This Could Become a Tech Buyout Target

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

Demand Media (NYSE: DMD) recently announced its intention to spin-off its domain-name registration division as a separate publicly-traded company, and trim its operations to focus exclusively on content generation.

Although Demand's management team has not yet made any announcements regarding the exact timing and structure of this deal, it appears likely that it execute the spin-off during the fourth quarter of 2013 or the first quarter of 2014.

Currently, the registration business accounts for about one-third of the company's total revenue. With a few key secular factors driving growth in the registration space, the newly spun-off business could see impressive revenue growth during its first few years of existence.

About Demand Media

Santa Monica, California-based Demand Media is a digital media company that specializes in various forms of content generation, and offers domain names for sale through its proprietary domain-registration business. The company sources written and multimedia content through a network of freelance contributors and monetizes it using banner, video, and in-line advertisements.

It operates popular "content aggregator" sites like eHow and Cracked. It also provides content services and other support functions for third-party sites like USAToday.com. The so-called registrar business provides authentication, web hosting, and support services to domain owners and e-commerce companies that operate in the United States and elsewhere. The company earned about $6.2 million on revenue of $380.6 million in 2012.

How the deal is structured

Demand Media has already notified regulators and shareholders that it would like this spin-off to be tax-free. At this point, it appears likely that the company will get its wish. Although the exact terms of the deal have not yet been finalized, it seems likely that current Demand Media shareholders will receive stock in the new company. Demand is likely to include a "when issued" clause, that allows shareholders to opt out of the spin-off using special stock certificates or warrants.

It should be noted that Demand Media had lost roughly one-sixth of its value during the two-month period that preceded the deal's announcement. Although it briefly recovered the bulk of those losses in the session that followed the announcement, investors appear to be skeptical about the pending deal. During the sessions that followed, the company's stock fell from a closing high of $8.31 per share on Feb. 20 to $7.73 per share on Feb. 22.

Given the deal's long time horizon, investors should approach Demand's stock cautiously. If the company issues a negative earnings report, it could fall further and provide an excellent opportunity for those who wish to establish a position in anticipation of a post-split bounce. The stock's short-term post-announcement spike to $9.75 per share hints at the potential size of this bounce. At these levels, a $2-per-share price increase would provide Demand's shareholders with a premium of 26%.

Legal issues and potential complications

The outcome of this deal is contingent on its certification as a tax-free transaction, as well as approval from Demand's board of directors and common shareholders. At this point, it is expected to clear each of these hurdles. As one of the largest players in a space dominated by small and medium-sized registrar businesses, it appears unlikely that Demand's domain registration division will become the target of a buyout or sale.

Competitors

Early media reports of the pending deal have focused on the fact that Demand Media's primary domain-registration rival has already been bought out by a private equity partnership. Better known by its popular GoDaddy.com domain name, the Go Daddy Group sold itself to a consortium of firms led by Kohlberg Kravis Roberts (NYSE: KKR) in 2011.

Go Daddy was purchased by KKR’s group for $2.25 billion. With KKR's nearly endless reserves of capital financing for Go Daddy's operations, Demand's domain registration business is at an inherent disadvantage. In this sense, the spin-off is well-advised. As a standalone company, Demand's registration business could secure additional rounds of funding through senior debt, secondary offerings, and other capital-raising strategies.

The domain registration space's barriers to entry are not particularly steep. In fact, dozens of smaller outfits collectively account for a significant chunk of the worldwide market for domain names. Going forward, Demand's business will also have to contend with these more nimble players.

Long-term outlook

Demand Media forecasts that a standalone registrar business could earn as much as $200 million in annual revenue during its first full year of existence. Meanwhile, out-year growth could be impressive. The force behind the division's expected growth is the expansion of customized domain suffixes, that carve out "special interest" pockets within the larger ecosystem of the Web. For instance, Demand has sought regulatory approval for a new ".actor" domain that could serve as a wiki-style repository for film-related information.

The long-term implications of this move are unclear. If the newly spun-off division can effectively harness this trend, it may develop into a robust standalone concern. In fact, Demand's content business may prove more vulnerable to market shocks or future takeovers.

Larger companies like Yahoo! (NASDAQ: YHOO) would love to get their hands on Demand's prime online media properties. Yahoo! has taken over a few content businesses in the past, including Associated Content, Citizens Sports, and BuzzTracker back in 2007. Given Yahoo’s deep pockets with over $4 billion in cash, they could easily make the purchase. If Demand Media is not able to adapt its offerings to an increasingly mobile-savvy consumer base, it may quickly become just another Yahoo! or KKR division.

The bottom line

In sum, investors who wish to bet on the long-term success of Demand's registrar business may wish to wait for a better entry point. Likewise, those who wish to benefit from a pre-deal spike in Demand's shares should nibble cautiously until the company offers more clarity about its financial situation. Since this deal will not close until late 2013 at the earliest, there is plenty of time to reap the rewards.


Mike Thiessen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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!

blog comments powered by Disqus