn't yielding what it used to. The company may be able to hit the brakes on spending, while aggressively buying page views in order to delay the day of reckoning on EBITDA, but I believe that day of reckoning is coming in the next few quarters.

Source: Why Demand Media Should Focus on Profits Rather Than Page Views