August 12, 2010

Demand Media’s IPO: Everything You Need to Know

Demand Media is the biggest pure-play SEO company in existence. And SEO is one of the fastest-growing marketing channels. So if you want to know what the marketing industry as a whole will look like, the best way to do it would be to take a look at Demand Media’s financial data. That information was available to investors and executives at the firm, but not to everyone else—until now.

On Friday, Demand Media filed a form S-1 with the SEC in preparation for going public. During the last week, I’ve read through it to see how much the world’s most successful SEO company makes from SEO.

There are a few big surprises; they’re less profitable than I expected, even though their accounting is more aggressive than I’d expected. But Demand Media has two major positive features. By combining their long-tail content business with their boring domain registration business, they may have created a domain registrar that can afford to offer lower prices than anyone else. And their content business could conceivably fix an economic inefficiency even larger than the one eBay solved.

eNom, Demand Media’s Registrar—The Boring Business

eNom was the first company Demand Media purchased, in early 2006. Demand’s financial data prior to that just comes from eNom, so it’s possible to get an idea of how valuable the registration business is as an independent entity.

Even better, there’s an older pure-play registrar, register.com, which was bought out in 2005, providing a starting point for a comparison multiple.

In Register’s last four quarters of operation, it generated revenue of $100mm, and operating cash flow of approximately $11.2mm. Their final purchase price was around $90mm excluding cash on hand. (Since then, it appears that Register.com hasn’t grown; they were recently purchased by Web.com, which touted a “combined company has a non-GAAP revenue run rate of approximately $180 million”—compare that to their trailing revenue of about $100mm, and it appears that Register is now doing about 20% less business than it was at the time of the acquisition).

eNom was actually less profitable than Register.com during the brief period that their financial statements overlap, but it makes up for it with strong growth. From 2005 to early 2007, annual revenue was basically flat. But from March to the end of the year in 2007, it grew at a 45% annual rate; the next year, eNom showed 61% growth. From 2008 to 2009, it grew by just 6%, but for the first half of 2010 they’re showing (unaudited) 40% growth.

If slow growth is worth .9X sales, what is 40% growth worth? It wouldn’t be surprising to see them valued at 2X to 3X sales.

But that revenue number may be conservative. Domain registrars book their revenues over the life of a registration, even though they generally get the cash upfront. So when eNom shows $X in new revenue this year, that $X will show up during each of the next few years. They don’t seem to disclose the average length of time for which their domains are registered, but one year is the minimum. This can provide an additional cushion to investors concerned about short-term accounting losses; as Godaddy’s CEO explains, “ during periods of sharp growth it is very difficult, in fact almost impossible, for us to show a profit.

Demand Media Studios: The Long-Tail Content Business

Demand Media was the first company to transform “long-tail” from a concept into a business. Starting with Chris Anderson’s Wired article, people have understood that the low transaction costs of online businesses mean that most of the growth comes from obscure stuff; Barnes & Noble would have to make some serious changes to fit 100% more books into their stores, while Amazon could make less significant changes to accommodate 1000% more titles.

But if Amazon’s business can take advantage of the Long Tail, the average SEO-focused business can thrive with it. One thing the original long-tail theory didn’t grasp was that specificity, on average, leads to higher engagement. And the best measure of “Engagement” is sales.

For example, consider someone trying to file their taxes late. They might start by searching for “taxes,” and find the information too generic. They’d narrow it down (and move into Long-Tail territory) with a more specific query like “File late taxes.” If that didn’t get them accurate enough results, they’d take it one step further—”file late 2008 taxes”. If they did that, they’d probably end up on the site of one of my clients. That client has ceded higher-traffic terms like “taxes” and “late taxes” to the IRS and competing tax sites. But as it turns out, specific terms are more likely to lead to a sale.

One of the strategies I used was to create content on “Article Directories,” (of which the most popular is EzineArticles.com—see my Ezine Articles SEO guide for details).

Article directories are Demand Media’s primitive ancestors. Their business model works a little like this:

1. Let people create content on whatever topics they want.

2. Edit the content to make sure it’s in acceptable English and not plagiarized (i.e. that it fits Google’s standards for minimum quality.)

