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Tucows, Inc. (NASDAQ:TCX)

Q1 2011 Earnings Call

May 11, 2011 5:00 p.m. ET

Executives

Elliot Noss - President, CEO

Michael Cooperman - Chief Financial Officer

Analysts

Thanos Moschopoulos – BMO Capital Markets

Operator

Good afternoon, ladies and gentlemen. Welcome to Tucows First Quarter Fiscal 2011 Conference Call.

Earlier this afternoon, Tucows has issued a news release reporting its financial results for the first quarter of fiscal 2011. The news release and financial statements are available on the company’s website at tucowsinc.com under the investor’s 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 Tucows website.

Before we begin today, let me remind you that the matters 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 report on Form 10-K and 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 them 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. For our call today, I’ll begin with a brief overview of the financial and operational highlights for the first quarter of the year. Mike will then review our financial results in more detail and I will return with some concluding comments before opening the call up to questions.

Our financial performance for the first quarter of 2011 was again demonstrative of the consistency and reliability in our business. Revenue grew by just over 10% from Q1 of last year to a record $22.6 million. Once again, we generated solid cash flow from operating activities at $1.6 million.

Each of the components of our business continued to perform well in the first quarter. Year-over-year growth in OpenSRS domain transaction volumes was 6% excluding the impact of the customers discussed last quarter, new registrations were up almost 15% and renewal registrations were up 10%, with our renewal rate remaining solidly above the industry average.

Domains under management grew almost 10% from Q1 of last year to just shy of $11 million and subsequent to the end of the quarter crossed the $11 million name threshold. All of this, contributed to year-over-year growth in domain services revenue of 14%.

Again this quarter we continued to win business. Our company-wide focus on wholesale continues to benefit us as does our persistence. One of these customer wins has been in the pipeline for nearly four years proving how this business is all about building and keeping relationships. The recent momentum in email, including the customer wins that I discussed on our last call, contributed to the strongest quarter for this service offering in more than a year, highlighted by year-over-year revenue growth of 7.4% and sequential revenue growth of 29%. We have also now had a customer launch email for the first time and grow organically from nothing to over 10,000 mailboxes another very positive sign.

Based on a strong pipeline, we expect this momentum to continue in 2011. There is a one customer win during the quarter, but although small is worth noting for its strategic relevance. A European hosting vendor, who is building a global wholesale business in hosting shows our OpenSRS email and platform because the breadth of languages supported in our Web Mail interface and the breadth of our country code domain coverage, exactly the kind of healthy relationship we like.

Our retail offering Hover was the strongest performing business unit. In fact, by some measures, this was the best quarter for our retail business ever. New transactions which include new domains, transfers in, domain email accounts and personal name email accounts increased 30% over Q4 last year and 52% over Q3 last year. Last quarter I noted that the number of transfers in was up 85% sequentially. And the transfers in now outpace transfers out 2 to 1. In Q1 transfers in grew another 75% sequentially and the ratio climbed to 3 to 1.

Customer growth remained strong, with new additions in Q1 more than doubling the already very good numbers in Q4 last year. I will note that renewal rates for both domain names and email, already above the industry norm also increased a few points from Q4 2010 levels. Year-over-year growth has been solid, please note, the deferral of revenue is actually hiding some of the underlying momentum in this business. We expect that momentum to continue throughout the remainder of the year with the year-over-year comparisons starting to look even better in Q2 as we start to see some increases in renewals which is 80% of the retail business.

In short, the results this quarter again confirm the strength of the Hover value proposition as a simple, no hassle domain registration management tool and email service and we expect the momentum to continue. Q2 has started off just as strong. It will see the launch of the new Hover control panel and with the control panel work behind us we’ll also see a renewed attention paid through our personal name services, which as many of you know is one I believe holds much latent value.

Our domain portfolio group, YummyNames, continues to perform well. Sales of brandables and gems grew 15% from Q1 of last year, achieving another record. We expect this strong performance to continue throughout this year. As I’ve discussed on previous calls, a material part of the YummyName’s revenue stream, now comes from the regular sale of Direct Navigation Names. We took significant steps to smooth Yummy’s contribution to the business, transitioning it from a lumpy revenue stream to a more consistent revenue stream.

Late last year, we moved to a new partner in a deal that was more broadly strategic. As will sometimes happen, circumstances changed for our new partner, such that they have recast their business strategy, leading to the need for us to find a new relationship. We are now close to completing this process.

