UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2012

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  ☒    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  ☒    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	☐  (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  ☒

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 October 31, 2012
Common Stock, $0.00001 par value	28,513,268

INDEX

			Page
Part I.	Financial Information
	Item 1.	Condensed Consolidated Financial Statements (unaudited)
		Condensed Consolidated Balance Sheets as of September 30, 2012 and December 31, 2011	2
		Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2012 and 2011	3
		Condensed Consolidated Statements of Comprehensive Income (Loss) for the Three and Nine Months Ended September 30, 2012 and 2011	4
		Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2012 and 2011	5
		Notes to the Condensed Consolidated Financial Statements	6
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	31
	Item4.	Controls and Procedures	32
Part II.	Other Information
	Item 1.	Legal Proceedings	33
	Item1A.	Risk Factors	33
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	33
	Item 6.	Exhibits	34
		Signatures	35

1

PART I

FINANCIAL INFORMATION

Item 1.         FINANCIAL STATEMENTS

REACHLOCAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

(Unaudited)

	September 30, 2012			December 31, 2011
Assets
Current Assets:
Cash and cash equivalents	$	86,710		$	84,525
Short-term investments		9,001			644
Accounts receivable, net of allowance for doubtful accounts of $279 and $363 at September 30, 2012 and December 31, 2011, respectively		4,982			4,240
Other receivables and prepaid expenses		10,557			9,226
Total current assets		111,250			98,635
Property and equipment, net		10,923			9,885
Capitalized software development costs, net		13,637			10,942
Restricted certificates of deposit		931			1,286
Intangible assets, net		2,968			1,957
Other assets		4,058			1,966
Goodwill		42,083			41,766
Total assets	$	185,850		$	166,437
Liabilities and Stockholders’ Equity
Current Liabilities:
Accounts payable	$	34,463		$	29,831
Accrued expenses		25,357			19,537
Deferred revenue and other current liabilities		36,490			30,747
Liabilities of discontinued operations		814			996
Total current liabilities		97,124			81,111
Deferred rent and other liabilities		3,208			3,039
Total liabilities		100,332			84,150
Commitments and contingencies (Note 7)
Stockholders’ Equity:
Common stock, $0.00001 par value—140,000 shares authorized; 28,520 and 28,552 shares issued and outstanding at September 30, 2012 and December 31, 2011, respectively		—			—
Receivable from stockholder		(89	)		(87	)
Additional paid-in capital		113,009			109,493
Accumulated deficit		(26,682	)		(26,844	)
Accumulated other comprehensive loss		(720	)		(275	)
Total stockholders’ equity		85,518			82,287
Total liabilities and stockholders’ equity	$	185,850		$	166,437

 

See notes to condensed consolidated financial statements.

2

REACHLOCAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(Unaudited)

	Three Months Ended September 30,					Nine Months Ended September 30,
	2012		2011			2012		2011
Revenue	$	118,891	$	98,629		$	335,106	$	275,439
Cost of revenue		59,500		50,265			167,546		141,363
Operating expenses:
Selling and marketing		42,860		36,769			122,579		103,457
Product and technology		5,448		4,257			14,180		10,800
General and administrative		9,966		8,821			30,241		24,470
Total operating expenses		58,274		49,847			167,000		138,727
Income (loss) from continuing operations		1,117		(1,483	)		560		(4,651	)
Other income, net		33		280			338		697
Income (loss) from continuing operations before provision for income taxes		1,150		(1,203	)		898		(3,954	)
Provision for income taxes		314		126			736		323
Income (loss) from continuing operations, net of income taxes		836		(1,329	)		162		(4,277	)
Loss from discontinued operations, net of income taxes		—		(3,272	)		—		(4,720	)
Net income (loss)	$	836	$	(4,601	)	$	162	$	(8,997	)
Net income (loss) per share from continuing operations, basic and diluted	$	0.03	$	(0.05	)	$	0.01	$	(0.15	)
Net loss per share from discontinued operations, basic and diluted		—		(0.11	)		—		(0.16	)
Net income (loss) per share, basic and diluted	$	0.03	$	(0.16	)	$	0.01	$	(0.31	)
Weighted average common shares used in computation of net income (loss) per share, basic		28,403		29,302			28,379		28,936
Weighted average common shares used in computation of net income (loss) per share, diluted		29,342		29,302			28,902		28,936

See notes to condensed consolidated financial statements.

3

REACHLOCAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands)

(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Net income (loss)	$	836		$	(4,601	)	$	162		$	(8,997	)
Other comprehensive loss, net of tax:
Foreign currency translation adjustments		(197	)		(441	)		(445	)		(325	)
Other comprehensive loss, net of tax		(197	)		(441	)		(445	)		(325	)
Comprehensive income (loss)	$	639		$	(5,042	)	$	(283	)	$	(9,322	)

 

See notes to condensed consolidated financial statements.

4

REACHLOCAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

	Nine Months Ended September 30,
	2012			2011
Cash flow from operating activities:
Net income (loss) from continuing operations, net of income taxes	$	162		$	(4,277	)
Adjustments to reconcile net income (loss) from continuing operations, net of income taxes, to net cash provided by operating activities:
Depreciation and amortization		9,669			7,635
Stock-based compensation, net		6,929			6,316
Provision for doubtful accounts		18			180
Impairment of intangible assets		—			764
Changes in operating assets and liabilities:
Accounts receivable		(679	)		(903	)
Other receivables and prepaid expenses		(1,291	)		273
Other assets		(216	)		163
Accounts payable and accrued expenses		10,034			4,734
Deferred revenue, rent and other liabilities		6,958			5,009
Net cash provided by operating activities, continuing operations		31,584			19,894
Net cash used for operating activities, discontinued operations		(182	)		(1,307	)
Net cash provided by operating activities		31,402			18,587
Cash flow from investing activities:
Additions to property, equipment and software		(11,591	)		(9,547	)
Acquisitions, net of acquired cash		(4,120	)		(6,210	)
Loan to franchisee		(1,863	)		—
Maturities of certificates of deposits and short-term investments		466			7,666
Purchases of certificates of deposits and short-term investments		(8,447	)		(280	)
Net cash used in investing activities, continuing operations		(25,555	)		(8,371	)
Net cash used in investing activities, discontinued operations		—			(1,244	)
Net cash used in investing activities		(25,555	)		(9,615	)
Cash flow from financing activities:
Proceeds from exercise of stock options		1,639			5,515
Common stock repurchases		(5,395	)		—
Net cash (used in) provided by financing activities		(3,756	)		5,515
Effect of exchange rate changes on cash and cash equivalents		94			(800	)
Net change in cash and cash equivalents		2,185			13,687
Cash and cash equivalents—beginning of period		84,525			79,906
Cash and cash equivalents—end of period	$	86,710		$	93,593
Supplemental disclosure of non-cash investing and financing activities:
Capitalized software development costs resulting from stock-based compensation and deferred payment obligations	$	228		$	1,237
Deferred payment obligation increase (decrease)	$	(75	)	$	1,878

 

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 North America, Australia, the United Kingdom, the Netherlands, Germany, Japan, Brazil and India. 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™), display retargeting (ReachRetargeting™), online marketing analytics (TotalTrack®), and 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, the RL Platform, its direct, “feet-on-the-street” sales force of Internet Marketing Consultants, or IMCs, and select third-party agencies and resellers. 

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 of America (“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, 2011. The condensed consolidated balance sheet as of December 31, 2011 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, with the exception of those mentioned in Note 9, “Stock-Based Compensation—Adjustment to Historical Stock-Based Compensation Expense” ) necessary for the fair presentation of the Company’s statement of financial position at September 30, 2012, the Company’s results of operations for the three and nine months ended September 30, 2012 and 2011, and the Company’s cash flows for the nine months ended September 30, 2012 and 2011. The results for the three and nine months ended September 30, 2012 are not necessarily indicative of the results to be expected for the year ending December 31, 2012. All references to the three and nine months ended September 30, 2012 and 2011 in the notes to the condensed consolidated financial statements are unaudited.

