Demand Media's amended IPO filing -- which reveals it is using dodgy accounting to reduce its editorial expenses -- provides more evidence for my theory that "content farms" are in a bubble and headed for a crash. And unfortunately for those looking for a new business model for the media, Demand's own numbers also show that advertising revenue does not appear to be high enough to sustain its operations despite that company's famously low pay for the freelancers who write its content.
Let's start with the way Demand accounts for its expenses, as that's the most controversial part of the IPO. Then we'll move on to the more basic question facing Demand: Can this business make money off advertising?
Demand's business model is to pay a vast army of freelancers $15-30 per article, and another $3.50 per article to 500 freelance editors who prep them for publication. This produces about 4,000 new "evergreen" articles per day on sites such as eHow. Demand then runs advertising next to the content, which is search engine optimized. Normally, publishers write off the cost of paying their writers at the time the article is published, and then recognize any revenue they earn from the advertising running next to it at the time. But not Demand. On page F-14 of the filing it says:
Capitalized media content is amortized on a straight-line basis over five years, representing the Company's estimate of the pattern that the underlying economic benefits are expected to be realized and based on its estimates of the projected cash flows from advertising revenues expected to be generated by the deployment of its content.What that means in plain English is that Demand splits the $33.50 it may have paid for an article into five equal chunks of $6.70 and then writes off that expense once a year for five years. The company alleges that the article will live for five years on the Web, earning revenue the whole time. At the end of the five-year period, Demand considers the article fully paid for.
This has an obvious effect on its income statement: Demand may earn $50 in ad revenue the first year the article runs, but it will only record a $6.70 expense, making the company look enormously profitable when in reality it paid $33.50 to make those sales. That's why everyone is up in arms. Amortizing your expenses also muddles together things you paid for this year with things you paid for five years ago. It makes it much more difficult for investors to figure out if Demand is a going concern right now.
Not for profit
But let's put that aside and see how Demand is doing based on its own numbers. The IPO is fascinating because for the first time it gives us a detailed look at a company with a content farm as a model, and it tells us whether providing content to users free of charge on the web can generate enough ad revenue to be profitable. The Demand filing suggests it is not: The company had $86 million in cash in December 2008; it now has only $29 million (see the balance sheet on page F-3). That's easy to interpret: This company is losing money over time.
Now look at the revenues (on page F-4). The company pulled in $179 million through September. Not bad. But after expenses it posted a net loss of $6.3 million, and hasn't been profitable for the last three years. Demand said it wrote down $24.4 million in "amortization," which includes those editorial costs. Demand loses money mostly because it's paying $95 million in "service costs" to keep its websites on the air.
Might it be that Demand is profitable on a cash basis? (Formal accounting rules sometimes disguise a business's true ability to generate money.) The cashflow statement says no: When the company adds back the non-cash amortization expenses, it produces $40.6 million in operating cashflow. But that is immediately eaten up by a $48.6 million loss on its investment activities -- mostly the purchase of "intangible assets," which Demand defines primarily as its editorial costs.
On page F-28, the company says the net book value of Demand's media content yet to be written off is $57.5 million. That's a lot of unnecessary future expenses for a business that already can't make money. The Business Insider's Henry Blodgett says Demand's amortization accounting is dodgy because it "makes it look profitable." I'd say it's worse than that: Even with the dodgy accounting, Demand appears to be an unprofitable, cash-losing business. The company seems to need the IPO to raise more cash, not because it needs investment money to grow faster.
That's depressing news for the media business generally: Even when you can generate $179 million in web ad revenue it still costs too much to create the content for those ads. (Unless, like the Huffington Post, you pay your writers nothing at all -- then you can actually make a profit.)
Related:photoclinique and happyeclair, CC.