Marchex Case Is a Prelude to Bigger Shorts to Come

The winner of the FactSet Best Short contest will be announced on Friday, October 10th. As a warm-up to that announcement, we've posted this tremendous piece of short-focused research by Mohammed Saidal Mohmand (GrizzlyRock Capital). Given that the idea was less than $500mm in Market Cap, it was not eligible for the contest. It was, however, an excellent piece of research that, within 10 short days, manifested itself by more than surpassing its stated target price. Please enjoy this post with our compliments and stay tuned for next Friday's announcement of the FactSet Best Short contest winner.

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On 9/18/2014, Marchex released an 8K noting a guide down and importantly the loss of their third largest customer, Allstate. Although this was somewhat unexpected, Allstate was Marchex's largest pay-for-call customer, a supposedly growing, profitable segment with extremely large TAM.

The loss of Allstate carries multiple implications, and our key takeaways from this are as follows : (1) product offerings are not differentiated and can be brought in-house or sourced from various private participants noted below. Furthermore, the value proposition on a variable cost (at best only slim margins for MCHX) does not perhaps generate sufficient ROIs for clients; (2) the opposite to what the sell-side/bulls wanted everyone to believe, the product offering(s) are NOT sticky; (3) shorting businesses with significant customer concentration can lead to pleasant surprises; and (4) I wouldn't be shocked to see future customers of pay-for-call category negotiate or move towards fixed-fee contracts, which would ultimately lead to this segment being a $0.

Although I think there could be more downside to the name, it is prudent to book gains given the ~50% return, which at ~$4 per share, which was better than my original $5.2 price target (notably did not include the Allstate loss). Finally, on the long side I wouldn't want to get involved with Marchex unless I could purchase the common equity below its net-net value given the Management team's specialty of setting cash on fire.

Background
We recommend a short position in Marchex, Inc. ("Marchex", "MCHX", or the "Company") with a ~12 month price target of $5.2 per share (using bullish assumptions). When valuing the business on reasonable valuation assumptions, potential profit to the short thesis could be up to a ~65% gain based on $3 per share value.

Marchex is reminiscent of the tech meltdown of 12(ish) years ago. The Company has been in existence for over 10 years yet have changed strategy three separate times. Management has currently positioned themselves well in taking advantage of the current frothy technology market as the stock is up over 100% in the past year with no material change to its underlying profitability.

On March 26th, Marchex priced a secondary for 5.7 million shares. Proceeds were split evenly between the Company and selling shareholders/founders with $28 million in proceeds to the Company (8.5% increase in shares outstanding). After reviewing the Company’s most recent prospectus and filings, it is evident that the Company is being misperceived by the market as a high-growth technology company, while in reality it is a low-margined advertiser which competes against and heavily relies on Google, Microsoft and Yahoo. As of 7/12/2014, MCHX has a market capitalization of ~$567MM and enterprise value of ~$530MM.

The thesis is predicated on the following attributes, which make the Company a highly attractive short at current prices:

Astronomic Valuation for a low ROIC Business: Marchex trades at over 39x EBITDA (excluding stock comp) and at a meager 2.6% FCF yield. For a Company that has never generated returns on invested capital in excess of 10%, the valuation is highly stretched by all means. Further, the Company is not likely to grow into its valuation, as the Company is only expected to generate ~$18MM in EBITDA (inclusive of stock comp) in FY14E.

 Disintermediation & Heavy Reliance on Vendors/Distributors: The Company relies heavily on a handful of distribution partners, for which the largest was paid ~15% of total revenue. Further, distributors can disintermediate MCHX at their discretion. On the vendor side, the Company relies heavily on Yellow Pages (~25% of revenue) and superpages.com for ads – who could ultimately stop reselling for Marchex and go out on their own or work with other vendors. As a point of reference, the Company’s top five customers represented ~60% of sales.

 Dis-alignment with Management: The Management team and founder’s actions do not appear to be aligned with nor support the Company’s future prospects, as the founders recently sold down ~30% of their shares in a secondary offering.

 Multiple Cases of Strategy Drift: Marchex has a colorful history skipping from tech trend to tech trend, transitioning from a search engine marketing (“SEM”) business model, to a cost-per-click network business to a domain portfolio and finally to its current business model as a mobile call focused advertiser. These pivots didn’t come cheap, as the Company spent well over $250MM since inception on CapEx and cash acquisitions. Furthermore, the Company in the past tried to monetize its domain portfolio through a spin-off, yet they did not go through with the transaction.

 Misperceived, Frothy Growth Promises and No Sign of Profitability on the Horizon: The Company is currently viewed by the market as a high-tech software business, yet its core growth drivers are derived from playing the intermediary between the end customers and search distributors. The Company touts its double digit growth prospects within its call business, downplaying its structurally low margin profile and weak returns on invested capital, which have not exceeded 10%.

 Low Short Interest: Although a technical point versus fundamental, a many attractive shorts currently have very high short interests and a high cost to borrow. With a short interest under ~4.5% of the float, MCHX is an actionable idea.

Bull thesis - The consensus bull thesis has been predicated on the following data points:

 Large Addressable Market

Rebuttal: Many assume MCHX target addressable market is ~$68B, yet this is spread among various mediums of call-based advertising. Furthermore, in the performance “click” and analytics space, Marchex competes against a variety of competitors for low margin business.

Only Public Vehicle to Benefit from the Call-Based Advertising Space

Rebuttal: Although MCHX may be the flavor of choice to play this space, upside is severely mitigated by the current valuation and poor past capital allocation history, demonstrated by the Company’s previous strategy drifts. If an investor wants “access” to the space, they could purchase benefactors of mobile technology, such as Google or others in the ecosystem and neglect Marchex as a low margined participant.

 Accelerating Revenue Growth Within the Call Segment

Rebuttal: Revenues overall have grown 20% over the past year and is projected by the sell-side to the rate of growth over the next couple years. Even considering this highly optimistic scenario, under the sell-side projections the business is not expected to materially grow earnings, for which ~$20MM in Adj. EBITDA (inclusive of stock-based comp) is expected by FY2015E. At the end of the day, free cash flow is a key determinant of intrinsic value, and the FCF prospects look weak in MCHX case.

 Less Competition in the Space as Calls are Hard

Rebuttal: The call space is highly competitive and crowded, with MCHX competing against various competitors such as Invoca, Callsource, ResponseTap, LogMyCalls and numerous others. Furthermore, as/if the need and market budgets develop for call tracking/analytics, it will be safe to assume larger well-capitalized technology companies will follow suit with a competing product while leveraging their existing customer relationships (important as companies often like to work with a smaller base of well-established vendors vis-à-vis numerous small vendors.