Short: Demand Media Inc.

TICKER: DMD

ANDREW D. JONES, CFA

Anatomy of a Short Candidate

1. FLAWED BUSINESS MODEL

2. INVENTIVE ACCOUNTING
3. BAD GOVERNANCE

PRICE TARGET: $5.00

POTENTIAL RETURN: 300%
Flawed Business Model

“SH*T DOESN'T JUST DISAPPEAR!”

-BEN STILLER IN ENVY

 Company Overview

Demand Media

Content Creation Registrar

(55% of revenue) (45% of revenue)

 Content creation comprises a number of sites that offer content based on

what people are searching for on the internet
o eHow.com; Livestrong.com
o Content is produced by a stable of 13,000 “freelance” writers
 Registrar business is second-largest to GoDaddy.com
 Demand is the 16th biggest web property by unique visitors as of December
2010
 The Content Creation Process

Demand mines data

from search engine These results are sent
providers using a through another Story ideas are sent to
proprietary algorithm to algorithm that generates editors who make sure
determine key phrases story ideas based on key that titles make sense
that people are phrases
searching for
 The Content Creation Process

Titles are
downloaded into Stories are sent to
database where series of editors to Stories published on
writers can reserve ensure accuracy and a variety of websites
up to 10 stories and authenticity
40 videos
 Types of Articles on eHow.com

 The Arbitrarily Location-Specific Article

 “How to pick blueberries in Iowa”

 The Suspiciously Product-Specific Article

 “How to unscrew the iTouchless pepper mill”

 The Article That Blows a Problem Out of Proportion

 “Ideas for organizing scrunchies”

 The Benignly Racist Article

 “Best colors for mediterranian men to wear”

 Types of Articles on eHow.com

 The Article Meant for Aliens Who Just Landed Here

 “Types of push buttons”

 The Article Offering Advice That Shouldn’t Be Followed

 “How to dress like a hipster”

 The Article for People in the Narrow Band of Humanity Who

Are Smart Enough to Know About Google But Not Smart

Enough to Figure Out How to Do the Thing They’re Googling
 “How to name a kids’ soccer team”
 Are these examples of quality content?

 How to calculate age from birth date

 Types of hats for kids
 How to put on a Speedo
 How to buy Canadian Molson
 How to buy condoms that fit
 Are these examples of quality content?

 How to understand Ukranian women

 How do I manually fill an ointment tube?
 How to belch
 What are the benefits of cleanliness on job sites?
Are Demand’s 13,000 freelancers really experts?

 Demand’s CEO claims that many of the content

creators are “professionals”
 75% have been published in magazines and newspapers
 25% have written a book
 25% have held professional marketing roles
 Collectively, Demand produces over 4,000 pieces of
content per day
 There are signs that author matters to search engines like
Google

 From patent #7,765,209, filed by Google:

 Claim 1: …second information, associated with the blog, from a source
different than the posts included in the blog; creating, by one or more
processors associated with the one or more server devices, a hybrid
document by combining the first information and the second
information; and using, by one or more processors associated with the
one or more server devices, the hybrid document to determine a
relevance of the post to a search query.
 The method of claim 1 where the extracting the second information
includes: extracting, from a feed, at least one of a title of the blog, an
author of the blog, or a profile of the author of the blog.
 The method of claim 3 where the extracting the second information
further includes: extracting, from the blog, at least one of a profile of
the author of the blog or a blogroll.
 The method of claim 5 where the document includes a profile of an
author of the blog.
 What does that mean?

 Basically, as a person posts articles on the internet,

and people visit or link to these posts, they become
associated with that topic in the eyes of Google’s
search engine
 They become an “expert” in that topic and anytime
they show up on a webpage with content related to
that topic, that page ranks highly in Google search
 How can Demand’s freelancers ever become
“experts” in the eyes of Google if they are just
pumping out content?
 What are the incentives for contributors?