Discontinued Operations

As a result of winding down and closing the operations of Bizzy, the local recommendation engine the Company developed, effective November 2011, 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 the notes unless specifically referenced.

6

Reclassifications and Adjustments

Certain prior period amounts have been reclassified to conform to the current period presentation and certain immaterial adjustments have been recorded in prior periods as further described in Footnote 9, “Stock-Based Compensation—Adjustment to Historical Stock-Based Compensation Expense”.

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. On an ongoing basis, management evaluates its estimates, including those related to revenue recognition, software development costs, goodwill, long-lived and intangible assets, stock-based compensation and income taxes. These estimates are based on information available as of the date of the financial statements. Therefore, actual results could differ from those estimates.

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 products 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. As the Company is the primary party obligated in the arrangement, subject to the credit risk, with 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, including a franchisee. Resellers integrate the Company’s services, including ReachSearch, ReachDisplay, and TotalTrack, into their product offerings. In most cases, the resellers integrate with the Company’s RL Platform through a custom Application Programming Interface (API). 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 has retained sufficient control and bears sufficient risks to be considered the primary obligor in those arrangements.

The Company offers future incentives to clients in exchange for 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.

7

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 total goodwill of $42.1 million and $41.8 million as of September 30, 2012 and December 31, 2011, respectively, is related to the Company’s acquired businesses.   In accordance with Accounting Standards Codification (“ASC”) 280, Segment Reporting, the Company has identified one reporting segment and two reporting units—North America and Australia—for purposes of evaluating goodwill. These reporting units each constitute a business or group of businesses for which discrete financial information is available and is regularly reviewed by segment management. North America assigned goodwill is $9.7 million and Australia assigned goodwill is $32.4 million as of September 30, 2012. The Company reviews the carrying amounts of goodwill for possible impairment whenever events or changes in circumstance indicate that the related carrying amount may not be recoverable. The Company performs its annual assessment of goodwill impairment as of the first day of each fourth quarter.

The Company follows the amended guidance for assessing qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, in accordance with ASC 350-20, Intangibles – Goodwill and Other. Entities are provided with the option of first performing a qualitative assessment on any of its reporting units to determine whether further quantitative impairment testing is necessary. An entity may also bypass the qualitative assessment for any reporting unit in any period and proceed directly to the quantitative impairment test. 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 a two-step impairment test is necessary. The first step of the impairment test involves comparing the estimated fair values of each of our reporting units with their respective carrying amounts, including goodwill. If the estimated fair value of a reporting unit exceeds its carrying amount, including goodwill, goodwill is considered not to be impaired and no additional steps are necessary. If, however, the estimated fair value of the reporting unit is less than its carrying amount, including goodwill, then the second step is performed to compare the carrying amount of the goodwill with its implied fair value. If the carrying amount of goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to the excess. The Company estimates fair value utilizing the projected discounted cash flow method and a discount rate determined by the Company commensurate with the risk inherent in its business model.

Long-Lived and Intangible Assets      

The Company reports 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 three years. Straight-line amortization is used because no other pattern over which the economic benefits will be consumed can be reliably determined.

The Company reviews the carrying values of long-lived assets, including intangible assets, for possible impairment whenever events or changes in circumstance indicate that the related carrying amount may not be recoverable. In its analysis of other finite lived amortizable intangible assets, the Company applies the guidance of ASC 350-20, Intangibles – Goodwill and Other, in determining whether any impairment conditions exist. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. Intangible assets are attributable to the various developed technologies and client relationships of the businesses the Company has acquired.  Long-lived assets to be disposed of are reported at the lower of carrying amount or estimated fair value less cost to sell.

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. 

8

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 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.

Variable Interest Entities

In accordance with ASC 810, Consolidations, the applicable accounting guidance for the consolidation of variable interest entities (“VIE”), the Company analyzes its interests, including agreements, loans, guarantees, and equity investments, on a periodic basis to determine if such interests are variable interests. If variable interests are identified, then the related entity is assessed to determine if it is a VIE. The Company’s analysis includes both quantitative and qualitative reviews. The Company bases its quantitative analysis on the forecasted cash flows of the entity, and its qualitative analysis on the design of the entity, its organizational structure including its decision-making authority, and relevant agreements. If the Company determines that the entity is a VIE, the Company then assesses if it must consolidate the VIE as its primary beneficiary.The Company’s determination of whether it is the primary beneficiary is based upon qualitative and quantitative analyses, which assess the purpose and design of the VIE, the nature of the VIE’s risks and the risks that the Company absorbs, the power to direct activities that most significantly impact the economic performance of the VIE, and the obligation to absorb losses or the right to receive benefits that could be significant to the VIE. See Note 5, “Variable Interest Entities”, for more information.

Loan Receivables

 Loan receivables are recorded at carrying value, net of potential allowance for losses. Losses on the receivables are recorded when probable and estimable. The Company routinely evaluates the receivable for potential collection issues that might indicate an impairment. Changes in such estimates can significantly affect the allowance and provision for losses. It is possible that the Company will experience losses that are different from its current estimates. Write-offs are deducted from the allowance for losses when the Company judges the principal to be uncollectible. Any subsequent recoveries are added to the allowance at the time cash is received on a written-off balance. See Note 5, “Variable Interest Entities”, for more information.

Net Income (Loss) Per Share

Basic net income (loss) per share is computed by dividing the net income (loss) for the period by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is computed by dividing the net income (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.

The following table sets forth the computation of basic and diluted net income (loss) per share (in thousands, except per share amounts):

	Three Months Ended September 30,					Nine Months Ended September 30,
	2012		2011			2012		2011
Numerator:
Net income (loss) from continuing operations	$	836	$	(1,329	)	$	162	$	(4,277	)
Denominator:
Weighted average common shares used in computation of net income (loss) per share from continuing operations, basic		28,403		29,302			28,379		28,936
Deferred stock consideration and restricted stock		93		—			53		—
Stock options and warrants		846		—			470		—
Weighted average common shares used in computation of net income (loss) per share from continuing operations, diluted		29,342		29,302			28,902		28,936
Net income (loss) per share from continuing operations, basic	$	0.03	$	(0.05	)	$	0.01	$	(0.15	)
Net income (loss) per share from continuing operations, diluted	$	0.03	$	(0.05	)	$	0.01	$	(0.15	)

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,
	2012		2011		2012		2011
Deferred stock consideration and restricted stock		—		108		—		281
Stock options and warrant		—		1,356		—		2,157
		—		1,464		—		2,438

 

In addition, certain other stock options have been excluded from the computation of diluted net loss per share because they would have 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, 2012 and 2011, the number of such securities was 2.7 million and 2.9 million, respectively, and for the nine months ended September 30, 2012 and 2011, the number of such securities was 6.0 million and 1.6 million, respectively.

9

3. Fair Value of Financial Instruments

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 atSeptember 30,2012		Quoted Prices inActive Marketsfor IdenticalItems(Level 1)		Significant OtherObservableInputs(Level 2)		SignificantUnobservableInputs(Level 3)
Cash and cash equivalents	$	86,710	$	86,710	$	—	$	—
Certificates of deposit	$	9,932	$	9,932	$	—	$	—

			Basis of Fair Value Measurement
	Balance atDecember 31,2011		Quoted Prices inActive Marketsfor IdenticalItems(Level 1)		Significant OtherObservableInputs(Level 2)		SignificantUnobservableInputs(Level 3)
Cash and cash equivalents	$	84,525	$	84,525	$	—	$	—
Certificates of deposit	$	1,930	$	1,930	$	—	$	—

The following table provides information about assets not carried at fair value in the Company’s Consolidated Balance Sheets (in thousands).

