INUVO, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

[November 08, 2012]

INUVO, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

(Edgar Glimpses Via Acquire Media NewsEdge) Certain statements in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere in this quarterly report on Form 10-Q constitute "forward-looking statements" within the meaning of the Federal Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements that are not historical, including statements regarding management's intentions, beliefs, expectations, representations, plans or predictions of the future and are typically identified by words such as "believe," "expect," "anticipate" "intend," "estimate," "may," "will," "should," and "could." These forward-looking statements involve numerous risks and uncertainties that could cause our actual results to be materially different from those set forth in the forward-looking statements including, without limitation, our lack of profitable operating history, changes in our business, potential need for additional capital and the other additional risks and uncertainties that are set forth in this Quarterly Report on Form 10-Q, as well as in our Annual Report on Form 10-K for the year ended December 31, 2011 and as filed with the Securities and Exchange Commission and our subsequent filings with the SEC. The risk factors described in our filings with the SEC are not the only risks we face. Additional risks and uncertainties not currently known to us or that we deem immaterial also may materially adversely affect our business, financial condition and/or operating results. The Company assumes no obligation to update any forward-looking statements as a result of new information or future events or developments, except as required by law. The following discussion should also be read in conjunction with the Consolidated Financial Statements and Notes thereto appearing elsewhere in this quarterly report on Form 10-Q.

Overview Inuvo® is an Internet marketing and technology company that manages a network of websites and builds and markets browser based consumer applications. We develop software and analytics technology that is accessible over the Internet for use by consumers, online advertisers and website publishers.

On March 1, 2012 we completed the acquisition of Vertro, Inc. ("Vertro"), an Internet company that owns and operates the ALOT product portfolio. After seven months of combined operations, management has reduced the number of reporting segments from three to two. The new segments are Software Search and the Publisher Network. The Partner Programs segment from the previous reporting segments has been absorbed into the other two segments with consumer focused initiatives going to Software Search and all other business going to the Publisher Network. For presentation purposes, prior period results included herein have been reclassified for the new segment structure.

The former Vertro's operations are now part of the Software Search segment. Our Publisher Network segment consists of the technology and analytics platforms that provide advertisers and publishers the capability to facilitate performance-based advertising. This segment also consists of websites we own and operate. The Software Search and Publisher Network segments represent approximately 50.9% and 49.1% respectively, of our total net revenue for the quarter ending September 30, 2012. Prior to 2012, we were organized under two segments; Web Properties and Performance Marketing.

The Company's consolidated financial statements as of September 30, 2012 include the operations and financial results of the Vertro subsidiary for only seven months. For presentation purposes, our prior period results included herein have been reclassified for our new segment structure.

Software Search Following our acquisition of Vertro, effective March 1, 2012, we include the ALOT product line into what we now call our Software Search segment. The ALOT product line offers two primary products to consumers; ALOT Home, a homepage product, and the ALOT Appbar, a software application that consumers install into their web browsers. Both ALOT Home and the ALOT Appbar include a search box from which consumers can conduct type-in web search requests. The ALOT Appbar provides access to a library of applications, which are used by consumers to receive dynamic information, perform useful tasks, or access their favorite content online. There are hundreds of apps available for consumers to choose from ranging from a weather app that provides an at-a-glance snapshot of the weather for the coming four days, to a radio app that enables consumers to instantly listen to thousands of radio stations from around the world. All ALOT products and apps are free to download and use.

The search box on the ALOT Home and ALOT Appbar products has historically been the source of a majority of the revenue. Users conduct millions of searches per day producing both algorithmic results and sponsored listings. Both the algorithmic results and sponsored listings are provided by third parties with whom we have contractual relationships. If users click on a sponsored listing after conducting a search, we earn a percentage of the total click-through revenue provided by the third-party that placed the advertisement. Historically, search revenue from Google accounted for over 80% of revenue from the ALOT operations.

The Software Search segment also consists of affiliate programs, display revenues, data sales, and BargainMatch. Non-search revenue is generated from the interaction consumers have with certain applications launched from within the Appbar. We refer to these as sponsored apps and they generate either pay-per-click or cost-per-action revenue. Website page-views are also monetized through cost-per-thousand display ads. We also utilize user data to enhance product offerings and generate additional revenue.

