Tucows' CEO Discusses Q3 2011- Earnings Call Transcript

Nov. 9.11 | About: Tucows Inc (TCX)

Tucows, Inc. (NASDAQ:TCX)

Q3 2011 Earnings Call

November 9, 2011 5:00 pm ET

Executives

Eliot Noss – President, Chief Executive Officer & Director

Michael Cooperman – Chief Financial Officer

Analysts

Analyst for Thanos Moschopoulos – BM Capital Markets

Operator

Welcome to Tucows, Inc.’s third quarter 2011 conference call. Earlier this afternoon Tucows issued a news release reporting its financial results for the third 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 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 as well as at Tucows’ website.

Before we begin, let me remind you that matters the company will be discussing including 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 report on Form 10K and Form 10Q. 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.

Eliot Noss

With me is Michael Cooperman our Chief Financial Officer. Today’s call will follow our usual format. I will begin with a brief overview of the financial and operational highlights for the quarter. 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.

Quarter-after-quarter our financial performance underscores the consistency and reliability of our business combined with our ability to achieve steady growth, and Q3 was no exception. Revenue grew by in excess of 18% year-over-year topping $25 million for the first time. With meaningful growth across all key areas of our business. Notably, YummyNames and Hover had particularly strong quarters as we continue to see the positive results of initiatives we have undertaken to grow these businesses.

In terms of cash generation, cash provided by operating activities for the quarter was a healthy $1.6 million. I’ll walk through the highlights of each of our services groups. In OpenSRS domain services revenue and transaction volumes were each up 19% compared to the third quarter of last year. We processed more than $2.1 million transactions in Q3, the first time we’ve exceeded that threshold and the third consecutive quarter we have surpassed the $2 million mark.

New registrations grew by 15% excluding the impact of the two customers that became registrars earlier this year. Renewals were particularly strong increasing by 24% with the renewal rate continuing to hold steady at a level well above the industry average. Total domains under management at the end of the quarter was up 16% from a year earlier to more than 11.7 million, the result of solid growth in transactions as well as the 400,000 domain names that were added with the acquisition of EPAG which was completed in July.

I will take this opportunity to note that the acquisition of EPAG has progressed very well. As we discussed on our last call, EPAG is one of the leaders in comprehensive top level domain or TLD coverage offering more than 200 TLDs. Integration is going well with the first traunch of more than 100 of these TLDs to be available to our resellers at year end. We plan to roll out the remaining TLDs to our channel in two phases in the first half of next year.

EPAG also bolsters our presence in Germany, Australia and Switzerland, three countries in which we have historically not been a strong as the rest of Europe. With EPAG we added more than 500 resellers expanding our customer base to more than 12,000 active resellers globally. The expansion of our TLD offerings of course extends beyond OpenSRS to our retail business Hover which I’ll discuss in a moment.

Our strong competitive position again, drove a number of key customer wins during the third quarter. Most notably we added two large hosting providers in southeast Asia, both of which were previously with one of our competitors. We’ve also made strong inroads into the Australia market over the past 12 months following our launch of .au the Australian top level domain.

Our OpenSRS email service showed continued momentum in Q3. Revenue was up 10% from the same quarter last year with a number of mailboxes under management increasing on both a year-over-year and sequential basis. Alongside growth in existing services we launched a number of new services to our reseller network in Q2. OpenSRS Offers, our newest service allows resellers to generate promotional control through the control panel or API they choose that they can then pass on to their customers.

A key element to the OpenSRS value proposition is that it enables our customers to be more competitive and Offers further strengthened that by allowing our customers who are too small to do direct deals themselves to stand on equal footing with larger competitors. The initial offering is for Google Adwords’ credits and we will add new promotions from different companies on a regular basis. I will note that this service is unique within our space, further strengthening our competitive position.

We also added two new products to our OpenSRS Trust service, both of which have received early interest from resellers. With Trust Easy privacy policy and certification services our resellers can offer their small business customers affordable privacy solutions as well as access to the widely recognized TRUSTe privacy seal. We are also now offering SiteLocks’ security services to our hosting customers which include website security services and website malware scanning that ensures a safe and productive Internet environment for online businesses.

I will add that these additions are also notable strategically and that they mark the completion of our plan to evolve our trust business beyond selling SSL certificates to offering our resellers a more complete suite of trust services so they can provide the right product to satisfy the diverse security need of their small to midsized business customers.

In addition to these new OpenSRS offerings during the quarter, we initiated the closed beta for Ting, our mobile phone offering which we intend to offer both through our reseller channel in the US and at a retail level. Ting is moving forward on plan with the next milestone being the retail beta early next year followed shortly by the reseller beta. I will note that any investor listening to the call who is interested in participating in the Ting closed beta, should feel free to email me. And I further note that it is a US only service.

