rloc 3q11 review

Equity Research

Brian Bolan Research

2 November 2011

DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED AT THE END OF THE REPORT. Investors should consider Brian Bolan Research as only a single factor in making their investment decision.

Initiating Coverage

Company Overview and Key Data

ReachLocal

(Nasdaq: RLOC)

SELL

Share Price: $10.37

Price Target: $7

52-Week Range: $9.10 - $28.39

Shares Outstanding: 29.2 million

Market Capitalization: $300 million

Dividend Yield: NA

ReachLocal, Inc. is an online marketing company that helps small and medium sized businesses, or SMBs, acquire, maintain and retain customers via the Internet. The Company offers a comprehensive suite of online

marketing and reporting solutions, including search engine marketing, display advertising, remarketing and online marketing analytics, each targeted to the SMB market.

Brian Bolan Twitter: @BBolan1 1 773 413 0285 [email protected]

2 November 2011

ReachLocal

(Nasdaq: RLOC)

3Q Earnings Release, Downgrade

Following the release of 3Q11 earnings, shares of ReachLocal have dropped to single digits and given the challenges the company is facing, it is best that investors sell shares of ReachLocal. The company discontinued Bizzy, yet the app remains available for download. ReachDeals saw its deal specialists terminated and offering shuttered. Management admitted what I noted in an August 8, 2011 note that show that IMC’s were seeing a lower graduation rate, increased churn and should expect lower commissions. Readers of Brian Bolan Research knew that was only a matter of time, and that Upperclassmen have the most to be concerned about as it is there 10% commission the company will try to avoid paying. The call did not have a decidedly “upbeat tone” as guidance came in well below expectations. The lower number of IMC’s suggests that there was no real plan for growth and just maintaining current customers is the goal of 4Q11. When pressed, management stated that the company will focus on its core customer of “doctors, dentists and plumbers” – leaving many scratching their heads. We anticipate numerous downgrades from other brokerages and price targets to shrink to teenagers on the high end. My rating is now SELL and the price target lowered to 7 from 15.

Brian Bolan Research ReachLocal (Nasdaq Global Markets: RLOC)

8 August 2011 Brian Bolan Research | 1 773 413 0285 | www.scribd.com 2

Inside

Summary 3Q11 3

Estimated Gradation Rate 4 Short Interest 5 Underclassmen Expense 6 Upperclassmen Expense 6 Commission Expense 7

Investment Risks 10

Appendix 11 Key Metrics 11


8 August 2011 Brian Bolan Research | 773 413 0285 | www.scribd.com 3

Summary of 3Q11 In a word, the quarter was underwhelming. The growth that investors have been paying up for was a mere 6% on a sequential basis and is expected to be even less next quarter. The discontinuation of business Bizzy and ReachDeals is further proof the management is hunkering down instead of looking to grow. Further, the fact that there will be a $3.3M loss from these operations yet Bizzy is still available for download. The company does not break out which products are responsible for what revenue, but they noted that display did well as did ReachCast with non-search advertising grown 183% on a year over year basis. We believe that ReachCast is the majority of this, and even its growth is decelerating. Last quarter, Zorik Gordon stated that he would rather open an office in “Tokyo rather than Toledo”. Just short ride from Toledo, down I-75 and 23 and you find yourself in Columbus which is home of the Ohio State Buckeyes and one of the newest ReachLocal offices. Urban population of Columbus is roughly 2x that of Toledo, but almost Tokyo is 28x that of Columbus. So why in 2Q11 was Tokyo highlighted and finally announced in 3Q11 and not to be ready until 1Q12 when Columbus, which is right down the road, is about to open? Could a better analogy been used? Of course, but this glaring miscue gives insight into management.