The BargainMatch consumer product shopping, comparison and rewards application is a browser-based application where consumers can earn cashback on purchases made online through sponsored merchants.

20 --------------------------------------------------------------------------------Publisher Network The Publisher Network segment is made up of thousands of different websites, from large, well-known portals to independent tech bloggers into which Inuvo serves advertisements. The technology that supports the Publisher Network, the Inuvo platform, is an open, fraud filtering, lead, click or sales generation marketplace designed to allow advertisers and publishers the ability to manage their transactions in an automated and transparent environment. The following brands continue to be used within the Publisher Network: The ValidClick® service at www.validclick.com. ValidClick is a fraud filtering, pay-per-click marketplace where publishers can integrate dynamically-generated advertisements within their websites based on the demographics and natural search behaviors of the consumer. ValidClick provides publishers with access to tens of thousands of advertisers in an easy-to-use XML-based implementation, giving the publisher greater control over content and integration than other competitive offerings.

The owned and operated websites including the Yellowise.com™ directory search website at www.yellowise.com and the recently launched Local.ALOT.com website. Both websites are local search and review sites powered by the LocalXML service which allows publishers the ability to make real-time calls to the LocalXML database and have users receive a listing of all local businesses that meet the search criteria. Users may also post reviews of their favorite and not-so-favorite businesses making the reviews available to all other users of the site.

The MyAP® Affiliate Platform at www.MyAP.com. MyAP is a complete affiliate tracking and management software solution providing advertisers the ability to sign up, manage and track the activities of their publishers through a reliable, easy-to-use, and privately-branded platform with full data transparency. Where the Inuvo Platform is an open platform where many advertisers and publishers interact, the MyAP platform is designed specifically to allow merchants to build private affiliate networks. Each advertising customer of MyAP is supported by a unique implementation of the software, customized to suit their individual needs and populated by publishers.

NYSE MKT On May 9, 2011, we received notice from the NYSE MKT, LLC (formerly NYSE Amex) (the exchange) that we did not meet certain of the exchange's continued listing standards due to stockholders' equity of less than $4.0 million and losses from continuing operations and/or net losses in three of our four most recent fiscal years as set forth in Section 1003(a) (ii) of the NYSE MKT Company Guide. The exchange accepted our plan to regain compliance with the continued listing standards and on September 11, 2012, we received notification from the exchange that the continued listing deficiencies were resolved. However, due to of the company's continuing net losses, the exchange's minimum requirement for continued listing becomes a minimum stockholders' equity of $6.0 million. At September 30, 2012, our stockholders' equity was $5.1 million and we did not meet the exchange's minimum listing requirement. We believe we will achieve the exchange's minimum stockholders' requirement and regain compliance with the continued listing standard in 2013 due to cost containment and revenue growth.

Cost Containment. With the Vertro merger we anticipated that we would save approximately $2.9 million in operating expense synergies on an annualized run rate. As of September 30, 2012 we were on a run rate of approximately $0.9 million ahead of that expectation and we expect these savings to flow through to our bottom line throughout the fourth quarter of 2012 and beyond.

Revenue Growth. Our Publisher Network segment had a revenue growth rate of 40% in the third quarter of 2012 compared to the second quarter of 2012.

Our Software Search segment had a revenue growth rate of 6% for the third quarter of 2012 compared to the second quarter of 2012. In September 2012, we attained revenue growth leading to a higher revenue share from Yahoo! for our Publisher Network segment and in July 2012, revenue growth in our Software Search Segment reached a level that yielded a higher revenue share from Google. We expect these higher revenue share rates to continue into the fourth quarter of 2012 and the higher percentage revenue share with each advertising partner is substantial and a meaningful component of our revenue growth. Our Yellowise and Local.alot owned and operated sites are contributing meaningful incremental revenues on a quarter by quarter basis and we expect their growth to continue. In addition we expect to see meaningful revenue coming from our BargainMatch.com product.

In aggregate, we believe the continued cost containment described above and the growth in revenue will allow us to satisfy the NYSE/MKT listing requirements for shareholder equity in 2013.

Hurricane Sandy Our corporate headquarters and a significant portion of our operations are located in New York City. Our office was closed for a week due to the impact of Hurricane Sandy. One of our data centers in New York City has been without power since the hurricane and we have been operating a portion of our Software Search segment business out of a redundant data center. Our business and operating systems were not materially impacted by the office closure and our employees were able to work remotely.

