reachlocal equity research report

Brian Bolan Research Prepared for Jack Murphy of Willams Capital

Equity Research

13 June 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)

Hold

Share Price: $17.02

Price Target: $18

52-Week Range: $12.00 - $28.39

Shares Outstanding: 28.8 million

Market Capitalization: $507 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]

13 June 2011

ReachLocal

(Nasdaq: RLOC)

Investment Concept

ReachLocal has found a sweet spot by aggressively growing its Internet Marketing Consultants despite the recent recession. These feet on the street drive the company’s growth by acquiring small and medium sized business (SMB) clients and aiding them in advertising the client company via search and display advertising. Approximately one year ago, I initiated coverage on ReachLocal just a few days following the IPO. The published report contained my estimates for 2010 & 2011. This report looks back over the last year and how my estimates were able to hold up. Then we take a look at the future. This report is only a preview of the complete report. Full edition reports are available for $79.95. Follow up reports following the earnings release will be priced at $29.99 and can be purchased in bulk. Email for payment options. .

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Brian Bolan Research ReachLocal (Nasdaq Global Markets: RLOC)

13 June 2011 Brian Bolan Research | 1 773 413 0285 | www.scribd.com 2

Inside

Investment Thesis 3

Company Background 3

ReachSearch 4

ReachDisplay 5

TotalTrack 6

TotalChat 6

ReachCast 6

ReachDeals 7

Acquisitions 8

Where the Growth Comes From 8

Segment Breakdown 9

Comparable Companies 9

Industry Discussion 11

Management 11

Headcount 11

Stock Trading 12

Traffic Analysis 13

Income Statement 14

Active Advertisers 14

Active Campaigns 15

Sales Staff Grows 15

Campaign ASP 16

Advertiser ASP 16

Revenue per IMC 17

Direct Local vs NBAR 18

Analysis of Key Metrics 18

Cost of Sales to Decrease 19

Balance Sheet 19

Investment Risks 20

Recomendation 20

Appendices 22


13 June 2010 Brian Bolan Research | 773 413 0285 | www.scribd.com 3

Investment Thesis ReachLocal has demonstrated a clear path to profitability, good growth history and good growth potential. A tight float and little selling from Venture Capital has played a role in the stock moving to its recent highs. The recent partnership with Google has cleared the way for future investment in eight foreign countries over the next three years. Over the last year, the company has added a key product, ReachCast, to its search and display offerings. ReachCast is the social media marketing tool that includes Facebook, Twitter, and SEO services for the site. Through 1Q11 the company has sold approximately 1,100 ReachCast’s to new and existing clients. Having launched in November, the retention rates for ReachCast will be a primary concern. Growth is predicated on the continued hiring of Internet Marketing Consultants (IMC’s) As the company adds more IMC’s the distance to profitability is likely to be shortened. We have used some conservative hiring estimates for 20112 and relied on company guidance for 2011.

Company Background Search remains the backbone of the internet and small businesses realize that they need to be on the internet. Most small businesses recognize that they can be on the internet with little effort directly through Google AdWords, but add in the complexity of Yahoo!, Bing, Ask.com and AOL and the task becomes too large for many small businesses. The company generates revenue from four segments. We have provided a brief summary of each below: ReachSearch is the company’s search engine marketing product places clients’ advertisements among the search results on leading search engines such as Google, Yahoo! and Bing, as well as an extensive network of local search and directory sites, called the ReachLocal Search Network. ReachDisplay is the company’s display advertising product which broadcasts an SMB’s message to a specific target online audience. ReachLocal offers more than 20 different display advertising products across a wide variety of publishing partners, including Yahoo!/Right Media, Google, Collective Media, Facebook, Fox Interactive Media, and Kelley Blue Book. In 1Q11 RLOC added Remarketing to all ReachDisplay campaigns. Remarketing a remarketing product allows the company to target consumers who have previously visited a specific SMB’s website through a ReachSearch or ReachDisplay campaign. TotalTrack. Powered by a reverse proxy technology TotalTrack allows clients to see exactly how much online and offline activity, including phone calls, is generated by their online advertising campaigns. ReachCast. As the Social Media Marketing tool for small businesses, ReachCast posts content to Facebook & Twitter and allows for an RSS feed to post to other blogs or sites. Through SEO back linking, the ReachCast site will often climb the organic listings for three or five desired keywords. ReachDeals The result of the $10M purchase of DealOn on 2/15/11, ReachDeals has yet to be launched and is still in beta. It is expected to fully launch in 2H11. As part of the Bizzy platform, ReachDeals will compete with Groupon, LivingSocial and others in the daily deal space. A detailed breakdown of each product is available via the full report.



