Tucows (NASDAQ:TCX) operates two separate businesses. The legacy business is as a domain registrar that provides domain name registration and value added-services (primarily e-mail) to resellers and retail customers. The new business, Ting, is a mobile virtual network operator ("MVNO"), or in simpler terms, a wireless phone carrier that uses the Sprint (NYSE:S) network. While these two product lines may not sound particularly interesting at first glance, there is a lot more under the hood that makes this company and stock very interesting.
The wholesale domain business has traditionally been the bulk of TCX's revenues and income. TCX acts as a registrar, in which they purchase domain names from the registry (such as the .com registry, owned by Verisign (NASDAQ:VRSN)), and then resells it to the public. The public isn't able to purchase from Verisign directly, so they have to go through companies such as TCX, GoDaddy, eNom, etc. TCX is slightly different from its competitors in that it is a wholesaler that sells domain names to other players, who then sell to the public. They generate income off the spread these transactions. TCX also makes a smaller amount of revenues (around 10% of their wholesale revenues) selling value added services, such as hosted e-mail and SSL certificates. While smaller, these value added services generate a much higher margin at around 80%.
The wholesale business has traditionally been slow growth and steady, but if you've been following the industry, you will know that ICANN has started to roll out new generic top level-domains (gTLDs) this year. gTLDs are new domain names that use different domains. For example, ".com", ".net", and ".org" are all gTLDs. ICANN is now in the process of approving and implementing over 1,400 new gTLDs over the next two years. The first batch in January were ones such as ".guru" and ".bicycle." This is expected to reaccelerate growth in domain name registrations, as people rush out to secure the newest and rarest domain names. Although these will never grow as big as the existing gTLDS, these gTLDs aren't priced at the typical rate of under $10 dollars a year, but closer to the $40-60 (and some at $100+) range. As a result, the industry is expected to reaccelerate as the rollout occurs. The company has publicly stated that new registrations will be in the 3-5% growth range, but with pricing at 4x and above for these new gTLDs, I expect overall revenue growth from this segment to be in the 10-12% range. Furthermore, margins should also expand as the mix shifts.
I wanted to note that there may be some confusion about registrar/registry and if TCX is bidding for these new gTLDs. TCX was considering becoming a registry for a few new gTLDs and sent in applications with some other partners. Since the initial process last year, TCX has decided that they are better off just running a registrar business and have withdrawn a majority of their applications. By withdrawing, they also recouped some of the fee that was associated with applications, which reflects their larger portfolio segment in their latest filing. That being said, TCX is still able to have access to all the new gTLDs coming out, selling wholesale to other sellers as they have done before. So while they aren't managing the registry, they are still selling domain names.
Hover is TCX's retail domain business. Hover sells domain names directly to retail customers. Although there are many competitors in this space, Hover has been able to grow a consistent 20% y/y. Hover's competitive advantage is its customer service - the product doesn't have any exceptionally innovative or differentiated products, but is focused on providing top of the line customer service. As a result, Hover is able to continue to grow through word of mouth and generate minimal sales expense. From my model (and what management has stated), Hover operates at high 50s/low 60s gross margin range. For 2014, I expect another year of 20% growth, along with some margin expansion due to selling gTLDs to retail as well.
While both Hover and Wholesale are steady businesses, the real thesis lies with their newest product - Ting. As mentioned before, Ting is a MVNO that runs off the Sprint network. On the surface, this doesn't sound like a great business. It's dependent on Sprint, there are a ton of MVNOs in the market, and the margins in the industry aren't great. However, after I took a closer look, I realized that Ting is completely opposite of this. But before we get into that, let's look at Ting's business model.
Ting operates on a transparent usage plan. The less you use, the less you pay. Each usage metric (voice minutes, texts, and data) are calculated independently. To date, about 98% of people who could potentially use Ting would save money compared to Verizon (NYSE:VZ) or AT&T (NYSE:T). You can try it out for yourself.
It's not that Ting is doing anything extraordinarily innovative, but really that Ting sees the sky high margins in the wireless space and is willing to charge less. Ting also doesn't lock people into contracts. A customer pays per month and can come in and out at any time.