21--------------------------------------------------------------------------------Results of Operations for the Three months and Nine Months ended September 30, 2012 and 2011 The following table sets forth selected information concerning our results of operations for the three months and nine months ended September 30, 2012 and 2011 (unaudited and in thousands): Three Months ended September 30 Nine Months ended September 30 2012 % of Revenue 2011 % of Revenue 2012 % of Revenue 2011 % of Revenue Net revenues $ 15,481 100 % $ 8,203 100 % $ 37,123 100 % $ 29,210 100 % Cost of revenue 6,745 43.6 % 4,636 56.5 % 18,190 49 % 16,106 55.1 % Gross Profit 8,736 56.4 % 3,567 43.5 18,933 51 % 13,103 44.9 % Total operating expenses 9,860 63.7 % 4,803 58.6 24,404 65.7 % 17,136 58.7 % Operating Loss (1,124 ) (7.3 %) (1,236 ) (15.1 %) (5,471 ) (14.7 %) (4,032 ) (13.8 %) Other expenses (202 ) (1.3 %) (132 ) (1.6 %) (474 ) (1.3 %) (817 ) (2.8 %) Income tax expense ( 9 ) (0.1 %) - -- (71 ) (0.2 %) - - Net loss from continuing operations (1,335 ) (8.6 %) (1,368 ) (16.7 %) (6,016 ) (16.2 %) (4,850 ) (16.6 %) Discontinued operations 14 0.1 % - - (143 ) (0.4 %) 257 0.9 % Net loss $ (1,321 ) (8.5 %) $ (1,368 ) (16.7 %) $ (6,159 ) (16.6 %) $ (4,592 ) (15.7 %) In the three months ended September 30, 2012, net revenues increased 88.7% from the same period of 2011. Additionally, gross profit also increased 144.9% in the three months ended September 30, 2012 compared to the same period of 2011. These increases were due primarily from revenue from our Software Search segment as a result of our merger with Vertro. In the three months ended September 30, 2012, our operating expenses increased by approximately 105.3% over the same period in 2011 due primarily to customer acquisition costs from our Software Search segment as a result of our merger with Vertro.

Our net loss from continuing operations for the three months ended September 30, 2012 decreased by approximately $33,000 or 2.4% from the same period in 2011 due to improved gross profit and the cost synergies derived from the merger with Vertro.

The financial results for the nine months ended September 30, 2012 include only seven months of combined financial results of the merger with Vertro on March 1, 2012. In the nine months ended September 30, 2012, net revenues increased 27.1% from the same period of 2011. Additionally, gross profit also increased by 44.5% in the nine months ended September 30, 2012 compared to the same period of 2011. These increases were due primarily from revenue from our Software Search segment as a result of our merger with Vertro. In the nine months ended September 30, 2012, our operating expenses increased by approximately 42.4% over the same period in 2011 due primarily to customer acquisition costs from our Software Search segment as a result of our merger with Vertro.

Our net loss from continuing operations for the nine months ended September 30, 2012 increased by approximately $1,166,000 from the same period in 2011 due to higher operating expenses.

22--------------------------------------------------------------------------------Net Revenue Total net revenue from our Publisher Network and Software Search segments for the three months ended September 30, 2012 and 2011 were as follows (unaudited and in thousands): Three Months Ended September 30 2012 ($) % of Revenue 2011 ($) %of Revenue $ Change % Change Publisher Network 7,605 49.1 % 8,153 99.4 % (548 ) (6.7 )% Software Search 7,876 50.9 % 50 0.6 % 7,826 15,652.0 % Total net revenue 15,481 100.0 % 8,203 100.0 % 7,278 88.7 % Net revenue from our Publisher Network segment decreased 6.7% for the three months ended September 30, 2012 compared to the same period of 2011 primarily due to the decrease in the number of transactions driven through our owned and operated websites and through third party affiliates using the ValidClick platform. In December 2011, Yahoo! provided preliminary notice that it had identified certain traffic irregularities across its publisher network, to which Inuvo is a contributor. While this irregular traffic did not originate within the Inuvo network, it passed through some websites the company manages and in some cases owns and operates. Yahoo! made advertiser refunds as a result of identified traffic irregularities that it charged back to us. In the first quarter of 2012, the chargeback was approximately $238,000. This amount was a reduction of our revenue in the first quarter 2012 and most of this amount has been charged back to our vendors. In the third quarter of 2012, we charged revenue a reserve of $170,000 in anticipation of an additional chargeback from Yahoo! We have reduced traffic to some websites we manage in response to these irregularities. While growing, these websites have not yet achieved the traffic levels reached in 2011. There can be no assurance that we will be able to successfully return these campaigns to their previous levels. We have also restructured the ValidClick business to focus on smaller publishers rather than larger ones where traffic origin is less certain. The revenue of this segment has been volatile due to the decrease in transactions as described above and though we expect the volatility to continue in the near future, we believe the focus on smaller publishers will improve traffic quality and promote a steady growth of the segment. In September 2012, the revenue growth had attained a contractual level yielding a higher revenue share from Yahoo! The recent trend in the Publisher Network segment is a revenue growth rate of 40% in the third quarter of 2012 over the most recent sequential quarter, the second quarter of 2012.