There has been a general decline in syndicated search revenue across the industry. This has a negative impact, not only on our parking revenue but also on our expiry sales which take place as a multiple of parking revenue. We continue to look for ways to improve both parking and expiry sales, but we remind that we view brandable sales as the most strategic part of the YummyNames business unit, especially due to our inventory of roughly 40,000 brandable names.

Turning now to Butterscotch, our content services group, there was a very powerful macro trend at work. Looking back 12 to 18 months, I don’t think anyone could have predicted decline in the importance of Windows desktop software. And it’s still the case that by far the largest proportion of Butterscotch traffic comes from the old tucows.com software library, which is primarily Windows desktop software. As a result, we are seeing some softness in Butterscotch.

On the positive side, we are already well into the transition of content towards video and towards mobile computing. It will take sometime however, for the revenue side of that business to catch up.

All-in-all, the first quarter of 2011 was another fine quarter that was again indicative of the consistency and reliability in our business within the context of growth.

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

Michael Cooperman

Thanks, Elliot. Net revenue for the first quarter of 2011 increased 10% to $22.6 million from $20.4 million for the first quarter of 2010, which as Elliot mentioned earlier is another record. Cost of revenues before network cost increased by $2 million or 14% to $15.7 million from $13.7 million for the first quarter of 2010.

Gross margin for the quarter increased 4% or $200,000 to $5.3 million from $5.1 million for the same period last year. On a percentage basis, gross margin decreased marginally to 24% from 25%, largely the result of the 7% price increase implemented by VeriSign in July of last year as well as the continued shift in sales mix from higher-margin services to lower-margin domain name services.

Gross margin from our OpenSRS service, which includes domain name services, email services and other wholesale services increased $400,000 or 9% to $4.4 million from $4 million for the first quarter of last year.

Gross margin for the domain services component of OpenSRS increased to $3 million from $2.8 million. Gross margin as a percentage of revenue decreased to 17% from 18% primarily as a result of the VeriSign price increase and sales mix shift I mentioned earlier.

Gross margin from YummyNames was $1.2 million compared with $1.5 million for the first quarter of 2010. This decrease was essentially due to two factors. One, gross margin for making domain sales in our portfolio available for sale or lease decreased by $200,000 to $1.1 million when compared to the first quarter of last year, and primarily reflect the timing of portfolio domain name sales that Elliot mentioned earlier.

Second, gross margin from our parked pages program decreased by $100,000 when compared to the same quarter last year and primarily reflects the lower contribution we received from third parties as a result of the shift in the economics of the industry and to a lesser extent on the lower number of names we have available for parking purposes.

Gross margin on a percentage basis fell slightly to 87% compared with 88% for the first quarter last year as a result of the relatively fixed cost of our domain name portfolio. Gross margin for Hover for the quarter increased to $776,000 from $730,000 in the same period last year as Hover continues to gain momentum. The increase primarily reflects the success of our marketing and branding initiatives that have had on our ability to attract new customers and retain existing ones.

The success of these initiatives has resulted in Hover cash receipts during the quarter, growing faster than revenue being recognized from prior periods. This marks an encouraging return of growth trend for Hover deferred revenue. As a percentage of revenue, gross margin for Hover was more or less unchanged at 65%.

Gross margin for Butterscotch increased marginally to $484,000 from $451,000 for the first quarter of last year with increases in revenue from the Butterscotch website offsetting declining revenue from our more traditional Tucows website display advertising, AdSense and other resource center revenues.

As we discussed in our prior calls these decreases reflect what we believe is a current preference of advertisers for more content rich websites and the elimination of Google’s enterprise level AdSense program. On a percentage basis, Butterscotch gross margin was also relatively unchanged at 96%.

Turning to our costs for the quarter, I will remind you that a significant portion of our operating costs are in Canadian dollars. And our results should therefore be viewed in the context of the continuing unfavorable impact that the stronger Canadian dollar relative to the U.S. dollar has on our performance.

We have had some success in mitigating the negative impact of the stronger Canadian dollar through our hedging strategies and our improved operating efficiencies but the higher Canadian dollar is having a dampening effect on our results. I will note that the Canadian dollar strengthen by approximately 6% relative to the U.S. dollar in the first quarter of 2011 relative to the first quarter of 2010.

Network cost for the quarter were down approximately 4% to $1.5 million from $1.6 million for the first quarter of last year, continuing to reflect the improved deficiencies we have experienced in operating and managing our co-location facilities.

