Tucows Inc (TCX) 2008 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen. Welcome to Tucows Inc. second quarter 2008 conference call. I would like to remind everyone that this conference call is being recorded. Now I would like to turn the conference over to Ken Schafer. Please go ahead sir.

Good afternoon operator, and everyone on the call. Thank you for joining us today. With me is Elliot Noss, our President and Chief Executive Officer, and Michael Cooperman, our Chief Financial Officer.

Earlier this afternoon Tucows issued a news release reporting our results for the second quarter of fiscal 2008. The news release and other information are available on our website at TucowsInc.com.

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 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.

Good afternoon and thanks for joining us today. On today's call I will provide an overview of our business during our second quarter ended June 30, 2008. Mike will then review the financial results, before returning the call to me for a discussion of our growth opportunities.

Our results for Q2 were on plan and position us to achieve year-over-year growth in revenue, profitability and cash flow in 2008. We have a number of new initiatives in place to help us achieve these goals. And we look forward to recognizing the benefits of the hard work we have done and continue to do.

This quarter's results were driven by our core business, which despite the price cut implemented last August, achieved revenue growth of 8% over the second quarter of last year, the results of increases in both new and renewal registrations.

Other major highlight was the finalization of our email migration, which now begins to provide material cost savings, as well as greater reliability and operating simplicity.

I would now like to review our progress by revenue source. First, looking at the domain registration business in a little more detail. We are encouraged by the continuation of a number of favorable trends during the second quarter. Again, we saw increased transaction volumes, a clear indication that the change in pricing of last August is having its intended effects. Renewal transactions are up. New domain transactions are up. And we have a significantly higher level of increased interest from new customers.

Increases across all of the metrics we track are obviously positive signs for our core business. There is always price pressure in this segment, but with transactions growing faster than we had expected, it bodes well for our ability to cross-sell and upsell to email, personal names and premium names.

I will also note that starting next quarter the year-on-year comparisons will start to look much better, due to the fact that the price decrease was last August, and Q3 will be the first quarter where we start to see some of those effects washed through.

Second, our email business. There are four things of positive note this quarter. Before I talk about the positives, I would be remiss if I didn't note that second quarter revenue for the email business was relatively flat compared to last quarter.

This is primarily the result of continuing to work through the transitions of a number of corporate customers that were still hanging around from the old Critical Path business, and which we have since -- and which have since moved on to suppliers that are probably more appropriate for their needs. We have been replacing these customers as we have attracted service providers whose needs are consistent with our offering.

On to the positives for the quarter. We had our first big competitive win on the new platform, which was all the more satisfying in that it was won through an RFP process. During the process our customer was very aware of the fact, because we were straight about it, that this is a new platform. While the platform has been in use now for some period of time, both internally and with some external customers, it is still a new platform. So a big competitive win through an RFP process is a real positive.

The second positive to note for this quarter is what I will call a competitive save. In the numbers you are not going to see this, but that doesn't diminish its importance. One of our largest customers had frankly become sick and tired of the inconsistencies of the Critical Path platform, and had found an alternate supplier. They had made the decision to leave. They let us know about it. And they, in fact, went as far as to migrate away. However, that migration was such a disaster they had to come back to us, and we quickly migrated them on to our new platform.

At first, we thought this was going to be an interim period, while they attempted to cleanup their problems. But it has turned out to be a permanent situation.

What this and other circumstances have demonstrated to us is that the investment we have made in migrations is really starting to pay off. It was our execution when this customer was in a jam that allowed us to keep the business.

This example also highlights one of the key differentiators of service offering, and that is customer service. Many of the large outsourced email providers like Google, Yahoo and Microsoft, lack the excellent customer service and account management that Tucows has, and that we believe will be a key competitive differentiator.

The third positive for the quarter was that we completed the migration off the old Critical Path system on schedule. Now, not only new customers but all customers are on the new platform. There was a feeling of great satisfaction within Tucows. And we look forward to experiencing some of the significant cost savings that I described in the last call.

Also the case, we are now experiencing much more efficient operations. Those are three significant positives from the quarter in email.

Finally, last quarter, we launched our Personal Names Service, which allows our resellers to offer their customers personal email addresses and websites using the customer's own name. We have a portfolio of over 39,000 surnames. And we believe that this will be one of the stickiest Internet services available, and will help to drive renewal rates and growth amongst our reseller channel, as well as in our retail offering.