ReachSearch (Detailed Breakout) The search product is the foundation of the company and one way to describe it is a massive recommendation engine of keywords, bids and estimated click through rates. ReachSearch will automatically populate a list of keywords across numerous search engines in order to maximize potential viewership for a customer’s ad. The product will suggest a budget for the specific clients given the proper category and then sub category. This budget will then be spent across the search engines throughout the cycle of approximately 30 days. The budget is greatly influenced by three main factors. The number of people that work / reside in the targeted area (area targeted can range from 10-100 miles, or access just a few neighbourhoods within a city), the historical click through rate (CTR), and the average cost per click (CPC). The number of people that live in the target area is used to derive the potential number of searches that are likely to be performed for all the keywords that the system will suggest. This method has its draw backs, including attracting unwanted clicks from non-focused keywords. The method to arrive at the budget can be generally described as Estimated Searches per month * CTR * CPC = monthly budget. This broad range allows for upside and downside surprises both as costs and click throughs tend to vary throughout any given cycle. As part of the evidence of this product working, the company has developed a technology that takes affect when a consumer clicks on the ad. This technology functions as the tracking system and allows ReachLocal to place a VOIP tracking phone number in a bar or on the site in a close replication to the original. This allows a client to see how many impressions the ads made (views), The number of clicks (visits), and how many people called at that time (or later with the tracking number provided at the time of the search). This allows a client to develop an ROI for the monthly ad spend based on the phone calls. Pros

This service is designed for people that are searching for a business, that they do not know by name. Search discovery is a key reason businesses use the service. People that know the name of the business are not as likely to click on the ad, unless the overall web presence of the business is so limited as not to be found in the organic listings / map section.

The tracking of phone calls allows a business to record and review the calls at any

time. This can not only be used to formulate an ROI, but can be a tool for checking on the front desk to make sure that calls are being answered properly.

The exposure is wide, and appears not just on the big three search engines, but

claims to be in front of 98% of where people search. This wide net can catch many of the opportunities that might otherwise have gotten away.

A budget will not end up over spending, and credits are easily carried over into the

next month. A reporting tool allows access 24 hours a day to the results. The system can make adjustments to any campaign at any time, and can adapt to spikes in traffic or clicks.

Cons

The 1,000-1,500 keywords that can be used result in numerous searches that are not as highly targeted as most business owners would prefer. In the absence of long tail keywords, a large percentage of the keywords are going to be less relevant and will ultimately lead to wasted clicks or bogus calls.

The retention rate for this service is a point of concern. It has been estimated that



churn for this product was in the low 60%’s not that long ago. We estimate churn on the search product to be around 50%.

Advertising against a business’s name may bring in a high number of phone calls,

but it’s unlikely to be the new business ReachSearch strives for. This method of search branding is more important to businesses that have name recognition in a particular area.

ReachLocal does not disclose its ultimate mark-up on the cost of the service. This

means that while most clicks could come in at reasonable prices, there will be instances of significantly higher than expected clicks that are the basis of the mark up. As a general rule of thumb, it can be expected that a service like this would have a mark-up of between 30%-60%. The company builds the mark up into the pricing per click, making comparisons difficult.