YummyNames, our domain portfolio group had an especially strong quarter with revenue up 46% from the same quarter last year and 38% from Q2 of this year. Sales of individual names or Brandable and Gems grew 30% compared to the third quarter of last year with average selling price reaching an all time high. This quarter we had a good number of individual name sales in excess of $10,000.

In addition, there was strong growth in expiry stream sales following our move to a new partner. Parking revenue was also up marginally compared to the third quarter of last year turning around a long term trend of decline. During the quarter we completed a number of initiatives at YummyNames designed to drive incremental contribution to our domain portfolio. We completed the technical integration of our domain sales distribution agreement with GoDaddy under which our inventory of the domain names is now displaced on the GoDaddy Domain Inquiry screen and made available for immediate purchase exposing it to tens of millions of additional perspective buyers.

Our retail services offering Hover also demonstrated strong growth once again this quarter with revenue up 15% compared to Q3 last year. And I will again remind you that the underlying performance of Hover continues to be somewhat masked by the deferral of revenue. New Hover transactions which include new domains, transfers in, and email accounts were up 42% over the same quarter last year and 9% over Q2 of this year. Net transfers in continue to be strong in Q3 with transfers in again outpacing transfers out by well over 3:1. Renewal rates also remained strong. We view both of these metrics as confirmation of Hover’s value proposition as the easiest way for individuals and small businesses to manage their domain names and email addresses.

We’re building on our recent success with customer acquisition in Hoover by expanding our retail offerings. In Q3 we began offering our OpenSRS premium name service [inaudible]. Late in the quarter we also launched Hover’s premium email service Mail Plus which provides Hover customers with a broader range of email functionality for an incremental fee over the cost of a regular mailbox. We’ve had good initial response to both of these initiatives and intend to build on these theme through 2012. Earlier I mentioned that the EPAG acquisition would also benefit Hover. In fact, we have a target for Hover to have TLD parity with OpenSRS over the next couple of quarters.

In summary, Q3 was another solid quarter both operationally and financially marked by continued growth in our existing services and the launch of new services that will further leverage our distribution network for growth. I would now like to turn the call over to Mike to review our financial results for the quarter in greater detail.

Michael Cooperman

Net revenue for the third quarter of 2011 increased by $4.1 million or 18% to $25.1 million from $21.2 million from the third quarter of last year. This increase was the result of meaningful growth in OpenSRS, YummyNames, and Hover. Cost of revenues before network costs were $17.7 million, an increase of $2.8 million or 18% from $14.9 million for the same quarter last year.

Gross margin before network costs for the quarter increased $1.1 million or 18% to $7.4 million from $6.3 million for the third quarter of last year. On a percentage basis, gross margin remained relatively flat a 30% when compared to the third quarter of last year. Gross margin from OpenSRS which includes domain name services, email services, and other wholesale services increased by $720,000 or 19% to $4.6 million from $3.8 million for the third quarter of 2010 with growth coming from all three service offerings.

Gross margins from domain name services increased by $528,000 or 20% to $3.2 million and reflects a combination of the increased transaction volumes we experienced from existing customers as well as the contribution to margin from the EPAG acquisition during the quarter. Email services gross margin increased by $82,000 or 17% to $562,000 primarily as a result of the increased volumes some of our email customers are experiencing.

Other OpenSRS services increased by $110,000 or 16% to $779,000 primarily as a result of the market development funds vendors have provided us to expand or maintain their market position for their services. I would note for you, that the vendors can elect to cancel or amend their marketing programs any time. So this increased may not be repeatable.

Gross margin from YummyNames increased $536,000 or 50% to $1.6 million from $1.1 million for the same period last year. The increase primarily reflects the timing of portfolio domain name sales as well higher expiry stream sales following our move to a new partner. On a percentage basis, gross margin for YummyNames increased to 90% from 86% for Q3 of last year.

Gross margin for Hover increased $96,000 or 13% to $863,000 from $767,000 for Q3 of last year primarily as a result of our ongoing success in attracting and retaining customers through our marketing and branding initiatives. As I discussed on the last call, the simplified Hover pricing model that we implemented as part of our market initiatives is have a small impact on our gross margin as a percentage of revenue which fell to 64% from 67% in the third quarter of last year.

Gross margin for Butterscotch decreased to $397,000 from $620,000 for the third quarter of last year. Similar to the second quarter of this year, the decrease primarily reflects the impact of custom video work that we undertook in 2010 not being repeated, as well as a lower contribution from display advertising from the www.Tucows.com desktop software libraries. On a percentage basis Butterscotch’s gross margin was essentially unchanged at 98%.

