Incorporated in January 2003, Marchex, Inc. is a search and media company focused on vertical and local online traffic through search marketing, local search, and direct navigation. The company's platform enables merchants to market and sell their products and services across multiple online distribution channels, including search engines, product shopping engines, directories and selected websites. Marchex also has its own proprietary network of more than 200,000 websites. Marchex currently has three main business segments:
Performance-Based Advertising (92% of 2006 revenue) This business enables merchants to reach their target audience through search engines in either sponsored/paid listing or algorithmic listings that are based on relevance. In this segment, Marchex has three major products. First, its pay-per-click campaign management offered through TrafficLeader allows its merchant advertiser customers to purchase keywords or keyword strings. When an Internet user clicks on a pay-per-click search result, they are redirected from a third party website (such as Yahoo!) or a MCHX owned website to a merchant advertiser website. The rank of pay-per-click advertisers is influenced on the amount that an advertiser pays for the click-through and the relevance of its advertisements. Next is contextual targeting, which is sold through Marchex's IndustryBrains service. Contextual targeting is "site specific advertising" and involves the selling of advertisements on specialized vertical and branded websites that relate to the advertisers product. Contextual results are prioritized by the amount the advertiser is willing to pay each time a user clicks on the ad and the relevance of the advertisement. Finally, feed management enables merchants to deliver comprehensive and up-to-date product and service listings to major search engines, such as Google and Yahoo!. Feed management uses MCHX's proprietary technology to crawl and extract relevant product content from merchant's database and websites to create highly targeted product and service listings.
Search Marketing Services This service is designed to help merchants who want to acquire customers through search-based marketing methods, optimize the performance of their online advertising campaigns, and refine their websites for increased relevance in algorithmic search engine indexes. Marchex has two major offerings in this segment. First bid management that allows merchants to track, monitor and optimize the placement of performance-based search advertising campaigns across a number of search engines and pay-per-click networks. Bid management also helps merchants evaluate the effectiveness of online advertising campaigns using conversion tracking and detailed reporting services. Next, natural search engine optimization services allows merchants to optimize key attributes of their websites to ensure the greatest opportunity for proper indexing, listing and inclusion in the editorial results of algorithmic search engines.
Outsourced Search Marketing Platforms Marchex offers an outsourced solution for strategic partners who have several hundred to several thousand direct merchant relationships. Partners can leverage this service in one of two ways, including as a fully outsourced solution or as a Web-based solution that allows aggregators or publishers to implement and manage campaigns directly.
In 2006, the company generated 92% of its total revenue from the United States, 2% from Canada, and 6% from other countries.
Since its inception in 2003, Marchex has established a significant presence in the Internet services industry, much of this coming from acquisitions. It acquired TrafficLeader and eFamily along with its wholly-owned subsidiary Enhance Interactive in 2003 goClick in 2004 Name Development, Pike Street, and IndustryBrains in 2005. IndustryBrains offers vertically-focused marketing solutions for advertisers, using keyword search and contextual, site-specific category targeting. The acquisition of Pike Street provided MCHX with a proprietary source of direct navigation traffic at a critical mass with the ability to monetize this traffic, providing it with a competitive advantage that few competitors have. The firm's direct navigation strategy provides it with a large and increasing potential customer base on a substantial low amount of capital invested as the cost of acquiring and maintaining a URL is very low. Further, this strategy does not require distribution partners, or the large expenses relating to traffic acquisition costs. Direct navigation could turn into a very high margin business for Marchex and has been responsible for the recent upside to numbers.
In order to add targeted vertical and local content to some of its proprietary websites, Marchex, in May 2006, acquired certain assets of Open List, which had approximately one million business listings and three categories. This acquisition had an immediate benefit as average monthly page views increased 70% for websites that integrated Open List during January 2007 versus average page views pre-integration during August, September, and October 2006, resulting in increased revenue. Since that time, Marchex has worked to further leverage the Open List assets. In June 2007, Marchex re-launched more than 100,000 of its local websites utilizing its content aggregation and publishing engine to populate selected Marchex Network websites, including tens of thousands of vertical, local, and local-vertical websites and Marchex's ZIP Code websites that cover 96% of all ZIP Code areas nationwide, such as www.90210.com. This integration of new content and functionality into its more than 75,000 ZIP Code websites will allow users to access Open List as the "home" search page from any of its websites, and will serve to monetize its Open List website primarily with its direct advertiser listings and advertiser listings from other strategic partners. As a result, at the end of September 2007, the average number of monthly organic unique visitors to those websites increased by 20% to more than 25.0 million over the average for the three months preceding the Open List integration. Marchex recently expanded Open List (www.openlist.com) content integration across more than 15 million business listings in more than 20,000 categories. Marchex has also added Open List content and technology to 50,000 additional websites, bringing the total number of local websites in its network to more than 150,000. Marchex currently has 1.0 billion pages of unique local content, which it distributes to 350,000 websites.
