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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2011
 
OR
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from            to            
 
Commission file number 001-34749

REACHLOCAL, INC.
(Exact name of registrant as specified in its charter)

 
Delaware
20-0498783
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
 
21700 Oxnard Street, Suite 1600
Woodland Hills, California
91367
(Address of principal executive offices)
(Zip Code)
 
Registrant’s telephone number, including area code: (818) 274-0260

 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer. See definition of “accelerated filer,” “large accelerated filer” and “smaller reporting company’ in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer
¨
Accelerated filer
¨
       
Non-accelerated filer
x  (Do not check if a smaller reporting company)
Smaller reporting company
¨
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.):    Yes  ¨    No  x
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
 
Title of Class
 
Number of Shares Outstanding on November 3, 2011
Common Stock, $0.00001 par value
 
29,392,406
 
 
1

 
INDEX
 
     
Page
Part I.
Financial Information
 
 
Item 1.
Condensed Consolidated Financial Statements (unaudited)
 
   
Condensed Consolidated Balance Sheets as of September 30, 2011 and December 31, 2010
       3
   
Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2011 and 2010
       4
   
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2011 and 2010
       5
   
Notes to the Condensed Consolidated Financial Statements
       6
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
15
 
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
29
 
Item 4.
Controls and Procedures
29
     
Part II.
Other Information
 
 
Item 1.
Legal Proceedings
30
 
Item 1A.
Risk Factors
30
 
Item 6.
Exhibits
30
   
Signatures
31
 
 
2

 
PART I

FINANCIAL INFORMATION

Item 1.
FINANCIAL STATEMENTS
 
REACHLOCAL, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
(Unaudited)
 
   
September 30,
   
December 31,
 
   
2011
   
2010
 
Assets
           
Current assets:
           
Cash and cash equivalents
  $ 93,593     $ 79,906  
Short-term investments
    627       8,208  
Accounts receivable, net of allowance for doubtful accounts of $376 and $373 at September 30, 2011
     and December 31, 2010, respectively
    4,052       3,295  
Prepaid expenses and other current assets
    2,097       2,372  
Assets of discontinued operations, net
          2,026  
Total current assets
    100,369       95,807  
                 
Property and equipment, net
    8,854       6,531  
Capitalized software development costs, net
    11,139       8,829  
Restricted certificates of deposit
    964       801  
Intangible assets, net
    2,503       2,963  
Other assets
    1,159       1,339  
Goodwill
    41,766       34,118  
Total assets
  $ 166,754     $ 150,388  
                 
                 
                 
Liabilities and Stockholders’ Equity
               
Current Liabilities:
               
Accounts payable
  $ 28,307     $ 27,471  
Accrued expenses
    17,649       14,042  
Deferred payment obligations
    1,939       530  
Deferred revenue and other current liabilities
    28,630       24,656  
Total current liabilities
    76,525       66,699  
                 
Deferred rent and deferred payment obligations
    2,461       1,673  
Total liabilities
    78,986       68,372  
                 
                 
Commitments and contingencies (Note 6)
               
                 
Stockholders’ Equity:
               
Common stock, $0.00001 par value—140,000 shares authorized; 29,394 and 28,165 shares issued and
     outstanding at September 30, 2011 and December 31, 2010, respectively
           
Receivable from stockholder
    (87 )    
 
(87
)
Additional paid-in capital
    113,209       98,140  
Accumulated deficit
    (25,041 )    
(16,044
)
Accumulated other comprehensive income (loss)
    (313 )     7  
Total stockholders’ equity
    87,768       82,016  
Total liabilities and stockholders’ equity
  $ 166,754     $ 150,388  
 
See notes to condensed consolidated financial statements.
 
 
3

 
REACHLOCAL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(Unaudited)
 

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Revenue
  $ 98,629     $ 77,121     $ 275,439     $ 211,109  
Cost of revenue
    50,265       42,172       141,363       115,458  
Operating expenses:
                               
Selling and marketing
    36,769       28,343       103,457       78,046  
Product and technology
    4,257       2,623       10,800       7,034  
General and administrative
    8,821       5,970       24,470       16,940  
Total operating expenses
    49,847       36,936       138,727       102,020  
Loss from continuing operations
    (1,483 )     (1,987 )     (4,651 )     (6,369 )
Other income, net
    280       155       697       410  
                                 
Loss from continuing operations before provision (benefit)
     for income taxes
    (1,203 )     (1,832 )     (3,954 )     (5,959 )
Provision (benefit) for income taxes
    126       83       323       (462 )
Loss from continuing operations, net of income taxes
    (1,329 )     (1,915 )     (4,277 )     (5,497 )
Loss from discontinued operations, net of income taxes
    (3,272 )     (956 )     (4,720 )     (2,022 )
Net loss
  $ (4,601 )   $ (2,871 )   $ (8,997 )   $ (7,519 )
                                 
Net loss per share from continuing operations, basic and diluted
  $ (0.05 )   $ (0.07 )   $ (0.15 )   $ (0.32 )
Net loss per share from discontinued operations, basic and diluted
    (0.11 )     (0.03 )     (0.16 )     (0.12 )
Net loss per share, basic and diluted
  $ (0.16 )   $ (0.10 )   $ (0.31 )   $ (0.44 )
                                 
                                 
Weighted average common shares used in computation of net
     loss per share, basic and diluted
    29,302       27,848       28,936       17,157  
                                 
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:
                               
Net loss per share from continuing operations, basic and diluted
  $ (0.05 )   $ (0.07 )   $ (0.15 )   $ (0.21 )
Net loss per share from discontinued operations, basic and diluted
    (0.11 )     (0.03 )     (0.16 )     (0.08 )
Net loss per share, basic and diluted
  $ (0.16 )   $ (0.10 )   $ (0.31 )   $ (0.29 )
                                 
Weighted average common shares used in computation of net loss
     per share, as if converted:
                               
Basic and diluted
    29,302       27,848       28,936       25,728  
 
See notes to condensed consolidated financial statements.
 
 
4

 
REACHLOCAL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
 
   
Nine Months Ended September 30,
 
   
2011
   
2010
 
Cash flow from operating activities:
           
Net loss from continuing operations
  $ (4,277 )   $ (5,497 )
Adjustments to reconcile net loss to net cash provided by operating activities:
               
Depreciation and amortization
    7,635       4,354  
Stock-based compensation, net
    6,316       3,966  
Provision for doubtful accounts
    180       234  
Impairment of intangible assets
    764        
Provision for deferred income taxes
          (702 )
Accrual of interest on deferred payment obligations
    25       (102 )
Changes in operating assets and liabilities:
               
Accounts receivable
    (903 )     (318 )
Prepaid expenses and other current assets
    273       (673 )
Other assets
    163       (368 )
Accounts payable and accrued expenses
    4,734       (50 )
Deferred revenue and deferred payment obligations
    4,984       7,008  
Net cash provided by operating activities, continuing operations
    19,894       7,852  
Net cash used for operating activities, discontinued operations
    (1,307 )     (1,683 )
Net cash provided by operating activities
    18,587       6,169  
                 
Cash flow from investing activities:
               
Additions to property, equipment and software
    (9,547 )     (5,899 )
Purchase of DealOn, net of acquired cash
    (5,793 )      
Purchase of SMB:LIVE, net of acquired cash
          (2,759 )
Payment of deferred obligations
    (417 )     (5,853 )
Proceeds from maturity of certificates of deposits
    7,666        
Purchase of restricted certificates of deposit
    (195 )     371  
Purchase of short-term investments
    (85 )     (136 )
Net cash used in investing activities, continuing operations
    (8,371 )     (14,276 )
Net cash used in investing activities, discontinued operations
    (1,244 )     (1,033 )
                 
Net cash used in investing activities
    (9,615 )     (15,309 )
Cash flow from financing activities:
               
Proceeds from exercise of stock options
    5,515       428  
Proceeds from initial public offering
          47,648  
Deferred offering costs
          (4,620 )
Net cash provided by financing activities
    5,515       43,456  
Effect of exchange rate changes on cash
    (800 )     460  
Net change in cash and cash equivalents
    13,687       34,776  
Cash and cash equivalents—beginning of period
    79,906       35,379  
Cash and cash equivalents—end of period
  $ 93,593     $ 70,155  
Supplemental disclosure of other cash flow information:
               
Cash paid for interest
  $     $ 184  
Cash paid for income taxes
  $ 150     $ 114  
                 
Supplemental disclosure of non-cash investing and financing activities:
               
Capitalized software development costs resulting from stock-based compensation
     and deferred payment obligations
  $ 1,237     $ 1,777  
Deferred payment obligations
  $ 1,878     $ 639  
 
See notes to condensed consolidated financial statements.
 
