Elliot Noss – President and CEO
Michael Cooperman – Chief Financial Officer
Thanos Moschopoulos – BMO Capital Markets
Tucows Inc. (TCX) Q3 2010 Earnings Call November 10, 2010 5:00 PM ET
Good afternoon, ladies and gentlemen. Welcome to Tucows Inc Third Quarter Fiscal 2010 Conference Call. Earlier this afternoon, Tucows issued a news release reporting its financial results for the third quarter of fiscal 2010. The news release and the financial statements are available on the company’s website at tucowsinc.com under the investor 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 third quarter financial results as well as at Tucows website.
Before we begin today, 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 details in the company’s documents filed with the SEC. Specifically, the most recently report on Form 10-K and Form 10-Q. The company urges you to read its security filings a full description of the risk factors applicable for its business.
I would now like to turn them over to Tucows, President and Chief Executive Officer, Mr. Elliot Noss. Please go ahead, sir.
Thank you, Operator. Good afternoon and thanks for joining us today. With me is Michael Cooperman, Tucows Chief Financial Officer. This afternoon’s call will follow our usual format. I will begin with a brief overview of our financial results and operational highlights for the quarter. Mike will then review our financial results in more detail and I will return for some concluding comments before opening the call up to questions.
The third quarter saw the continuation of the solid results that we delivered in the first half of the year, as each of our business units continued to perform well. Revenue grew by 3.5% compared to the third quarter of last year to a record $21.2 million. And as was the case in Q1 and Q2, we achieved this growth despite the lower contributions from our email service and direct navigation name sales.
Adjusted cash EBITDA for the quarter was $1.8 million and cash flow from operations was $1.9 million. I will now briefly review some of the operating highlights for the quarter beginning with OpenSRS. Again this quarter, OpenSRS domain service saw strong year-over-year growth in transaction volumes. Total transactions grew 16% compared to the third quarter of last year and new registrations grew 25%. Both of which were buoyed by the launch of the new .CO TLD that I discussed last quarter.
Net of the CO launch, new transactions grew a healthy 15%. Renewal transactions remain strong with year-over-year growth of 11% and our renewal rate held steady at a level that is firmly above the industry average. Domains under management were up 8.6% year-over-year to $10.1 million.
Growth in transactions contributed to a year-over-year increase in domain service revenue of 9.4% and our strong competitive position once again resulted in a number of a significant customer wins during the quarter. We have continued to post solid growth numbers as a result of our core competitive strength. Our ability to build and maintain long-term customer relationships, as well as our ability to deliver innovative new services.
In this win, subsequent to the end of the third quarter, we introduced the first phase of a major enhancements of the OpenSRS platform, a unified control panel that provides resellers with a single modern interface for managing all OpenSRS services. This is a big piece of work. The first major update to our reseller interfaces since they became available in 2000. When complete, this unified control panel will not only make it much easier for resellers to support their customers, it will also make it much easier for us to cross sell and upsell our services.
Cross-selling and up selling our services, getting more domain customers to buy email for example, is a significant opportunity that we can now take greater advantage of. The first service to benefit from the unified control panel is our expanded trust service, what we refer to in the past as our SSL or digital certificates business launched this quarter.
As the Internet continues to grow and evolve, the issues of security authentication and privacy are becoming increasingly important to users. And therefore increasingly essential to the sites with which they are interacting. We’ve offered SSL or digital certificates for almost a decade. However, they are just one element of the broader trust service spectrum. We are expanding this offering to include a density verification, malware scanning and other related services in a flexible format that allows resellers to pick the services that best meet their customer’s needs.
It is worth other noting that our SSL service has posted strong growth recently with a number of certificates sold up 18% from 12 months ago, a clear demonstration of our ability to introduce and be successful with new services. And we are confident that the expanded trust service offering will continue that trend.
YummyNames, our domain portfolio group continues to perform well. We continue to see the revenue mix transition from the sale of direct navigation names to brandable’s and to a lesser extent jams. In fact, this category of name sales brandable’s and jams more than doubled from Q3 last year. This quarter’s results should be viewed in the context of last year’s clearing out of excess track navigation inventory and general softness in per page ad revenue in the domain parking sector broadly.
