Reading between the lines of Demand Media’s S1 (hint: there’s more cash than you think)

By , August 10, 2010

There has been a lot of coverage in domainer circles (and beyond) of Demand Media’s S1, most of which run along the theme “Demand Media is losing money, why would anybody invest”. Which is a good question. I remarked the same back when Godaddy’s S1 revealed that even though they were the largest registrar in the world, they too were operating at a loss.

It begs the question: why? At the risk of going completely off on a tangent, I will observe that going public used to be a way for profitable companies with operating histories of a decade or more to raise capital in order to expand. In today’s hit-and-run trader’s market of hot money and fast deals, going public is really just a mechanism to provide liquidity to the early stage investors, most often the VC’s – who’s interest is not necessarily to build a profitable business but rather to garner successive funding rounds at higher valuations until the IPO or other “exit”.

We live in a bizarro world where money losing and pre-revenue companies go public while profitable ones are taken private. So it goes.

With that off my chest, I feel duty bound to point out that even in Demand Media’s case, it may be a misnomer to label them as “unprofitable”. They are cashflow positive (which we’ll get to) and they are narrowing the operating loss at a pretty decent rate. It brings to mind a comment on TheDomains:

Demand Media’s revenue is setting records and net losses experiencing a downward trend. It looks to be a prudent investment. Smaller businesses need to pay attention to fundamentals, but larger businesses with vision can depend on trends. Think about Amazon. I remember working in online research and SEO for a little startup in 2000 in the same business as Amazon, and we gossiped how Amazon was losing $$ year after year. But I noticed, the gap was getting smaller, then finally it started breaking even. Finally it made a profit.

Back in the early days of Amazon (when I thought I new everything about investing), I derided Amazon as a money-losing machine that was less profitable than my own, microscopic DNS company. I have learned much since and now realize I know next to nothing. Amazon is a machine alright, a profitable one. Too bad it’s trading at multiples that aren’t attractive to me. At the right price, I’d be all over it.

In Demand Media’s case, the operating losses are largely due to non-cash items like amortization and depreciation of intangible assets. When you back out those non-cash items to look at the straight cash flows, Demand Media is cash flow positive. This is good.

This doesn’t make them a value investor’s stock by a long shot. It makes them, like Amazon, a growth stock story. Value investors do not eschew growth stocks, but they strive for “GARP”: Growth At a Reasonable Price. Whether we can get that with Demand Media (assuming further analysis indicates it to be otherwise favourable) remains to be seen.

Gone are the days when IPOs by definition soared on issue day. Some do, some don’t, but it seems to be more at the mercy of the wider market sentiment nowadays than being in the updraft of a pervasive market bubble.

But I wanted to point out that Demand Media is making money, when you back out the non-cash items that put them at an operating loss. And I should also mention by contrast, this was not the case with Godaddy, where the non-cash items were narrower than the operating loss.

For the year ended 2009, Demand Media’s loss from operations was ~ $18M while the non-cash charge for depreciation and amortization was $32M. For the six-months ended 2010, the loss from operations was roughly $4M while the same non-cash charge was $16M. Add to the non-cash losses dividends on the preferred shares of $30M in 2009 and another $16M for the six-months in 2010 and we can see where the cash went.

I’m not saying this makes it a screaming buy, but Demand Media is spinning off more cash than may meet the eye at first glance.

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