 
5

 
REACHLOCAL, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. Organization and Description of Business
 
ReachLocal, Inc. (the “Company”) was incorporated in the state of Delaware in August 2003. The Company’s operations are located in the United States, Canada, Australia, the United Kingdom, India, the Netherlands and Germany. The Company’s mission is to help small- and medium-sized businesses (“SMBs”) acquire, maintain and retain customers via the Internet. The Company offers a comprehensive suite of online marketing solutions, including search engine marketing (ReachSearch™), Web presence (ReachCast™), display advertising (ReachDisplay™) and remarketing, deal commerce (ReachDeals™) , online marketing analytics (TotalTrack®), and an out-of-the-box assisted chat service (TotalLiveChat™), each targeted to the SMB market. The Company delivers this suite of services to SMBs through a combination of its proprietary technology platform and its direct, “feet-on-the-street” sales force of Internet Marketing Consultants, or IMCs, and select third party agencies and resellers.  The Company has discontinued and is winding down the operations of Bizzy, which is a wholly owned subsidiary of the Company. The Company is headquartered in Woodland Hills, CA.
 
2. Summary of Significant Accounting Policies
 
Principles of Consolidation
 
The condensed consolidated financial statements include the accounts of ReachLocal, Inc. and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
 
Basis of Presentation
 
The accompanying condensed consolidated financial statements are unaudited. These unaudited interim condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) and applicable rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Certain information and note disclosures normally included in the financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Accordingly, these interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010. The condensed consolidated balance sheet as of December 31, 2010, included herein was derived from the audited consolidated financial statements as of that date, but does not include all disclosures including notes required by GAAP.
 
The unaudited interim condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and include all adjustments (consisting only of normal recurring adjustments) necessary for the fair presentation of the Company’s statement of financial position at September 30, 2011, the Company’s results of operations for the three and nine months ended September 30, 2011 and 2010, and the Company’s cash flows for the nine months ended September 30, 2011 and 2010. The results for the three and nine months ended September 30, 2011 are not necessarily indicative of the results to be expected for the year ending December 31, 2011. All references to the three and nine months ended September 30, 2011 and 2010 in the notes to the condensed consolidated financial statements are unaudited.
 
Discontinued Operations

As a result of the winding down of the operations of Bizzy, the Company has reclassified and presented all related historical financial information as “discontinued operations” in the accompanying Consolidated Balances Sheets, Consolidated Statements of Operations and Consolidated Statements of Cash Flows. In addition, all Bizzy related activities have been excluded from footnote disclosures unless specifically referenced. Refer to Note 10 “Subsequent Events” for additional information.

Use of Estimates
 
The preparation of financial statements in conformity with GAAP requires management 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 financial statements and the reported amounts of income and expenses during the reporting period. These estimates are based on information available as of the date of the financial statements. Therefore, actual results could differ from those estimates.
 
 
6

 
Software Development Costs
 
The Company capitalizes costs to develop software when management has determined that the development efforts will result in new or additional functionality or new products. Costs capitalized as internal use software are amortized on a straight-line basis over the estimated three-year useful life. Costs incurred prior to meeting these criteria and costs associated with ongoing maintenance are expensed as incurred and are recorded along with amortization of capitalized software development costs as product and technology expenses within the accompanying condensed consolidated statements of operations.
 
Goodwill

The Company’s goodwill is attributable to business acquisitions completed from 2009 through 2011. Management evaluates 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 estimated fair value of an internal reporting unit with its carrying amount, including goodwill. If the estimated 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 estimated 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. Management performs an annual impairment test of goodwill as of the first day of each fiscal fourth quarter (October 1).
 
Revenue Recognition
 
The Company recognizes revenue for its services when all of the following criteria are satisfied:
 
             
persuasive evidence of an arrangement exists;
 
services have been performed;
             
the selling price is fixed or determinable; and
 
collectability is reasonably assured.
 
The Company recognizes revenue as the cost for the third-party media is incurred, which is upon delivery of the advertising on behalf of its clients. The Company recognizes revenue for its ReachSearch product as clicks are recorded on sponsored links on the various search engines and for its ReachDisplay product when the display advertisements record impressions or as otherwise provided in its agreement with the applicable publisher. The Company recognizes revenue for its ReachCast product on a straight-line basis over the applicable service period for each campaign. The Company recognizes revenue when it charges set-up, management service or other fees on a straight-line basis over the term of the related campaign contract or the completion of any obligation for services, if shorter. When the Company receives advance payments from clients, management records these amounts as deferred revenue until the revenue is recognized. When the Company extends credit, management records a receivable when the revenue is recognized.
 
When the Company sells through agencies, it either receives payment in advance of services or in some cases extends credit. The Company pays each agency an agreed-upon commission based on the revenue it earns or cash it receives. Some agency clients who have been extended credit may offset the amount otherwise due to the Company by any commissions they have earned. Management evaluates whether it is appropriate to record the gross amount of campaign revenue or the net amount earned after commissions. When the Company is primary obligor, is subject to the credit risk, and has discretion over both price and media, management recognizes the gross amount of such sales as revenue and any commissions are recognized as a selling and marketing expense.
 
The Company also has a small number of resellers. Resellers integrate the Company’s services, including ReachSearch, ReachDisplay, ReachCast, remarketing and TotalTrack, into their product offerings. In each case, the resellers integrate with the Company’s platform, the RL Platform, through a custom application programming interface. Resellers are responsible for the price and specifications of the integrated product offered to their clients. Resellers pay the Company in arrears, net of commissions and other adjustments. Management recognizes revenue generated under reseller agreements net of the agreed-upon commissions and other adjustments earned or retained by the reseller, as management believes that the reseller retains sufficient control and bears sufficient risks to be considered the primary obligor in those arrangements.
 
 
7

 
The Company offers varying incentives to clients in exchange for certain minimum commitments. In these circumstances, management estimates the amount of the future incentives that will be earned by clients and defers a portion of the otherwise recognizable revenue. Estimates are based upon a statistical analysis of previous campaigns for which such incentives were offered. Should a client not meet its minimum commitment and no longer qualify for the incentive, management recognizes the revenue previously deferred related to the estimated incentive.
 
During the first quarter of 2011, the Company began selling discounted deals to consumers on behalf of its SMB clients through the Company’s ReachDeals platform. The Company earns 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, the Company does not record redemption or breakage of the deals. The Company applies a sales allowance for potential consumer refunds.
 
Stock-Based Compensation
 
The Company accounts for stock-based compensation based on fair value. The Company follows the attribution method, which reduces current stock-based compensation expenses recorded by the effect of anticipated forfeitures. Management estimates forfeitures based upon its historical experience, which has resulted in a small expected forfeiture rate.
 
The fair value of each award is estimated on the date of the grant and amortized over the requisite service period, which is the vesting period. The Company uses the Black-Scholes option pricing model to estimate the fair value of stock-based awards on the date of grant. Determining the fair value of stock-based awards at the grant date under this model requires judgment, including estimating the value per share of common stock, volatility, expected term and risk-free interest rate. The assumptions used in calculating the fair value of stock-based awards represent management’s estimate based on judgment and subjective future expectations. These estimates involve inherent uncertainties. If any of the assumptions used in the Black-Scholes model significantly changes, stock-based compensation for future awards may differ materially from the awards granted previously.
 
