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Tucows Inc. (NASDAQ:TCX)

Q2 2011 Earnings Conference Call

August 10, 2011 17:00 ET

Executives

Ken Schafer – Executive Vice President of Products

Elliot Noss – President and Chief Executive Officer

Michael Cooperman – Chief Financial Officer

Analysts

Thanos Moschopoulos – BMO Capital

Alex Grassino – Laurentian Bank Securities

Operator

Good afternoon ladies and gentlemen and welcome to Tucows Inc. Second Quarter 2011 Conference Call. Earlier this afternoon, Tucows issued a news release reporting its financial results for the second quarter. The news release and the financial statements are available on the company’s website at www.tucowsinc.com under the Investor Heading.

Please note that today’s call is being broadcast live over the internet and will be archived for both replay by the 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 as well as at Tucows website.

Before we begin 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. The 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 Form 10-Q. The company urges you to read their securities filings for a full description of the risk factors applicable for its business.

I would now like to turn the call over to Tucows’ Executive Vice President of Products, Mr. Ken Schafer. Please go ahead Mr. Schafer.

Ken Schafer – Executive Vice President of Products

Thank you, operator. Good afternoon. Thanks for joining us. With me is Michael Cooperman, our Chief Financial Officer and unfortunately due to a family matter our President and CEO, Elliot Noss is not able to be with us today. I’ll be taking his place.

Despite that this call will follow the usual format. I’ll begin with a brief overview of the financial and operational highlights for the quarter and then Mike will review our financial results in more detail. After that I’ll return with some concluding comments before opening up the call to questions.

Second quarter 2011 was another very solid quarter that was again indicative of the consistency and reliability in our business within the context of growth. Revenue grew by almost 11% for Q2 – sorry, from Q2 of last year to $22.6 million which was another record and cash provided by operating activities was $1.4 million after adjustments for non-cash working capital items. To discuss OpenSRS, we continued to perform well with an overall growth in revenue of 15%.

Total domain transaction volume for the quarter were up 15% to just over two million and that’s the second consecutive quarter that we topped the $2 million – sorry, two million mark in domains. New registrations were up 21% if we exclude the impact of two customers that became registrars on their own earlier this year. Renewals were up 15% and our renewal rate held steady at a level that remains well above the industry average. This growth in transaction push domains under management at the end of the quarter up 10% for the same period last year exceeding $11 million names for the first time.

The OpenSRS email service continue to experience the momentum that we’ve discussed in the last several calls. Revenue was up 8% year-over-year and mail boxes under management grew on both the year-over-year and sequential basis. We believe our overall competitive position is strengthening primarily due to our unwavering focus on wholesale relationships with service providers. And Q1 once again bore this out with a number of key competitive wins for OpenSRS. This week at HostingCon we announced the partnership with Parallels who is a leader in the hosting and cloud services space. The partnership integrates OpenSRS services directly into Parallels platform allowing for easy provisioning and management of their sorry of our services by Parallels customers from within Parallels control panels.

Hover also continued its momentum this quarter. New transactions which include new domains, transfers in and email accounts increase 90% over sorry 96% over Q2 of last year and 8% over Q1 of this year. The number of transfers in for Q2 through more than 5.5 times over the same period last year underscoring Hover’s value proposition as a simple no hassle domain registration management tool and email service. In fact transfers in are driving approximately half of the growth in new transaction. In addition, transfer in continue to steadily outpace transfers out at a pace of over three to one. Renewal rates also remain strong. All of this contributed to a 15% year-over-year increase in Hover revenue and I would remain you that the underlying performance in this business is somewhat massed by the deferral of revenue.

On our last call, Elliot talked about the impending launch of our new control panel for Hover, during the quarter we completed the migration of all customers to these new domain email management tools. The new control panel further strengthens Hover’s value to customers and the initial feedback from it’s been excellent. YummyNames our domain portfolio group, saw increased sales of individual domain names contribute to another solid quarter note that while we brought consistency to YummyNames on annual basis, there is still some from quarter-to-quarter. Sales of domains, the reclassify as brandable or gem names through 7% from q2 of last year. The average selling price remain healthy during the quarters and we had a number of individual name sales priced in the five figure range.

The quarter also reflect at the end of our relationship with our previous expiry stream partner and now that we’ve completed that migration to our new partner, but early are excellent which should make quarter-on-quarter comparisons strong starting in Q3. The Gem will decline in syndicated search revenue industrywide continue to have a dampening effect on parking revenue. During Q2, we began testing with a new parking partner, and the early results are quite favorable in fact, fort the first time in recent memory we’ve seen a lift in parking revenue.

