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Tucows Inc. (NASDAQ:TCX)

Q3 2012 Earnings Call

November 13, 2012 5:00 pm ET

Executives

Elliot Noss – President and Chief Executive Officer

Michael Cooperman – Chief Financial Officer

Analysts

Aram Fuchs – Fertilemind Capital

Operator

Good afternoon ladies and gentlemen. Welcome to Tucows Third Quarter 2012 Conference Call. Earlier this afternoon Tucows issued a news release reporting its financial results for the third quarter. That news release and the financial statements are available on the company's website at tucowsinc.com under the investors heading.

Please note that today's call is being broadcast live over the internet and will be archived for replay both by telephone and via the internet beginning approximately 1 hour following the completion of this call. Details on how to access the replays are available in today's news release, as well as at Tucows’ website.

Before we begin, let me remind you that matters the company will be discussing include forward looking statements and as such are subject to risks and uncertainties that could cause the actual results to differ materially. These risk factors are described in detail in the company's documents filed with the SEC. Specifically, the most recent reports on the Form 10-K and Form 10-Q. The company urges you to read its security filings for a full description of the risk factors applicable for its business.

I would now like to turn the call over to Tucows’ President and Chief Executive Officer, Mr. Elliot Noss. Please go ahead Mr. Noss.

Elliott Noss

Thank you, operator. With me is Michael Cooperman, our Chief Financial Officer. As per our usual format, I'll begin today’s call with a brief overview of the financial and operational highlights for the quarter. Mike will then review our financial results in detail. Then I will return with some concluding comments before opening the call up to questions.

Q3 was another solid quarter for Tucows, once again demonstrating the growth, consistency, and leverage in our business. Total revenue grew 17%, compared to $28.2 million, our tenth consecutive quarter of revenue and another record. Cash flow from operations was $2.2 million, a substantial portion of which we used to repurchase another 1.3 million shares under our normal course issuer bid, as we continue to return capital to our shareholders.

Each of the three components of our business wholesale, retail, and portfolio continue to perform well during the quarter. Beginning with wholesale, revenue from domain services for Q3 was up 13% year-over-year, despite number of transactions being more or less flat, compared to last year at $2.21 million.

Renewal registrations continue to show solid growth, increasing 14% year-over-year and our renewal rate remains above the industry average. New registrations declined by 12%, impacted by general industry softness in North America and Europe and some one-time events. We know that this decline had a relatively small impact on gross margin as it related to extremely low margin customers.

Transfers-in increased 8%, excluding the impact of a large one-time bulk transfer-in during Q3 of last year. Total domains under management at the end of Q3 increased 14.1 million, up 21% from the same time last year. The increase is largely the result of the acquisition of a reseller by one of our customers, who then shipped new registrations to hit accreditation on our platform.

We continue to be successful in winning new business. During the quarter, we were selected as the exclusive supplier for domains and email by a leading supplier of digital and online marketing solutions operating the U.S., UK, Spain and three South American countries with more than 6 million customers.

We will begin transitioning there are more than 500,000 domains and more than 250,000 email boxes this quarter, starting with our U.S. business. With the remainder of the businesses to follow next year, one of the primary reasons for their decision to go with us was the breadth of our ccTLD support. Including several ccTLDs, we are able to support as a result of our EPAG acquisition. Q3 was also another good quarter for our domain name expiry stream.

Before I move onto retail, a quick update on the new gTLDs. On last quarter’s call, I said that we expect to know more about the contention process, following the Toronto ICANN meeting in October. I previously said that I wouldn’t be surprised, if we didn’t see any revenue contribution until 2014.

My best guess right now would be that for the bulk of the best new gTLDs. The contested gTLDs, I would stick with 2014. If we are lucky, we may start to see some of the uncontested attractive names like some of the geonames clip out in the second half of 2013. And we will see the next stage of information in and around the Beijing meeting in April.

Thus we are unlikely to have material news on next quarter’s call. In the retail component of our business, Hover revenue grew 22% year-over-year and 1% sequentially. And we continued our trend of strong customer growth, which increased 13% year-over-year. New transactions, which include new domains, transfers an email accounts grew 49% year-over-year.

Renewal rates continued at their previously high levels. Transfers-in also continued to be very strong in Q3, up a 103% from Q3 of last year, with the ratio of transfers-in to transfers-out climbing to 7 to 1, once again underscoring the competitive strength of Hover value proposition. The other component of retail is Ting. We continue to be very pleased with the progress of Ting in terms of not only the positive reception by the market, but also how that reception is translating into new accounts.

On our conference call in February, I expressed that we didn’t intend to talk about subscriber numbers for at least a few quarters. We have decided to disclose this data now, a little earlier than we had initially intended. Because we are required to recognize the revenue from devices sold to our customers and during Q3, this number was large enough that it substantially skewed the overall retail revenue and gross margin.

