ReachLocal IPO: Fundamental Growth Story Should Draw Investors

May.17.10 | About: ReachLocal Inc. (RLOC)

Founded in 2003 by four online entrepreneurs, ReachLocal (NASDAQ:RLOC) operates an automated online marketing platform that helps small and medium-sized businesses (SMBs) acquire customers by creating, optimizing and tracking online campaigns. Taking the playbook from the local yellow pages, the company sells primarily direct through its 569 person and growing "feet on the street" sales force and, for a fixed fee, takes a client's online ad budget and allocates it across various channels, such as paid search engines and online display ads. The company plans to raise $75 million by offering 4.2 million shares at a proposed range of $17-$19. JPMorgan (NYSE:JPM) and BofA Merrill Lynch (NYSE:BAC) are acting as joint bookrunners on the deal, which is expected to price Wednesday, May 19, and trade on the NASDAQ the following day under the ticker "RLOC."

Impressive growth should allow for strong long-term profitability and cash flow

ReachLocal has successfully leveraged its local sales rep model to amass 15,700 small businesses in various verticals, such as home repair, auto sales and health services, that spend $500-$3,000 per month with the company. This has allowed the company to drive top-line growth at a 166% CAGR since 2005 to $203 million in sales while maintaining positive cash flow. With the proceeds from the offering ReachLocal plans to invest heavily in its sales force, both in North America and internationally, in an attempt to solidify its leading position in the large, yet underpenetrated local online advertising market, which is benefitting from the secular shift away from traditional offline media. Management estimates these investments will drive top-line growth north of 30% over the next several years and expects margins and cash flow to scale as the productivity of new reps improve.

Key Issues

The firm's heavy investments in direct sales headcount to support rapid growth will cause it to remain unprofitable in the near-term, and the rising productivity of its sales force is critical to the company reaching its long-term model. Given the company's limited operating history, it is difficult to estimate long-term attrition rates for its sales force and the mature production of a rep. Additionally, ReachLocal purchases the majority of media from Google (NASDAQ:GOOG) as well as Yahoo! (NASDAQ:YHOO) and Microsoft (NASDAQ:MSFT), which also compete with the company through self-service ad platforms.

Growth stories have drawn strong investor interest

The IPO market has faced pricing pressure on the part of investors over the past month. In fact, seven of the nine May IPOs have priced at or below the low end of the range. Nevertheless, investors have shown continued interest in growth stories, which has translated into strong performances from recent IPOs including Financial Engines (NASDAQ:FNGN), MaxLinear (NYSE:MXL), and QuinStreet. Although ReachLocal has yet to scale profitability like these firms, the company's unique fundamental growth story and the stock's discounted valuation are likely to draw significant interest on the part of investors.