Tuesday, February 22nd, 2011...11:48 pm

Demand Media – Digital IPO

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You may have noticed Demand Media popped off with an IPO in late January. Demand Media consists of a bunch of nondescript digital properties including eHow, Livestrong, Cracked and Answerbag. They also offer other digital tools such as social media solutions for partner websites, content channels (ex. Youtube Channel) and eNom domain registry service. Here are all of their properties and products.

The IPO made a bit of a splash in the news since it’s both the first digital media and venture-backed company to go public in this recent digital upswing. In the last few weeks LinkedIn, Pandora and Active Network (the largest company in recreational sports space) all have filed for IPO’s so this very well could be the start of a new, perhaps bubbly, trend. I’m not sure how this will all play out. Legendary early stage investor Alan Patricof drops some knowledge on the current state of the IPO market.

I steer clear of investing in individual stocks in the public markets. I’m suspicious about how the markets work. I still can’t get a solid explanation of how quant trading influences stock prices and what constitutes insider trading. I decided long ago that I’ll leave the fun and games to the hot shot finance guys on Wall Street.

But these digital companies interest me because, well, they’ve always interested me. I read approximately 40 tech/digital media blogs on a daily basis through my Google RSS reader. A key part to working in the fast-paced digital world is keeping up with all of the industry news. I breath, sleep, read and blog this stuff.

So I want to put on my virtual Armani suit and Berluti shoes and share some of my thoughts on Demand Media.

Demand Media calls itself an online media company but it’s really just a damn good content farm. Content farms are the cutesy term given to websites that generate lots of very cheap content specifically designed to rank highly on Google searches. These types of sites receive most of their visitors from people entering popular terms and then clicking on the top results. Often the user doesn’t realize or even care what website that they are on. The large amounts of web traffic are monetized through advertising, affiliate fees or lead generation. Read this article from WIRED for a fascinating look into Demand Media’s strategy. Compare it to a bar in Times Square. It doesn’t necessarily have to provide a good experience and doesn’t even need to do much marketing because it’s going to get a new wave of street traffic every day from tourists (and whoever else hangs out in Times Square) with a high DEMAND for a drink.

The content farm strategy has become popular because it’s a formulaic way to monetize content. It’s challenging, expensive and unpredictable to build large web audiences through sticky, engaging content. Besides a few major media brands like ESPN and the NY Times, most digital content publishers (including AOL SEED, Yahoo’s Associated Content) have employed some kind of SEO (search engine optimization) content farm strategy.

There’s a big fat under belly of the internet in which you can use all types of tricks and hacks to manipulate the flow of traffic. Demand is good at this. It’s in their company DNA. Their CEO, Richard Rosenblatt, helped launch MySpace using many of the same traffic-driving voodoo tricks. He knows how to do this. DM is not encumbered by trying to create quality content or trying to retain users.

Since Demand’s websites rely almost exclusively on Google to provide a fire hose of traffic it stands to reason that they must stay in Google’s good graces. Yet Google just announced they want to put an end to “gaming” of their search results (many believe this was directed at Demand Media and their digital agrarian friends). If you interested to stay abreast of how Google deals with SPAM and their search results then follow Googler Matt Cutts and his blog.

Before you eTrade it up and short shares of Demand realize the dynamics at play here. While Google has to organize the world’s information, Demand just has to figure out how to make a tweak here or there to stay in the search results and be the “best click” on Google. It’s like how every time the IRS changes the tax code, the savvy tax accountants always figure out a new loophole for their clients.

As I did some quick research for this blog post almost every article I read was negative. Apparently Demand hasn’t yet conquered the search results for “Demand Media IPO”. Yes, some of the negativism comes from the bleeding-heart journalists who gripe that the apocalyptic end of quality journalism is upon us. Others question how Demand will survive if Google has a Bulls Eye on them.

I see it a bit differently. Demand is smart enough to continue to stay ahead of the traffic curve. Demand will remain successful in driving traffic to their network of sites and will even figure out ways to expand their network through acquisitions and network effects. Even if Google tweaks its search algorithms Demand will still beat out other websites that have objectives other than just trying to optimize for search rankings.

But there are three reasons why I’m down on Demand.

1) In the short term, more content farms will pop up leading to more direct competition at the top of the search results.

2) As content farms grow in prominence they will get a bad rap (it’s already happening). Consumers will become more weary of this subpar content. Advertisers will no longer be willing to pay the premiums that Demand’s direct sales team is peddling. Instead Demand will be viewed as Ad Network traffic and will watch it’s CPM’s quickly shrink. It will get much more difficult to monetize.

3) If content farms continue to dominate search results users will begin to use other methods besides search to find information. Social media platforms like Facebook and Twitter will become more efficient ways to find what you are looking for. People you know will replace the little hamsters spinning on wheels in Google’s server rooms. Yeah, for this to happen Google will take a big hit. But more than anything, this further proves out the point that Demand is just capitalizing on an abnormality in the search market. Kudos for them for taking advantage of it but there’s no reason to expect this inefficiency to last.

Although not yet profitable, Demand Media’s valuation is $1.5 Billon. Blogger Peterk Kafka explains how that is a higher valuation then the NY Times. If you had asked me a few weeks ago to estimate Demand Media value I probably would have said $100MM. That’s around the same price that Yahoo acquired Associated Content (another content farm) for last May. The major difference is that DM does a better job monetizing/selling their content to advertisers while Associated Content focused on the content creation and distribution.

I’ve looked over Demand Media’s S-1 filing (a new hobby of mine). First off, 40% of Demand Media’s revenue is from their domain registry business. This is a low-margin no frills business that is very separate than the media part of their business. You might expect Demand Media is printing money with their laser focused formula on aggregating and monetizing content. But that’s not the case. They haven’t been able to SPAM their way to profitability even with annual revenues reaching about $200MM.

Ultimately, although I’m impressed by their business strategy innovation I’m down on the company. Demand Media doesn’t create value for any of it’s customers or stakeholders. It’s hard to get behind a company whose whole existence is based on an arbitrage move on the market. It feels like Richard Rosenblatt is running a scheme as shaky as Rich Rodriguez system at Michigan. Users seem to be better off clicking on a different search result. Advertisers willing to pay a premium will see better performance on sites with better content. Both these things will happen (they already are happening). When it does I’m not sure what Demand will do.

I’ll continue to follow DM and interested to see how this all plays out. I’m sure I’ll keep my eye on the stock price as well. BTW, If Littyhoops was an analyst that farted out lofty projections he might say Demand Media would fall to less than $10 per share within the next 12 months.