 Authors load their queues with titles they can

produce quickly and with the least amount of effort
 Writers earn about $15 per story while videographers
earn about $20 per clip
 Paid weekly via paypal
Demand is highly dependent on Google for pageviews and
advertising revenue

Nine Months thru

September, 2010
% advertising revenue atrributable to GOOG 28.0%
% of traffic from other search engines 8.2%
% of traffic from GOOG 32.8%

% of revenue from eHow 23.0%

% of eHow traffic generated by GOOG 66.0%

Owned and Operated page

Thousands of page views 6,000,000.0
page views attr. To GOOG 1,968,000.0
other page views 4,032,000.0
Revenue per thousand page views $12.60
Total Revenue $75,600,000.00

Network of customer pages

Thousands of page views 9,300,000.0
page views attr. To GOOG 3,050,400.0
other page views 6,249,600.0
Revenue per thousand page views $3.24
Total Revenue $30,132,000.00
 Google is moving to eliminate low-quality content from
search results

 From Google’s official blog, 1/21/2011:

 This would greatly affect the future prospects for Demand

 From Google Chrome’s official blog, 2/14/2011:

While some have argued that Demand is not a content farm, Google has
offered specific examples related to Demand’s sites
 The article Google references as low-quality content is on
eHow.com

Source: eHow.com
 The article Google references about content farms is from
PBS.org and references Demand heavily

 From PBS.org:
 This is a first-hand account of a former Demand freelancer

Source: PBS.org
What would be the impact on revenue if Demand is tagged as
a content farm?

Nine Months thru

September, 2010 Adjusted
% advertising revenue atrributable to GOOG 28.0%
% of traffic from other search engines 8.2%
% of traffic from GOOG 32.8% 20.0%

% of revenue from eHow 23.0%

% of eHow traffic generated by GOOG 66.0%

Owned and Operated page

Thousands of page views 6,000,000.0 5,232,000.0
page views attr. To GOOG 1,968,000.0 1,200,000.0
other page views 4,032,000.0 4,032,000.0
Revenue per thousand page views $12.60 $12.60
Total Revenue $75,600,000.00 $65,923,200.00 ($9,676,800.00)

Network of customer pages

Thousands of page views 9,300,000.0 8,109,600.0
page views attr. To GOOG 3,050,400.0 1,860,000.0
other page views 6,249,600.0 6,249,600.0
Revenue per thousand page views $3.24 $3.24
Total Revenue $30,132,000.00 $26,275,104.00 ($3,856,896.00)
($13,533,696.00)
 Demand’s Competitors

 About.com
 Mahalo
 Answers.com
 wikiHow
 AOL
 Yahoo!
 Inventive Accounting

"I'M BEGINNING TO THINK NOT ONLY DID

HE INVENT THE INTERNET, BUT HE
INVENTED THE CALCULATOR AS WELL. IT'S
FUZZY MATH."

- PRESIDENT GEORGE W. BUSH

 You Capitalize WHAT?

 “We publish long-lived media content generated by our content

studio which we commission and acquire from third party freelance
content creators. Direct costs incurred for each individual
content unit that we determine embodies a probable
future economic benefit are capitalized. The vast majority of
direct content costs represent amounts paid to freelance content
creators to acquire content units…”
 “In determining whether content embodies probable future
economic benefit required for asset capitalization, we make
judgments and estimates including the forecasted number of page
views and the advertising rates that the content will generate.
These estimates and judgments take into consideration
various inherent uncertainties including, but not limited to,
our expected ability to renew at favorable terms or replace certain
material agreements with Google that currently provide a
significant portion of our revenues…”
 You Capitalize WHAT?

 “Capitalized content is amortized on a

straight-line basis over five years, representing
our estimate of the pattern that the underlying
economic benefits are expected to be realized and
based on our estimates of the projected cash flows
from advertising revenues expected to be generated
by the deployment of our content.”
 Capitalizing content acquisition costs sounds a little strange

 Prior to Demand’s IPO, the Securities and Exchange

Commission approved a controversial accounting
technique allowing the firm to amortize its content
costs over five years.
 Demand says the “evergreen” content it creates will garner
internet traffic for a longer period of time than traditional
news articles, which tend to expire on the next day.
 Demand has not even been around for 5 years, so
how can they know this?
 Leaves the door open for large writedowns going
forward
 Bad Governance
MAY I HELP YOU DR...?

