Tucows' CEO Discusses Q2 2012 Results - Earnings Call Transcript

| About: Tucows Inc (TCX)

Tucows Inc. (NYSEMKT:TCX)

Q2 2012 Earnings Call

August 13, 2012 5:00 p.m. ET

Executives

Elliott Noss – President, CEO

Michael Cooperman – CFO

Analysts

Rami Nasser - BMO Capital Markets

Jim Kennedy - Marathon Capital Management

Aaron Fuchs - Fertilemind Capital

Operator

Good afternoon ladies and gentlemen. Welcome to Tucows second quarter 2012 conference call. Earlier this afternoon Tucows issued a news release reporting its financial results for the second quarter. That news release and the financial statements are available on the company's website at tucowsinc.com under the investors heading.

Please note that today's call is being broadcast live over the internet and will be archived for replay both by telephone and via the internet beginning approximately 1 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. These risk factors are described in detail in the company's documents filed with the SEC. Specifically, the most recent reports on Form 10-K and Form 10-Q. The company urges you to read its security filings for a full description of the risk factors applicable for its business.

I would now like to turn the call over to Tucows’ President and Chief Executive Officer, Mr. Elliot Noss. Please go ahead Mr. Noss.

Elliott Noss

Thank you, operator. With me is Michael Cooperman, our Chief Financial Officer. For our usual format, I'll begin today’s call with a brief overview of the financial and operational highlights for the quarter. Mike will then review our financial results in detail. Then I will return with some concluding comments before opening the call up to questions.

The second quarter once again shows the growth, consistency and leverage in our business. We continued to see meaningful growth across each of our service categories, with overall revenue for the quarter increasing 22% year over year to $28.2 million, our ninth consecutive quarter of revenue growth.

We continued to generate cash flow from operations with in Q2 we used to repurchase additional shares and to take advantage of the new generic top level domain opportunity that I have discussed on past calls. I will now review the highlights for each of the three components of our business: wholesale, retail and portfolio.

Wholesale which I will remind you includes our OpenSRS domain service and other value added services had another solid quarter. Domain service transactions were up 12% compared with Q2 of last year to more than 2.3 million and domain service revenue was up 19%.

Renewal registrations grew a very healthy 27% year over year. New registrations were more or less unchanged from Q2 last year. However I will note that growth was held down by two factors. First, several large resellers launched one-time promotions in Q2 last year. And second, one large reseller this year was acquired by one of our registrar customers who shifted their registrations on to their accreditation on our platform.

Outside of these events, new registrations grew 16% year over year. Transfers-in were up 28% after factoring other large one-time bulk transfer-in during Q2 of last year. Renewal rates remained above the industry average and have increased slightly to 75%.

Total domains under management at the end of the quarter were 13.9 million, up 24% from the end of Q2 last year and up 15% from the end of the first quarter of this year. The jump from Q1 was primarily the result of the acquisition of a reseller by one of our customers who then shifted new registrations to its accreditation on our platform. Q2 was also another good quarter for our domain name expiry stream which saw revenue more than doubled from the second quarter of last year.

Our retail business which includes Hover and Ting continued a strong performance in Q2. I will note the Ting revenue is still dominated by zero margin or low margin device sales, and accordingly, we will talk about Hover and Ting separately when talking about retail.

Hover revenue grew 28% year over year and 7% sequentially, and we continued our trend of strong customer growth. New transactions which include new domains, transfers and email account grew 29% year over year and renewals grew 14% year over year. Renewal rates ticked up slightly from an already high level as a result of our great customer service and customer experience. Transfers-in remained strong in Q2 growing 34% year over year with transfers-in exceeding transfers-out by a ratio of 5 to 1 which is an incredible performance in this competitive space.

Ting is the other component of retail services. Q2 was the first full quarter of operations for Ting. As of the end of June, Ting has been in the market for over four months and things continued to go quite well. We were extremely pleased with the way of the services being received both by customers and by the broader technology, telecom and mobile communities. We’ve clearly been identified as a thought leader in the MVNO space.

