TMCnet News
REACHLOCAL INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS In this document, ReachLocal, Inc. and its subsidiaries are referred to as "we," "our," "us," the "Company" or "ReachLocal." The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q and our 2010 Annual Report on Form 10-K. This quarterly report on Form 10-Q contains "forward-looking statements" that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. The statements contained in this Quarterly Report on Form 10-Q that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are often identified by the use of words such as, but not limited to, "anticipate," "believe," "can," "continue," "could," "estimate," "expect," "intend," "may," "will," "plan," "project," "seek," "should," "target," "will," "would," and similar expressions or variations intended to identify forward-looking statements. These statements are based on the beliefs and assumptions of our management based on information currently available to management. Such forward-looking statements are subject to risks, uncertainties and other important factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled "Risk Factors" included in our 2010 Annual Report on Form 10-K. Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements. Overview Our mission is to help small- and medium-sized businesses, or SMBs, acquire, maintain and retain customers via the Internet. We offer a comprehensive suite of online marketing and reporting solutions, including search engine marketing, Web presence and social media marketing, display advertising, remarketing, deal commerce and online marketing analytics, each targeted to the SMB market. We deliver these solutions to SMBs through a combination of our proprietary RL Platform and our direct, "feet-on-the-street" sales force of Internet Marketing Consultants, or IMCs, and select third-party agencies and resellers. We use our RL Platform to create advertising campaigns for SMBs to target potential customers in their geographic area, optimize those campaigns in real time and track tangible results. Through a single Internet advertising budget, we enable our clients to reach local customers across the Internet, including through all of the major search engines and leading general interest and vertically focused online publishers. In 2010, we expanded the RL Platform to include ReachCast, our full-service Web presence and social media solution, and in 2011, we added ReachDeals, a deal-commerce platform, to our suite of products available to our SMB clients. Empowered by the RL Platform, our IMCs, which are based in or near the cities in which our clients operate, establish a direct consultative relationship with our clients and provide our solutions to achieve their marketing objectives. We generate revenue by providing online advertising solutions for our clients through our portfolio of online marketing and reporting solutions. We sell our search engine marketing product, ReachSearch, our display advertising product, ReachDisplay, and our remarketing product based on a package pricing model in which our clients commit to a fixed fee that includes the media; the optimization, reporting and tracking technologies of the RL Platform; and the personnel dedicated to support and manage their campaigns. We also generate revenue from digital marketing solutions for our clients that do not include the purchase of third-party media, including our campaign performance tracking product, TotalTrack, our assisted chat product, TotalLiveChat, ReachCast and ReachDeals. Generally our products are sold to our clients in a single budget to simplify the purchasing process. We offer our products and services through two primary channels. Our IMCs sell our products and services directly to SMBs, which we refer to as our Direct Local channel. We also sell our products and services through third-party agencies and resellers, and to national or regional businesses with multiple locations, such as franchisors, which we refer to as national brands. Because the sale to agencies, resellers and national brands involves negotiations with businesses that generally represent an aggregated group of SMB advertisers, we group them together as our National Brands, Agencies and Resellers channel. 15 -------------------------------------------------------------------------------- Starting in late 2010, we extended our product vision to include consumer web sites with a local market focus. In November 2010, we launched the beta version of Bizzy, a personalized local business recommendation engine for consumers. By accessing Bizzy through its website or through applications available on the iPhone and Android mobile operating systems, consumers can submit their favorite local businesses and receive recommendations from people who have evidenced similar interests for places to eat, shop or be entertained. Business Model and Operating Metrics Our Direct Local channel represents the majority of our revenue. As a percentage of revenue, Direct Local revenue has increased to 77% for the six months ended June 30, 2011, from 74% during the six months ended June 30, 2010. Growth in Direct Local revenue is primarily driven by the growth in the number of IMCs and increases in IMC productivity. Number of IMCs Our ongoing investment in increasing the number of our IMCs has been the principal engine for our growth. Typically, each month we hire 40-60 IMCs, with the hiring weighted towards the first ten months of the year. We refer to IMCs with 12 months or less of experience as Underclassmen. In particular, our growth is driven by the increase in the number of Upperclassmen, who are significantly more productive than our Underclassmen. As such, we believe that our ability to grow our business is highly dependent on our ability to grow the number of our Upperclassmen. Beyond our hiring practices, which determine the number of IMCs to be hired as well as the