I will remind you that we sell our devices at or slightly below cost. Device sales in Q3 accounted for approximately $900,000 of the total $3 million in retail revenue. And $1.1 million of the $2.1 million in retail cost of goods sold. If any of you who have been with us for some period of time are aware, we strive to help our investors easily follow and under the business.

We believe that if we didn’t start breaking out seeing subscriber information, the retail line would become too confusing. During the quarter, we added approximately 3,000 new accounts and approximately 4,500 new devices bringing the total number of accounts to more than 5,000 and the total number of devices to more than 8,000.

As I have discussed before, we view an account as a person, while our competitors view an account as a device. Again, we are very pleased with this performance. This is an industry that is driven by net ads and every bit of feedback we are getting from the industry as a whole has us believing that our performance is as strong as we feel it is.

Gross margin continues to track in the 35% to 45% range and the business remains on track to exit the year on a run rate that would have at or approaching Tucows’ second largest service behind domain names. But as always, what’s most important to us in these early days is that Ting is truly resonating with people. They are saving money and they are thrilled with the customer experience. And interest continues to grow.

Unique monthly visitors to the Ting website increased a 137% from April to September. And total likes on our Facebook page, increased to 170%. Since the beginning of June Ting is consistently averaged nearly 6% customer growth per week. And this number has not show signs of abating. We believe all of this bodes well for the future.

The third component of our business, portfolio, also had another solid quarter. Portfolio includes a resale of names from our domain names portfolio and advertising revenue from those names, as well as our two advertising supported websites. Q3 was again marked by solid individual domain sales, which were up 32% year-over- year and exceeded $1 million for the fourth consecutive quarter. As I discussed last quarter, it has been our objective to boost the unit sales volume of our brandable names, by packaging them up and selling them in box, targeted buyers. We are continuing to have success with this initiative with the number of names sold in Q3 doubling year-over-year and up more than 60% quarter-over-quarter. Sales of gems also continue to be strong.

In summary, Q3 was another solid quarter for Tucows. Our three core businesses wholesale, Hover and portfolio continue to deliver consistency and reliability while driving growth. And the leverage in our business model has enabled us to efficiently launch Ting, which now looks to clearly be a business success.

I would now like to turn the call over to Mike to review our financial results for the quarter in greater detail. Mike.

Michael Cooperman

Thanks Elliot. Net revenue for the third quarter of 2012 grew to $29.2 million, up $4.2 million or 70% from $25.1 million for the same quarter of last year and an another record. Cost of revenues before net works costs were $21.4 million, an increase of $3.8 million or 21% from $17.7 million from the third quarter of last year. Gross margin before network costs increased $365,000 or 5% to $7.8 million, from $7.4 million for the same quarter of 2011. As a percentage of net revenue, gross margin before network costs decreased to 27% from 30%. The decrease is primarily the result of revenue derived from the sale of Ting devices, which as Elliot mentioned are sold at or slightly below cost.

I will now walk through the gross margin performance in each of our three service categories, wholesale, retail and portfolio. Gross margin for wholesale services, which includes domains and other values added services, provisions through OpenSRS, as well as the sale of the domain names and advertising from the OpenSRS Domain Expiry Stream increased by $373,000 or 7% to $5.7 million from $5.3 million.

As a percentage of revenue, gross margin from wholesale services was 23%, compared with 24% for the same period of last year. Gross margin for the domain services component of wholesale increased by $395,000 or 12% to $3.6 million from $3.2 million. The increase is the result of several factors, most notably the higher transaction volumes from existing customers, the impact of the transfer of significant number of names by two of our customers from our registrar accreditation to their own accreditation on our platform, and the contribution of the EPAG acquisition that we completed during the third quarter of last year.

Gross margin for the other value added services component of wholesale remains essentially flat at $2.1 million primarily the result of one of our direct navigation partners temporary scaling back their purchases for a couple of months. They have since resumed their more historical purchasing patterns and we should begin to see growth here again going forward.

Gross margin for retail services which concludes the contributions of Hover and Ting, increased $37,000 or 4.3% to $900,000 from $863,000. With Hover we are continuing to benefit from the initiatives we have undertaken to attract new customers and to retain existing ones. As I noted last quarter however growth in our retail gross margin is being negatively impacted by our strategy to sell Ting devices at or slightly below costs.

As a percentage of revenue retail services gross margin was 30% compared with 64% for the third quarter of last year, the decrease again is the result of the sale of the Ting devices at or slightly below cost and the lower gross margin generated for Ting services.