What's also interesting about Ting is that they allow, and actually encourage, their customers, to bring their device ("BYOD"). Any phone that works on the Sprint network (except for the newest flagship phones), will work on Ting. The company isn't using the subsidy/higher monthly contract model to lure you in. They really just want to get you on their service. In fact, the company might end up losing money selling phones because they have to flash the software and ship the phone to you. If you don't have a phone to buy, Ting has partnered up with a company called Glyde to purchase used phones. Lastly, Ting is all about customer service. The company is consistently praised for their customer service. You can see from their Facebook comments and the Nov 2013 Lifehacker poll. Read the comments - people LOVE Ting. I think it is interesting to note that although Ting finished 2nd in the voting (1,400 votes to Republic Wireless' 1,700 votes), Ting has 16,000 likes on Facebook while Republic Wireless has 95,000 (I use Facebook likes as a metric because I don't have the number of users for Republic Wireless). While this isn't a bulletproof data point, it does imply that either Ting's smaller customer base tends to be socially active and/or they like the product so much they are willing to support it through various forms of media. I can't say I can put a particular value on this, but having a network of users that are social influencers is a great thing. Most of what you read online is negative publicity, so to have such a great user base is a valuable asset for Ting. It also implies a much sticker user base with lower churn (will get to that later) and a lower customer acquisition cost.
Ting also wins customers by working with the carriers to provide the best phones and availability. For example, Ting was the first MVNO to offer 4G LTE service and has recently started accepting (and also selling) the iPhone 5, Nexus 5, and soon to be released Galaxy S5.
So the company's edge is cheaper, more transparent pricing, flexibility (in their BYOD program), and customer service. How does this translate into a good investment?
1. Ting is a rapidly growing business hidden within the larger TCX umbrella.
TCX does not break out Ting revenues and exact margins, but I was able to back it out through the last eight earnings calls and financial statements. Ting started organically in Feb 2012. By the end of 2012, the company had 10,000 customers and $4m in revenues. By the end of 2013, Ting had 48,000 customers and $16.5m in revenues. Given the Q4 run rate and growth, I project Ting to reach 100,000 customers and $35m in revenues by the end of 2014. Essentially, you have a company with 100% growth that very few people know about because the company has not disclosed it in the financial statements. Even more importantly, Ting is cash flow positive! This isn't a high flying tech stock with huge sales expenses and no profitability. Ting is accretive to the company and doesn't require an outside source of funding to grow. Which gets me to my second point.
2. Ting's gross and operating margins are growing and much higher than the industry.
This might sound far-fetched, but at maturity, I estimate Ting's margins to be much better than other MVNOs, even though they charge less. This is partially due to their BYOD program. As it increases from 60% to 67% to 75% (over the past few quarters), Ting gets more and more of their revenues from the monthly service fees and less from equipment sales. Many carriers are trying to sell hardware at a loss to sign up customers, but Ting does not need to do this. In fact, when the Nexus 5 came out (one of their most used phones), Ting offered to sell it, but told its customers to buy it from Google (NASDAQ:GOOG) directly at a lower price! If you don't believe me, here is the post. So having a smaller percentage of their revenues coming from transactional equipment sales which can vary quarter to quarter, Ting is building a higher margin stable business. Furthermore, Ting doesn't operate retail stores. This allows Ting to save on store costs and run a lean operation with just their online site and customer service centers. However, this isn't all.
3. Ting's customer acquisition cost and churn is much lower than their peers.
As I alluded to before, people love Ting. So much, in fact, that in their most recent earnings call, Ting stated that their churn numbers after the first month are similar to Verizon/AT&T. This is incredible because Verizon/AT&T get to that churn number because they lock their customers into contracts. Ting doesn't need to do this, as their customers are incredibly loyal and sticky. In addition, Ting controls its customer acquisition costs by leveraging innovative marketing and word of mouth. You won't see Ting advertisements on television or national media, but instead, the company uses social media and other forms of marketing to get the word out. For example, Ting runs a campus rep program that incentivizes students to sign up other students and earn referral credits. Ting also pays out 25% of early termination fees if you come from another carrier. These simple, yet effective, ways to market help Ting generate a customer acquisition cost of only $80 per customer. These customers also tend to be influencers - as they become happy with the service, they will add on additional phones for their parents, siblings, and partners.
Just to clarify, churn is typically calculated after the first month because there is a disproportionate amount of churn in the first month due to people unhappy with the network (I believe this is the same way that Verizon/AT&T calculates churn). Although Ting is new, I expect that the typical Ting user will say around 5 years and generate about $1,500 in revenues and $1,000 in gross margin. At a CAC of $80, this results in over a 10 to 1 payback, with payback occurring within half a year. These metrics are incredible, and the street agrees as well. In the most recent call, the portfolio manager at Fertilemind Capital, a buy-side firm, said:
Okay, but I don't argue, and I don't think I have ever said this to CEO, is that don't give me the money back if these IRRs always good as they seem to be especially if you forecasting a below industry churn. I mean I would say it just goose it on the spending.