Analysis With multiple competitors in the market, the likelihood that RLOC will have to lower its mark-up is a near certainty. The high churn rate of this product, while unknown if cost is the major factor or if its quality, is a red flag. Still the number of campaigns continues to increase as advertisers move to the web for new customers. As a core product for the company, we believe that more than 85% of customers use ReachSearch. ReachDisplay (detailed breakout) ReachDisplay is the company’s solution for businesses that want to advertise via graphical display ads. These ads are delivered across an entire metro area and are driven by a CPM (cost per thousand) method. In buying remanent inventory from publishers, ReachLocal is able to produce a significant number of display impressions for its clients at reasonable costs. In following the web standards for banner, tower and block ads, ReachDisplay is capable of serving ads on numerous ad networks and can even offer geo and behavioural targeting. Reaching the comScore top 1000 websites, the intention of display advertising is based more on the idea of building awareness than achieving a meaningful click through rate. During 1Q11 the company added the remarketing feature into all of its ReachDisplay packages. Remarketing is the practice of serving an ad to a computer user that has been to a designated client site (cookied) in the following 24 hours with as many as 4 advertisements as a reminder to return to the clients website. As a highly effective tool, the cost can make the service nearly prohibitive by charging CPM’s of between $10 and $15. The rates for the an awareness campaign (no behavioural targeting) range between $1 and $4 CPM. As the company’s display advertising product which broadcasts an SMB’s message to a specific target online audience. ReachLocal offers more than 20 different display advertising products across a wide variety of publishing partners, including Yahoo!/Right Media, Google, Collective Media, Facebook, Fox Interactive Media, and Kelley Blue Book. In 1Q11 RLOC added Remarketing to all ReachDisplay campaigns. Analysis Display is associated more with building awareness or branding than customer acquisition. This makes the product less attractive to the SMB’s that have not established a brand in terms of service or advertising. Those that do have a brand and are willing to continue to invest in the brand will certainly look to lower costs after seeing what results actually come. It has been widely reported that SMB’s that have used display advertising have been less than satisfied with the results. As the SMB’s become even slightly more savvy with their



budgets, they will look to ad networks that can provide the same service for significantly less. TotalTrack (detailed breakdown) - TotalTrack is the phone recording system that allows advertisers to learn exactly where a potential customer has learned of their goods or service. The tracking system is a VOIP phone line that records the phone calls and tracks the use via a transparent website. This allows the advertiser to see the number and caller detail (including all caller ID functions) to determine which advertising is the most effective. Analysis As far as VOIP services go, $29.99 a month is more than most services, but its integration into the ReachLocal platform more than makes up for the added cost. At such a low cost, TotalTrack is rarely a material factor when looking at revenue models TotalChat - the chat solution for ReachLocal is a lead generator for customers that is built into the clients website and is operated by a third party. The advertiser pays a monthly fee and a price per lead. Analysis Chat services can be found via numerous providers, and while its costs are generally slightly more than the average provider, its integration into the platform makes sense for advertisers that are already running a search campaign. ReachCast (detailed breakdown) - ReachCast is the Social Media Marketing tool that the company offers for advertisers. ReachCast offers business a website that functions much like a blog that syndicates the content that ReachLocal generates onto social media sites such as Facebook and Twitter. Through an RSS feed, the advertiser can have the content published on external blogs or on a blog as well but this must be done by the advertiser. There are two levels of service offered by ReachCast, the Pro and Pro3. ReachCast Pro offers 4 custom content pieces that are written for the business and published on the ReachCast page and 8 back linked articles that are meant for SEO purposes. The cost per month for ReachCast Pro is $1299 a month. ReachCast Pro3 has 8 customer pieces of content and 24 back linked articles and costs $1799 per month. Contract lengths are 6 and 12 months. Pros

For the business that doesn’t have time to develop and post content, ReachCast offers a solution that addresses most of the pain points that businesses have.

Results in organic listings have been fairly strong, with some customers moving to

the very top of the list on Google and Yahoo.

Instead of hiring a social media employee, the cost is substantially less for a business that wants a social media marketing tool, but does not want to be that involved.

Cons

Many of the services that are offered (Facebook, Twitter and YouTube accounts) are free, even a content syndication service (Hoot Suite) is free. Suggesting that the pricing is based solely on content and backlinks.

Content generation is outsourced at what could be a significantly low rate. The back

linking is also outsourced, and the back linking company also decides on the



focused keywords. This could be in direct contradiction to the customers stated goals.

The back-linking is done for the benefit of the ReachCast site, not the home site of

the advertiser, which becomes less valuable if the service is cancelled (though the company does note that you get to keep all the content that is created.