Net Loss Per Share
 
Basic net loss per share available to common stockholders is computed by dividing the net loss available to common stockholders for the period by the weighted average number of common shares outstanding during the period. Diluted net loss per share available to common stockholders is computed by dividing the net loss for the period by the weighted average number of common and potential dilutive shares outstanding during the period, to the extent such shares are dilutive. Potential dilutive shares are composed of incremental common shares issuable upon the exercise of stock options, warrants and unvested restricted shares using the treasury stock method and convertible preferred stock under the if-converted method, where such conversions would be dilutive.
 
The following potentially dilutive securities have been excluded from the calculation of diluted net loss per common share as they would be anti-dilutive because the Company had net losses for the periods below (in thousands):
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Convertible preferred stock
                      8,571  
Restricted stock subject to repurchase
    52       365       87       294  
SMB:LIVE acquisition—deferred stock consideration
    56       133       194       115  
Stock options and warrant
    1,356       1,507       2,157       1,589  
      1,464       2,005       2,438       10,569  
 
In addition, certain other stock options have been excluded from the computation of diluted net loss per share because they had an anti-dilutive impact as the deemed proceeds under the treasury stock method were in excess of the average fair market value for the period.  For the three months ended September 30, 2011 and 2010, the number of such securities was 2,862,000 and 1,814,000, respectively, and for the nine months ended September 30, 2011 and 2010, the number of such securities was 1,583,000 and 1,225,000, respectively.

 
8

 
Recently Issued Accounting Standards

Accounting Standards Codification (“ASC”) Topic 220-10, Comprehensive Income - Presentation of Comprehensive Income, specifies an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. Under both options, an entity will be required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. Furthermore, regardless of the presentation methodology elected, the entity will be required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income. The amendments do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. The amendments also do not affect how earnings per share is calculated or presented. ASC Topic 220-10 is effective for the Company on January 1, 2012. Although adopting the guidance will not impact the Company’s accounting for comprehensive income, it will affect its presentation of components of comprehensive income by eliminating the Company’s practice of showing these items within the Consolidated Statements of Shareowners’ Equity.
 
ASC Topic 820-10, Fair Value Measurement - Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (International Financial Reporting Standards), clarifies existing fair value measurement and disclosure requirements, amends certain fair value measurement principles and requires additional disclosures about fair value measurements.  Adoption of this provision, which is effective for the Company on January 1, 2012, is not expected to have a material impact on the Company’s consolidated financial statements.

ASC Topic 350-20-35-3, Intangibles – Goodwill and Other, provides an entity with the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount.  If an entity determines that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is necessary. The amended guidance will be effective for the Company as of January 1, 2012, and early adoption is permitted. The Company is currently assessing the impact of the amended guidance on its consolidated financial statements.

3. Fair Value of Financial Instruments

The Company applies the fair value hierarchy for financial instruments. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value maximize the use of observable inputs and minimize the use of unobservable inputs. The fair value hierarchy is based on three levels of inputs, of which the first two are considered observable and the last is considered unobservable, that are used to measure fair value:

 
Level 1—Quoted prices in active markets for identical assets or liabilities.
 
Level 2—Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
 
Level 3—Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

 
The following table summarizes the basis used to measure certain of the Company’s financial assets that are carried at fair value (in thousands):
 
         
Basis of Fair Value Measurement
 
    Balance at
September 30,
2011
   
Quoted Prices in
Active Markets
for Identical
Items
(Level 1)
   
  Significant Other
Observable
Inputs
(Level 2)
   
  Significant
Unobservable
Inputs
(Level 3)
 
Cash and cash equivalents
  $ 93,593     $ 93,593     $     $  
                                 
Certificates of deposit
  $ 1,591     $ 1,591     $     $  
 
           
Basis of Fair Value Measurement
 
   
Balance at
December 31,
2010
   
Quoted Prices in
Active Markets
for Identical
Items
(Level 1)
   
Significant Other
Observable
Inputs
(Level 2)
   
Significant
Unobservable
Inputs
(Level 3)
 
Cash and cash equivalents
  $ 79,906     $ 79,906     $     $  
                                 
Certificates of deposit
  $ 9,009     $ 9,009     $     $  
 
 
9

 
 4. Acquisitions

Intangible Assets Acquired in Prior Periods

As of September 30, 2011, intangible assets from the acquisitions of ReachLocal Australia Pty Ltd. (“ReachLocal Australia”) and SMB:LIVE Corporation (“SMB:LIVE”) included customer relationships of $727,000 (net of accumulated amortization of $1,573,000) and developed technology of $1,086,000 (net of accumulated amortization of $1,214,000). Intangible assets are amortized on a straight-line basis over the estimated useful life of three years. Based on the current amount of intangibles subject to amortization, the estimated amortization expense for the succeeding three years is as follows (in thousands):
 
Year Ended December 31,
     
2011 (3 months)
  $ 383  
2012
    1,302  
2013
    128  
Total
  $ 1,813  
 
For the three months ended September 30, 2011 and 2010, amortization expense related to the ReachLocal Australia and SMB:LIVE intangibles was $383,000 and $384,000, respectively, and for the nine months ended September 30, 2011 and 2010, was $1,150,000 and $1,024,000, respectively.

Acquisition of DealOn

On February 8, 2011, the Company entered into an agreement to acquire all of the outstanding member interests of DealOn, LLC (“DealOn”) for consideration of up to approximately $9,566,000 in cash and stock. DealOn is a deal commerce company that operates in the United States and provided the Company with a turnkey platform to strategically enter the deal commerce space.

On the closing date, the Company paid $5,793,000 in cash and issued 82,878 shares of its common stock, valued at $1,895,000 based on fair value of the Company’s stock on the acquisition date. The balance of the purchase price of $1,955,000 (the “DealOn Deferred Consideration”) is payable in cash of $1,468,000 and in 21,297 shares of the Company’s common stock, and is subject to adjustment under the terms of the acquisition agreement. The following table summarizes the DealOn Deferred Consideration milestone payments, subject to adjustment under the acquisition agreement (in thousands):
 
   
Deferred
Cash
Consideration
   
Deferred
Stock
Consideration
   
Total
 
February 2012
  $ 734     $ 243     $ 977  
August 2012
    367       122       489  
February 2013
    367       122       489  
Total Deferred Consideration
  $ 1,468     $ 487     $ 1,955  
 
 
10

 
For purposes of determining the Company’s acquisition consideration, management discounted the DealOn Deferred Consideration to its then present value, or $1,878,000, and recorded this amount at the time of acquisition. The Company has accrued interest on the deferred consideration originally recorded. As of September 30, 2011, the Company has a total deferred payment obligation of $1,840,000, after certain purchase price adjustments, of which $1,379,000  is classified as a current liability.  The Company recorded the acquired assets and liabilities at their respective fair values. The following table summarizes the fair value of assets and liabilities acquired (in thousands):
 
At September 30, 2011, the remaining amortization of DealOn’s intangibles is as follows (in thousands):
 
Year Ended December 31,
     
2011 (3 months)
    162  
2012
    274  
2013
    229  
2014
    25  
Total
  $ 690  
 
As of September 30, 2011, intangible assets included customer relationships and developed technology of $690,000 (net of accumulated amortization of $626,000).  For the three and nine months ended September 30, 2011, amortization expense related to the acquired intangibles was $243,000 and $626,000, respectively.

In connection with the DealOn acquisition, the Company incurred approximately $414,000 in costs that are reflected in “general and administrative expense” in the accompanying Consolidated Statements of Operations for the nine months ended September 30, 2011.
 