FLETCH: OH, IT'S ME, DR. ROSENPENIS. I'M JUST HERE

TO CHECK OUT ALAN STANWYK'S FILE.

DR. WHO?

FLETCH: DR. ROSENROSEN, I'M HERE TO GET TO THE

RECORDS ROOM.

WHAT WAS THAT NAME AGAIN?

FLETCH: IT'S DR. ROSEN, I WANT TO CHECK THE

RECORDS ROOM.

DR. WHO?

FLETCH: DR. ROSEN. WHERE'S THE RECORDS ROOM?

Eric Estrada Richard Rosenblatt
 CEO Richard Rosenblatt has a less than savory track record

 1993: Richard Rosenblatt set up a company that offered a

$3,000 web-design seminar that came with a custom-
built website
 The company, iMall, went public at $18 en route to $112
 FTC investigated the company’s claim that its clients’ sites were
earning $11,000 per month (they weren’t, surprisingly)
 The company killed the seminar division, losing 95% of its $16
million in annual revenue
 Rosenblatt sold iMall to Excite@Home for $500 million
 2000: Rosenblatt took over drkoop.com, an online site
tied to C. Everett Koop
 Wanted to turn the Koop into a brand like Martha Stewart or Walt
Disney
 Created a line of Dr. Koop Men’s Prostate Formula pills
 The company folded
C. Everett Koop
Rosenblatt’s history even includes outright devious behavior

 2004: Rosenblatt was tapped to run eUniverse (later

renamed Intermix Media), an internet conglomerate
that happened to own MySpace
 NYAG Elliot Spitzer charged Intermix with bundling adware
and spyware with its free games and screensavers
 The company settled immediately for $7.5 million (the entire
cash holdings of Intermix)
Elliot Spitzer
The Board is not as independent as you would think at first
glance

Demand Media Board of Directors

Name Notes
John Hawkins
Victor Parker
Joshua James
Gaurav Bhandari Goldman Sachs MD (lead underwriter)
Peter Guber
Robert Bennett
Richard Rosenblatt
Fredric Harman
James Quandt Served on Intermix board with Rosenblatt
Valuation
 Key Statistics

 Market Cap: 1.64 billion

 Enterprise Value: 1.54 billion

 EV/Revenue: 6.55x
 EV/EBITDA: 35.93x

 Current Price: $20.00

 Target Price: $5.00
 Potential Return: 300%
 Expected future content revenues

Nine Months thru

2008 2009 September, 2010 2010E 2011E 2012E 2013E 2014E 2015E
Owned and Operated page
Thousands of page views 5,900,000.0 6,800,000.0 6,000,000.0 8,000,000.0 9,600,000.0 12,000,000.0 15,000,000.0 18,750,000.0 23,437,500.0
15.3% 17.6% 20.0% 25.0% 25.0% 25.0% 25.0%
Revenue per thousand page views $10.56 $10.69 $12.60 $12.60 $11.50 $11.75 $12.00 $12.25 $12.50
Total Revenue $62,304,000.00 $72,692,000.00 $75,600,000.00 $100,800,000.00 $110,400,000.00 $141,000,000.00 $180,000,000.00 $229,687,500.00 $292,968,750.00

Network of customer pages

Thousands of page views 5,400,000.0 10,000,000.0 9,300,000.0 12,400,000.0 15,500,000.0 19,375,000.0 24,218,750.0 30,273,437.5 37,841,796.9
85.2% 24.0% 25.0% 25.0% 25.0% 25.0% 25.0%
Revenue per thousand page views $4.04 $3.45 $3.24 $3.24 $3.25 $3.25 $3.25 $3.25 $3.25
Total Revenue $21,816,000.00 $34,500,000.00 $30,132,000.00 $40,176,000.00 $50,375,000.00 $62,968,750.00 $78,710,937.50 $98,388,671.88 $122,985,839.84

Total Content Revenue $84,120,000.00 $107,192,000.00 $105,732,000.00 $140,976,000.00 $160,775,000.00 $203,968,750.00 $258,710,937.50 $328,076,171.88 $415,954,589.84
27.4% 31.5% 14.0% 26.9% 26.8% 26.8% 26.8%

