Berk Sure Has A Way

Motley Fool’s Rick Aristotle Munarriz had an article about Marchex this week. I thought I would address some of what Rick said. All quotes in this article are his and the full article is here.

Rick: “Anyway, Marchex certainly wouldn’t seem to be a company in need of fixing. The stock has shot up nearly 80% since bottoming out in August. Marchex is profitable and, last month, posted a 110% spurt in revenue.  The company toils away in the lucrative online advertising market. It owns a few contextual pay-per-click marketing outfits like IndustryBrains and Enhance Interactive.”

Myth 1: 110% spurt in revenue – this is not on a pro forma basis. Y/Y revenue growth was 25% and the business has only grown 7% from Q1 to Q3 of this year. See my post about the lack of organic growth at MCHX.

Myth 2: lucrative online advertising business – this is true only for traffic owners. Enhance, IndustryBrains and GoClick are low margin businesses that need to share most of their revenue with their partners. In the case of Enhance and GoClick, these partners are likely low quality traffic sources. Less than a third of Marchex’s revenue comes from traffic they own.  See my post on Enhance and GoClick.

Rick: “Anyway, if you want to know why I bought Marchex, it’s because one of its biggest domains is hardware-update.com. It may not exactly roll off the tongue, but it was a site that Microsoft (Nasdaq: MSFT) used to send users of Windows 2000 to when they received hardware-related error messages. Some schmuck at Microsoft forgot to renew the domain, and a company that Marchex went on to acquire gobbled it up.

However, if you go there, you’ll see that the sponsored listings have little to do with Windows operating system problems, computer upgrades, or attractive peripherals. No, most of the ads in the main body of the page are for replacement windows for the home. Talk about a blown opportunity. I have no idea how poorly targeted the other Marchex properties may be, but although this might be indicative, my excitement is still there. It’s an easy fix, and it represents untapped profit potential that will come around once the company wakes up from its shortcomings.”

Myth 3: All of MCHX’s domains have long term value. Some of MCHX’s domains have inherent value (debts.com for example) as type in direct traffic destinations. But some of MCHX’s domains (e.g. hardware-update.com) are expired links with residual traffic from existing links on the web. Without the external links from Microsoft, no one would ever find hardware-update.com. Marchex could invest in making these domains more targeted, but over time (usually a few years) expired domains lose almost all of their traffic as links are removed or replaced. See the Alexa traffic chart below to see how this domain has lost traffic over time – even though it has been mentioned in a few articles recently it still is not in the top million sites even though it used to be. Revenue from these domains with expired links will need to be replaced with new sources or prove to be a drag on MCHX’s revenue and profits.

I own puts on MCHX shares.

Since my initial JCOM analysis, the stock has performed quite well – up over 30%. People are asking me if they should sell their shares. Since my last post, I have purchased and sold calls as well as sold about 10% of my holdings. I sold mainly to diversify. JCOM is still my largest holding (over 30% of my portfolio!) and I still believe their business and stock have a ton of potential, but I do have some short term concerns. I will start with my concerns and then move to long term potential.

Short Term Concerns:

Revenue growth is slowing – that is well known. It is hard to keep 50%+ revenue growth up (unless you are Google). What would be a true concern if growth stops (or god forbid declines) in the US market – this could indicate market saturation or a slowdown driven by a housing market downturn. Overall, I expect that any slowdown could be addressed with product and marketing shifts (different product tiers to convert more free subs, more aggressively licensing and partnerships). However, a slow growth quarter could severely hurt the stock in the near term.

Q3’s performance was within guidance. JCOM hit the top end of their guidance range (48-49 cents), but did not exceed it as it usually does. For many high-growth companies, this is fine, but JCOM has historically given conservative guidance.  For JCOM to only "hit" the top end of the range, it may indicate that growth was not as robust as they had hoped. To be fair, JCOM was coming off of strong growth in Q2. Nonetheless, it is worth watching earnings growth rates.

Q4’s guidance is wide and the low end implies low growth. Q3’s earnings (excluding a one time gain) was $0.49 and guidance for Q4 is $0.50 to $0.54. I could say, “Hey, $0.54 would be great!” But… the contrarian in me says: “Why the wide range? They generally are able to predict their quarters pretty accurately.” and “ Only $0.50? That’s only one penny more than Q3.” Part of their explanation was potential licensing deals. More likely is that acquisitions are beginning to play a bigger role in top and bottom line growth.

Long term potential:

Patent Licensing. Over the years I’ve wondered how efax has kept competition at bay. Clearly efax is a good brand and that helps, but I’ve come to the conclusion that the larger players that would like to add the faxing functionality have decided it is not worth the litigation risk to launch the product without licensing JCOM’s patents. From last quarter’s call it sounds like JCOM is starting to hold more active discussions on this front. If done right, patent licensing could become JCOM’s biggest profit center as telecom, cable and internet firms battle it out for customer ownership. JCOM’s features could provide a differentiator to attract and retain bundled customers.

Buyout Candidate? If JCOM’s patents hold up and they can convince anyone to license them, they may be an excellent candidate for a telco or web titan with global ambitions.  Online access to unified messaging is clearly part of our telecom future and many of JCOM’s features could immediately plug directly into Skype (owned by Ebay), Google Talk, Yahoo Messenger, or MSN Messenger. Alternatively, a telco or cable company looking to improve their position in their country, gain leverage over competitors and get some international exposure may pick them up. Likeliest candidates in my mind are the more innovative large firms – AT&T, Verizon, BT or Comcast.