We remain encouraged by the maturation of the market for brandable’s and jams and believe that in 2011, YummyNames, will again continue to experience robust growth. Turning to Hover, our retail service. We continue to see the contribution of our reinvigorated sales and marketing effort. New transactions which include new domains, transfers in, domain email accounts and personal name email accounts were up 85% year-over-year. And new customers were up even more dramatically than that. And new transactions were up over 33% compared to Q2 this year.
Although revenue was down slightly on a year-over-year basis, Billings were up 27%, the third consecutive quarter of year-over-year growth in Billings. Hovers positioning is a simple no hassle domain registration and management tool, is really being validated in the market. Hovers performance in the third quarter has especially validated that positioning and we’re looking forward to taking what we have learned here and sharing it with our wholesale customers.
At Butterscotch, our content services group, revenues for the third quarter grew 37% year-over-year, with all key performance metrics continuing to trend favorably. Both page views and site visits increased again this quarter up 7% and 8% respectively compared to the second quarter. Video plays on the Butterscotch site, while down slightly from Q2 due to seasonality were up 36% from a year earlier. Video plays away from butterscotch continue to show even more impressive growth.
Plays on YouTube were up 45% from the second quarter and up 10 fold those in Q3 last year. Off website traffic is becoming more important than on website traffic. That massive growth in outside video plays is part of a larger trend towards mobile computing. The other place that Butterscotch is seeing this trend is in what video contents is most popular, but here clearly the butterscotch content that is helping people choose, use an understandable mobile devices is dominating its most popular. In 2011, you will see Butterscotch focus to an even greater degree on mobile computing to capitalize on this trend.
In summary our third quarter results were once again demonstrative of the consistency and reliability in our business, driven by continued strength in both OpenSRS and YummyNames, along with increased contribution from our reinvigorated Hover and Butterscotch services. Building on this, we are in the process of launching our unified control panel and our expanded trust services offering. And later this year we will launch another new service that demonstrates the value we bring to the table as a conduit between suppliers and our customers.
I’ll to you more about this new service shortly, but first I’d like Mike to talk about our financial results in greater detail. Mike?
Thanks, Elliot. Net revenues for the third quarter of fiscal 2010 increased 3.5% to $21.2 million from 20.5 million for the third quarter of last year. Cost of revenues before network costs for the quarter increased by $1.3 million, or $9.8 to $14.9 million from $13.6 million for the same quarter of last year.
Gross margin for the third quarter of this year decreased to $4.9 million from $5.3 million for the same quarter last year. On a percentage basis, gross margin decreased to 23% from 26%. Largely the result of the 7% price increase implemented by the assigned in July and the continued shift in sales mix from higher-margin services to lower margin domain name services that we’ve discussed on previous calls.
Gross margin from our OpenSRS service which includes domain services, email services and other wholesale services was $3.8 million or 18% of net sales compared with $4.2 million or 23% of net sales for the third quarter of 2009. This decrease is primarily attributable to the lost contribution of the three media portal email customers that we have previously discussed and to a lesser extent, the success of our strategy to grow revenue from higher volume lower priced customers.
Domain services gross margin percentage decreased to 16.3% from 18.4% last year due mainly to the additional 7% pricing increase that the VeriSign registry levied on July 1. Gross margin for YummyNames decreased by $500,000 to $1.1 million, when compared to the third quarter last year and primary reflects the timing of larger portfolio sales of domain names.
In addition our bulk name sales from the portfolio also resulted in our having a smaller inventory of names available for delivery of third-party advertising on park pages. Gross margin percentage for YummyNames declined marginally to 86% from 88% for the same quarter last year.
Gross margin for Hover increased $0.8 to $767,000 from $711,000 for the third quarter of last year and reflects the strengthening trend we are seeing for hover as a result of the significant development work we undertook last year. We expect to hovers results to continue to strengthen as we now focus on driving sales by implementing marketing program.
On a percentage basis, gross margin increased to 67% from 59% of the same quarter of last year. The increase is mainly the result of the introduction of high-end margin offerings. Gross margin for Butterscotch increased 42% to $620,000 from $436,000 for the same quarter of 2009. This increase primarily resulted from the higher video advertising and corporate video revenues, as advertisers continue to migrate their advertising spend to more content rich websites such as Butterscotch. This increase has been partially offset by the decline in our Author Resource Center resource revenue as advertisers continue to show a preference for more content rich traffic, as well as a significant decrease we have experienced in AdSense revenue, the result of Google’s elimination of their enterprise level, ADSense program.