ReachCast Analysis With 1100 ReachCasts being sold through March 31, 2011 we can expect that the vast majority are of the $1299 variety as opposed to the $1799 price. Projecting a 95% / 5% split, ReachCast generated $4.5M of revenues in 1Q11 and we estimated that level has increased to $5.7M in 2Q11. Backing into an estimate of 1450 ReachCast sales implies a solid 33% sequential growth rate. Our estimate includes a 2.8% ASP increase in the quarter, in line with the campaign average. We now know that ReachCast is responsible for $6M per quarter, an increase of only $300,000 from the end of 2Q11. This would be deplorable if accurate and cause concern for the future of the company as it was sold as the next big thing. Channel checks have long indicated strong growth / demand for ReachCast, but this figure is a large red flag. Head Count / Underclassmen and Upperclassmen. Looking back at the results of the last quarter, we believe it is important that investors look at the IMC counts and where issued guidance is directing the company. We believed the growth of the company was predicated on the increase in IMC’s, as the direct local sales force would be responsible for the majority of the growth. The foundation of the company is the growth of Upperclassmen, but this is achieved only through a development of Underclassmen. We know from guidance that Underclassmen headcount will drop 15% from 3Q11 to 4Q11, a rate that is accelerated from the same period a year ago where the drop was 12%.



Our estimates suggest that graduation rate will fall precipitously in the next calendar year. Guidance on IMC numbers no longer implies a spike in the estimated rate in 4Q11. Our estimates following CY2011 indicate that the graduation rate will continue to fall as the company moves to eliminate more underclassmen while focusing on international expansion. Shelf Offering of Shares The pending sale of 6M shares in a secondary transaction is also weighing on investors. VantagePoint Partners is selling 5M shares and the company and a few insiders are selling the other 1M shares. We note that when the company was going public, it was priced between 17-19, and ended up being priced at 13. This low pricing was a result of weak institutional demand.



Commission Expense Breaking down the income statement a little further, we find that ReachLocal has been decreasing the amount it pays its IMC’s. By dividing the commission expense by total revenue, we see that a disturbing trend, as shown on the chart below. While a positive for shareholders, the likely effect on employee morale will begin to offset the marginal impact.

This information was used in an attempt to back into the gross revenue number, or the amount ReachLocal charges its customers. ReachLocal reports revenue on a net basis, not a gross basis so the 50% gross margin line is not indicative of the markup it charges its customers. Though this exercise, while intended to discover the amount ReachLocal collects in gross, shows only that ReachLocal has consistently found ways to pay less and less to its IMC’s. There are several reasons that the Commission Expense would trend lower, but our overall belief is that management has been attempting to find ways to not pay commissions. IMC’s with a book (gross revenue) of $50,000.00 for more than three consecutive months receive a commission of 10%, with a book of $100,000 or more, an IMC can receive 11%, and a 12% commission can be earned if a book of $100,000 has revenue growth. These IMC’s have also been at the firm for more than 2 years. All other IMC’s earn a 6% commission on the amount of spend, which can differ from the contracted amount. It is our belief that underclassmen, as a rule, do not have $50,000 books. It was noted during the road show for ReachLocal that the average IMC has 18 clients after the first year and 30 after the second. The average advertiser pays $1653, as of 2Q11, making the average IMC book after one year just shy of $30,000 (assuming the avg advertiser spend is gross, which it is not) and until then end of the second year does an IMC, with 30 clients on average, achieve a $50,000 book. Based on these broad averages, we believe that only 10-15% of all IMC’s earn a 10% commission. That suggests that approximately 33-50 IMC’s earn monthly commissions of $5,000 or more. Channel checks indicate there are a handful of IMC’s with $100,000 or more of monthly spend (gross revenue for ReachLocal), and one IMC with $200,000 in monthly spend. Valid reasons for the decreases as a percentage of revenue are the frequent churn among employees, especially those earning 10% and those accounts being re-assigned to either lower earnings IMC’s or account retention specialists (CRS). Another reason for the reductions could be from non-IMC’s that collected commissions on overall sales. These reductions would likely not have been phased out slowly, but rather in one single act.



Income Statement Without having had a significant discussion with management on how to think about modelling the company out, we adopted a use everything approach to come to our estimates Our estimates are based on a number of moveable parts in the ReachLocal model, including but not limited to: 1) number of campaigns 2) number of advertisers 3) number of sales people 4) campaign ASP’s 5) advertiser ASP’s and 6) revenue per sales person 7) Direct Local sales 8) National Brands, Agencies and Resellers. Active Advertisers We continue to believe that churn rates are still over 55%, but that said, the company added at least 1,300 advertisers in the quarter. Adding the growth of advertisers shows us slowed significantly in the last two years, and is expected to remain in a tight range for the next year.