In May 2006, Marchex acquired the assets of AreaConnect, a provider of local online traffic to Yellow and White Page publishers. This acquisition adds one million unique local visitors, not duplicated by MCHX's current business, which will add to its base of users for local advertisers. In addition, Marchex added global and distribution network on Yahoo! by which Marchex will convert search ad listings from its pay-per-click engine, Enhance Interactive, into Yahoo! Sponsored Search listings. Weakness in 2006 was largely due to softness at Yahoo!, as Yahoo! Search Marketing accounted for approximately 29% of revenue in 2006. Yahoo s launch of Panama appears successful, with click through rates increasing. Although not a smooth ride, we expect Yahoo! to show improved click-through rates in 2008, which should carry over to Marchex. The company recently renewed its agreement with Yahoo! for another two years, whereby Yahoo will continue to deliver its sponsored search results to Marchex's network of local and vertical websites. Meanwhile, Marchex has improved its pay-per-click network, Enhance Interactive, over the past year to increase the volume of high quality traffic, including the volume of local traffic. Marchex has added traffic to the network from locally operating websites, and has also added new local and premium search distribution from partners, including Yahoo. Marchex has also provided conversion tracking, improved reporting capabilities and campaign management tools to advertisers. This should provide advertisers using Marchex's pay-per-click engine with premium traffic and broader global reach.
To strengthen its leadership position in local online advertising, the company acquired VoiceStar, one of the largest providers of call-based advertising services, to offer large aggregators a comprehensive and unique platform with pay-per-phone-call and call-tracking solution. In the third quarter of 2007, Marchex added more than 20,000 new advertisers through its partnerships, direct sales channel and the addition of more than 16,000 call-based local advertisers through its acquisition of VoiceStar. Marchex now has more than 50,000 advertisers and expects to have more than 80,000 advertisers using its products and services by the end of 2009.The Kelsey Group, which provides independent, objective perspectives on Yellow Pages, electronic directories and local media, estimates that the pay-per-phone-call market will reach $4 billion annually by 2009, while a recent Kelsey survey reports that 71% of local advertisers would rather pay for phone calls than pay for clicks. Marchex recently extended its partnership agreement with YellowPages.com, a subsidiary of AT&T, to 2011. Under the agreement, Marchex will continue to provide its local Internet search marketing services. In addition Marchex entered into a partnership with more than 100 local and national advertisers including Comcast, the Cobalt Group, Roto-Rooter, Cox Auto Trader, Geico and Carnival Cruise Lines as well as leading agencies including Avenue A and Reprise Media to build the largest base of local online advertisers.
We believe that as online advertising becomes a more integral potion of merchants advertising strategies, more money will be spent on services such as Marchex's as companies seek to maximize their return. Within the Internet advertising market, paid search has become one of the fastest growing sectors, which bodes well for the performance-based advertising services segment. Contributing to growth in online advertising is the growth in video, which offers a new way of reaching consumers. The amount spent on Internet video ads represented just over half of 1% of all TV advertising budgets, and made up just 2.6% of total online ad spending in 2006. By 2010, eMarketer predicts that more than one out of every 10 online ad dollars will be spent on video. For 2008, eMarketer estimates U.S. online ad spending will grow to $27.5 billion, up 28.5% over 2007. According to ZenithOptimedia, global advertising spending should rise 6.7% in 2008, compared to 5.3% growth in 2007. Moreover, merchant advertisers are increasingly turning to performance-based online advertising for competitive return-on-investment. We expect pay-per-click rates to continue rising. According to a January 2006 study by WebSideStory study, direct navigation traffic (when users type a domain or keyword directly into their browser bar or use a bookmark) converts at 4.23% on average, a higher rate than other sources, including search engines at 2.30%. MCHX believes the direct navigation market currently represents 10% or more of the paid search market and is growing at comparable annual rates. The growth of the direct navigation market is a result of consumers' increasing interest in utilizing the Internet as a resource tool, coupled with their desire to quickly find targeted information.
In addition to its expansion of local sites, Marchex is working on several initiatives that if successful, could benefit the company in late 2007 and 2008. To grow its international business, Marchex acquired more than 100 Spanish-language websites from two separate parties, and partnered with Fox's Latin American Channels division to jointly develop a set of Spanish-language websites. In addition, the company is developing a third-party traffic network that provides advertisers with competitive returns on more focused advertising campaigns. Through its IndustryBrains subsidiary, Marchex's network has more than 100 vertically focused online publishers, such as Business Week Online, Forbes.com, TheStreet.com, The Motley Fool, and the Ziff Davis online properties as well as well known brands from the finance sector, such as Morningstar, Chicago Board Options Exchange (CBOE). Further strengthening its relationship with The Motley Fool, IndustryBrains renewed and expanded its contextual advertising agreement to provide services to the Motley Fool's popular financial discussion boards and Motley Fool CAPS, a stock rating service.
Meanwhile, to return value to shareholders, Marchex's Board of Directors has authorized the repurchase of up to $3 million shares of the company's Class B common stock. Marchex has repurchased approximately 1.4 million shares of its outstanding Class B common stock or 3% of its outstanding common shares, to-date for approximately $13.6 million. It also paid a quarterly cash dividend of $0.02 per share for holders of its common stock during the third quarter.