As a percentage of net revenue, Butterscotch gross margin increased to 98% from 95%. Turning to cost please remember that a significant portion of our operating costs are in Canadian dollars. Our results should therefore be viewed considering the unfavorable impact of the stronger Canadian dollar relative to the U.S. dollar has had on our performance. I will note that when compared to the third quarter of last year, the Canadian dollar relative to the U.S. dollar has strengthened on average by approximately 5%.
Network costs decreased by $176,000 or 11.2% to $1.4 million from $1.6 million, this result reflects the lower depreciation costs we have incurred as a result of both improved use of computer hardware, as well as the improved efficiency we have experienced in operating and managing our co-location facilities.
Total operating expenses for the third quarter increased by $1.4 million or 56% to $3.8 million or 18% of revenue from $2.4 million or 12% of net revenue for the corresponding quarter of last year. As I have noted on previous calls, the changing value of our foreign exchange contracts remains the principal reason for the variance in our operating expenses from period-to-period.
For the third quarter of this year, the fair value adjustment on unrealized foreign exchange from our contracts resulted in a net gain of 140,000 compared to a net gain of 1.9 million for the same quarter last year, a differential of $1.7 million between the two periods. Breaking down, our 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 4.4% to $4 million from $3.8 million for the third quarter of last year.
Our improving efficiencies around core operating expenses were partially offset by the approximately 5% increase in the Canadian dollar when compared to the third quarter of last year. As a percentage of revenue, core operating expenses were up slightly at just under 19%.
Other income for the quarter was $200,000 compared with other income of $1.4 million for the same quarter last year. The difference is primarily the result of the changing fair value of foreign exchange contracts that I discussed earlier, as well as the impact of realized exchange rate fluctuation.
Net income for the third quarter was $1.1 million or $0.2 per share compared with $5.2 million or $0.8 per share for the third quarter last year. In comparing these results, I will remind you that net income for the third quarter last year included both a gain in the fair value of our foreign exchange contracts of $1.9 million, as well as the receipt of $1.9 million generated by the final payment for the sale of our equity stake in affiliates. Compared to the third quarter, these two items resulted in a difference of $3.6 million between the two periods.
In addition, the third quarter last year included a recovery of income taxes of 450,000 compared to a tax payment this year of $25,000. If you exclude these items compared to the third quarter last year, net income remains essentially flat. To further put this into context if we do the same analysis for the nine months today, net income grew by 14% when compared to last year.
Turning to the balance sheet and cash flow. Cash and cash equivalents at the end of the third quarter of this year was $5.4 million down from $9.6 million at the end of December last year but up from $4.1 million at the end of the second quarter of this year. The main reason for the decrease in cash from year end is the success we’ve experienced with our share buyback initiative.
As Elliot will discussed, since December we have spent $6.9 million a year-to-date on our buyback programs. The $1.4 million increase in cash compared to the second quarter of this year is primarily due to the generation of cash flows from operations of $1.9 million, which was partially offset by our making capital payments of $479,000 on our credit facility with the Bank of Montreal.
On the subject of our credit facility, we have now contributed our previously discussed negotiations with the bank with regard to future facilities. The details of the new facilities, we have in place can be found in our Form 8-K filing dated September 13, 2010. Essentially, under the terms of this new facility the bankers waived its cash sweep payment in respect of 2009 and our current facility of $1.8 million remains in place.
In addition the bank has made available an additional $2 million specific purpose for this facility to assist us in financing any future stock buyback programs we may undertake. I would note for you that we funded October share purchase buyback fully from available cash and have not utilized any of our new facility to date. The bankers also improved in operating line of $1 million which we can use to fund operational requirements on an as needed basis.
Deferred revenue at the end of the third quarter of this year was $62.3 million, an increase of $5.8 million from $56.5 million at the end of the third quarter and $2.3 million from $60 million at the end of this second quarter of this year. To reiterate Elliot’s earlier comments our financial results for the third quarter and throughout 2010 are indicative of the consistency and reliability inherent in our business.