Turning to our costs for the quarter, I would remind you of the impact the strengthening Canadian dollar relative to the US dollar has on our operating results. In accessing our results for the quarter, the Canadian dollar relative to the US dollar has strengthened on average by approximately 8% when compared to the three months ended September 30, 2010.

Network costs for the quarter decreased 1% to $1.38 million from $1.4 million for the third quarter of last year. The result of the efficiencies we have achieved in operating and managing our colocation facilities as well as the decreased commitment we have needed to make in capital expenditures on network commitment.

Total operating expenses for the quarter increased $3 million or 79% to $6.8 million from $3.8 million for the same period last year. As a percentage of revenue, total operating expenses increased to 27% from 18%. I will note that foreign exchange losses accounted for $2.6 million of this increased. During the third quarter, we recognized a loss on exchange of $1.9 million inclusive of a mark-to-market loss of $2.2 million. This compares with a gain on exchange in the third quarter of last year of $700,000 inclusive of a mark-to-market gain of $100,000. Excluding the impact of the foreign exchange contracts, total op ex expenses as a percentage of revenue actually feel by 1% to 20%.

Net loss for the third quarter of 2011 was $1.2 million or $0.02 per share compared with net income of $1.1 million or $0.02 per share for the third quarter of last year. I will note that while our third quarter results reflect a loss we have provided for income taxes. This is a result of the large loss in foreign exchange forward contracts which I mentioned for which we do not obtain a current tax deduction.

Cash and cash equivalents at the end of the third quarter of 2011 were $4.7 million down from $5.4 million at the end of the third quarter of last year and up slightly from $4.3 million at the end of the second quarter of this year. Cash flow from operating activities remains our primary source of liquidity and for the third quarter of this year was $1.6 million. During the quarter we also drew $2.5 million from our amended credit facility with the Bank of Montreal to fund the acquisition of EPAG which was completed effective August the 1st.

During the quarter we repaid $1 million of the funds advanced to finance the EPAG acquisition as well as $320,000 of our original loan and as of the end of September had a total of $1.6 million owing under our amended credit facility. During the third quarter we also invested $140,000 in property and equipment.

Deferred revenue at the end of the third quarter was $68.9 million, an increase of 11% from $62.3 million at the end of the third quarter last year and up 3% from $66.8 million at the end of the second quarter this year. In summary, our financial performance for the third quarter and for the year-to-date continue to underscore our ability to achieve growth in the context of improved operating efficiencies, all while consistently generating cash from operations.

I would now like to turn the call back to Eliot.

Eliot Noss

As we have said many times, we believe Tucows has the best distribution channel in the Internet economy and that leveraging this channel by selling a broader range of services was our path to greater growth. 2011 has been helpful in doing just that. We’ve had a fantastic year in terms of winning new business, probably the best year in the last five. We have launched more new services than we ever have in a single year. We made significant progress on the control panel and on our data management which sets us up to take advantage of all of these things in 2012.

And of course, the closed Ting beta has launched. That, combined with the broader range of CCTLVs that the EPAG acquisition provides as well as the new GTLD program which launches next year, sets us up nicely to become the business we have always wanted to be, a wholesaler of a broad range of Internet services rather than a domain registrar. Domains will always be a very important part of our business. They’re great for attracting customers and getting them integrated with the platform, and it’s a very sticky business.

However, the core GTLDs like .com are also relatively low margin for us. The additional services generate significantly higher margins. I would also note that at the current exchange rate 2012 is likely to be the first year since 2003 in which our actual cost of the Canadian dollar will be essentially flat year-over-year eliminating a significant drag on profitability. Please remember that actual exchange rate differences will continue to show up in our GAAP accounting.

Before opening the call to questions, a few words about the open market share repurchase program that we announced today. Our intention is to repurchase up to 3,840,000 shares which equates to approximately 10% of the public float which we can do through the facilities of either the TSX or the AMEX and of course subject to the restrictions of both these exchanges.

As we look out to 2012 we have opportunities before us that may require us to invest a little more capital than others have required us in the past. These would mostly be capital expenditures not operating expenses. Specifically here we are thinking about Ting and new GTLDs. I want to be clear that we still deeply believe in returning capital to shareholders unless there are better uses of those funds and 2012 may require a little more flexibility than years past.

This is a good thing as these are unique growth opportunities that are very consistent with our core strategy. I will not however, that we do have some very interesting off balance sheet assets and we are always looking for the right opportunities to monetize these which of course creates the ability to return capital to shareholders. With that, I’d like to open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Analyst for Thanos Moschopoulos – BM Capital Markets.

Analyst for Thanos Moschopoulos – BM Capital Markets

A couple of questions, first of all the Hover business is obviously doing quite well the last few quarters. Can you maybe comment on how sustainable this growth is and perhaps how big you think this business can get longer term?

