Description

Demand Media (DMD) -  $5.20

In January 2011, DMD went public with close to a $1 billion enterprise value and currently has a $65M ev. On the surface, DMD has been left for dead and for completely understandable reasons: new management, change in business strategy, shrinking revenue, and full year loss in 2015. However, we think DMD is massively undervalued and poised to be revalued at substantially higher valuation in 2016. Why? In short, the events that led to an extremely low valuation should reverse in 2016. First, management is sharp: the CEO Sean Moriarty was formerly the CEO/Chairman of Ticketmaster and CFO Rachel Glaser came from Realtor.com. Both businesses sold for over $1 billion in the last several years. Second, downside is well-protected by what we are high quality businesses at key inflection points. Both business segments are #1, #2, or #3 players and possess asset-light balance sheet characteristics: no inventory, little accounts receivables, no fulfillment services, or taking of design risk, net cash of ~$2 per share,  and +$5 a share in NOL’s. Third, Marketplaces is growing at 60%+ organically and makes up 40% of total revenue. While Content and Media, in aggregate viewed by more than 50 million people a month and rank in the top 50 most visited online properties in the US.  We think DMD is undervalued by a wide margin with a 0.6x sales multiple, 20% revenue growth and return to generating cash in 2016. If this happens we think DMD could reach into the $10-15 in 2016 or +100-200% upside from current prices.

While I am skeptical of most management promotion, I believe the CFO November 5th 2015 comments are directionally accurate:

“Even with today's financial picture, we believe there's significant value dislocation in how the market is viewing Demand Media. As CFO of the company, I would be remiss not to punctuate this point. We have endeavored to be more transparent with you about the component parts of our business, making a sum of the parts analysis pretty simple. Let's do the math. First, we have a Marketplace business that is approaching $50 million in annual revenue and growing over 50% year-over-year on an organic basis. Second, we have an integrated content marketing business that is on a run rate to do $15 million annually and currently growing over 40% year-over-year. There are recent private market valuations for similarly sized and positioned competitors in this space that are believed to be well north of $150 million. Third, we have media properties that reach nearly 50 million unique users in the United States on average per month. And though revenue has been declining in recent quarters, we are on solid footing for a return to growth. Given these facts and our operating plan that we have put in place, we firmly believe that at today's trading price, we have the potential for considerable upside in value. We look forward to discussing that thesis with you in follow-up meetings and future calls.”

In short, the comment “we are on solid footing for a return to growth” combined with DMD’s properties re-entering the Comscore’s Top 50 U.S. Digital Media Properties as of October 2015 holds true, we think DMD is significantly undervalued.

Demand operates two business lines:

1.       Content and Media (C&M): eHow, Livestrong, Cracked, StudioD, and others.

2.       Marketplaces (e-commerce): Society6, SaatchiArt

DMD historically was infamously recognized as for eHow’s “content farms”, where they would mass produce low-quality and inexpensive to create ($20), how-to articles that would index well on Google’s past algorithm and have a long tail of value (net $50 over several years). Google did not like this arbitrage that led low quality user experience and changed their algorithm (Panda update) in efforts to improve search results.  Low-quality articles were pushed down page rankings and the algorithmic changes brought the decline of DMD.  The content farm arbitrage while it worked threw off about $100 million in EBITDA less CAPEX from 2010-2014 or $5 per share (vast majority from Content/Media segment).  New management bit the bullet and transitioned DMD old content farm business from a high risk business model led by GOOG supplier concentration, low quality user experience, yet significant positive cash flows to a business model that is far higher quality and heavily misunderstood by Wall Street. For the C&M business, DMD switched the focus to put quality in front of quantity by renovating/taking down poor content, reducing number of ads per page and producing “high-quality” content. Out of 3 million articles, the new team took down 2.3 million low quality articles and fundamentally changed their distribution and content creation strategy. Not surprisingly, after taking down 67% of the content in late 2014, 2015 revenue declined -50%. Currently, DMD is bringing on influencers/content creators who have authority, credibility, with large base of followers on Pinterest, Twitter, or other social media typically with 500 to 5,000+ followers.  DMD pays approximately $150 to $200+ per high quality article and in turn eHow hopes to generate in excess of 1,500 to $2,000 over the life of the article. Obviously, if this holds true this is a much better arbitrage but probably lower volume of content and also much lower GOOG risk on distribution. You can see the quality of content and improvement in writers at eHow:  http://www.ehow.com/contributor/sylvie_tremblay_msc/