rate at which we hire them, 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 us. We do not expect all Underclassmen to become Upperclassmen, and our investment decisions anticipate the cost of attrition. As of June 30, 2011, we had 330 Upperclassmen and 439 Underclassman, for a total of 769 IMCs, as compared to 246 Upperclassmen and 395 Underclassman, for a total of 641 IMCs, as of June 30, 2010. Underclassmen Expense Underclassmen do not, in the aggregate, make a positive contribution to operating income. Our largest operating expenses include the hiring, training and retention of Underclassmen in support of our goal of developing more Upperclassmen. Underclassmen Expense is a number we calculate to approximate our investment in Underclassmen and is comprised of the selling and marketing expenses we allocate to Underclassmen during a reporting period. The amount includes the direct salaries and allocated benefits of the Underclassmen (excluding commissions), training and sales organization expenses, including depreciation, allocated based on relative headcount and marketing expenses allocated based on relative revenue. While we believe that Underclassmen Expense provides useful information regarding our approximate investment in Underclassmen, the methodology we use to arrive at our estimated Underclassmen Expense was developed internally by management, is not a concept or method recognized by GAAP and other companies may use different methodologies to calculate or approximate measures similar to Underclassmen Expense. Accordingly, our calculation of Underclassmen Expense may not be comparable to similar measures used by other companies. Underclassmen Expense was $21.1 million during the six months ended June 30, 2011, as compared to $16.5 million during the six months ended June 30, 2010. The increase in Underclassmen Expense was primarily attributable to increased hiring of Underclassmen as compared to the prior period, including hiring for our recent expansion into Germany. Active Advertisers and Active Campaigns We track the number of Active Advertisers and Active Campaigns to evaluate the growth, scale and diversification of our business. We also use these metrics to determine the needs and capacity of our sales forces, our support organization and other personnel and resources. Active Advertisers is a number we calculate to approximate the number of clients directly served through our Direct Local channel as well as clients served through our National Brands, Agencies and Resellers channel. We calculate Active Advertisers by adjusting the number of Active Campaigns to combine clients with more than one Active Campaign as a single Active Advertiser. Clients with more than one location are generally reflected as multiple Active Advertisers. Because this number includes clients served through the National Brands, Agencies and Resellers channel, Active Advertisers includes entities with which we do not have a direct client relationship. Numbers are rounded to the nearest hundred. 16--------------------------------------------------------------------------------Active Campaigns is a number we calculate to approximate the number of individual products or services we are managing under contract for Active Advertisers. For example, if we were performing both ReachSearch and ReachDisplay campaigns for a client, we consider that two Active Campaigns. Similarly, if a client purchased ReachSearch campaigns for two different products or purposes, we consider that two Active Campaigns. Numbers are rounded to the nearest hundred. As of June 30, 2011, we had approximately 18,700 Active Advertisers and 26,300 Active Campaigns, as compared to approximately 16,700 Active Advertisers and 21,400 Active Campaigns as of June 30, 2010. Active Advertisers and Active Campaigns increased over the period due to an increase in the number of IMCs and an increase in the number of products available for our IMCs to sell. Recent Transactions On February 8, 2011, we acquired all of the outstanding member interests of DealOn, for consideration of up to approximately $9.6 million in cash and stock. On the closing date, we paid $5.8 million in cash and issued 82,878 shares of our common stock. The balance of the purchase price, $1.5 million in cash and 21,297 in shares of our common stock, is payable, subject to adjustment under the terms of the acquisition agreement, in three installments, with 50% payable in February 2012, 25% payable in August 2012, and 25% payable in February 2013. On April 25, 2011, we entered into a Google Inc. AdWords Reseller Addendum with Google Inc., and on May 9, 2011, ReachLocal Netherlands B.V. and Google Ireland Limited entered into a Google AdWords Reseller Agreement. Together, the agreements provide that we are an authorized reseller of Google's AdWords product in the designated territories and provide us with performance bonuses if advertiser targets and certain share of retail requirements are met. The agreements have a three-year term, subject to broad mutual termination rights as are customary in Google reseller contracts. Basis of Presentation Sources of Revenue We derive our revenue principally from the provision and sale of online advertising to our clients. Revenue includes the sale of our ReachSearch, ReachDisplay, remarketing and other products based on a package pricing model in which our clients commit to a fixed fee that includes the media, the optimization, reporting and tracking technologies of the RL Platform, and the personnel dedicated to support and manage their campaigns; the sale of our ReachCast, TotalTrack and TotalLiveChat products; and set-up, management and service fees associated with these products and other services. We distribute our products and services directly through our sales force of IMCs, who are focused on serving SMBs in their local markets through an in-person, consultative process, which we refer to as our Direct