Description

Marchex, Inc. (Nasdaq: MCHX, www.marchex.com, 3.8% dividend yield) is a very rare find. Based in Seattle, MCHX is a severely mispriced, fast-growing, free cash flow and intellectual property rich company that has been left for dead by investors after series of guidance reductions relating to its non-core business units.  As the sale of non-core assets is completed as expected, MCHX will be transformed into a market-leading, pure-play digital/mobile call advertising company with strong free cash flow, fast growth and mission-critical IP assets that will most likely be acquired by a major technology/media company driven by both offensive (growth) and defensive (IP) motives. 

Buyers of the stock at $3.65 today are getting the core, $15mm+ EBITDA, fast-growing business and IP assets potentially for free, at an estimated Adjusted TEV ranging from $(26)mm to $44mm, creating an opportunity for investors to return several multiples on their investment as value is realized.  When one peels back the onion, it becomes clear why management is aggressively buying stock in both personally (via new 10b5-1 plans) and for the company (via a 2mm share repurchase) at these levels.  A limited float, extremely high short interest (21 days to cover) and several near-term catalysts could easily drive the stock back over $10.00 on a standalone basis, and potentially much higher as MCHX is ultimately sold to a large strategic buyer (MSFT/GOOG/YHOO/FB, etc.), where a valuation could be multiples of MCHX’s annual revenues given the company’s leading technology and strategic patent portfolio, and the fast-growing smartphone/mobile advertising market.

Keys to the thesis are as follows:

• Valuation – core business free or nearly free:  While MCHX is quite cheap on the surface at 5.7x EBITDA, after accounting for the company’s large non-core assets, which are in the process of being monetized, one will realize that the core business and mission-critical IP is available for free at this price.  Further, I expect MCHX’s core digital call business to grow sales from $115mm in 2012 to $125mm+ in 2013, and EBITDA from ~$15mm in 2012 to $18-19mm+ in 2013, as margins increase on the path to management’s target of 20%+.

• Highly strategic patents:  MCHX owns patents critical to the online and mobile advertising and call generation business, substantially increasing the likelihood that MCHX will be acquired by a large digital marketing company (i.e. MSFT, GOOG, YHOO, FB, et al).  See list of patents later in this write-up. 

• Valuable deferred tax assets:  MCHX has $48mm of deferred tax assets on its balance sheet that the company expects to realize.  As a result, the company will not be a cash taxpayer for the near future.  While these DTAs are likely worth 30%+ of book value on a cash basis, I have conservatively estimated a range of values from $5-15mm herein.  It is unclear at this point whether non-core asset sales will result in any DTAs being used.

• Monetization of non-core businesses:  MCHX has announced its intention to sell its non-core, declining legacy businesses and create a pure-play mobile and call advertising and analytics company.  The non-core businesses, including directory, pay-per-click and reputation management, generate approximately $5mm of EBITDA in total.  Applying a 3-4x multiple on this cash flow yields an estimated value of $15-20mm.

• Strong and incentivized management team:  MCHX was founded and is led by Russell Horowitz, who previously founded Go2Net, a Seattle search firm that was ultimately sold to InfoSpace for $3.9bn in 2000.   The company’s President, CAO & General Counsel, and Executive Vice Chairman are each also Go2Net veterans.  In total, insiders own 15.6mm MCHX shares, representing over 40% of the shares outstanding.

• Senior management 10b5-1 stock purchase commitment:  On May 3, MCHX announced that Chairman & CEO Russell Horowitz, CFO Michael Arends, Executive Vice Chairman John Keister and CAO & GC Ethan Caldwell intend to purchase MCHX shares in the open market over the balance of the year.  Horowitz, who already owned over 7mm Class A shares, stated his intention to purchase up to $1 million of additional Class B shares prior to year end.  Since this announcement, Horowitz has been actively acquiring stock in the open market.
  • The 10b5-1 programs are very significant as management clearly does not want to be prohibited from acquiring stock as likely event catalysts emerge.

• Doubled share repurchase program:  On May 14, MCHX announced that it had increased its share repurchase program from 1mm to 2mm shares.  The CEO commented “when we add up the value of our domain assets, cash on our balance sheet and present value tax assets, in addition to our core mobile performance call-driven business, we believe Marchex has built significant but under-recognized value as a company. When weighed against our current valuation, this is one of the reasons why the company has bought back a significant amount of stock and our other executives for purchasing Marchex in the open market.”