Most importantly, customers are saving even more money than we anticipated, and we are thrilled with the customer experience. Again, I pointed to the Ting Facebook page and the Ting blog. If you are interested in following Ting’s progress, those are the two best places to understand the amazing level of customer engagement we are seeing.

We are also pleased with the early performance. On last quarter’s call, I shared that gross margins for Ting were expected to be in the 30% to 50% range. And our objective for 2012 was to see Ting exit the year on a run rate that would have at or approaching Tucows’ second largest service.

I am pleased to report that we are well on track in both of this respect. It would have tightened the gross margin range to 35% to 45% which is right about where we liked it to be. With that, that we now have enough operating history to say that we believe each account will contribute in the range of $120 to $180 per year before customer acquisition costs which are one-time costs. We remind you that we view an account as a person while our competitors view an account as a device.

Finally, we have enough operating history and customer traction to be comfortable saying that we expect Ting to make a meaningful contribution to Tucows’ evident growth in 2013.

Moving now to portfolio, which as a reminder includes the resale of names from our domain names portfolio and advertising revenue from those names, as well as our two advertising supported websites. Q2 portfolio revenue increased 19% compared to last year. It was another very solid quarter for individual domain sales which were up more than 40% from Q2 last year and exceeded the 1 million mark for the third consecutive quarter.

Average selling price was up 25% versus Q2 last year and sales of gems remained strong. During the quarter, we undertook two new marketing initiatives to support our inventory sales. In the first we developed the means by which to package some of our brandable domains to sell in bulk to targeted buyers. We completed three large sales during the quarter and another one subsequent to quarter end. We are continuing to mine our inventory for other such opportunities.

In the second, we developed an efficient way to categorize the more than 40,000 brandable and gem domains in our portfolio. Previously if someone wants to see our list of wedding related domains for example, it was an arduous time consuming process based on keyword searches, and some relevant domains would still be missed. Now we can address such request in a matter of minutes.

In summary, Q2 was another solid quarter for Tucows. Wholesale continues to benefit from new service introductions and customer wins. Retail continues to grow as a result of our relentless focus on customer experience and our portfolio is providing predictable revenue streams with strong inventory sales. All of that adds up to the consistency and reliability in our results as we continue to deliver steady and improving 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 second quarter of 2012 grew by $5.1 million or 22% to a record $28.2 million, from $23 million for the same quarter of last year. Cost of revenues before network costs was $20.1 million, an increase of $3.9 million, or 24%, from $16.2 million. Gross margin before network costs increased $1.2 million or 18% to $8 million from $6.8 million for the same quarter of 2011. As a percentage of net revenue, gross margin before network costs was down slightly to 29% from 30%.

Before reviewing the gross margin for each of our businesses, I would remind you that last quarter we began breaking out our gross margin performance into three service categories: wholesale, retail and portfolio. This was done to better reflect the manner in which our revenue streams are generated and assessed internally.

I will start with wholesale services. Wholesale services includes domain and other value added services provision through OpenSRS as well as the sale of the domain names and advertising from the OpenSRS domain expiry stream. Gross margin for wholesale services for Q2 increased by $890,000 or 18%, to $5.7 million from 4.8 million. As a percentage of revenue, gross margin from wholesale services was unchanged from the second quarter last year at just under 24%.

Gross margin for the domain services component of wholesale increased by $540,000 or 17% to $3.7 million. The increase is the result of several factors, most notably the higher transaction volumes from existing customers and the contribution of the EPAG acquisition that we completed during the third quarter of last year.

Gross margins for the other value-added services component of wholesale increased $350,000 or 21% to $2.1 million from $1.7 million. The increase primarily reflects the improved results we have been achieving through our relationship with our current Expiry Stream partner that we migrated to at the end of the second quarter of last year.

Gross margin from retail services which is primarily composed of services we sold through our Hover websites, increased $82,000 or 10% to $940,000 from $860,000. The increase is the result of the continued success of the initiatives we have undertaken to attract new customers and to retain existing ones. I will note that gross margin growth has been negatively impacted by the effect that the sale of Ting phones has on our margins as a result of our decision to sell Ting phones at or slightly below the cost.