	September 30, 2012						December 31, 2011
			Assets						Assets
	Notional amount		Carrying amount (net)		Estimated fair value		Notional amount		Carrying amount (net)		Estimated fair value
Loan receivable	$	—	$	1,863	$	1,863	$	—	$	—	$	—

 

The OxataSMB loan receivable is not actively traded and its fair value is estimated based on valuation methodologies using current market interest rate data adjusted for inherent credit risk.

4. Acquisitions

Recent Acquisition

On July 3, 2012, the Company acquired certain assets and liabilities and hired certain employees of  RealPractice, Inc. (“RealPractice”). At closing, the Company paid $2.6 million in cash of the estimated $2.9 million purchase price. The remaining amount of $0.3 million is payable in cash on the 18-month anniversary of the closing date, subject to adjustment. The Company issued 150,292 restricted stock units to the hired employees.

10

The Company recorded acquired assets and liabilities at their respective fair values. The following table summarizes the fair value of acquired assets and liabilities acquired (in thousands):

Assets acquired:
Property and equipment	$	36
Other current assets		13
Intangible assets		2,550
Other assets		4
Goodwill		317
Total assets acquired		2,920
Liabilities assumed:
Deferred revenue		20
Total fair value of assets and liabilities acquired	$	2,900

Intangible assets acquired from RealPractice included customer relationships and technology, which are amortized over one and three years, their respective estimated useful lives, using the straight line method.

Deferred Consideration

In connection with the RealPractice acquisition, we are obligated to pay an additional $0.3 million in cash on the 18-month anniversary of the closing date, subject to adjustment.

Pursuant to the terms of its 2011 acquisition of DealOn, LLC (“DealOn”), on February 8, 2012, the Company made a deferred payment in the amount of $0.5 million, net of the working capital adjustment and certain other adjustments, and issued 10,649 shares of its common stock. On August 8, 2012, the Company made an additional deferred payment in the amount of $0.4 million and issued 5,324 shares of its common stock. The following table summarizes the remaining DealOn deferred consideration milestone payment as of September 30, 2012, subject to adjustment under the acquisition agreement (in thousands):

	Deferred Cash Consideration		Deferred Stock Consideration		Total
February 2013	$	367	$	122	$	489

 

As part of the consideration paid to acquire SMB:LIVE Corporation (“SMB:LIVE”), on February 22, 2012, the Company paid $0.6 million in cash and issued 181,224 shares of its common stock. The February 22, 2012 payment represented the final payment of deferred consideration in connection with the SMB:LIVE acquisition.

Intangible Assets

As of September 30, 2012, intangible assets from acquisitions included developed technology of $2.9 million (net of accumulated amortization of $2.8 million) amortized over three years, and customer relationships of $0.1 million (net of accumulated amortization of $3.4 million) amortized over one year. Based on the current amount of intangibles subject to amortization, the estimated amortization expense over the remaining lives are as follows (in thousands):

Year Ending December 31,
2012 (3 months)	$	461
2013		1,207
2014		875
2015		425
Total	$	2,968

 

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For the three months ended September 30, 2012 and 2011, amortization expense related to acquired intangibles was $0.6 million and $0.6 million, respectively, and for the nine months ended September 30, 2012 and 2011, amortization expense related to acquired intangibles was $1.5 million and $1.8 million, respectively.

5. Variable Interest Entities

On July 6, 2012, the Company completed a transaction with OxataSMB B.V. (“OxataSMB”), in which the Company entered into a franchise agreement with OxataSMB permitting it to operate and resell the Company’s services under the ReachLocal brand in Slovakia, Czech Republic, Hungary, Poland and Russia. Pursuant to the franchise agreement, OxataSMB will receive access to the RL platform, training, marketing and branding materials, media purchasing, campaign management and provisioning, sourcing of telephony, and technical support. The Company does not currently anticipate that OxataSMB will pursue activities other than as a franchisee. In addition, the Company entered into a market development loan agreement with OxataSMB pursuant to which the Company agreed to provide financing to OxataSMB of up to €2.9 million ($3.7 million), of which €1.45 million ($1.9 million) has been advanced. The ability to draw down the remaining loan amount is dependent on OxataSMB achieving certain milestones by June 29, 2013, subject to a six-month extension at the Company’s option. The loan has a two-year term and accrues interest at 4% per annum, but does not require principal or interest payments for two years, and can be extended for an additional 24 months based on achievement of certain milestones. Prior to advance of the loan, OxataSMB had €1.45 million ($1.9 million) of contributed capital. As of September 30, 2012 OxataSMB had assets of less than $4 million and its results of operations since inception were not significant. In addition, the Company has an option to buy OxataSMB at an independently-determined fair value at the end of the initial loan term, subject to extension.

OxataSMB is considered a VIE with respect to the Company because OxataSMB may not have sufficient equity to finance its activities without additional financial support depending on its performance. At September 30, 2012, the Company was not the primary beneficiary of OxataSMB because it does not have: (1) the power to direct the activities that most significantly impact OxataSMB’s economic performance or (2) the obligation to absorb losses of OxataSMB or the right to receive benefits from OxataSMB that could potentially be significant. Therefore, the Company did not consolidate the results of OxataSMB and transactions with OxataSMB results were accounted for similarly to the Company’s resellers. The loan receivable is included in “Other assets” in the accompanying Consolidated Balance Sheet. As of September 30, 2012, the Company’s maximum exposure to loss related to unconsolidated VIEs consisted of its loan receivable of $1.9 million and its contingent commitment to provide €1.45 million ($1.9 million) of additional debt financing. No allowance for loan losses has been recorded against the loan receivable.

6. Software Development Costs

Capitalized software development costs consisted of the following (in thousands):

	September 30,2012			December 31,2011
Capitalized software development costs	$	29,085		$	21,686
Accumulated amortization		(15,448	)		(10,744	)
Capitalized software development costs, net	$	13,637		$	10,942

 

The Company recorded amortization expense of $1.7 million and $1.3 million for the three months ended September 30, 2012 and 2011, respectively, and $4.7 million and $3.5 million for the nine months ended September 30, 2012 and 2011, respectively. As of September 30, 2012 and December 31, 2011, $3.9 million and $1.2 million, respectively, of capitalized software development costs relate to projects still in process.

7. Commitments and Contingencies

Deferred Payment Obligations

In connection with the February 8, 2011 acquisition of DealOn, on February 8, 2012, the Company paid $0.5 million in cash and issued 10,649 shares of its common stock. On August 8, 2012, the Company paid an additional $0.4 million in cash and issued 5,324 shares of its common stock. The Company remains obligated to pay up to approximately $0.4 million in cash and issue 5,323 shares of its common stock, subject to adjustment under the terms of the acquisition agreement (see Note 4).

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In connection with the July 3, 2012 acquisition of RealPractice, the Company is obligated to pay up to approximately $0.3 million in cash, subject to adjustment under the terms of the acquisition agreement (see Note 4).

Loan Commitment

In connection with the franchise agreement with OxataSMB, the Company entered into a market development loan agreement with OxataSMB pursuant to which the Company agreed to provide financing to OxataSMB of up to €2.9 million ($3.7 million), of which €1.45 million ($1.9 million) has been advanced. The ability to draw down the remaining loan amount is dependent on OxataSMB achieving certain milestones by June 29, 2013, subject to a six-month extension at the Company’s option.

Litigation

The Company is subject to various legal proceedings and claims arising in the ordinary course of business. Although occasional adverse decisions or settlements may occur, management believes that the final disposition of existing matters will not have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows.

8. Stockholders’ Equity

Common Stock Repurchases

On November 4, 2011, the Company announced that its Board of Directors adopted a program that authorized the repurchase of up to $20.0 million of the Company’s outstanding common stock. At September 30, 2012, the Company had repurchased 1.5 million shares of its common stock under the program for an aggregate of $11.9 million, of which $1.4 million or 114,000 shares were repurchased during the three months ended September 30, 2012, and $5.2 million or 636,000 shares were repurchased during the nine months ended September 30, 2012. 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.

