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Tucows Inc. (NASDAQ:TCX)

Q2 2007 Earnings Call

August 7, 2007 8:30 pm ET


Leona Hobbs - Director of Communications

Elliot Noss - President and CEO

Michael Cooperman - CFO


Thanos Moschopoulos - BMO Capital Market

Tucows logo


Good afternoon, ladies and gentlemen. Welcome to the Tucows Inc., Second Quarter Fiscal 2007 Results Conference Call. Please note that today's call will be archived for replay both by telephone and via the Internet, beginning approximately 1 hour following completion of the call. To access the archived conference call by telephone, dial 416-640-1917 or 1877-289-8525 and enter the pass code 212-40-796. The telephone replay will be available until Tuesday August 14, 2007 at mid-night. To access the archived conference call via the internet, go to

I would now like to turn the call over to Leona Hobbs, Director of Communications for Tucows Inc. This call is being recorded Tuesday August 7, 2007. Please go ahead, Ms. Hobbs.

Leona Hobbs

Thank you, operator. Good morning, everyone, and thank you for joining us for today's call. With me is Elliot Noss, Tucows President and Chief Executive Officer; and Michael Cooperman, our Chief Financial Officer.

Earlier this morning, Tucows issued a news release reporting the company's results for the second quarter of fiscal 2007 ended June 30th, 2007. The news release and other information for investors are available by going to and clicking on Investors.

Before we begin today, I would like to point out that the matters we will be discussing include forward-looking statements, and as such, are subjected to risks and uncertainties that could cause actual results to differ materially. These risk factors are described in detail in our documents filed with the SEC, specifically the most recent reports on Form 10-K and 10-Q. We urge you to read our securities filings for a full description of the risk factors applicable to our business.

I would now like to turn the call over to Elliot.


Tucows logo

Tucows Inc. is the largest Internet services provider for hosting companies and ISPs. Through our network of 7,000 service providers around the world we provide millions of email boxes, billing solutions and manage over seven million domains. Tucows is an accredited registrar with ICANN (the Internet Corporation for Assigned Names and Numbers). Tucows remains one of the most popular software download sites on the Internet.

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Elliot Noss

Thank you, Leona. Good morning, and thanks for joining us today. Before I begin, I would like to note that the primary reason for having the call this morning is that I will be leaving here for the airport to go to the RBC Capital Markets North American Technology Conference in San Francisco where I will be participating in a panel on online content in Internet domains tomorrow.

Today's call will follow our usual format. I'll begin with an overview of the highlights of the second quarter. Mike will then provide a detailed review of our financial results. And, I'll close the call by bringing together a number of the data points from the second quarter and discussing them in the context of our fiscal 2007 results.

Let me begin by briefly running through the financial results for the quarter. The second quarter was marked by continued strong financial performance but with some unique elements. Revenue grew 33% year-over-year to a record $20.8 million. Adjusted net income grew to $4.7 million, also a record. Net income was $3.2 million our 20th consecutive quarter of profitability.

Cash flow from operations was $2.4 million, our 22nd consecutive quarter of positive cash flow from operations. And net deferred revenue or deferred revenue less prepaid registry fees increased to 11% compared to the end of the second quarter last year. I will note that our results from the second quarter included the contribution of the sale of a block of 25 00 domain names, from our portfolio in June for $3 million. I will also note that we achieved these results despite the fact that the second quarter was the first time since competition in which we saw a year-over-year quarterly decrease in new domain registrations.

Now to be clear, this is not total registrations which were up 10% or renewals which were up strongly at 27%, but new domain registrations. The decline in new registrations resulted in gross margin dollars on our domain name business essentially flat compared to the second quarter of last year. This was also something that was new for our business in the second quarter.

In Q1 in the first quarter, new registrations were up nearly 12.5%, in Q2 they were down 7%. An important factor in this was a number of M&A transactions involving our customers. Affinity was acquired by Hostway, Fasthosts was acquired by 1&1. first signed an exclusive cross-selling deal with and then sold to Website Pros and as it was widely covered in the press RegisterFly which was a large customer in the second quarter of last year, imploded, and as a result ceased doing business.

