Don’t Buy Market Optimism for Demand Media Inc (DMD)

If you bought Demand Media Inc (NYSE:DMD) shares on Tuesday’s post-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. The share price declined less than 1% on the news.

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.