9. Stock-Based Compensation

Stock Option Exchange

On May 29, 2012, the Company commenced an offer to exchange options to purchase shares of its common stock with an exercise price equal to or greater than $10.91 per share or, for the Company’s executive officers subject to Section 16 of the Securities Exchange Act of 1934, as amended (“executive officers”), $16.71 per share, for replacement options to purchase a lesser number of shares of common stock having an exercise price equal to the fair market value of the Company’s common stock on the replacement grant date, or for replacement options issued to the Company’s executive officers, an exercise price equal to the greater of the fair market value of the Company’s common stock on the replacement grant date or $13 per share.

The stock option exchange closed on June 25, 2012.  All exchanged options were cancelled at that time and immediately thereafter, the Company granted replacement options under the Amended and Restated ReachLocal 2008 Stock Incentive Plan. Employees other than executive officers received options covering an aggregate of 158,752 shares, each with an exercise price of $10.56, which was the closing price of the Company’s common stock on the NASDAQ Global Select Market on June 25, 2012, and executive officers received options covering an aggregate of 396,998 shares, each with an exercise price of $13.00. After cancelling exchanged options to purchase an aggregate of 834,875 shares and granting replacement options to purchase an aggregate of 555,750 shares, the Company’s total number of shares subject to outstanding stock options was reduced by 279,125 shares.

The fair value of the replacement options granted was measured as the total of the unrecognized compensation cost of the original options exchanged plus any incremental compensation cost of the replacement options. The incremental compensation cost of the replacement options was measured as the excess of the fair value of the replacement options over the fair value of the exchanged options immediately before cancellation. The total remaining unrecognized compensation expense related to the exchanged options and the incremental compensation cost of the replacement options will be recognized over the four-year vesting period of the replacement options. The incremental compensation expense of the replacement options was immaterial.

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Stock Options

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 stock option activity (in thousands, except years and per share amounts):

	Number of Shares			WeightedAverageExercisePrice per Share		Weighted Average Remaining Contractual Life (in years)		Aggregate Intrinsic Value
Outstanding at December 31, 2011		6,411		$	12.52
Granted		2,190		$	9.75
Exercised		(235	)	$	5.42
Forfeited/Exchanged		(1,440	)	$	18.60
Outstanding at September 30, 2012		6,926		$	10.62		4.9	$	16,912
Vested and exercisable at September 30, 2012		3,683		$	10.45		3.7	$	9,338
Unvested at September 30, 2012, net of estimated forfeitures		3,059		$	10.84		6.2	$	7,146

 

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, 2012 and 2011.

	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Expected dividend yield		0	%		0	%		0	%		0	%
Risk-free interest rate		0.61	%		1.12	%		0.78	%		2.04	%
Expected life (in years)		4.75			4.75			4.90			4.75
Expected volatility		60.4	%		56.9	%		59.2	%		57.4	%

 

The per-share weighted-average grant date fair value of options granted during the nine months ended September 30, 2012 was $6.08. The aggregate intrinsic value of stock options exercised during the nine months ended September 30, 2012 was $1.4 million.

Restricted Stock and Restricted Stock Units

The following table summarizes restricted stock awards and restricted stock unit awards (in thousands, except per share amounts):

	Number of shares			Weighted Average Grant Date Fair Value
Unvested at December 31, 2011		123		$	16.33
Granted		395		$	9.61
Forfeited		(76	)	$	10.37
Vested		(83	)	$	12.96
Unvested at September 30, 2012		359		$	10.96

 

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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,
	2012		2011		2012		2011
Stock-based compensation	$	2,662	$	2,574	$	7,157	$	7,409
Less: Capitalized stock-based compensation		67		243		228		1,093
Stock-based compensation expense, net	$	2,595	$	2,331	$	6,929	$	6,316

 

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,
	2012		2011		2012		2011
Stock-based compensation expense, net
Cost of revenue	$	73	$	60	$	198	$	176
Selling and marketing		437		325		1,122		1,068
Product and technology		488		421		868		976
General and administrative		1,597		1,525		4,741		4,096
	$	2,595	$	2,331	$	6,929	$	6,316

 

As of September 30, 2012, there was $21.5 million of unrecognized stock-based compensation related to restricted stock, restricted stock units and outstanding stock options, net of estimated forfeitures. This amount is expected to be recognized over a weighted average period of 1.6 years. Future stock-based compensation expense for these awards may differ in the event actual forfeitures deviate from management’s estimates.

Adjustment to Historical Stock-Based Compensation Expense

In conjunction with the transition to an integrated stock-based compensation tracking and reporting system, immaterial adjustments relating to the impact of forfeitures on the computation of stock-based compensation expense were identified. As a result, stock-based compensation expense was understated by $0.2 million in 2011, $0.3 million in 2010, and $0.2 million in 2009 and prior periods. Based on an analysis of qualitative and quantitative factors, management has concluded that these adjustments were not material to any historical period, although the cumulative impact of correcting for the adjustments in 2012 would have been material to the current period. As a result, the affected balances have been revised as adjustments to additional paid-in capital and accumulated deficit as of December 31, 2011.

10. 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 months ended September 30, 2012 and 2011, the income tax provisions were $0.3 million and $0.1 million, respectively, and for the nine months ended September 30, 2012 and 2011, the income tax provisions were $0.7 million and $0.3 million, respectively. The income tax provision for the nine months ended September 30, 2012 relates to federal, state and foreign income taxes, including the deferred tax impact of prior business combinations.

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.

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11. Segment Information

Revenue by geographic region with respect to the Direct Local and National Brands channels 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 and long-lived assets by geographic region (in thousands):

	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
Revenue:
North America	$	84,212	$	75,068	$	243,364	$	214,002
International		34,679		23,561		91,742		61,437
	$	118,891	$	98,629	$	335,106	$	275,439

	September 30, 2012		December 31, 2011
Long-lived assets (excluding intangibles):
North America	$	6,857	$	7,203
International		4,163		2,721
	$	11,020	$	9,924

 

The results of the Australia geographic region have been included in the Company’s consolidated financial statements and include revenues of $19.0 million and $15.6 million for the three months ended September 30, 2012 and 2011, respectively, and $52.9 million and $40.5 million for the nine months ended September 30, 2012 and 2011, respectively. Long-lived assets of the Australia geographic region were $1.6 million and $1.4 million at September 30, 2012 and December 31, 2011, respectively.

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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 2011 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 2011 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 (ReachSearch), Web presence (ReachCast), display advertising (ReachDisplay), display retargeting (ReachRetargeting), online marketing analytics (TotalTrack), an out-of-the-box assisted chat service (TotalLiveChat), and other related products and services, each targeted to the SMB market. We deliver these solutions to SMBs through a combination of our proprietary platform, the 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—whether using traditional computing devices or mobile devices—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 September 2012, we launched ReachRetargeting, a ReachDisplay product targeting local consumers who have recently searched for an SMB’s business keywords as well as those who have recently visited their website. We continue to expand the RL Platform to include additional advertising products designed specifically for the needs of 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 advertising solutions. We sell ReachSearch and ReachDisplay 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 ReachCast, TotalTrack and TotalLiveChat. 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.

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In 2006, we entered our first market outside of North America through a joint venture in Australia, and in 2009, we acquired the remaining interest in the joint venture. We entered the United Kingdom and Canada in 2008, Germany and the Netherlands in 2011, and Japan and Brazil in 2012. We also serve clients in New Zealand, Slovakia and Poland through our resellers, including a franchisee. In 2010, we commenced campaign management and provisioning operations in India.

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 79% for the nine months ended September 30, 2012, from 78% for the nine months ended September 30, 2011. Growth in Direct Local revenue is primarily driven by the growth in the number of IMCs, the maturity of our IMCs, the increase in the number of international IMCs as a percentage of our total IMCs, and the increase in IMC productivity. Underclassmen expenses for the nine months ended September 30, 2012 and 2011 were $33.8 million and $32.7 million, respectively.