Management agreed, and is now looking to take their CAC from the $80 level to $100-$110 level as they attempt to accelerate growth.
4. Ting is still just a tiny piece of the pie.
Even at 100,000 customers next year, Ting is still just a small piece of the overall market. Verizon has over 100m subscribers, and the bigger (and now acquired) MVNOs such as Boost and Virgin Mobile are both in excess of 5m. I believe that Ting has a huge runway left to continue to grow 3-5 years out as they continue to take share away from the larger carriers. Let's put it in this context - if Ting has a million subscribers, generates 300m in revenues, and generates 100m in EBITDA, I'm not so sure Verizon even bats an eye. Yet the entire company trades for 140m in market cap currently.
5. Ting doesn't have carrier risk
First, Ting is complementary to Sprint. Over 70% of Ting customers come from a carrier other than Sprint, so they bring in additional revenue to Sprint (my understanding is that Ting pays Sprint for service/bandwidth, so the more Ting makes, the more Sprint makes as well). The remaining amount are actually Sprint customers who leave Sprint due to dissatisfaction and then are scooped back up by Ting. Ting has stated that Sprint actually makes more money if a customer is on Ting compared to their own business, because Ting is so much more efficient around customer acquisition and customer support costs.
Back to the overall business. I also wanted to mention that TCX is a Canadian based company, and so far only has Canadian sell-side coverage. As such, I believe that it is under most of Wall Street's radar. If the company is able to pick up U.S. coverage and get the Ting story out to the public, the company could really see a boost in interest and investors. It's interesting to note that Ting actually does not operate in Canada - the Canadian wireless industry is full of collusion which is hampering Ting from ever taking off.
Lastly, I want to mention that TCX generates good FCF that should continue to increase as Ting becomes more and more accretive. The company currently yields 5% FCF, and also has a net cash position of $6m, or $0.50/share. Even with the organic rollout of Ting, the company does not spend very much on capex. Furthermore, TCX has recently announced a $20m share buyback program, which at current levels should take approximately 15% of shares outstanding off the table. TCX does not pay a dividend, and is not expected to, as its shareholder base is largely Canadian and subject to detrimental dividend tax rates.
I provide three scenarios for valuing TCX. Hover and the Wholesale Domain tend to be more stable businesses, so my valuation assumptions don't vary wildly. I'm going to assume negative 10% growth for their portfolio segment in all scenarios(I haven't discussed this because it is a very small and declining segment of the business, less than 10% of revenues/margin). For my bear case, I assume that Wholesale only grows at 8%, Hover at 15%, and Ting at 75%. These are all lower than what management has stated or based off my projections. At 4x EBITDA for Wholesale, 6x EBITDA for Hover, and 2x Sales for Ting, I believe the stock is valued at $11 in 2014 and $14 in 2015. If I include share repurchases, these amounts get to $11.75 in 2014 and $16.25 in 2015. I want to state that this bear case is VERY conservative - a growing company with no significant obstacles shouldn't be valued at 4x EV/EBITDA.
For my base case, I assume Wholesale grows at 10%, Hover at 20%, and Ting at 100% for 2014. I apply a 5x EV/EBITDA multiple to Wholesale, 8x EV/EBITDA to Hover, and a 3x Sales to Ting. This gets me to $16.50 for 2014 and $23.50 for 2015, without repurchases. With repurchases, I'm closer to $17.50 and $27. As I mentioned before, I see these multiples are realistic once investors take a closer look at the company and understand Ting's economics.
For my bull case, I assume Wholesale grows at 15%, Hover at 25%, and Ting at 150%. My 100% growth assumption only assumes that Ting grows at the current net subscriber add that it did in the past. If the company is able to accelerate these net adds (they have done so every period), the sky is really the limit. Using a 6x EV/EBITDA for Wholesale, 10x EV/EBITDA for Hover, and 5x Sales for Ting, the price trades at $28 for 2014 and $48 for 2015. With repurchases, I get closer to $30 and $55, or basically a 4-bagger by 2015.
Given the current price at $14.40 at current prices, I believe that TCX provides significant asymmetrical risk/returns. I've looked at this multiple ways, and I'm not sure where TCX can go wrong given its strong positioning, competitive advantages, and industry tailwinds.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.