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DMD > SEC Filings for DMD > Form 10-K on 17-Mar-2014All Recent SEC Filings

Show all filings for DEMAND MEDIA INC.

Form 10-K for DEMAND MEDIA INC.


17-Mar-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with Part II, Item 6, "Selected Financial Data" and our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. In addition to historical data, this discussion contains forward-looking statements about our business, operations and financial performance based on current expectations that involve risks, uncertainties and assumptions. Our actual results may differ materially from those discussed in the forward-looking statements as a result of various factors, including but not limited to those discussed in "Special Note Regarding Forward-Looking Statements" and Item I, Part 1A, "Risk Factors" included elsewhere in this Annual Report on Form 10-K.

Overview

We are a diversified digital content & media and domain name services company. We have developed a leading Internet-based model for the professional creation and distribution of high-quality content, and we have recently expanded our commerce-based products and services. We are also a leader in the domain name industry, with a complete suite of products and services that our customers utilize as the foundation to build their online presence, including operating wholesale and retail domain name registrars, serving as a domain name registry and providing related services.

Our business is comprised of two service offerings: Content & Media and Domain Name Services. Our content & media service offering includes an online content creation studio with a large community of freelance creative professionals, a portfolio of leading owned and operated websites, and a digital artist marketplace and e-commerce platform. We deploy our proprietary content & media platform to our owned and operated websites, such as eHow.com, Livestrong.com and Cracked.com, and to websites operated by our customers. We also leverage our content creation studio for third-party brands, publishers and advertisers as part of our content solutions service offering. As a complement to our traditional content offerings we have recently integrated certain e-commerce and paid content offerings. In June 2013 we acquired Society6, LLC ("Society6"), a digital artist marketplace and e-commerce platform that enables a large community of talented artists to sell their original designs on art prints, phone cases, t-shirts and other products. We also offer certain on-demand services for purchase on an a la carte or subscription basis, such as eHow Now, a platform where customers chat directly with experts to receive advice and guidance. Our content & media service offering also includes a portfolio of websites primarily containing advertising listings, which we refer to as undeveloped websites.

Our domain name services include services provided by our domain name registrars, domain name registry and related services. Historically, this service offering has been comprised solely of our registrar service offering, which provides domain name registration and various related services to our customers, and we refer to this service offering as our Registrar service offering for historical periods. We own and operate the world's largest wholesale Internet domain name registrar and the world's second largest registrar overall, based on the number of names under management. We are also positioned to become a leading domain name registry through our participation in ICANN's New gTLD Program, which is designed to expand the total number of domain name suffixes. Under the New gTLD Program, our domain name services business has entered into 21 registry operator agreements with ICANN to date, and we launched our first seven gTLDs into the marketplace in the first quarter of 2014. We also began providing registry back-end services to Donuts, a third-party domain name registry, in the fourth quarter of 2013. The combination of our existing registrar business and our new registry business will make us one of the largest providers of end-to-end domain name services in the world.

Our principal operations and decision-making functions are located in the United States. We report our financial results as one operating segment, with two distinct service offerings. Our operating results are regularly reviewed by our chief operating decision maker on a consolidated basis, principally to make decisions about how we allocate our resources and to measure our consolidated operating performance. Together, our service offerings provide us with proprietary data that facilitate the creation of commercially valuable, long-lived content, which we combine with broad distribution and targeted monetization capabilities. We currently generate the vast majority of our Content & Media revenue through the sale of advertising, sales of products and to a lesser extent through subscriptions to our social media applications and through licensing, e-learning and other on-demand services. Substantially all of our Registrar revenue is derived from domain name registration and related value-added service subscriptions. Our chief operating decision maker regularly reviews revenue for each of our Content & Media and Registrar service offerings in order to gain more depth and understanding of the key business metrics driving our business. Accordingly, we report Content & Media and Registrar revenue separately.

