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Tucows Inc. (NASDAQ:TCX)

Q1 2010 Earnings Call

May 12, 2010 5:00 pm ET

Executives

Elliot Noss - President and CEO

Michael Cooperman - CFO

Analysts

Jim Kennedy – Marathon Capital

Operator

Welcome to Tucows, Inc.’s first quarter 2010 conference call. Earlier this afternoon, Tucows issued a news release reporting its financial results for the first quarter of fiscal 2010. The news release and 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 one hour following the completion of this call. Details on how to access the replays are available in today’s news release reporting the first quarter financial results as well as at Tucows website.

Before we begin today, let me remind you that the matters that the company will be discussing include forward-looking statements, and as such, are subject to risks and uncertainties that could cause 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 Form 10-K and 10-Q. The company urges you to read its Securities filings for a full description of the risk factors applicable for its businesses.

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

Elliot Noss

Thank you, operator. Good afternoon, and thanks for joining us today. With me is Michael Cooperman, Tucows Chief Financial Officer.

As per the usual format for our calls, I will begin with a brief overview of our financial performance and some of the operational highlights for the quarter. Mike will review our financial results in more detail and I will return for some concluding comments before opening the call up to questions.

First an overview of the financial results. Q1 marked another quarter of solid financial performance for Tucows with results that continue to demonstrate the consistency and reliability in our business. At a high level, revenue for the first quarter was $20.4 million up about 2% from the first quarter of last year. I would note that this growth is despite the expected impact of the loss of revenue from email and direct navigation sales we have discussed previously. Adjusted cash EBITDA for the first quarter was $2.3 million and we once again generated positive cash flow from operations of $1.4 million.

Turning to some operating highlights, with OpenSRS, I would now like to briefly review those highlights and starting with OpenSRS. The domain service is the foundation of the consistency and reliability in our business. That was evident again in the first quarter of 2010. The domain service saw continued steady growth in transaction volumes. New registrations grew almost 12% compared to the fourth quarter of 2009 and 12% on a year-over-year basis factoring out the special registry promotion in the first quarter of 2009.

Renewals were up 24% from the fourth quarter and 11% on a year-over-year basis. I will note with respect to the sequential growth renewals tend to spike in the first quarter given this was the quarter we first launched our domain registration service in 2000. Our renewal rate, already several points above the industry average, saw a small bump in the first quarter, a result of both the improved economic environment and improved retention in a specific segment of our customer base that we acquired several years ago.

Continued growth in our transaction volumes pushed the number of domains under management to more than 10 million. We are proud to say we are one of only three domain registrars that have reached this milestone. It is a testament to our wholesale business model as well as our strong competitive position. All of this contributed to year-over-year domain service revenue growth of over 8% and we have seen this momentum and growth continue in April.

We are seeing more customers in the pipeline going live as we get better and more efficient at getting our resellers started with us. A number of these new customers are coming from markets outside of North America which are now consistently seeing higher growth. We have always talked about our global footprint and clearly that is having a positive impact. I also note for the first time since the launch of the domain service in 2000 we are seeing consistency in gross margin.

As expected, email service revenue declined somewhat markedly compared to Q1 of last year, the result of the departure of the three large customers at various points throughout 2009 as discussed on previous calls. We have a good base to build from going forward. Our email service is now very solid and extremely strong relative to competition. We are heads down around selling and looking to build our book of business from here.

All of the trends that initially attracted us to email and made us think it was a strong strategic opportunity for Tucows are still present and we are seeing the emergence of new opportunities as privacy and user’s control of their own information, things we strongly believe in, become more of a mainstream issue.

YummyNames, our domain portfolio group, had another solid quarter highlighted by strong performance from individual name sales. The strong momentum in brandable names we have discussed in prior quarters continued through Q1, the result of increased auction activity as well as the increased exposure through our distribution agreements with Name Media and Sedo. We have also increased our promotional efforts around gems.

These are the names in our portfolio with the highest value. We are seeing and will continue to see the transition in YummyNames revenue from bulk sales of direct navigation names to individual sales of brandables and gems. We expect these growth areas inside of YummyNames to continue to contribute positively to the business. Overall, YummyNames is continuing to perform well.

Moving to butterscotch revenue was consistent year-over-year and some of the work in the pipeline has us confident we will see growth in the remainder of the year. All of the key traffic metrics for butterscotch continue to trend in the right direction during Q1. Notably page views were up 9% from the fourth quarter. Site visits were up 13% and video plays were up 23%. The number of videos available on butterscotch at the end of Q1 increased to more than 2,500 from 2,000 at the end of Q4.