Analysis With 1,100 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 an 85% / 15% split, ReachCast generates $4.5M of revenues per quarter. We are hesitant to project significant growth in ReachCast sales beyond a few hundred as retention figures should be released on the 2Q11 conference call. We do believe that RLOC will see significant margin improvement due to ReachCast. At a recent investor conference we learned that the company generates $1.4 per month in revenue, slightly below our estimates above. This is due to the early customers that had preferential pricing on the SMB: Live product. Pricing irregularities will likely continue throughout 2011. Our estimates on the actual costs of building out a site, providing content and back-linking indicated that ReachCast likely carries a very high net margin. ReachDeals (detailed breakout) The acquisition of DealOn brought the daily deal to ReachLocal. Its planned to be incorporated with the Bizzy mobile app and will offer recommended deals based on user input to the Bizzy app. The idea of a recommended offer that is personalized to each user is tantalizing to many small businesses, as it promises to be presented to customers that will want your service as opposed to a mass emailed offer than has few controls on it. The example would be a restaurant that only offers the deals as business ebbs and flows. Pros

Controlled about and timing of offers gives the local business confidence that is getting its offer to people that would likely use it.

As purchased deals are redeemed, the business can elect to replace the deals to

the same or new customers. Cons

The deal is recommended, and therefore Bizzy must be an active app on a consumers smartphone. Given the app has been available for some time, the company has not given any information as to the numbers of users.

Competition in this field is extreme, with Groupon and LivingSocial dominating the

nascent field. Other daily deal offerings from local TV news stations to smaller one offs means that one more offering from a company that hasn’t advertised to support its offerings

Analysis Using the same format as the search recommendation format, a deal could be personalized to each user, each day based on any number of social signals that smartphones allow. This unique offering is, of course, predicated on the adoption of the Bizzy app. Groupon has already offered consumers rebates or Groupon bucks for a smartphone app download, in effect buying the land grab of being the preferred coupon provider.



Acquisitions DealOn was acquired for $10M on February 15, 2011. DealOn will allow ReachLocal to compete in the daily deal space that is dominated by Groupon and Living Social. In an effort to separate the offering, DealOn was focused on “Check Outs” as opposed to the popular “Check Ins” offered by FourSquare and other geo-locational companies. On February 22, 2010, ReachLocal acquired SMB:LIVE for up to approximately $8.5 million in cash and stock. On the closing date, the company paid $2.8 million in cash. The balance of the purchase price, or the Deferred Consideration, of up to $5.7 million will be payable based upon the achievement of certain milestones. December 2006, ReachLocal entered its first market outside of North America through a joint venture in Australia. On September 11, 2009, they acquired the remaining interest in the joint venture. In connection with the ReachLocal Australia acquisition, the company recognized a non-cash gain of $16.2 million and will pay $6.1 million in deferred cash compensation upon the closing of this offering.

Where the growth will come from Ad dollars shifting from other sources to Online Advertising dollars have shifted away from traditional mediums like the yellow pages and newspapers to the Internet. This trend is expected to continue for the next several years which will create and expanding market for ReachLocal to service. We have already seen significant shifts in business models that newspapers used, and we expect that in the coming years the Yellow pages or directory segment will see the same pressures. The more IMC’s the company has, the more sales they will likely be able to produce. We believe that the SMB market is dramatically underserved and to a degree intimidated by the overwhelming process of building an advertising campaign. ReachLocal aims to help these SMB’s to move from a website that hopes to be found to a professionally designed and tailored site that brings in customers via search and display advertising. We believe that the search and display market will continue to grow over the coming years producing a win-win affect for ReachLocal. Certain verticals that ReachLocal targeted have seen a high degree of success in the last year, while others have lagged behind. Home Improvement continues to be the most highly penetrated vertical, with more than 1 of every 4 clients coming from that segment. Not surprisingly, the Home Improvement segment saw growth of almost 11% over the last year. The table below highlights the segments that have seen growth and those that have not.



Segment Breakout Over the last year the number of advertisers has been tracked to show there has been little change in the segments. The message of getting more phone calls to set appointments has resonated in the automotive segment, real estate and physicians segments. The below charts show the Brian Bolan Research estimates of advertiser breakouts.

