Tucows Inc.
Q2 2009 Earnings Call Transcript

Published: 14 Aug 2009

[Operator:]

Welcome to Tucows Inc. second quarter fiscal 2009 conference call. I would like to advise everyone that this conference call is being recorded. I will now turn the call over to James McNally. Please go ahead, James.

[James McNally:]

Good afternoon. Thank you for joining us today. With me is Elliot Noss, our President and Chief Executive Officer, and Michael Cooperman, our Chief Financial Officer. Yesterday Tucows issued a news release reporting our financial results for the second quarter of fiscal 2009. The news release and financial statements are available on our Web site. Please visit tucowsinc.com and click 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 subject 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 Forms 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.

[Elliot Noss:]

Good afternoon and thanks for joining us today. Before we start, I would like to apologize for breaking our normal practice and issuing our results a day before the conference call. I was in Washington, D.C. for HostingCon. It's a very big event for us and there was a reception that was scheduled for Wednesday night at the last moment, where some U.S. government officials were going to be there, as well as the incoming CEO for ICANN. This came up at the last moment and required me to change my plans. I had to travel this morning so we were unable to have our board meeting today, as we had originally planned. But I apologize for that; I apologize for that day lag and we will certainly do everything to see that that doesn't happen again. With that said, I will be begin with a brief overview of our financial performance and some of the operational highlights for the second quarter of 2009, after which Mike will provide a detailed review of our financial results for the quarter. I will return for some concluding comments and to take your questions. Q2 was another solid quarter for Tucows. Revenue, once again, topped $20.0 million, more or less unchanged from the second quarter of last year and from the first quarter of this year. I note that the second quarter of last year included revenue from both the Web hosting customer portfolios and the first quarter of this year included close to $1.0 million generated by a one-time domain portfolio transaction. We generated cash flow from operations of $2.6 million, driven by revenue growth, continued solid cost control, and low capital expenditures, as we are now clearly benefitting from the investments we've made over the previous couple of years. We are especially pleased with our performance in the context of a quarter in which the majority of public companies are reporting financial results that are weaker, and often much weaker, than last year. On our last call, in early May, we flagged the first indications of market weakness in the Internet services space and we saw that trend continue through the remainder of the second quarter. While we did feel some of the effect of this weakness during the quarter, the impact on our business was offset by a stronger competitive performance, all of which netted out to overall solid financial results. Operationally, the overall business continues to perform well. Let me walk through some of the highlights for the second quarter. Our open SRS domain service saw continued growth in domain registrations in both the new and renewable basis. New registrations grew 10% compared to the second quarter of last year, while renewals were up approximately 15%. While we are always very conservative in projecting our gross margin, to continually tick slightly down to this very competitive market, we did see the margins pretty much hold during the second quarter with overall transactions up 12% and billed gross margin up 11%. We think this is strong competitive performance, especially given the weakness that is starting to creep into the industry. This strong performance contributed to very healthy year-over-year growth in domains under management of 14% to roughly 8.0 million. In our open SRS email service we are starting to close a few deals. It's a tough environment but we've now been at it with our new platform for almost a year and we believe that the reliability of our new platform this year has given us more credibility with prospective customers, and those customers are no longer concerned about trusting their emails with a new and unproven platform. And remember, our customers are quite savvy and like to look under the hood. In our YummyNames domain portfolio business, we completed one large portfolio transaction sale during the second quarter, with another following subsequent to quarter end. Both transactions were comfortably in the six-figure range. In general, as you all know, we've been working towards providing some more consistency here and we're typically going to see one such deal per quarter with additional deals being an added bonus. Advertising revenue from YummyNames decreased, in part because our success with the sale of domain name portfolios has decreased the number of direct navigation domains we have. We note also that syndicated search-based advertising continues to suffer for the same reasons that I've discussed on past calls. We continue to identify and execute on opportunities to further optimize parking revenue and as this business unit continues to evolve, we are also testing and evaluating alternative monetization options for the portfolio. Our switch to a new expired domain auction partner last quarter continues to be a steady source of revenue with more domains selling at a higher average selling price than in the past. Our great focus, and we believe the greatest long-term opportunity for YummyNames, continues to be in the sale of brandable names. Our efforts there continue to be encouraging with strong growth both quarter-on-quarter and year-on-year and now that we have the other pieces in the YummyNames businesses—direct navigation, direct navigation sales, parking, and auctions—well at hand, this is where the bulk of our attention will go. On our last call I talked at length about the re-launches of Butterscotch and Hover and how these businesses fit into the company. Each of these units performed well in the second quarter and in both cases we saw the types of positive indications that you like to see with new business directions. In summary, the second quarter, like the first, was a good solid quarter. Operationally, we are executing well and we are winning business from our competitors. We continue to add large customers and are making good progress on redesigning open SRS to be a success with even the smallest of service providers. Our costs are well under control and we are seeing the benefits from the work we have done over the past couple of years on operational and capital expenditures. I talked previously about 2009 looking a lot more like 2007 than 2008 from a cash flow from operations perspective and the first half of the year has proven that out. And I note that in terms of free cash flow we expect capex to come in at less than half that of 2007. I would now like to turn the call over to Mike to walk through our financial results in detail.