With Hover, Q1 marked the first quarter of billings growth in some time and results through April have been equally encouraging. Clearly these simplified domain registration and management processes that we implemented last year are having an impact on this business. This was especially evident in our renewal rate which was up 9% from the previous quarter. In addition, two recent changes make us even more excited going forward. Hover recently introduced No Hold Customer Service which means that Hover’s customers will now have their support calls answered directly by a human being without having to deal with an annoying phone system.

Unsurprisingly, customers have been delighted with this. In addition, we relaunched the homepage of Hover and instituted a new sales process that has greatly increased conversions, all of which we believe will help us continue to grow from this new foundation.

In summary, the top line performance across each of the components of our business continues to demonstrate the consistency and reliability in our model. The cost side of the equation however is also a major contributor to our consistency and reliability. Over the past few years we have often discussed the considerable leverage in our business, our ability to scale revenue in the absence of proportional increase of expenses.

That leverage is readily apparent in a comparison of our operating margin over the last few years. In 2006 total cash operating expenses including network costs were 36%, over 1/3 of billings. In 2009 that number was just 24%. A look at our headcount underscores this point as we have grown our billings by more than 15% over the last three years we have reduced our average headcount by about 17%. I will note that we achieved this within the context of a 10% appreciation in the Canadian dollar over that period as well as a general increase in the level of salaries as we have elevated the quality of our personnel.

My intention here is not to intimate we will be cutting costs going forward. We have and will continue to effectively manage our cost structure. When we really see opportunity on the expense side is in continuing to reap the rewards of the leverage in our business as we grow our revenue.

I would now like to Mike to walk through our financial results in detail. Mike?

Michael Cooperman

Thanks Elliott. Net revenue for the first quarter fiscal 2010 was $20.4 million, an increase of 2% from $20.1 million for the first quarter of last year. I will review the impact on the quarter of revenue for each of our services in my comments on gross margin contribution.

Cost of revenues before network costs in the quarter increased by $1.1 million or 8.7% to $13.7 million from $12.6 million for the same quarter of last year. Network costs were down marginally compared to the first quarter of last year at $1.6 million. In assessing all of our operating costs including network costs I think it important to bear in mind the significant strengthening of the Canadian dollar relative to the U.S. dollar we have seen over the past year or so. You will recall the majority of our network and operating costs are in Canadian dollars.

In fact, when compared to the first quarter of last year, the Canadian dollar has appreciated on average by approximately 15%. Gross margin for the first quarter of this year was 25% down from 29% for the same quarter of last year primarily the result of a shift in our sales mix from higher margin services to lower margin domain names.

Gross margin from our OpenSRS service which includes domain services, email services and other wholesale services was $4 million or 20% of net sales compared with $4.5 million or 22% of net sales for the first quarter of 2009. This decrease is primarily attributable to the expected loss of three media portal email customers that we have previously discussed and to a lesser extent on the success we have been seeing from our strategy to grow revenue from higher volume, lower priced customers as we continue to aggressively compete to attract new resellers and retain existing customers.

Gross margin from domain services on a dollar basis was essentially flat when compared to the first quarter of last year at $2.8 million. On a percentage basis, gross margin from domain services fell to 18.1% from 20% primarily due to the increase of registry price increases have had on our percentage gross margin and to a lesser extent on the strategy to compete for higher volume, lower price customers. As a reminder, our gross margin percentage will be further impacted by an additional 7% price increase that the VeriSign registry will implement on July 1 of this year.

Gross margin from email services decreased to $531,000 from $942,000 for the first quarter of last year, largely as a result of the expected loss of the three media portal customers. As our marketing efforts have not yet to date been successful in offsetting these customer losses, they continue to impact our email gross margin. With the last of these customers having completed their migration we now look forward to building from our current base. As a percentage of revenue gross margin from email services was relatively unchanged from the corresponding quarter of last year.

Gross margin for YummyNames decreased by $171,000 to $1.5 million from $1.7 million for the same quarter of last year. This decrease essentially resulted from the impact of sales of non-strategic domain names has had on our inventory of domain names and the fact we were able to sell the bulk of our backlog of nonstrategic names during fiscal 2009. This has impacted on the value of names we have available for our regular by-monthly sale of names as well as the number of names we have available for parking purposes. These decreases have been partially offset by the continued success we have been having with brandable and gem names.

Gross margin percentage for YummyNames decreased slightly to 88% from 90% in the first quarter of last year. Gross margin for Hover decreased to $730,000 from $787,000 for the first quarter of 2009 mainly as a result of the previously announced steps we took to improve our retail platform while we were transitioning our retail customers from Domain Direct net identity and IYD services to our new retail platform.