Comparable Companies Competition comes from numerous sources and could, in the future, come from new companies and or divisions of old companies. We view Google as a likely entrant into the market despite the fact that they have traditionally focused on much larger clients. Google has made every effort to get smaller businesses to advertise directly with them, reducing overall costs for the businesses and have moved to allow SMB’s to appear on Google Maps with no advertising spend. ReachLocal’s feet on the street give it a direct advantage to several companies in this list. Local.com (NASDAQ: LCOM) - Local.com Corporation operates an Internet search engine. The Company assists users in finding local businesses and services. Marchex (NASDAQ: MCHX) - Marchex, Inc. provides technology-based services to merchants engaged in online transactions. The company's Internet marketing services, including paid inclusion, pay-per-click listings, conversion tracking and search marketing, help merchant customers sell their products and services online. Verto (NASDAQ: VTRO) – Vertro, Inc. owns a portfolio of products that allow users to search the Internet and display the results as they wish. The products allow users to search and then display the results in customizable toolbars, homepages, and desktop products.



Constant Contact (NASDAQ: CTCT) – Constant Contact, Inc. provides web-based e-mail marketing tools and services to businesses, associations, and organizations to help them connect with their customers and members. Limelight Networks (NASDAQ: LLNW) Limelight Networks Inc. is a content delivery network for internet distribution of video, music, games and downloads. The company's advanced content delivery network provides the world's top media companies high performance delivery of digital media and software via the Internet. ValueClick (NASDAQ: VCLK) ValueClick, Inc. provides Internet advertising solutions for publishers of Web sites and online advertisers. The Company offers performance-based Internet advertising solutions in which an advertiser only pays when an Internet user clicks on its banner advertisement. QuinStreet (NASDAQ: QNST) QuinStreet, Inc. provides Internet advertising solutions for publishers of Web sites and online advertisers. The company focuses on building lead aggregation websites for specific industry verticals.



Industry Discussion Small and medium sized businesses (SMB’s) have traditionally relied on the yellow pages for customer acquisition. The decline in use of the yellow pages and similar services can be traced to the rapid growth and dynamic capability of the internet. Small businesses used to launch around the publication of a phone book, but now it’s the internet is the main point of contact for discovery of new and old businesses alike. The Yellow Pages industry is estimated to be a $12 billion industry within the last few years, but with most of the business headed online, we believe this number is fairly aggressive in the current environment. The Yellow Pages and its kin (Superpages.com) and the slew internet directory services have targeted basic advertising models based on page views and reach. ReachLocal had developed a model that stretches through the reliance on page views and banner ads, but instead pushes SMB’s onto the internet and assists with client acquisition. SMB’s traditional experience in advertising has been using a fax machine to purchase a yellow pages ad or maybe an ad in a newspaper. The complexity of purchasing search and or display advertising on the internet has been an intimidating factor for business that do not traditionally invest a lot of time in advertising. A web presence today is mandatory but few SMB’s have adopted the paid search or display type advertising. Management There is little in terms of track record for the upper management of reach local. At this time we do not view this as having a material impact on the stock. Zorik Gordon is co-founder, President and Chief Executive Officer, as well as a member of the board of directors, since 2003. From 1999 to 2003, Mr. Gordon served as Chief Executive Officer and Vice President, Corporate Development for WorldWinner, a provider of prize-based tournaments in online games. Mr. Gordon previously founded Jackpot.com, which grew to become the Connexus Corporation, an online marketing company. Michael Kline, is a co-founder and has been Chief Operating Officer and Chief Product Officer since 2003. Mr. Kline served as Vice President, Product Development at WorldWinner from 2002 to 2003. From 2001 to 2002, Mr. Kline served as Senior Manager, Media & Entertainment, at Deloitte Consulting, and from 1999 to 2000, he served as Senior Vice President of Strategy & Product Development for AdStar.com, a provider of advertisement management solutions. Mr. Kline holds a Bachelor of Arts degree in literature from Harvard College. Ross G. Landsbaum is the Chief Financial Officer. Prior to joining ReachLocal, Mr. Landsbaum held various executive positions at MacAndrews and Forbes’ Panavision, a service provider to the motion picture and television industries, including Chief Financial Officer from 2005 to 2007 and Chief Operating Officer in 2007. Mr. Landsbaum holds a Master of Accounting and a Bachelor of Science in Accounting from the University of Southern California. Head Count / Underclassmen and Upperclassmen. The ongoing investment in increasing the number of Internet Market Consultants (IMCs) has been the principal engine for growth. The growth is driven by the increase in the number of Upperclassmen, who are significantly more productive than Underclassmen. The increase in the number of Upperclassmen depends primarily on the productivity of Underclassmen, as the majority of Underclassmen attrition has been involuntary and is based on performance relative to a standard level of revenue growth and other performance metrics determined by



