Tucows' (TCX) CEO Elliot Noss on Q2 2014 Results - Earnings Call Transcript

Aug.12.14 | About: Tucows Inc (TCX)

Tucows Inc. (NASDAQ:TCX)

Q2 2014 Earnings Conference Call

August 12, 2014 5:00 PM ET

Executives

Elliot Noss – President and Chief Executive Officer

Michael Cooperman – Chief Financial Officer

Analysts

Hubert Mak – Cormark Securities Inc.

Roy Liao – Goudy Park Capital

Operator

Good afternoon, ladies and gentlemen. Welcome to Tucows’ Second Quarter 2014 Financial Results Conference Call. Earlier this afternoon, Tucows issued a news release reporting its financial results for the second quarter. That news release and the financial statements are available on the Company’s website at tucows.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.

Before we begin, let me remind you that matters that 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.

Elliot Noss

Thank you, operator and thanks everyone for joining us today. With me is our Chief Financial Officer, Michael Cooperman. As per our usual format, I’ll begin today’s call with an overview of the financial and operational highlights for the quarter. Mike will then review our financial results for the quarter in detail. And I’ll return with some closing thoughts before opening the call to questions.

Quarter after quarter, we have demonstrated the underlying consistency and reliability of our business. This quarter, with the increasing impact of Ting on our financial results, we’re starting to show appreciable growth in earnings.

Consolidated revenue grew more than 14% year-over-year to $35.6 million, which was in line with our previous record in Q3 of last year when we had an outsized portfolio contribution.

Gross margin, however, grew 42%, which took our gross margin percentage up 5 percentage points, from 22% to 27%. The bulk of this increase was driven by the growing contribution of Ting and that’s despite the impact of essentially no margin on over $1 million of devices. We’ll continue to see this trend in the coming years as Ting becomes a bigger and bigger part of the business. This will be helped along by the now improving margins in the Wholesale domains business, which I’ll discuss more in a moment.

Q2 was another solid quarter of customer growth for Ting. On our last call, we projected that Q2 net adds would land somewhere between those of Q3 and Q4 of last year, or between 11,000 and 12,000 accounts. We ended up matching Q4, adding just over 12,000 accounts and 18,000 devices. That represents a 20% growth in our customer base in total, bringing our totals to over 73,000 accounts and 112,000 devices.

Until today, we have reported just net adds on the Ting business. Our customer base is now large enough and the performance now settled enough that we can start to provide churn data. We are primarily doing this in order to give investors a bit more help with their modeling, as we look at net promoter score as most our most important measure of customer satisfaction.

Churn for Q2, and in fact pretty consistently for the past year, was in the 2% to 2.5% range per month. We provide this number for two main reasons. First, this is the number one data request from investors as they build out their financial models. We always try and provide as much transparency as possible in order to allow investors to track the business.

Second, we want to make sure that the investors appreciate that if the Ting customer base matures and grows the number of gross adds needed to sustain growth also grows. We have been clear with investors that the largest expense categories for Ting are customer acquisition costs and customer service costs, which are both primarily driven by gross, not net adds.

And looking at our churn on a competitive level, based upon reported numbers best we can tell, our churn results are a bit better than Sprint and T-Mobile and a bit worse than Verizon and AT&T. This is as we have discussed on previous calls. It is also worth mentioning that after 30 days of service when customers tend to determine whether they are getting sufficient network coverage, our churn rate drops comfortably below 2% per month. Network performance remains the top reason for churn.

Our churn seems to indicate strong customer satisfaction and retention, especially given the fact that our customers do not enter into contract and given how easy it is for a customer to cancel the Ting service. They simply need to press a button on the website. Even with that high level of satisfaction we continue to do everything we can to identify the reasons for churn and address them. We are warning customers when network upgrades in their neighborhood might cause temporary declines in service. We are securing more reliable devices at lower prices. We are helping customers change their usage habits and set up alerts as they switch from unlimited plans to our utility pricing.

Let me summarize for those of you modeling at home. The margins of trajectory in the Ting business are becoming clear each quarter. We finished the quarter with 73,000 customers with 112,000 devices. Customers are spending about $35 a month on their phone bills. Gross margins are 45% to 50%. We spend under $100 to acquire a customer. We’ve added 15,000, 16,000 new customers on a gross basis each of the last three quarters and have churned between 2% and 2.5% of our base.

