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Demand Media's Dodgy Accounting Decoded: It May Never Make a Profit

Demand Media's (DMD) dodgy accounting -- in which it amortizes its editorial budget rather than expensing it on a quarterly basis as the cash is spent -- is not helping the company achieve profitability, according to the content farm's SEC disclosures. Demand's Q2 2011 earnings statement showed the owner of eHow and again failed to make a profit despite revenues of $79 million, which rose 32 percent.

Demand uses a controversial accounting method which many suspect either lessens the appearance of the company's losses or will help it achieve apparent profitability sooner. But as time has dragged on, the effect of that accounting gimmick is becoming less significant. That's one reason Demand is still not profitable even though it has rising revenue and has weathered changes to Google's search algorithm that many believed would hurt it.

Normally, publishers with large editorial bills like Demand expense the amount they pay for that material on a quarterly basis. Demand, however, argues that as its content will continue to earn ad revenue over several years, its content is a long-lived intangible asset. As such, its expense should be amortized, or spread over five years. This is a perfectly legal thing to do, and there is a reasonable argument to be made that Demand's assets -- its articles and stories -- may indeed generate revenue for that long.

The problem is that amortization obscures how much the company is actually spending on a quarterly basis to pay its freelancers and staff. It may pay $50 in cash for an article today, but the "expense" of that will only be recognized as $2.50 per quarter for five years. Thus Demand's expenses on its income statement might appear lower than they actually are (and the company may benefit by looking more profitable than it actually is.)

Things get more difficult in future periods when Demand is still recognizing expenses it actually paid a long time ago. That has the effect of increasing some of its apparent costs.

What Demand actually spends
Those expenses aren't completely impenetrable, however. On Demand's cashflow statements the company accounts for movements of cash as they actually happened in each quarter. By comparing the amount of unspent cash "saved" from amortization with the amount spent to purchase new intangible assets you can identify broadly whether the company is saving more or spending more. (Yes, these are the gymnastics you must perform to understand how this company works!) Currently, it's about the same. Here's a chart comparing the money spent with the money saved since 2007:

Note that the time periods are uneven -- that's the way Demand presented them. Still, it's clear that earlier in Demand's history amortization worked out well: It saved more money than it spent buying content. As time went on, however, the cash expenditures increased and are now roughly equal to the accumulated amortization savings. Here's the same information but represented as the percentage difference between the money spent and the money saved. Presenting the data this way make the uneven time periods irrelevant, because it shows only the proportional differences between the spending and the saving:

As time goes by, the company has squandered its amortization savings by ramping up its cash expenditures to match them. This, of course, will increase its amortized expenses in the future, decreasing the likelihood of it showing a net profit then (although it may have positive cashflow). But it doesn't alter the fact that Demand has now had it both ways: a period in which its spending was less than its saving (2007 through 2009) and a period in which its spending was the same as its saving (2010 through Q2 2011). In neither cycle did it show a profit. Worse, it didn't lower the company's operating costs enough to generate an operating profit before taxes (click to enlarge):

Demand's operating costs appear to be in lockstep with its revenues, suggesting that the company cannot generate greater sales without generating greater expenses that immediately cannibalize the cash from those sales:

So how does Demand stay afloat? Basically, it sells stock certificates. Demand added $72 million in cash to its coffers in the first six months of this year, almost none of which came from its operating or content buying activities. It came from a $79 million sale of stock. (Interestingly, Pandora and Groupon are in a largely identical positions.)

Those investors might want to ask themselves why they are holding onto that stock when the company's own numbers show that its prime generator of money is the sale of stock, and not the business it purports to be in.


Image by Flickr users photoclinique, CC.