5. Software Development Costs

Capitalized software development costs consisted of the following (in thousands):
 
   
September 30,
2011
   
December 31,
2010
 
Capitalized software development costs
  $ 20,709     $ 14,839  
Accumulated amortization
    (9,570 )     (6,010 )
Capitalized software development costs, net
  $ 11,139     $ 8,829  
 
The Company recorded amortization expense of $1,323,000 and $758,000 for the three months ended September 30, 2011 and 2010, respectively, and $3,517,000 and $1,727,000 for the nine months ended September 30, 2011 and 2010, respectively.  As of September 30, 2011, $1,275,000 of capitalized software development costs are related to projects still in process.

 
11

 
 
6. Commitments and Contingencies

Deferred Payment Obligations

On February 22, 2011, the Company made a deferred payment required under the SMB:LIVE acquisition agreement in the amount of $165,000 and issued 90,062 shares of its common stock. The payment reflected an adjustment for working capital as contemplated by the SMB:LIVE acquisition agreement.

On August 22, 2011, the Company paid $252,000 and issued 93,346 shares of its common stock under the SMB:LIVE acquisition agreement. The payment reflected deferred payment obligations under the SMB:LIVE acquisition agreement based on achieving certain milestones tied to employee retention objectives. The remaining deferred payment obligations are also based on achieving certain milestones tied to employee retention objectives through February 22, 2012 and include $575,000 of deferred cash consideration and 181,284 shares of the Company’s common stock.
 
As part of the acquisition of DealOn, the Company is obligated to pay up to approximately $1,468,000 in cash and 21,297 shares of its common stock, subject to adjustment under the terms of the acquisition agreement (see Note 4).
 
Litigation

From time to time the Company is involved in legal proceedings arising in the ordinary course of its business. The Company believes that there is no litigation pending that is likely to have a material adverse effect on its results of operations and financial condition.

On March 1, 2010, a class action lawsuit was filed by two of the Company’s former employees in California Superior Court in Los Angeles, California. The complaint alleged wage and hour violations in a Fair Labor Standards Act collective action and a California class action. On May 6, 2011, the Court granted preliminary approval of a settlement of the class action for $800,000, which together with legal costs resulted in a charge of $832,000 recorded in fiscal 2010. On or about February 2, 2011, a second class action lawsuit was filed by former employees alleging substantially similar wage and hour violations. The second class action was settled for a de minimis amount was dismissed by the court on September 27, 2011.

DealOn, which the Company acquired in February 2011, had been sued in two patent infringement matters. Both of the cases were dismissed without prejudice.

7. Stock-Based Compensation

Stock-based compensation cost is measured at the grant date, based on the fair value of the award, and recognized on a straight-line basis over the requisite service period, which is generally the vesting period.

The following table summarizes vested and unvested options activity (number of shares in thousands):
 
   
All Options
   
Vested Options
   
Unvested Options
 
   
Shares
   
Weighted
Average
Exercise
Price
   
Shares
   
Weighted
Average
Exercise
Price
   
Shares
   
Weighted
Average
Exercise
Price
 
Outstanding at December 31, 2010
    6,235     $ 9.88       3,247     $ 7.58       2,988     $ 12.45  
                                                 
Granted
    1,466       21.61       1       20.98       1,465       21.61  
Options vesting
                1,033       11.66       (1,033 )     11.66  
Exercised
    (932 )     5.87       (932 )     5.87              
Forfeited
    (270 )     14.53       (4 )     10.03       (266 )     14.59  
Outstanding at September 30, 2011
    6,499     $ 12.90       3,345     $ 9.32       3,154     $ 16.85  
 
During the nine months ended September 30, 2011, the Company granted 1.5 million stock options with exercise prices ranging from $16.70 per share to $25.51 per share, and vesting periods of 4 years.
 
12

 
The following table presents the weighted-average assumptions used to estimate the fair values of the stock options granted during the three and nine months ended September 30, 2011 and 2010.
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Expected dividend yield
    0 %     0 %     0 %     0 %
Risk-free interest rate
    1.12 %     1.70 %     2.04 %     4.75 %
Expected life (in years)
    4.75       4.75       4.75       4.75  
Expected volatility
    57 %     57 %     57 %     57 %
 
The weighted average remaining contractual life of all options outstanding as of September 30, 2011 was 5.2 years. The remaining contractual life for options vested and exercisable at September 30, 2011 was 4.6 years. Furthermore, the aggregate intrinsic value of all options outstanding as of September 30, 2011 was $6,198,000, and the aggregate intrinsic value of options vested and exercisable at September 30, 2011 was $6,120,000, in each case based on the fair value of the Company’s common stock on September 30, 2011. The per-share weighted-average grant date fair value of unvested options as of September 30, 2011 was $7.82. The per share weighted-average grant date fair value of options vested during the nine months ended September 30, 2011 was $4.47. The per-share weighted-average grant date fair value of options forfeited during the nine months ended September 30, 2011 was $6.30. The total fair value of options vested during the nine months ended September 30, 2011was $4,620,000. The aggregate intrinsic value of stock options exercised during the nine months ended September 30, 2011 was $14,174,000.
 
Restricted Stock Units

The following table summarizes restricted stock unit activity (in thousands):
 
   
Restricted
Stock Units
   
Vested
   
Unvested
 
Outstanding at December 31, 2010
    2,662       2,535       127  
                         
Issuance of restricted stock units
    90       7       83  
Cancelled
    (4 )           (4 )
Vested
          27       (27 )
Outstanding at September 30, 2011
    2,748       2,569       179  
 
 Stock-Based Compensation Expense

The Company records stock-based compensation expense net of amounts capitalized as software development costs. The following table summarizes stock-based compensation (in thousands):
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Stock-based compensation
  $ 2,574     $ 2,122     $ 7,409     $ 5,345  
Less: Capitalized stock-based compensation
    243       598       1,093       1,379  
Stock-based compensation expense, net
  $ 2,331     $ 1,524     $ 6,316     $ 3,966  
 
 
13

 
 
  Stock-based compensation expense, net of capitalization, is included in the accompanying condensed consolidated statements of operations in the following captions (in thousands):
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Stock-based compensation expense, net
                       
Cost of revenue
  $ 60     $ 51     $ 176     $ 212  
Selling and marketing
    325       318       1,068       757  
Product and technology
    421       284       976       766  
General and administrative
    1,525       871       4,096       2,231  
    $ 2,331     $ 1,524     $ 6,316     $ 3,966  
 
As of September 30, 2011, there was $23,771,000 of unrecognized stock-based compensation related to restricted stock units and outstanding stock options, net of estimated forfeitures. This amount is expected to be recognized over a weighted average period of 1.5 years. Future stock-based compensation expense for these awards may differ in the event actual forfeitures deviate from management’s estimates.
 
8. Income Taxes

The Company follows ASC Topic 740-270, Income taxes—Interim Reporting, for the computation and presentation of its interim period tax provision. Accordingly, management estimates the effective annual tax rate and applies this rate to the year-to-date pre-tax book income or loss to determine the interim provision for income taxes. For the three and nine months ended September 30, 2011, the income tax provisions were $126,000 and $323,000, respectively, and relate to federal, state, local and foreign income taxes. The income tax benefit for the nine months ended September 30, 2010 was primarily attributable to the acquisition of SMB:LIVE, in which we recorded a one-time discrete deferred tax benefit of $702,000.
 
The Company and its subsidiaries file income tax returns in the U.S. federal, various state and foreign jurisdictions. All of the Company’s income tax returns since inception are open to examination by federal, state, and foreign tax authorities. In August of 2010, the Internal Revenue Service initiated an examination of the Company’s U.S. consolidated 2008 income tax return that was finalized in March 2011 with no proposed adjustments.