the company. The company states that the underclassmen attrition rate is historically approximately 50%, but evidence points to a higher level over the last year. An Underclassman earns a salary and receives a commission of 6% while an Upperclassman receives 10%. When an underclassman has commissionable sales of $50,000 and maintains that level, the commission moves from 6% to 10%. We believe that each underclassman costs the company approximately $77,000 a year in salary and other expenses, but that the company receives a full return on that investment a little after the end of the second year of the average upperclassmen. We have learned that after 12 months, the average underclassman that makes the transition to becoming an upperclassmen has approximately 18 clients. After two years the average number of clients expands to 30. After three years the average upperclassman has approximately 50 clients. Given that the company does not have a significant history we look forward to learning how these averages trend over time.

Stock Trading IPO

Underwriters priced the ReachLocal offering between $17 - $19 a share with expectations to raise $59.6 million at the midpoint. The deal was not as warmly received by the institution community and ended up pricing at $13, well below expectations. The company raised $43 million by being priced at $13 and incurred approximately $5M in expenses relating to going public It should be noted that insiders did not sell into this offering and were locked up for a period of 180 days. Since that time, there has been a number of insider selling. Most notably is that CEO Zorik Gordon has sold very little while the top members of the sales force have been active in selling their shares. Over the last year, trading in ReachLocal has been light. Over the last three months, the stock has averaged 209K shares per day, up significant from the 80K average volume that was witnessed in 4Q10. Major Shareholders VantagePoint Venture Partners (VPVP) invested was the lead investor in a $7.75M round in April of 2005 and looks to have maintained its shares more than a year after the IPO. As of April 2011, VPVP held 12.5M shares or approximately 43.1% of the shares outstanding.



Rho Capital Partners, another venture capital investor in ReachLocal holds 3.3M shares or approximately 11.5% of the shares outstanding. Rho Capital was one of three investors of $55M round in September of 2007. Fidelity Management & Research Company holds 7.6% of the shares outstanding, or about 2.2M and the CEO Zorik Gordon rounds out the top five with 5.5% of the shares outstanding which equates to 1.6M shares. The concentration of shares held by few shareholders presents a problem for many potential future investors. With 54% of the company being held by two of its venture partners, investors may be waiting for these companies to decrease their influence in the company before making a significant investment. Similarly, a large sale of stock by any of these large holders could be seen as a signal to eliminate smaller positions. The top five shareholders account for more than 67% of the shares outstanding. Traffic Analysis Taking a look at the traffic estimates for ReachLocal.com, we see some differing data points. Quantcast.com suggests that ReachLocal.com has seen its reach in terms of visits decrease significantly in the past year.

Compete.com has data that suggests an opposite move in terms of unique users over the last year.



Quantcast clearly indicates that its data is a “rough estimate” but still gives us some pause when looking at the overall growth of the company. To round out the idea of looking at traffic here are the sources of traffic. The clickstream is the basically where a visitor was before the target site and after the target site. The data is provided by Alexa, a division of Amazon.

The clickstream can show some important information and give an idea as to where users are coming to ReachLocal from and where they are going to. The upstream flow from Google is significant, and could present a diversification problem for the company. With 4.7% coming from Yahoo! And only 1.3% coming from Bing! the importance of the Google partnership becomes more apparent. 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. A detailed breakdown of all the metrics is available in the full report. Active Advertisers Despite the fact that the churn rate of new advertisers is likely to be higher than 50%, the company continues to find new customers via 700 man sales force. Expansion into new cities will continue to be a driver of growth, but with 50 offices already installed, significant growth from this avenue should not be expected. This should, however, be a significant portion of international expansion.