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 worldwide, 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. Our revenue growth is also driven by the increase in the number of our international IMCs as our international IMCs are on average more productive than our IMCs in North America, which we attribute to lower levels of competition and lower existing online advertising consumption by SMBs in those markets. The ongoing increase in the number of international IMCs is a result of our international expansion.

At September 30, 2012, we had 407 Upperclassmen and 450 Underclassman, for a total of 857 IMCs, as compared to 344 Upperclassmen and 464 Underclassman, for a total of 808 IMCs, as of September 30, 2011.

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.

We determine the amount to invest in Underclassmen based on our objectives for development of the business and the key factors affecting IMC productivity described above. The increase in Underclassmen Expense for the nine months ended September 30, 2012 as compared to the preceding year period was primarily attributable to our international expansion, partially offset by a reduced investment in North America.

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Active Advertisers and Active Campaigns

We track the number of Active Advertisers and Active Campaigns to evaluate the growth, scale and diversification of our business. We also use these metrics to determine the needs and capacity of our sales forces, our support organization, and other personnel and resources.

Active Advertisers is a number we calculate to approximate the number of clients directly served through our Direct Local channel as well as clients served through our National Brands, Agencies and Resellers channel. We calculate Active Advertisers by adjusting the number of Active Campaigns to combine clients with more than one Active Campaign as a single Active Advertiser. Clients with more than one location are generally reflected as multiple Active Advertisers. Because this number includes clients served through the National Brands, Agencies and Resellers channel, Active Advertisers includes entities with which we do not have a direct client relationship. Numbers are rounded to the nearest hundred.

Active Campaigns is a number we calculate to approximate the number of individual products or services we are managing under contract for Active Advertisers. For example, if we were performing both ReachSearch and ReachDisplay campaigns for a client, we consider that two Active Campaigns. Similarly, if a client purchased ReachSearch campaigns for two different products or purposes, we consider that two Active Campaigns. Numbers are rounded to the nearest hundred.

At September 30, 2012, we had approximately 22,100 Active Advertisers and 32,900 Active Campaigns, as compared to approximately 18,700 Active Advertisers and 27,000 Active Campaigns as of September 30, 2011. Active Advertisers and Active Campaigns increased over the period due to an increase in the number and maturity of IMCs, an increase in the number of products available for our IMCs to sell, and an increase in the productivity of our National Brands, Agencies and Resellers channel.

Recent Transactions

On July 3, 2012, we acquired certain assets and liabilities and hired certain employees of  RealPractice, Inc. The acquisition provided us with a technology team with expertise in marketing automation. At closing, we paid $2.6 million in cash of the estimated $2.9 million purchase price. The remaining amount of $0.3 million is payable in cash on the 18-month anniversary of the closing date, subject to adjustment. We issued 150,292 restricted stock units to the hired employees.

On July 6, 2012, we completed a transaction with OxataSMB B.V., in which we entered into a franchise agreement with OxataSMB permitting it to operate and resell our services under the ReachLocal brand in Slovakia, Czech Republic, Hungary, Poland and Russia. Pursuant to the franchise agreement, OxataSMB will receive access to the RL platform, training, marketing and branding materials, media purchasing, campaign management and provisioning, sourcing of telephony, and technical support. In addition, we entered into a market development loan agreement with OxataSMB pursuant to which we agreed to provide financing to OxataSMB of up to €2.9 million ($3.7 million), of which €1.45 million ($1.9 million) has been advanced. The ability to draw down the remaining loan amount is dependent on OxataSMB achieving certain milestones. The loan has a two-year term and accrues interest at 4% per annum, but does not require principal or interest payments for two years, and can be extended for an additional 24 months based on achievement of certain milestones. In addition, we have an option to buy OxataSMB at an independently-determined fair value at the end of the initial loan term, subject to extension.

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 (i) the sale of our ReachSearch, ReachDisplay, and other products based on a package pricing model in which our clients commit to a fixed fee that includes the media, optimization, reporting and tracking technologies of the RL Platform, and the personnel dedicated to support and manage their campaigns; (ii) the sale of our ReachCast, TotalTrack, TotalLiveChat, and other products and services; and (iii) 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.

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We typically enter into multi-month agreements for the delivery of our ReachSearch, ReachDisplay and ReachCast products. Under our agreements, our SMB clients typically pay, in advance, a fixed fee on a monthly basis, which includes all charges for the included technology and media services, management, third-party content and other costs and fees. We record these prepayments as deferred revenue and only record revenue for income statement purposes as we purchase media and perform other services on behalf of clients. Generally, when at least 85% of requisite purchases and other services have occurred and an additional campaign cycle remains under the agreement, we make an additional billing or automatic collection for the next campaign cycle.

Our National Brands, Agencies and Resellers clients enter into agreements of various lengths or that are indefinite. Our National Brands, Agencies and Resellers clients either pay in advance or are extended credit privileges with payment generally due in 30 to 60 days. There were $4.0 million and $3.8 million of accounts receivables related to our National Brands, Agencies and Resellers at September 30, 2012 and December 31, 2011, respectively.

Cost of Revenue

Cost of revenue consists primarily of the costs of online media acquired from third-party publishers. Media cost is classified as cost of revenue in the period in which the corresponding revenue is recognized. From time to time, publishers offer the Company rebates based upon various factors and operating rules, including the amount of media purchased. We record these rebates in the period in which they are earned as a reduction to cost of revenue and the corresponding payable to the applicable publisher, or as an other receivable, as appropriate. 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. In addition, the cost of agency commissions is included in selling and marketing expenses.

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.

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Product and technology expenses also include the amortization of the technology obtained in acquisitions and expenses of the deferred payment obligations related to acquisitions attributable to product and technology personnel.

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, public company costs and other corporate expenses.

Critical Accounting Policies and Estimates

The preparation of our condensed consolidated financial statements in conformity with GAAP, requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenue and expenses. We continually evaluate our estimates, judgments and assumptions based on available information and experience. Because the use of estimates is inherent in the financial reporting process, actual results could differ from those estimates.

There have been no material changes to our critical accounting policies. For further information on our critical and other significant accounting policies, see our 2011 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

•     Goodwill

•     Long-lived and intangible assets

•     Stock-based compensation

•     Variable interest entities

Revenue Recognition

We recognize revenue for our 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.

We recognize revenue as the cost for the third-party media is incurred, which is upon delivery of the advertising on behalf of our clients. We recognize revenue for our ReachSearch product as clicks are recorded on sponsored links on the various search engines and for our ReachDisplay products when the display advertisements record impressions or as otherwise provided in our agreement with the applicable publisher. We recognize revenue for our ReachCast product on a straight line basis over the applicable service period for each campaign. We recognize revenue when we charge 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 we receive advance payments from clients, we record these amounts as deferred revenue until the revenue is recognized. When we extend credit, we record a receivable when the revenue is recognized.

When we sell through agencies, we either receive payment in advance of services or in some cases extend credit. We pay each agency an agreed-upon commission based on the revenue we earn or cash we receive. Some agency clients that have been extended credit may offset the amount otherwise due to us by any commissions they have earned. We evaluate whether it is appropriate to record the gross amount of campaign revenue or the net amount earned after commissions. As we are the primary party obligated in the arrangement, subject to the credit risk, with 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.

We also have a small number of resellers, including a franchisee. Resellers integrate our services, including ReachSearch, ReachDisplay and TotalTrack, into their product offerings. In each case, the resellers integrate with the our RL Platform through a custom Application Programming Interface (API). Resellers are responsible for the price and specifications of the integrated product offered to their clients. Resellers pay us in arrears, net of commissions and other adjustments. We recognize revenue generated under reseller agreements net of the agreed-upon commissions and other adjustments earned or retained by the reseller, as we believe that the reseller has retained sufficient control and bears sufficient risks to be considered the primary obligor in those arrangements.

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We offer future incentives to clients in exchange for minimum commitments. In these circumstances, we estimate the amount of the future incentives that will be earned by clients and defer 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, we recognize the revenue previously deferred related to the estimated incentive.