9. Segment Information

Revenue by geographic region with respect to the Direct Local channel and national brands is based on the physical location of the sales office, and with respect to agencies and resellers, is based on the physical location of the agency or reseller. The following summarizes revenue by geographic region (in thousands):

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Revenue:
                       
North America
  $ 75,068     $ 63,726     $ 214,002     $ 176,834  
International
    23,561       13,395       61,437       34,275  
    $ 98,629     $ 77,121     $ 275,439     $ 211,109  
                                 
                                 
                   
September 30,
2011
   
December 31,
2010
 
                                 
Long-lived assets (excluding patents and other intangibles):
                               
North America
                  $ 7,900     $ 6,800  
International
                    3,045       1,649  
                    $ 10,945     $ 8,449  
 
10. Subsequent Events

On November 1, 2011, the Company announced that it will wind down the operations of Bizzy due to insufficient consumer adoption of the Bizzy recommendation engine and determined that Bizzy would be considered a discontinued operation as of the third quarter of 2011. In connection with this decision, the Company recorded a noncash charge of $2.5 million in the third quarter of 2011to reflect the impairment of capitalized software development costs. The Company expects to record a charge to discontinued operations in the fourth quarter of 2011 of approximately $0.7 million, consisting of personnel and severance costs, operating losses, and facilities and other costs. As the Company is in an overall tax loss position, it has recorded a full valuation allowance against any tax benefit resulting from the losses from discontinued operations.
 
    On November 4, 2011, the Company announced that its Board of Directors authorized the repurchase of up to $20 million of the Company’s outstanding common stock. Purchases will be made from time-to-time in open market or privately negotiated transactions as determined by the Company’s management. The amount and timing of the share repurchase will depend on business and market conditions, stock price, trading restrictions, acquisition activity, and other factors. The share repurchase program does not obligate the Company to acquire any particular amount of common stock, and the repurchase program may be suspended or discontinued at any time at the Company’s discretion.
 
 
14

 
 
Item 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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

 
 
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 78% for the nine months ended September 30, 2011, from 74% for the nine months ended September 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 revenue growth is driven by the increase in the number of our 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 September 30, 2011, we had 344 Upperclassmen and 464 Underclassman, for a total of 808 IMCs, as compared to 264 Upperclassmen and 432 Underclassman, for a total of 696 IMCs, as of September 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 $32.7 million during the nine months ended September 30, 2011, as compared to $26.0 million during the nine months ended September 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 and the Netherlands.

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, but excludes advertisers sold by our dedicated deal marketing consultants. 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, but excludes campaigns sold by our dedicated deal marketing consultants. 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 September 30, 2011, we had approximately 18,700 Active Advertisers, and 27,000 Active Campaigns as compared to approximately 17,100 Active Advertisers and 22,500 Active Campaigns as of September 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. These numbers reflect the exclusion of the Active Advertisers and Active Campaigns sold by our dedicated deal marketing consultants due to the elimination of those positions.  The second quarter of 2011 was the only quarter in which we included campaigns sold by our dedicated deal marketing consultants in the counts for Active Advertisers and Active Campaigns. If during the second quarter of 2011 the numbers of Active Advertisers and Active Campaigns were calculated in the foregoing manner, they would have been 18,200 and 25,500, respectively.

Recent Events
 
During the third quarter of 2011, we adjusted our business strategy for ReachDeals and eliminated the dedicated deal sales force given the increasingly competitive deal-of-the-day landscape.  In connection with such actions, we determined that the value of the customer list acquired with the acquisition of DealOn has diminished since the date of acquisition.  As a result, we recorded an impairment in the amount of $0.8 million in the third quarter of 2011.

On November 1, 2011, we announced that we will wind down the operations of Bizzy due to insufficient consumer adoption of the Bizzy recommendation engine and determined that Bizzy would be considered a discontinued operation as of the third quarter of 2011. In connection with this decision, we recorded a noncash charge of $2.5 million in the third quarter of 2011to reflect the impairment of capitalized software development costs. We expect to record a charge to discontinued operations in the fourth quarter of 2011 of approximately $0.7 million, consisting of personnel and severance costs, operating losses, and facilities and other costs.

Basis of Presentation

      Discontinued Operations

As a result of the winding down of the operations of Bizzy, we have reclassified and presented all related historical financial information as “discontinued operations” in the Consolidated Balance Sheets, Consolidated Statements of Operations and Consolidated Statements of Cash Flows. In addition, we have excluded all Bizzy related activities from the following discussions, unless specifically referenced.

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.

 
17

 
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 $4.1 million of related accounts receivable at September 30, 2011.

Through the ReachDeals platform, we now offer our SMB clients the ability to offer consumers discounted deals which we promote through our publisher network and our deal exchange. 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.

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. Cost of revenue also includes the amortization and impairment charges on certain acquired intangible assets.

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.

 
18

 
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

Stock-Based Compensation

  We granted stock options with the following exercise prices during the nine months ended September 30, 2011:
 
Grant Dates
 
Number of Shares
Underlying
Options
   
Exercise Price
Per Share
   
Estimated Fair
Value Per
Underlying
Share as of
Grant Date
   
Intrinsic Value
Per Share at 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     $  
August 2011
    229,650     $ 16.70     $ 16.70     $  
 
The following table summarizes the weighted average assumptions relating to our stock options granted during the nine months ended September 30, 2011:
 
Expected dividend yield
    0 %
Risk free interest rate
    2.04 %
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 $5.8 million during the nine months ended September 30, 2011, which includes $0.8 million of SMB:LIVE deferred stock compensation during such period. At September 30, 2011, we had unrecorded compensation costs of $21.0 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 1.5 years.
 
During the nine months ended September 30, 2011, we also issued 90,159 restricted stock units and recorded non-cash stock-based compensation expense of approximately $0.5 million related to restricted stock units. At September 30, 2011, we had $2.8 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 $1.7 million and $1.9 million of software development costs during the three months ended September 30, 2011 and 2010, respectively.  We capitalized $5.7 million and $5.0 million of software development costs during the nine months ended September 30, 2011 and 2010, respectively. During the three and nine months ended September 30, 2011, we recorded a $2.5 million loss in discontinued operations related to the impairment of capitalized software development costs of our Bizzy subsidiary.

 
19

 
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 September 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.

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. As discussed above, we recorded a $764,000 impairment charge on acquired DealOn intangible assets during the three and nine months ended September 30, 2011.
 
 
20

 
Results of Operations

Comparison of the Three and Nine Months Ended September 30, 2011 and 2010

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
(in thousands)  
2011
   
2010
   
2011
   
2010
 
Revenue
  $ 98,629     $ 77,121     $ 275,439     $ 211,109  
Cost of revenue (1)
    50,265       42,172       141,363       115,458  
Operating expenses:
                               
Selling and marketing (1)
    36,769       28,343       103,457       78,046  
Product and technology (1)
    4,257       2,623       10,800       7,034  
General and administrative (1)
    8,821       5,970       24,470       16,940  
Total operating expenses
    49,847       36,936       138,727       102,020  
Loss from continuing operations
    (1,483 )     (1,987 )     (4,651 )     (6,369 )
Other income, net
    280       155       697       410  
                                 
Loss from continuing operations before provision (benefit) for income taxes
    (1,203 )     (1,832 )     (3,954 )     (5,959 )
Provision (benefit) for income taxes
    126       83       323       (462 )
Loss from continuing operations, net of income taxes
    (1,329 )     (1,915 )     (4,277 )     (5,497 )
Loss from discontinued operations, net of income taxes
    (3,272 )     (956 )     (4,720 )     (2,022 )
Net loss
  $ (4,601 )   $ (2,871 )   $ (8,997 )   $ (7,519 )
 
(1)           Stock-based compensation, net of capitalization, and depreciation and amortization, included in the above line items (in thousands):
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Stock-based compensation:
                       
Cost of revenue
  $ 60     $ 51     $ 176     $ 212  
Selling and marketing
    325       318       1,068       757  
Product and technology
    421       284       976       766  
General and administrative
    1,525       871       4,096       2,231  
    $ 2,331     $ 1,524     $ 6,316     $ 3,966  
                                 
                                 
                                 
Depreciation and amortization:
                               
Cost of revenue
  $ 194     $ 97     $ 551     $ 267  
Selling and marketing
    413       257       1,080       745  
Product and technology
    1,862       1,084       5,033       2,555  
General and administrative
    359       278       971       787  
    $ 2,828     $ 1,716     $ 7,635     $ 4,354  
 
