Lack of demand for Demand Media

December 30, 2010: 3:00 AM ET

Sure the content mill has found a way to survive and thrive for years now. But a planned IPO has exposed weaknesses in its business model and accounting methods. Can Demand Media survive, let alone thrive?

By Dan Mitchell, contributor

The websites of Demand Media

The websites of Demand Media

Let's take it as a given: festooning the Web with terrible content is a real, viable business. Like it or not, it's probably here to stay in one form or another.

But does that mean it's a business worthy of raising money on the New York Stock Exchange ? Demand Media thinks so. The company, especially through its CEO, Richard Rosenblatt, does its best to convince people that it does something more than churn out cheap, substandard, sometimes hilariously bad content. The proof, however, is in the posting.

Demand pays peanuts to its army of freelancers, who churn out as much stuff (such as – really – "How to Calculate Age From Birthdate") as they can as fast as they can. Costs are low, and the quality generally, though not always, follows suit. Demand is nevertheless able to collect page views thanks to the algorithm it created to learn what people are searching for and base "how-to" and other articles around that. It then employs an elaborate system of search engine optimization tricks to force its content high in Google's (GOOG) search results. The quality of the content is ultimately (and dishearteningly, to people who care about such things) a tertiary consideration at best. The content is almost designed to be bad.

The fact is that if it's marketed correctly, crap sells. The only question is how much. Demand says it took in $200 million in 2009. Other companies are replicating its model—which, as far as it goes, is fairly compelling. As media companies struggle to make their online content pay for itself by adding value to it, Demand takes the opposite approach: removing value, by lowering the cost to below what advertisers are willing to pay for it, and ramping up volume to an insane degree. It reportedly pays freelance writers between $5 and $15 for each article. Videographers get $20 (Demand is the biggest supplier of YouTube videos). It posts about 20,000 new items each month.

But as things stand, Demand's initial public offering, which had been expected to price before the end of the year, is increasingly unlikely to take place at all, at least any time soon. Last week's news that the Securities and Exchange Commission is looking into the company's accounting methods might prove to be the final nail in the IPO's coffin.

But there are deeper, more structural reasons that Demand's business might not scale much further. Foremost is Google: Demand's whole business depends heavily on the search engine's algorithm, which determines how high up Web pages appear in search results. But Google can flip the switch any time it wants to, burying Demand's content on the second, third, or fiftieth page of results -- and Google already has plenty of reason to do so.

Much of Demand's revenue comes from AdSense ads on its pages, from which AdSense owner Google takes a cut. But less than 1 percent of Google's revenue comes from Demand. The search giant became No. 1 because of the quality of its search results, and if it continues to allow Demand's often-terrible pieces of content to rise to the top, Google's own reputation could suffer. That's not worth the short-term revenue gains Google enjoys from Demand's AdSense business, especially considering that Microsoft's (MSFT) Bing search engine is improving all the time and snatching market share. Google changes its algorithm all the time to keep spammers, pornographers, "article marketers" and the like out of the top of its results. It won't hesitate to do the same to Demand – which is itself just a glorified article marketer.

The venture capitalist Bo Peabody in November noted that the top Google result on the search phrase "how to roast a chicken" was an eHow recipe that was "absolutely useless." The top result at Bing was a recipe published by Epicurious, the Conde Nast-owned foodie site. Presumably, Epicurious paid a writer a lot more for its high-quality recipe than Demand paid for its useless one.

That points to another long-term problem with Demand's model: it locks the company into running the cheapest ads. Few companies pushing a brand want that brand associated with schlock, so Demand's ads tend to be from small, often fly-by-night companies.

The rise of social media also presents a big risk. People are more and more likely to ask their friends on Facebook or Twitter for advice or practical information, meaning they're less likely to search the Web for it. Your buddy who is in a band is probably a better source to learn "How To Play an Electric Guitar Manually" than Demand's eHow is (and your buddy probably wouldn't bother reminding you to plug the guitar in, or, for that matter, inform you that guitar-playing is a manual operation.)

Further, as Peabody noted in November, eHow is far from sticky: only about a quarter of users click beyond the page they land on. Most back out, perhaps looking for a more actionable chicken recipe. Sometimes, they click on an ad, which reportedly earns Demand somewhere between 15 cents and 75 cents. The site's AdSense links are "often the most compelling thing on the page," Peabody wrote.

Demand at the top

For investors, the chief concern might be CEO Rosenblatt himself.  Though he has a track record of sometimes eye-popping success, questions have followed him, or the companies he has run, throughout his career.

His first venture after graduating from law school in 1994 was iMall, which started out offering seminars on Web design. It went public, but then became the subject of an FTC investigation into its claims that clients' Web sites were earning $11,000 a month, which apparently they weren't.  The seminar business was shut down. But Rosenblatt shifted efforts into iMall's e-commerce platform business and sold the company to Excite@Home for $565 million.

Next for Rosenblatt was drkoop.com, where he tried to turn the Amish-looking former surgeon general into a brand.  The site sold marginal remedies like "prostate formula." The company disintegrated.

Soon after Rosenblatt became head of Intermix Media, which owned MySpace, Eliot Spitzer, New York's attorney general, accused the firm of planting spyware on users' computers. After paying a big cash settlement, Rosenblatt deftly engineered a deal to sell MySpace to News Corp. for $650 million.

For a couple of years up until last August, Rosenblatt repeatedly claimed that Demand Media is "profitable." But when the company filed its S-1 in preparation for its IPO, it turned out that the company wasn't profitable at all – certainly not by the standards set by the Securities and Exchange Commission. By those standards, Demand lost $22 million in 2009 and $6 million in the first half of 2010. The company is currently in its IPO "quiet period" and isn't talking to the media.

The SEC last week decided that the way Demand accounts for its costs was worthy of investigation, at a minimum delaying the IPO. The company spreads its costs of acquiring content over five years – something that by all accounts no other online-media enterprise does. That makes Demand's current-year losses appear to be smaller, since four-fifths of its costs are deferred to future accounting periods. Demand says that most of its content consists of "evergreen" articles that will generate page views over that term. (Yes, we will still roast chickens in 2015).

The theory might make sense, but it's certainly novel, and it will be a challenge to get it past regulators.Even if Demand somehow succeeds in doing so, investors will surely take it into account, which could hurt the stock price.

The stock price is already likely to be held down by Demand's highly uncertain future—another aspect of which is the fact that 40 percent of its revenues come from its domain-name operation, a business that earns even lower margins than online media. That business is integral to the way Demand draws Google mojo: it fills "dummy sites" with links to Demand content, making it appear popular to search algorithms. And if it gets lucky and has a domain some big company wants, it occasionally gets to sell that domains for a lot of money.

Still, you don't see a lot of domain-name companies trading on the New York Stock Exchange. Indeed, GoDaddy, a big domain name registrar, pulled its IPO filing in 2006, after its revenues were questioned. But then, GoDaddy doesn't have a published library of articles like "How to Buy Canadian Molson" to fall back on, does it?

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