I said last quarter that one of our strategic priorities on Ting is helping our customers and prospects buy and sell used devices. We have made some real progress there, but I think it’s worth mentioning. We have redesigned the device section of our site to guide users, first, to the device that best suit their needs, and second, to the best place to buy that device at the right device. As a result, we have been directing hundreds of customers from our sites to quick successful purchases on eBay, Amazon and Glyde.

We have been promoting our personal shopper program more aggressively, leveraging our outstanding customer support reps to actually work dozens of prospects everyday through the entire process of choosing and purchasing a Ting-ready device.

Finally, we have launched a swap program that reimburses the people in the form of a Ting credit for any financial loss incurred when they sell an AT&T, Verizon or T-Mobile device and buy a Ting-ready equivalent. The enthusiastic response to these programs indicate that we’re addressing a crucial barrier switching to Ting. We’ll continue our efforts to eliminate both the financial and logistical burden of trading a device in hand for one that can be used on our service.

The Domain Services side of the business continued its trend of steady performance. As I mentioned last quarter, we’ve begun to see a resurgence in gross margin and OpenSRS, the Wholesale domains channel due to the shift in our sales mix to higher margin domains and services.

While most volume metrics such as transactions and domains under management were relatively flat compared to last year, gross margin dollars on Wholesale domains in Q2 grew more than 11%. This growth appeared strong relative to the industry. As we move through the remainder of the year, we expect the increased contribution from ccTLDs and the new gTLDs to sustain this higher gross margin. We are already offering nearly 200 new gTLDs from eight different registry operators. We expect to add support for over 20 more in the coming months.

Last quarter, I talked about one of the metrics that we’re watching closely, the ratio of new gTLD sales to those of common net. For the market as a whole, that number increased from 6.5% in Q1 to over 10% in Q2. Although that does include some registries giving away a large number of domains for free. For OpenSRS, it grew from 3% in Q1 to 4% in Q2. And for Hover, it grew from 6.5% in Q1 to 9.5% in Q2, with all those domains being sold at a healthy margin.

Again, when we look at these numbers, we consider the fact that on one hand new gTLD sales will likely be inflated in the early launch period at least at retail. But on the other, these are not likely to be the most popular new gTLDs.

OpenSRS relies on reseller adoption first and end-user adoption second and we’re pleased with how we are moving along that path. Hover offers perhaps the clearest, most usable presentation of all TLD options in the industry. The fact that Hover appears to be selling more than its fair share of new gTLDs, indicates to us that the true market numbers and certainly the OpenSRS numbers should continue to rise as more end users started encountering that clear full breadth of choices.

Finally, as impressive and perhaps as important is Hover’s quarterly 20% revenue gains versus prior year is a steady climb in net promoter score or customer satisfaction score. Hover posted an all-time best net promoter score of 71 in Q2. We take comfort in that. Competitors like Google are entering the retail domain space. They might have aggressive pricing or bundling strategies, but we’re confident that nobody will match our focus on usability and customer support.

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. As Elliot discussed at the outset, the second quarter again saw solid year-over-year revenue growth, $4.4 million or 14% to $35.6 million from $31.2 million for the second quarter of last year.

Cost of revenues before network costs were $24.7 million, up $1.7 million or 8% from $23 million. Gross margin before network costs increased by $2.7 million or 33% to $10.9 million from $8.2 million and as a percentage of net revenue increased to 30% from 26% compared to Q2 of last year.

I’ll now review gross margin performance in each of our service categories. As a reminder, last year we began breaking our team separately under the heading Network Access with our wholesale, retail and portfolio domain revenue streams being classified as Domain Services. Starting with Domain Services, gross margin for all Domain Services in aggregate increased $261,000 or 4% to $7.6 million.

Gross margin for the wholesale component of Domain Services, which includes wholesale domain services and other value added services increased $172,000 or 3% to $5.5 million from $5.4 million for the same quarter last year. Within Wholesale gross margin from wholesale domain services increased by $380,000 or 11% to $3.7 million from $3.3 million for the same quarter last year.

This increase is primarily the result of the ongoing shift we are seeing in sales mix to higher margin services that Elliot touched on earlier. This shift offset the negative impact on margin of a handful of larger customers that have migrated their businesses to their own accreditations. The migrations also impacted transaction growth such that transactions process during the quarter were relatively flat from the same period last year.