These transactions generally resulted in registrations, especially new registrations being moved away from Tucows. I will note and it's important to note, that in previous quarters we have generally benefited from these types of transactions. In other words, it was our customer who was the acquirer. We also saw this trend in new registration hit the fat middle of our customer base, and we will discuss our response to this later in the call.

Our renewal transaction numbers and the gross margin on renewal transactions for the quarter were actually quiet good. But new registrations which is the first thing the company's move and they get sold were down slightly year-over-year. And this is further evidence of the shift in the importance from the primary market to the secondary market for domain registrations, both to the industry, in general, and to this company in particular.

Now let me turn to some of the other unique elements for the quarter that I alluded to earlier. Last week, we announced that we have acquired itsyourdomain or IYD an ICANN accredited registrar with more than 700,000 domain names under management for $10.35 million in cash plus up to an additional $1.05 million upon the achievement of certain performance thresholds.

IYD's business model is similar to that of Tucows in that it is a wholesale model in nature. But it's slightly different than ours in that they are focused on the segment of the service provider market that wanted to simply resell domain names without deeper technical integration.

IYD's service offering is a lot more like that of Wild West which is GoDaddy's wholesale business or a significant portion of eNom's wholesale business, and is a segment that we've not historically addressed.

From a financial perspective, we expect the acquisition to contribute approximately $7 million in revenue annually, and once the synergies are achieved, between $1 million and $2 million in adjusted net income. Where we end up within that range, will to a great extent, a function of the value of some of the secondary market opportunities that may flow from the base of names.

At this time, we do not contemplate taking on any of IYD's personnel, although because we'll be using portions of their technology, there will be a knowledge transfer period with associated transitional costs of approximately $300,000. We believe that this was perhaps the only substantial wholesale registration base that is likely to become available in the foreseeable future.

I get asked on a regular basis, what kind of acquisitions we are looking to make? We are not really interested in buying our way into a new service offering for our customers. But we are very interested in transactions that create a significant number of additional customer relationships for us.

Also of note this quarter, we soft launched our redesigned website around the middle of July and later in the month told the world about it in a news release. The early results are quite satisfactory; the most important date that we are seeing seems to indicate that many more people that come to the front door are venturing inside the site and actually taking advantages of some of the solutions that we are offering.

To give you a sense of that, it is historically been the case that the people who arrived at the front door, three out of four would go further and one out of four would turn around go somewhere else. We believe, that because of both the cleaner design and in the change in focus from software downloads to solutions that help people use the Internet more effectively that number has now increased from 3 and 4 people to 97 or 98 in every hundred people going into this site.

We believe that we have accomplished a number one goal of the redesign which was to re-engage users, and turning the sites to something more relevant for the Internet today. We have now begun the process of finding those improvements and then we will start to take advantage of them at a business level. I would now like to turn the call over to Mike to discuss the financial results for the quarter.

Michael Cooperman

Thanks Elliot. To reiterate Elliot's comments earlier in the call, the second quarter of fiscal 2007 was highlighted by continued strong financial performance as we delivered recoded revenues, recoded adjusted net income, strong cash flow from operations and continued growth in our deferred revenue balance.

Net revenues for the second quarter increased 33% to 20.8 million from 15.7 million for the corresponding quarter of last year. Net revenue from domain name and other internet services increased by $5 million or 34%, to $19.6 million from $14.6 million. Revenue from domain registrations was up 16% to $12.3 million and accounted for 59% of total revenue compared to 67% for the second quarter of last year.

Revenue from other internet services including the sale of domain names increased by 80% to $7.3 million compared to the second quarter of last year, largely as a result of the $3 million in revenue generated by the sale of the 2,500 names in June. Revenue from other internet services accounted for 35% of total revenue, up from 26% of total revenue for the second quarter of last year. Again, this increase was largely driven by the sale of the 2,500 domain names.