 
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2011
   
2010
   
2011-2010
% Change
   
2011
   
2010
   
2011-2010
% Change
 
                                     
Revenue:
                                   
Direct Local
  $ 76,814     $ 57,245       34.2 %   $ 213,168     $ 156,816       35.9 %
National Brands, Agencies and Resellers
    21,815       19,876       9.8 %     62,271       54,293       14.7 %
Total revenue
  $ 98,629     $ 77,121       27.9 %   $ 275,439     $ 211,109       30.5 %
                                                 
At period end:
                                               
Number of IMCs:
                                               
Upperclassmen
                            344       264       30.3 %
Underclassmen
                            464       432       7.4 %
Total
                            808       696       16.1 %
Active Advertisers (1)
                            18,700       17,100       9.4 %
Active Campaigns (2)
                            27,000       22,500       20.0 %
 
 
21

 
 

(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, but excludes advertisers sold by our dedicated deal marketing consultants. 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. These numbers reflect the exclusion of the Active Advertisers sold by our dedicated deal marketing consultants due to the elimination of those positions.  The second quarter of 2011 was the only quarter in which we included advertisers sold by our dedicated deal marketing consultants in the counts for Active Advertisers. If during the second quarter of 2011 the numbers of Active Advertisers was calculated in the foregoing manner, it would have been 18,200. 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, but excludes campaigns sold by our dedicated deal marketing consultants. 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. These numbers reflect the exclusion of the Active Campaigns sold by our dedicated deal marketing consultants due to the elimination of those positions.  The second quarter of 2011 was the only quarter in which we included campaigns sold by our dedicated deal marketing consultants in the counts for Active Campaigns. If during the second quarter of 2011 the numbers of Active Campaigns was calculated in the foregoing manner, it would have been 25,500. Numbers are rounded to the nearest hundred.
 
Direct Local revenue increased $19.6 million, or 34.2%, for the three months ended September 30, 2011 compared to the three months ended September 30, 2010, and $56.4 million, or 35.9%, for the nine months ended September 30, 2011 compared to the nine months ended September 30, 2010. The increases in our Direct Local revenue were largely attributable to incremental revenue from new Upperclassmen, that is, IMCs who were Underclassmen at September 30, 2010, but became Upperclassmen by September 30, 2011, increased productivity of our existing Upperclassmen, that is, IMCs who were already Upperclassmen at September 30, 2010, and revenue generated by new Underclassmen.

National Brands, Agencies and Resellers revenue increased $1.9 million, or 9.8%, for the three months ended September 30, 2011 compared to the three months ended September 30, 2010, and $8.0 million, or 14.7%, for the nine months ended September 30, 2011 compared to the nine months ended September 30, 2010.  The increases were primarily due to $2.6 million and $8.2 million in higher revenue from our National Brands clients during the three and nine months ended September 30, 2011, respectively, which we attribute to greater productivity from our direct sales efforts. The increases in National Brands revenue were slightly offset by decreases of $0.7 million and $0.2 million in revenues from Agencies and Resellers during the three and nine months ended September 30, 2011, respectively, which was due to a decrease in both the number of active Agencies and Resellers and their productivity, which we believe a part of which can be attributed to the macro-economic environment.
 
 Cost of Revenue
 
   
Three Months Ended
September 30,
     
2011-2010
    Nine Months Ended
September 30,
     
2011-2010
 
   
2011
   
2010
   
% Change
   
2011
   
2010
   
% Change
 
                                     
(in thousands)
                                   
Cost of revenue
  $ 50,265     $ 42,172       19.2 %   $ 141,363     $ 115,458       22.4 %
                                                 
As a percentage of revenue:
    51.0 %     54.7 %             51.3 %     54.7 %        
 
The decrease in our cost of revenue as a percentage of revenue for the three months ended September 30, 2011 compared to the three months ended September 30, 2010, was primarily due to an increase in publisher and vendor rebates and performance bonuses, changes in product and service mix, including increased sales of ReachCast and ReachDisplay, and improved media buying efficiencies related to our core products introduced in late 2010. The decrease as a percentage of revenue was partially offset by DealOn operating costs and a $764,000 impairment charge related to DealOn’s intangible asset for the acquired customer list.
 
The decrease in our cost of revenue as a percentage of revenue for the nine months ended September 30, 2011 compared to the nine months ended September 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 an increase in publisher and vendor rebates and performance bonuses.
 
Publisher rebates as a percentage of revenue increased to 3.9% of revenue in the three months ended September 30, 2011 from 2.1% for the same period a year ago, and to 2.8% of revenue in the nine months ended September 30, 2011 from 2.1% 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 costs of support and delivery.
 
22

 

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
September 30,
     
2011-2010
  Nine Months Ended
September 30,
     
2011-2010
   
2011
   
2010
   
% Change
 
2011
   
2010
   
% Change
(in thousands)
                                   
Salaries, benefits and other costs
  $ 26,086     $ 19,246       35.5 %   $ 73,047     $ 53,174       37.4 %
Commission expense
    10,683       9,097       17.4 %     30,410       24,872       22.3 %
Total selling and marketing
  $ 36,769     $ 28,343       29.7 %   $ 103,457     $ 78,046       32.6 %
                                                 
Underclassmen Expense included above, excluding commissions (1)
  $ 11,591     $ 9,540       21.5 %   $ 32,714     $ 26,025       25.7 %
                                                 
As a percentage of revenue:
                                               
Salaries, benefits and other costs
    26.4 %     25.0 %             26.5 %     25.2 %        
Commission expense
    10.8 %     11.8 %             11.0 %     11.8 %        
Total selling and marketing
    37.3 %     36.8 %             37.6 %     37.0 %        
 

(1)
See “Non-GAAP Financial Measures” for our definition of Underclassmen Expense.

The increases in absolute dollars of salaries, benefits and other costs in selling and marketing expenses for the three and nine months ended September 30, 2011 compared to the three and nine months ended September 30, 2010, were 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 DealOn operations, which did not exist in the prior year periods, and due to expansion of sales operations in Germany and the commencement of sales operations in the Netherlands, partially offset by increasing productivity from pre-existing markets.

The increases in commission expense in absolute dollars for the three and nine months ended September 30, 2011 compared to the three and nine months ended September 30, 2010, were 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 increases in Underclassmen Expense for the three and nine months ended September 30, 2011 compared to the three and nine months ended September 30, 2010, were primarily due to increased IMC hiring, particularly in international markets. As we continue to invest in additional Underclassmen and retain additional Upperclassmen, selling and marketing expenses will continue to increase in absolute dollars.
 
 
23

 
Product and Technology
 
   
Three Months Ended
September 30,
   
2011-2010
% Change
 
Nine Months Ended
September 30,
   
2011-2010
% Change
   
2011
   
2010
   
2011
   
2010
 
                                     
(in thousands)
                                   
Product and technology expenses
  $ 4,257     $ 2,623       62.3 %   $ 10,800     $ 7,034       53.4 %
Capitalized software development costs
     from product and technology resources
    1,682       1,889       (11.0 )%     5,690       5,038       12.9 %
Total product and technology expenses and
     capitalized costs
  $ 5,939     $ 4,512       31.6 %   $ 16,490     $ 12,072       36.6 %
                                                 
As a percentage of revenue:
                                               
Product and technology expenses costs
    4.3 %     3.4 %             3.9 %     3.3 %        
Capitalized software development costs from
     product and technology resources
    1.7 %     2.5 %             2.1 %     2.4 %        
Total product and technology costs expensed
     and capitalized
    6.0 %     5.9 %             6.0 %     5.7 %        
 
The increase in product and technology expenses in both absolute dollars and as a percentage of revenue for the three months ended September 30, 2011 compared to the three months ended September 30, 2010, was primarily attributable to $0.7 million of  increased salaries and compensation expense as a result of increased headcount and ongoing development of the RL Platform, including ReachCast, $0.6 million of increased amortization expense related to previously capitalized software development costs,  and $0.4 million of incremental salary and other costs associated with DealOn, for which no corresponding amounts existed during the prior-year period.
 