Pieces of content created per day 4,000.0 5,479.5 6,500.0 7,500.0 9,000.0 11,000.0 13,000.0
37.0% 18.6% 15.4% 20.0% 22.2% 18.2%
Total pieces of content created 1,460,000.0 2,000,000.0 2,372,500.0 2,737,500.0 3,285,000.0 4,015,000.0 4,745,000.0
Total page views per piece of new content 11.5 10.2 10.6 11.5 11.9 12.2 12.9
 Projected Income Statement
Projected Income Statement for Demand Media Inc.
Dollars in millions, except per share
2010-2015
2008 2009 2010 2011 2012 2013 2014 2015 CAGR

Revenues 170.3 198.5 239.1 $265.3 $316.0 $378.7 $456.6 $553.5 18.27%
16.6% 20.5% 10.9% 19.1% 19.9% 20.6% 21.2%
Content 84.8 107.7 141.5 $160.8 $204.0 $258.7 $328.1 $416.0
27.0% 31.4% 13.6% 26.9% 26.8% 26.8% 26.8%
Registrar 85.4 90.7 97.7 104.5 112.0 120.0 128.5 137.5
6.2% 7.6% 7.0% 7.2% 7.1% 7.1% 7.0%
Cost of Sales 98.2 114.5 126.9 145.9 172.2 204.5 244.3 293.3
Gross Profit 72.1 83.9 112.2 119.4 143.8 174.2 212.3 260.1 18.31%

SG&A 43.4 48.5 58.5 66.3 77.4 90.9 107.3 127.3

Product Development 14.3 21.7 25.5 26.5 31.6 37.9 45.7 55.3
Amortization of Intangibles 33.2 32.2 32.6 33.0 33.0 33.0 33.0 33.0
Other Operating Expense/(Income) 0 0 0 0.0 0.0 0.0 0.0 0.0
EBIT (18.8) (18.4) (4.4) (6.5) 1.8 12.4 26.4 44.5 #NUM!
Plus: Depreciation & Amort. 43.7 47.1 49.9 48.0 48.0 48.0 48.0 48.0
EBITDA 24.9 28.7 45.5 41.5 49.8 60.4 74.4 92.5

Interest Expense (2.1) (1.8) (0.7) (0.7) (0.7) (0.7) (0.7) (0.7)
Interest Income 1.6 0.5 0.0 0.0 0.0 0.0 0.0 0.0
Other Non-operating Inc./(Exp) (0.3) (0.0) (0.2) (0.2) (0.2) (0.2) (0.2) (0.2)
Unusual Items 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Income Taxes (4.6) 2.8 3.2 (1.6) 0.4 3.1 6.6 11.1
Minority Interest 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Net Income ($14.9) ($22.5) ($8.5) ($5.7) $0.4 $8.5 $18.9 $32.5 #NUM!

Diluted Shares Outstanding 72.8 72.8 92.0 92.0 92.0 92.0 92.0 92.0

EPS ($0.20) ($0.31) ($0.09) ($0.06) $0.00 $0.09 $0.21 $0.35 #NUM!
 Discounted Cash Flow
Discounted Cash Flow Analysis for Demand Media Inc.
Dollars in millions, except per share
0 1 2 3 4 5 2010-2015
2008 2009 2010E 2011 2012 2013 2014 2015 CAGR

Sales $170.3 $198.5 $239.1 $265.3 $316.0 $378.7 $456.6 $553.5 18.3%

EBITDA 24.9 28.7 45.5 41.5 49.8 60.4 74.4 92.5

EBITDA Margin 14.6% 14.5% 19.0% 15.7% 15.7% 16.0% 16.3% 16.7%
Depreciation (43.7) (47.1) (49.9) (48.0) (48.0) (48.0) (48.0) (48.0)
EBIT (18.8) (18.4) (4.4) (6.5) 1.8 12.4 26.4 44.5 #NUM!
Less: Taxes @ 25.0% 4.6 (2.8) (3.2) 1.6 (0.4) (3.1) (6.6) (11.1)
Tax-Effected EBIT (14.2) (21.2) (7.6) (4.9) 1.3 9.3 19.8 33.4