I would note that while we do expect to make such sales from our portfolio of names periodically, we do not anticipate that they will be of this magnitude, either in terms of the number of names or the value of the transaction. Revenue from advertising and other content sources for the second quarter increased 16% to $1.2 million from $1.1 million for the same quarter of last year.

The growth in advertising and other content revenue was driven by our direct navigation business, which increased to 496,000 from 174,000 in the second quarter of last year. This increase was partially offset by a decline in our Google Ad Spends revenue of 124,000 and a decline in advertising revenue of 45,000 compared to the second quarter of last year. This decrease primarily resulted from a further contraction in the yields from our syndicated Google Feed that Elliot mentioned, which impacts both our software library and direct navigation revenue.

Advertising and other revenue as a proportion of total revenue decreased to 6% from 6.9% for the same quarter last year. The decrease is largely due to the change in revenue mix resulting from the sale of the 2,500 domain names and the contraction we are experiencing from our Google Feed.

Cost of revenues for the second quarter increased by 23% to $13.2 million from $10.8 million for the second quarter of last year. Primarily as a result of higher costs associated with higher volumes of domain name registrations and other internet services of $1.8 million and an increase in network costs of 687,000. The increase in network cost is attributable primarily to the additional depreciation on assets deployed in our datacenters of 316,000 and other network cost increases, which reflect the work we undertook to stabilize our hosted email services.

Cost of domain names as a proportion of total cost of revenues was 69%, compared to 70% for the corresponding quarter last year. While the cost of other internet services including the sale of domain names as a proportion of total costs of revenues was 7.9% compared to 9.4% for the same quarter last year.

Gross margin for the second quarter was 36% compared to 31% for the second quarter last year and 32% for the first quarter of this year. The increase in gross margin was primarily the result of the $3 million contribution from the sale of 2,500 domain names. Looking ahead it should be recognized that the price reduction we announced with our new cost-plus domain pricing is likely to adversely impact gross margin in the short-term and may or may not result in increased volumes, which could impact our revenues and profitability accordingly in the long term.

Operating expenses for the second quarter decreased by $434,000 to $4.3 million or 21% of net revenue from $4.8 million or 30% of net revenue for the same quarter of fiscal 2006. As I usually do to assist you in understanding our operating expenses I will discuss them in terms of cooperating expenses and other operating expenses.

As a reminder, we define our cooperating expenses as those costs relating to ongoing sales, marketing, development and administrative costs. For the second quarter, cooperating expenses remained essentially flat at $5 million compared to the second quarter of last year. Cooperating expenses decreased as a percentage of net revenue to 24% from 32% for the second quarter of last year.

Other operating expenses for the second quarter decreased by four hundred and one thousand compared to the second quarter of last year essentially for three reasons.

First, in connection with our acquisition of the Hosted email assets from Critical Path in January 2006, we incurred transitional costs of $292,000 during the second quarter last year that were not repeated in the current quarter.

Second, as I have discussed in the past from time-to-time we enter into foreign exchange contracts to manage our exposure to the Canadian dollar. For the second quarter, this resulted in the recognition of an incremental gain of $180,000 on our foreign exchange transactions compared to the second quarter last year.

And third, during the quarter we reversed a contingency for some marketing programs that we have set up in prior periods of 94,000 that is no longer required.

These decreases were offset by higher depreciation of $133,000 primarily related to the acquisition of new computer equipment and higher amortization of $291,000 resulting from the acquisitions we have made in prior years.

Adjusted net income for the second quarter increased by $2.9 million to $4.7 million from $1.8 million for the second quarter of last year. This increase is primarily attributable to the sale of the block of domain names.

Net income for the second quarter of fiscal 2007 was $3.2 million or $0.04 per share, compared with $226,000 or less than $0.01 per share for the corresponding quarter of last year.

Turning to the balance sheet, cash, short-term investments and restricted cash at the end of the second quarter decreased to $6.2 million from $6.6 million at the end of the first quarter of fiscal 2007. The decrease was primarily the result of our investing $1.1 million in repurchasing shares under our normal course issue a bid and $1.7 million to acquire equipment related to our hosted email service.