While we’ll continue to I’m sorry, while we’ll continue to optimize both parking and (re-stream) revenues sales of brandable names represent the real opportunity for YummyNames and we’ve a number of initiatives underway to expand our sales channels to brandables. But we have example, after the quarter’s end YummyNames entered into a distribution relationship with sorry, with name media, whereby our brandable names are now listed as buy it now so instant transaction names across the Afternic DLS, Domin Listing Service network. One of the other highlights of note is the acquisition of EPAG Domainservices, which we announced last week. EPAG is a Germany based company registrar with more than 400,000 domain names under management.

More importantly for us however is that they are one of the leaders in comprehensive top level domain offerings, which will strengthen our competitive position as we get ready for the introduction of new domain extensions, which Elliot as made referenced to on previous calls. I’ll discuss EPAG and what the acquisition means to us in more detail in a few minutes.

To summarize, our performance in Q2 was again indicative of the consistency and reliability in our business as we continue to achieve solid year-over-year growth. I would now like to turn the call over to Mike to review financial results for the quarter in greater detail. Mike?

Michael Cooperman – Chief Financial Officer

Thanks, Ken. Net revenue for the second quarter of 2011 increased 10.6% to $23 million from $20.8 million for the second quarter of last year. Cost of revenues before network costs were $16.2 million, an increase of $2 million or 14% from $14.2 million for the same quarter last year.

Gross margin for the quarter increased 6% from $303,000 to $5.4 million from $5.1 million for Q2 of 2010. On a percentage basis, gross margin decreased marginally to 23% from 24% largely the result of the 7% price increase implemented by VeriSign in July of last year as well as the continued shift in our sales mix from higher margin services to lower margin domain name services.

Gross margin from OpenSRS which includes domain name services, email services and other wholesale services, increased almost $700,000 or 18% to $4.5 million from $3.8 million for the second quarter of 2010. Gross margin for the domain services component of OpenSRS increased by 17% to $3.1 million from $2.7 million. Gross margin on a percentage basis of revenue increased marginally to 17.1% from 16.9% mainly as a result of $300,000 we received from vendors as part of marketing development initiatives they have conducted through us to expand or maintain their market positions. As these vendors may elect at any time to cancel or amend their marketing programs, these increases may not be repeatable.

Gross margin from YummyNames was $1.1 million compared with $1.4 million for the second quarter of 2010. The decrease primarily reflects the timing of portfolio domain name sales as well as the impact changes in advertising vendors continue to make to their search methodologies and algorithms that have a negative impact on our search yields from our pay per click advertising or park pages programs.

On a percentage basis, gross margin for YummyNames remained essentially flat at 84% when compared to the second quarter of last year. Gross margin for Hover increased to $860,000 from $761,000 from Q2 of last year primarily as a result of the momentum Hover has been seeing from their marketing and branding initiatives attracting and retaining customers. The consequence of this has been the resumption of a growth trend in Hover’s deferred gross margin. I would also note for you that as part of our marketing initiatives we simplified our Hover pricing model, which has resulted in a slight decline in our gross margin as a percentage of revenue to 67% from 69%.

Gross margin for Butterscotch decreased to $382,000 from $664,000 for the second quarter of last year. This decrease primarily reflects the lower contribution from display advertising from our tucows.com desktop software libraries and with the resource center. On a percentage basis, Butterscotch gross margin increased to 99% from 96%.

As Ken mentioned earlier, in assessing Butterscotch’s performance it should be noted that our policy is not to allocate any inter-corporate transactions. So, Butterscotch have not been given any credit for the important projects that haven’t completed in support of other areas of our business such as Ting, OpenSRS and Hover.

Turning to our costs for the quarter, I will once again remind you that a significant portion of our operating costs are in Canadian dollars. Accordingly, our results should be considered in the context of the continuing unfavorable impact that the stronger Canadian dollar relative to the U.S. dollar has on our performance. For reference, the Canadian dollar strengthened by approximately 6% relative to the U.S. dollar in the second quarter of this year compared to the second quarter of last year. As I have discussed previously, we have been able to mitigate some of the negative impact of the strong Canadian dollar through our hedging strategies and our improved operating efficiencies. With this in mind, network costs for the quarter decreased 6% to $1.46 million from $1.55 million for the second quarter of last year. The result of the efficiencies we have achieved in operating and managing our colocation facilities.