Although online advertising revenue has been growing, and we believe that the trend towards increased spending on Internet advertising and away from traditional media will continue, the trend could slow down if the economy slows over the near term. The sector is highly sensitive to the economy and any slowdown is likely to impact both online and traditional media as spending on advertising campaigns is cyclical. This fact was supported by Yahoo!'s disappointing 4Q06 results due to a slow-down in advertising revenue from mortgage lenders and the automotive industry. Although this slow-down was confined to specific industries, it does highlight the maturation of online advertising and indicates that online advertising is not immune to the economic cycle. This was reflected in MCHX's reduced fiscal 2006 revenue guidance during the third quarter when revenues were lower-than-expected, which management attributed to lower third-party inventory and lower advertiser budgets. With Marchex dependent on Yahoo! for a portion of its revenue (approximately 29% of 2006 revenue), we are concerned that continued struggles at Yahoo! will hamper Marchex growth. Weakness in 2006 was largely due to softness at Yahoo!, and Marchex has criticized Yahoo! for its shortcomings in the recent quality-based pricing initiatives, leading Marchex to lower its 2007 revenue outlook. Moreover, a slowdown in consumer spending could delay advertising spending in the consumer products industry on which we are counting for the bulk of growth in online spending. As per eMarketer.com, growth in internet spending will slow in 2007 due to a sluggish global economy before rebounding in 2008. Meanwhile, U.S. internet ad spending is expected to grow only 18.9% in 2007, while the entire advertising industry set to grow by only 1.4%.
Marchex's focus on local sites hurts its brand identity relative to its global competitors, Yahoo! and Google, limiting its competitive advantage. We are also concerned with the company's lack of intellectual property and, therefore, the sustainability of its competitive position. Though Marchex owns a number of local domain names, we do not believe this establishes a barrier to entry, leaving it susceptible to much larger competitors that may decide to pursue the local market. For example, Yahoo! has invested significantly in local sites that compete directly with Marchex. Another risk for Marchex is a shortfall in growth in the search market, which would also lead to a significant price hit. While the firm's top-line is growing, Marchex needs to spend a large proportion of these revenues on traffic acquisition costs with distribution partners, which limits the firm's bottom-line growth potential. Further, the firm's reliance on revenues from Yahoo! is another significant risk. Yahoo! Search Marketing, its largest distribution partner, represented approximately 7% of total 2006 revenue. Separately, Yahoo! Search Marketing was responsible for 29% of total revenue during the same period principally in respect of the revenues associated with its portfolio of domains. Thus, the risks inherent in Marchex's business model are very high.
Marchex has a limited operating history with limited profitability on a GAAP basis. Given this short history, the business model is mostly untested. While the firm plans to take advantage of strategic opportunities when available, Marchex's financial resources are limited, compared to its larger peers such as Yahoo! and Google. As such, Marchex needs to continue investing in its strategy to maintain or enhance its current position in the ultra-competitive paid search category. During 2006, the firm's product development cost increased 124.6% year-over-year. Meanwhile, the market for qualified online sales and marketing professionals and other positions has become much more competitive in recent months, resulting in higher salaries and driving up expenses by 107.2% in 2006. Marchex relies on distribution sources for its advertisers, and in order to cultivate new relationships, the company expects it will need to pay more to partners. This will drive up distribution costs over time. In addition, while the firm is likely to seek strategic acquisitions when available, the firm must be cautious not to try to spend its way to success. Acquisitions made by Marchex since its inception has eaten up a considerable portion of its net profit in terms of amortization cost, which increased 11.0% year-over-year during 2006. Though the company passed the inflection point towards profitability in fiscal 2005, it still runs the risk of falling into the red, given the rising level of operating expenses, a fear that was realized in the December quarter when operating expenses increased 41.5% year-over-year. During the nine months ended September 2007, revenue grew just 7.6% higher year-over-year despite growth initiatives and exposure to high-growth markets. The company also suffered a drop in operating margin (excluding amortization of acquired intangible assets, facility relocation, and gain on sales and disposals of intangible assets), which fell to 10.3% from 12.7% in the previous quarter.
Competition is expected to increase with the growth in online advertising markets. With low barriers to entry, the market for marketing technology products is very competitive. Moreover, consolidation of internet advertising networks, web portals, internet search engine sites, and web publishers is likely to strengthen its competitors. Recently announced acquisitions of aQuantive, Inc. by Microsoft and DoubleClick by Google are expected to increase competition as both Microsoft and Google are equipped with much better resources and the ability to price more competitively, if necessary. Meanwhile, competitors have begun to auction off excess advertising capacity on second tier websites, with Yahoo! the most notable entrant into this space. This trend is likely to drop the price for advertising on less trafficked websites.
Lastly, Marchex's founding executive officers control 96.1% of the outstanding shares of its Class A common stock, which represented 87.9% of the combined voting power of all outstanding shares of its capital stock excluding shares of Class B common stock issuable upon conversion of the preferred stock. Due to the disparate voting rights, there may be an adverse effect on the price of its Class B common stock. In addition, this concentration of control could be detrimental to other stockholders as these executives will be in a position to control all fundamental matters affecting the company, including all corporate actions requiring stockholder approval.