Gross margin from our portfolio revenue stream decreased slightly by $46,000 or 4% to $1.2 million from just under $1.3 million for the third quarter last year, primarily the result of the timing of domain name sales. On a percentage basis gross margin from our portfolio was 86% down slightly from 88% for the third quarter of last year.

Turning to costs, network expenses for the third quarter of 2012 decreased $25,000 or 2% to $1.4 million primarily the result of the efficiencies we have realized in operating and managing our collocation facilities as well as the lower capital expenditures we require for our operating platforms. Total operating expenses for the third quarter were $4.2 million, down $2.6 million or 38% from $6.8 million for the same quarter of last year. The decrease was primarily the result of two factors. First, we incurred a gain on foreign exchange contracts of $615,000 in the third quarter of this year compared with the loss of $1.8 million from the third quarter of last year.

Second, work force costs were impacted during the quarter by our reversing and overachievement bonus accrual that was established primarily in the first quarter. We accrued conservatively and have now reversed most of the accrual as it does not now appear likely that we will incur any meaningful cost in this quarter. As a percentage of revenue, total operating expenses decreased to 14% from the 27% in the third quarter of last year. Net income for the third quarter of 2012 was $1.6 million or $0.04 per share, compared with the net loss of $1.2 million or $0.02 per share for the third quarter of last year.

Cash and cash equivalents at the end of the quarter were $5 million, up $316,000 from $4.7 million at the end of the same quarter a year-ago, and up $458,000 from $4.5 million at the end of the second quarter of this year. Cash flow generated by operating activities during the third quarter of this year was $2.2 million, compared with $1.6 million for the same quarter last year. During the third quarter, cash flow from operating activities benefited from the refund of our application fee of $370,000, following our decision to withdraw two of our six applications to create and operate new gTLD registries. During the third quarter, we also used $1.6 million in cash to fund the repurchase of $1.3 million of our shares under our normal course issuer bid. In addition, during the quarter, we invested $162,000 on equipment purchases.

Deferred revenue at the end of the third quarter of this year was $73.3 million, an increase of 6% from $68.9 million at the end of the third quarter of last year, and a decrease of 3% from $74.5 million at the end of the second quarter of this year. I would notify you that the decline in deferred revenue from the second quarter resulted from the transfer of the significant number of domain names by two of our customers from our registrar accreditation to their own registrar accreditation on their platforms that I mentioned earlier. This required us to recognize all remaining deferred revenue associated with the transfer domain names during the quarter.

In summary, our third quarter results were once again demonstrative of the consistency and reliability of our business, the leverage inherent in our business model and our ability to deliver steady growth.

And with that, I’d now like to turn the call back over to Elliot.

Elliot Noss

Thanks, Mike. As I discussed in the past, we view Ting as a prime example of the efficiency in our business model. our core business, the non-Ting part of the business is healthy and continuing to do quite well. And we’ve been able to invest a little less there while we are investing more in Ting. Much of this investment is simply a reallocation of existing resources within the organization. What cash investment has been acquired is primarily around on-boarding and acquiring new customers.

We are very pleased with our customer acquisition costs today. and I think we are doing it very effectively. I’m not going to give a precise number, but will note that it is well south of $100. We contrast this with the industry average, which we understand to be in the range of $350 to $400, and that’s before device subsidies, which we don’t do.

Another fundamentally different aspect of customer acquisition for us is that $350 to $400 spent by our competitors is primarily big traditional media spend such as television, which enriches the networks and the ad agencies. The bulk of our customer acquisition spend is coupon codes, which goes directly into the pockets of the customer.

These customer acquisition costs as well as the bulk of customer support costs, which relate primarily to on-boarding new customers, are a function of growth in new customer. As long as the additions to the base are high relative size of the total base, these costs will be relatively high.

However over time, as the size of the additions relative to the base goes down. These costs become smaller. there are two things happening at once that investors should keep clear. we’ve been able to launch successful high potential new offerings with a remarkably low level of investment and we have shown stronger growth in our core businesses. The investment in Ting in the range of $1 million to $2 million in 2012 and likely $1.5 million to $2.5 million in 2013, hide some of the growth in the historical lines of business.

We saw some of the benefit of the maturing of Ting operations translated to cash flow this quarter. last quarter, I discussed that we had an over investment in devices on hand, as a result of Sprint transaction from WiMax to LTE phones as well as the fact that we are still ramping up or learning around the supply chain. We saw about $500,000 of this, come back to us in Q3.

this is left about whether that number is going to go down or not going forward. Because as our additions continue to increase, sort of the amount of prepaid devices we have. But it does show the efficiencies we expected. Even in the case where we had significantly more device sales in Q3 than Q2. Our dollars in inventory still came down over 40%.

before we open the call to questions, I’d like to take a couple of minutes to discuss our latest modified Dutch Tender option, which we announced earlier today. As I discussed many times Tucows is committed to returning capital to the shareholders over the long-term. we believe that the ability to do so is one of the fundamental benefits of being a publicly traded company.