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 record 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.

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

Our total goodwill of $42.1 million and $41.8 million as of September 30, 2012 and December 31, 2011, respectively, is related to our acquired businesses. In accordance with Accounting Standards Codification (“ASC”) 280, Segment Reporting, and have identified one segment and two reporting units—North America and Australia—for purposes of evaluating goodwill. These reporting units each constitute a business or group of businesses for which discrete financial information is available and is regularly reviewed by segment management. At September 30, 2012 and December 31, 2011, assigned-goodwill was $9.7 million for North America and $32.4 million for Australia, and $9.4 million for North America and $32.4 million for Australia, respectively. We review the carrying amounts of goodwill for possible impairment whenever events or changes in circumstance indicate that the related carrying amount may not be recoverable. We perform our annual assessment of goodwill impairment as of the first day of each fourth quarter.

We apply the guidance of ASC 350-20, Intangibles – Goodwill and Other. Entities are provided with the option of first performing a qualitative assessment on any of its reporting units to determine whether further quantitative impairment testing is necessary. An entity may also bypass the qualitative assessment for any reporting unit in any period and proceed directly to the quantitative impairment test. 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 a two-step impairment test is necessary. The first step of the impairment test involves comparing the estimated fair values of each of our reporting units with their respective carrying amounts, including goodwill. If the estimated fair value of a reporting unit exceeds its carrying amount, including goodwill, goodwill is considered not to be impaired and no additional steps are necessary. If, however, the estimated fair value of the reporting unit is less than its carrying amount, including goodwill, then the second step is performed to compare the carrying amount of the goodwill with its implied fair value. If the carrying amount of goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to the excess. We estimate fair value utilizing the projected discounted cash flow method and discount rate determined by management to commensurate the risk inherent in our business model.

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Long-Lived and Intangible Assets      

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 three years. Straight-line amortization is used because no other pattern over which the economic benefits will be consumed can be reliably determined.

Management reviews the carrying values of long-lived assets, including intangible assets, for possible impairment whenever events or changes in circumstance indicate that the related carrying amount may not be recoverable. In our analysis of other finite lived amortizable intangible assets, we apply the guidance of ASC 350-20, Intangibles – Goodwill and Other, in determining whether any impairment conditions exist. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. Intangible assets are attributable to the various developed technologies and client relationships of the businesses we have acquired.  Long-lived assets to be disposed of are reported at the lower of carrying amount or estimated fair value less cost to sell.

Stock-Based Compensation

We account for stock-based compensation based on fair value. We follow the attribution method, which reduces current stock-based compensation expenses recorded by the effect of anticipated forfeitures. We estimate forfeitures based upon our historical experience.

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. We use 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 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.

Variable Interest Entities

In accordance with ASC 810, Consolidations, the applicable accounting guidance for the consolidation of variable interest entities, or VIEs, we analyze our interests, including agreements, loans, guarantees, and equity investments, on a periodic basis to determine if such interests are variable interests. If variable interests are identified, then the related entity is assessed to determine if it is a VIE. Our analysis includes both quantitative and qualitative reviews. We base our quantitative analysis on the forecasted cash flows of the entity, and our qualitative analysis on the design of the entity, its organizational structure including its decision-making authority, and relevant agreements. If we determine that the entity is a VIE, we then assess if we must consolidate the VIE as its primary beneficiary.Our determination of whether we are the primary beneficiary is based upon qualitative and quantitative analyses, which assess the purpose and design of the VIE, the nature of the VIE’s risks and the risks that we absorb, the power to direct activities that most significantly impact the economic performance of the VIE, and the obligation to absorb losses or the right to receive benefits that could be significant to the VIE.

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Results of Operations

Comparison of the Three and Nine Months Ended September 30, 2012 and 2011

	Three Months Ended September 30,					Nine Months Ended September 30,
	2012		2011			2012		2011
(in thousands)
Revenue	$	118,891	$	98,629		$	335,106	$	275,439
Cost of revenue (1)		59,500		50,265			167,546		141,363
Operating expenses:
Selling and marketing (1)		42,860		36,769			122,579		103,457
Product and technology (1)		5,448		4,257			14,180		10,800
General and administrative (1)		9,966		8,821			30,241		24,470
Total operating expenses		58,274		49,847			167,000		138,727
Income (loss) from continuing operations		1,117		(1,483	)		560		(4,651	)
Other income, net		33		280			338		697
Income (loss) from continuing operations before provision for income taxes		1,150		(1,203	)		898		(3,954	)
Provision for income taxes		314		126			736		323
Income (loss) from continuing operations, net of income taxes		836		(1,329	)		162		(4,277	)
Loss from discontinued operations, net of income taxes		—		(3,272	)		—		(4,720	)
Net income (loss)	$	836	$	(4,601	)	$	162	$	(8,997	)

 

(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,
	2012		2011		2012		2011
Stock-based compensation:
Cost of revenue	$	73	$	60	$	198	$	176
Selling and marketing		437		325		1,122		1,068
Product and technology		488		421		868		976
General and administrative		1,597		1,525		4,741		4,096
	$	2,595	$	2,331	$	6,929	$	6,316
Depreciation and amortization:
Cost of revenue	$	131	$	194	$	401	$	551
Selling and marketing		457		413		1,576		1,080
Product and technology		2,385		1,862		6,435		5,033
General and administrative		536		359		1,257		971
	$	3,509	$	2,828	$	9,669	$	7,635

 

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Revenue

	Three Months Ended September 30,							Nine Months Ended September 30,
	2012		2011		2012-2011 % Change			2012		2011		2012-2011 % Change
(in thousands)
Direct Local	$	93,537	$	76,814		21.8	%	$	263,534	$	213,168		23. 6	%
National Brands, Agencies and Resellers		25,354		21,815		16.2			71,572		62,271		14.9
Total revenue	$	118,891	$	98,629		20.5	%	$	335,106	$	275,439		21.7	%
At period end:
Number of IMCs:
Upperclassmen									407		344		18.3	%
Underclassmen									450		464		(3.0	)
Total									857		808		6.1	%
Active Advertisers (1)									22,100		18,700		18.2	%
Active Campaigns (2)									32,900		27,000		21.9	%

(1) Active Advertisers is a number we calculate to approximate the number of clients directly served through our Direct Local channel as well as clients served through our National Brands, Agencies and Resellers channel. We calculate Active Advertisers by adjusting the number of Active Campaigns to combine clients with more than one Active Campaign as a single Active Advertiser. Clients with more than one location are generally reflected as multiple Active Advertisers. Because this number includes clients served through the National Brands, Agencies and Resellers channel, Active Advertisers includes entities with which we do not have a direct client relationship. Numbers are rounded to the nearest hundred.

(2) Active Campaigns is a number we calculate to approximate the number of individual products or services we are managing under contract for Active Advertisers. For example, if we were performing both ReachSearch and ReachDisplay campaigns for a client, we consider that two Active Campaigns. Similarly, if a client purchased ReachSearch campaigns for two different products or purposes, we consider that two Active Campaigns. Numbers are rounded to the nearest hundred.

The increase in Direct Local revenue of $16.7 million and $50.4 million for the three and nine months ended September 30, 2012, respectively, compared to the same periods in 2011 was largely attributable to an increase in the number of Upperclassmen and the productivity of Upperclassmen driven by their increased tenure. Also contributing to the increase was growth in the number of international IMCs who, on average, are more productive than our IMCs in North America.

The increase in National Brands, Agencies and Resellers revenue of $3.5 million and $9.3 million for the three and nine months ended September 30, 2012, respectively, compared to the same periods in 2011, was due to increases in revenue from our domestic and international National Brands clients of $1.6 million and $4.9 million for the three and nine months ended September 30, 2012, respectively, and increases in revenue of $2.0 million and $4.4 million from our domestic and international Agencies and Resellers for the three and nine months ended September 30, 2012, respectively. In each period, these increases were primarily driven by increases in spend from existing National Brands clients and existing Agencies and Resellers, as well as an increase in the number of Agencies and Resellers.

