The house rules are simple in this weekly column:

  • I bash a stock that I think is heading lower.
  • I offset the sting by recommending three stocks as portfolio replacements.

Who gets tossed out this week? Come on down, Demand Media (NYSE: DMD).

Old McDonald had a farm
The content farm behind eHow, comedy site Cracked, and health tracker Livestrong.com held up reasonably well in its first quarter as a public company last night.

Revenue before traffic acquisition costs climbed 35% to $70.3 million. The typically profitless dot-com posted a rare profit, and adjusted earnings nearly tripled to $5.6 million. So far, so good. But Demand Media's story begins to fall apart when we sprinkle in model uncertainty, uninspiring guidance, and a lofty valuation.

Demand Media brags about its organic reach to more than 100 million unique visitors every month. In other words, it doesn't shell out boatloads of cash to advertise for traffic. Instead, Demand Media relies on optimization techniques to rank high on search engine query results. It also has the art of getting its thousands of freelancers to write timely content down to a science.

Unfortunately, Google (Nasdaq: GOOG) has come under criticism lately. Content farms are effectively -- and legally -- gaming the system. Big G and its lesser rivals are now under pressure to circumvent the influx of narrowly focused and ad-slapped articles that these massive content producers are cranking out.

Demand Media is defending both its content and its techniques, but it may not be able to outsmart Google's ever-changing algorithms forever. Meanwhile, its competition is heating up. AOL (NYSE: AOL) will ramp up its content generation this quarter, targeting greater page views through enhanced optimization. Don't laugh at AOL; it's run by a former Google executive who knows Big G well.

Moving on to guidance, Demand Media sees its revenue before traffic acquisition costs climbing 23% to 29% this year. That's good. However, it sees itself reverting back to an operating loss for the current quarter and the year as a whole. That's bad.

After its IPO and the conversion of preferred shares into common stock, Demand Media has roughly 90 million shares outstanding. A fast-growing Internet company with spotty profitability could have commanded a $2 billion market cap easily during the dot-com bubble days, but investors are too cynical now.

I can nitpick a little more. I'm a fan of Demand Media's eNom registrar site, but this cutthroat niche still accounts more than a third of the company's revenue. It's also problematic to see its monetization efficiency slip on a page-view basis on its faster-growing network of third-party websites. Thankfully, its slower-growing owned sites are smoking hot on that front.

Demand Media is an intriguing company at a time when content is king, but I'm not sold on the valuation. It seemed overpriced at its IPO price of $17 last month; after digesting last night's report, my opinion stands.  

Still, as I do every week, I won't talk down a stock unless I have three alternatives that I believe will outperform the company getting the heave-ho:

Google
The search giant may not be growing as quickly as Demand Media these days, but its 26% top-line spurt and explosive profitability in its latest quarter make it no slouch. As Demand Media wannabes flood the market, I'd rather bet on the platform that will remain the world's top search engine, and on which all these content-farm contenders hope to rank well.

Yahoo! (Nasdaq: YHOO)
In retrospect, Yahoo! got a sweet deal when it nabbed the smaller, yet still relevant, rival content farm Associated Content for $100 million last year. Yahoo! may have outsourced its search functionality through Microsoft's (Nasdaq: MSFT) Bing, but it's still collecting hefty tolls on its traffic. Yahoo! also has a portfolio of lucrative healthy Asian investments, even with Alibaba coming under fire amid a recent selling-fraud scandal.

Sohu.com (Nasdaq: SOHU)
I'm resisting the obvious temptation to go with Baidu (Nasdaq: BIDU) for this final slot. China's leading search engine is a brilliant speedster, but it's also potently priced. If I'm talking down Demand Media on valuation, it's only fair that I come back with a cheapie in China. Sohu runs the small Sogou.com search engine in China, but its namesake portal is also an advertising magnet. Revenue and earnings grew 28% and 41% respectively in its latest quarter. Despite the heady growth, Sohu is trading for just 17 times this year's projected profitability, and less than 15 times next year's target.

Prove me wrong, Demand Media. I'm a sucker for the law of surprise and Demand.