When Demand Media floated earlier this week it started out at $17 a share, rocketed on first day trading to a high of $24, and even after falling back to trade around $22 last night its market cap of $1.8bn still makes it worth more than the New York Times. It's that "worth more than the New York Times" bit that evidently set journalists' teeth on edge - if the US paper of record is worth less than a five-year-old content farm, what hope for journalism?
It's neither surprising nor informative that journalists almost universally hate Demand Media and want it to fail. People who make a living from writing and take pride in crafting sentences are hardly disinterested observers of a content farm that treats articles like commodities and has driven down the price of an article to $15.
The good news for journalism is that there is no rational basis for believing that Demand Media is worth more than the New York Times. Looking at the numbers behind the IPO, Demand Media's almost $2bn valuation doesn't make an iota of sense.
Demand Media is really two businesses, the well-known content farm and a less well-known (and substantially older) domain registrar. Revenues are now split approximately 60/40 across the two, with revenues flat at the registrar and revenue growth over the past two years (and therefore presumably in the future) coming from the content side. While the IPO prospectus makes some optimistic noises about the two businesses supporting one another they don't, really - like many companies, Demand Media just happens to own two businesses in vaguely related sectors.
Over at SeekingAlpha Kevin Berk does an excellent job of breaking down some benchmarks that can be used to value the two businesses that make up Demand Media, comparing the registrar business to Tucows and the content farm to IAC, Answers.com and Marchex. He concludes, on some overtly optimistic revenue multipliers, that Demand Media should be valued not at its current $22 per share but at $10 per share. On a realistic multiplier he says he could make a case for <$5 a share. I agree.
And that's just taking at face value the Demand Media numbers, and discounting the major risk factors. Let's look at some unusual features of the numbers first (there are two major ones).
First, and other people have commented on this elsewhere, Demand's accounting policy regarding the costs of content creation is highly unusual. Rather than writing off the costs of creating articles (ie fees to freelance writers) as incurred, the company chooses to depreciate those costs over five years on the basis that five years is the useful commercial life of an article. Everyone else in the content business just writes off content costs as incurred; Demand is effectively taking them onto the book as an asset and depreciating them, which will make their short-term content costs appear superficially lower than they would be under the accounting policy applied to similar costs by other companies in this field.
Second, and I have seen no-one else query this, the way in which Demand recognises ad revenues also appears to be unusual. To quote the IPO filing (p65):
"We recognize revenue when four basic criteria are met: persuasive evidence of a sales arrangement exists; performance of services has occurred; the sales price is fixed or determinable; and collectability is reasonably assured. We consider persuasive evidence of a sales arrangement to be the receipt of a signed contract." The filing goes on, on p66, to explain more about this arrangement for recognising ad revenues and concludes "Historically, any difference between the amounts recognized based on preliminary information and cashcollected has not been material to our results of operations."
In other words, from the wording of the IPO filing it appears that Demand Media is recognising (non-performance) ad revenues not as the ads are served and billed but on receipt of a "persuasive" contract from an advertiser with a decent credit rating. If so this is an unusual approach when compared to other ad-funded media businesses and could expose the company, and its investors, to various risks - if for example ad revenues that have been recognised in this way are not in the event collected. It could also expose the company to apparent but ultimately unrepresentative fluctuations in revenues, for example in reporting periods during which large, long-term contracts are signed by advertisers.
On top of all that, the main risk factor faced by Demand Media is already a near certainty. Google has openly stated an intention to improve its search results by limiting the exposure of content farms. That means the major source of traffic to Demand Media's owned websites is likely to diminish sharply as a matter of deliberate policy, and while the company has enjoyed success in generating partnerships and revenues from third-party publishers the majority of its media revenues continue to arise from its own properties such as eHow and Livestrong. Unless something changes the seemingly inevitable curtailment of traffic to those sites will hammer Demand Media's core revenue stream.
At $25 a share Demand was worth north of $2bn - more than the New York Times. At a more realistic valuation of $10 a share that market cap looks more like $800m, and at $5 a share around $400m - the same scale as a minor UK newspaper publisher such as Trinity Mirror, or a niche US online publisher like The Knot. For a five-year-old online publisher which has yet to achieve profitability and faces serious risks to its core businesses that would be no mean feat at all. But $2bn simply isn't credible, and if the Demand Media IPO tells us anything it's that in the run-up to Facebook's flotation we are facing a new internet bubble - and your best bet is once again not to be holding the shares when it bursts.