[Michael Cooperman:]

Net revenue for the second quarter of fiscal 2009 was $20.0 million, in line with revenue for the second quarter of last year of $20.5 million and revenue for the first quarter of this year of $20.1 million. In comparing revenue across quarters, I would note that both the second quarter last year and the first quarter this year included larger than usual portfolio domain name sales in the $1.0 million range. In addition, revenue for the second quarter of last year included roughly $400,000 from the Web hosting assets that we have since sold, and email services revenue declined by some $700,000 we paid to the quarter last year for the reasons that we have discussed at length on previous calls. These decreased in revenue were largely offset by higher revenue from domain registration, driven by a combination of factors, most important being higher transaction volumes and the impact of the 7% registry price increase from last October. Cost of revenues before network costs for the second quarter increased by just under 14%, or $1.6 million, to $13.2 million from $11.7 million for the same quarter of last year. This increase was also primarily the result of the 7% registry price increase that was levied by some of our domain name suppliers last year. I would again remind you that ICANN has given the registries the right to levy two additional price increases of up to 7% in two of the next four years. Network costs for the second quarter decreased by $1.2 million, or 42%, $1.7 million from $2.9 million for the second quarter of last year. The decrease is primarily the result of lower colocation costs spinning from the closure and relocation of our U.S.-based colocation facilities following the successful completion of the email migration at the end of last summer. In addition, the decrease is also the result of the restructuring we implemented last November as well as the decline of $330,000 in network depreciation costs, primarily due to our retiring most of the older hardware used at our closed colocation facilities. Gross margin for the second quarter decreased to 16% from 29% for the same quarter of last year. The decline is primarily the result of a shift in sales mix from higher-margin services such as domain name sales, domain registrations services, as well as the impact of the 7% registry price increase I mentioned earlier. The decrease in gross margins was partially offset by the decrease in network costs that I mentioned a moment ago. I will now review gross margins for each of our service categories. You will note that as of this quarter we have realigned the way we present our service categories. Elliott will discuss the rationale for this in a few minutes. I would also direct you to our financial results new release which contains a complete breakdown of revenue and cost of sales for each of these categories. Gross margin for open SRS services, which includes domain services, email services, and other wholesale services, was $4.2 million, or 25% of net sales, compared to $5.1 million, or 32% of net sales. Breaking this down into key components, gross margin from domain services, which we in the past have referred to as traditional domain registration services, was $2.8 million, basically unchanged from the second quarter of fiscal 2008. As a percentage of domain service revenue, gross margin decreased to 19% from 21%. The decrease in gross margin percentage was essentially the result of the shifting our sales mix to higher volume, lower-priced customers from higher-priced, lower volume customers and the impact of the 7% registry price increase discussed earlier. Steps we continue to take to fortify our already strong competitive position in the domain services market are continuing to have their intended effect as we continue to achieve growth in new registrations and domains under management in the context of an overall weaker market. Gross margin from email services decreased $721,000 from $1.6 million for the second quarter of last year. This decline, which was expected and which we have discussed at length in the past, is due to two factors

[Elliot Noss:]

As you may have noticed, this quarter we changed the way in which we break out the various components of our business in our disclosure. We have always endeavored to have our public disclosure mirror the way that we look at and operate the business on a day-to-day basis so that investors are hearing a message that is consistent with what customers and other stakeholders are hearing. Over the last 12 months we started to operate the business much more along the line of business units. To be clear, this is not segment accounting. We still have a lot of shared expenses, but operationally we have been able to bring additional focus and create better execution by using more of a business unit paradigm and we're seeing the benefits of this in our performance. There are three reasons for the change

[Operator:]

(Operator Instructions) Your first question comes from David Shore - Research Capital Corp.

