Don't Buy Market Optimism for this Stock

Calla is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

If you bought Demand Media (NYSE: DMD) shares on Tuesday’s pre-earnings dip, congratulations! With Wednesday’s 9% pop, now may be a great time to sell. If Demand Media is on your watch list, resist the urge to buy now. I present three reasons that I chalk up Demand Media’s pop as market over-exuberance and why the company’s business model relies on similar questionable strategies even with the domain name business splitting off from the content business.

What Happened

Demand Media is a small-cap company that operates a domain registration business and a content generation business. After a heady IPO in 2011, Demand Media’s share prices crumpled and spent most of 2012 between $8 and $10. Since January, the share price has been floating downward toward $7.

On Tuesday, the company announced Q4 earnings of 12 cents, one cent above estimates, and an earnings forecast of 39 cents to 43 cents per share for 2013, a few cents under estimates.

After the market closed, Demand Media announced that it was exploring splitting the domain business from the content business, which would likely mean a special distribution in 2013 to shareholders. The share price jumped 20% in after-hours trading and has kept 7% gains on Wednesday.

Don’t Buy It

First, the split and especially how shareholders would benefit is not certain. Demand Media stated that the company was exploring the possibility, and that the process will take nine to 12 months. During that time, any number of buyers could drop out, Demand Media could decide not to sell, or problematic accounting measures or revised valuations could come to light (as with Demand Media’s IPO). The share price will continue to fluctuate during the process, and given the company’s small size and high valuations, it will likely fluctuate a lot.  If you insist on buying, wait for an inevitable pull back.

Second, Demand Media still makes most of its money from questionable content: a third of its revenues come from eHow alone. Do you really want to invest, particularly for the long term, in how many people visit eHow?

If the domain business is sold, Demand Media will make all of its money from questionable content – and content is an area in which Demand Media may have lost its market edge. When Demand Media was founded, it was one of the only companies producing search engine optimized (SEO) content. But now, small and large companies alike use computer programs to reproduce and optimize content or hire freelance writers to produce custom optimized content. Furthermore, Demand Media pays more than it needs to for its content; it starts pay at $15 per article, a $10 premium over the going rate of $5 on freelance work sites such as Elance or ODesk, but without a noticeable difference in quality.

Finally, Demand Media is still largely dependent on Google’s (NASDAQ: GOOG) search algorithms. Demand Media makes more money the more people visit its websites, which is highly dependent on where eHow and related websites appear in search result rankings. Search result logarithm changes can throw off traffic until Demand Media adjusts its content. This is exactly what happened in 2011: Google’s Panda algorithm change resulted in a massive traffic and quarterly revenue drop. In response, Demand Media reworked its business model, culling particularly bad content from its sites, tightening its editorial guidelines, and attempting to link content into other websites and social media.

The adjustment got Demand Media’s traffic back up, but it did not resolve the company’s reliance on Google’s algorithms. Demand Media is just as vulnerable to future Google updates, particularly if, like the 2011 Panda update, they target mass produced content.

Demand Media is an extremely risky and expensive small cap headed for short-term volatility and long-term losses. Wednesday’s jump is due to speculations on a possible sale, not to concrete changes in the company’s underlying business structure or profitability.

The jump means that the company is priced as a highly speculative growth stock. However, unless you believe in the transformative power of getting directions from eHow, buying Demand Media now is either a poor bet on innovation and value-added products, or a cynical bet on internet literacy.


CallaMarie has no position in any stocks mentioned. The Motley Fool recommends Google. The Motley Fool owns shares of Google. 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. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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