3. Let writers include a link or two to their own content, so it’s worth writing.

4. Plaster the articles in ads.

5. Use every possible SEO trick to make the articles rank well on Google.

This business has great margins. As long as the cost of editing and hosting articles (probably under $4/article) is less than the revenue from ads, the business will thrive. And improvements in SEO will increase revenue for all of the articles.

Demand Media tweaked the formula. Their typical article is not “whatever topic you want”—it’s a specific subject that they’ve picked out based on search traffic data. In exchange for determining the article topic, Demand Media pays writers, often $15 per article.

It doesn’t take much for this to be an effective strategy. As long as:

1. Demand Media has good data on what’s being searched;

2. They have a large operation—for any topic they come up with, they can find a writer;

3. They can maximize the number of clicks on ads, versus on links; and

4. Demand Media has superior SEO: if an article directory is going to rank for a term, it will be their article directory;

Then they’ll have a competitive advantage over everyone else in the industry. And at that point, the only thing that limits their profits is the number of commercially-viable long-tail searches.

Do they have this advantage?

That’s a tougher question. But they’ve made some intelligent moves. As mentioned before, their domain registration business gives them a unique source of data and traffic. As long as they’re already in the business of monetizing pageviews based on traffic data, that’s going to provide them with extra profits.

And they’ve purchased some great domain names. Google has a policy of giving extra weight to established sites; if you’ve been online for a decade, you’re not going to throw away your reputation, so Google can afford to rank you better. eHow was registered in 1998. Cracked was registered in 1997. Trails.com was registered in 1999. You can only beat that by paying for it, and it’s tough to find cheap domain names that were registered that long ago. (It wasn’t so expensive a few years ago, when Demand Media was buying.)

They’ve also picked up some domains that will naturally earn links, like Livestrong.com, which was brilliant. They took goodwill for Lance Armstrong, as expressed by links, and turned it into a high-ranking health website.

But Demand Media’s real advantage may be their article quality. They’ve set prices at a point that makes it uneconomic to write a lengthy, well-researched article; better to write something quick that covers the topic without ultimately answering the question. And that is the perfect way to create an article that is less compelling than the ads. Right now, I can see the Demand Media is offering $16.00 to write “How to Build an Acorn Skiff”. I could write 500 words on the subject, but if someone read what I had to say, and saw ads for an “Acorn Skiff Kit,” or “Acorn Skiff Instructions,” they’d probably opt for the ad.

Demand has revealed their return on new articles, and the numbers are stunning. According to their own metrics:

We base our capital allocation decisions primarily on our analysis of a predicted internal rate of return and have generally observed favorable historical returns on content. For example, our article content published on eHow in the third quarter of 2008, or Q308 cohort, generated a 58% internal rate of return. This internal rate of return measure does not account for any revenue after June 30, 2010, although we anticipate that our Q308 cohort will continue to generate revenue for the foreseeable future and therefore achieve a higher internal rate of return. For example, article content produced in the Q308 cohort achieved 62% revenue growth in the second quarter of 2010 as compared to the second quarter of 2009.

Oddly enough, Demand is almost keeping two sets of books. While their IRR is calculated as:

the discount rate that, when applied to the advertising revenue, less certain direct ongoing costs, generated from the cohort over a period of time, produces an amount equal to the initial investment in that cohort.

But:

[W]e have paid substantially all of our freelance content creators upon the creation of text articles and videos, rather than on a revenue share basis, and we capitalize these payments.

In other words, the reported results for their content strategy bear only a tangential relationship to how profitable it is. Their return on new content is ridiculously high, but they report the upfront cost over several years.

And it’s growing. As of their S-1 filing, they generated “5,700 text articles and videos,” per day. Compare that to “the 4,000 videos and articles that Demand Media publishe[d] every day” as of last October. Later in their report, they reveal the “RPM” (revenue per thousand pageviews) for their content business over the last few years. In 2008, that number averaged $10.56; for the first six months of 2010, it was $11.81. Compared to the first half of 2009, total page views are up 23% (to 3.9 billion). Meanwhile, they have 2.2mm pieces of content (videos and articles). If that number is growing at 5,800 per day, it’s growing at approximately 24% per quarter.