Our wholly owned subsidiary, Rightside Group, Ltd. ("Rightside"), filed a Registration Statement on Form 10 with the SEC in January 2014, which Rightside amended in February 2014, in connection with the planned separation of the Company into two independent, publicly traded companies: a pure-play Internet-based content and media company and a pure-play domain name services company (hereinafter referred to as the "Proposed Business Separation"). Upon completion of the Proposed Business Separation, Rightside will operate the domain name services business, while we will continue to own and operate our content and media business. The Proposed Business Separation is being structured as a pro rata distribution of Rightside shares to holders of our common stock (the "Distribution"). Consummation of the Proposed Business Separation is subject to final approval by our board of directors which may, in its absolute and sole discretion, decide at any time prior to the Distribution not to proceed with the Proposed


Business Separation or to change any of the terms related to the Proposed Business Separation or the Distribution. Consummation of the Proposed Business Separation is also subject to the satisfaction of several conditions, including receipt of a private letter ruling from the IRS, together with an opinion of our tax counsel, substantially to the effect that, among other things, the Proposed Business Separation will qualify as a transaction that is tax-free for U.S. federal income tax purposes under Sections 355 and 368(a)(1)(D) of the Code, having the Registration Statement on Form 10 declared effective by the SEC and receipt of listing approval. We received the private letter ruling from the IRS on January 31, 2014. We have not yet finalized all of the details of the Proposed Business Separation.

In January 2011, we completed our initial public offering and received proceeds, net of underwriters discounts but before deducting offering expenses, of $81.8 million from the issuance of 5.2 million shares of common stock. As a result of the initial public offering, all shares of our convertible preferred stock converted into 61.7 million shares of common stock and warrants to purchase common stock or convertible preferred stock net exercised into 0.5 million shares of common stock.

For the years ended December 31, 2013, 2012 and 2011, we reported revenue of $394.6 million, $380.6 million and $324.9 million, respectively. For the years ended December 31, 2013, 2012 and 2011, our Content & Media offering accounted for 62%, 65% and 63% of our total revenue, respectively, and our Registrar service accounted for 38%, 35% and 37% of our total revenue, respectively.

Key Business Metrics

We regularly review a number of business metrics, including the following key metrics, to evaluate our business, measure the performance of our business model, identify trends impacting our business, determine resource allocations, formulate financial projections and make strategic business decisions. Measures which we believe are the primary indicators of our performance are as follows:

Content & Media Metrics

- page views: We define page views as the total number of web pages viewed across (1) our owned and operated websites and/or (2) our network of customer websites, to the extent that the viewed customer web pages host our monetization, social media and/or content services. Page views are primarily tracked through internal systems, such as our Omniture web analytics tool, contain estimates for our customer websites using our social media tools and may use data compiled from certain customer websites. We periodically review and refine our methodology for monitoring, gathering, and counting page views in an effort to improve the accuracy of our measure.

- RPM: We define RPM as Content & Media revenue per one thousand page views.

Registrar Metrics

- domain: We define a domain as an individual domain name paid for by a third-party customer where the domain name is managed through our Registrar service offering. Beginning July 1, 2011, the number of net new domains has been adjusted to include only new registered domains added to our platform for which we have recognized revenue. This metric does not include any of our owned and operated websites.

- average revenue per domain: We calculate average revenue per domain by dividing Registrar revenue for a period by the average number of domains registered in that period. The average number of domains is the simple average of the number of domains at the beginning and end of the period.


The following table sets forth additional performance highlights of key business metrics for the periods presented:

Year ended December 31, % Change 2013 2012 2011 2013 to 2012 2012 to 2011 Content & Media Metrics(1):
Owned & operated
Page views (in millions) 16,348 13,192 10,378 24 % 27 % RPM $ 11.96 $ 13.53 $ 15.14 -12 % -11 % Network of customer
websites
Page views (in millions) 16,793 18,989 17,436 -12 % 9 % RPM $ 3.03 $ 3.58 $ 2.77 -15 % 29 % RPM ex-TAC $ 2.08 $ 2.55 $ 2.06 -18 % 24 % Registrar Metrics(1):
End of Period # of Domains
(in millions) 15.0 13.7 12.7 9 % 8 % Average Revenue per
Domain(2) $ 10.36 $ 10.19 $ 10.08 2 % 1 %

(1) For a discussion of these period-to-period changes in the number of page views, RPM, end of period domains and average revenue per domain and how they impacted our financial results, see "Results of Operations" below.