Domain services and YummyNames continue to exhibit strong performance and Hover and Butterscotch are increasingly contributing to our results. Our business model is allowing us to improve productivity which has assisted us in offsetting some of the impact of the strong Canadian dollar. This has enabled us to consistently generate cash flow from operations providing continued support for our objective of returning capital to shareholders.
I would now like to turn the call back to Elliot.
Thanks, Mike. Let me begin with an update on our share repurchases. In the second half of 2010 we’ve continued to deliver on our objective of returning capital to shareholders. In September, we initiated our fifth modified Dutch auction tender in the last two years with the intention to purchase up to 2.9 million shares with the option to take up additional 2% of our total shares outstanding at the time of the announcement.
With more than 3.9 million shares tendered we exercised that option, repurchasing the entire amount at a price of $.70 per share for a total cost of just over $2.7 million. This brings the total number of shares repurchased this year including both Dutch tenders and open market purchases to almost 13.7 million or more than 20% of our shares outstanding at the end of last year. Since initiating our share buyback programs we have now repurchased a total of 23.2 million shares representing 30% of total shares outstanding at that time.
We remain committed to returning capital to our shareholders and continue to believe that buybacks either via Dutch auction or the open market are an excellent means by which to achieve this.
On last quarter’s call, I discussed opportunities for growth. Over the last decade, domain registrations have been a tremendous platform from which to build a large and diverse customer base. Over the past few years, we extended and enhanced our retail channel and we are now seeing thrive at Hover. We revamped and rebranded our content business and are now watching it drive as Butterscotch. And we are now rolling out our unified control panel for open SRS and introducing new things for resellers to sell like trust services.
As I noted earlier, before the year ends we will be launching GoMobi a service that allows website owners to very easily set up a mobile version of their website. There are four mobile phones for every computer and most websites don’t work well, if at all on a mobile phone. GoMobi addresses this issue, identifying the type of device, site visitors using and customizing the user interface to that particular devices’ capability.
I think it’s worth noting that the addition of this service was driven from both the demand side and the supply. Our customers wanted to access the service through us and the supplier of GoMobi preferred to sell the service through us as well. In fact we accelerated its release to satisfy the strong interest on both sides.
Mobile computing is now the dominant trend in technology. With the introduction of GoMobi and the enhanced focus on mobile content and Butterscotch you are seeing the first two manifestations of how cows will take advantage of mobile computing. This trend will invariably create a huge level of transformation in the technology landscape. When Internet hit desktop computing, everything changed. That change created unprecedented opportunity for a whole new wave of companies.
Tucows capitalized on that change with its original software download site which put the company on the map and subsequently with the introduction of OpenSRS in the domain registration space. We were able to take advantage of these opportunities because of our fantastic distributions channel built through our relationships with service providers around the world. We expect the level of change brought on by the mobile revolution to equal or maybe even surpassed that created by the introduction with desktop Internet.
We believe that the combination of our powerful distribution channel and our demonstrated ability to take advantage of opportunities created by change will make the coming years especially exciting.
And with that, I would like to open the call to questions. Operator?
(Operator Instructions) Your first question comes from the line of Thanos Moschopoulos, BMO Capital Markets. Your line is open.
Thanos Moschopoulos – BMO Capital Markets
Hi. Good afternoon.
Eliot, just in terms of the growth you are seeing on the OpenSRS front, can you provide with more color as to what’s driving that and you said that the coTLD was part of it, but aside for that is it really been driven by new customer wins or more transactions coming from the same customers? Is it sort of the market recovering from, I guess, whatever modest economic impact there was last year, what’s driving -- some of the growth we are seeing this year on that front?
I think that you’re seeing primarily -- while that the single largest factor is market growth and we are supplementing that with customer wins. Now, you’ve probably heard me talking over the last couple of quarters a little bit more about customer wins on the domain side. Those do tend, as you know, to take time to ramp up. So, we feel like if it’s a year from -- now you are asking me the same question, the waiting is going to be a little but more towards competitive wins than markets. But certainly, the market is, I would describe it as fine and we are doing quite well competitively.
Thanos Moschopoulos – BMO Capital Markets
And so the customer wins are those customers that were using other wholesalers previously or in some cases were they registrars themselves?