Eliot Noss

There’s probably three comments I would make. A short answer would be yes, we think the growth is sustainable. The bulk of Hover’s customer acquisition momentum is due to word of mouth and great leverage through social media of some of the fantastic customer service and the experience these customers are having. Hover is still a very small business relative to many, many of its competitors so we don’t see a problem there.

The second thing I’d note that with Hover, and I’ll call it out a little more specifically, in 2012 we really think we have that customer acquisition engine going very strongly. But that customer acquisition is primarily around domains transferred in or new registrations. We really want to focus now on some upsell and cross sell there in a very smooth way that is consistent with the Hover experience. We think there’s the opportunity of continued customer growth at the same rates and hopefully higher ARPUs

In terms of how big this business can get, I think that there’s two things. There’s loads of headroom for Hover. Probably most importantly though, wholesale is still our bread and butter and it’s still where we come from. We really continue to think that the whole sale business is the engine that drives Tucows and what we do in retail is a fantastic way to show to the rest of our channel all the great opportunities that are out there.

Analyst for Thanos Moschopoulos – BM Capital Markets

Just shifting gears a bit, on the Ting launch it sounds like it’s sort of meeting your expectations at this point. Maybe if you could just provide a little bit more color on that and kind of wondering what the timeline is in terms of when we know whether this is going to get real traction?

Eliot Noss

What this is, is a closed beta to a couple of hundred people. We’ll probably start rolling that out to a slightly wider circle through the rest of the year. The goal in this closed beta is to sand all the rough edges off the service. First and most importantly our fair and transparent pricing model which is really unique in mobile has been very well received by the beta group. I should not that that beta group consists significantly of a number of resellers.

So they are a tough customer segment. They bring themselves to the closed beta as customers, not as resellers at this point and they have taken it up quite nicely. The sort of go forward from here and I should note, we’re now focusing on things like better visibility to your delivery around your phones, to a better activation process, so really kind of sanding the rough edges off that user experience.

We’ve been thrilled with especially the depth and level of feedback that we’ve been getting. You’ll see early in the new year the roll out of what I’ve referred to as a retail beta and then a little bit later – so probably both of those inside the Q1 timeframe but with all of these things we’ll be making game time decisions with roll out of the reseller beta. Where we’re testing a reseller program with a small group of resellers.

In terms of when we’ll know if it gets traction, we’re taking a unique approach to a massive market. We’re in this for the long haul in the sense that we’re going to take an approach that we think will be successful but we’re also very open to learning from it and keeping our eyes open. So there’s no specific benchmarks I’d set there.

Analyst for Thanos Moschopoulos – BM Capital Markets

Can you just comment on the M&A landscape more sort of generally? Obviously it sounds like the integration of EPAG has gone fairly well. Are there other sort of EPAG like targets out there that you’re keeping an eye on or what would you say about that?

Eliot Noss

The short answer is nothing on the horizon. We like to be very thoughtful about M&A and there’s nothing that we can see right now that rivals the growth opportunities that exist inside the building. We’d really like to keep our head down and execute on some of the things that are in front of us. Tomorrow, something could always present itself as an opportunity, but right now we’re very excited with the plate we have in front of us.

Analyst for Thanos Moschopoulos – BM Capital Markets

Curious about the Parallels partnership you mentioned on the call last quarter. Can you give us an update on that? Has there been much progress on that front?

Eliot Noss

Yes, we’re rolling out deeper integration across the whole Parallels suite of services. I don’t know how well you know that business but it’s a very broad business. They provide control panel functionality and billing functionality from the very, very smallest of hosting companies to very large Telco like customers. So there’s a number of places where that integration is taking place but the companies have known each other for a long time, have great relationships and that’s going completely on schedule. Parallels has their industry event in February which is one of the two largest events in the hosting industry every year and I think you’ll see us pretty predominately there.

Analyst for Thanos Moschopoulos – BM Capital Markets

Is there much change in your expectations on the op ex level? Things seem to have leveled off here a bit in the last few quarters. Have we kind of hit a new run rate?

Eliot Noss

The business feels very nicely efficient which is always one of the things that A) we think has been our hallmark over the years and B) is something that we strive for. We live in an industry that benefits from Moore’s law around a lot of the physical components. That leads to lot of places for efficiency. So we feel good about op ex levels and we see nothing really driving that. If Ting explodes in growth which would be a fantastic problem to have, there might be some op ex along with that but I look forward to that.

Operator

There are no further questions in queue at this time. I turn the call back over to the presenters.

Eliot Noss

Thanks to all of you for joining us and I look forward to speaking with you again next quarter.

Operator

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

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