Demand Media's IPO: The Devil Is in the Details

Demand Media, a much-discussed content startup whose audacious business model has drawn some controversy, filed for an initial public offering Friday to raise up to $125 million. Investors may be drawn by the buzz of its top-flight underwriters, but the proverbial devil is in the details of its prospectus. This is not a bad IPO, but it's also not as promising as the company would like you to think.

Demand Media describes itself as "a leader in a new Internet-based model for the professional creation of high-quality, commercially valuable content at scale." That's quite a mouthful, but really, not much of that description is at all new: The Internet has been around for a few decades now, and much more established is the idea of professionals creating content that's high quality or commercially valuable, or even both. The key word is the final one -- scale.

Algorithms to Determine What Readers Want

As the Web has sprawled, content has proliferated, audiences have fragmented and the old, expensive business models of producing content don't work anymore. That's Demand Media's view, and it's assembled a "studio" of 10,000 freelancers generating 5,700 articles and videos a day. This is the "grey-goo" school of media, yet all that content has helped Demand Media become the 17th-largest Web property in the U.S., according to comScore, with 86 million visitors calling up 550 million page views in June.

Fragmented audiences are good for advertisers hoping to target specific kinds of consumers. Demand Media says it's found a way to figure out what readers want, so that freelancers in its crowded studio can churn out just-in-time articles to sate their appetites. The company has developed algorithms that scour search terms, popular keywords in online ads and trending themes on social networks like Twitter, which prompts a writer to create an article.

The new business model has been bringing in revenue. Demand Media saw $187.9 million in revenue (excluding traffic acquisition costs) in 2009, up 16.6% from 2008. In the first six months of 2010, the company reported $108 million in revenue, up 23.9% from the same period a year earlier, suggesting growth is accelerating. Recent content-sharing partnerships with USA Today and the San Francisco Chronicle could keep revenue climbing for the rest of the year.

Not a Single Dime in Profits

Demand Media may not be a brand name on the Web, but its IPO is going to be closely watched. Having Goldman Sachs (GS) and Morgan Stanley (MS) as co-lead underwriters will help, as will eight other names on the prospectus, including UBS (UBS) and Jefferies, which will help in stirring up interest among institutional investors in an IPO market that's still very cautious.

And there's more at stake in Demand Media's IPO as well. In the past couple of years, venture capitalists have gone from regarding content startups as financial black holes to an area that could produce modest but steady profit growth. And Demand Media's methods are not without controversy. TechCrunch founder Michael Arrington blasted the notion of demand-driven media as "a race to the bottom", and Wired portrayed the company as "a factory stamping out moneymaking content."

Investors are inclined to focus on the moneymaking part of that equation. So it will come as a surprise to some that Demand Media hasn't made a dime since it was founded in 2006. In fact, it's lost a total of $52 million since it set up shop. However, revenue is growing fast enough that the losses are shrinking -- from $13.9 million in the first six months of 2009 to $6.05 million in the first six months of 2010.

Other Vulnerabilities

A few other details in the numbers may alter some general assumptions of Demand Media's business model as well. The much-touted content business is only 56% of its revenue stream. The other 44% comes from a domain registration business called eNom. Cheap domain registrations is a business with very low barriers to entry, so nearly half of Demand Media's revenue is very sensitive to competition. The company's content business also faces competition from rivals including About.com (NYT) and Aol (AOL), which operates DailyFinance.

Demand Media's content business is also quite dependent on Google (GOOG). The company said that 60% of the content it produced in the most recent quarter was published on one site, eHow.com. That site in turn derives 60% of its page views from Google searches.

In theory, Google could jump into Demand Media's market overnight and compete directly with it. A much bigger concern, however, is that Demand Media's ad agreements with Google are expiring over the next couple of years. And Google is constantly tweaking its own algorithms to keep advertisers and users from gaming their way up its search results. Those tweaks could hurt Demand Media's ability to generate page views over time.

2010 IPOs Haven't Fared Well

Given its growth and unique model, Demand Media is likely to find a home on the public markets. But given its losses and risks, the stock probably won't have the kind of stellar debut that could ignite a flurry of investor interest in other content company IPOs.

In fact, IPOs this year have been debuting below their initial pricing ranges. According to Renaissance Capital, 49.4% of IPOs in 2010 have begun trading below the price ranges set by underwriters, the highest ratio in at least a decade. Another 39.5% began trading above the proposed range, while only 11.1% placed above it. So in the end, Demand Media's IPO may not be something worth writing home about, not even for $5 an article.