As a percentage of revenue, retail services gross margin was 41% compared with 67% for the second quarter of last year with the decline again being the result of the sale of Ting phones at or slightly below cost.

Gross margin from our portfolio revenue stream increased $240,000 or 21% to $1.4 million from $1.1 million. This increase primarily reflects the impact of the sale of domain names from our portfolio which totaled $1.1 million for the second quarter compared to $770,000 for the second quarter of last year. On a percentage basis, gross margin for the portfolio revenue stream was 87%, up from 85% for the second quarter of last year.

Turning to costs, network expenses for the second quarter of 2012 decreased $30,000 or 3% to $1.4 million from $1.5 million primarily the result of the efficiencies we have realized in operating and managing our co-location facilities, as well as the lower capital expenditures we required for network equipment.

Total operating expenses were $5.6 million, up $915,000 from $4.7 million for the same quarter of last year. The increase was predominantly the result of the impact of our incurring a loss on foreign currency contracts of $384,000 during the quarter compared to a again of $117,000 for the second quarter of last year. In addition, the incremental workforce costs of approximately $250,000 and an increase in marketing spend of $100,000 contributed to the increase. As a percentage of revenue, total operating expenses was relatively unchanged from the second quarter of last year at 20%.

Net income for the second quarter of 2012 was $696,000 or $0.02 per share, compared with $566,000 or $0.01 per share for the second quarter of last year. Cash and cash equivalents at the end of the quarter were $4.5 million, up $163,000 from $4.3 million at the end of the same quarter a year ago and down $1.9 million from the end of the first quarter of this year.

Cash flow generated by operating activities during the second quarter of this year was $4000 compared with $825,000 from the same quarter of last year. Cash flow generated by operating activities during the quarter was impacted by our investing a total of $1.1 million for applications to create and operate the registries of six gTLDs under the new gTLD program that Elliott discussed in the past.

We subsequently decided to withdraw two of our applications and still have four undergoing the evaluation process. Under the terms of the new gTLD program, we will receive a refund of $370,000 for the two withdrawn applications. It was used $1.6 million in cash during the quarter to fund the repurchase of 1.1 million of our shares under our normal course issuer bid.

In addition, during the quarter we invested $175,000 on equipment purchases and made capital repayments of $312,000 on our bank facility. At the end of the quarter, we had an outstanding balance under our bank facilities of $4 million.

Deferred revenue at the end of the second quarter of this year was $74.5 million, an increase of 12% from $66.8 million at the end of the second quarter of last year and up 2% from the end of the first quarter of this year.

In summary, the second quarter was another solid quarter financially with our results once again indicative of our ability to generate growth, the consistency and reliability of our business, as well as the leverage that is inherent in our business model.

And with that, I would now like to turn the call back over to Elliot. Elliot?

Elliott Noss

Thanks Mike. On last quarter’s call I noted that the deadline for applications to create and operate registries under the new generic top level domain program have been extended but the no firm date was set. That deadline was eventually set and the applicants and applied for gTLD stings were revealed on June 13.

Program itself was a huge success with a total of 1930 applications submitted. It is now public that we have applications for four new gTLDs, dot group, dot marketing, dot media and dot online, all have contention. Meaning at least one other applicant did it (ph).

Our strategy is to launch these and upgrade top level domains. That strategy is laid in our application which you can view online at gtldresult.icann.org. Our goal is to take an operating position in all of these top level domains, either by ourselves or with partners.

In terms of timing, there was now a process of a numbers of months to evaluate applications and resolve contention. We expect the next milestone to be the ICANN meeting in October which conveniently for us happens to be in Toronto. I expect to be able to tell you more about the contention process on the conference call.