(2) Beginning July 1, 2011, the number of net new domains has been adjusted to include only new registered domains added to our platform for which we have recognized revenue. Excluding the impact of this change, end of period domains at December 31, 2012 would have increased 13% and average revenue per domain during the year ended December 31, 2012 would have decreased 4%, each compared to the corresponding prior-year period.

Opportunities, Challenges and Risks

To date, we have derived the majority of our revenue from the sale of advertising in connection with our Content & Media service offering and domain name registration subscriptions in connection with our Domain Name Services offering. We believe there is an opportunity to diversify our Content & Media revenue streams through commerce initiatives to offer products and on-demand services for purchase and to create and distribute content for third party brands and publishers. To further our commerce initiatives, in June 2013 we acquired Society6, a digital artist marketplace and e-commerce platform that enables a large community of talented artists to sell their original designs on art prints and other products. Additionally, while our content is currently targeted primarily at users in the United States, we believe that there is an opportunity in the longer term for us to create content and sell products targeted at users located outside of the United States and thereby increase our revenue generated from countries outside of the United States. We may incur additional expenses associated with expanding our business internationally.

Our Content & Media revenue is currently primarily advertising-based and principally dependent upon page views and RPMs. We believe that there are opportunities to grow our page views by improving the user experience on our websites, creating more content in a greater variety of formats, particularly formats better suited for mobile devices, and expanding our network of customer websites where we can distribute content produced through our platform. However, we rely largely on search engine referrals to our owned and operated websites for page views. Google, the largest provider of search engine referrals to the majority of our websites, regularly deploys changes to its search engine algorithms. Since 2011, we have experienced fluctuations in the total number of Google search referrals to our owned and operated websites, including eHow.com and Livestrong.com, and during 2013, we experienced several negative changes in Google referrals that, in the aggregate, were larger in magnitude than previous changes, and these changes resulted in substantial declines in traffic to our owned and operated websites. Other search engines may deploy similar changes. Additional changes to search engine algorithms may result in material fluctuations in our financial performance. Our RPMs may also be negatively impacted by changes in the online advertising marketplace, which could include lower rates received for mobile and other ad units as well as changes in the manner in which we sell our ad inventory.

In an effort to improve user experience and engagement, we regularly evaluate and strive to continuously improve our websites, content library and content creation platform. Such improvements include redesigning our websites, refining our content library through select removals and additions, establishing more stringent criteria for the admission of content creators, adding processes to ensure that each additional unit of content published is unique in relation to existing content units, creating new content formats designed to further diversify our content offering, renovating and improving existing content, and integrating commerce products and services with our content experience. For example, in response to the changes in search engine algorithms since 2011, we performed evaluations of our existing content library to identify potential improvements. As a result of these evaluations, we elected to remove certain content assets from service, resulting in $2.4 million, $2.1 million and $5.9 million of related accelerated amortization expense in the years ended December 31, 2013, 2012 and 2011, respectively. We may perform similar content remediations in the future, which could result in additional accelerated amortization expense related to the content that we remove from our library.


Our advertising revenue is primarily generated by advertising networks, which include both performance-based advertising, such as cost-per-click advertising where an advertiser pays only when a user clicks on their advertisement, and display advertising, where an advertiser pays each time an advertisement is displayed. The majority of our advertising revenue has historically been generated by our relationship with Google, and for the year ended December 31, 2013, approximately 34% of our total consolidated revenue was derived from our advertising arrangements with Google. Google maintains the direct relationships with advertisers and provides us with cost-per-click and display advertisements, which we deploy to our owned and operated websites as well as certain websites owned by our customers with whom we share a portion of the advertising revenue. Any change in the type of services that Google provides to us could adversely impact our results of operations. Google also serves as the technology platform partner in connection with our programmatic ad sales offering.