Over the last three years there were two times where sequential growth of active advertisers was negative. The first instance was between 3Q08 and 4Q08 with a decrease of approximately 100 advertisers. The second occurrence was between 3Q10 and 4Q10 where the decrease was 200 advertisers, but off of a significantly higher base. 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.

There are several broad scenario’s that benefit the concept of consistent growth for ReachLocal. The shifting of ad dollars from traditional mediums to the internet will continue, and could likely accelerate in the next several quarters. The SMB market is under served and under penetrated in terms of online capabilities. ReachLocal’s business model of having feet on the street knocking on doors and calling business proves to be a better method of acquiring customers than using internet flypaper. We modelled 46% topline growth for the company in 2010 and 37% in 2011. ReachLocal had growth of 44% in 2010, just shy of my estimate. The updated model is call for topline growth of 27% in 2011 and 29% in 2012. Sales Staff Grows Over the last few years, ReachLocal has grown its sales staff through its boot camp training of new sales people. The Company does not disclose its graduation rate, but simple analysis can show what historical rates have been and what we can expect in the near term. The analysis shows that the company saw a significant drop in graduations in 3Q10, as competition increased and the job market loosened significantly from the recession. Our view is that the company will continue to weed out Underclassman at a 70-75% rate, and even move to eliminate a percentage of its Upperclassmen to avoid paying higher commissions than what is necessary. Analysis of the Upperclassmen and Underclassmen numbers suggest that the graduation rate, which the company noted was 40%-50%, is moving significantly lower. When looking at the increase of Upperclassmen over a year period and dividing that by the number of Underclassmen we arrive at our estimated graduation rate. This rate ignores the idea that there are generally two boot camps per month for 10 months (50-60 new IMCs per month) and also ignores an attrition rate for Upperclassmen. When averaged out over the years, the estimated graduation rate moves to 39% for 2009, 29% for 2010 and is estimated to be 17% for 2011 and could move to single digits for 2011. The average ignores the attrition of upperclassmen and the idea that the throughout the quarter the total number of IMC’s is generally far higher than what is reported at the end of the quarter.



Campaign ASP’s Over the last few years, the average sales price per campaign has seen steady increases. This metric is an excellent proxy on the average cost per click for the entire search market, as the rate of revenue will likely grow to a corresponding rate of CPC increases. On a year over year basis, the campaign monthly ASP has grown 6.8% in 2008, 12.6% in 2009, and 7.1% in 2010. The forecast calls for continued modest growth in ASP’s for 2011 and 2012.

In looking at Campaign ASP’s, both the sequential and year over year changes are charted below. While the sequential changes are choppy and subject to some good size swings, the year over year look shows steady growth. Given the continued growth, the challenge of increasing the ASP looks to be solved via ReachCast and its potential cost increases.

Advertiser ASP An important concept to look at is growth in ASP per advertiser. While campaigns are the function that actually spends the budget, we note that some campaigns such as TotalTrack and TotalChat are very low cost and as such could skew the campaign data. To prevent this from affecting our analysis, we also scrutinize advertiser ASP’s.



The average monthly advertiser ASP has grown 9.8%, 17.6% and 19.2% on a year over year basis for the years 2008, 2009 and 2010 respectively. This substantial and continued growth is a positive especially given the high churn rates that company is most likely experiencing.

When the advertiser ASP numbers are analysed on a sequential basis, the growth story breaks down to reveal a lumpier, less smooth trend line as exhibited on the Monthly Advertiser ASP line. The takeaway from this is that the growth is relatively constant on the Advertiser ASP, but the focus should be on the sequential. A good signal that the business is having significant challenges would be if that line moves negative over consecutive quarters. Revenue per IMC As a sales focused operation, looking at the overall effectiveness of the sales force can be helpful when determining the progress. There are several ways to look at the effectiveness of the IMC’s such as revenue per IMC or advertiser / campaign per IMC. When looking at Revenue per IMC, we break down the revenue numbers outside of NBAR vs. the Direct Local sales. We do not have clarity on whether or not the IMC count includes the NBAR staff. We are assuming they are not included in the IMC headcount numbers.