Local channel, as well as a separate sales force targeting our National Brands, Agencies and Resellers channel. The sales cycle for sales to SMBs ranges from one day to over a month. Sales to our National Brands, Agencies and Resellers clients generally require several months. We typically enter into multi-month agreements for the delivery of our ReachSearch, ReachDisplay and ReachCast products. Under our agreements, our SMB clients typically pay, in advance, a fixed fee on a monthly basis, which includes all charges for the included technology and media services, management, third-party content and other costs and fees. We record these prepayments as deferred revenue and only record revenue for income statement purposes as we purchase media and perform other services on behalf of clients. Generally, when at least 85% of requisite purchases and other services have occurred and an additional campaign cycle remains under the agreement, we make an additional billing or automatic collection for the next campaign cycle. Our National Brands, Agencies and Resellers clients enter into agreements of various lengths or that are indefinite. Our National Brands, Agencies and Resellers clients either pay in a manner similar to Direct Local clients or are extended credit privileges with payment generally due in 30 to 60 days. There was $3.1 million of related accounts receivable at June 30, 2011. With the acquisition of DealOn, we now offer our SMB clients the ability to offer consumers discounted deals which we promote through our DealOn subscriber list, our publisher network and our deal exchange, all through the ReachDeals platform. We earn a commission for acting as an agent in these transactions which are recorded on a net basis and are included in revenue upon completion of the sale of the deal to the consumer. The liability for redemption and potential income for breakage remain with the SMB client; therefore, we do not record redemption or breakage of the deals. We record a sales allowance for potential consumer refunds. 17--------------------------------------------------------------------------------Cost of Revenue Cost of revenue consists primarily of costs of online media acquired from third-party publishers. From time to time, publishers offer the Company performance bonuses or rebates based upon various factors and operating rules, including the amount of media purchased. Cost of revenue also includes third-party telephone and information services costs, data center and third-party hosting costs, credit card processing fees, third-party content and other direct costs. In addition, cost of revenue includes costs to initiate, operate and manage clients' campaigns, other than costs associated with the Company's sales force, which are reflected as selling and marketing expenses. Cost of revenue includes salaries, benefits, bonuses and stock-based compensation for the related staff, including the cost of Web Presence Professionals who are the principal service providers for the Company's ReachCast product, and allocated overhead such as depreciation expense, rent and utilities, as well as an allocable portion of our technical operations costs. Operating Expenses Selling and Marketing. Selling and marketing expenses consist primarily of personnel and related expenses for our selling and marketing staff, including salaries and wages, commissions, benefits, bonuses and stock-based compensation; travel and business costs; training, recruitment, marketing and promotional events; advertising; other brand building and product marketing expenses; and occupancy, technology and other direct overhead costs. A portion of the compensation for IMCs, sales management and other employees in the sales organization is based on commissions. Product and Technology. Product and technology expenses consist primarily of personnel and related expenses for our product development and technology staff, including salaries, benefits, bonuses and stock-based compensation, and the cost of certain third-party service providers and other expenses, including occupancy, technology and other direct overhead costs. Technology operations costs, including related personnel and third-party costs, are included in product and technology expenses. We capitalize a portion of costs for software development and, accordingly, include amortization of those costs as product and technology expenses as the RL Platform addresses all aspects of our activities, including supporting the IMC selling and consultation process, online publisher integration, efficiencies and optimization, providing insight to our clients into the results and effects of their online advertising campaigns and supporting all of the financial and other back-office functions of our business. General and Administrative. General and administrative expenses consist primarily of personnel and related expenses for executive, legal, finance, human resources and corporate communications, including wages, benefits, bonuses and stock-based compensation, professional fees, insurance premiums and other expenses, including occupancy, technology and other direct overhead, certain costs of being a public company and other corporate expenses. Critical Accounting Policies and Estimates The preparation of our condensed consolidated financial statements in conformity with GAAP, requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenue and expenses. We continually evaluate our estimates, judgments and assumptions based on available information and experience. Because the use of estimates is inherent in the financial reporting process, actual results could differ from those estimates. There have been no material changes to our critical accounting policies. For further information on our critical and other significant accounting policies, see our 2010 Annual Report on Form 10-K. We believe that the following critical accounting policies involve our more significant