Total operating expenses for the quarter increased to $4.8 million from $4.2 million for the same period last year. As a percentage of revenue, total operating expenses were relatively unchanged at 21%.

Net income for the first quarter of 2011 was $728,000 or $0.01 per share compared with $569,000 or $0.01 per share for the first quarter of last year. I will note that as a result of a routine order undertaken by the third party who was commercializing the [inaudible] patents that we assigned to them in 2002, were receiving an additional payment of $323,000 in March this year.

Cash and cash equivalents at the end of the first quarter of 2011 were $4.2 million down from $5.2 million at the end of the first quarter last year and relatively unchanged from the end of the fourth quarter last year.

During the first quarter of this year, operating activities contributed $1.6 million towards cash flow from operations, which was partially offset via using an additional $800,000 in working capital. The $762,000 we generated in cash flow from operations was essentially used to fund capital repayments of $479,000 on our credit facility with the Bank of Montreal and are investing $329,000 in the acquisition of fixed assets. I will note that our liability under the credit facility at the end of the quarter was $827,000, which, if BMO elect to exercise their rights in terms of the cash sweep will be fully repaid by June.

Deferred revenue at the end of the first quarter was $64.9 million, an increase of 9% from $59.5 million at the end of the first quarter of last year and up 4% from $62.6 million at the end of the fourth quarter of 2010.

In summary, first quarter was again demonstrative of the consistency in our business highlighted by record revenue and solid cash flows. We are continuing to achieve growths across our business while prudently managing costs and continued improvements in our operating efficiencies is allowing us to mitigate some of the negative impact of the stronger Canadian dollar.

I would now like to turn the call back to Elliot. Elliot?

Elliot Noss

Thanks Mike. A couple of quarters ago I spoke for the first time about our new unified control panel that will provide resellers with a single modern interface for managing all OpenSRS services. The new control panel will not only make it easier for resellers to support the customers but also make it much easier for us to cross sell and up sell our services.

During the first quarter our customers began to see what the new control panel will look like, as we launched our new trust service and our new publishing service. Last week, we launched a completely redesigned control panel for domain services, the most important of the bunch. To accomplish this, we have had to perform some fairly significant re-architecture of the OpenSRS platform itself. It is now worth observing that we are nearing the completion of the re-architecture of all our major business units.

We built YummyNames from scratch. We took three disparate retail businesses and combined them into Hover which has seen great success. We took an old Windows desktop software download business and with Butterscotch we focused it on mobile and video and we completely rebuilt our email system. With OpenSRS specifically we are taking an important step forward with its potential as a service delivery platform for what we believe is the best distribution channel in the internet economy.

Even more impressively, we have done of all this not only without materially impacting our cash operating expenses but after controlling for the Canadian dollar actually lowering our cash operating expenses from where they were four or five years ago. At the same time we reduced CapEx significantly. We’ve done all of this and returned significant capital to shareholders, which we think inarguably shows the consistency and reliability of the Tucows’ business and its ability to generate cash and operate efficiently all in the context of growth.

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

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Thanos Moschopoulos with BMO Capital Markets. Your line is now open.

Thanos Moschopoulos – BMO Capital Markets

Hi. Good afternoon.

Elliot Noss

Hello.

Thanos Moschopoulos – BMO Capital Markets

Hi, Elliot. So, on the OpenSRS line as you mentioned last quarter that was affected by two of your customers transitioning off. I believe you said at the time if there was limited margin impact from that. Is that correct?

Elliot Noss

Yeah, that’s right. There is still in the case of one of them very significant business with us and then the other still a nice amount of business. And both are very high volume, therefore relatively lower margin, that’s right.

Thanos Moschopoulos – BMO Capital Markets

And, so the revenue impact from that transition in the quarter, are we talking below seven figures or could you just quantify it?

Elliot Noss

I would have to think about that, I don’t want to jump to an answer there.

Thanos Moschopoulos – BMO Capital Markets

Okay. It’s good to see you have some good growth despite that impact on that front?

Elliot Noss

Yeah. And where you especially see that is at new registrations. Because that’s where people tend to first migrate to the new platform.

Thanos Moschopoulos – BMO Capital Markets

Okay. The Hover business obviously as you mentioned, very strong growth there. And so how sustainable do you think that is as you mentioned from a GAAP perspective the deferral means that we’ll see that growth continue for some quarters. But from I guess the bookings perspective, do you see this momentum continuing for the next while?