On to the domain portfolio line of business, where I will remind you that we own more than 150,000 high-value domain names. Our domain portfolio generates revenue in two ways. The first is direct navigation revenue. The second quarter saw a 40% increase in revenue from our direct navigation names compared to the second quarter last year. However, revenue was down 12% compared to last quarter in direct navigation or parking revenue. This decrease is industrywide, as Google and Yahoo have started to decrease payouts to syndication partners.

The second way we generate revenue from our portfolio of domain names is through the sale of those names. You'll recall that in Q2 of last year we had one unusually large domain name transaction of just over $3 million. In Q2 of this year we had another bundle sale of roughly 3,700 names for a little under $1 million. Outside of those two transactions, revenue from the domain portfolio is up 61% year-over-year, showing the growth we expected.

Additionally, we're starting to see progress as our resellers are adopting our premium name and surname platform as a compelling offering to their customers.

All in all, it is very encouraging that the growth we're looking for from this line of revenue is right on track and is representative of the growth opportunity we see from our domain portfolio.

There has been a downturn over the past year, and especially the past six months, with direct navigation names being pressured by Google and Yahoo paying out smaller revenue shares. In the brandable segment, the underlying demand continued to grow unabated, as its primary driver is the secular trend of advertising moving from off-line to online. This is the segment that we are most focused on long term.

In the retail business we saw strong year-on-year growth. The bulk of which was the result of our IYD acquisition in July of 2007. The hard work in the Retail Group, as discussed last quarter, was in creating a new platform for three distinct brands -- Domain Direct, NetIdentity and IYD Retail, and rolling them into a single new brand, Hover.com.

We invite you to go to Hover.com and see the new retail implementation that we launched in beta earlier today. I will provide more information on this after Mike reviews the financial results.

I will also note that in Q2, as we talked about last quarter, we sold off some of our nonstrategic assets, which in this case was a group of our old hosting customers, to Hostopia for $1.4 million. That transaction is now closed and the bulk of the migration is now completed.

I will now turn the call over to Mike for a detailed review of our financial results.

Our financial results for the second quarter were in line with our expectations as we made further progress in positioning key elements of our business for the future, highlighted by the completion of the customer migration to our new email platform.

While we experienced some of the impact of these initiatives in the second quarter, we expect they will make a more material contribution to our financial results in the second half of this year and in 2009.

Net revenue for the second quarter of fiscal 2008 was $20.5 million compared to $20.8 million for the corresponding quarter of last year. The slight decrease in revenue is primarily the result of the higher revenues from our traditional domain registration and retail services being offset by lower revenues from our email and domain portfolio services.

I will remind you that revenue in the second quarter of last year was unusually high in that it included an atypically large sale of a block of domain names from our portfolio for $3 million.

Cost of revenues, including network costs for the second quarter, increased by 10% to $14.5 million from $13.2 million. And consistent with the first quarter, primarily reflect lower margins following the price reduction on wholesale domain names implemented in August of last year, and the higher registration fees we're paying as a result of the 7% registry price increase in October last year.

These were partially offset by a decrease in network costs that resulted from lower people costs and lower depreciation and amortization.

As Elliot discussed earlier, we have now fully completed the migration of our customers to our new hosted email platform, which will result in a significant reduction in cost in the second half of this year.

Gross margin for the second quarter was 29% compared to 36% in the same quarter last year. The decrease is primarily attributable to a change in sales mix resulting from the atypically large name sale during the second quarter of last year, and to a lesser extent, the lower contribution from the price reduction on wholesale domain registrations we implemented last August. We expect the impact from the price reduction to be lower in the third quarter, as it will have been in place for just under a year.

Looking at gross margin contribution by revenue source, gross margin for traditional domain name registration service for the second quarter decreased to $2.8 million from $3.2 million for the same quarter last year, which we primarily attribute to the price reduction. We are, however, beginning to realize the intended benefits from the price reduction in the form of higher transactional volumes and renewed customer interest, as Elliot described earlier.

Gross margin from domain portfolio services was $1.7 million compared to $3.4 million for the same quarter of last year, largely as a result of the $3 million domain name sale during the second quarter of last year.

