Google, Demand Media, Lance Armstrong and ‘the worst IPO of the year’

Lance Armstrong is an American cyclist who earlier this week finished 67th in Mike Rann’s annual bread-and-circuses show that is the Tour Down Under around the streets of Adelaide.

Demand Media is a “content farmer” that next week is set to test the investment waters with one of the biggest IT public share offerings of the post-bust era.

Google? Well it is just Google. When a company becomes a verb there isn’t much more you need to say.

On Saturday, Matt Cutts, Google’s principal engineer, issued a post on Google’s blog noting that after many months of user complaints about search quality, Google had listened to “feedback from the web loud and clear: people are asking for even stronger action on content farms and sites that consist primarily of spammy or low-quality content.”

Cutts said that Google had taken steps to cull the proliferation of “webspam”, that is, “junk you see in search results when websites try to cheat their way into higher positions in search results or otherwise violate search engine quality guidelines”.

Google’s attention has now shifted to:

“… content farms … sites with shallow or low-quality content … people are asking for even stronger action on content farms and sites that consist primarily of spammy or low-quality content.”

Cutts didn’t name names, and he didn’t have to. It is clear that Google has sites such as Yahoo’s Associated Contributor network, Suite 101 and Demand Media squarely in its sights.

For Google, the crux of the issue is customer satisfaction — if you are unhappy with the results from a Google search you might vote with your fingers and go elsewhere — perhaps to Microsoft’s coming challenger Bing, for example.

Most of us haven’t heard of Demand Media — but key in a Google search such as “How to tie a double Windsor knot” and there is every chance you’ll end up at an eHow page such as this one, which is loaded with teasers for information you don’t really need to know like “How to Protect a Dog’s Paws in Winter”, “How to Make Paw-print Moulds”, “How to Eat Well for Less”, “How to Format a Hard Drive with Windows XP” and “How to Remove a Red Wine Stain”, etc, etc.

eHow is a subsidiary of Demand Media, which in August last year filed documents with the US Securities and Exchange Commission indicating its intention to raise capital through an Initial Public Offering (IPO).

That announcement launched a lot of comment of the “lipstick on a pig” kind in the business press.

Peter Kirwan in Wired.com put Demand Media’s IPO in context:

“There’s quite a lot riding on Demand Media. Venture capitalists have invested nigh-on $350 million in the company, and voices close to Demand Media are suggesting valuations of between $1 billion and $1.5 billion. The former would make Demand Media the first $1 billion+ IPO since 2004 … the latter would make Demand Media more valuable than The New York Times Co, which has a market cap these days of about $1.2 billion.”

In November venture funder Bo Peabody in Business Insider went further, saying that of all the low-quality content companies that feed off Google, Demand Media turns the cleverest trick on Google’s search engine by running a:

“… giant arbitrage of the Google ecosystem. Demand contracts with thousands of freelancers to produce hundreds of thousands of pieces of low-quality content, the topics for which are chosen according to their search value, most of which are driven by Google … Google’s algorithm places Demand content high on their search engine result pages. Demand also fills dormant domains they own with links to ‘dummy’ content sites, further exploiting Google’s algorithm.”

Industry commentators have identified no shortage of other flaws with the Demand Media IPO, with the  consensus being that it is a dud.

Last Thursday Herb Greenberg at CNBC hoisted several red flags about Demand Media’s prospectus, noting that Demand Media had never turned a profit, had accumulated losses of $52 million and that it is very dependent on advertising revenue, 28% of which is fed through Google.

Greenberg reserved his strongest language for the Demand Media insiders who are selling off an “enormous amount of stock”. Of the 7.5 million shares on offer 3 million are coming from insiders.

“You never want to see big insider sales on the offering. Never. Ever. Especially when the company is profitless. Especially when it’s less than five years old.”

And the ageing cyclist Lance Armstrong’s role in all of this?

According to the Demand Media prospectus issued on January 12, 2011*, in 2008 Lance Armstrong, and his not-for-profit Lance Armstrong Foundation (the LAF), received beneficial ownership of a shared total of 231,250 warrants in Demand Media. Of those, 61,563 are up for offer in the IPO (or were, see the note below).

Capital Sport & Entertainment (CSE), which owned and managed Armstrong’s US Postal Service and Discovery Channel squads and now owns and manages Armstrong’s current Team Radio Shack, was also in on the Demand Media deal, with beneficial ownership of 18,750 Demand Media shares — 4991 of which will be up for offer.

In addition, Armstrong, the LAF and CSE have several outstanding warrants to purchase Demand Media shares — Armstrong has 531,250, the LAF 625,000 and CSE 93,750 warrants.

And the deal?

In 2008 Demand Media acquired perpetual and exclusive worldwide licensing rights to use the LAF’s registered trademark (LIVESTRONG™ — for more see here).

Soon after that deal, Demand Media launched the very much for profit Livestrong.com, which was described at the time as a “wellness” site. Livestrong.com is the main online port of call for Armstrong’s very visible web presence.

Larry Dignan at ZDNET.com described Livestrong.com as “a useless stray link on damn near anything health related I’ve researched. So I’d give permission to Google to just kill that site.”

LAF got a guarantee of a certain amount of traffic and content from Demand Media. Armstrong and Demand Media made a separate deal whereby Armstrong entered into an “Endorsement and Spokesman Agreement” with Demand Media “under which he provides certain services and endorsement rights”.

Demand Media’s initial estimates were that its shares would go to the market at $12. That soon rose to $15, then to $17, which is what 8.9 million shares sold for when the market opened on Tuesday this week. Earlier today shares were trading at $23 after a high of $25, giving Demand Media a valuation of $1.9 billion — well above the New York Times.

Demand Media is well aware of the risks associated with any change to Google’s search engines in its prospectus. Google is mentioned there 62 times — including the warning that Google could “easily change its existing … methodologies and metrics for valuing the quality of internet traffic and delivering cost-per-click- advertisements” that could have a negative effect on Demand Media’s business.

As Business Insider noted over the weekend:

“Google does not actually promise it will take any action against companies like Demand Media. But what Google does is almost worse: vaguely suggest that it might someday do something to smash Demand Media’s business. Google just introduced lots of fear and uncertainty into the minds of any potential Demand investors.”

Chris Nerney at ITWORLD, in an article headed “Demand Media: Worst IPO of the Year”, reckons that Demand Media bells the cat for investors with this note in its 33 pages of “Risk factors” listed in the IPO:

“The assumed initial public offering price of our common stock is substantially higher than the net tangible book value per outstanding share of our common stock immediately after this offering. As a result, you will pay a price per share that substantially exceeds the book value of our tangible assets after subtracting our liabilities. Purchasers of our common stock in this offering will incur immediate and substantial dilution of $13.92 per share in the net tangible book value of our common stock based upon an assumed initial public offering price of $15.00 per share.”

It is too early to say whether Demand Media will be the “worst IPO of the Year” — there are quite a few more coming down the pipeline yet — or whether Google will deliver on its promise to crack down on content farmers like Demand Media.

But it is safe to say that Demand Media will be one of the most controversial — and most watched — stocks thrown into what US President Obama yesterday touted as a stock market that is “roaring back”.

*These numbers appear to be a bit of a movable feast.  According to the Securities and Exchange Commission website that tracks documents related to the Demand Media IPO, there have been seven different versions of the Form S-1 document produced to date, see here, with the most recent iteration produced on January 24 in the US — today in Australia.