We have recently shifted our advertising strategy to focus on programmatic offerings that utilize advertising network exchanges rather than a direct sales force. This shift requires us to actively manage the sale of inventory for our owned and operated websites on an advertising exchange. An inability to successfully implement and manage this process could negatively impact our results. Additionally, brands and advertisers are increasingly focusing a portion of their online advertising budgets on social media outlets such as Facebook and Twitter. If this trend continues and we are unable to offer competitive or similarly valued advertising opportunities, this could adversely impact our revenue from display advertising.

Substantially all of our Domain Name Services revenue is currently derived from domain name registrations and related value-added service subscriptions from our wholesale and retail customers to our registrar platform. Growth in our revenue is dependent upon our ability to attract wholesale and retail customers to our registrar platform, to sustain those recurring revenue relationships by maintaining consistent domain name registration and value-added service renewal rates and to grow those relationships through competitive pricing on domain name registrations, differentiated value-added service and customer service offerings, and best-in-class reseller integration tools. Over the past few years our revenue growth has been driven by the addition of reseller customers with large volumes of domain names as well as the acquisition of Name.com, a leading retail registrar. Certain of our large reseller customers account for a large portion of our Domain Name Service revenue, and from time to time, we enter into multi-year agreements with those customers.

Going forward, we are diversifying our Domain Name Service offerings and expect to become a leading domain name registry offering new gTLDs, which we believe will help us attract new wholesale and retail customers as well as grow domain name registration volumes with existing customers. During the years ended December 31, 2013 and 2012, we paid $3.9 million and $18.2 million, respectively, for certain gTLD applications under the New gTLD Program in the pursuit of our ownership of certain gTLD operator rights.

Our service costs, the largest component of our operating expenses, can vary from period to period, particularly as a percentage of revenue, based upon the mix of the underlying Content & Media and Domain Name Services revenue we generate. In the near term, we expect that the period-over-period growth in our Content & Media revenue will be slightly declining offset by growth in our Domain Name Service revenue, and we expect that our service costs will increase in 2014 compared to 2013 in line with Registrar and Society6 revenue growth. We believe that these factors, together with costs associated with our investment in new gTLDs, will constrain our operating margin growth in the short-term as we increase our investment in new business initiatives to support future growth. We will also continue to monitor changes and emerging trends in search engine algorithms and methodologies, including the resulting impact that these changes may have on future operating results, the economic performance of our long-lived assets, the market price of our stock, anticipated future cash flows and other indicators of the fair value of our reporting units to determine if an interim impairment test is necessary. If we are required to record an impairment charge on the carrying value of our long-lived assets, including our media content and goodwill arising from acquisitions, it could have a material adverse effect on our results of operations and financial condition, particularly in the period such charge is taken.

We are currently pursuing the separation of our business into two independent, publicly-traded companies: an Internet-based content and media company and a domain name services company. We expect to complete the proposed business separation by the end of the third quarter of 2014, but completion of the separation is at the discretion of our board of directors and subject to the satisfaction or waiver of various conditions, and the separation may not be consummated. Furthermore, the proposed business separation requires significant time and attention from our management and employees and requires us to incur significant costs, which could disrupt our ongoing operations and adversely affect our results of operations. Additionally, following completion of the proposed business separation, we will be a less diversified company and our results may be more likely to fluctuate from period to period.


Basis of Presentation

Revenue

Our revenue is derived from our Content & Media and Registrar service offerings.