I sent my traffic arbitrage post to folks at Yahoo and Google. It looks like the two examples I blogged about were removed from Google – I wonder if they found others.

After my blog post about Marchex’s arbitraging, additional examples were sent to me by another investor. Some of the ads were relevant to the queries below are relevant, others not. One example for “cups online” that takes the user to lensoutlet domain:

Additional examples:

“Endoscopic” has an ad for siliconeimplant.com

“Job Information” has an ad for informationjobs.com

“Flight attendant” has an ad for bigemployment.com

“Atlanta jobs”, “Boston jobs”, “New York Jobs” has ads for bigemployment.com, sometimes
informationjobs.com (ad on the “more sponsored results” pages)

“Practice GED” has an ad for GED.com

“High School” has an ad for GED.com (ad on the “more sponsored results” pages)

“Plastic surgery” has an ad for siliconeimplant.com

In addition here is a trick to find more examples on Google partners:

1) Search for one of their domains with the following
format on Google:
+”www.breastenlargementcreams.com” +ads +by
+google +search
2) Click on a cache link next to a result
3) Find the highlight text on the page with the URL
4) Notice the query that caused the ad to be served – many times it is not relevant

Other examples you can use in the same format

“www.siliconeimplant.com”
“www.job-sites.com”
“www.bigemployment.com”
“www.informationJobs.com”
“www.JobOnline.com”
“www.ged.com”
“www.merchantproviders.com”

You will notice that while some of the queries that spawned these ads were somewhat relevant, many are not.

Should Google or Yahoo care about this recycled traffic? After all, YHOO, GOOG, MCHX all win in these situations because they all get paid. Users of Google search and Google’s partner sites lose because they are inconvenienced if they are taken to a place that doesn’t make sense to them – another page of paid links. The real loser may be Yahoo’s advertisers. If the traffic is not relevant, then their high priced ads won’t convert to customers.

I don’t know what Yahoo and Google plan to do, but if I were responsible for it, I would probably be doing a lot of investigating.

From Google’s perspective, I would: 

• Take down the ads as I find them
• Investigate the other ads in same account to see if they are “real” sites and not paid link pages
• Search through all the accounts to find other Marchex domains to see if they have multiple accounts arbitraging at once

From Yahoo’s perspective, I would:

• Investigate the sources of traffic that Marchex provides via web logs, query logs, etc.
• Evaluate conversion tracking trends for Marchex’s pages over time as well as versus other more organic traffic on Yahoo.com for the same keywords
• Check Marchex’s contract and the Yahoo terms of service to see if this is prohibited
• Convene the Marchex account team to determine how to deal with it
• Ask Marchex to outline how widespread this is and to send over their traffic logs that might help fill in the gaps – who knows they might undercover other sketchy traffic sources

Back to the numbers. Who knows how much MCHX has spent arbitraging, but it is clear they are spending more on sales and marketing. Sales and marketing expenses have were $1.32 mil in Q1, $1.54 mil in Q2, and $2.76 mil in Q3. That’s a 79% increase. I wonder where that money is going.

I own puts on MCHX shares at various prices.

Why has Marchex’s stock price not withered like the rest of the tier two search stocks?  This graph shows MCHX, INSP, MIVA, LOOK, and INCX over the past twelve months:

Marchex has increased dramatically while the other players have withered.  Two likely reasons:

1) Smart domain acquisitions have masked deterioration in the rest of their businesses

2) Quarterly acquisitions make it confusing to analyze the stock

The other search players have seen their stocks swoon when the market realizes that they are shrinking, not growing.  If investors get a clearer picture of Marchex’s pro forma revenue numbers, MCHX’s stock price may wither like the rest of the tier two search players.

MCHX Value on a Comparables Basis

Let’s assume that MCHX has not overpaid for acquisitions that the domains and other acquisitions are worth what they paid for them (just this year!) – $164.4 mil for name development, $20.5 mil for Pike Street, $30.6 mil for Industry Brains and $12 mil for new domains for a total of $227.5 million.

Since I see no difference between the rest of MCHX (Enhance / GoClick / TrafficLeader) and the other tier two players, I will use revenue comps (since only INSP is making money).

Applying the aggregate revenue multiple of these comparable tier two players (1.24X) to the TTM revenue of for Enhance/GoClick/TrafficLeader ($62 million) one would arrive at an implied valuation of $76.6 mil for this part of the business.  Add that to $227.5 mil from acquisitions and $5 mil in net cash to get $309 mil valuation.  Divide that by 38.3 mil shares outstanding to get a value of $8.07 per share.

For giggles, if you use INSP as a comp against all of MCHX (the closest full company comparable since INSP owns traffic too), you get a value of $4.35 per share.

Amazingly, Marchex’s enterprise value of $890 mil (using the 10/30/05 close of $23.4), makes MCHX more valuable than INSP, LOOK, MIVA and INCX combined!  Maybe MCHX will go shopping or file a secondary!

I own puts on MCHX shares at various prices.