The investment in equipment for our hosted email service reflects our ongoing commitment to support this service, including the issues or of the significant increase in inbound spams that Elliot described in previous calls.

These uses of cash were partially offset by the generation of cash flow from operations of $2.4 million. I would like to comment on the increase in our working capital usage over the past six months. We have in fact, increased our operating working capital by $2 million over that period and if you remove the net effect of the deferred revenue process $3.1 million.

We do however believe that this is not representative of our ongoing working capital. Our working capital needs by the end of the fiscal year will improve for the following reasons. First the natural ebb and flow of accounts receivable, accounts payable and accruals is higher at the moment then we would like it to be. Our experience with this has been that these things tend to go in cycles and we expect this to improve by the end of the year.

And second, prepaid expenses including a number of contracts that were prepaid for periods in excess of one year to enable us to take advantage of discounted prices. The amount of these prepayments will decrease as we expense them over time. The above reasons we expect that we will no longer need to deploy as much cash in operating working capital and that operating working capital will decrease by around $2 million by the end of this fiscal year.

Deferred revenue at the end of the quarter grew to a record $49 million up 13% from $43.2 million at the end of the second quarter of fiscal 2006 and up 2% from $48 million at the end of the first quarter of this year. Although we delivered another strong quarter financially, our organic growth was not as strong as we would have liked. We remain committed to the continued long term growth of the company and during the second quarter took a number of steps in this regard including the launch of our premium domain name service, the implementation of our email platform, the completion of the IYD acquisition subsequent to the quarter end.

And the announcement of a price reduction in our list price for wholesale domain name registrations. This announcement is an important component of our domain strategy so I will leave it to Elliot to provide you with the details. I would now like to turn call back to Elliot.

Elliot Noss

Thanks, Mike. I would like to talk about the unique elements of the quarter and tie them together. I noted earlier, that we sold a of 2500 domain names for $3 million. The names sold were almost exclusively from our expired portfolio, not our surnames or premium portfolios. And there were names with smooth financial not semantic value. The transaction itself was probably not a typical domain name transaction for us.

While we will be selling domain names on a regular basis, both from our expired portfolio and our premium portfolio, going forward this particular transaction was a typical, both in terms of the number of names 2500 and in terms of the value $3 million.

We expect typical transactions to include fewer names, most often only one name and to be less than $3 million in value. However, when we look ahead, we do not think the $3 million in domain name sales in a year will be a typical. That may be a bit high, when thinking about next year, or it may not, that may be the average over the next two years. It will probably be the average over the next three years, and it will certainly be the average over the next five years. It is still very early days in this market and we would be learning every quarter as we move forward.

The next point that I'd note about this quarter, is that organic growth outside of that domain name transaction was lower than we'd have liked. This was primarily attributable to three factors, one that was expected and two that were disappointing. First, the lower number of new domain transactions that I discussed in detail earlier, disappointing. Second, we had just launched our new email platform and the sale cycle as noted previously is somewhere in the four to eight month range. We are just at the beginning of that cycle.

I talked at length on previous calls about some our challenges around the old email platform; email revenue was flat compared to the second quarter of last year. That was expected, that was not a surprise. It was exactly what we expected, and I have talked about on previous calls. In fact, we would not be surprised to see this number potentially a little down over the next quarter or may be even June. And while we expect to continue to work through some of these challenges over the next quarter or two, after that we deeply believe in email as a significant growth driver for our business.

And third, again, this quarter our advertising revenue from Google was disappointing. As we noted last quarter, we understand that this is something that is being experienced by Google partners in this true light at least from our discussion at an industry level. We continued to increase the number of domains in our portfolio and the number of domains that we have part. We continue to increase our page views and are searches. But, because of the nature of that relationship we cannot control our yields, and again this quarter, yields were down, that was disappointing.

