Equity Research

Brian Bolan Research

8 August 2011

Initiating Coverage
Company Overview and Key Data
ReachLocal (Nasdaq: RLOC)
Share Price: Price Target: 52-Week Range: Shares Outstanding: Market Capitalization: Dividend Yield: $16.26 $15 $12.69 - $28.39 29.2 million $469 million NA

Hold

ReachLocal (Nasdaq: RLOC)

IMC Analysis
Following the release of 2Q11 earnings, shares of ReachLocal have dropped through our target price of $15. Macro issues are certainly weighing on investors and contributed to the sell-off, but we believe that a deeper look into IMCs and the companys guidance is warranted.

ReachLocal, Inc. is an online marketing company that helps small and medium sized businesses, or SMBs, acquire, maintain and retain customers via the Internet. The Company offers a comprehensive suite of online marketing and reporting solutions, including search engine marketing, display advertising, remarketing and online marketing analytics, each targeted to the SMB market.

Present and future potential IMCs will want to pay close attention to page 7 of this report, which discusses how ReachLocal handles commission expense.

Brian Bolan 1 773 413 0285

Twitter: @BBolan1 bbolan1@Gmail.com

8 August 2011

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

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ReachLocal (Nasdaq Global Markets: RLOC)

Inside
Summary 2Q11

Estimated Gradation Rate Short Interest Underclassmen Expense Upperclassmen Expense Commission Expense
Investment Risks

3 4 5 6 6 7 10 11 11

Appendix Key Metrics

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Brian Bolan Research

ReachLocal (Nasdaq Global Markets: RLOC)

Summary of 2Q11
ReachLocal has demonstrated a clear path to profitability, good growth history and good growth potential. Its recent partnership with Google has cleared the way for future investment in eight foreign countries over the next three years. Over the last year, the company has added a key product, ReachCast, to its search and display offerings. ReachCast is the social media marketing tool that includes Facebook, Twitter, and SEO services for the site. Through 1Q11 the company has sold approximately 1,100 ReachCasts to new and existing clients. Growth is predicated on the continued hiring of Internet Marketing Consultants (IMCs) As the company adds more IMCs the distance to profitability is likely to be shortened. On the conference call we learned that international expansion will be the key to future growth. ReachCast Analysis With 1100 ReachCasts being sold through March 31, 2011 we can expect that the vast majority are of the $1299 variety as opposed to the $1799 price. Projecting a 95% / 5% split, ReachCast generated $4.5M of revenues in 1Q11 and we estimate that level has increased to $5.7M. Backing into an estimate of 1450 ReachCast sales implies a solid 33% sequential growth rate. Our estimate includes a 2.8% ASP increase in the quarter, in line with the campaign average. Head Count / Underclassmen and Upperclassmen. Looking back at the results of the last quarter, we believe it is important that investors look at the IMC counts and where issued guidance is directing the company. We believed the growth of the company was predicated on the increase in IMCs, as the direct local sales force would be responsible for the majority of the growth. The foundation of the company is the growth of Upperclassmen, but this is achieved only through a development of Underclassmen. We know from guidance that Underclassmen headcount will drop 15% from 3Q11 to 4Q11, a rate that is accelerated from the same period a year ago where the drop was 12%.

The intersection of upperclassmen and underclassmen is clearly a tipping point in the making. From guidance we extrapolated out where headcounts are likely to go, and then focus of a graduation rate.

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Brian Bolan Research

ReachLocal (Nasdaq Global Markets: RLOC)

The company has stated that they hire 40-60 new IMCs per month but slow the hiring pace slows at the end of the year. The table below highlights the trends of IMC growth and in red reduction.

We counted growth rates of 1% as a cause for concern, especially the recent 1% growth rates of Underclassmen in 2Q11 and the expected 1% growth rate the company guided to for 3Q11. In order for there to be increases in Upperclassmen, the company must hire and retain more Underclassmen. The graduation rate of underclassmen is predicated on the number of underclassmen and the increase in upperclassmen from the year ago period. This graduation rate is an estimate and does not reflect the employee churn. The employee churn rate is likely several basis points higher than the inverse of the graduation rate.

Our estimates suggest that graduation rate will fall precipitously in the next calendar year. Guidance on IMC numbers implies a spike in the estimated rate in 4Q11. Our estimates following CY2011 indicate that the graduation rate will continue to fall as the company moves to eliminate more underclassmen while focusing on international expansion.

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Brian Bolan Research

ReachLocal (Nasdaq Global Markets: RLOC)

Short Interest

There has been no let up on the number shares that have been sold short. We see from the two graphs that both the number of shares sold short the percentage of overall shares sold short have increased. The pending sale of 6M shares in a secondary transaction is also weighing on investors. VantagePoint Partners is selling 5M shares and the company and a few insiders are selling the other 1M shares. We note that when the company was going public, it was priced between 17-19, and ended up being priced at 13. This low pricing was a result of weak institutional demand.