• 3.8% dividend yield:  With the Q2 earnings release, MCHX announced that it increased the quarterly dividend from $0.02 to $0.035 per share of both the Class A and Class B shares, stating “Marchex believes the continued cash generating characteristics of its business, domain sales, and other potential asset sales or divestitures can adequately fund the dividend and ongoing capital needs of the company.”

• Large and fast-growing market:  BIA/Kelsey recently estimated the mobile and pay-per-call market to grow to $5 billion annually in the U.S. by 2016, up from a nascent market today.  http://www.biakelsey.com/Company/Press-Releases/120627-Growth-in-Call-Based-Advertising-Spawns-Purchase-Intercept-Market-for-Redirecting-Valued-Telephone-Leads-to-Businesses.asp

• Strong business momentum:  Following are selected quotes from the Q2 conference call, which occurred on August 2:
  • Horowitz:  “In the second quarter, we saw record levels of customer growth and usage with our call analytics platform.  Through our Digital Call Marketplace, Marchex works with more than 100 different publishing sources, including some of the largest mobile carriers and mobile applications providers, to deliver quality inbound consumer calls to some of the largest advertisers in the country, as well as the hundreds of thousands of small businesses on a pay-per-call performance basis. Customers who participate in our Digital Call Marketplace receive call analytics as part of the service we provide.”
  • Horowitz:  “In the second quarter, we continued to add new advertisers, including performance-based call advertising entrants, such as Hertz and the University of Phoenix. We're continuing to make progress at increasing our advertiser breadth in many core categories, including auto, cable and satellite, education, financial services, health, home services, local, real estate, retail and travel. We also grew many of our existing relationships as our performance exceeds alternative channels, including search, display and other digital advertising forms.”
  • Arends:  “We expect momentum to continue into the back half of 2012 with sequentially increasing call-driven revenues for the third and fourth quarters.”

• High short interest:  Short interest presently sits at 2.3mm shares per Capital IQ, representing approximately 21 days to cover.  When positive catalysts arrive, there simply will not be sufficient supply of shares available to purchase near current prices, likely setting up a powerful short squeeze.

Business:

MCHX is the market leader in digital call advertising focused largely on smartphone users, and generates revenue primarily through its performance-based digital call advertising products, the Marchex Digital Call Marketplace and the Marchex Call Analytics platform. 

As succinctly described in Seattle Business Magazine, this is how MCHX’s call advertising works:

• Marchex helps advertisers insert special local or toll-free phone numbers into advertisements that can run anywhere — online, offline, on a billboard, in a print ad or on a flier.
• Once a prospective customer picks up the phone and calls an ad’s phone number, the magic begins. Using its sophisticated Call Analytics software, Marchex determines whether it leads to an actual sale. If a customer buys a product or service, Marchex or the digital advertising agency or network licensing Marchex’s software gets paid $20, $30, $60 or more for delivering the customer.
• That’s a far cry from the $2,000 a month some service providers are spending to advertise in the Yellow Pages, and one that advertisers in the know are scrambling to use.
• Marchex gets fees from the reseller depending upon the services rendered by the Seattle company, which can include call tracking, analytics, advertising services or distribution over its own network.

Patents

MCHX owns the following pending patent applications and issued patents:

• U.S. Patent Number 7,668,950 entitled “Automatically Updating Performance-Based Online Advertising System and Method” was issued February 23, 2010.
• U.S. Nonprovisional Patent Application Number 11/985,188 entitled “Method and System for Tracking Telephone Calls” was filed on November 14, 2007 and a corresponding divisional Patent Application Number 13/294,436 was filed November 11, 2011.
• U.S. Patent Number 6,822,663 entitled “Transform Rule Generator for Web-Based Markup Languages” was issued November 23, 2004.
• U.S. Nonprovisional Patent Application Number 12/512,821 entitled “Facility for Reconciliation of Business Records Using Genetic Algorithms” was filed on July 30, 2009.
• U.S. Nonprovisional Patent Application Number 12/829,372 entitled “System and Method to Direct Telephone Calls to Advertisers” and U.S. Nonprovisional Patent Application Number 12/829,373 entitled "System and Method for Calling Advertised Telephone Numbers on a Computing Device” and U.S. Nonprovisional Patent Application Number 12/829,375 entitled "System and Method to Analyze Calls to Advertised Telephone Numbers" were all filed on July 1, 2010. U.S. Respective corresponding PCT Application Numbers PCT/US11/42792, PCT/US11/42812 and PCT/US11/42819 were filed July 1, 2011.
• U.S. Nonprovisional Patent Application Number 12/844,488 entitled “Systems and Methods for Blocking Telephone Calls” was filed on July 27, 2010 and corresponding PCT Application Number PCT/US11/45403 was filed July 26, 2011.
• U.S. Patent Number 7,212,615 entitled “Criteria Based Marketing For Telephone Directory Assistance” was issued May 1, 2007 owned by Jingle Networks, Inc. (“Jingle”) which we acquired in 2011.
• U.S. Patent Number 7,702,084 entitled “Toll-Free Directory Assistance With Preferred Advertisement Listing” was issued April 20, 2010.
• U.S. Patent Number 7,961,861 entitled “Telephone Search Supported By Response Location Advertising” was issued June 14, 2011 and corresponding European Application Number 5826299.99 was filed November 29, 2005.
• U.S. Nonprovisional Patent Application Number 11/290,148 entitled “Telephone Search Supported By Advertising Based On Past History Of Requests” was filed November 29, 2005.
• U.S. Nonprovisional Patent Application Number 11/291,094 entitled “Telephone Search Supported By Keyword Map To Advertising” was filed November 29, 2005.
• U.S. Nonprovisional Patent Application Number 11/728,189 entitled “Toll-Free Directory Assistance With Automatic Selection Of An Advertisement From A Category” was filed March 23, 2007.
• U.S. Nonprovisional Patent Application Number 11/897,262 entitled “Directory Assistance With Data Processing Station” was filed August 29, 2007.