judgments, assumptions and estimates and, therefore, could have the greatest potential impact on our condensed consolidated financial statements: • Revenue recognition • Software development costs • Income taxes • Goodwill and intangible assets • Stock-based compensation 18--------------------------------------------------------------------------------We granted stock options with the following exercise prices during the six months ended June 30, 2011: Estimated Fair Value Per Number of Shares Underlying Intrinsic Value Underlying Exercise Price Share as of Per Share at DateGrant Dates Options Per Share Grant Date of Grant February 2011 244,650 $ 20.98 $ 20.98 $ - February 2011 700,000 $ 22.46 $ 20.98 $ - April 2011 236,100 $ 25.51 $ 25.51 $ - June 2011 56,045 $ 17.32 $ 17.32 $ - The following table summarizes the valuation assumptions, on a weighted-average basis, relating to our stock options granted during the six months ended June 30, 2011: Expected dividend yield 0% Risk free interest rate 2.22% Expected life, in years 4.75% Expected volatility 57% Using the Black-Scholes option pricing model, we recorded non-cash stock-based compensation expenses related to employee stock option grants of approximately $3.6 million during the six months ended June 30, 2011, which includes $0.5 million of SMB:LIVE deferred stock compensation during such period. At June 30, 2011, we had unrecorded compensation costs of $22.4 million related to unvested stock options and deferred stock consideration. The unrecognized compensation expense is expected to be recognized over a weighted average period of 1.6 years. During the six months ended June 30, 2011, we also issued 68,559 restricted stock units and recorded non-cash stock-based compensation expense of approximately $0.4 million related to restricted stock units. At June 30, 2011, we had $2.7 million of unrecognized compensation expense related to unvested restricted stock units. Changes in assumptions could impact the amount of restricted stock compensation expense. The unrecognized compensation expense is expected to be recognized over a weighted average period of 1.6 years. Software Development Costs We capitalize our costs to develop internal-use software when management has determined the development efforts will result in new or additional functionality or results in new products. Costs incurred prior to meeting these criteria and costs associated with ongoing maintenance are expensed as incurred. We track our costs by project and by each release and objectively determine which projects resulted in additional functionality or new products for which we can improve our offerings and market presence. Our developers, engineers and quality assurance staff currently estimate their time spent on various projects on a weekly basis so we may determine the approximate amount of costs that should be capitalized. Our senior management team reviews these estimates to determine the appropriate level of capitalization. We monitor our existing capitalized software and reduce its carrying value as the result of releases that render previous features or functions obsolete or otherwise reduce the value of previously capitalized costs. We capitalized $2.5 million and $2.3 million of software development costs during the three months ended June 30, 2011 and 2010, respectively. We capitalized $4.9 million and $3.9 million of software development costs during the six months ended June 30, 2011 and 2010, respectively. Costs capitalized as software development costs are amortized on a straight-line basis over the estimated useful life of the software of three years. Amortization of those costs is included in product and technology expenses as the RL Platform addresses all aspects of our activities, including supporting the IMC selling and consultation process, online publisher integration, efficiencies and optimization, providing insight to our clients into the results and effects of their online advertising campaigns and supporting all of the financial and other back office functions of our business. Goodwill and Intangible Assets At June 30, 2011, we had $41.8 million of goodwill, which resulted from the acquisition of the portion of ReachLocal Australia that we did not previously own and the acquisitions of SMB:LIVE and DealOn. In addition, in accounting for these acquisitions, we recorded other intangible assets related to pre-existing client relationships and purchased technology. We report finite-lived, acquisition-related intangible assets at fair value, net of accumulated amortization. Identifiable intangible assets are amortized on a straight-line basis over their estimated useful lives of one to three years. Straight-line amortization is used because no other pattern over which the economic benefits will be consumed can be reliably determined. 19 -------------------------------------------------------------------------------- We evaluate our goodwill for impairment using a two-step process that is performed at least annually, or whenever events or circumstances indicate that goodwill may be impaired. The first step is a comparison of the fair value of an internal reporting unit with its carrying amount, including goodwill. We have reporting units representing the various domestic and international markets in which we currently operate. If the fair value of the reporting unit exceeds its carrying value, goodwill of the reporting unit is not considered impaired and the second step is unnecessary. If the carrying value of the reporting unit exceeds its fair value, the second step is performed to measure the amount of impairment by comparing the carrying amount of the goodwill to a determination of the implied value of the goodwill. If the carrying amount of goodwill is greater than the implied value, an impairment is recognized for the difference. We evaluate our intangible assets for impairment whenever events or circumstances indicate an impairment may exist. The impairment loss is the amount by which the carrying value of the asset exceeds its fair value. We estimate fair value utilizing the projected discounted cash flow method and a discount rate determined by our management to be commensurate with the risk inherent in our current business model. When calculating fair value, we make assumptions regarding estimated future cash flows, discount rates and other factors. No impairment of goodwill or intangible assets was recorded during the six months ended June 30, 2011. 