Gross margin for e-mail services was $1.6 million compared to $1.7 million for the corresponding quarter of last year. The decrease was the result of the lower revenue in the quarter for the reasons that Elliot described earlier, which were partially offset by lower licensing and royalty costs payable to third-party service providers on our new email platform, as well as the reversal of an estimated migration cost that was lower than anticipated.

Gross margin from retail services increased to $1.5 million from $791,000 for the same quarter last year. Growth in gross margin was primarily attributed to higher sales volume, which were driven by three factors. An increased contribution of $400,000 from the provisioning of personalized emails to our portfolio of surname-based domain names through the NetIdentity website. An increased contribution from Domain Direct of $200,000, after recognizing the $300,000 impact on deferred revenue as a result of the sale of certain hosting customers to hostopia.com Inc in May. And an increased contribution of $100,000 generated by the retail [essence] of IYD, which we acquired subsequent to the end of the second quarter of last year.

Gross margin from other services was $1.3 million compared to $1.4 million for the second quarter of last year. This decrease primarily resulted from a lower contribution in the amount of $170,000 from our content services, as we continue to see reduction in the yield from our syndicated Google feeds and lower advertising revenues through our website.

Total operating expenses for the second quarter increased by 17% to $5.1 million or 25% of net revenue from $4.3 million or 21% of net revenue for the same quarter of last year.

Drilling down a little deeper. For operating expenses, which I would remind you that we define as costs relating to ongoing sales, marketing, development and administrative costs, decreased by $200,000 to $4.8 million from $5 million for the same quarter last year, but remained essentially flat when measured as a percentage of revenue at 24%.

Other operating expenses for the second quarter were $255,000 or 1% of net revenue, compared to other operating income of $657,000 for the second quarter of last year. The difference is primarily the result of the following three factors.

First, is the impact of foreign exchange. As we have discussed on previous calls, a large portion of our costs are in Canadian dollars. During the second quarter we recognized a gain on foreign exchange transactions of $249,000, which includes a gain on the change in the fair value of the forward exchange contracts that was still outstanding at the end of the quarter of $226,000. This compares to a gain on foreign exchange transactions recognized in the second quarter last year of $961,000, which included a gain on the change in the fair value of the forward exchange contracts of $886,000.

Second, amortization increased to $377,000 from $223,000, primarily as a result of the acquisitions we have made. Lastly, during the second quarter of last year we reverse an accrual of $94,000 that we had accrued for certain marketing initiatives that we did not pursue.

Adjusted net income for the second quarter of fiscal 2008 was $1.8 million, compared to $4.7 million for the second quarter of fiscal 2007. Net income for the quarter was $2.2 million or $0.03 per share, compared with net income of $3.2 million or $0.04 per share for the corresponding quarter last year.

Turning to the balance sheet. Cash, cash equivalents and restricted cash at the end of the second quarter was $2.9 million, a decrease of $3.3 million from $6.2 million at the end of the second quarter of last year, and a decrease of $4.6 million from $7.5 million at the end of the first quarter of this year.

It is important to note that we continued to generate strong cash flow from operations during the quarter, and the decrease in our cash position was the result of our paying down $7.5 million of debt.

First, we paid the $6 million promissory note payable to the former shareholders of mailbank.com. Second, we made payments of $1.5 million against our bank credit line, which included an annual cash sweep payment of $1 million.

These payments were funded partially by the $2.6 million of cash flow we generated from operations. In addition, during the quarter we generated an additional $1.4 million through the sale of 14,000 hosting accounts to Hostopia.

I would also note for you that, excluding the use of just over $100,000 in the third quarter of 2006, this quarter marked our 27th consecutive quarter of positive cash flow from operations.

Deferred revenue at the end of the second quarter grew to a record $54.7 million, up 12% from $49 million at the end of the second quarter of last year, and up 2% from $53.6 million at the end of the first quarter of this year. I will note that growth of our deferred revenue balance was somewhat dampened by the loss of $300,000 in deferred revenue as a result of the sale of the hosting accounts to Hostopia.

Over the past few years we have spent a considerable amount of time and effort retooling key elements of our business to allow us to take full advantage of the opportunities afforded us by the scalability of our business model. We believe we have now reached that point where we will begin to realize the financial benefits of all our hard work.