Growth rates have slowed, but 2Q11 showed a much needed acceleration as opposed to the decelerations that pervious four quarters showed. It should be noted the high base of advertisers makes significant growth a challenge.



Active Campaigns As a foundation for our model, active campaigns is a key metric when analysing ReachLocal. The number of campaigns per advertiser has been growing, and as the company adds new products and services, that increase should expand. Growth in campaigns is more important than growth of advertisers, as multiple campaign customers are far less likely to result in churn.

Growth in campaigns remained more robust than growth in advertisers.

The overall trend of growth for campaigns is decreasing slightly, but is expected to remain above the 20% threshold. Consecutive quarters below the 20% growth rate would be a sign of advanced deceleration.



Investment Risks If the company experiences any or all of the following risk factors, as well as others, the company’s stock price may be affected. Advertisers move disproportionately to mobile internet budgets. At the current time,

the company does not have a significant mobile product for its clients. Should the demand for mobile grow disproportionately larger than traditional sources then ReachLocal could be negatively impacted.

A better advertising platform is developed for internet advertising. Search has been

the dominant application on the internet for the last ten years. Should another application become more acceptable than search, advertisers could move budgets from search to that platform.

Competition is intense and moves quickly. Google could make a significant effort to

compete with ReachLocal, which would severely impact ownership of ReachLocal shares. Other competitors have moved to replicate the success of the company and others may continue to do the same.

Future growth is predicated on growth of IMC’s. Many of our assumptions of growth

are based on the future success IMC’s. Should another company offer a better compensation plan or should the commissions paid be cut, we believe that a mass exodus of trained IMC’s would be a negative for the company

Loss of key management. A loss of the CEO or co-founders would be viewed as a

significant loss to the company. The management team has been together for several years, and this continuity is an asset.

One major shareholder could sell. As of 4/21/11, Vantage Point Ventures held

approximately 12.5M shares of RLOC or 43.1% of the outstanding stock. Next on the list was Rho Capital Partners, another venture capital backer of RLOC, with 3.3M or 11.5% of the shares outstanding. Either one of these stake holders selling could lead to a loss of confidence by the greater market and smaller shareholders.

Implications of higher employee turnover / increases in commissions. Earlier in the report it was noted that the graduation rate appears to be moving significantly lower. This implies a high employee turnover that may cause the company to re-org its commission / expense structure. We note that most competitors pay its sales staff significantly more than the 6% and 10% rates that ReachLocal pays. As it becomes harder to find and hire qualified salespeople, the company may move to increase commissions and or salaries. This would have a negative impact on margins. Recommendation and Valuation We are lowering the rating on ReachLocal to SELL and have a price target of $7 a share based on multiple of earnings in 2012.



Appendix



2Q11 Earnings Review



Coverage Initiated on 6/13/11 with HOLD rating and $19 price target

8/3/11 2Q11 Earnings Update, Price target lowered to $15 from $19

11/2/11 3Q11 Earnings Update, Downgrade to SELL, price target $7

ReachLocal (Nasdaq GM: RLOC)

Historical Price Chart

Source MarketWatch / Yahoo!

Brian Bolan Research ReachLocal (Nasdaq Global Markets RLOC)

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Important disclosures:

Analyst Certification: The following analysts hereby certify that their views about the companies and securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this report: Brian Bolan. As of the date of this report, the analyst has no financial interest in any companies mentioned in this report.

Ratings: Buy: The stock’s total return is expected to exceed 15% over the next 6-12 months. Hold: The stock is expected to have a positive return of less than 15% over the next 6-12 months. Sell: The stock is expected to have a negative return over the next 6-12 months.

Disclosures: None

Sources: Unless otherwise noted in the text of the report, sources are company reports and Brian Bolan Research.

rloc 3q11 review

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