20 -------------------------------------------------------------------------------- Results of Operations Comparison of the Three and Six Months Ended June 30, 2011 and 2010 Three Months Ended Six Months Ended June 30, June 30, (in thousands, except per share data) 2011 2010 2011 2010 Revenue $ 92,752 $ 70,362 $ 176,810 $ 133,988 Cost of revenue (1) 46,598 38,447 91,098 73,286 Operating expenses: Selling and marketing (1) 34,716 26,341 67,135 50,281 Product and technology (1) 4,005 2,522 7,544 4,866 General and administrative (1) 8,572 5,618 15,649 11,003 Total operating expenses 47,293 34,481 90,328 66,150 Loss from operations (1,139 ) (2,566 ) (4,616 ) (5,448 ) Other income (expense), net 221 265 417 255 Loss before provision for income taxes (918 ) (2,301 ) (4,199 ) (5,193 ) Provision (benefit) for income taxes 31 93 197 (545 ) Net loss (949 ) (2,394 ) (4,396 ) (4,648 ) Net loss per share, basic and diluted $ (0.03 ) $ (0.09 ) $ (0.15 ) $ (0.59 ) Weighted average common shares used in computation of net loss per share, basic and diluted 29,043 25,621 28,752 7,939 The following earnings per share information is presented as if all preferred shares were converted into common stock as of the beginning of the period presented Net loss per share, as if converted: Basic and diluted $ (0.03 ) $ (0.09 ) $ (0.15 ) $ (0.19 ) Weighted average common shares used in computation of net income (loss) per share, as if converted: Basic and diluted 29,043 25,621 28,752 24,651 -------------------------------------------------------------------------------- (1) Stock-based compensation, net of capitalization, and depreciation and amortization, included in the above line items (in thousands): Three Months Ended Six Months Ended June 30, June 30, 2011 2010 2011 2010 Stock-based compensation: Cost of revenue $ 65 $ 70 $ 116 $ 161 Selling and marketing 382 260 760 441 Product and technology 342 259 600 523 General and administrative 1,480 811 2,571 1,360 $ 2,269 $ 1,400 $ 4,047 $ 2,485 Depreciation and amortization: Cost of revenue $ 201 $ 98 $ 357 $ 170 Selling and marketing 347 249 677 494 Product and technology 1,964 838 3,659 1,508 General and administrative 314 262 612 509 $ 2,826 $ 1,447 $ 5,305 $ 2,681 21--------------------------------------------------------------------------------Revenue Three Months Ended June 30, Six Months Ended June 30, 2011-2010 2011-2010 2011 2010 % Change 2011 2010 % Change (in thousands) Direct Local $ 71,839 $ 52,323 37.3% $ 136,354 $ 99,571 36.9% National Brands, Agencies and Resellers 20,913 18,039 15.9 40,456 34,417 17.5 Total revenue $ 92,752 $ 70,362 31.8% $ 176,810 $ 133,988 32.0% At period end: Number of IMCs: Upperclassmen 330 246 34.1% Underclassmen 439 395 11.1% Total 769 641 20.0% Active Advertisers (1) 18,700 16,700 12.0% Active Campaigns (2) 26,300 21,400 22.9% -------------------------------------------------------------------------------- (1) Active Advertisers is a number we calculate to approximate the number of clients directly served through our Direct Local channel as well as clients served through our National Brands, Agencies and Resellers channel. We calculate Active Advertisers by adjusting the number of Active Campaigns to combine clients with more than one Active Campaign as a single Active Advertiser. Clients with more than one location are generally reflected as multiple Active Advertisers. Because this number includes clients served through the National Brands, Agencies and Resellers channel, Active Advertisers includes entities with which we do not have a direct client relationship. Numbers are rounded to the nearest hundred. (2) Active Campaigns is a number we calculate to approximate the number of individual products or services we are managing under contract for Active Advertisers. For example, if we were performing both ReachSearch and ReachDisplay campaigns for a client, we consider that two Active Campaigns. Similarly, if a client purchased ReachSearch campaigns for two different products or purposes, we consider that two Active Campaigns. Numbers are rounded to the nearest hundred. Direct Local revenue increased $19.5 million, or 37.3%, for the three months ended June 30, 2011 compared to the three months ended June 30, 2010, and $36.8 million, or 36.9%, for the six months ended June 30, 2011 compared to the six months ended June 30, 2010. The increase in our Direct Local Revenue was largely attributable to incremental revenue from new Upperclassmen, that is, IMCs who were Underclassmen at June 30, 2010 but became Upperclassmen by June 30, 2011, revenue generated by new Underclassmen, and increased productivity of our existing Upperclassmen, that is, IMCs who were already Upperclassmen at June 30, 2010. 