March into local Internet advertising with Marchex (Nasdaq:MCHX)

• Buy MCHX under $13

Marchex Inc. is an Internet search and media company focused on local search, local content, and direct navigation. Marchex owns and operates a portfolio of over 200,000 Internet domains.

Marchex has a market cap of about $485 million, $54 million in cash and no significant long term debt. The trailing P/E is about 500 (the company is just barely profitable) and the forward P/E is estimated at about 24.

Although Marchex has a promising portfolio of domain names and the company has consistently grown revenues year over year, profits have failed to impress and the stock has dropped from its post IPO high of $24 to its current price near $11.50.

Until recently, most of Marchex’s domains have been “parked” with the pages serving up pay per click ad pages with little or no content. Last spring Marchex re-launched over 100,000 new websites with local content. Although most of these websites still lack individuality, the creation of value added local websites is certainly a step in the right direction.

In May of 2006, Marchex acquired OpenList, a local information service designed to help consumers find, rate, and review local businesses. Marchex plans on using OpenList content combined with content from partner sites such as opentable.com, contractors.com, healthgrades.com, and judysbook.com to populate its network of local sites. Marchex recently announced that organic traffic growth at the 100,000 local sites integrated into the OpenList network has increased 20% in the last 3 months.

Although operating profits have failed to impress investors, Marchex generates a healthy amount of cash with 2006 operating cash flow of nearly $32 million. Most of this cash has been used to create and improve the Marchex network of local websites and to make strategic acquisitions. As seen by the recent traffic growth for the Marchex network of sites, these investments are starting to pay off. Although the initial surge in traffic is promising, the Marchex sites could really start to shine as user created content increases. The local sites operated by Marchex will become more useful and traffic will increase as user created content in the form of reviews and message boards starts to grow.

Although Marchex’s stock has performed poorly since its IPO, at Wall Street Mayhem we think Marchex shares are currently undervalued. As the value of domain names continues to appreciate, Marchex’s portfolio of 200,000+ domains could already be worth more than the companies’ market cap of $485 million. However, the real potential for Marchex is in the growth and development of its local network of websites. Local on-line ad spending is expected to reach $25 billion over the next decade. If Marchex can continue to improve its network of local websites, the company is well positioned to become the market leader in local on-line advertising.

The shear number of websites operated by Marchex makes the creation of value added websites a difficult task. In order to obtain sustainable traffic growth, Marchex must create sites that draw repeat users instead of relying on traffic from direct navigation. However, considering the current market cap, we think Marchex is a relatively low risk stock considering the underlying value of the Marchex domain portfolio. If Marchex succeeds in creating a large network of value added user friendly local websites, the stock could soar. If Marchex fails, the break up or buyout value of Marchex would still be close to the current market cap due to the value of the domain portfolio.

Full disclosure: Wall Street Mayhem is long MCHX