On the 3rd Quarter Transcript re: Content/Media:

• “The most difficult and costly work is substantially behind us, and we are now building from a stable foundation.” – Sean Moriarty, CEO of DMD

• “It is worth nothing that the sequential decline in C&M was down 4% versus Q2, while Q2 revenue was down 7% versus Q1. So the decline is decelerating and we are cautiously optimistic about what is ahead.” – Rachel Glaser, CFO of DMD

eHow (how-to, DIY website) – Stabilizing

• Answers.com was acquired by Apax Partners August 2014 for ~$900mm, 5.9x Sales and 18x EBITDA.  Answers.com operating at 25%+ EBITDA margins.

Livestrong (#3 Health and Fitness Website behind #2 EVDY and #1 WBMD) – Stabilizing

• Popular and growing Myplate app (calorie tracker),MyQuit (smoking cessation), and MyWater (tracking water consumption) are seeing strong engagement with MAU up 30% YoY.

• Leading medical experts writing articles for 7 different verticals (another 28 rolling out next year) that cater to people with common medical conditions. For example, Dr. Nancy Baxi, a board-certified internal medicine physician with nearly 2 decades of experience, authored “The Fibromyalgia Center” and Dr. Eric Kezirian, a leader in surgical treatment of sleep apnea and teacher at USC Keck School of medicine, authored the Sleep Apnea center.

• They are also bringing on social media influencers such as Kayla Itsines, an Instagram fitness sensation with over 3 million followers.

• Livestrong comps such as Everyday Health (EVDY) trade at 1.2x sales and WebMD trades at 3.1x (WBMD) sales. We believe there are better opportunities monetize through improved ad rates similar to WebMD and EveryDayHealth (EVDY) through customized ad campaigns for pharma.  Demand has hired salespeople specifically for this purpose.

Cracked (Humor Website whose comps include The Onion and FunnyorDie) + 11% Growth

• 11% revenue growth over Q3 with over half of its visitors navigating directly to the site and 34% coming from social media sources. Cracked YouTube subscriber base increased 54% YoY, reaching ~900K subscribers.

• Jason Pargin (whom readers may know better as New York Times bestselling author David Wong) created the democratic freelance model and the editorial process Cracked uses today, where the highest voted pitches are brought to the editor’s attention faster so Cracked can develop for their audience. Many freelancers graduate into full-time Cracked staff.

• A comp to Cracked, Wetpaint.com, was acquired by Viggle end of 2013 for $30mm or 5x revenue.

StudioD (creator and publishing platform with content solution services) +43% growth

• Leveraging its library of content and community of talent, StudioD creates custom content (like an ad agency) and takes care of ad placement and optimization through its media properties.

• StudioD has a programmatic ad sales model as well as a branded sales model and generates revenue by revenue sharing on the content monetization. StudioD has signed deals with some big brands such as Samsung, Kroger, Office Depot, Famous Footwear, Choice Hotels, etc. (DMD was the first comscore publisher to go fully programmatic in 2014 and is a pioneer in the programmatic ad sales model.)

• i.e.)  Cracked created a very successful native advertising campaign for Proctor & Gamble, and Hulu.

• StudioD grew from nowhere to ~15M in annual revenues that are expanding at 43% YoY, with 70%+ renewal rates.  A recent transaction in the space; King Content had $15 million in revenue and was acquired for $48 million or 3.2x sales.

In Content and Media: StudioD run rating $15mm, Livestrong run rating $12-15mm, Cracked generating $12nn growing low double digits, and eHow generating $15-20mm, we believe DMD’s C&M assets will generate $50-$60mm in 2016. Even when applying the lowest multiple of its peers (EVDY’s 1.2x multiple) for the whole ball of wax to C&M 2016 sales, the value of the C&M segment is $60mm or $3.00 per share. We believe Content/Media should be at least a 15%+ EBITDA margin type business.

Marketplaces: these are two businesses that are among the fastest growing e-commerce businesses in public equity with a growth rate of 2x Etsy’s which trades at 2x sales. The two e-commerce businesses were acquired in separate transactions for a total of ~$110 million or $5.50 per share.