[David Shore:]

Could you just remind me on the promissory note, how much is left and when that's due.

[Michael Cooperman:]

Do you mean on the loan?

[David Shore:]

Yes.

[Michael Cooperman:]

On the loan there is $4.2 million due at the end of June.

[Elliot Noss:]

By the end of June of next year.

[David Shore:]

June 2010.

[Michael Cooperman:]

The loan is payable back at roughly $0.5 million a quarter and there is an obligation to do a cash sweep once a year based on our financials and we estimate that the cash sweep for 2009 will be in the $1.2 million range.

[David Shore:]

The G&A expenses as a percent of revenue had dropped this quarter. Do you see that as the level going forward?

[Michael Cooperman:]

Now, remember that G&A is the line item where we do deal with the impact of foreign exchange and it is impacted by that on a quarterly basis so there is no way that I can really predict which direction that will take. Absent that caveat, we think it will be pretty static.

[David Shore:]

Taxes. Where do you stand as far as when you'll be paying taxes?

[Michael Cooperman:]

We are in a taxable position now and have already started providing for current taxes. We have estimated that our effective tax rate for 2009 will be roughly 14% and have been accruing taxes at that rate. And we will obviously start paying taxes this year.

[David Shore:]

And capex plans for the rest of this year, what would that look like?

[Elliot Noss:]

We've talked about the year coming in in the kind of $1.5 million to $2.0 million and we're really comfortable with that. There's a quick note on G&A. It's really kind of a level of G&A that's going to remain pretty consistent so as the business continues to grow, we've always talked there being leverage in the business. You know that percentage should tick down slightly as we go forward.

[Operator:]

Your next question comes from Thanos Moschopoulos – BMO Capital Markets.

[Thanos Moschopoulos:]

I missed a bit of the opening remarks, I apologize if this was covered, but Elliot, you mentioned last call that the economy might start to have an impact on some of your business, especially the domain name registration business. It didn't look like it from the numbers. Can you comment as to what effect you're seeing, if any, from the economy?

[Elliot Noss:]

We're seeing what I would call a continual slight downward drift. And I'm glad to bring a little more color to that. So we definitely see broadly all kinds of weak macro factors, just like everybody does. And the way it seems to be kind of manifesting itself in domain registration is that a market level, you know, slightly less new registrations than we would expect, slightly less renewals than we would expect. And again, that's kind of an industry piece. We think we've been at least sort of covering whatever softness there is with kind of good competitive wins and competitive strength. So when you say you didn't see it in the numbers, that's because we're doing fairly well competitively. That's kind of picking up for some of that weakness, but we definitely do see that weakness there.

[Thanos Moschopoulos:]

And I think you said you feel good about where you are as far as gaining market share. Do you have any quantitative metrics as far as where your share ranks or is that just really hard to put together, given a lot of the lack of disclosure on some of the numbers out there?

[Elliot Noss:]

Well, it's not the lack of disclosure. As you know, all of the sort of public materials that are out there. You know, the zone file is public and there are a couple of Web sites that track.

[Thanos Moschopoulos:]

I guess some of the things like are people registering on behalf of their own account or the customers.

[Elliot Noss:]

And while that may or may not be less prevalent, it's getting more complicated. As you've watched this industry, domain registration, for years now. It never stops evolving. And so it's, well the absolute level of some of those kind of registrations that we don't really consider from a market share perspective may have slightly gone down, being able to tell what's what has gotten more complicated.

[Thanos Moschopoulos:]

In the G&A line, what would the foreign exchange translation gain or loss have been?

[Michael Cooperman:]

Around $300,000 in the quarter.

[Thanos Moschopoulos:]

And was that a gain or loss?

[Michael Cooperman:]

That was a loss.

[Thanos Moschopoulos:]

As far as the email business, has it reached an inflection point, at some point? Or how do we think about that going forward? I guess there's still a bit more downside to come when the large customer finally meets the transition?

[Elliot Noss:]

Yes. I would say once that large customer is gone, the numbers are just up from there. We are very solid with all of our existing customer base. Very low concentration. And we are starting to see some rays of sunshine on the sales side. And by the way, I should note, that on the kind of pure anti-spam side, we also offer the anti-spam service separately, there was another existing competitor that got bought, AmexLogic got bought by I think it was MacAfee this quarter, and those situations always tend to help us because they will generally be a little more enterprise focused. And it tends to make it a little bit easier in the service provider sector. We think there are some good opportunities going forward.

