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
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.
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
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:
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.
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
I'm resisting the obvious temptation to go with Baidu
Prove me wrong, Demand Media. I'm a sucker for the law of surprise and Demand.
Google and Microsoft are Motley Fool Inside Value selections. Baidu, Google, and Sohu.com are Motley Fool Rule Breakers picks. Yahoo! is a Motley Fool Global Gains recommendation. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Google, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
Longtime Fool contributor Rick Munarriz doesn't mind taking out the garbage every so often. He does not own any of the stocks in this story. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.