I have been very conservative in setting investors’ expectation around the contribution of the new top level domains. What I have said until now is not to expect any revenue until 2013 the earliest. I would now push that back even further, and I would say do not expect any revenue until the second half of 2013 and I would not at all be surprised that extended into 2014. That’s true whether I am talking about our applications to run our registry ourselves, the four that I have talked about, or any benefits we will receive by being a registrar, and as any of you who listened to the calls regularly know I believe the greatest benefit of the new gTLD program to Tucows will be in our role as registrar where we have the best wholesale distribution channel in the world, and one of the two best distribution partners for gTLDs in the world.

Finally, as Mike mentioned a couple of moments ago, during the quarter we continued to be active with respect to buying back our shares under our current open market program. During the quarter we repurchased just over 1.1 million shares at an average price of $1.43 per share for a total of nearly $1.6 million. The shares we purchased represents a 2% of shares outstanding at the beginning of the quarter. When added to the modified Dutch auction tender that we completed in January, to date in 2012 we have repurchased a total of 8.7 million shares or 16% of shares outstanding since the end of last year. And since our first Dutch tender in 2007, we have now purchased a total of 31.9 million shares or 42% of shares outstanding at the end of 2006.

We continue to see the stock as value and remain committed to our stated objective to return capital to shareholders. We will continue to weigh our investments in our shares against other uses of capital while taking advantage of opportunities afforded by the monetization of our off-balance sheet assets as I have talked about in the past.

Growth in the existing businesses continues to accelerate. Ting is very much on track and represents a significant opportunity for the company. We continue to see efficiency in our business and we continue to efficiently use the capital that results. We are in a position where continued focus on execution of both our business plan and our finance strategy will allow us to provide strong returns for shareholders.

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Rami Nasser from BMO Capital Markets.

Rami Nasser - BMO Capital Markets

Hi good afternoon. It’s Rami for Thanos Moschopoulos. So question on the portfolio revenue, it was down slightly quarter over quarter from Q1. Is there a trend there or just the normal seasonality?

Elliott Noss

No, what you are seeing there primarily is we had an especially strong quarter for gems in the first quarter. And gems names that go for over $10,000 a piece, they tend to be able to swing things a little bit. So nothing at all by way of trend there, we are still feeling very good about that business.

Rami Nasser - BMO Capital Markets

And on the retail business it was very strong this quarter, I am guessing Ting had a lot to do with it. What sort of seasonality do you expect for Ting going forward? Is the back to school and the Christmas seasonal will have the uptick and so on or what do you see ---

Elliott Noss

Right. Well do remember when you are looking at the retail results that we have got all that on revenue in there and boy, we love to show that a little separately but that’s just not possible. So it was a strong quarter but you do have to remember the phone. The seasonality question is extremely interesting. We are in our first half year of operations at this point and I have engaged with a bunch of folks in the industry. And the mobile industry tends to have a few different spike. You mentioned a couple of them, certainly back to school, the Christmas season, turns our Father’s Day, little bit around the Valentine’s Day apparently.

But we are marketing very differently. We are doing our marketing as you know primarily through podcasts and social marketing and social media. So we – again in talking this over with a lot of folks in the industry we are not quite sure when those typical spike happen in the industry. If that’s going to be positive, neutral or negative for us, it might be the case that while everybody else is blanketing television with ads, and blanketing buses with billboards, that might take a way of little from us. It also might bring people into the purchase process who will then do a little research and find out about it. So we are really entering our first seasons like that, and we are just kind of going to sit back and learn with everybody else.

Rami Nasser - BMO Capital Markets

Now looking at the Ting website, I have noticed that you added some new phones. Could you comment on the phone inventory, do you think it’s going to go up or stay stable over the next year?

Elliott Noss

So we think that inventory actually might start to tick down a bit, not because phones in inventory will tick down a bit but because we think data in inventory will start to come down enough to narrow that a little bit. And we say that primarily for two reasons. One is just the experience. We are getting better and better in managing the supply chain and at the same time Sprint is getting better and better as a partner especially around wholesale devices.

But another factor there is you are seeing the transition right now at Sprint between WiMAX and LTE phones. And so what that meant was there were a few more phones than usual going end of life and a few more phones that usual coming into the mix which required the inventory on our part to be a little bit spike here. So performance going end of life we knew it was really popular, there was going to be a bit of a gap at that category, we had to over invest a little bit. And similarly we had to play that transition from WiMAX to LTE which meant we had to carry a little bit more inventory than we might usually.