Changes to our pricing model in our traditional domain registration service that we introduced in August last year is resulting in higher transaction volumes and a higher level of interest from new customers.

The recently completed migration to our new email platform allows us to begin pursuing new business with confidence that we are in a position to start realizing the significant reduction in costs that our new platform affords us.

The main portfolio services also continued to show signs of growth. And we are about to launch the rebrand of our aggravated retail services into a market where we believe there is significant opportunity for a quality retail offering.

All of this has positioned us to achieve our objective of growing revenue, cash flow from operations and profitability in 2008, and to create shareholder value over the long term.

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

Now that Mike and I have updated you on the progress of the business, I would like to take a final few minutes to discuss our strategy as to why I believe we are in a better position than we have been at any time in our history.

First, OpenSRS. A couple of weeks ago we relaunched OpenSRS as the name for our wholesale reseller business. We're focusing our OpenSRS team on two simple goals -- win new resellers and increase revenue per reseller.

To achieve these goals we're emphasizing three broad strategies. First, we are reducing the time it takes for a new reseller to start selling our services. This includes improving on our self-serve tools to help new resellers to get signed up and selling faster.

Also, we're developing a hosted storefront for resellers who don't want to invest the development time and resources to undertake a deep technical integration with our systems. The launch of Storefront this fall will allow resellers to go from signup to selling our services in minutes instead of months.

Any reseller looking to us for email demand easy migration from competitors or their own in-house systems. The faster we can get them up and running on our system, the better for us and for the reseller. We have developed and continue to refine our tools to facilitate fast, reliable, low impact data migrations. In fact, our level of service and sophistication is already a competitive advantage.

Second, we are creating new and innovative domain name and email services that ultimately appeal broadly to the resellers' full customer base, and therefore increased reseller ARPU. We're focused on providing choice and flexibility to our resellers to reduce the need or desire for them, and by extension their customers, to look elsewhere.

Internet users are a demanding bunch. They expect their online services to just work. The third point of our strategy is to continue to develop simple, worry-free services that scale as our resellers do, are rock-solid and reliable, and easy to customize.

This extends to our end-user interfaces, which we continue to refine to be simple and easy to use. Outsourcing to us means our resellers are freed from the hassles and costs associated with providing competitive services in-house, helping us gain and retain resellers.

Another component of our growth strategy is to re-energize our Retail Group by more aggressively and directly targeting consumers and small businesses. As noted, this fall we will combine our three current retail services into one service called Hover. With Hover we're trying to present a new way of thinking about retail domain names and email addresses in order to move beyond the Web savvy audience that is the current market for those services.

We feel confident average consumers will want to buy domain names and email addresses if the process is simple enough and the benefit obvious enough. To achieve this, Hover is very much focused on the way people use the Internet today, not how they have used it historically. Service is built from the ground up for ease-of-use and helps people leverage sites like Facebook, Google Maps, Flickr Photos and hundreds of others.

Over the next few months the Retail Group will be concentrated on the launch of Hover, and migration of existing retail customers to the new service. Once that work is complete, we can begin marketing Hover as a unique way to buy, manage and most importantly, use Web and email addresses.

I would note that if you are listening to the call today, you will be the first to hear that you can go now to Beta.Hover.com and try it out for yourself.

Over the past several years we have made major changes to almost all areas of the business. We are just now beginning to see these efforts reflected in the marketplace. We're confident all our hard work maintains our competitive advantage and re-establishes us as one of the most forward-thinking companies in the business.

Our work will contribute positively to our financial performance in the remainder of 2008, and even more meaningfully in 2009 and beyond. At the same time we will continue to seek opportunities to realize value from some of the nonstrategic assets that we have, as we pursue our goal to generate steady growth in revenue, profitability and cash flow from operations, thereby building value for our shareholders.

In closing, I would like to thank our shareholders, resellers, customers, staff and partners for their continued support, which allows us to grow a great business in the rapidly changing environment we all face today.

With that, I will now turn the call over to the operator for questions.

(OPERATOR INSTRUCTIONS). Thanos Moschopoulos, BMO Capital Markets.