This could be a sign that their ability to find profitable long-tail content to create is diminishing. (At some point, we’ll run out—or at least get to the point where the amount of content available expands based on new searches, not existing searches that are underexploited.)

Assuming the 24% quarterly growth number is correct, their annual growth in total content is around 136%, compared to their year over year pageview growth of 23%.

For their content business to generate continued growth, they need to do two things: they need continued RPM growth to counter the fact that they can’t buy as many pageviews as they once could. And they need to exploit higher-quality content.

Demand Media and eBay: Is an Attic Full of Collectibles like a Stay-at-Home Mom with a Masters Degree?

Demand Media is a puzzle, but you can put the pieces into place by examining what economic inefficiencies they exploit. Their name emphasizes the first one—they create content based on demand, which they can determine algorithmically. But an equally big story may be their supply.

Demand Media’s content business has solved a huge labor market inefficiency: there are millions of people who can write reasonably well, but who can’t efficiently get a full-time job. Think of students, housewives, retirees—and ignore anyone below the 90th percentile. It’s a gigantic population of people who are unlikely to get full-time jobs, but who can’t effectively spend their time doing piecework or freelance writing.

Thanks to Demand Media, they can do incremental writing work. If they can’t work full-time and it’s hard to judge them part-time, their labor is massively undervalued; in fact, if you look at the rise of blogging, tweeting, Wiki-ing, Q&A sites, etc., you could assume that the median price of their time is zero. By paying more than zero, at a huge scale, Demand Media may be able to buy and judge more hours of decent writing than any other company.

Treat those underused hours like assets, and you can see Demand Media as an opportunity like eBay. What propelled eBay’s growth was that a huge number of households owned knicknacks and antiques that they couldn’t cost-effectively sell. eBay created an efficient market in those products, and in just over a decade they cleaned out a couple million attics and garages, at a profit. Now that the big opportunity is gone, their growth has slowed down, but they’ve still established a wildly profitable business.

Demand Media has a similar opportunity—at a scale at least an order of magnitude larger. What’s the book value of all the antiques in the US? Something in the tens of billions sounds reasonable; something in the low hundreds of billions might be the upper limit. eBay earns commissions on those sales, with a maximum of fifteen percent.

Now, compare that to the value of the potential labor everyone in the 90th percentile of writing or movie-making skill, who doesn’t have or doesn’t want a full-time job, but would like some extra income. Figure $30/hr times two hours per week times population times (1 – labor force participation rate) times 10%, and you get a total value of $29 billion per year. That’s the amount of money left on the table if the top 10% of the 30% of people in the US who are not members of the labor force could have each written four articles for eHow.

But that’s just the price. If Demand Media earns even a small positive return on those otherwise unused hours of labor, the value could go up even more.

It gets better. Demand can afford to target the top 10%, but what about the top 1% or the top .1%? Once they have a system for ranking everyone’s quality, they can also start selling off premium talent at a premium price.

And that’s exactly what they’re doing. Many of Demand Media’s newer deals aim for a higher price point: premium content on SFGate.com and NFL.com, and $80 homepage HowTos for eHow.

As more of their writers are making (and earning!) $80 for a good article instead of $15 for a mediocre one, they’ll be able to attract better writers. At their current growth rate, there’s a good chance that they will be able to pay a more accurate market price than anyone for writing talent. We could see an online world in which people are divided into a) brand-name authors, most of whom make basically nothing, and a few of whom have great name recognition, and b) Demand Media authors, whose skill and value are efficiently quantified, and who make exactly what they’re worth.

That’s the big opportunity for Demand Media. Every day, talented people are wasting their time. And valuable content that could be written doesn’t get written. Matching these two parties is a many billion-dollar opportunity, and (at least in the short term), Demand can capture the majority of the value from arbitraging it.

That’s the upside. A $30 billion market, coming out of nowhere, where Demand Media has a de facto monopoly.

Ten Questions for Demand Media’s Management

If you’re thinking of investing in Demand Media, or you get a chance to participate in their IPO roadshow, here are some unanswered questions that could firm up their valuation.

1. Why equity? If investing in new long-tail content produces such a high IRR, with such low marginal cash requirements, why not issue bonds instead?

