Demand Media Faces Harsh Spotlight En Route to IPO

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Demand Media CEO Richard Rosenblatt

Updated: Whenever a company files for an initial public offering (IPO) — particularly in the IPO-starved technology sector — it gets put under a microscope, since it’s the first chance observers have to see the actual numbers behind the business. Demand Media is the latest to see its weaknesses exposed under the glare of this public spotlight, as it prepares for an initial stock offering that is expected to be in the $1.5 billion range. The content-generating company filed an S-1 document detailing its finances late last week, and that’s drawn some red flags; in addition, there are concerns about the company’s web traffic, and a consortium of traditional content companies wants producers like Demand to submit to industry guidelines governing the quality of its content.

The Case of the Missing Profits

In Demand’s securities filing, the company breaks down the finances of its main business: the content-production unit Demand Studios, which produces web copy, photos and videos based on algorithms that look at which advertising keywords are getting the most traction. According to the document, this business had revenue of $198 million in 2009, and booked a net loss of $18 million, while in the first six months of this year, it had revenue of $114 million and a net loss of $4.2 million. Yet (as the Wall Street Journal notes) Demand CEO Richard Rosenblatt has repeatedly insisted that the company is profitable, including in an interview with Om, which is embedded below.

Profit, of course, is a fluid concept — as any Wall Street investment banker knows. Rosenblatt could well have been referring to the fact that the company has consistently generated a profit from its actual operations, since the net loss has been driven by amortization of acquisitions, something accountants require companies to book but doesn’t really affect the actual profitability of the business itself. Still, saying “we are profitable” traditionally means bottom-line profitable, not on a cash-flow or EBITDA (earnings before interest, taxes, depreciation and amortization) basis. If the Demand CEO meant operating profit, he should probably have said operating profit.

A Traffic Cop Named Google

Meanwhile, questions have been raised about Demand’s traffic, which appears (based on some rankings) to have dropped sharply. According to an analysis by peHUB, which looked at Quantcast data, traffic to the company’s various web properties (which include the Cracked.com humor site and bike-racing star Lance Armstrong’s Livestrong site) dropped precipitously from more than 7 million daily visitors to less than 2 million. A glitch? Perhaps — since other measurements show no drop. Demand is in a “quiet period” mandated by securities regulators in advance of the IPO, and so can’t comment. But one of the concerns about the kind of content that Demand offers is that it is susceptible — as the company notes in its filing — to the whims of Google’s algorithm, which generates about 40 percent of the company’s traffic. If Google decides to devalue it, it’s worth less, period. And there’s also the chance that Google will compete with it.

Attack of the Traditional Content Providers

Speaking of devalued content, a group of content producers have recently taken aim at Demand (although they don’t mention it by name) and similar auto-generated content companies that they believe are devaluing content online. Known as the Internet Content Syndication Council, the group yesterday sent out proposed content-publishing guidelines to its members, who include Reuters, Sony BMG and Google, as well as New York Times subsidiary About.com, which some would argue takes a very similar approach to content as Demand Media. The guidelines (which are voluntary) include requiring publishers to “clearly display the credentials of the sources used to create the material” and “ensure that all content submitted is vetted by established and qualified editorial reviewers.”

The spotlight on Demand’s business will get turned up another notch when the IPO is finally priced — which should happen within the next month or two — and analysts can debate the valuation of the company, a job that some have already started on. According to some estimates based on market multiples for its content business and domain-registration unit, the company could be worth as much as $1.8 billion. But that assumes the spotlight doesn’t turn up any other uncomfortable blemishes on the company’s business.

Update: As a reader has pointed out in the comments, Demand’s domain-registration business has also come in for criticism, based on the reportedly large numbers of websites hosting malware, viruses and other abusive or illicit content that have registered their domains through the company’s eNom business. An earlier report accused the company of knowingly registering domains to illegal pharmaceutical distributors.

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