Content & Media Revenue

We currently generate a vast majority of our Content & Media revenue through the sale of advertising, and to a lesser extent through subscriptions to our social media applications and select content and service offerings. Articles and videos, each of which we refer to as a content unit, generate revenue both directly and indirectly. Direct revenue is revenue directly attributable to a content unit, such as advertisements, including sponsored advertising links, display advertisements and in-text advertisements, on the same webpage on which the content is displayed. Indirect revenue is also derived primarily by our content library, but is not directly attributable to a specific content unit. Indirect revenue includes advertising revenue generated on our owned and operated websites' home pages (e.g., home page of eHow), on topic category webpages (e.g., home and garden category page), on user generated article pages that feature content that was not acquired through our proprietary content acquisition process, and from subscriptions. Our revenue generating advertising arrangements, for both our owned and operated websites and our network of customer websites, include cost-per-click performance-based advertising, display advertisements where revenue is dependent upon the number of page views, and lead generating advertisements where revenue is dependent upon users registering for, or purchasing or demonstrating interest in, advertisers' products and services. We generate revenue from advertisements displayed alongside our content offered to consumers across a broad range of topics and categories on our owned and operated websites and on certain customer websites. Our advertising revenue also includes revenue derived from cost-per-click advertising links we place on undeveloped websites owned both by us, which we acquire and sell on a regular basis, and certain of our customers. To a lesser extent, we also generate revenue from our subscription-based offerings, which include our social media applications deployed on our network of customer websites and subscriptions to premium content or services offered on certain of our owned and operated websites. Other revenue is generated through the sale or license of media content or the sale of undeveloped websites. Revenue from the sale or perpetual license of content and sale of undeveloped websites is recognized when the content and undeveloped websites have been delivered and the contractual performance obligations have been fulfilled. Revenue from the license of content is recognized over the period of the license as content is delivered or when other related performance criteria are fulfilled.

Where we enter into revenue sharing arrangements with our customers, such as those relating to our advertiser network and our undeveloped customer websites, and when we are considered the primary obligor, we report the underlying revenue on a gross basis in our consolidated statements of operations, and record these revenue-sharing payments to our customers as traffic acquisition costs, or TAC, which are included in service costs. In circumstances where we distribute our content on third-party websites and the customer acts as the primary obligor we recognize revenue on a net basis.

We recognize revenue from product sales upon delivery, net of estimated returns based on historical experience. Payments received in advance of delivery are included in deferred revenue in the accompanying consolidated balance sheets. Revenue is recorded at the gross amount due to the following factors: we are the primary obligor in a transaction, we have inventory and credit risk and we have latitude in establishing prices and selecting suppliers. Product sales and shipping revenue is recognized net of promotional discounts, rebates, and return allowances. We periodically provide incentive offers to customers to encourage purchases. Such offers may include current discount offers, such as percentage discounts off current purchases, and other similar offers.

Registrar Revenue

Our Registrar revenue is principally comprised of registration fees charged to resellers and consumers in connection with new, renewed and transferred domain name registrations. In addition, our registrar also generates revenue from the sale of other value-added services that are designed to help our customers easily build, enhance and protect their domain names, including security services, email accounts and web hosting, and the performance of services for registries. Finally, we generate advertising and domain name sales revenue as part of our aftermarket service offering. We generate this aftermarket revenue on domain names that we own, as well as by providing these services to third parties. Our revenue varies based upon the number of domain names registered or utilizing our aftermarket service offerings, the rates we charge our customers, our ability to sell value-added services, our ability to sell domain names from our portfolio, and the monetization we are able to achieve through our aftermarket service offerings. We primarily market our wholesale registration services under our eNom brand, and our retail registration services under our Name.com brand.

We began our service offering related to our New gTLD Initiative in the fourth quarter of 2013. The amount as well as the timing of revenue is uncertain and is dependent upon when our back-end registry customers' applications for gTLDs are approved by ICANN, the outcome of negotiations or auctions to acquire the operating rights for gTLD applications contested with other participants, and the continued progress of the overall ICANN New gTLD initiative. To the extent that our registry will offer performance incentive rebates to our partners, those incentives will be recognized as a reduction to revenue.


Operating Expenses

Operating expenses consist of service costs, sales and marketing, product development, general and administrative, and amortization of intangible assets. Included in our operating expenses are stock-based compensation and depreciation expenses associated with our capital expenditures.

Service Costs

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