Elliot Noss

Well, so I think it’s going to – depend on a couple of things. First, we don’t see any slowdown at this point. So that’s continuing, which is obviously very promising. Second, the limits will come around our ability to find really two things, additional great promotional vehicles, like some of the ones that we’ve had real success with. And what we are seeing as a continuing social media ground as well. So, Facebook and especially Twitter are now great contributors to this business and as you know, you can’t buy that word of mouth. We’re seeing that accelerate not decelerate. So it’s tough to say, I think that that’s a question that I invite you to ask me again next quarter and keep with. But right now, we’re still very encouraged. I should add, I mentioned the personal names business, there is one or two other irons in the fire that we think can sort of keep this momentum going.

Thanos Moschopoulos – BMO Capital Markets

Okay. On the OpEx front, should we be looking at OpEx coming down at all since you completed to meet your R&D initiatives or will you be reallocating that budget towards other projects?

Elliot Noss

No, what you’ve really seen there is that as we finished those initiatives, we have moved investment from working on fixing old thing, first fixing things that are broken then building them for the future. And now you’ll really see – we’ll see us reallocate that stuff. So, we want to take that and put it towards the future. So I think that we think we’ve got a nice controlled level of OpEx and if you look at our OpEx levels, they’re pretty reasonable. So, we expect to sort of push that towards future initiatives.

Thanos Moschopoulos – BMO Capital Markets

Okay. Now you have some hedges in place. So as those hedges roll off, does that mean that we’ll start to see a bit of an increase just as the effect of the Canadian dollar gets more reflected in your results?

Elliot Noss

We’d like to give ourselves as much runway as possible. It’s tough to predict the future of the currency. We’re certainly good for a few more quarters anyway. And we’re always selectively trying to extend our coverage out on softness. But, the one thing that we do that as you heard me talk lots about the fact that I’d like to give ourselves runway. So, we’re always keeping ourselves with a lot of room to of course correct if we need to.

Thanos Moschopoulos – BMO Capital Markets

Okay. Then Mike, if you could just clarify what the magnitude of the ForEx translation gain or loss was in the income statement?

Michael Cooperman

The gain was $113,000 if I remember correctly. Give me a second, I’ll just make sure. Yeah, $113,000.

Thanos Moschopoulos – BMO Capital Markets

Okay. And then finally, I guess regarding the new TLDs it sounds like that process is sort of kind of politically, any thoughts there in terms of whether that moves ahead or what the outlook is in that front?

Elliot Noss

Yeah, I think that everybody is still hopeful. I think we’re watching the political process play out. And really the Singapore meeting is going to be extremely important. So, I think you could see anything from the Singapore meeting starting gun goes off, and the process is initiated to what I would call indeterminate delays. But, I will say that the Singapore meeting is really the first meeting where there is a material chance that we get this whole process started. And I’m certainly hopeful. And that by the way is in third week in June or so.

Thanos Moschopoulos – BMO Capital Markets

Okay. That’s very helpful. Thanks guys. I’ll pass the line.

Elliot Noss

Thanks Thanos.

Operator

(Operator Instructions) You have a question from Thanos Moschopoulos from BMO Capital Markets. Your line is open.

Thanos Moschopoulos – BMO Capital Markets

I thought I could hop back in for one more.

Elliot Noss

Sure.

Thanos Moschopoulos – BMO Capital Markets

So, regarding the new OpenSRS platform, what would your expectation be in terms of that starting to have an impact? I guess your launch get around now it will take some time for that to rollout. But how should we think about I guess the timing and sort of the magnitude of impact that we’ll have driving some more top line revenue for you guys?

Elliot Noss

So, everything we do it’s always a slow ramp. And building that big snowball to sort of keep rolling and I mean that’s a beauty and the consistency of it. I don’t think there is anything that would be kind of a shot in the arm type increase till Q3, where email gets on the platform, where email gets on the new control panels and then we’ll really start to go out to cross sell there. And that’s something where we could see some pick up that would be a little bit of step function. And we’d love to have you out and give you a little demo too.

Thanos Moschopoulos – BMO Capital Markets

Okay. Sounds good, thanks guys.

Elliot Noss

Thanks Thanos.

Operator

At this time, there are no more questions in the queue. I’ll turn the call back over to Mr. Noss.

Elliot Noss

Thank you operator, and thank you all for joining us. And I look forward to speaking with you again 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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