There are other small issues like the content redesign which is likely to cost us a little bit of revenue in the short term as we work through new placements with advertisers and discover what works and what doesn't. There will be some put and takes from the IYD transaction, as I noted there will be a few hundred thousand dollars in transition cost as well as some other expenses in connection with the transaction like interest.

In addition, the term loan that we took, as I noted, will cost us a few hundred thousand dollars in Interest.

The last point I want to discuss, is the change that we have decided to make proactively. On October 15th of this year, for the first time since competition came to domain name registration, the price of a dot-come domain name will increase, the result of a deal between ICANN and VeriSign, a registry. This is a deal that we strenuously opposed, and that we still believe is wrong in many respects. And we note that there will be price increases following in all other major top level gTLDs.

We've decided that given all of the above, it was time to make two changes to our pricing models. First, effective today we will begin charging our customers on a cost plus basis. The price that we charge our customers will be separated from the fee charged by ICANN and the registry. This means that going forward, the domain names supplied under each top-level domain will have a different price. Second, we have decided that we will lower our price. Effective immediately, our standard price for domain registration would decrease from cost plus $3.85 to cost plus $3.

As discussed in the past, the majority of our transactions occur with high-volume customers that are already receiving aggressive pricing. But, for the majority of our customers, as opposed to the majority of our transactions, this will mean a significant price decrease.

Today, more than ever, primary domain registration is an entry point into relationships for premium names and email, and we must make an investment in our business to ensure the breath of customer relationships.

This is an investment that we are choosing to make in the business, and in our customers and it is an investment that has been facilitated by some of the opportunities provided by the secondary market for domain names. All of these moving parts combine together lead to me expecting our cash flow from operations for 2007 to still to be in excess of $10 million.

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

Question-and-Answer Session


Ladies and gentlemen, we will now conduct a question-and-answer session. (Operator Instructions). One moment please for your first question.

Your first question comes from Thanos Moschopoulos of BMO Capital Market. Please go ahead.

Thanos Moschopoulos - BMO Capital Market

Hi, good morning.

Elliot Noss

Hi, Thanos.

Thanos Moschopoulos - BMO Capital Market

Hi, Elliot. Just want to go a bit deeper on the decline in new domain registrations this quarter, should we think of that as being entirely attributable to the M&A activity among your customer base, or does that reflect in addition to that underlying issues in the industry which is why we are seeing the pricing reduction that you are now pursuing?

Elliot Noss

Well. I think that there are a couple of things, first, certainly if the cases have declined in new transactions lines up well with the pricing reduction, but it was something that we have been talking about, sort of, preceding that data coming in. I noted and I want to make sure that I stress, in Q1 new transactions were actually up, and up in exactly the way that I have expected them to be historically. So right now, if there is one quarter's worth of data you ask specifically was it completely attributed to the M&A? No, that certainly was an important contribution, but we saw that impacting across customer segments.

We segment our customers by size pretty deeply. And what we saw in new transaction performance was pretty consistent across segments. It's also worth noting that there was not a congruent increase in transfer out activities, which means it does not appear from the data that we are losing customers.

So, right now what we are looking at is a quarter where new transactions declined across the base that was not marked by customer loss. So we think that there was just some price competition that was impacting our channel broadly and this is just a great step to try since it's one of a couple steps, but this is a great first step to try and sort of take advantage or to try and respond to.

Thanos Moschopoulos - BMO Capital Market

Okay, so the renewal rate was pretty much consistent with prior quarters?

Elliot Noss

The renewal rate, and most importantly when you are looking at sort of the customer issue transfer out.

Thanos Moschopoulos - BMO Capital Market

Okay, I don't know if this is question you can answer, but how should we think about the magnitude of the margin impact from the reduction in pricing. As you mentioned, the majority of your transactions were getting lower pricing to begin with anyway, so how do you really think about the incremental impact from the new pricing structure?