22-------------------------------------------------------------------------------- National Brands, Agencies and Resellers revenue increased $2.9 million, or 15.9%, for the three months ended June 30, 2011 compared to the three months ended June 30, 2010, and $6.0 million, or 17.5%, for the six months ended June 30, 2011 compared to the six months ended June 30, 2010. The increase was primarily due to a $3.0 million and $5.6 million increase in revenue from our National Brands clients during the three months and six months ended June 30, 2011, respectively, which we attribute to our continued increased focus on the National Brands portion of this channel. The increase in National Brands revenue during the three months ended June 30, 2011 was slightly offset by a decrease of $0.1 million in Agencies and Resellers during the period, while Agencies and Resellers contributed $0.4 million of increased revenues during the six month period ended June 30, 2011. Cost of Revenue Three Months Ended June 30, Six Months Ended June 30, 2011-2010 2011-2010 2011 2010 % Change 2011 2010 % Change (in thousands) Cost of revenue $ 46,598 $ 38,447 21.2% $ 91,098 $ 73,286 24.3% As a percentage of revenue: 50.2 % 54.6 % 51.5 % 54.7 % The decrease in our cost of revenue as a percentage of revenue for the three and six months ended June 30, 2011 compared to the three and six months ended June 30, 2010, was primarily due to changes in product and service mix, including increased sales of ReachCast and ReachDisplay, improved media buying efficiencies related to our core products introduced in late 2010, and increases in publisher and vendor rebates and performance bonuses. Publisher rebates as a percentage of revenue increased to 3.0% of revenue in the three months ended June 30, 2011 from 2.0% for the same period a year ago, and to 2.1% of revenue in the six months ended June 30, 2011 from 2.0% for the same period in 2010, due to more favorable rebate terms, primarily from Google. Our cost of revenue as a percentage of revenue will be affected in the future by the mix and relative amount of media we purchase to fulfill service requirements, the availability and amount of publisher rebates, the mix of products and services we offer, our media buying efficiency and the increased costs of support and delivery. Operating Expenses Over the past several years, we have significantly increased the scope of our operations. We intend to continue to increase our sales force, product offerings and the infrastructure to support them. In growing our business, particularly in international markets, we are incurring expenses to support our long-term growth plans, acknowledging that these investments may put pressure on near-term periodic operating results and increase our operating expenses as a percentage of revenue. Selling and Marketing Three Months Ended Six Months Ended June 30, 2011-2010 June 30, 2011-2010 2011 2010 % Change 2011 2010 % Change (in thousands) Salaries, benefits and other costs $ 24,449 $ 17,976 36.0% $ 47,397 $ 34,506 37.4% Commission expense 10,267 8,365 22.7 19,738 15,775 25.1 Total selling and marketing $ 34,716 $ 26,341 31.8% $ 67,135 $ 50,281 33.5% Underclassmen Expense included above, excluding commissions (1) $ 10,728 $ 8,679 23.6% $ 21,124 $ 16,485 28.1% As a percentage of revenue: Salaries, benefits and other costs 26.4 % 25.5 % 26.8 % 25.8 % Commission expense 11.1 % 11.9 % 11.2 % 11.8 % Total selling and marketing 37.4 % 37.4 % 38.0 % 37.5 % -------------------------------------------------------------------------------- (1) See "Non-GAAP Financial Measures" for our definition of Underclassmen Expense. 23-------------------------------------------------------------------------------- The increase in absolute dollars of salaries, benefits and other costs in selling and marketing expenses for the three months ended June 30, 2011 compared to the three months ended June 30, 2010, was due primarily to costs associated with the expansion, both domestically and internationally, of our sales force of IMCs and the related recruiting, training, and facilities costs. As a percentage of revenue, salaries, benefits and other costs increased primarily due to costs associated with the inclusion of DealOn and the expansion of its operations, and the launch of our German sales operations in 2011. The increase in absolute dollars of salaries, benefits and other costs in selling and marketing expenses for the six months ended June 30, 2011 compared to the six months ended June 30, 2010, was due to costs associated with the expansion, both domestically and internationally, of our sales force of IMCs and the related recruiting, training, and facilities costs. As a percentage of revenue, salaries, benefits and other costs increased primarily due to costs associated with the launch of our German sales operations in 2011 and the inclusion of DealOn and the expansion of its operations. The increase in commission expense in absolute dollars for the three and six months ended June 30, 2011 compared to the three and six months ended June 30, 2010, was due to increased sales. As a percentage of revenue, commission expense decreased due to a higher percentage of Direct Local revenue, for which we pay lower commission rates. We do not expect continued decreases in commission expense as a percentage of revenue due to an expected higher percentage of Upperclassmen, who generally earn higher commission rates based on increased productivity. The increase in Underclassmen Expense for the three and six months ended June 30, 2011 compared to the three and six months ended June 30, 2010, was primarily due to increased IMC hiring, including in Germany. As we continue to invest in additional Underclassmen and retain additional Upperclassmen, selling and marketing expenses will continue to increase in absolute dollars. Product and Technology Three Months Ended Six Months Ended June 30, 2011-2010 June 30, 2011-2010 2011 2010 % Change 2011 2010 % Change (in thousands) Product and technology expenses $ 4,005 $ 2,522 58.8 % $ 7,544 $ 4,866 55.0 % Capitalized software development costs from product and technology resources 2,492 2,315 7.6 % 4,879 3,874 25.9 % Total product and technology expenses and capitalized costs $ 6,497 $ 4,837 34.3 % $ 12,423 $ 8,740 42.1 % As a percentage of revenue: Product and technology costs costs 4.3 % 3.6 % 4.3 % 3.6 % Capitalized software development costs from product and technology resources 2.7 % 3.3 % 2.8 % 2.9 % Total product and technology costs expensed and capitalized 7.0 % 6.9 % 7.0 % 6.5 % The increase in product and technology expenses in both