Local.com: A Call Option on Local Search and Free 411

Jul.30.07 | About: Local Corporation (LOCM)

In recent articles, we have discussed Local.com’s (NASDAQ:LOCM) patents and the likelihood of the company being acquired by a larger player for a price in the $100 million to $200 million range.

Subsequent articles and commentary from analysts suggest that a LOCM valuation in the $100 million range must be driven by speculation of a buyout premium or that investors are erroneously pricing in royalty payments for the use of the intellectual property protected by these patents. Apparently, this sentiment is highly regarded among some traders/speculators, as the short interest for LOCM is more than double (close to 2 million shares) what it was when we last commented on it.

We believe that LOCM should be valued in the $100 million range irrespective of any buyout speculation and we further believe that LOCM is well positioned to benefit significantly from royalty payments and possibly much sooner than such commentators are expecting. We believe the current valuation of LOCM shares does not fairly represent the potential of LOCM's core business to achieve and ramp profitability quickly and expect to see this accomplished much sooner than analysts currently estimate.

Though recent positive developments will not impact the Q2 numbers to be reported in a few weeks, we do expect these events to have a material positive impact on Q3 numbers. It appears that investors might be overlooking some of these developments including:

- the “ancillary benefits” mentioned in our previous article resulting from the recent extraordinary attention from the financial media has the potential to significantly boost direct navigation traffic to the Local.com website. What if 4 or 5 out of every 100 of the millions of persons who saw the local.com domain mentioned in discussions of the stock on TV or in the business section of the paper typed it into their browser and then clicked on one of the sponsored listings? Such activity would not be a big deal to a Google or a Yahoo, but to a company that makes more than $1 per click for many search related ads who is only expecting revenue in the $5 million range for the quarter, a few hundred thousand extra clicks is not a small thing.

- the recent conversion of the preferred stock issued during Q1 removed the significant interest expense that would have been incurred going forward. This would have been nearly $700,000 over the remainder of the year and it has all gone away as of mid July. Additionally, the consequential increase in shares outstanding will actually reduce the reported loss per share.

- the recent acquisition of Premier Guide. This is a good example of one avenue for Local.com to quickly ramp to profitability. The company is essentially doubling its organic traffic for the price of $2 million . With LOCM’s demonstrated ability to monetize searches at 3x the rate achieved by Premier Guide, this should allow LOCM to pay for the acquisition in full from its own earnings in less than 2 years.

Further, we believe the recent boost in LOCM’s stock price could enable management to make even more accretive acquisitions, hastening the movement towards profitability. We believe these developments along with LOCM’s highly capable management team’s laser like focus on perfecting the monetization of what is already the local search industry’s best search technology will result in the company’s achieving profitability much sooner than analysts currently predict.

We also believe that LOCM’s bottom line could be enhanced by royalty revenue sooner than most apparently believe. Investors should not overlook the operating relationships LOCM has developed with Google, Yahoo and Idearc and consider some scenarios that could play out. Absent some catalyst, we would not expect Google, Yahoo or Idearc, etc. to sign up to pay royalties to license LOCM’s patents. However, if it became apparent that Microsoft or Infospace were making overtures in an attempt to buy the company, we might see one of these three come calling with checkbook in hand.

Faced with the possibility of seeing the patents covering crucial aspects of the local search methodology fall into the hands of a deep pocketed hostile competitor who can afford aggressively enforce them, I think its not a stretch to assume that they would proactively seek a license and/or give serious consideration to scenarios that would allow them to lock in a license for some period of years, particularly if such a deal were really only an extension of existing deals. Take Google for instance. Traffic acquisition costs are the single largest expense item on LOCM’s income statement and Google receives about 90% of that spend. Based on recent spending for traffic acquisition, one might expect that LOCM could spend nearly $15 million with Google over the next 12 months.

What if Google could license LOCM’s 411 patent and/or local search patent for an annual $15 million credit towards clicks? It would be a win/win scenario, as Google would be locking in a big annual pay per click contract while also insuring that they would not be hit with patent infringement suits that could materialize if LOCM were purchased by a competitor. Would Google be willing to barter $15 million in clicks for insurance to protect what will likely be a billion dollar revenue stream, avoiding the potential $100 million plus license fees that a MSFT or INSP might try to extract?

Note the impact such a deal would have on LOCM’s financials. LOCM is currently estimated to book a loss in the range of $9 million during calendar 2007 (we believe the company’s recent acquisition and its own improving execution will beat the expected earnings range, we are simply using these numbers to make the point). If $15 million in expenses were taken away from LOCM’s traffic acquisition costs and all other things remained equal, the company would have a profit in the range of $6 million or more than 50 cents per share.

Going over to the over side of the ledger we have Yahoo, which currently provides LOCM with about half of its incoming revenue in a deal that pays a percentage share of the revenue generated from each click on the Local.com ads syndicated from Yahoo’s network. Assuming revenue from Yahoo of around $11 million or so, what would happen if Yahoo were offered a multiyear license to use one or both of LOCM’s patents in exchange for an increased percentage share of click revenue? The current percentage paid is not disclosed, but assuming its an equal split, would they be willing to pay LOCM 70% instead?

Regardless what the actual payout percentage is, if LOCM could get a 40% increase in the payout, it could make up about half of the loss expected for calendar year 2007. We know of several companies with similar distribution deals with Yahoo that have recently extracted 30 - 35% gains in revenue share and they did not have anything even close to the value of these licenses to offer in return.

That seems like a pretty cheap deal, so I would expect that Yahoo would have to throw in a few million in clicks to boot, which would further reduce the paid traffic acquisition costs for LOCM. In any case, its easy to see that there are a number of ways that LOCM could conceivably benefit in the near term from the patents that were recently granted, particularly in the context of its existing deals with the larger search industry players.

Our recent conversations with CEO Heath Clarke lead us to believe that his team is working on a number of creative methods of maximizing the value of these patents. Irrespective of whether any such deal is ultimately reached, shares of LOCM are trading at levels that do not reflect the upside potential of the company’s core operations or the monetization possibilities inherent with their intellectual property. We note that the company has recently taken the steps necessary to put the big search players on notice that their existing search functions infringe on! LOCM‘s patented methodology.

This starts the meter running and lays the foundation for their claim of treble damages at such time in the future that LOCM or its acquiror decide the time is right to collect from those players who are partaking of the billions of advertising dollars flowing through that space. We perceive ownership of that local search patent and the patent covering methods currently used in the monetization of the free 411 directory assistance niche as essentially a no premium, at the money multi year “call option” (no pun intended) on the development and build out of each respective niche and we note that each niche is attracting venture capital investment worth 4 or 5x LOCM’s existing market cap.

Retail investors rarely get the opportunity to invest in the early stage of a company that stands among the best positioned to profit from the development of a hot technology niche that is widely expected to mature into a $10 billion + industry. With LOCM shares trading below $9 per share, we believe they are getting that opportunity (call option) for free.

Disclosure: Author is long LOCM