Elliot Noss

We are not going to put a hard number out there. I will give you a couple of thoughts on it. Let me be clear, it's a very expensive choice to make. When you are looking at what I've called historically for any business the tyranny of the spread sheet, this is one of those decisions that you face where you have to decide whether and how deeply you want to cannibalize yourself. And one of the things that I am really pleased about is that organizationally, on an Executive level or a Director level, everybody was stepping up to making this decision. It's a very hard decision to make. It can have real impacts.

I think that one of the reasons that it's tough to quantify with great specificity Thanos is because we hope that it has two impacts. We hope that yet stocks some of that, flow of new registrations as it allows our customers to get out there and be a little more competitive. In addition, we hope that it starts to provide some opportunities for us to win some business from some of our competition. One of the things that we have heard regularly and it's a very interesting comment is we would love to do business with you guys, we prefer to do business with you guys relative to our existing supplier, but you are just a bit too expensive. So, there is no two mitigating factors that we hope to be able to have some impacts on that price reduction and how much it costs us. But be clear, it is expensive.

Thanos Moschopoulos - BMO Capital Market

Okay regarding the email revenue you alluded to the fact that might be down in the next quarter to and subsequent to that we should start seeing an increase as we get further in the sale cycles. But why should we expect to see a decrease, is that also being affected by the M&A activity?

Michael Cooperman

No. I think that that's just much more about the tail end of some of that previous email experience. You have a couple of factors there like customers who are rightly frustrated and are deciding what they should do. And until we get them migrated on to the new platform, they can't see their brave new world. It's very hard to go to a customer who's confidence is shaken and say hey here's this solution to the problem, trust me. So there might be a little bit there and there is also to a smaller extent when I say to a smaller extent in one or two customer situations, working out through some of the critical pass [tubs]. If you remember when we made that transaction we noted that it was kind of 80/20 service provider to enterprise. We would have been shocked if we worked through some of that enterprise stuff, because we are not a supplier to enterprise we'll always do our best, but we are not necessarily a supplier.

Thanos Moschopoulos - BMO Capital Market

Okay, and then as far as the sequential weakness in the advertising revenue, was that entirely attributable to the lower Google Ad Spend yields or was part of that lost revenue from the three million names that you sold?

Elliot Noss

Certainly, there is a little bit of each, right I would say that the Google yields had a greater impact then the names that we sold. So both of those things contribute, as of the fact the Q2 is worse than Q1 generally. Right, remember Q1 and to all those closely followed by Q4 were the two best quarters for advertising in particular, once kind of a Memorial day and Victorian day and people actually start to go outside and just consume less web pages

Thanos Moschopoulos - BMO Capital Market


Elliot Noss

Get a little bit of seasonality in there too.

Thanos Moschopoulos - BMO Capital Market

Okay, and my final question regarding the acquisition. Is it just the 300,000 in conditional costs, we should expect to see or will there be other one time costs, next quarter from this?

Michael Cooperman

Thanos, there will be some deal related costs for example things like professional fees and the cost of evaluation and so on and I would estimate those to be more or less $100,000 to $150,000.

Thanos Moschopoulos - BMO Capital Market

Okay, and so all that will be expensed along with the 300?

Michael Cooperman

That will be on top of the 300.

Thanos Moschopoulos - BMO Capital Market

Yeah, yeah, okay but all expensed in working capitalized rates.

Michael Cooperman

Yes those will be capitalized.

Thanos Moschopoulos - BMO Capital Markets

Okay I will pass the line, thank you.

Elliot Noss

Thanks, Thanos.


(Operator Instruction) Mr. Noss, there are no further questions at this time. Please continue.

Elliot Noss

Thank you, operator. Thanks to all, who are there and we look forward to speaking to you again next quarter. Thank you.


Ladies and gentlemen, this concludes the conference call for today. Thank you for participating. You may now disconnect your lines.


Tucows logo

Tucows Inc. is the largest Internet services provider for hosting companies and ISPs. Through our network of 7,000 service providers around the world we provide millions of email boxes, billing solutions and manage over seven million domains. Tucows is an accredited registrar with ICANN (the Internet Corporation for Assigned Names and Numbers). Tucows remains one of the most popular software download sites on the Internet.

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