Total operating expenses for the quarter decreased $1.3 million or 21% to $4.7 million from $5.9 million for the same period last year. Total operating expenses, as a percentage of revenue decreased to 20% from 28%. This decrease was primarily the result of the impact that our policy of managing foreign exchange risk by purchasing foreign exchange contracts has had on neutralizing some of the fluctuations between the U.S. dollar and the Canadian dollar.

Net income for the second quarter of 2011 was $566,000 or $0.01 per share compared with a net loss of $772,000 or $0.01 per share for the second quarter of last year. Cash, and cash equivalents at the end of the second quarter of 2011 was $4.3 million up from $4.1 million at the end of the second quarter last year and $4.2 million at the end of the first quarter of this year. This increase of $200,000 in cash when compared to the first quarter of this year resulted from our generating cash flow from operating activities of $800,000 from which we used $479,000 to pay down our credit facility with the Bank of Montreal and $162,000 for investment in equipment. With regard to our credit facility, the Bank of Montreal chose not to exercise the 2010 cash sweep option with the result that this facility will now be fully repaid by September.

Subsequent to the end of the quarter, we amended our credit facility with the Bank of Montreal the details of which can be found in our Form 8-K filed on July the 27th. Most notably, the new facility gives us greater flexibility, a higher cash sweep threshold for any new borrowings and more favorable interest rates.

In addition, as Ken mentioned earlier, last week we announced that effective from August 1, 2011, we have acquired EPAG Domainservices on an aggregate purchase price of $2.5 million. The purchase price consisted of a payment of approximately $2.1 million for EPAG’s shares and a working capital adjustment of approximately $400,000. The purchase was funded through the amended credit facility that I mentioned a moment ago. I will note that the purchase price is subject to a cash adjustment based on the net asset value of EPAG at August 1st relative to June 30, 2011.

Deferred revenue at the end of the second quarter was $66.8 million, an increase of 11% from $60 million at the end of the second quarter of last year and up 3% from $64.9 million at the end of the first quarter of this year. In summary, we continue to deliver solid revenue growth and cash flow from operations while at the same time achieving better operating efficiencies which have been evolved us to mitigate some of the unfavorable impact of this stronger Canadian dollar.

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

Ken Schafer – Executive Vice President of Products

Great. Thanks, Mike. All right, so let’s return to the EPAG acquisition. As I mentioned earlier EPAG is one of the leaders in comprehensive TLD coverage offering more than 200 TLDs. Prior to the acquisition we had strong domain coverage it was on par with our major competitors but we wanted to move to offering comprehensive coverage in advance of ICANN’s rollout of new TLDs. Generally companies that are looking to offer comprehensive selection work with one of three or four smaller registrars who specializing comprehensive selection. Based on their TLD on the TLDs that they offer and their great reputation of the industry we chose to work with EPAG as our supplier.

Now during the negotiations with them their parent company QSC AG let us know that there was an opportunity to do something a little more strategic and thus it made perfect sense for us to pursue an acquisition rather than merely having them as a supplier. While we expect to deal to be accretive, we do not expected to be material strategically however EPAG allows us to provide comprehensive TLD coverage to our channel of resellers which is over 12,000 active resellers now and to do so with attractive economics. We will expand the TLDs that we offer from 33 now to more than 200 by the end of the year.

And in addition as we’ve discussed in the past although we are the leading domain wholesaler in Europe we have not been so strong in German speaking countries namely Germany, Austria and Switzerland. And this is exactly where EPAG’s customer concentration lies. So, this is the nice fit for us from a customer perspective as well.

Finally, in terms of EPAG with 2012 marking a year where a lot of preparation needs to be done to get ready for the new TLDs, deepening our bench strength in domain name expertise is especially valuable to us and EPAG’s people will be a great addition to our team and we welcome them. There is one other development that I would like to touch on before we open the call to questions.

Elliot has talked a number of times about our view of mobile computing as the largest trend in technology for the foreseeable future. Consistent with this, we recently announced our intention to launch a mobile phone service called Ting. The service will be a U.S. based MVNO that’s a mobile virtual network operator, using the Sprint network. We believe there is an opportunity to offer a mobile service that is fundamentally different from what is being offered today. We launched a teaser slide at Ting.com in late June and I would ask you to check that out for more information about what we’re doing with Ting. While we will be launching a close data with 100 users to 200 users at the end of September roughly and we probably run that for 60 days to 90 days and after that we will open it up as an open data for retail customers, we expect to begin offering Ting on a wholesale basis to our OpenSRS customers in early 2012.