Gross margin for value-added services decreased by $206,000 or 10% to $1.8 million from $2 million, primary the result of one large customer no longer using our email platform and the impact that Google makes to its search engine algorithms or having on the secondary domain name market.

Gross margin for retail services increased by $262,000, or 22% to $1.4 million from $1.2 million in the second quarter of last year. This increase reflects our continuing success in both adding new Hover customers and growing sales to existing customers. As a percentage of revenue, gross margin for retail services was 56% compared to 58%, the result of our continuing to engage in promotional campaigns with somewhat more aggressive pricing.

Gross margin for portfolio services decreased by $173,000 or 20% to $675,000 from $849,000 for the second quarter of last year as the secondary domain name market generally continues to experience softness as it adapts TO the challenges we’ve talked about in the past. On a percentage basis, gross margin from Portfolio services was 76%, down from 79% for Q2 of 2013.

Turning to costs, network expenses for the second quarter of this year were $1.3 million, down $138,000 or 9% from $1.5 million for the same period a year ago. This decrease reflects our continuing ability to generate efficiencies in the operation and management of our co-location facilities and costs.

Total operating expenses for the second quarter were $7.5 million, up $1.6 million or 28% from $5.8 million for Q2 of last year. This increase is primarily the result of three factors. First, we continue to invest in workforce, marketing and other costs primarily related to acquiring and supporting Ting customers. Second, in Q2 last year, we recognized a 2010 Government of Ontario Interactive Digital Media Tax Credit of $460,000, which was not repeated this year. And third, as part of our normal portfolio renewal process, during the quarter we assisted a further batch of domain names we acquired with the June 2006 acquisition of Mailbank.com should not be renewed and were allowed to expire.

Accordingly, these domain names for the book value of $326,000 had been written off and recorded as an impairment of indefinite life intangible assets. At this time we are not anticipating additional material write-offs through the balance of this year.

As a percentage of revenue, total operating expenses increased to 21% from 19%. Net income for the second quarter of 2014 was $1.3 million or $0.12 per share, compared with $588,000 or $0.06 per share for the same period last year. Again, Q2 of this year was impacted by the $326,000 write-off domains I just mentioned, while Q2 of last year benefited from the $460,000 tax credit I discussed earlier.

Cash and cash equivalents at the end of the second quarter of 2014 were $14.2 million, up from $13.5 million at the end of the first quarter of this year and $6.5 million at the end of the second quarter of last year.

During the second quarter, we generated cash flow from operating activities of $1.1 million. In addition, we received $130,000 from the exercise of stock options, repaid $325,000 of our bank loan and invested $313,000 in equipment purchases.

Deferred revenue at the end of the second quarter of 2014 was $73.6 million, up about 1% from $73 million for the second quarter of last year and $72.8 million for the first quarter of this year.

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

Elliot Noss

Thanks Mike. Most investors will remember that in Q2 last year we reported that subsequent to the quarter end we had a large gain from the resolution of contention in two new gTLD applications, .media and .marketing. We had the same thing happen this year with the resolution of contention for .group. We had a minority stake in one of a group of applicants for the string. We will recognize the revenue in Q3 in our portfolio line of business. It is certainly smaller than last year’s gain and is much like a nice large sale in the portfolio business. The specifics are subject to confidentiality.

We have remaining minority interest in the applications for three strings .online, .tech and .store. We have no expected timeline for resolution of the rest. We also do not know whether we will win the strings and require capital, resolve the menu private option whereas the loser will be compensated or resolve the (indiscernible) option whereas the loser will receive nothing. I’m really saying that investors should view these applications as having option value.

With the strong performance in Q2 and the successful result of the .group application, we would like to adjust upwards our guidance for 2014. Previously, we were expecting our EBITDA for 2014 to be in $13 million to $13.5 million range. We are now comfortable in the $14.5 million to $15 million range.

In summary, the quarter was strong. We are executing well. We continue add Ting customers at a nice clip and we are now seeing the benefits from the Ting business to both gross margin and net income. Things are unfolding as they should and in a way that continues and will continue to reward of long-term investors.

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

Question-and-Answer Session

Operator

(Operator instructions) Your first question is from Hubert Mac with Cormack Securities.

Hubert Mak – Cormark Securities Inc.

Hey, guys. Maybe I’ll just start with Ting, now that we’re in August and maybe a comment sort of where you think the quarterly add is going to be as we move over the next couple of quarters?

