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Market turns its eyes to Internet content companies

Demand Media Inc. is so far winning the battle of the content-company IPOs by jumping more than 20 per cent from its first-day price last week, compared with a more modest 9-per-cent gain from Nielsen Holdings NV .

It is Nielsen, however, that emerges victorious in a different measure: fewer red flags for investors.

The excitement around Demand Media, which owns websites such as eHow and answerbag, is no surprise. It was slated to become the biggest Internet initial public offering since Google , even before the company ratcheted up the size of its stock sale Tuesday due to heavy demand.

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It claims to be the future of content on the Internet, producing millions of articles crafted to answer Web users' search queries and grabbing the advertising money. At nearly $1.7-billion (U.S.) in market value, it's now a more valuable media property than the New York Times Co.

Nielsen is an ancient, old-media name by comparison, known best for its oft-cited television ratings. It generates about $5-billion in revenue annually, primarily in its "what consumers watch" segment, which tracks viewing of television, websites and mobile phones, and its "what consumers buy" business, which produces consumer-behaviour data primarily for the packaged-goods industry.

Nielsen says the average length of relationships with its top 10 clients – which include Coca-Cola Co., NBC Universal, Nestlé SA, News Corp., Procter & Gamble Co. and Unilever – is more than 30 years.

A group of private-equity firms took Nielsen private in 2006; Tuesday's IPO was their exit strategy. Yet none of the shareholders sold stock in the offering. Instead, the $1.5-billion Nielsen raised was used primarily to retire high-priced debt left over from the leveraged buyout. (The private-equity firms did take a $101-million fee to terminate their management agreements, according to Nielsen's securities filings.)

In contrast, Demand Media chief executive officer Richard Rosenblatt and other insiders are cashing in already: Nearly half the shares sold in the IPO were offered by insiders, with no proceeds going to the company. Mr. Rosenblatt and other executives sold roughly one-tenth of their holdings, even as investors made their company one of the hottest stocks of the week.

Nielsen's revenues have been growing at a steady but unspectacular rate of 6.2 per cent annually from 2006 to 2009. Gross margins over 50 per cent and low-double-digit margins of earnings before interest and taxes have been undercut by interest payments on the company's massive pre-IPO debt load.

Nielsen's $8.5-billion in debt at Sept. 30 exceeded six times its earnings before interest, taxes, depreciation and amortization, according to data from Standard &Poor's Capital IQ. The IPO proceeds should cut debt below $7.4-billion, but the company's high degree of leverage remains one of Nielsen's primary risks.

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While Nielsen looks to be a steady-growth cash flow play, valuation metrics for Demand Media reflect significant expectations for growth. It's unprofitable, so it has no P/E, but it trades at roughly 10 times its trailing revenue. It's been posting 25-per-cent year-over-year sales growth in 2010.

Will it continue? About 28 per cent of Demand Media's revenue comes from Google searches, as the primary business model at Demand Media involves analyzing Internet users' searches for very specific instructional content. (An example given by Mr. Rosenblatt, according to a road show transcript posted by the website, is "how to barbecue a lobster tail.")

Yet Demand Media skeptics point to a post on the official Google blog by principal engineer Matt Cutts saying, "people are asking for even stronger action on content farms and sites that consist primarily of spammy or low-quality content." To Demand Media's critics, this fits the company's sites perfectly.

And it infuriates Mr. Rosenblatt, who said in an interview with website All Things Digital that Google's post "is not directed at us in any way … He's talking about duplicate, non-original content. Every single piece of ours is original. Written by somebody."

Mr. Rosenblatt argues that Demand Media's content, because it addresses ageless questions like "how to clean hardwood floors with white vinegar," has a longer, more lucrative life than most newspaper stories.

That philosophy has led to the company's controversial accounting choice of treating the money it pays its freelance writers and editors not as ongoing expenses, but as the purchase of intangible assets with a five-year life. The practical effect is to boost net income by pushing out over a five-year period costs that would normally show up all at once in the expense statement. It also makes the balance sheet more attractive by showing a higher value for assets.

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In its securities filings, Demand Media says if it cut the amortization period for its costs by one year, to four, it would add $2.4-million to the $4.0-million net loss in the first nine months of 2010.

An even better way to examine Demand Media's accounting is to look at a free cash flow measure that subtracts both capital expenses and the costs of purchasing content from its operating cash flow. Even as the company has reported narrowing net losses over the last six quarters, its free cash flow has gone negative: It had negative $4-million in free cash flow in the third quarter of 2010, compared with positive free cash flow of $1.8-million in 2009's third quarter.

Special to The Globe and Mail

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