While we will be talking about Ting more in future quarters, at this time there are two key points that I would like to leave you with. The first is that we view Ting as a mobile access offering which we think is very different than what the way most mobile services are presented today in the space. Ting is really about connecting smartphones to data networks where they’re fundamentally different and better experience in terms of customer service, ease of use and most importantly with much fair and more transparent pricing, which we believe will save money for the vast majority of Ting customers. We believe there is compelling opportunity for disruption in this market through a different type of service delivery with fundamentally different economics both in terms of price and costs. You will notice that I have said that we are ready to launch our close beta in September. You will also notice that there is no blip in our quarterly operating expenses. You should infer from this that we have been able to source research, build and prepare this service for launch with virtually no noticeable cost implications.

The ultimate scale and success of Ting will greatly depend on our wholesale channels ability to sell mobile services to their customers. And we are confident in this regard and the initial feedback from our reseller has been very positive. These, there could be no more powerful conformation of the fact that the OpenSRS platform and the power of our distribution channel provide us with the unique opportunity to source, build and launch potentially disruptive services in an incredibly efficient manner.

And with that, I would like to open the call up to questions. Operator?

Question-and-Answer Session

Operator

Our first question comes from the line of Thanos Moschopoulos from BMO Capital. Your line is open.

Thanos Moschopoulos – BMO Capital

Hi, good afternoon. You answered most of my questions in your comprehensive prepared remarks but just a couple of follow-ons. Regarding OpEx I guess between the Ting launch your comment was we shouldn’t see an appreciable impact there. What about with respect to the acquisition should we see a slight uptick from that or should we expect OpEx to be fairly consistent in the coming quarters?

Michael Cooperman

Hey Thanos its Mike. How are you doing? As far as EPAG is concerned, EPAG does have a real revenue stream attached to it. So, while you will see a marginal increase in our overall operating expenses as we start accounting for Ting, we don’t expect that it will have a negative impact on the bottom line. It will be marginally accretive once it becomes absorbed.

Thanos Moschopoulos – BMO Capital

Okay. All right. And then what about the as you highlighted the Canadian dollars obviously showing some appreciation although I guess it’s gone either way in recent days. But how far out that your hedges extend and then at what point do we start to see some more of the impact of the currency start to flow into the OpEx if those hedges come off?

Michael Cooperman

Well, obviously in an environment with the Canadian dollars moved for a sustained period of time in the – if you wish for our reporting purposes the wrong direction that generally slowly catches up to you what we’ve been able to do to-date is we’ve been able to mitigate that fairly significantly through buying forward contracts and obviously increasing our underlying productivity underneath the process to enable us to deliver the results that we have. As far as the hedging is concerned, we continue to hedge and have been buying forward contracts into 2012.

Thanos Moschopoulos – BMO Capital

Okay. Okay was that Ken relatively consistent over the last two quarters?

Ken Schafer

Yes, it is.

Thanos Moschopoulos – BMO Capital

Okay. And then maybe just finally maybe just a little bit more on Ting and I guess I appreciate that you kind of limited and how much color you can provide given that this is still in beta. But maybe some more color around the potential magnitude of the opportunity, the timeframe over which we might expect to see the revenues ramp and start to have sort of a meaningful impact on the top line?

Ken Schafer

I think the big impact is really going to be known when we see what happens with our reseller base. We will do some retail efforts to build the brand and to build the customer base that way. Our expectation isn’t that that’s going to be a very large part of the business at this point. We expect that wholesale adoption is going to be the thing that really drives it. And it’s really too early to say that at this point, we’ve gone out and talked broadly to our resellers about it and they’d been very interesting in the idea of offering of mobile service to their customers. But, what we wanted to do this time was to prove that out of retail basis, first let them be able to get in there, experience to themselves, kind of kick the tires if you will, and then for them to pass along to their customers. So, I think you’re right I think it is too early to tell. And, we’ve kind of structured it from an operational standpoint so that it is fairly efficient for us to run we haven’t had to make major investments to support it. So, either way it kind of positions us well for this whether it’s a small success or huge success.

Thanos Moschopoulos – BMO Capital

So I guess ultimately the idea is that if it starts to get traction, it will ultimately become one more of the comprehensive slate of services that you are offering to your reseller partners?

Ken Schafer

That’s right.

Thanos Moschopoulos – BMO Capital

Right. Okay, all right. And then finally maybe on the sorry the Butterscotch business we saw some weakness there that just reflects the ongoing challenges in the display ad market or what’s behind that?

