Demand Media kicks off Web bubble 2.0

January 26, 2011

Demand Media’s IPO seems to have kicked off Web bubble 2.0. Investors clamored for a piece of the Internet content sweatshop. The company upsized its offering, raised the sale price and the shares still popped 38 percent in their debut. Yet Demand is festooned with red flags. Just imagine how higher-quality Web firms would be received.

Investors are attracted to Demand’s growth: revenues grew at a 25 percent clip in the first nine months of 2010. And since Internet businesses tend to scale well, there’s the prospect of rising margins as sales growth outpaces costs. Yet it’s hard to see how the seventeenth largest U.S. website can really justify a market value greater than that of The New York Times.

For starters, Demand gets about 40 percent of revenue from registering Internet domain names, a slow-growing business. So investors have latched onto Demand’s sexier operation of paying freelancers $15 or so for articles on topics suggested by an algorithm to maximize ad revenue. It’s this business that makes Demand equally intriguing and frightening.

Advertising on Google accounted for 28 percent of Demand’s revenue in the first nine months of 2010. Yet Google’s principal engineer wrote last week that the search giant needed to do a better job of eliminating low quality articles and videos made by “content farms” from polluting search results. That can’t be a good sign for Demand.

Moreover, the company’s accounting practices look aggressive. Demand says its content has a lifespan of five years, so it amortizes the cost of creating it over this period. If enough articles such as “How to be a hipster in Chicago”, have a shorter shelf-life, the result would be high revenues up front and costs spread out over an unrealistic period. That would suggest current margins are inflated and its losses understated.

Yet investors are ignoring these risks – happily snatching up $151 million of stock (around half of which comes from Demand’s backers and its chief executive). That an unprofitable company with aggressive accounting and a questionable business model can receive such a warm welcome shouldn’t be overlooked in the halls of Facebook, Zynga or any of the other Internet companies debating their public debuts.

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