These initiatives have now reached the stage where our retail platform is well positioned to begin to grow. Gross margin percentage for Hover increased to 65% from 61% for the first quarter of last year mainly as a result of the changes we made to the Hover platform allowing us to achieve a higher average selling price for our services.

Gross margin for butterscotch decreased slightly to $451,000 from $501,000 for the same quarter of 2009. As we have discussed previously the sales mix for butterscotch has changed significantly over the past several quarters. As we continue to execute on our strategy of exposing more of the Tucows.com website traffic to the content rich butterscotch.com traffic, this market driven shift has resulted in more video based revenue which for the most part has been offset by the lower yields from our syndicated Google feeds. As a percentage of net revenue, gross margin for butterscotch decreased to 96% from 99%.

Total operating expenses for the first quarter of 2010 decreased by $473,000 or 10% to $4.2 million or 21% of net revenue from $4.7 million or 23% of net revenue for the corresponding quarter of last year. Again, I will note this decrease in operating expenses is within the context of the Canadian dollar that appreciated on average by 15% against the U.S. dollar over the last year.

Looking at our total operating expenses in terms of core and other expenses, core operating expenses which we define as those expenses relating to ongoing sales, marketing, development and administrative costs increased by $911,000 or 26% to $4.4 million from $3.5 million for the first quarter of last year. As a percentage of net revenue, core operating expenses increased to 21% from 18%. If we exclude the impact of the increase in the Canadian dollar has had on core operating expenses, core operating expenses as a percentage of revenue would only have increased to 19%.

The majority of this increase is attributable to higher work force costs as we reallocated certain network operating functions to customer service and invested in additional marketing and customer service personnel. All of this reflects our increased focus on sales and marketing.

Other operating income for the quarter was $105,000 compared to other operating expenses of $1.2 million for the first quarter of last year. The favorable change in other operating expenses of $1.3 million is primarily the result of foreign exchange. In the first quarter of this year we recognized a gain on foreign exchange of $688,000 inclusive of a mark-to-market gain of $114,000 compared to a loss on foreign exchange for the first quarter of last year of $666,000 inclusive of a mark-to-market gain of $85,000.

In addition, other operating expenses were impacted by our incurring a one-time payment of $126,000 in severance costs as part of our sales and marketing initiatives. I would note for you that as we have highlighted on prior conference calls the accounting impact of the movement in the Canadian dollar relative to the U.S. dollar on our outstanding forward contract has resulted in our raising a significant non-cash derivative instrument asset on our balance sheet of $2.3 million at March 2010.

As we continue to assess mark-to-market adjustments for open forward contracts in future periods this asset will reverse as the contracts pertaining to it mature and/or are exchanged. At that time we will record a significant non-cash loss on foreign exchange for the affected contracts. Net income for the first quarter of 2010 was $569,000 or $0.01 per share compared with $1 million or $0.01 per share for the first quarter of 2009.

Turning to the balance sheet, cash and cash equivalents at the end of the first quarter of this year increased to $5.2 million from $4 million at the end of the first quarter of last year. However, it decreased from $9.6 million at the end of the fourth quarter of last year. The decrease in cash of $4.5 million from the end of 2009 is the result of our using $5.2 million to repurchase 7.3 million shares and in the modified Dutch tender offer we completed in January and the open market buyback program we launched in February. In addition we also made capital payments of $479,000 on our bank loan, reducing it to $2.7 million at the end of the quarter.

With regard to the bank line I would also note for you the cash suite payment which will be based on our audited 2009 results and we will be paying during the second quarter will be sufficient to pay off in full the outstanding balance of our bank loan. These uses of cash were partially offset by our generating $1.4 million in cash flow from operations. Deferred revenue at the end of the first quarter of 2010 was $59.5 million, an increase of 5% from $56.7 million at the end of the first quarter last year and an increase of 6% from $56.3 million at the end of the fourth quarter of last year.

To conclude, the first quarter marks a solid start to 2010. Our results have demonstrated the consistency in our business driven by the continued momentum in our core domain services unit, the strength of our YummyNames domain portfolio business and the revitalization we are beginning to see with butterscotch and Hover. We continue to execute well and spend prudently. Moreover, I think the fact we will have fully repaid our bank loan a full two years ahead of its scheduled repayment is a further indicator of our ability to consistently generate cash flows from operations. With the repayment of the loan behind us this quarter we look forward to continuing to deliver on our stated objective of returning capital to shareholders.

I would now like to turn the call back to Elliott.

Elliott Noss

Thanks Mike. For some time now whenever a shareholder or prospective investor asks me about what makes Tucows a good investment, I answer, “Consistency, reliability and visibility in the context of growth.” We are a milk and eggs type of business. Our revenue base is composed of a large volume of transactions at a low per-unit price. The vast majority of our business is subscription based with high renewal rates and we have very low customer concentration.