Ken Schafer

Yes pretty much. I mean in short and sweet I think that’s an accurate assessment. What we’ve done though fairly successfully internally as we’ve been not allowing those resources to go idle or but have been taking full advantage of them in helping us position and market in other areas of the company and we’ve been very encouraged by the results we’ve been achieving.

Thanos Moschopoulos – BMO Capital

Okay. All right, thanks guys. I’ll pass the line.

Ken Schafer

Thank you.

Operator

Our next question comes from the line of Alex Grassino, Laurentian Bank Securities. Your line is open.

Alex Grassino – Laurentian Bank Securities

Good afternoon, gentlemen. I was just wondering if you could perhaps provide a little bit more color on how EPAG would strengthen your ability to respond to the expanded TLDs. What specific processes or steps do you feel will be improved upon or how will EPAG help you to meet the upcoming increase more effectively?

Elliot Noss

First to offer domain now or in the future sort of different of these, it requires us to integrate both at a business process level, contractual level and at a technical level with the registries. What EPAG brings is expertise with over 200 different registries that they currently connect with. So, they have built a system that allow them to organize that and they built a body of knowledge around how to integrate with these people very quickly and manage that process. Because we then are connecting with them through kind of one standardized interface, it means that to a large extent the connections to the registries which is always something that the OpenSRS development team and product management team have had to take on. That work now kind of gets offloaded to the EPAG team and allows us to connect much more quickly with people – sorry, people registries. So, we feel that that’s going to give us real leverage when it comes to new TLDs.

Alex Grassino – Laurentian Bank Securities

Okay, great. Thanks. Also in terms of Ting, on your website it sort of talks about how you’re planning on revamping the customer experiences well namely by providing increased training to your service reps. In terms of incremental costs for the inbound call centers for problems out sort of thing online presence, is there any way to sort of conceptually think about it or is it just still early days?

Ken Schafer

Yeah, I think it’s very early days. We’re taking a lot of the lessons that were learned with Hover in terms of giving great service. A big part of that is about having a mindset that says that we have experts on staff that are answering these questions and we’re giving them a level of authority to actually resolve the presence on the first call. So, that’s making the entire process much simpler. The kind of no-wait policies, no-transfer policies that we put in place at Hover, all translate incredibly well to Ting. And in fact we’ve done some slight changes organizationally internally so that Hover and Ting will share a common customer service base both from a staff and a technical standpoint. And I think we’ll get a fair bit of efficiency out of that in cross training and kind of reuse of technology and effective tools.

Alex Grassino – Laurentian Bank Securities

And can you just sort of give us an idea of what the headcount on that is currently?

Ken Schafer

For Ting or for Hover overall?

Alex Grassino – Laurentian Bank Securities

For Hover overall, for the customer service component specifically?

Ken Schafer

Roughly 15 to 20 people.

Alex Grassino – Laurentian Bank Securities

15 to 20 people, okay thank you. Just conceptually over the last several quarters you’ve been talking a lot about looking at perhaps enhancing shareholder value through buybacks. I’m just wondering if there has been any change in philosophy on that wasn’t really mentioned on this call. So just sort of wanted to go back and verify that you are still looking at that as an option or is it perhaps more of a back burner things or initiatives you have with the recent acquisition you made?

Elliot Noss

Well, I think the answer to that is, is that it’s certainly one of the strategies that we do regularly and successfully explored. I think you’re right that for the immediate future we do have this acquisition to absorb and we may not buy anything in the immediate future. But it is something that we do consider and do discuss pretty much at pretty much every board meeting.

Alex Grassino – Laurentian Bank Securities

Perfect. And finally just a small one, in terms of your prepaid expenses, I noticed there was a slight quarter-over-quarter bump up. Do you expect it to revert back down to lower levels or is this sort of a new level that we’ll be looking at going forward?

Ken Schafer

The – I think the answer is I think it will fluctuate and it will depend on the operational need at that time. On occasion we can operate those registries a little tighter. And then other times it’s the funnel of renewals maybe slightly skewed towards the beginning of the following month in which case we won’t take a chance of running out of money. So we’ll deploy more resources into it.

Alex Grassino – Laurentian Bank Securities

Okay, perfect. Thank you.

Operator

And there are no further questions in queue at this time.

Ken Schafer – Executive Vice President of Products

All right. Thank you, operator and thanks to everyone for being on the call with us today. We look forward to speaking with you on the next call.

Operator

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

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