The increase in product and technology expenses in both absolute dollars and as a percentage of revenue for the nine months ended September 30, 2011 compared to the nine months ended September 30, 2010, was primarily attributable to $1.8 million of increased amortization expense related to previously capitalized software development costs, $1.0 million of incremental salary and other costs associated with DealOn, for which no corresponding amounts existed during the prior year period, and $1.0 million of increased salaries and compensation expense as a result of increased headcount and ongoing development of the RL Platform, including ReachCast.

The decrease in the amount of capitalized software development costs in absolute dollars for the three months ended September 30, 2011 compared to the three months ended September 30, 2010 was due to the timing of capitalizable and non-capitalizable projects.  The increase in the amount of capitalized software development costs in absolute dollars for the nine months ended September 30, 2011 compared to the nine months ended September 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 RL Platform, and DealOn. The decreases in the amount of capitalized software development costs as a percentage of revenue for the three and nine months ended September 30, 2011 compared to the three and nine months ended September 30, 2010, were due to timing of capitalizable and non-capitalizable projects.

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 cycles.
 
24

 

General and Administrative
 
   
Three Months Ended
September 30,
   
2011-2010
% Change
   
Nine Months Ended
September 30,
   
2011-2010
% Change
 
   
2011
   
2010
   
2011
   
2010
 
                                     
(in thousands)
                                   
General and administrative
  $ 8,821     $ 5,970       47.8 %   $ 24,470     $ 16,940       44.4 %
                                                 
As a percentage of revenue:
    8.9 %     7.7 %             8.9 %     8.0 %        
 
The increase in general and administrative expenses in absolute dollars and as a percentage of revenue for the three months ended September 30, 2011 compared to the three months ended September 30, 2010, was primarily due to $1.1 million of increased 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 increased stock-based compensation expense; and $0.5 million of increased facilities and related 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 nine months ended September 30, 2011 compared to the nine months ended September 30, 2010, was primarily due to $2.7 million of increased tax, consulting and legal professional fees, including costs to support our international expansion and comply with the Sarbanes-Oxley Act of 2002; $1.9 million of increased stock-based compensation expense; $1.1 million of increased employee costs to support the growth of the business and the requirements associated with being a public company; and $1.0 million of increased facilities and related 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 $0.3 million for the nine months ended September 30, 2011 compared to the nine months ended September 30, 2010. The change was attributable to an increase in interest income during the current period resulting from higher invested balances.

Provision (Benefit) for Income Taxes

The income tax provision of $0.3 million for the nine months ended September 30, 2011 relates to federal, state, local and foreign income taxes. The income tax benefit of $0.5 million for the nine months ended September 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.

Loss from Discontinued Operations

On November 1, 2011, we announced that we will wind down the operations of Bizzy due to insufficient consumer adoption of the Bizzy recommendation engine and determined that Bizzy would be considered a discontinued operation as of the third quarter of 2011. In connection with this decision, we recorded a noncash charge of $2.5 million in the third quarter of 2011to reflect the impairment of capitalized software development costs. We expect to record a charge to discontinued operations in the fourth quarter of 2011 of approximately $0.7 million, consisting of personnel and severance costs, operating losses, and facilities and other costs.
 
 
25

 

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 nine months ended September 30, 2011 and 2010 our Adjusted EBITDA and Underclassmen Expense were as follows:
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
(in thousands)
                       
Adjusted EBITDA (1)
  $ 4,530     $ 1,286     $ 10,674     $ 2,493  
Underclassmen Expense (2)
  $ 11,591     $ 9,540     $ 32,714     $ 26,025  
 
(1)
Adjusted EBITDA. We define Adjusted EBITDA as net income (loss) from continuing operations before interest, income taxes, depreciation and amortization expenses, excluding, when applicable, stock-based compensation, the effects of accounting for business combinations (including any impairment of acquired intangibles and, in the case of the acquisition of SMB:LIVE, the deferred cash consideration), and amounts included in other non-operating income or expense. This definition excludes the effect of Bizzy as a discontinued operation and the impairment of certain intangibles acquired in the DealOn acquisition.
(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.
 
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.

 
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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
September 30,
   
Nine Months Ended
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
(in thousands)
                       
Loss from continuing operations
  $
(1,483
)   $
(1,987
)   $ (4,651 )   $ (6,369 )
Add:
                               
Depreciation and amortization
    2,828       1,716       7,635       4,354  
Stock-based compensation, net
    2,331       1,524       6,316       3,966  
Acquisition and integration costs
    854       33       1,374       542  
                                 
Adjusted EBITDA
  $ 4,530     $ 1,286     $ 10,674     $ 2,493  
 
 Liquidity and Capital Resources
 
   
Nine Months Ended September 30,
 
Consolidated Statements of Cash Flow Data:
(in thousands)
 
2011
   
2010
 
Net cash provided by operating activities
  $ 18,587     $ 6,169  
Net cash used in investing activities
  $ (9,615 )   $ (15,309 )
Net cash provided by financing activities
  $ 5,515     $ 43,456  
Capital Expenditures (1)
  $ 9,547     $ 7,056  
 

(1)
Represents purchases of property and equipment and the amount of software development costs capitalized, on an aggregate basis.

At September 30, 2011, we had cash and cash equivalents of $93.6 million and short-term investments of $0.6 million. Cash and cash equivalents consist of cash, money market accounts and certificates of deposit. Short term investments consist of certificates of deposit with original maturities in excess of three months. To date, we have experienced no loss of our invested cash, cash equivalents or short-term investments. We cannot, however, provide any assurances that access to our invested cash, cash equivalents and short-term investments will not be impacted by adverse conditions in the financial markets.

At September 30, 2011, we had no long-term indebtedness for borrowed money and are not subject to any restrictive bank covenants. At September 30, 2011, we had $1.0 million in restricted certificates of deposit to secure letters of credit issued to landlords and as security for certain other operating activities.

Although we expect that cash flow from operations and our existing cash balances will be sufficient to continue funding our expansion activities, these investments, including investments in developing new products and services for our clients, could require us to seek additional equity or debt financing, and that financing may not be available on terms favorable to us or at all. In addition, we intend to continue to increase our investment in Underclassmen and in the development of new products and services for our clients, which could require significant capital and entail non-capitalized expenses that could diminish our income from operations.
 
 
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Operating Activities

Our cash flow from operating activities during the nine months ended September 30, 2011 resulted primarily from changes in our operating assets and liabilities and non-cash operating expenses. Our loss from continuing operations of $4.3 million was offset by increases in accounts payable and accrued expenses of $4.7 million, reflecting a return to more normalized accounts payable levels versus the prior year period, and increases in deferred revenue and deferred payment obligations of $5.0 million, both due to the growth of our business.  Cash flow from operating activities also resulted from non-cash depreciation and amortization of $7.6 million, and non-cash stock-based compensation of $6.3 million.

Our cash flow from operating activities during the nine months ended September 30, 2010 resulted primarily from changes in our operating assets and liabilities, with deferred revenue increasing $7.0 million. We had a loss from continuing operations for the nine months ended September 30, 2010 of $5.5 million, which was offset by non-cash depreciation and amortization of $4.4 million and non-cash stock-based compensation of $4.0 million. During the third quarter ended September 30, 2010, there was also a temporary reduction in accounts payable of $6.0 million due primarily to a change in the timing of payments to certain vendors, resulting in an unfavorable impact on cash flow from operations.