2. Why is capitalized content amortized over five years, and not based on lifetime expected traffic?

3. How fast is the total amount of long-tail traffic growing? When will Demand Media saturate the immediate market?

4. What were the circumstances behind buying The Daily Plate from Demand Media employees—and are other employees working on similar projects?

5. Does the RPM for content vary based on how it’s found? Is there more growth in low-RPM or high-RPM traffic sources?

6. What is the IRR for Demand Media’s different content types—long articles, short answers, and video content?

7. Does Google view eHow, in its current form, as a problem?

8. What aspects of Demand Media’s niche-targeting strategy are not replicable?

9. What IRR do competitors get on content they create?

10. Does Demand Media expect to compete by paying more for content, earning less on ads, or both?

Demand Media is the most exciting IPO since Google. It’s a transformative business—for anyone who works online, sells online, or could do valuable work with a more efficient labor market. For many people, it’s disruptive; I expect Demand Media to reduce the demand for the work I do, and to outbid me for the people I’d like to hire. But overall, the effect is positive. Ultimately, Demand Media is living up to their name—they’re matching supply and demand, and they could make a fortune from it.

Full Disclosure: This is complicated. I have written content for Demand Media, and gotten paid for it, but not enough to affect my lifestyle. I also compete with Demand Media, in the sense that we’re both often trying to create content that ranks for similar terms. And since I’ve used ads on Google’s Content Network, I’ve also contributed to Demand Media’s revenue.

You should subscribe to my feed or follow me on Twitter.

I’m currently the Co-Founder and CEO of a startup providing equity research and M&A due diligence to investors analyzing online businesses.

  • http://topsy.com/www.byrnehobart.com/blog/demand-medias-ipo-everything-you-need-to-know/?utm_source=pingback&utm_campaign=L2 Tweets that mention Demand Media’s IPO: Everything You Need to Know | Byrne’s Blog — Topsy.com

    [...] This post was mentioned on Twitter by Byrne Hobart, JC Hewitt. JC Hewitt said: RT @byrneseyeview: NEW post!: Demand Media's IPO: Everything You Need to Know http://bit.ly/9LMOIL [...]

  • http://blog.authoritylabs.com/billion-dollar-seo-company/ Demand Media – The Billion Dollar SEO Company | AuthorityLabs Blog

    [...] so we thought we’d try and make it a bit clearer. Byrne Hobart helped break things down in his post about the Demand Media IPO. Wired broke down Demand Media’s business model in detail and their S-1 filing fills in many [...]

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  • http://twitter.com/p6trick Patrick White

    Excellent article. I was disappointed to see that it had received no votes (other than your own) on HN. I usually rely on HN to make sure I see something like this. And interestingly, I ended up here after seeing your profile on Quora. A sign of the times, perhaps?

  • http://twitter.com/p6trick Patrick White

    I’m not understanding the difference btw revenue and operating cash flow. Care to help me out? (a bit of Googling didn’t, so I’m a bit stuck ;-)

  • http://www.byrnehobart.com/blog/ byrneseyeview

    Revenue = all the money paid to the company, ignoring expenses.

    Operating cash flow = revenue, minus expenses relating to the operations of
    the business, ignoring depreciation and cash flow.

    So if your lemonade stand sells $10 of lemonade, that’s your revenue. If
    it’s staffed by volunteers and you used $5 worth of lemons, your operating
    cash flow is $5. If you invested $1 in a pitcher, and paid $2 in interest on
    the loan you used to get started, your total cash flow is $2 ($10 in
    revenue, minus $5 in operating costs, $1 in capital expenditures, and $2 in
    financing cash flows).

  • http://www.byrnehobart.com/blog/ byrneseyeview

    Thanks!

    Social bookmarking sites either do vastly better or vastly worse than
    expected; an article like this, posted on HN, will either get 50 views or
    5,000, but rarely anything in between.

  • http://twitter.com/p6trick Patrick White

    Thanks for the response! That clarifies it for me.

    Where’d you get the financial info for register.com? Directly from their filings or from somewhere else?

  • http://www.byrnehobart.com/blog/ byrneseyeview

    It’s in an old press release on the merger, I believe. Or possibly from
    their last 10-K, which is on sec.gov.

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