Net revenue from our Software Search segment is primarily a result of the merger with Vertro on March 1, 2012. Net revenue from the Software Search segment is derived from the ALOT users conducting searches that produce both algorithmic results and sponsored listings. Both the algorithmic results and sponsored listings are provided by third parties with whom we have contractual relationships. When users click on a sponsored listing after conducting a search, we earn a percentage of the total click-through revenue provided by the third-party that placed the advertisement. This segment also includes the non-search revenue generated from the ALOT products. The largest portion of non-search revenue is derived from display ads presented on the Alot homepage.

Recently we have seen a decline in Display advertising due to implementation changes made by our display advertising provider. The recent trend in the Software Search segment is an increase of net revenue of 6% for the three months ended September 30, 2012 compared to the most recent sequential quarter, ended June 30, 2012. In July 2012, for the first time in over a year, revenue growth had attained a contractual level yielding a higher commission rate from Google.

One provider of paid search results for our Software Search segment accounted for approximately 49.2% of our consolidated revenues for the three months ended September 30, 2012. No revenue from that paid search provider was included in our consolidated revenue for the three months ended September 30, 2011.

Additionally, one provider of paid search results for our Publisher Network segment accounted for approximately 42.4% and 88.8% of consolidated revenues for the three month periods ended September 30, 2012 and 2011, respectively. The lower percentage this year is due to the diversification of the revenue streams achieved by merging with Vertro in March 2012.

23 -------------------------------------------------------------------------------- Total net revenue from our Publisher Network and Software Search segments for the nine months ended September 30, 2012 and 2011 were as follows (unaudited and in thousands): Nine Months Ended September 30 2012 ($) % of Revenue 2011 ($) % of Revenue $ Change % Change Publisher Network 19,429 52.3 % 29,160 99.8 % (9,731 ) (33.4 )% Software Search 17,694 47.7 % 50 0.2 % 17,644 35,288 % Total net revenue 37,123 100.0 % 29,210 100.0 % 7,913 27.1 % Net revenue from our Publisher Network segment decreased 33.4% for the nine months ended September 30, 2012 compared to the same period of 2011 primarily due to the decrease in the number of transactions driven through our owned and operated websites and through third party affiliates using the ValidClick platform as described above.

Net revenue from our Software Search segment is entirely a result of the merger with Vertro on March 1, 2012 as described above.

One provider of paid search results for our Software Search segment accounted for approximately 41.8% of our consolidated revenues for the nine months ended September 30, 2012. No revenue from that paid search provider was included in our consolidated revenue for the nine months ended September 30, 2011.

Additionally, one provider of paid search results for our Publisher Network segment accounted for approximately 44.7% and 86.4% of consolidated revenues for the nine month periods ended September 30, 2012 and 2011, respectively. The lower percentage this year is due to the diversification of the revenue streams achieved by merging with Vertro in March 2012.

Cost of Revenue and Gross Profit Cost of revenue for the three months ended September 30, 2012 and 2011 were as follows (unaudited and in thousands): Three Months Ended September 30 2012 ($) % of Revenue 2011 ($) % of Revenue $ Change % Change Affiliate expenses 5,472 35.4 % 3,922 47.8 % 1,550 39.5 % Data acquisition 1,054 6.8 % 688 8.4 % 366 53.2% % Merchant processing fees and product costs 219 1.4 % 26 0.3 % 193 742.3 % Total cost of revenue 6,745 43.6 % 4,636 56.5 % 2,109 45.5 % The lower affiliate payments as a percentage of revenue in the three months ended September 30, 2012 compared to the same period in 2011 is due primarily to restructuring the ValidClick business to focus on smaller publishers to host advertising.