Elliot Noss

I think the things are sort of chugging along. Last year we definitely saw an uptick through the – but that uptick was in the back half of August and through September and then of course Q4 is supposed to be seasonally very strong for the industry and it was for us as well. So I think what we’re seeing now first time on Q3 is consistent with what we’ve been doing. And we’ll have to see we if benefit from some of that seasonality.

Hubert Mak – Cormark Securities Inc.

Okay. And then on the gross margin – on the Ting here, it’s gone up from Q1 here and I’m guessing has it do with hardware component. So would you tell us what the hardware amount was in Q1?

Elliot Noss

Mike, do you have that number? You mean in Q1 or Q2?

Hubert Mak – Cormark Securities Inc.

Q2, I think, it was $1 million, right. So I’m just wondering whether Q1 was…

Michael Cooperman

Hubert, in Q1 it was a similar amount to Q2, just over $1 million.

Hubert Mak – Cormark Securities Inc.

Okay. And then I believe you talked about $35 per month per sub. Is that a trend that can you – sort of seeing over the past few quarters like – and is that something that you feel is going to be consistent going forward here?

Elliot Noss

Yes. So that’s been a generally consistent number with a very slight upward trend. One of the interesting phenomenon that we have seen is when we dropped our pricing in February, we saw a [confident] (ph) increase in usage, especially and primarily around data. So most of the price savings were around data and most of the usage increase was around data.

And what was especially interesting about that is we’ve talked in the past about how we get a unique view of behavioral data, both around people’s device selection and around their phone usage. We don’t have phone subsides. We don’t have unlimited plans. So we see pure behavior. And when we have that price drop we saw a surprisingly large, exceeding our expectations, a surprisingly large increase in usage.

Hubert Mak – Cormark Securities Inc.

Okay. And then, I know and you talked about the customer acquisition costs, still below $100. And is it still well below $100 and do you expect to keep that up to $100 or is that still may be well below $100 going forward?

Elliot Noss

Yes, right so. I think that you didn’t hear me talk about any experimentation like I did in Q1. We’ll try and call that out. I think unless we’re talking about it, particularly you should think that it’s pretty consistent with that.

Hubert Mak – Cormark Securities Inc.

Okay. And there are such a lot of domains here. I don’t see any margins has moved up here quarter-over-quarter and not see you’re going to comment right here in terms of sales mix. Can you just maybe give us more color in terms of this higher margin services like what are the reason, what’s driving that? And maybe is it more new services that’s driving this or is it gTLDs that are driving the end margins?

Elliot Noss

I think it’s a good healthy range of some additional subscription type services around domain names, very simple stuff. And, again, we’re seeing increases in both ccTLDs and the new gTLDs, both of which we have higher margins on than we do with the more traditional common in fact.

Hubert Mak – Cormark Securities Inc.

Okay. So as the new gTLD continue to come through here is that the thinking here that the margins will continue to pick up here going forward.

Elliot Noss

Yes, but I think that the primary driver on gross margins will continue to be Ting’s percentage of the business. So Ting is growing so much faster than the domain side of the business and has appreciably better margins. So that will be the primary impact. You’ll see margin continue to pick up, but slowly and on a decreasing percentage of the total business.

Hubert Mak – Cormark Securities Inc.

Okay. And then just on the Hover here, the margins. Obviously you guys showing some promotions here. What do you think is a good margin, like moving forward here do you guys expect to spend more here or is that…

Elliot Noss

We think, Hover, is going to be pretty consistently in the low to mid 60. So it’s the highest margin of the major contributors.

Hubert Mak – Cormark Securities Inc.

Okay. And then a high level question. Obviously you guys have pretty good cash net cash flow on the balance sheet. Actually, maybe, first of all, do you think Ting right now is more of a self-sustaining business now or do you still think you have to fund this with the Domain business here?

Elliot Noss

No, it’s self-sustaining.

Hubert Mak – Cormark Securities Inc.

Okay. So I guess given your cash balance and the cash flow coming through from your Domain business and now that Ting obviously is now self-sustaining, what’s the thinking here in terms of the cash here? Are you guys being more active here on the share buyback here or…?

Elliot Noss

Yes, so I think there’s probably three things worth noting. One, we definitely have a view consistent with our focus on return on assets that you don’t want cash just sitting around just add management. Second, we remain committed to returning capital to shareholders. And third, we’re always looking for opportunities, both strategically and around deploying capital. So I think all those things are true. And you know us well enough to know that we have some specific to talk about that we will.