Recent Jingle Networks Acquisition

On April 11, 2011, MCHX announced its pending acquisition of mobile voice search leader Jingle Networks for $62.5mm of cash and stock (http://investors.marchex.com/phoenix.zhtml?c=175199&p=irol-newsArticle&ID=1672433&highlight=).  Having made an $18mm cash payment to Jingle holders in April 2012, the final payment of $18mm is due in October.  While MCHX has the option to issue stock for this payment, all indications are that this payment will be made in cash.  CFO Michael Arends noted on the latest conference call:  “We have a little over $33 million cash on hand at the end of June, and we are cash-generating, as you know, every quarter from an operating cash flow. We generated actually $8 million in operating cash flow this last quarter. The Jingle payment in October is $18 million, and so by that point in time, we will one have -- continued to increase our cash coffers just from operating cash flow. But in addition to that, we still see a significant interest on the part of different parties out there and some of our domain name assets, and so that would be incremental from a cash perspective, any sales that we have on top of our operating cash flow. So we should have a fairly satisfactory level of cash flow, as well as cash balances, by the October payment date.”

How Will Value Be Realized?

I expect value to be realized in multiple steps here:

1. Domain name sale(s).  The ramping up of this process will bring this otherwise hidden/ignored asset to light as having substantial value, which I estimate will range between $50-100mm, which may prove conservative.
2. Non-core business sale.  While likely worth $15-20mm, this will also create a pure-play digital call advertising company which will command a premium valuation.
3. Margin expansion.  Management expects the core business to grow EBITDA margins from low teens to 20%+ in forward years.
4. Sale to large strategic buyer:  The most likely acquirers of MCHX are MSFT, GOOG, YHOO, and FB.  While GOOG is a “self-service” provider in the digital call advertising segment, MCHX is known for its best-in-class Marchex Call Analytics package and top-notch customer service.  The most likely acquirer of MCHX is probably MSFT, which lacks capabilities in this segment.  Moreover, as MCHX is also based in Seattle, and MCHX board members include Nic Hanauer (former Chairman of Microsoft Advertising/aQuantive) and Wayne Wisehart (former CFO of aQuantive), the relationships here would seem to be strong.  YHOO may also be a candidate given its new strategic plans for growth, while FB is also a potential buyer.  As noted above, strategic buyers will surely be motivated by both offensive (growth) and defensive (IP) factors.

Risks

The primary risks relate to the ability to execute on the stated business plan, withstand competition and continued ability to reduce its concentration with YP Holdings (formerly AT&T Interactive), which represented 28% of Q2 2012 revenue.  With regard to YP, Horowitz said on the 8/2/12 call "We feel good about where the relationship is. We're not giving specific commentary about spend levels, but we support them on an exclusive basis with multiple products. Our Call Marketplace is, I think, a critical piece of the value proposition that their end customers get. We are the most cost-effective provider of high-quality leads, and so we think there's opportunities for growth in general and with that relationship, particularly, as we think about the balance of the year and beyond."

Disclaimer:  The author of this idea presently has a long position in securities of this issuer and may trade in and out of these positions without notice.  The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates.  No representation or warranty is made as to the accuracy of the data or opinions contained herein.

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