absolute dollars and as a percentage of revenue for the three months ended June 30, 2011 compared to the three months ended June 30, 2010, was primarily attributable to $0.9 million of increased amortization expense related to previously capitalized software development costs and $0.6 million of incremental salary, amortization of acquired intangibles and other costs associated with DealOn, for which no corresponding amounts existed during the prior-year period, ReachCast, and ongoing development of the RL Platform. The increase in product and technology expenses in both absolute dollars and as a percentage of revenue for the six months ended June 30, 2011 compared to the six months ended June 30, 2010, was primarily attributable to $1.7 million of increased amortization expense related to previously capitalized software development costs and $1.0 million of incremental salary, amortization of acquired intangibles and other costs associated with DealOn, for which no corresponding amounts existed during the prior year period, ReachCast, and ongoing development of the RL Platform. 24 -------------------------------------------------------------------------------- The increase in the amount of capitalized software development costs in absolute dollars for the three months ended June 30, 2011 compared to the three months ended June 30, 2010 was a result of investment in the continuing development of the ReachLocal Platform, Bizzy, and DealOn, offset by reduced capitalization of ReachCast software development costs following its launch in the fourth quarter of 2010. The increase in the amount of capitalized software development costs in absolute dollars for the six months ended June 30, 2011 compared to the six months ended June 30, 2010 was a result of investment in the development of ReachCast, which commenced in the first quarter of 2010 with the acquisition of SMB:LIVE, the ReachLocal Platform, Bizzy, and DealOn. The decrease in the amount of capitalized software development costs as a percentage of revenue for the three and six months ended June 30, 2011 compared to the three and six months ended June 30, 2010, was due to capitalized software development costs growing at a slower rate than revenue as we released significant projects such as ReachCast. We expect the amount of product and technology costs expensed and capitalized to continue to increase in absolute dollars due to the continued expansion of our product development efforts, including the ongoing development and roll-out of the technology acquired in our acquisitions and the increased costs associated with supporting a broader product offering. The amount of such costs capitalized will vary from period to period depending upon the status of our product development efforts. General and Administrative Three Months Ended Six Months Ended June 30, 2011-2010 June 30, 2011-2010 2011 2010 % Change 2011 2010 % Change (in thousands) General and administrative $ 8,572 $ 5,618 52.6% $ 15,649 $ 11,003 42.2% As a percentage of revenue: 9.2 % 8.0 % 8.9 % 8.2 % The increase in general and administrative expenses in absolute dollars and as a percentage of revenue for the three months ended June 30, 2011 compared to the three months ended June 30, 2010, was primarily due, to $0.9 million of tax, consulting, and legal professional fees, including costs to support our international expansion and to comply with the Sarbanes-Oxley Act of 2002, $0.7 million of employee-related costs to support the growth of the business and the requirements associated with being a public company for the entire quarter, $0.7 million of stock-based compensation expense, and $0.4 million of facilities and business license and tax costs supporting the growth of the business. The increase in general and administrative expenses in absolute dollars and as a percentage of revenue for the six months ended June 30, 2011 compared to the six months ended June 30, 2010, was primarily due to $1.5 million of tax, consulting and legal professional fees, including costs to support international expansion, comply with the Sarbanes-Oxley Act of 2002, and support acquisition activity, $1.2 million of stock-based compensation expense, $0.8 million of employee-related costs to support the growth of the business and the requirements associated with being a public company, and $0.5 million of facilities and business license and tax costs supporting the growth of the business. We expect general and administrative expenses to increase in absolute dollars as we continue to add administrative personnel and incur additional professional fees and other expenses resulting from continued growth and the compliance requirements associated with being a public company. Other Income (Expense), Net Other income increased in absolute dollars by approximately $0.2 million for the six months ended June 30, 2011 compared to the six months ended June 30, 2010. The change was attributable to an increase in interest income during the current period resulting from higher invested balances. 25 --------------------------------------------------------------------------------Provision (Benefit) for Income Taxes The income tax provision of $0.2 million for the six months ended June 30, 2011 relates to federal, state, local and foreign income taxes. The income tax benefit of $0.5 million for the six months ended June 30, 2010 was primarily attributable to the acquisition of SMB:LIVE, in which we recorded a one-time discrete deferred tax benefit of $0.7 million, partially offset by state income taxes of $0.2 million. Non-GAAP Financial Measures In addition to our GAAP results discussed above, we believe Adjusted EBITDA and Underclassmen Expense are useful to investors in evaluating our operating performance. For the three and six months ended June 30, 2011 and 2010 our Adjusted EBITDA and Underclassmen Expense were as follows: Three Months Ended Six Months Ended June 30, June 30, 2011 2010 2011 