Investing Activities

Our primary investing activities have consisted of purchases of property and equipment, capitalized software development costs, short-term investments, and business acquisitions. Our purchases of property and equipment and capitalized software costs may vary from period to period due to the timing of the expansion of our operations and our software development efforts. During the nine months ended September 30, 2011, we invested $5.8 million, net of cash acquired, in the purchase of DealOn. The terms of the purchase agreement require us to make additional payments in 2012 and 2013 of up to $2.0 million. During the nine months ended September 30, 2010, we acquired SMB:LIVE and invested $2.8 million, net of cash acquired. We expect to continue to use capital for acquisitions, purchases of property and equipment and development of software.

Financing Activities

During the nine months ended September 30, 2011, we received $5.5 million in proceeds from the exercise of stock options. In May 2010, we received $42.1 million in proceeds, after deducting underwriting discounts and commissions and estimated offering costs payable by us, from the sale of shares of common stock in connection with our initial public offering.
 
Future cash flows from financing activities may also be affected by our repurchases of our common stock. On November 4, 2011, we announced that our Board of Directors authorized the repurchase of up to $20 million of our outstanding common stock. Purchases will be made from time-to-time in open market or privately negotiated transactions as determined by our management. The amount and timing of the share repurchase will depend on business and market conditions, stock price, trading restrictions, acquisition activity, and other factors. The share repurchase program does not obligate us to acquire any particular amount of common stock, and the repurchase program may be suspended or discontinued at any time at our discretion.
 
Off-Balance Sheet Arrangements

At September 30, 2011, we did not have any off-balance sheet arrangements.

Recently Issued Accounting Standards

Accounting Standards Codification (“ASC”) Topic 220-10, Comprehensive Income - Presentation of Comprehensive Income, provides that an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. Under both options, an entity will be required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. Furthermore, regardless of the presentation methodology elected, the entity will be required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income. The amendments do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. The amendments also do not affect how earnings per share is calculated or presented. ASC Topic 220-10 is effective for us on January 1, 2012. Although adopting the guidance will not impact our accounting for comprehensive income, it will affect our presentation of components of comprehensive income by eliminating our practice of showing these items within the Consolidated Statements of Shareowners’ Equity.
 
ASC Topic 820-10, Fair Value Measurement - Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (International Financial Reporting Standards), clarifies existing fair value measurement and disclosure requirements, amends certain fair value measurement principles and requires additional disclosures about fair value measurements.  Adoption of this provision, which is effective for us as of January 1, 2012, is not expected to have a material impact on our consolidated financial statements.
 
 
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ASC Topic 350-20-35-3, Intangibles – Goodwill and Other, provides an entity with the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount.  If an entity determines that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is necessary. The amended guidance will be effective for us as of January 1, 2012, and early adoption is permitted. We are currently assessing the impact of the amended guidance on our consolidated financial statements.
 
Item 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risk in the ordinary course of our business. These risks primarily include interest rate, foreign exchange and inflation risks.

Interest Rate Fluctuation Risk

We do not have any long-term indebtedness for borrowed money. Our investments include cash, cash equivalents and short-term investments. Cash and cash equivalents and short-term investments consist of cash, money market accounts and certificates of deposit. The primary objective of our investment activities is to preserve principal while maximizing income without significantly increasing risk. We do not enter into investments for trading or speculative purposes. Our investments are exposed to market risk due to a fluctuation in interest rates, which may affect our interest income and the fair market value of our investments. Due to the short-term nature of our investment portfolio, we do not believe an immediate 10% increase in interest rates would have a material effect on the fair market value of our portfolio, and therefore we do not expect our operating results or cash flows to be materially affected to any degree by a sudden change in market interest rates.

Foreign Currency Exchange Risk

We have foreign currency risks related to our revenue and operating expenses denominated in currencies other than the U.S. dollar, principally the Australian dollar, the British pound sterling, the Canadian dollar, the Indian Rupee, and the Euro. An unfavorable change in these exchange rates relative to the dollar would result in an unfavorable impact on revenue and operating income. For the three months ended September 30, 2011, an unfavorable 10 percent change in exchange rates would result in a decrease in revenue of $2.6 million and an increase in our operating loss for the period of less than $0.2 million. We currently do not hedge or otherwise manage our currency exposure given the immaturity and lesser predictability of our international operations. As our international operations grow and mature, our risks associated with fluctuations in currency rates will become greater, and we will continue to reassess our approach to managing this risk. In addition, currency fluctuations or a weakening U.S. dollar can increase the costs of our international expansion.

Inflation Risk

We do not believe that inflation has had a material effect on our business, financial condition or results of operations. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could harm our business, financial condition and results of operations.
 
Item 4.
CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b) as of September 30, 2011. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in reports we file or submit under the Exchange Act is (1) recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and (2) is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.

Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting during the quarter ended September 30, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 
 
29

 
 
PART II

OTHER INFORMATION

Item 1.
LEGAL PROCEEDINGS

From time to time we are involved in legal proceedings arising in the ordinary course of its business. We believe that there is no litigation pending that is likely to have a material adverse effect on our results of operations and financial condition.

On March 1, 2010, a class action lawsuit was filed by two of our former employees in California Superior Court in Los Angeles, California. The complaint alleged wage and hour violations in a Fair Labor Standards Act collective action and a California class action. On May 6, 2011, the Court granted preliminary approval of a settlement of the class action for $800,000, which together with legal costs resulted in a charge of $832,000 recorded in fiscal 2010. On or about February 2, 2011, a second class action lawsuit was filed by former employees alleging substantially similar wage and hour violations. The second class action was settled for a de minimis amount and was dismissed by the court on September 27, 2011.

DealOn, which we acquired in February 2011, had been sued in two patent infringement matters. Both of the cases were dismissed without prejudice.
 
Item 1A.
RISK FACTORS

Investors should carefully consider the risk factors in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2010, in addition to the other information contained in our Annual Report and in this quarterly report on Form 10-Q.

Item 6.
EXHIBITS
 
   
Exhibit No
Description of Exhibit
10.1*
Third Amendment to Office Lease, dated as of July 22, 2011, between Douglas Emmett 2000, LLC, as Landlord and ReachLocal, Inc., as Tenant
10.2*
Form of Dutch Stock Option Agreement
10.3*
Form of Japanese Stock Option Agreement
31.1*
Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2*
Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1†
Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2†
Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS**
XBRL Instance
101.SCH**
XBRL Taxonomy Extension Schema
101.CAL**
XBRL Taxonomy Extension Calculation
101.DEF**
XBRL Taxonomy Extension Definition
101.LAB**
XBRL Taxonomy Extension Labels
101.PRE**
XBRL Taxonomy Extension Presentation
 
*
Filed herewith.
Furnished herewith.
**
XBRL information is furnished and not filed or a part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, as amended, is deemed not filed for purposes of section 18 of the Securities Exchange Act of 1934, as amended, and otherwise is not subject to liability under these sections.
 
 
30

 
 
SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
   
REACHLOCAL, INC.
   
By:
/s/ Zorik Gordon
Name:
Zorik Gordon
Title:
President and Chief Executive Officer
   
By:
/s/ Ross G. Landsbaum
Name:
Ross G. Landsbaum
Title:
Chief Financial Officer
Date: November 4, 2011
 
 
31

 
 
EXHIBIT INDEX
 
   
Exhibit No
Description of Exhibit
10.1*
Third Amendment to Office Lease, dated as of July 22, 2011, between Douglas Emmett 2000, LLC, as Landlord and ReachLocal, Inc., as Tenant
10.2*
Form of Dutch Stock Option Agreement
10.3*
Form of Japanese Stock Option Agreement
31.1*
Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2*
Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1†
Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2†
Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS**
XBRL Instance
101.SCH**
XBRL Taxonomy Extension Schema
101.CAL**
XBRL Taxonomy Extension Calculation
101.DEF**
XBRL Taxonomy Extension Definition
101.LAB**
XBRL Taxonomy Extension Labels
101.PRE**
XBRL Taxonomy Extension Presentation
 
*
Filed herewith.
Furnished herewith.
**
XBRL information is furnished and not filed or a part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, as amended, is deemed not filed for purposes of section 18 of the Securities Exchange Act of 1934, as amended, and otherwise is not subject to liability under these sections.