We last wrote about Demand Media in April, when we discussed how the company was killing it and was poised to be the first billion dollar Internet IPO since Google. As a private company, we weren’t privy to their financials, but were impressed with the creativity of their business model, and more impressed by their traffic growth.
Now six months later, Demand’s growth has continued, the company has filed their S-1 to go public, and amended it, and we feel vindicated by our earlier assessment. Demand is truly onto something big.
So we were surprised to read an article on Business Insider by Bo Peabody, a successful long-time VC, detailing why he was “down” on Demand.
Here’s why we continue to be a fan of Demand Media.
Demand Media has a media business and a domain registration business. Bo used the chart below using data in the S-1 to break out the historical revenue between the two businesses.
Photo: Demand Media’s S-1 filing
In their S-1, Demand describes their media business by saying they “…create highly relevant and specific online text and video content that we believe will have commercial value over a long useful life.” To produce that content, Demand Media engages a “robust community of over 13,000 highly-qualified freelance content creators.” Bo and others refer to that process of scaled content production as a “content farm.” While meant to be a dismissive term, as we discuss below, the production process keeps costs low, and the content produced has a huge and growing audience.
We Find The Quality of the Content Consistent and Surprisingly Good
There is a belief by many that “content farms” can’t possible produce quality content. We believe that’s a mistake. One ehow article Bo discusses is “How to roast a chicken,” which is the top result on Google and Bo describes as “utterly useless.” We are not sure what Bo’s cooking credentials are, but three of the four comments on the article were complimentary, and 49 readers liked the article enough to share it with their Facebook friends. We’ve cut and pasted two of the comments below, which also gives a sense of the community ehow is building.
The bottom line is that ehow’s content is professionally made (people get paid for it), it meets strict standards set forth by Demand, and readers like it enough to comment and share in volume.
ehow’s Reach Continues To Grow
It’s like the early days of cable when the networks and critics derided cable’s low quality content. Cable didn’t care about the critics, they cared about the eyeballs. Eyeballs are what Demand Media and its investors, care about as well. The bottom line is that ehow’s content is attracting a massive and growing numbers of eyeballs. Take a look at the Alexa chart for their flagship property, ehow, now the 15th most trafficked Website in the U.S., according to comScore:
ehow has been able to achieve that rapid growth rate, in part, by optimising the content so it can be found via search. In fact, part of the brilliance of Demand’s model is that they decide what content to produce, in part, by looking for what people are searching for in the long tail, that doesn’t have compelling content. Demand tries to fill the content gaps. Demand Media’s algorithms almost assure that every piece of content Demand produces will be profitable. Demand Media’s S-1 states the IRR of the content made in 3Q ’08 is 76%, assuming it generated no future revenue. Given that revenue for the Q3 ’08 content was 67% higher in 3Q ’10 than 3Q ’09, the IRR is certainly going to grow far beyond 76%. If the content is worth today only what it cost to create, the S-1 says the IRR would be 112%.
We Believe Brand Advertisers Will Increase Their Spend on ehow, Driving Up RPMs
Bo states that brand advertisers wouldn’t be interested in ehow content because they “….are sensitive to the context in which their advertisements appear,” and he’s right, brand advertisers are interested in context. That’s why when we looked around ehow recently, we saw tons of brand advertising. In fact, every single page of the “Home” section of the ehow was filled with Home Depot brand advertising.
What great context for Home Depot. The opportunity to sell brand advertising to Fortune 1000 advertisers is why highly respected industry vet Joanna Bradford, formerly Yahoo SVP of U.S. Revenue, joined Demand in March. And she’s obviously making great headway. While brand advertising is building, ehow is making good revenue from other sources including Google AdSense (34% of accounts receivable). Driven by the growth in brand advertising, and solid monetization by Google and others, RPM (revenue per thousand pages) on owned and operated properties increased 22% year over year, to $12.60 YTD in Q3 (up from $11.81 YTD in Q2).
Photo: Demand Media’s S-1 filing
With page views growing rapidly (up 20% y/y), and revenue per page view growing even faster, what’s not to like?
We Believe ehow’s Ability To Leverage Google Is A Long-Term Competitive Advantage
Bo derides Google for having an algorithm that “weighs consistent and constant content over quality content.” The fact is that Google built a $190 billion market cap juggernaut by providing the world’s greatest search results relative to the search inquiries of its users. It’s not perfect, and people successfully game it, generally for short periods of time or in small quantities. Google continues to send traffic to ehow because Google’s ever-improving algorithms thinks ehow provides highly relevant content for its users. As Google’s forever iterating their algorithms, ehow’s ability to continually optimise it’s articles and videos such that they are shown near or at the top of Google searches is a core competency and a long term competitive advantage.
While ehow’s bounce rate (the number of visitors that only look at one page and leave) is relatively high (at 67% per Alexa) we don’t view that as a sign that the content is not engaging. People generally go to ehow to find a single piece of content (e.g., “How To Prepare a House For Winter”). If ehow does its job, and answers the question, then one page is all a user needs. Wikipedia, a reference site we view as comparable in many ways to ehow, has a bounce rate of about 44%.