The increase in data acquisition costs for the three months ended September 30, 2012 as compared to the same period of 2011 is due primarily to acquiring bundled downloads to drive revenue through our ALOT Appbar which was acquired in the Vertro acquisition in March 2012. We do not expect these costs to increase in the future.

24--------------------------------------------------------------------------------Cost of revenue for the nine months ended September 30, 2012 and 2011 were as follows (unaudited and in thousands): Nine Months Ended September 30 2012 ($) % of Revenue 2011 ($) % of Revenue $ Change % Change Affiliate expenses 14,119 38.0 % 14,090 48.2 % 29 0.2 % Data acquisition 3,572 9.7 % 1,943 6.7 % 1,629 83.8 % Merchant processing fees and product costs 500 1.3 % 73 0.3 % 427 584.9 % Total cost of revenue 18,191 49.0 % 16,106 55.1 % 2,085 12.9 % The affiliate payments in the nine months ended September 30, 2012 compared to the same period in 2011 were nearly the same. The lower affiliate payments as a percentage of revenue for the nine months ended September 30, 2012 compared to the same period in 2011 is primarily due to restructuring the ValidClick business to focus on smaller publishers to host advertising.

The increase in data acquisition costs both in dollars and as a percentage of revenue for the nine months ended September 30, 2012 as compared to the same period of 2011 is due primarily to acquiring bundled downloads to drive revenue through our ALOT Appbar which was acquired in the Vertro acquisition in March 2012.

We do not expect these costs to increase in the future.

The following table provides information on gross profit by operating segment for each of the periods presented (unaudited and in thousands): Three Months Ended September 30 2012 ($) % of Revenue 2011 ($) % of Revenue $ Change % Change Publisher Network 1,894 12.9 % 3,517 42.9 % (1,623 ) (46.1 )% Software Search 6,842 50.9 % 50 0.2 % 6,792 13,584.0 % Total gross profit 8,736 63.8 % 3,567 43.1 % 5,169 144.9 % Gross profit from our Publisher Network segment decreased 46.1% for the three months ended September 30, 2012 compared to the same period of 2011 primarily due to lower revenue of owned and operated websites associated with reducing traffic as described above in "Net Revenue".

Gross profit from the Software Search segment increased as a result of the ALOT operations acquired in the merger with Vertro in March 2012.

The following table provides information on gross profit by operating segment for each of the periods presented (unaudited and in thousands): Nine Months Ended September 30 2012 ($) % of Revenue 2011 ($) % of Revenue $ Change % Change Publisher Network 4,326 11.7 % 13,053 44.7 % (8,727 ) (66.9 )% Software Search 14,606 39.3 % 50 0.2 % 14,556 29,112 % Total gross profit 18,932 51.0 % 13,103 44.9 % 5,829 44.5 % 25-------------------------------------------------------------------------------- Gross profit from our Publisher Network segment decreased 66.9% for the nine months ended September 30, 2012 compared to the same period of 2011 primarily due to lower revenue from owned and operated websites associated with reducing traffic as described above in "Net Revenue".

Gross profit from the Software Search segment is resulted from the ALOT operations acquired in the merger with Vertro in March 2012.

Operating Expenses Operating expenses for the three months ended September 30, 2012 and 2011 were as follows (unaudited and in thousands): Three Months Ended September 30 2012 ($) % of Revenue 2011 ($) % of Revenue $ Change % Change Search costs 5,832 37.7 % 1,959 23.9 % 3,873 197.7 % Compensation and telemarketing 1,649 10.7 % 1,481 18.1 % 168 11.3 % Selling, general and administrative 2,379 15.4 % 1,363 16.6 % 1,016 74.5 % Total operating expenses 9,860 63.7 % 4,803 58.6 % 5,057 105.3 % Our operating expenses by segment were as follows for the periods presented (unaudited and in thousands): Three Months Ended September 30 2012 ($) % of Revenue 2011 ($) % of Revenue $ Change % Change Publisher Network 718 4.6 % 2,379 29.0 % (1,661 ) (69.8 )% Software Search 5,427 35.1 % 92 1.1 % 5,335 5,798.9 % Corporate 3,715 24.0 % 2,332 28.4 % 1,383 59.3 % Total operating expenses 9,860 63.7 % 4,803 58.6 % 5,057 105.3 % Search costs increased 197.7% for the three months ended September 30, 2012 compared to the same period of 2011 primarily due to the advertising spend to create download traffic for the ALOT appbar. This expense is expected to increase, though not significantly in the future as we grow the ALOT user base and revenue.