As with most of the one off and quick analysis aspects of ReachLocal, the Revenue per IMC looks to be a smooth and steady trend up. When we look deeper into the “effectiveness” of each IMC, we see a slightly different picture.



The “effectiveness” of the average IMC show that the number of advertisers per IMC continues to trend lower, but at the same time the number of campaigns per IMC is only expected to trend higher. It should be noted that the IMC’s are the primary driver of all key metrics. The most pronounced chart that shows the effectiveness of the IMC’s is the Campaigns per Advertiser chart below. This shows that once ReachLocal and IMC are viewed as trusted partners, it is very likely that advertisers will continue to spend with the company in other areas.

Direct Local vs NBAR The company breaks out its direct local sales numbers versus the National Brands, Agencies and Resellers (NBAR). The basic difference is determined by the number of locations an advertiser has, with any number more than 20. The concept of agencies / affiliates or resellers is an evolving one, that can and has changed throughout the history of the company. In each of the company’s quarterly statements, Direct Local Sales figures are broken out from the total sales numbers, as are the NBAR and international sales numbers. As of 12/31/10, there were approximately 360 agencies and resellers.

Analysis of key metrics for ReachLocal The metrics paint a picture that is mostly positive, especially given the slow and steady growth expectations that are built into the model. The growth in advertisers continues to be the foundation of the revenue growth for ReachLocal. Despite the significant churn of advertisers, the growth continues to be the foundation of campaigns and revenue. The number of campaigns per advertiser is another testament to the company and its IMC’s that have become the trusted solution for many of its clients.



On the negative side, the glaringly low graduation rate suggests that employee churn could be greater than 80% and could turn into a significant risk for investors. The implication of having three or four mainstays at each office with a virtually revolving door of underclassmen is an uneasy one that brings stability of the entire company into question. At the end of the third quarter, it is estimated that the company had 41 domestic offices (47 worldwide as of 12/31/10), with at least one domestic expansion and two international office expansions since that time. Cost of Sales to Decrease as a percentage of Sales Nearly all of the cost of revenue is for the purchase of media and nearly all of the media purchased is from Google, Yahoo! and Microsoft. A substantial majority of the media purchased is from Google. In keeping with global search averages, I have modelled in approximately 69% of cost of sales coming from Google. Costs of sales are affected by the mix and relative amount of media purchased to fulfil service requirements, the availability and amount of publisher rebates, the mix of products and services offered, media buying efficiency and increased costs of support and delivery as the company grows. Google has a high degree of influence on this line item as its forces third parties to disclose prices paid for search advertising, which is often less than what is being charged to the customer. There has been some confusion over the cost of sales being the effective mark-up that ReachLocal charges. This is not the case as the company is reporting net revenue not gross revenue. If the company reported gross revenue, then the cost of sales number would be the effective mark-up it charges its clients. We believe that over the long term, ReachLocal will continue to find ways to improve efficiency and maximize its gross profit. Balance Sheet At the end of 1Q11 the company had $76.4M in cash, up from $32.7 million at the end of 1Q10. The company saw its cash balance decrease from $79.9 million which it had at the end of 4Q10. Current liabilities of $59.3 million is up from $54.9 million in the previous quarter and significantly higher than the $27.7 million posted at the end of the year in 2008. Short Interest At the end of 1Q11 short interest stood at more than 2.1M shares, or about 7.6% of the shares outstanding. Since that time, short interest has increased to 2.5M shares outstanding or about 9.1% of the total. The relative quick growth of short interest is a reason for concern when also taking the concentration of shareholders into perspective.



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 A year ago I started coverage of ReachLocal with a Buy rating and a one year price target of $18. The stock was $13 at the time, and been as high as $28,39. Given the current levels and risk / reward ratios a buy rating is not warranted given the increased competition and increased volatility. ReachLocal has a Hold rating and a $18 price target.



Appendix

2Q10 Earnings Review




ReachLocal Income Statement Forecast



Balance Sheet



Statement of Cash Flow



ReachLocal (Nasdaq GM: RLOC)

Historical Price Chart

Source Google

Brian Bolan Research ReachLocal (Nasdaq Global Markets RLOC)

13 June 2011 Brian Bolan | 773 413 0285 | www.scribd.com 30

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

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