[Thanos Moschopoulos:]

As far as the ongoing ramp of the premium domain business, what can really help drive that going forward? Is it more function of the access to capital returning or is it sort of the ad market getting better, or a bit of both? What would really drive some good growth there?

[Elliot Noss:]

Well, I've identified three things. I would take access to capital and kind of the ad market returning, in this business, as one. That's the same thing. Because as that ad business returns, the typical buyers of certainly the direct navigation portfolios, you know, that's their source of capital. I think that the days of large pools of private equity money, what we saw some of in 2007, not coming back. But there's still lots of action. So point one would certainly be that ad market coming back. I think the second point is we see just now at a market level a little more efficiency, a little more efficiency every quarter. You know, the services, some of these multiple-listing type services, they get a little bit more mature. It's the case that the segment of the market that we like to really pay attention to. Small- to medium-size businesses buying domain names to run a business or Web site on, again, we think that's the best long-term opportunity. There's always a few more and a few more of them every quarter. That's just efficiency coming to the overall market. And I think the third thing is really just time. Every quarter that YummyNames business get a little better, gets a little tighter, is able to move on to the next level of opportunity. You know one of the things that we will hopefully start to do very soon is take our brandable name portfolio and be listing those in some of these multiple-listing service type offerings. And that should immediately provide a lot more exposure for the portfolio. Each quarter you will see that efficiency, whether the market level, and then for YummyNames in particular, getting a little bit better. And the thing the Internet is most magical at is bringing efficiency to inefficient markets. And I think we see that. Always taking one step forward and another step forward as it relates to secondary market for domain names.

[Thanos Moschopoulos:]

As far as your investment in new names just from the expirations, has that changed a lot from quarter to quarter or is it sort a steady state or a bit of a ramp as your registrations ramp. What's that been like?

[Elliot Noss:]

What we're adding to our brandable names portfolio tends to be fairly consistent and it does tick up with the size of our customer base. But you're going to see that very slowly because if the size of our names under management grows 8% to 10% a year, that's not going to be very perceptible. Remember that we're still adding to our portfolio vastly in excess of our ability to sell it. So the most important variable for our financial results for at least the next couple of years is going to be our ability to generate higher and higher levels of inventory turn.

[Thanos Moschopoulos:]

You alluded to this in the prepared remarks. I think I missed some of it. Can you just clarify again what the impact is of the increased registry fee. Did that affect the margin in the domain registration business?

[Michael Cooperman:]

We recognize that the registry fee increase would be a challenging item for people going forward and we actually moved, if you remember, our cost plus model so that we would keep our fee consistent in spite of the registry increases. But obviously when we report revenue, we report revenue which includes that registry fee component and as that goes up obviously it affects the margin.

[Thanos Moschopoulos:]

So for the most part, the customers haven't moved o the cost plus model.

[Elliot Noss:]

They have but the way that it sits in the numbers, if our margin, if our dollars are staying the same and the registry and ICANN portion of it is going up, then the percentage is going to change. Two things about that. One, they have, and I believe it's now baked, but there will not be an increase this year. There is something that is quite interesting that we're starting to see for the first time in I don't know how long. Maybe since the onset of competition. But some of the very large retailers have actually started to tick up in price. There's been one or two price increases that we've seen out in the marketplace. And whether that's test, whether that's chasing growth, we don't know. Whether it's successful or not we don't know, but it certainly doesn't hurt us. And more importantly, our customers reaching out to end users competitive position.

[Operator:]

Your next question comes from Aram Fuchs – Fertilemind Capital.

[Aram Fuchs:]

I was wondering if you could give us a little more data on Hover and the popularity of that. Specifically, can you quantify the renewal rate that you're getting from your previous retail customers, like an IYD customer? What is the likelihood that they are renewing compared to what they are renewing on IYD side?

[Elliot Noss:]

We're not breaking that out. It's a tough number to sort through for a couple of reasons. There are some IYD customers in particular who were at extremely low prices, prices that frankly, it was business, and you know we work at pretty slim margins there. It was business that we weren't really interested in supporting. So we started really, it was kind of June or so, certainly July and the current month, where we're starting to see what we call a clean set of numbers. So we're not breaking anything out right now. What I'll tell you is that we were certainly pleased with, as it got cleaned up, June was decidedly better than April and May were, and that was really just the tail end of working through the transition. And finding out who was going to stick around and who wasn't.

[Aram Fuchs:]

So you're saying for Q3 you could have a clean number?