Compensation and telemarketing expense increased 11.3% for the three months ended September 30, 2012 compared to the same period of 2011 primarily due to the merger with Vertro. At September 30, 2012, we had a headcount of 45 employees compared to 28 employees at September 30, 2011.

Selling, general and administrative expense increased approximately $1 million or 74.5% for the three months ended September 30, 2012 compared to the same period of 2011 primarily due to higher depreciation and amortization expense ($544,000), IT services expense of ($205,000), rent expense ($91,000), professional fees ($89,000), and other related to the acquired operations from the merger with Vertro in March 2012.

Operating expenses for the nine months ended September 30, 2012 and 2011 were as follows (unaudited and in thousands): Nine Months Ended September 30 2012 ($) % of Revenue 2011 ($) % of Revenue $ Change % Change Search costs 13,098 35.3 % 6,749 23.1 % 6,349 94.1 % Compensation and telemarketing 4,571 12.3 % 6,367 21.8 % (1,796 ) (28.2 )% Selling, general and administrative 6,735 18.1 % 4,019 13.8 % 2,716 67.6 % Total operating expenses 24,404 65.7 % 17,135 58.7 % 7,269 42.4 % 26--------------------------------------------------------------------------------Our operating expenses by segment were as follows for the periods presented (unaudited and in thousands): Nine Months Ended September 30 2012 ($) % of Revenue 2011 ($) % of Revenue $ Change % Change Publisher Network 1,696 4.6 % 9,769 33.4 % (8,073 ) (82.6 )% Software Search 12,649 34.1 % 193 0.7 % 12,456 6,453.9 % Corporate 10,059 27.1 % 7,174 24.6 % 2,885 40.2 % Total operating expenses 24,404 65.7 % 17,136 58.7 % 7,268 42.4 % Search costs increased 94.1% for the nine months ended September 30, 2012 compared to the same period of 2011 primarily due to the advertising spend to create download traffic for the ALOT appbar. This expense is expected to increase, though not significantly in the future as we grow the ALOT user base and revenue.

Compensation and telemarketing expense decreased 28.2% for the nine months ended September 30, 2012 compared to the same period of 2011 primarily due to discontinuing the telemarketing operations in the 2011.

Selling, general and administrative expense increased approximately $2.7 million or 67.6% for the nine months ended September 30, 2012 compared to the same period of 2011 primarily due to increases in depreciation and amortization expense of ($1,020,000), rent of ($584,000), IT services of ($298,000), consulting expense of ($205,000), and other general expenses of ($639,000) due to the infrastructure growth related to the Vertro merger in March 2012.

Other Income (Expense), Net During the third quarter of 2012, we settled a lawsuit resulting in a $75,000 charge. In the third quarter of 2011, we wrote off approximately $78,000 of capital development associated with delays in launching a new business line.

Interest expense, net which is primarily associated with our borrowings from Bridge Bank, increased by 142% during the three months ended September 30, 2012 to approximately $128,000 as compared to approximately $53,000 for the same period in 2011. This increase in interest expense is primarily is due to the larger outstanding balance in the 2012 period compared to the same period in 2011, and to the amortization of fees to acquire the credit facilities.

During the nine month period ended September 30, 2012, we settled a lawsuit resulting in a $75,000 charge. In the same nine month period of 2011, we incurred a charge to litigation settlements of approximately $374,000 associated with settlements of lawsuits brought by two former employees. In addition, we wrote-off a note receivable of approximately $101,000 as a result of the cancellation of our outsourced call center contract during the second quarter of 2011. In the third quarter of 2011, we wrote off approximately $78,000 of capital development associated with delays in launching a new business line.