Primarily from other wholesalers and sometimes from customers who have grown, you know, they might have been using registrars who have smaller wholesale businesses relative to the retail businesses and they’ve now grown to a size where a dedicated wholesale supplier fits better.
Thanos Moschopoulos – BMO Capital Markets
Okay. And as far as competitive wins is this to be a function of them looking at your broader offering and seeing the value of that offers relatively to current supplier that was driving that?
I think the single largest reason is focus. And, you know, you’ve heard me say for some time that we really are the registrar who is most focused on the wholesale channel. That’s the core of our business and no other registrar can really say that.
And at the end of the day, we spent a lot of time and effort on relationships. You know, these are companies for whom domain registrations -- your hosting company, domain registration is a very important part of your business, not necessarily one that will drive your bottom line, but is really central to smooth and strong operation. So, having that kind of deeper relationships, really is valued and that’s why you see us primarily win customers and very, very rarely lose them.
Thanos Moschopoulos – BMO Capital Markets
Okay. On the upper side, there you mentioned there was good transaction growth there, could you provide more color as to why we didn’t see it on the revenue lines? And I realize that most of the revenue in that line is from deferred from previous quarters but nonetheless I would have thought we would’ve seen more of an impact?
Yeah. Quite frankly, I was a little surprised and took a second look at that myself. I will tell you that if you remember back to the middle of 2009 we really re-launched Hover in 2009 and in that re-launch we merged three brands together and we were working through some things. Not only in the original Hover design, but also dealing with some customers who were a little bit -- who didn’t necessarily fit as well any more.
And so, you really saw that kind of relatively flattened through the middle of the year with Hover last year which just makes those year-over-year comparisons quite stark and very, very strong. You know I did want to add, as you heard me say in my remarks, that the quarter-over-quarter comparisons were strong as well. So, I think what you are seeing there is that we’ve got the positioning right. We’ve now got kind of the front door of the website right and really starting late in the second quarter and driving through the third quarter, now we think we’ve got the first elements of a very strong customer acquisition strategy right. So, we feel pretty encouraged about that going forward and there’s more change to come. You are going to see a pretty significant redo of the control panels underneath which will, again, improve retention ability to cross sell customer happiness in general.
One of the things that’s really quite remarkable now there is what’s going on in the customer service side? Customer service just leads into happy customers more word-of-mouth, stronger renewals. They are now, I think I referred last quarter to the fact that we have this kind of no hold customer service but if you phone in, the phone brings right to a customer service rep. We now have it for most of the last number of months, you were kind of getting the phone picked up 99 plus percent of the time in sub 20 seconds recently. That’s up 10 seconds and we’ve seen days where the average call pickup time is in 5 seconds which is quite remarkable when you’re calling in for customer service in any organization.
Thanos Moschopoulos – BMO Capital Markets
Okay. It is. On the GoMobi front, I think it’s an interesting model whereby you’re taking a third party offering and acting as a channel, selling into your installed base? Do you see more opportunity to do that in the future?
The short answer is yeah. One of the – I think I should take a step back, first you heard me talk about control panels. That tends to be – it’s kind of under the covers work it’s not very sexy, but the reason that I did talk about it a fair bit on this call is because it’s really all of that work that allows us to spend up new services more effectively.
So, I think you will see more of that. And the GoMobi side in particular, it either was really very, I guess, reassuring to see I mentioned it, but I am going to say it again, the customers were coming to us and say, hey we really want to offer this. It’s in the market what are your plans. And then think because it really like to get it sooner we don’t want to go direct, please let us get it from you.
And at the same time the suppliers say, look we don’t want to deal with all of these customers directly, hey -- and we also don’t want to leave demand on the table, could you pick it up a little bit?
So it’s was very kind of re-affirming of our view of our role in a relationship between the suppliers and customers.
Thanos Moschopoulos – BMO Capital Markets
Okay. That’s great. I’ll pass the line, thanks.
(Operator Instructions) There are no further questions at this time, Mr. Noss I will return the call back over to you.
Thanks very much and I look forward to speaking with you all again next quarter. Thank you, Operator.
Ladies and gentlemen, this concludes the conference call for today. Thank you for participating and please disconnect your line.