Hubert Mak – Cormark Securities Inc.

Okay. And then, lastly, here on the guidance, I know you’re taking you guidance up. Is that mainly driven by the sales in Q3, or is other things involved in this certain domain?

Elliot Noss

You said mainly. So I don’t want to split it into dollars to precisely. Certainly the resolution of – it’s not on the scale, but the resolution of contention in the .group process contributed, but just sort of good consistent strong operating, a little bit better than we expect the results contributed.

Hubert Mak – Cormark Securities Inc.

Okay, thanks. I’ll pass the line.

Elliot Noss

Thanks.

Operator

(Operator Instructions) The next question is from Roy Liao with Goudy Park Capital.

Roy Liao – Goudy Park Capital

Hi, Elliot, great quarter. Thanks again for the transparency and the terrific churn numbers that really helped investors out.

Elliot Noss

Thanks.

Roy Liao – Goudy Park Capital

So my first question is just to talk about the EBITDA margins. It’s been trending up pretty significantly. Obviously it’s coming from Ting. Can you talk a little bit about two, three years now as Ting gets to 100,000, 200,000 subscribers, Companywide EBITDA margins hit 15%, 20%. I mean is this realistic?

Elliot Noss

Companywide, I really have to think that the way that the two lines of business would grow there. So I think you’ve heard me say this before, really – what do long-term margins look like questions. And I our [gateway] (ph) investors want to think. To me, I think the best thing that we can do is telling you where we are and telling you what the trends are like, because it’s so (indiscernible).

So if you could take that couple of hundred thousand subscriber number, you could go higher than that, very different results. And by the way those results are very (indiscernible) how fast or how slow the growth is to get there. I really want to continue to resist it and give you as much transparency in a short-term. And help you kind of take a model going forward and built sensitivity there.

Roy Liao – Goudy Park Capital

Okay. But it’s safe to assume that the Ting EBITDA margins are significantly higher than everything else besides Hover, right?

Elliot Noss

Yes, that’s right.

Roy Liao – Goudy Park Capital

Okay, great, thanks. And just wanted to talk about the $300,000 impairment. It sounds like it’s one time in nature. Just want to confirm if that’s the case.

Elliot Noss

Mike?

Michael Cooperman

Yes, we did as part of the routine process, we do from time to time assess with output. And these were names that are more European names and no longer really had economic value either from an advertising perspective or sales perspective. So we just chose not to renew them, and because we carry that to write it off. But that said, in assessing the balance, I think that there will be any more material write-offs that we will have to take over the next six, twelve months.

Roy Liao – Goudy Park Capital

Okay, great. And just wanted to talk about currency a bit. I know in the last call you guys said about $13 million to $13.5 million EBITDA guidance and not accounting for any currency benefits. Given your updated guidance, do you kind of expect that there may be some upside to that EBITDA number given any changes in currency swings?

Michael Cooperman

So what I was talking about last year, if you remember the way that we were protecting, all of the benefits of that currency are 2015 benefit. So our needs for 2014 are lost in and have been for a long time. What I want to make sure (indiscernible) to the folks, as people started to look at 2015 numbers going forward, was that we are going to go into 2015 with a bit of a tailwind.

Roy Liao – Goudy Park Capital

Okay, sounds great. And just last thing for me. You just mentioned you talked about the .group’s resolutions. Is it safe to say that your remaining three interest (indiscernible) these could be a little bit more significant than .group, if you choose to not win the bet and kind of the bid price back.

Michael Cooperman

Yes. So I think I would say…

Elliot Noss

So first of all I was really trying to stress that this could go any which way with all of these things. We’re interested in all of the enterprise. And so, just its operating and therefore using some capital there, right. And as Hubert mentioned, there’s some capital to use. And the second thing is the different mix of applicants and there’s a different sort of a different ownership in each of those applications. So it’s really, really tough to generally (indiscernible) my preference it would be $3 up right.

Roy Liao – Goudy Park Capital

Okay, great, thanks. And thanks again for having a great quarter.

Elliot Noss

Thank you.

Operator

There are no further questions at this time. I will turn the call back over to you, Mr. Noss for closing remarks.

Elliot Noss

Thank you. And I look forward to speaking with you all again next quarter. Thank you, operator.

Operator

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

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