Interest expense, net which is primarily associated with our borrowings from Bridge Bank, increased by 51.1% during the nine months ended September 30, 2012 to $399,000 as compared to $264,000 for the same period in 2011. This higher interest expense in 2012 is primarily due to higher outstanding loan balances and the write-off of $100,743 of fees related to the February 2011 Bridge Bank credit facility that was superseded by a March 2012 Bridge Bank credit facility.

27 --------------------------------------------------------------------------------Income (Loss) from Discontinued Operations, Net of Tax Expense The gain from discontinued operations for the three months ended September 30, 2012 was approximately $14,000 and is primarily attributed to Vertro's European operations.

The loss from discontinued operations for the nine months ended September 30, 2012 was approximately $143,000 and is primarily attributed to the denial by European authorities to hear our appeal for refunding of Value Added Taxes in Germany. In the same nine month period of 2011, we reported a gain from discontinued operations of approximately $257,000 due to a favorable litigation settlement of a lease.

Liquidity and Capital Resources Liquidity is our ability to generate adequate amounts of cash to meet the company's needs for cash. At September 30, 2012 and December 31, 2011, we had working capital deficit of approximately $3.0 million and $2.0 million, respectively. Our principal sources of liquidity are cash from operations, cash on hand and the Bridge Bank credit facility.

While we do not have any commitments for capital expenditures which come due within the next 12 months, in the past our liquidity had been negatively affected, as a result of a reduction in search marketing revenue. In response, we implemented a cost reduction plan throughout 2011 to offset the reduced revenue which included a reduction in employees and related expenses. We also delayed payments to publishers and vendors in the management of our cash flows.

Additionally in 2011, our directors, executive officers and certain senior managers agreed to a deferral of cash compensation which was ultimately converted to common shares.

Upon merging with Vertro on March 1, 2012 we eliminated duplicate costs in public company expense, and in the accounting, legal, and IT functions. The program to reduce duplicate costs continues beyond the third quarter. We also entered into a new Business Financing Agreement with our bank (see below). At September 30, 2012 cash increased $3.2 million from the end of 2011 and bank debt correspondingly increased from $2.9 million at December 31, 2011 to $7.9 million at the end of the third quarter 2012.

On March 1, 2012, we entered into a new Business Financing Agreement with Bridge Bank for a revolving credit facility with a maximum limit of $10 million (the "Revolving Credit Line") and a term loan with a maximum limit of $5 million (the "Term Loan"). The Revolving Credit Line replaced the Company's then existing $8 million revolving credit facility with Bridge Bank. The new credit facility will be used primarily to satisfy our working capital needs. As of September 30, 2012, there was approximately $1.1 million credit available on the Revolving Credit Line and $0 on the Term Loan. Subject to the terms of the new agreement, we are entitled to obtain advances against the Revolving Credit Line up to 80% of eligible accounts receivable balances, which are generally those balances owed by U.S. based customers that are less than 90 days from the date of invoice plus $1 million up to the maximum limit of $10 million. In addition, subject to the terms of the agreement, we are entitled to borrow up to $5 million under the Term Loan portion of the credit facility, which is repayable in 45 equal monthly installments beginning June 2012. The Revolving Credit Line portion of the credit facility expires on February 28, 2014, at which time all loan advances under the Revolving Credit Line become due and payable. The Term Loan expires in February 2016. Under the terms of the new agreement, we must maintain certain depository, operating and investment accounts at Bridge Bank; provide Bridge Bank a first priority perfected security interest in all of our accounts and personal property; provide various monthly, quarterly and annual reports; and limit additional indebtedness to $500,000 of purchase money including capital leases and an additional $500,000 of all other indebtedness.

In addition, the new agreement required that we maintain through May 2012 an "operating profit" of net income plus interest and taxes plus non-cash expenses for amortization, depreciation, stock based compensation, discontinued operations, non-recurring non-cash items and certain closing costs associated with the Merger Transaction with Vertro of not less than $200,000 for the immediate proceeding three month period; after May 2012 a Debt Service Coverage Ratio of at least 1.50 to 1.0 tested on the immediate proceeding three month period; and an Asset Coverage Ratio of not less than 1.10 to 1.0 at all times until September 30, 2012 and 1.25 to 1.0 thereafter. Interest on the Revolving Credit Line is payable monthly at prime plus 0.5% (3.75% at September 30, 2012) plus a monthly maintenance fee of 0.125 percentage points on the average daily account balance. Interest on the Term Loan bears interest at prime plus 1% (4.25% at September 30, 2012). In connection with establishing the credit facility, the Company incurred fees payable to Bridge Bank of approximately $100,000. The agreement calls for a termination fee until the first anniversary and prepayment fee on the Term Loan until the first anniversary.