Plus: Depreciation 43.7 47.1 49.9 48.0 48.0 48.0 48.0 48.0
Less: Capital Expenditures (20.1) (15.3) (22.1) (20.0) (20.0) (20.0) (20.0) (20.0)
Less: Purchase of Intangibles (19.3) (22.7) (45.9) (30.0) (30.0) (30.0) (30.0) (30.0)
Less: Changes in Working Capital 1.7 3.3 2.6 5.7 6.9 8.2 9.9

Unlevered Free Cash Flow (10.4) (22.3) (4.2) 5.0 14.2 26.0 41.3 #NUM!
Unlevered Free Cash Flow Growth Rate 114.6% (81.1%) (219.7%) 181.9% 83.2% 58.7%

Perpetuity Growth Method EBITDA Multiple Method

Discount rate 15.0% Discount rate 15.0%

Net present value of free cash flow $45.7 Net present value of free cash flow $45.7

Growth rate of FCF after 5th year 3.0% Exit multiple 4.0x
Terminal Value $354.3 Terminal value $369.9
Present value of terminal value $179.2 Present value of terminal value $187.0
Terminal value as a % of enterprise value 79.7% Terminal value as a % of enterprise value 80.4%

Enterprise value $224.8 Enterprise value $232.7

LESS: Debt, pref. stock & minority interest ($11.9) LESS: Debt, pref. stock & minority interest ($11.9)
PLUS: Cash & equivalents $105.0 PLUS: Cash & equivalents $105.0
Equity value $317.9 Equity value $325.8

Diluted shares 92.0 Diluted shares 92.0

Equity value per share $3.46 Equity value per share $3.54
 What if the income statement was adjusted for a loss in
Google traffic and content acquisition costs were expensed?
Projected Income Statement for Demand Media Inc.
Dollars in millions, except per share
2010-2015
2008 2009 2010 2011 2012 2013 2014 2015 CAGR

Revenues 170.3 198.5 239.1 $265.3 $316.0 $378.7 $456.6 $553.5 18.27%
Revenue lost from Google $13.3 $15.8 $18.9 $22.8 $27.7
Cost of Sales 98.2 114.5 126.9 145.9 172.2 204.5 244.3 293.3
Gross Profit 72.1 83.9 112.2 106.1 128.0 155.3 189.5 232.5 15.68%

SG&A 43.4 48.5 58.5 66.3 77.4 90.9 107.3 127.3

Content Acquisition 11.0 10.5 26.0 10.9 12.9 15.3 18.3 22.0
Product Development 14.3 21.7 25.5 26.5 31.6 37.9 45.7 55.3
Amortization of Intangibles 31.0 30.1 27.4 30.8 30.4 29.9 29.3 28.6
Other Operating Expense/(Income) 0 0 0 0.0 0.0 0.0 0.0 0.0
EBIT (27.6) (26.8) (25.2) (28.5) (24.4) (18.8) (11.1) (0.8) -49.99%
Plus: Depreciation 43.7 47.1 49.9 48.0 48.0 48.0 48.0 48.0
EBITDA 16.1 20.3 24.7 19.5 23.6 29.2 36.9 47.2

Interest Expense (2.1) (1.8) (0.7) (0.7) (0.7) (0.7) (0.7) (0.7)
Interest Income 1.6 0.5 0.0 0.0 0.0 0.0 0.0 0.0
Other Non-operating Inc./(Exp) (0.3) (0.0) (0.2) (0.2) (0.2) (0.2) (0.2) (0.2)
Unusual Items 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Income Taxes (4.6) 2.8 3.2 (7.1) (6.1) (4.7) (2.8) (0.2)
Minority Interest 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Net Income ($23.7) ($30.9) ($29.3) ($22.2) ($19.2) ($14.9) ($9.2) ($1.5) -45.04%