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ReachLocal (Nasdaq Global Markets: RLOC)

Underclassmen Expense We have seen Underclassmen expense increase over the last few quarters, and we expect that trend to continue. We broke down the Underclassmen expense and found a disturbing fact. The Underclassmen expense is expected to continue to increase, and the chart below shows the expense on a per employee basis. Our expectations reflect the need for more and more churn in the underclassmen category.

Underclassmen expense excludes commissions, and in backing those out, we are introducing the Upperclassmen Expense. We note that the Upperclassmen Expense is not a number that is not sanctioned by ReachLocal and is not an exact figure as there are other salaries baked into the Sales & Marketing line item.

Our Upperclassmen Expense estimate backs the commissions and underclassmen expense out of the Sale & Marketing. There are other salaries, such as a CSC (generally one per office) and Web Presence Professionals in the sales & marketing line.

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Brian Bolan Research

ReachLocal (Nasdaq Global Markets: RLOC)

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

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

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Brian Bolan Research

ReachLocal (Nasdaq Global Markets: RLOC)

Income Statement Without having had a significant discussion with management on how to think about modelling the company out, we adopted a use everything approach to come to our estimates Our estimates are based on a number of moveable parts in the ReachLocal model, including but not limited to: 1) number of campaigns 2) number of advertisers 3) number of sales people 4) campaign ASPs 5) advertiser ASPs and 6) revenue per sales person 7) Direct Local sales 8) National Brands, Agencies and Resellers.

Active Advertisers We continue to believe that churn rates are still over 55%, but that said, the company added at least 1,300 advertisers in the quarter. Adding the growth of advertisers shows us slowed significantly in the last two years, and is expected to remain in a tight range for the next year.

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

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Brian Bolan Research

ReachLocal (Nasdaq Global Markets: RLOC)

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

Growth in campaigns remained more robust than growth in advertisers.

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

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Brian Bolan Research

ReachLocal (Nasdaq Global Markets: RLOC)

Investment Risks
If the company experiences any or all of the following risk factors, as well as others, the companys stock price may be affected. Advertisers move disproportionately to mobile internet budgets. At the current time, the company does not have a significant mobile product for its clients. Should the demand for mobile grow disproportionately larger than traditional sources then ReachLocal could be negatively impacted. A better advertising platform is developed for internet advertising. Search has been the dominant application on the internet for the last ten years. Should another application become more acceptable than search, advertisers could move budgets from search to that platform. Competition is intense and moves quickly. Google could make a significant effort to compete with ReachLocal, which would severely impact ownership of ReachLocal shares. Other competitors have moved to replicate the success of the company and others may continue to do the same. Future growth is predicated on growth of IMCs. Many of our assumptions of growth are based on the future success IMCs. Should another company offer a better compensation plan or should the commissions paid be cut, we believe that a mass exodus of trained IMCs would be a negative for the company Loss of key management. A loss of the CEO or co-founders would be viewed as a significant loss to the company. The management team has been together for several years, and this continuity is an asset. One major shareholder could sell. As of 4/21/11, Vantage Point Ventures held approximately 12.5M shares of RLOC or 43.1% of the outstanding stock. Next on the list was Rho Capital Partners, another venture capital backer of RLOC, with 3.3M or 11.5% of the shares outstanding. Either one of these stake holders selling could lead to a loss of confidence by the greater market and smaller shareholders.

Implications of higher employee turnover / increases in commissions. Earlier in the report it was noted that the graduation rate appears to be moving significantly lower. This implies a high employee turnover that may cause the company to re-org its commission / expense structure. We note that most competitors pay its sales staff significantly more than the 6% and 10% rates that ReachLocal pays. As it becomes harder to find and hire qualified salespeople, the company may move to increase commissions and or salaries. This would have a negative impact on margins. Recommendation and Valuation Our HOLD rating is maintained, but we are lowering our price target to $15 from $19 to reflect the lower expected number of IMCs. The larger overhang on the stock is the secondary offering of approximately 6M shares. Given how the IPO was priced at $13 after being given a rage of $17-$19, this offering is likely going to be facing some significant challenges.

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Brian Bolan Research

ReachLocal (Nasdaq Global Markets: RLOC)

Appendix
2Q11 Earnings Review

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Brian Bolan Research

ReachLocal (Nasdaq Global Markets: RLOC)

Coverage Initiated on 6/13/11 with HOLD rating and $19 price target 8/3/11 2Q11 Earnings Update, Price target lowered to $15 from $19

ReachLocal (Nasdaq GM: RLOC) Historical Price Chart

Source MarketWatch / Yahoo!

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Brian Bolan Research Important disclosures:

ReachLocal (Nasdaq Global Markets RLOC)

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

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

Disclosures:
None

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

3 August 2011

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