28 -------------------------------------------------------------------------------- On October 11, 2012 we entered into the Second Business Financing Modification Agreement with Bridge Bank (the "Second Amendment") changed the minimum asset coverage ratio to 0.9 to 1.0 for September 2012 and October 2012, 1.0 to 1.0 for November and December 2012 and 1.15 to 1.0 for each measuring period thereafter beginning January 2013. It also changed the minimum operating profit measured monthly on a trailing 3 month basis to not less than $600,000 for the September 2012 measuring period and $1,000,000 for the October 2012 measuring period. Also changed was the minimum debt service ratio, measured monthly on a trailing 3 month basis, to not less than 1.1 to 1.0 for November 2012 measuring period, 1.25 to 1.0 for December 2012 and 1.50 to 1.0 for each measuring period thereafter beginning January 2013. Further, the Second Amendment waived the event of default caused by the non-compliance of the operating profit in July and August 2012. Additionally, pursuant to the Second Amendment, the Company issued Bridge Bank a warrant to purchase 51,724 shares of our own common stock exercisable at $0.87 per share until October 2017.

As of September 30, 2012, we were not in compliance with all terms of the amended Bridge Bank credit facility, however we regained compliance upon execution of the Second Amendment.

We may seek to raise additional capital through public or private equity financings in order to fund our operations, take advantage of favorable business opportunities, develop and upgrade our technology infrastructure, develop new product and service offerings, take advantage of favorable conditions in capital markets, sell certain of our operations or respond to competitive pressures in an effort to maintain our market position. We cannot be assured that additional financing will be available to us on favorable terms, or at all. If we issue additional equity, our existing stockholders may experience substantial dilution. If we continue to generate losses and are unable to comply with the continued listing standards of NYSE MKT, we could be delisted and be unable to raise additional capital at a reasonable cost. At September 30, 2012, we had a working capital deficit of approximately $3 million and availability under our revolving line of credit of approximately $1.1 million. We believe with the continued improvement in cash flow, the reduction of duplicate costs with respect to the merger with Vertro and the higher limit of the new bank facility, we will have sufficient cash for the next twelve months.

Cash flows Net cash provided in operating activities for the nine months ended September 30, 2012 totaled approximately $541,000 compared to approximately $408,000 during the same period in 2011. The net cash provided in operating activities in 2012 is primarily due to stock compensation costs of $632,000, an increase in accounts receivable of $881,000 and prepaid expenses and other assets of $266,000. This was offset by uses of cash to decrease accounts payable ($263,000) and other accrued expenses and current liabilities ($842,000). The net cash provided by operating activities for the nine months ended September 30, 2011 was primarily due to a decrease in accounts receivable of approximately $1.5 million and the deferred compensation program instituted last year to preserve the company's cash reserves ($368,000) partially offset by a decrease in accounts payable of $1.3 million.

Net cash used in investing activities in 2012 of $1,254,000 was primarily due to the purchase of bundled downloads for the Alot AppBar and capitalized development costs. Net cash used in investing activities for the nine months ended September 30, 2011 of $2.6 million was primarily associated with the purchase of names for resale in the BabytoBee and lead generation businesses.

Net cash provided by financing activities during the nine months ended September 30, 2012 and 2011 were approximately $3.9 million and $3.2 million, respectively. The cash provided by financing activities for the period in 2012 resulted from the proceeds from the bank term note and draw downs from the bank credit facility. In the nine month period of 2011, the cash provided was primarily from the sale of our common stock in June 2011 and due to draw downs from the bank credit facility.

Off Balance Sheet Arrangements As of September 30, 2012, we do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors. The term "off-balance sheet arrangement" generally means any transaction, agreement or other contractual arrangement to which an entity unconsolidated with us is a party, under which we have any obligation arising under a guarantee contract, derivative instrument or variable interest or a retained or contingent interest in assets transferred to such entity or similar arrangement that serves as credit, liquidity or market risk support for such assets.

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