Our business continues to consistently generate cash while delivering steady growth with little capital investment. as Mike mentioned earlier, to-date this year, we have repurchased 2.4 million shares in the open market under our normal course issuer bid, plus another 7.6 million under the Dutch Tender at the beginning of the year. And since initiating our first share buyback program in February of 2007, we have repurchased the total of 33.2 million shares or almost 45% of our shares outstanding.

Based on our continuing confidence in our business, our deep belief in Ting and the attractiveness of our share price, we have made a decision to undertake a new Dutch Tender option, for 7 since the beginning in 2007, under which we intend to repurchase up to 6.5 million shares or 14.7% of our shares outstanding as of yesterday.

shareholders will have the opportunity to tender some or all of their shares at a price within the range of $1.35 to $1.50. and if more than the targeted 6.5 million shares are tendered, we have the option of increasing that amount up to 2% of outstanding shares or another 885,000. The tender is scheduled to commence the week of November 19, and remained open for at least 20 business days. We entered 2013 with solid momentum in the core business and with Ting the best growth opportunity we’ve had since the launch of OpenSRS.

We believe we have the best distribution channel in the Internet economy and a great business opportunity in the mobile, the most important technology trend in the next decade. Our ability to operate efficiently and consistently generate cash, and our commitment to returning capital to shareholders over the long term will more than ever reward our investors.

And with that, I’d like to open the call to questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Aram Fuchs from Fertilemind Capital, your line is open.

Aram Fuchs – Fertilemind Capital

The portfolio business, how could an outside investor , figure out if this is still a recurring revenue, or is this a selling off of the gems, you have had for in the inventory for a few years?

Elliot Noss

Well, I think that the gems are such Aram that we have slightly under a 1,000 of them. And in a quarter, we rarely will sell more than single digits. So just doing the math there are decades worth of supply. So I think it’s very, there it’s really about consistently generating those sales, and do remember that the bulk of the transaction revenue, the bulk of the sales revenue in that line of business is the brandable names, not the gems.

Aram Fuchs – Fertilemind Capital

Thanks. And then in Ting, should we look at increased sales on phones, as a proxy’s increased revenue, future revenue; it’s sort of like a DR line, right?

Elliot Noss

Yeah, I think that’s right. Well, it’s not like a DR line, but it’s like a deferred revenue line, but it certainly indicates new customers. So I think that the reason that we decided to disclose the subscriber numbers and make that easy was because we didn’t want people to have to go through the effort of trying to take the phone revenue and triangulating back to customers. We thought that was really a waste of your time. So we figured, it was simpler just to give you the subscriber data at that point.

Aram Fuchs – Fertilemind Capital

Right.

Elliot Noss

And because of that, you really don’t have to even look at it as a proxy. you can just look at the subscriber data. We’ve said in the past that our customers were in the $150 a year range to us and we’ve told you what the gross margin is and that $150 by the way is a margin number, not a revenue number. So you don’t have to do any proxy.

Aram Fuchs – Fertilemind Capital

Great, great.

Elliot Noss

You can just do simple multiplication.

Aram Fuchs – Fertilemind Capital

Great, okay, that’s helpful. And the burn rate you mentioned that the loss estimate on Ting, what is that, that’s coming off from the income statement or that’s including the subsidies on the inventory or can you be a little more specific on that?

Elliot Noss

Yeah, it’s our income statement. So the bids that come around a device subsidy or things like shipping or flashing of phones that sits in COGS. But the things like, coupon codes, marketing other customer acquisition type expenses, that set is an OpEx, both of which are income statement items. So the number that I put out is kind of a cash number, that’s not an investment in the capital goods.

Aram Fuchs – Fertilemind Capital

Right, okay. And lastly, regarding the share buyback, your obviously shareholders like getting capital returns then, I’m just curious that your stock is not overly liquid though, and when did you stop with the buybacks and start with dividends? how do you think about that?

Elliot Noss

Well, for me, it’s not a question of liquidity; it’s a question of value. we think the stock is really attractive use of capital, right now to buyback. and so to me, that’s really the primary driver and the liquidity is funny thing, because everybody is a seller at a price. so liquidity is really a function of what price you’re a seller at, not whether you would sell, because as you and I have certainly discussed, people are in this with an investment. So, everybody has got a price.

Aram Fuchs – Fertilemind Capital

Right. Okay, great. thanks for your time.

Elliot Noss

Thanks, Aram.

Operator

(Operator Instructions) We have no further questions at this time.

Elliot Noss

Thanks, everyone. and we will see you again in next quarter.

Operator

This concludes today’s conference call. you may now disconnect.

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