Diluted Shares Outstanding 72.8 72.8 92.0 92.0 92.0 92.0 92.0 92.0

EPS ($0.33) ($0.42) ($0.32) ($0.24) ($0.21) ($0.16) ($0.10) ($0.02) -45.04%
 Adjusted DCF
Discounted Cash Flow Analysis for Demand Media Inc.
Dollars in millions, except per share
0 1 2 3 4 5 2010-2015
2008 2009 2010E 2011 2012 2013 2014 2015 CAGR

Sales $170.3 $198.5 $239.1 $265.3 $316.0 $378.7 $456.6 $553.5 18.3%

EBITDA 16.1 20.3 24.7 19.5 23.6 29.2 36.9 47.2

EBITDA Margin 9.5% 10.2% 10.3% 7.4% 7.5% 7.7% 8.1% 8.5%
Depreciation (43.7) (47.1) (49.9) (48.0) (48.0) (48.0) (48.0) (48.0)
EBIT (27.6) (26.8) (25.2) (28.5) (24.4) (18.8) (11.1) (0.8) (50.0%)
Less: Taxes @ 25.0% 4.6 (2.8) (3.2) 7.1 6.1 4.7 2.8 0.2
Tax-Effected EBIT (23.0) (29.6) (28.4) (21.4) (18.3) (14.1) (8.3) (0.6)

Plus: Depreciation 43.7 47.1 49.9 48.0 48.0 48.0 48.0 48.0
Less: Capital Expenditures (20.1) (15.3) (22.1) (20.0) (20.0) (20.0) (20.0) (20.0)
Less: Purchase of Intangibles (19.3) (22.7) (45.9) (30.0) (30.0) (30.0) (30.0) (30.0)
Less: Changes in Working Capital 1.7 3.3 2.6 5.7 6.9 8.2 9.9

Unlevered Free Cash Flow (18.8) (43.1) (20.7) (14.6) (9.2) (2.1) 7.3 #NUM!
Unlevered Free Cash Flow Growth Rate 129.3% (51.9%) (29.7%) (36.8%) (77.2%) (449.1%)

Perpetuity Growth Method EBITDA Multiple Method

Discount rate 15.0% Discount rate 15.0%

Net present value of free cash flow ($33.2) Net present value of free cash flow ($33.2)

Growth rate of FCF after 5th year 3.0% Exit multiple 1.5x
Terminal Value $62.9 Terminal value $70.8
Present value of terminal value $31.8 Present value of terminal value $35.8
Terminal value as a % of enterprise value (2,246.8%) Terminal value as a % of enterprise value 1,376.9%

Enterprise value ($1.4) Enterprise value $2.6

LESS: Debt, pref. stock & minority interest ($11.9) LESS: Debt, pref. stock & minority interest ($11.9)
PLUS: Cash & equivalents $105.0 PLUS: Cash & equivalents $105.0
Equity value $91.7 Equity value $95.7

Diluted shares 92.0 Diluted shares 92.0

Equity value per share $1.00 Equity value per share $1.04
 Sum-of-the-parts
Revenue Total Value Per Share
Content
2008 $84.8
2009 107.7 27.0%
2010E 141.5 31.3%
2011E 160.8 13.6% 5.0 803.9 8.74

Registrar
2008 85.4
2009 90.7 6.2%
2010E 97.7 7.6%
2011E 104.5 7.0% 2.0 209.0 2.27
Enterprise Value $1,012.9

Less: Debt, pref. stock & contractual obs. (386.0)

Plus: Cash 105.0

Equity Value $731.9

Diluted Shares Outstanding 92.0

Equity Value per share $7.96

 Conclusion

1. DMD IS IN A BUSINESS THAT IS

DEPENDENT ON LOW-QUALITY CONTENT
THAT IS UNDER SCRUTINY BY ITS BIGGEST
SOURCE OF REVENUE
2. DEMAND USES ACCOUNTING PRACTICES
THAT ARE DUBIOUS AT BEST
3. DEMAND’S CEO HAS A LESS THAN SAVORY
PAST AS A BUSINESSMAN

•P R I C E T A R G E T : $ 5 . 0 0
•P O T E N T I A L R E T U R N : 3 0 0 %