2010 (in thousands) Adjusted EBITDA (1) $ 4,062 $ 455 $ 5,256 $ 227 Underclassmen Expense (2) $ 10,728 $ 8,679 $ 21,124 $ 16,485 (1) Adjusted EBITDA. We define Adjusted EBITDA as net income (loss) before interest, income taxes, depreciation and amortization expenses, excluding, when applicable, stock-based compensation, the effects of accounting for business combinations (including in the case of the acquisitions of SMB:LIVE and DealOn, the amortization of acquired intangibles and the deferred cash consideration) and amounts included in other non-operating income or expense. (2) Underclassmen Expense. We define Underclassmen Expense as our investment in Underclassmen, which is comprised of the selling and marketing expenses we allocate to Underclassmen during a reporting period. The amount includes the direct salaries and allocated benefits of the Underclassmen (excluding commissions), training and sales organization expenses including depreciation allocated based on relative headcount and marketing expenses allocated based on relative revenue. While we believe that Underclassmen Expense provides useful information regarding our approximated investment in Underclassmen, the methodology we use to arrive at our estimated Underclassmen Expense was developed internally by the company, is not a concept or method recognized by GAAP and other companies may use different methodologies to calculate or approximate measures similar to Underclassmen Expense. Accordingly, our calculation of Underclassmen Expense may not be comparable to similar measures used by other companies. Our management uses Adjusted EBITDA because (i) it is a key basis upon which our management assesses our operating performance; (ii) it may be a factor in the evaluation of the performance of our management in determining compensation; (iii) we use it, in conjunction with GAAP measures such as revenue and income (loss) from operations, for operational decision-making purposes; and (iv) we believe it is one of the primary metrics investors use in evaluating Internet marketing companies. Our management believes that Adjusted EBITDA permits an assessment of our operating performance, in addition to our performance based on our GAAP results, that is useful in assessing the progress of the business. By excluding (i) the effects of accounting for business combinations and associated acquisition and integration costs, which obscure the measurable performance of the business operations; (ii) depreciation and amortization and other non-operating income and expense, each of which may vary from period to period without any correlation to underlying operating performance; and (iii) stock-based compensation, which is a non-cash expense, we believe that we are able to gain a fuller view of the operating performance of the business. We provide information relating to our Adjusted EBITDA so that investors have the same data that we employ in assessing our overall operations. We believe that trends in our Adjusted EBITDA are a valuable indicator of operating performance on a consolidated basis and of our ability to produce operating cash flow to fund working capital needs, capital expenditures and investments in Underclassmen. 26 -------------------------------------------------------------------------------- In addition, we believe Adjusted EBITDA and similar measures are widely used by investors, securities analysts, ratings agencies and other interested parties in our industry as a measure of financial performance and debt-service capabilities. Our use of Adjusted EBITDA has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are: • Adjusted EBITDA does not reflect our cash expenditures for capital equipment or other contractual commitments; • Although depreciation and amortization are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and Adjusted EBITDA does not reflect capital expenditure requirements for such replacements; • Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs; • Adjusted EBITDA does not consider the potentially dilutive impact of issuing equity-based compensation to our management team and employees; • Adjusted EBITDA does not reflect the potentially significant interest expense or the cash requirements necessary to service interest or principal payments on indebtedness we may incur in the future; • Adjusted EBITDA does not reflect income and expense items that relate to our financing and investing activities, any of which could significantly affect our results of operations or be a significant use of cash; • Adjusted EBITDA does not reflect certain tax payments that may represent a reduction in cash available to us; and • Other companies, including companies in our industry, calculate Adjusted EBITDA measures differently, which reduces their usefulness as a comparative measure. Adjusted EBITDA is not intended to replace operating income (loss), net income (loss) and other measures of financial performance reported in accordance with GAAP. Rather, Adjusted EBITDA is a measure of operating performance that you may consider in addition to those measures. Because of these limitations, Adjusted EBITDA should not be considered as a measure of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on our GAAP results, including cash flows provided by operating activities, and using total Adjusted EBITDA as a supplemental financial measure. The following table presents a reconciliation of Adjusted EBITDA to our loss from operations for each of the periods indicated: Three Months Ended Six Months Ended June 30, June 30, 2011 2010 2011 2010 (in thousands) Loss from operations $ (1,139 ) $ (2,566 ) $ (4,616 ) $ (5,448 ) Add: Depreciation and amortization 2,826 1,447 5,305 2,681 Stock-based compensation, net 2,269 1,400 4,047 2,485Acquisition and integration costs 106 174 520 509 Adjusted EBITDA $ 4,062 $ 455 $ 5,256 $ 227 27-------------------------------------------------------------------------------- |