Rami Nasser - BMO Capital Markets

Now my last question is on operating expenses, what’s your outlook for near term operating expenses for Q3 and Q4?

Elliott Noss

We expect things to sort of stay relatively stable. We already talk about trying to keep growth and build gross margin such that it drives about $0.50 on $1 spent in OpEX, we think we are going to comfortably be below that as we go forward. So for the second half of the year things – you won’t see a much of a change there.

Operator

I do have a question in queue from Jim Kennedy from Marathon Capital Management.

Jim Kennedy - Marathon Capital Management

A quick question on the high level domain contention process, although it’s going to be further defined in October, how does it now stand? How are they thinking these things will be resolved? I thought maybe they go to an auction or something. Is there a different pathway so far?

Elliott Noss

The process itself is big. So anybody that we are in contention with, there is a period of time when ICANN is letting all of the parties kind of stare each other in the eye a little bit, see if they can resolve the contention, maybe work together, maybe come to some other arrangement. And at the end of that period, which will probably be a few months to six months, then if there is still contention, then there will be an auction.

So really when I say hey, I will have more to talk about in October after Toronto, that’s because we will be – it will be a second opportunity to sit down with the folks that we are in contention with. Like everybody in Prague, with kind of feeling each other out, there were good discussions there. I think in Toronto, people are going to get little bit more serious about trying to sit down and get down to business.

Jim Kennedy - Marathon Capital Management

So obviously you know who you are contention with.

Elliott Noss

That’s right.

Jim Kennedy - Marathon Capital Management

Public information at this point?

Elliott Noss

Yeah it is.

Jim Kennedy - Marathon Capital Management

Okay. Where would one find that?

Elliott Noss

That – if you go to the url I referenced earlier gtldresult.icann.org, you will find it. If you drop me an email, I will be happy to bounce you a couple of links.

Operator

Your next question comes from the line of Aaron Fuchs from Fertilemind Capital.

Aaron Fuchs - Fertilemind Capital

I was wondering Mike mentioned something that your – capital efficiency where you are not required to buy equipment with as much as horsepower, it sounded like - did I infer that correctly or were you trying to communicate something else?

Michael Cooperman

No I was trying to communicate something else. The issue for us is that we have been able to increase the efficiency with which we are running our operations and our network operating costs and with that, we’ve had to invest quite a bit less money than we have in the past. We are investing in whatever equipment we need and certainly buying all the (indiscernible) we need.

Elliott Noss

By the way lot of those benefits really come from virtualization. Just the gains in utilization are amazing. That’s an industry comment, not a Tucows set of comments.

Aaron Fuchs - Fertilemind Capital

And then on the wholesale channel, is the product that splits build roughly the same or are any of those minor products like search taking off or is there anything we should watch out for – or is it mainly still demand?

Elliott Noss

The mix is pretty much the same. We are seeing a growth across most. So there is no significant breakout in anything there. So the mix is roughly the same.

Aaron Fuchs - Fertilemind Capital

And again related to the channel, and sponsorship of Ting, you had mentioned you saw as a channel, your channel, your resellers would take up Ting. I was wondering if you can give us an update on the actual gross adds, are they coming from your direct marketing to consumers or from the channel or what’s split – any feedback on that?

Elliott Noss

Yeah I think we will start to provide a little bit more color next quarter. We – maybe it was half a quarter that the program was out now. And I think that right now we are kind of working through that first iteration. We’ve had a pretty good sign-up and we are starting to see some contribution but the numbers we are seeing so far are primarily from retail. We are certainly seeing little bit more, little bit more, little bit more, on the wholesale side. But that’s not yet really taking into the numbers.

Operator

And there are no further questions in the queue. Mr. Noss, I will turn the call over to you.

Elliott Noss

Thank you, operator. We look forward to seeing you all next quarter.

Operator

And this concludes today’s conference call. You may now disconnect.

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