Demand Media’s Accounting Problem

At first glance, the performance of Demand Media (NYSE:DMD), which critics have long derided as a “content farm,”  seems impressive. In fiscal 2010, it reported that cash flow from operations rose 57% to $61.6 million and then gained 39% to $86 million the following year. But the company lost almost $24 million on a net basis during those two years.

Unfortunately, as the blog Grumpy Old Accountants has recently noted, there’s even less to Demand Media’s balance sheet than meets the eye.

“Demand Media is overstating its balance sheet cash by including accounts receivable as cash even though it has yet to receive the monies,” according to the blog, which is run by two accounting professors, who add that the company is counting funds transferred from its credit processors as unrestricted cash. “What’s the rush? Why the need to manipulate the balance sheet this way?” they ask. “We don’t know exactly how much in receivables is included in cash, so we can’t assess the impact on the balance sheet or the statement of cash flows. Nevertheless, this is troubling to say the least.”

The Securities & Exchange Commission fined Orbitz Worldwide (NYSE:OWW) for doing the same thing, the blog says. The site also raised red flags about Demand Media’s use of non-GAAP financial measures such as adjusted OIBDA, which is basically profit minus unpleasant stuff that companies don’t like to think about but are nonetheless very real, such as acquisition costs.

These are all fair questions, for which shareholders should demand — no pun intended — answers.

Demand Media’s board, though, doesn’t inspire confidence. For one thing, it gave CEO Richard Rosenblatt a $25 million options award in 2010, which, given these accounting concerns, deserves a second look. According to the most recent proxy, Rosenblatt was awarded options for an aggregate of 4.6 million shares in four equal tranches at strike prices of $18, $24, $30 and $36 a share ahead of its 2011 IPO. The options, which vest over the next few years, remain underwater because DMD shares trade for about $7 — well under the $25 height they reached after the IPO.

The grant — which gave Rosenblatt a higher compensation that year than the heads of Fortune 500 firms such as General Electric (NYSE:GE), IBM (NYSE:IBM) and McDonald’s (NYSE:MCD) — was outrageous on its face. For one thing, Demand Media has been unprofitable for the past three years, while these far larger companies made money.

Nonetheless, Demand Media’s board felt that Rosenblatt and fellow executives should be rewarded for “contributing to the significant out-performance of the Company’s business growth prospects for 2010.” About the only good thing that could be said about the grant is that more apparently are not in the works.

“In light of the size and structure of Mr. Rosenblatt’s option grant, our Board and compensation committee do not currently intend to issue additional equity awards to Mr. Rosenblatt in the next four to five years,” the proxy says.

Rosenblatt’s options grant, though, could impede a potential sale of the company, which given its circumstances isn’t a far-fetched idea. Demand Media’s proxy says the executive, who at one time headed Internet flameout, is entitled to a $45.4 million payout in the event of a change in control. Of course, a potential buyer would also carefully scrutinize the books, considering the accounting questions now being raised.

Wall Street, which has bid up many money-losing Internet companies lately, has shrugged off the allegations leveled against Demand Media. Shares of the company are up about 5.5% this year. The average one-year price target on Demand Media’s stock is $9.35, more than 30% above where it recently traded.

A spokesperson for Demand Media, which is based in Santa Monica, Calif., didn’t return a phone call seeking comment. James R. Quandt, Demand Media’s lead independent director, didn’t respond to an email.

Jonathan Berr has no positions in the companies listed. Follow him on Twitter@jdberr

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