Can you just comment on the environment for large bulk sales? Has that remained pretty consistent with what we see in the recent past, despite what is going on with the Google and Yahoo syndication fees and the like?

The Google and Yahoo sort of pressing upstream definitely has an impact on those sales, so it doesn't make the market -- there are just as many participants, but it does have an impact on the multiples.

I think that is one of reasons why we guess, I think uniquely, have always been looking to take a little bit of money off the table as we went along with that asset class.

What I was calling out earlier on the call was the fact that that does have an impact. And from our perspective the fact that we have been more focused strategically on the brandable side, looks like it was the right choice.

Just in terms specifically of your own direct navigation revenue and how that is being affected, where do you think we start to see the bottoming out of this issue with the syndication fees? Because you have been talking about it for a few quarters now. Is there any signs of the trend slowing down or coming to a bottom, or this is ongoing pressure we will see for some time?

I talked about it, I think, last quarter. I don't believe I talked about it two quarters ago. This is the first quarter that you see it in the numbers. I was getting out ahead of it when I was talking about it.

I will also tell you that in terms of where is the bottom -- we have started to see a little bit of a pick up now. So we may have hit the bottom.

There's another point here that I think is important, which is that it is not just that Google and Yahoo have pushed back on the payouts, they have also started to get more aggressive with some of the grayer parts of the market. And long term that affects us positively, because we have got a very clean book of business. So the more bad traffic and bad clicks that are pushed out of the system, the better it is for us in the long term.

Then turning to the e-mail business, now that the migration to the new platform is complete, and you mentioned you are starting to win new business, I think you have commented on this in the past. Should we expect to see sort of a slow and steady gradual ramp, or might it be a bit of a step function as you sign some big customers? Or what should we expect as far as the growth profile of that going forward?

I think there is two things. There is slow and steady, that is the way we focused the ramp. I think that the only -- it is sort of all positive out there, with a small cloud on the horizon around some of the very biggest customers, and some of the competitive threat we do see at the very top end from Google. The longer we are able to fend that off, the more progressive will be the ramp.

I think it is tough to see a step function, because we really don't go after the very, very largest -- you might see one or two or three -- I shouldn't say don't go after. You see one or two or three massive deals a year. That is not where we focus our efforts.

So in a given year we might be lucky enough to win one of those deals that would have a step function up, but that is really not something we're counting on when we build our model.

A question for Mike. Basically the cost structure should remain pretty flat go forward, adjusting for some of the network costs coming off now with the migration complete?

Yes. I think that is a pretty accurate categorization.

So the new retail side being launched, no particular expenses of significance associated with that, beyond what the current runrate is, I guess?

You have seen them already. They are in the numbers. Definitely check it out and let me know what you think.

I have already registered my address. Then on the Tucows site in the past you had mentioned exploring strategic alternatives for that business, any update there?

I think what I would say at this point is we're probably going to be talking about that shortly. I will say that we have looked at the possibility of a transaction. And we have very happily come to the place where we think we've got a new operating strategy that we're all very excited about. But more to follow shortly.

(OPERATOR INSTRUCTIONS). Aram Fuchs, Fertilemind Capital.

I was wondering if you can give us a little more detail on your distribution strategy for the low end brandable names out to your resellers. I understood you were going to go with -- try and work with your top 50. Maybe you can talk about the response and how that is working out.

I think that we're getting positive feedback. You are talking about -- it is both brandable -- remember, both brandable and personal names that we're going out with that.

The feedback has been good. People -- it is very tough to get on people's roadmap in the summer. Get them to kind of lift. But the interest I think has at a minimum met our expectations there.

How is the revenue split? What is the revenue split that you're offering there in terms of retail partners?

There is a 20% agency fee on any transaction through the system. And that is split equally. 10% us, 10% to the Web hosting company or ISP.

When you look at that relative to a typical domain name transaction, it is extremely lucrative. Not only that, but once a customer has bought a premium name, you can be very certain that that is something they're going to use. Making that easy for people really has a lot of knock-on effects too.

(OPERATOR INSTRUCTIONS). Mr. Noss, we have no further questions at this time. Please continue with any closing remarks.

We look forward to speaking to you all again next quarter. Thanks.

Ladies and gentlemen, this concludes our conference for today. Thank you for your participation. You may now disconnect. Have a pleasant day.