Cost of Revenue

	Three Months Ended September 30,									Nine Months Ended September 30,
	2012			2011			2012-2011 % Change			2012			2011			2012-2011 % Change
(in thousands)
Cost of revenue	$	59,500		$	50,265			18.4	%	$	167,546		$	141,363			18.5	%
As a percentage of revenue:		50.0	%		51.0	%					50.0	%		51.3	%

 

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The decrease in our cost of revenue as a percentage of revenue for the three months ended September 30, 2012 compared to the same period in 2011 was primarily due to an increase in publisher rebates and the change in our product and service mix, partially offset by the change in our geographic mix. The decrease for the nine months ended September 30, 2012, compared to the same period in 2011, was primarily due to an increase in publisher rebates, partially offset by the change in our geographic, product and service mix. As we enter new markets the initial sales focus is on our ReachSearch product, which affects our product and service mix.  

Publisher rebates as a percentage of revenue increased to 4.5% of revenue in the three months ended September 30, 2012 from 3.9% for the same period in 2011, and to 4.6% of revenue in the nine months ended September 30, 2012 from 2.8% for the same period in 2011, due to more favorable rebate terms from various publishers.

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 geographic mix, our media buying efficiency, and the costs of support and delivery.

Operating Expenses

Over the past several years, we have significantly increased the scope of our operations. We intend to continue to increase our sales force, product offerings and the infrastructure to support them. In growing our business, particularly in international markets, we are incurring expenses to support our long-term growth plans, acknowledging that these investments may put pressure on near-term periodic operating results and increase our operating expenses as a percentage of revenue.

Selling and Marketing 

	Three Months Ended September 30,									Nine Months Ended September 30,
	2012			2011			2012-2011 % Change			2012			2011			2012-2011 % Change
(in thousands)
Salaries, benefits and other costs	$	30,305		$	26,086			16.2	%	$	86,560		$	73,047			18.5	%
Commission expense		12,555			10,683			17.5	%		36,037			30,410			18.5	%
Total selling and marketing	$	42,860		$	36,769			16.6	%	$	122,597		$	103,457			18.5	%
Underclassmen Expense included above, excluding commissions (1)	$	11,441		$	11,591			(1.3	)%	$	33,824		$	32,714			3.4	%
As a percentage of revenue:
Salaries, benefits and other costs		25.5	%		26.4	%					25.8	%		26.5	%
Commission expense		10.6	%		10.8	%					10.8	%		11.0	%
Total selling and marketing		36.0	%		37.3	%					36.6	%		37.6	%

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

The increase in selling and marketing salaries, benefits and other costs in absolute dollars for the three and nine months ended September 30, 2012, compared to the same periods in 2011, was primarily due to an increase in our IMC headcount and related recruiting, training and facilities costs.  The decrease in these costs as a percentage of revenue for the three and nine months ended September 30, 2012, compared to the same periods in 2011, was primarily due to increased productivity and operational scale in our established markets, partially offset by expenses related to our entrance into new international markets.

The increase in commission expense in absolute dollars for the three and nine months ended September 30, 2012, compared to the same periods in 2011, was due to increased sales. As a percentage of revenue, commission expense was slightly lower compared to the prior periods. 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.

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Underclassmen Expense for the three months ended September 30, 2012 was slightly lower compared to the same period in 2011, primarily due to decreased IMC hiring in our established markets, offset by increased hiring in our newer markets. The increase for the nine months ended September 30, 2012, compared to the same periods in 2011, was primarily due to increased IMC hiring in our newer markets, partially offset by reduced IMC hiring in our established markets. As we continue to invest in additional Underclassmen and retain additional Upperclassmen, selling and marketing expenses will continue to increase in absolute dollars.

Product and Technology

	Three Months Ended September 30,									Nine Months Ended September 30,
	2012			2011			2012-2011 % Change			2012			2011			2012-2011 % Change
(in thousands)
Product and technology expenses	$	5,448		$	4,257			28.0	%	$	14,180		$	10,800			31.3	%
Capitalized software development costs from product and technology resources		2,224			1,682			32.2	%		6,295			5,690			10.6	%
Total product and technology expenses and capitalized costs	$	7,672		$	5,939			29.2	%	$	20,475		$	16,490			24.2	%
As a percentage of revenue:
Product and technology expensescosts		4.6	%		4.3	%					4.2	%		3.9	%
Capitalized software development costs from product and technology resources		1.9	%		1.7	%					1.9	%		2.1	%
Total product and technology costs expensed and capitalized		6.5	%		6.0	%					6.1	%		6.0	%

 

The increase in product and technology expenses in both absolute dollars and as a percentage of revenue for the three months ended September 30, 2012, compared to the same period in 2011, was primarily attributable to $0.8 million of increased salaries and compensation expense as a result of increased headcount related to the ongoing development of the RL Platform and new product initiatives, in particular those resulting from the acquisition of RealPractice.

The increase in product and technology expenses in absolute dollars for the nine months ended September 30, 2012, compared to the same period in 2011, was primarily attributable to $2.8 million of increased salaries and compensation expense as a result of increased headcount related to the ongoing development of the RL Platform and new product initiatives, and $0.9 million of increased amortization expense related to previously capitalized software development costs. The increase as a percentage of revenue was primarily attributable to increased salaries and compensation expense as a result of increased headcount related to the ongoing development of the RL Platform and new product initiatives.

The changes in the amount of capitalized software development costs in both absolute dollars and as a percentage of revenues for the three and nine months ended September 30, 2012, compared to the same periods in 2011, were primarily due to the timing and mix of capitalizable and non-capitalizable projects.

General and Administrative

	Three Months Ended September 30,									Nine Months Ended September 30,
	2012			2011			2012-2011 % Change			2012			2011			2012-2011 % Change
(in thousands)
General and administrative	$	9,966		$	8,821			13.0	%	$	30,241		$	24,470			23.6	%
As a percentage of revenue:		8.4	%		8.9	%					9.0	%		8.9	%

 

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The increase in general and administrative expenses in absolute dollars for the three months ended September 30, 2012, compared to the same period in 2011, was primarily due to $1.8 million of increased employee and facilities costs to support the growth of the business, including our international expansion, partially offset by $0.7 million of decreased professional fees, which consist of tax, consulting, audit and legal fees. General and administrative expense decreased slightly as a percentage of revenue for the three months ended September 30, 2012 as a result of the aforementioned decrease in professional fees.

The increase in general and administrative expenses in absolute dollars and as a percentage of revenue for the nine months ended September 30, 2012, compared to the same period in 2011, was primarily due to  $5.3 million of increased employee and facilities costs to support the growth of the business, including our international expansion, and $0.6 million of increased stock-based compensation expense, partially offset by $0.3 million of decreased professional fees, which consist of tax, consulting, audit and legal fees.

We expect general and administrative expenses to increase in absolute dollars as we continue to add personnel and incur additional professional fees and other expenses to support our continued domestic and international growth.

Other Income , Net

Other income, net decreased for the three and nine months ended September 30, 2012 compared to the same periods in 2011 due to foreign exchange rate fluctuations and lower interest rates on invested balances. Other income, net primarily consists of interest income resulting from invested balances.

Provision for Income Taxes

The income tax provisions of $0.7 million and $0.3 million for the nine months ended September 30, 2012 and 2011, respectively, relate to federal, state and foreign income taxes, including the deferred tax impact of prior business combinations.

Loss from Discontinued Operations

There was no activity in the discontinued operations of Bizzy during the three and nine months ended September 30, 2012. The loss from discontinued operations of $1.5 million and $4.7 million for the three and nine months ended September 30, 2011, respectively, was related to the wind-down of the operations of Bizzy.