We also believe that ehow’s ability to scrape search data and other sources to understand the content that people are looking for and the content gaps that exist is unique, as they were an early user of that practice , and certainly one of the largest spenders in terms of developing that competency.
Bo writes that the business model “relies on Demand creating low quality content” so people click on the Google ads. Again the inference here, we believe, is that Google is so incompetent that it can’t tell that the ehow content is low quality. Or worse, as Bo suggests, the scheme is so “insidious” that Google wants low quality so more people click on the Google ads on ehow to get away from the bad content. The truth is Demand produces surprisingly high quality content within the confines of its scaled production content business model. The company has a stellar Advisory Board (including Andrea Wong former CEO of Lifetime Networks and Kevin Smith the President of the Society of Professional Journalists) who help Demand iterate the way the company’s content “…is created, experienced, and shared by consumers”.
Bo also writes that the emergence of social is a threat to the value of Demand’s algorithmic search expertise. This is a valid risk, as there is no denying that Facebook and Twitter and others are driving an increasing amount of traffic. Social is going to be important. In fact, few are as bullish on the future of social as we are.
And ehow is embracing social, having deployed Facebook’s Like button and a share button to leverage Twitter and 300 other social sites. But social is not going to kill algorithmic search. The future of search is going to be a mash up of algorithmic and social signals. On this point, it’s also important to note that much of what ehow focuses on is long tail content that is not broadly found around the Net. What are the odds that a search of my friend’s content is going to include a musing of theirs on “How to roast a chicken?” To the degree social helps in that search, it’s probably because one of my friends has liked an ehow article.
We Also Like The Domain Name Business And Believe It Has Synergies With The Media Business
The domain business is significant for Demand at 40.8% of revenue YTD, but it’s shrinking in importance (it was 47% in the first nine months of 2009) as the media side of the company continues its rapid ascent. As the second largest domain registrar in the world (behind GoDaddy) they have meaningful scale. While the domain registration business will never have the margins that the media business will achieve, domain names are an important part of the Internet ecosystem. People pay millions of dollars for good domain names, because they drive traffic and are easy to remember. Being a leading registrar positions Demand to benefit from strong names that their customers drop because they don’t appreciate the value of a great name. Also, with over 1mm new registration queries a day, Demand has access to real time data about what’s trending that can be a useful signal in its content algorithms.
We Love The Media Side Of The Business As It Marches It’s Way to Significant Free Cash Flow Generation
We largely focus on free cash flow, because that’s what most smart institutional investors focus on. The starting point for understanding free cash flow is the HYPERLINK “http://bit.ly9Z9ELr” Statement of Cash Flows in the S-1, which shows over $40 million generated from operating activities in the first nine months of 2010. Now that figure doesn’t include capital expenditures (computers, servers, other fixed assets), which was $16 million, decreasing the cash flow to $24 million. Finally, there was $34 million invested in content production, bringing free cash flow to a loss of $10 million. But what investors will focus on is that the $34 million spent to produce content year to date is going to continue to monetise for years to come. People are going to be roasting chickens in 2011, and 2012, and 2013. In fact, what Bo misses is that the content produced this year will likely generate MORE revenue in 2011 than in 2010, in our opinion. That’s how long tail content works. It “seasons” over time as it gets indexed by search engines and linked to by third parties. More people will likely see it next year and advertisers will likely pay more for each one of those eye balls. Demand should give greater insight into that phenomenon on their road show.
We get some insight in to the long term revenue generation by noting that the IRR on content produced in Q3 ’08 was 58% as of Q2 2010, when the first S-1 was filed. The second amended S-1, included Q3 ’10 revenue, and the IRR from content produced in Q3 ’08 shot up to 76%. That means Demand generated about $28 in revenue in Q3 2010 for every $100 spent on content production in Q3 2008. That’s why we love this business. The IRR should keep on climbing for the foreseeable future.
It’s hard to comprehend content growing in value like that over time. While reference content like ehow’s is not the norm, it is not unique. The majority of Wikipedia’s reference content has been there for years, and it still continues to season and grow its audience:
When will Demand Media actually start generating free cash flow? It depends on how long they keep on investing at rates exceeding 100% IRR. If we were an investor, we’d want them to invest heavily, because we don’t know how to get 100% returns on our money if they gave it back to us.
If it’s of any solace to Demand Media, Bo wrote another piece earlier in the year entitled “Facebook And Twitter Will Always Be Crappy Businesses,” and we all now know how those business are turning out. So we know Bo’s hot for high quality content, and he should be, there’s tremendous value in that content. But we believe that he’s missing the point about the ability of the other 6 billion people on the planet not working full-time for Everyday Health and other professional organisations to produce compelling content that people want to consume, and advertisers want to be associated with. Maybe Bo thinks it’s an either or, that either high end professional content will succeed or “content farms” will win. It’s not an either or Bo. It’s like network TV and cable TV. There’s room for both to be profitable, and the lines will continue to blur over time.
I, Lou Kerner, certify that the views expressed in this report accurately reflect my personal opinion and that I have not and will not, directly or indirectly, receive compensation or other payments in connection with my specific recommendations or views contained in this report.
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