[Elliot Noss:]

Yes, we're able to—when I say clean number, we have now kind of a place where we're very comfortable starting from to say here's what we want to improve from.

[Aram Fuchs:]

On Butterscotch, can you give us a little more detail on the operations there and maybe if you can give us a breakdown on the revenue there between the old Tucows download site and the revenue that you're getting from the new ad model on Butterscotch.

[Elliot Noss:]

There are two comments I'll make there. First, it will be probably for the next three or four quarters anyway that the revenue is overwhelmingly coming from the old Tucows site, from the existing revenue streams. Over time, and I know you're somebody who will always poke around, I'm sure you've seen, deeper integration, and for instance, we added on the Butterscotch side a freeware search tab. That has an immediate plausitive impact in traffic. Now that's content that's coming from the Tucows side that's driven from Butterscotch. So the egg kind of gets more and more scrambled. But what I would call unique new revenue opportunities from the video efforts, we're really just getting at that. We're very positively encouraged by the business we're starting to write there and by the level of interest but it's going to be three or four quarters before you're really going to start seeing that be a meaningful part of that total content pie. The old Tucows site was still very large and still generated real money. And there's one more point I would want to make about both Hover and Butterscotch. You know, I talked lots about them sort of strategically and how they fit in last quarter. Over the next quarter or two we're going to be figuring out what operating metrics make the best sense there and I will help you to follow along, but we're not there yet. I should note that we're really encouraged by the traffic growth on the Butterscotch side. People are really taking to the content. Very positively received and both page views and video views, both on the site and syndicated continue to go up very nicely.

[Aram Fuchs:]

And on the YummyNames business, that sale as you quoted as comfortably into six figures, was that brandable or was that a direct nav?

[Elliot Noss:]

That was direct nav. And I don't mind giving you a little bit more color on that. You know we've been striving for the last couple of years, really since we started selling those direct nav portfolios, to bring more consistency to it and I talked a couple of quarters ago about where we think we are finally bringing some consistency to it. And so there you should see at least a transaction a quarter. That's pretty established now. And that will be in the low- to mid-six figures. Then on top of that there will be once or twice a year an additional transaction that could have a whole range. Now, purely on the direct nav side I'm talking there. If somebody wants to come along and be very, very aggressive and one-off again, that's possible, but not as likely as it was in the past where there was the $3.0 million and the $1.0 million and the $1.0 million transactions. But we think we've been successful bringing a lot more consistency to that.

[Aram Fuchs:]

And on the gems category, there's a really big sale this quarter, candy.com. I was surprised in this economic environment. Can you talk about your gems there and talk about the art of pricing those.

[Elliot Noss:]

It is art, not science. I don't think we have a name in our portfolio that I would quite put in the category of candy.com. And I will give you a great example. You know, candy, single word, generic. You could see a similar single word or generic verb—read, write, talk, walk. Talk might be a bad example because it does brand well. Read, write, walk, things like that where you might see a transaction in the mid-to-high five figures. So there is a big discrepancy. You know, if you're mars or one of the world leading candy companies, there really is a nearly incalculable level of value in that and so there is no right price. If you want to get it, you've got to go out and get it. And I don't know if you saw some of those interesting acronyms, the OMG.com sale for instance. So it's really very difficult. I can tell you, when we're going to be sitting down soon for the 2010 budget, we're not going to really think about gems as part of that. Brandables, on the other hand, that's where we're really paying a lot of attention, putting a lot of effort in.

[Aram Fuchs:]

On Hover.com you have the ability to allow the person to sell their personal names but you're not selling your, nor is there any way to even find out about the brandable or the gems.

[Elliot Noss:]

Right.

[Aram Fuchs:]

Are you worried that that might be short-sighted?

[Elliot Noss:]

First of all, inside the Hover experience I think there's a few points I would want to make. The first is, we really want to keep that extremely clean. And the second point I would make there is we're iterating all the time. And I think that you're a customer, if I'm not mistaken, and you will see constant changes there. And the third point I would want to make is that we think that the best short-term opportunity there is around personal names into the large percentage of existing Hover customers who don't have a personal names offering right now. And we just literally, in the last few days, started our first test campaign there, where we plan on just getting better and better at marketing that personal names product. And we think that there's great lessons that we can learn in there and roll back out to the wholesale channel. You know, I think down the road, when we kind of mine some of what we think are these richer veins, I would expect that you will see premium names as part of the Hover experience.

[Operator:]

There are no further questions in the queue.

[Elliot Noss:]

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

[Operator:]

This concludes today’s conference call.