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, 2012 and 2011, our Adjusted EBITDA and Underclassmen Expense were as follows:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
(in thousands)
Adjusted EBITDA (1)	$	7,221	$	4,530	$	17,190	$	10,674
Underclassmen Expense (2)	$	11,441	$	11,591	$	33,824	$	32,714

 

(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.

(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.

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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.

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.

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The following table presents a reconciliation of Adjusted EBITDA to our income (loss) from operations for each of the periods indicated:

	Three Months Ended September 30,					Nine Months Ended September 30,
	2012		2011			2012		2011
(in thousands)
Income (loss) from continuing operations	$	1,117	$	(1,483	)	$	560		(4,651	)
Add:
Depreciation and amortization		3,509		2,828			9,669		7,635
Stock-based compensation, net		2,595		2,331			6,929		6,316
Acquisition and integration costs		—		854			32		1,374
Adjusted EBITDA	$	7,221	$	4,530		$	17,190	$	10,674

 

Liquidity and Capital Resources

	Nine Months Ended September 30,
Consolidated Statements of Cash Flow Data:	2012			2011
(in thousands)
Net cash provided by operating activities, continuing operations	$	31,584		$	19,894
Net cash used in investing activities, continuing operations	$	(25,555	)	$	(8,371	)
Net cash used by discontinued operations	$	(182	)	$	(2,551	)
Net cash provided by (used in) financing activities	$	(3,756	)	$	5,515

At September 30, 2012, we had cash and cash equivalents of $86.7 million and short-term investments of $9.0 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 but less than 12 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, 2012, we had no long-term indebtedness for borrowed money and are not subject to any restrictive bank covenants. At September 30, 2012, we had $0.9 million in restricted certificates of deposit to secure letters of credit issued to landlords and others.

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 decrease our income from operations.

Operating Activities

Our cash flow from operating activities during the nine months ended September 30, 2012 resulted from income from continuing operations, net of income taxes, of $0.2 million, supplemented by non-cash depreciation and amortization of $9.7 million, and non-cash stock-based compensation of $6.9 million. Cash flow from operating activities also reflected increases in accounts payable and accrued expenses of $10.0 million due to growth of the business and the fluctuation in timing of payments to certain vendors, including the normalization of rebates receivable, and increases in deferred revenue, rent and other liabilities of $7.0 million due to the growth of our business.

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 and increases in deferred revenue, rent and other liabilities 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.

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Investing Activities

During the nine months ended September 30, 2012, our primary investing activities consisted of purchases of property and equipment, capitalized software development costs, short-term investments, and business acquisitions. Our purchases of property and equipment and capitalization of software costs increased by $2.0 million year-over-year reflecting our increased investment in technology and facilities and newer markets. Purchases of property and equipment and capitalization of software costs will vary from period to period due to the timing of the expansion of our operations and our software development efforts.

We entered into a market development loan agreement with OxataSMB pursuant to which we agreed to provide financing to OxataSMB of up to €2.9 million ($3.7 million), of which €1.45 million ($1.9 million) has been advanced. We also purchased certificates of deposits and short-term investments of $8.4 million.

In addition, we made acquisition related payments of $4.1 million, consisting of payments on deferred obligations related to the DealOn and SMB:LIVE acquisitions totaling $1.6 million, and payment for the RealPractice acquisition of $2.6 million. We have remaining obligations totaling $0.8 million related to these acquisitions.

During the nine months ended September 30, 2011, we invested $6.2 million, net of cash acquired, in the purchase of DealOn and other acquisition obligations.

Financing Activities

Our cash used in financing activities during the nine months ended September 30, 2012 resulted primarily from repurchases of our common stock of $5.4 million pursuant to our share repurchase program, partially offset by $1.6 million in proceeds from exercise of stock options. During the nine months ended September 30, 2011, we received $5.5 million in proceeds from exercise of stock options

Future cash flows from financing activities may also be affected by our repurchases of our common stock pursuant to our share repurchase program. On November 4, 2011, we announced that our Board of Directors authorized the repurchase of up to $20.0 million of our outstanding common stock. At September 30, 2012, we had executed repurchases of $11.9 million or 1,506,000 shares of our common stock under the program. Purchases may 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, 2012, we did not have any off-balance sheet arrangements. Please refer to “Overview-—Recent Transactions” discussion under the “Liquidity and Capital Resources” section for information on our market development loan agreement with OxataSMB.

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.

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Foreign Currency Exchange Risk

We have foreign currency risks related to our investments, 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 euro, the Japanese yen, and the Indian rupee. For the nine months ended September 30, 2012, a 10% increase in these exchange rates relative to the dollar would have resulted in a decrease in revenue of $10.1 million and an increase in operating income of $0.5 million. A 10% decrease in these exchange rates relative to the dollar, however, would have resulted in an increase in revenue of $10.1 million and a decrease in operating income of $0.5 million. We currently do not hedge or otherwise manage our currency exposure. As our international operations expand to more countries 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, 2012. 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

During the quarter ended September 30, 2012, we migrated our financial accounting system to an enterprise-wide systems solution. In addition, we transitioned to an integrated stock-based compensation tracking and reporting system. These system implementations are part of our ongoing efforts to enhance the design and documentation of our internal control over financial reporting processes to maintain suitable controls over our financial reporting.

Except as described above, there were no changes in our internal control over financial reporting during the quarter ended September 30, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II

OTHER INFORMATION

Item 1.      LEGAL PROCEEDINGS

From time to time we are involved in various legal proceedings and claims arising in the ordinary course of business. Although occasional adverse decisions or settlements may occur, we believe that the final disposition of existing matters will not have a material adverse effect on our financial position, results of operations or cash flows.

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, 2011, in addition to the other information contained in our Annual Report and in this quarterly report on Form 10-Q.

Item 2.      UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

On November 4, 2011, we announced that our Board of Directors adopted a program that authorized the repurchase of up to $20.0 million of our outstanding common stock. At September 30, 2012, we had repurchased approximately 1.5 million shares of our common stock under the program for an aggregate of $11.9 million, of which $1.4 million was repurchased during the three months ended September 30, 2012. 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.

Common stock repurchases during the quarter ended September 30, 2012 were as follows:

Period	Total Number of Shares Purchased			Average Price Paid Per Share	Total Number of Shares Purchased as Part of a Publicly Announced Program		Maximum Value of Shares That May Yet Be Purchased Under a Publicly Announced Program
July 2012		17,877	$	9.97		17,877	$	9,329,436
August 2012		69,535	$	12.36		69,535	$	8,467,751
September 2012		26,494	$	12.44		26,494	$	8,137,352

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Item 6.          EXHIBITS

Exhibit No	Description of Exhibit
10.01	Amendment Number Three to the Google Adwords Reseller Agreement, dated August 17, 2012, between ReachLocal EuropeBV and Google Ireland Limited
10.02	Transition Agreement between ReachLocal, Inc. and Michael Kline, dated November 1, 2012
31.01	Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.02	Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.01	Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.02	Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS	XBRL Instance Document
101.SCH	XBRL Taxonomy Extension Schema Document
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF	XBRL Taxonomy Extension Definition Linkbase Document
101.LAB	XBRL Taxonomy Extension Label Linkbase Document
101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document

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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:	Chief Executive Officer
By:	/s/ Ross G. Landsbaum
Name:	Ross G. Landsbaum
Title:	Chief Financial Officer

Date: November 6, 2012

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EXHIBIT INDEX

Exhibit No	Description of Exhibit
10.01	Amendment Number Three to the Google Adwords Reseller Agreement, dated August 17, 2012, between ReachLocal EuropeBV and Google Ireland Limited
10.02	Transition Agreement between ReachLocal, Inc. and Michael Kline, dated November 1, 2012
31.01	Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.02	Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.01	Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.02	Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS	XBRL Instance Document
101.SCH	XBRL Taxonomy Extension Schema Document
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF	XBRL Taxonomy Extension Definition Linkbase Document
101.LAB	XBRL Taxonomy Extension Label Linkbase Document
101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document

* Certain provisions of this exhibit have been omitted pursuant to a request for confidential treatment.

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