Society6: Since the acquisition in 2013, Society6 revenue has nearly tripled from $15 to $50 million and is growing 63%+ organically. At the time of the acquisition Society6 had 27% EBIT margins or $4 million with revenues of $15mm and was acquired for $95 million (over 6x revenue). In 2016, we think Society6 will be pushing $65-$80 million in revenue. Society6 takes zero inventory, design, or fulfillment risk as artists upload images, take a cut of a sale and Society6 outsources the production/fulfillment of the order.  Society6 sells 25 different type of products (iPhone covers, etc.) and the average sale price is $50.  Additionally, Society6 has 74% of traffic coming from direct or referrals (no customer acquisition cost) and the company does a good job of reaching out to millennials with a presence in 10 of the largest college campuses.  Redbubble, a direct comp to Society6, is filing for an IPO in Australia (it generates 60% of its revenue in the U.S.)

SaatchiArt: SaatchiArt is an e-commerce platform for emerging artists. The site has an extensive global artist community with 60,000 artists and 600,000+ pieces of work with an average sale of approximately $1,750. Saatchi has a “vast selection of high-quality art, world-class curation, white glove customer support and expert shipping services” that differentiates Saatchi from any other online art platform.   DMD takes 30% of transaction revenue and artists gets 70%. We believe Saatchi can push $10M in revenue by 2016.

Altogether, the Marketplaces segment for DMD has grown revenues by 63%, increasing traffic, improving conversion rates, and increasing the average price per transaction. In short, we think e-commerce platform businesses could have $75-95 million in revenue in 2016. Given the growth, we would assign a 2x multiple to Sales, valuing this segment at $150-180 million or $7.50-9.00 per share.

IF Content/Media is sold for 1x sales, DMD would have $80 million net cash and should be 50-60% grower with $75-95 million in 2016 revenue. This would likely be valued at $225-285 million or $11-$14 plus $4.00 in net cash per share or $15.00-18.00 per share. Content/Media given transition, has considerably depressed the value of the high growth Marketplace/ecommerce side of the business.  

In the past year, the whole management team has been revamped.  Sean Moriarty was an acquihire through Saatchi in 2014 and formerly worked as the EVP, COO, CEO, and President of Ticketmaster under Barry Diller/John Malone. Sean was part of the IAC family for 10 years and led Ticketmaster through numerous acquisitions to make it a billion dollar company.  Moriarty decided to forego his 2014 bonus and has 700K options striking at $9.77. DMD also has CTO Brian Pike, who used to work with Moriarty at Ticketmaster as the CTO and moved on to become the CTO of the Rubicon Project, a yield optimization ad tech company, and led the company to a successful IPO.  Also on the team is CFO Rachel Glaser who spent many years at Disney, Finance at Yahoo!, and is well known as the former CFO Realtor.com which sold to News Corp for $1 billion. Top-tier talent resonates throughout the whole company. DMD brought on Mitchell Pavao as new General Manager of eHow and Brett Woitunski as VP of product at eHow. Both founded PureVolume (music web product that was acquired by Spin Media in 2010) and Virb.com (social network business acquired by Media Temple in 2008). There is a similarity among all these individuals in that they all built a company and either sold it for a billion dollars or took the company public.

The board seems to be impressed with CEO Sean Moriarty, in January 2016 Sean had his contract extended until January 2019.

Disclosure: This does not constitute a recommendation to buy or sell shares of DMD. We own shares in DMD and we may buy or sell shares without updating this board. 

Catalyst

Both expectations, valuation are extremely low and DMD has been left for dead. By peeling back layers of an under researched micro cap company, we have a high level of confidence that the company will grow rapidly with solid economics in 2016 and beyond.

2014 to 2015: 34% decline in revenue and operating cash flow +$25 million to -$10 million

We estimate from 2015 to 2016: +16 to +20% revenue growth with positive operating cash flow!

Low expectations: Very lightly covered business with two very conservative #’s (one guy has revenue declining in 2016, and does not do quarterly revenue estimates)

Marketplaces segment: Accelerating revenue at Society6 with 63% revenue growth with approximately $50 million in revenue. When DMD acquired Society6 the company had 27% operating margins.

Content/Media: approaching stability and poised to grow in 2016, given recent trends

Good balance sheet: with just under $2 a share in net cash

SOTP Analysis

·         Stabilizing C&M Properties: 50-60M at 1x sales or $2.50-$3.00 per share

·         Rapidly growing Marketplaces Properties: 75-95M at 2x sales or $7.50-$9.50 per share

·          Net Cash: $2.00 per share

·         ~$12 a share; currently trading at ~$5