To follow that up with several pieces of data that demonstrate this over the long-term. We have grown revenue every year for 14 years. We have generated positive cash flow from operations for the last 8 years. The number of domains under management has grown every year since we entered the industry a decade ago. The five individuals on our senior management team have been at Tucows an average of 8 years out of the last 10. As I discussed earlier on the call, all of this is supported by a track record of expense control and the significant leverage in our business.

While billings have grown almost 15% over the past three years, total cash operating expenses have decreased 23%, again despite the appreciate in the Canadian dollar over that period. At the same time, we were able to pursue growth opportunities without consuming too much capital. I again point to the successful re-launches of butterscotch and Hover which you don’t see in our costs and we continue to deliver on our stated intention to return capital to shareholders.

I will note since we implemented our open market share buyback programs in February of this year we have repurchased an additional 956,000 of our own shares. That brings the total number of shares we have repurchased since the beginning of January 2009 to $13.4 million or 18% of the company.

Throughout our history we have consistently demonstrated our ability to grow the business. A decade ago we turned great opportunity in the content business into a great opportunity in the wholesale domain business. We then layered on top of that additional revenue streams from digital certificates and the secondary domain name market. Then we reinvented some of those older business lines to add new growth opportunities from previously static or declining revenue streams.

While there have certainly been some challenges and even some failures along the way we have maintained our momentum. We continue to have excellent growth opportunities going forward and have the advantage of being able to capitalize on them in a way that doesn’t impact our ability to maintain this consistent, reliable business with the will and demonstrated ability to return capital to shareholders.

Most importantly, every year we add more customers. Every year we add more domains. Every year we grow our distribution channel and that grows the great platform we have for long-term growth; one that provides consistency and reliability.

With that, I would like to open the call for questions. Operator?

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of Jim Kennedy – Marathon Capital.

Jim Kennedy – Marathon Capital

Since I am somewhat new to the story, could you articulate the challenges…you were talking about growth internationally. Could you talk about the challenges in terms of how you do that internationally? Is it that much different than what you might do domestically, say here in the U.S. versus overseas? Is it incrementally harder? How do you build that momentum globally and what sort of challenge is that?

Elliott Noss

I think we have always been blessed by the fact our roots in the software download business, the old Tucows.com software libraries were extremely popular especially outside of North America. So when we launched wholesale domain registration we came in with people knowing Tucows and therefore the Open SRS brand. So we were able to at the beginning establish a pretty good footprint globally.

Over time all business is local. Where we have done best internationally is where we could actually put some people on the ground. In Europe for example we have a couple of heads and we spend a lot of time and effort flying around and meeting people. Both our VP of sales and myself try to get over there at least once or twice every year. Similar, although to a little lesser extent in South America and Africa where again we have pretty good bases and pretty good penetration.

Asia in particular presents a unique challenge and that is one we have really kind of taken a bit of a finer focus to for the next year or two. Now, we are very lucky that in the wholesale model it is our partners that really do all of the heavy lifting in terms of penetrating a market. In a market like Poland where we have a great footprint or any number of markets in Europe it is that partner that is going the dealing with the language and providing support in the local language and taking payments according to local currency and customs.

So we get away with bits of that. But these businesses; hosting businesses, ISP businesses are local businesses and that is true all over the world. So you have to hustle a little more but there is still incredible leverage.

Jim Kennedy – Marathon Capital

What sort of language barriers exist in terms of your being able to port things electronically or present them? I know you have local partners that do a lot of the selling and interfacing but is language an issue?

Elliott Noss

There are two elements to that. Luckily English is very much the Lingua Franca of the internet. When we are dealing with a customer it is overwhelmingly likely they kind of grew up in and around the internet and have a working knowledge of English so we are able to conduct business. That being said, our people on the ground in Europe I want to say cover between 6-8 languages between them.

Certainly, again as we are dealing in certain parts of Asia language you really do need that. On an interface level where the one place that manifests itself is web mail. When we are selling our email product, our hosted email service, there if somebody is providing it to their end users we do have to provide a translated version. It is a tad limited. So I think now we cover somewhere again between 8-9 different languages with our web mail interface and that is something we tend to expand on in sort of an as-needed basis based on customer demand.

Operator

There are no further questions in queue. Mr. Noss I will turn the call back over to you.

Elliott Noss

Thanks very much, operator. We look forward to seeing you all next quarter.

Operator

Ladies and gentlemen this concludes the conference call for today. Thank you for participating. Please disconnect your lines.

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Source: Tucows Inc. Q1 2010 Earnings Call Transcript
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