Tucows Inc (TCX) 2008 Q3 法說會逐字稿

Good Welcome to Tucows Inc.'s Third Quarter of 2008 Conference Call. I would like to advise everyone that this conference call is being recorded. I will now turn the call over to Leona Hobbs. Please go ahead, Leona.

Thank you, operator. Good afternoon and 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 third quarter of fiscal 2008. The news release and financial statements are available on our website. 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 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.

Thanks, Leona.

Good afternoon and thanks for joining us today. On today's call, I will provide an overview of our business during our third quarter ended September 30, 2008, and the outlook going forward. Mike will then review the financial results before returning the call to me for final comments.

There were a number of highlights during the third quarter. First, I'm pleased to report that we grew revenues 13% over the same quarter of last year. This growth was driven primarily by higher revenue from core domain name registration and a strong performance by our domain portfolio services, now known as Yummy Names, as well as growth in retail services.

Second, we divested the remainder of our non-core hosting assets, which generated just under $1 million in cash.

And third, we signed our first significant Personal Names deal with web.com, through which web.com will offer the OpenSRS Personal Names Service to its extensive network of customers. More on this in a few moments.

There is an event that occurred subsequent to the end of the quarter that I would like to discuss as well. Last week, we sold our stake in Afilias, the global registry services business in which we were founding shareholders in 2000. We sold it back to the company for $7.4 million in an all-cash transaction. We received $3.2 million in November -- on November 7 and are conditionally scheduled to receive the remaining $4.2 million in two equal payments in June and December of 2009. Those last two payments are conditional upon Afilias having sufficient distributable reserves as that concept is defined in Irish law.

As a result of the proceeds generated by this transaction, we have significantly strengthened both the balance sheet and our ability to execute on the share buyback program.

Before going any further, I want to take a minute to address our performance for the year to date and our expectations for the year as a whole.

We have spent much of 2008 focused on strengthening key aspects of our business which we are confident will contribute to long-term growth. While we are benefiting from this -- from these initiatives, a number of unanticipated factors during the year have impacted our financial performance. As I will discuss in a moment, e-mail revenue was weaker than expected, a decline in gross margin from domain registrations was greater than expected, and advertising revenues have been dampened by the weakness in the economy, which has put some downward pressure on domain portfolio advertising revenues, but especially on bulk domain portfolio sales.

While we expect to achieve our guidance of growth in revenue and profitability compared to last year, we no longer expect to achieve the year-over-year growth in cash flow. Further, over the coming quarters, we expect to lose our three largest e-mail customers. Two, our customers acquired through the critical path transaction in 2006. One of the customers will migrate by the end of the year, and we anticipate that the other two will migrate by the end of the first quarter of 2009. In each case, the decision to leave was a strategic decision that was part of a larger relationship -- two with Google and one with Microsoft. In each case, e-mail was a small part of a much larger strategic relationship for our customer. In no case was the decision made at an operating level where our customer relationships were. We have no other customers with similar corporate structure where this type of risk exists. While this has some impact on 2008, the greater effect will be felt in 2009.

We expect e-mail revenue in 2009 to be approximately $4 million, down significantly from both this year and last year. Though we are now experiencing the cost savings related to our new platform and have been successful in securing new customers, overall, this is a disappointment. To be clear, we remain committed to this line of business and still believe it to be strategic and to hold the opportunity for significant long-term growth.

A positive piece of news in our e-mail business is that we signed a key e-mail and Personal Names deal with web.com. As you know, we have a portfolio of over 39,000 surnames, and we believe this will be one of the stickiest internet services available, especially as the growth in what I would call the Personal Internet continues. We believe Personal Names will help drive renewal rates and growth amongst our reseller channel, as well as our retail offering. This deal underscores the value that Personal Names can bring to our customers.

I will now review in more detail the performance of our other three lines of business.

First, domain registration. There were a number of encouraging signs during the third quarter. We saw continued growth in domain registration transaction volumes. In fact, volumes throughout the year have been higher than expected. For the third quarter, new transactions were up 13% year over year, renewal transactions were up 16% year over year, and we continue to achieve customer wins and see a significantly higher level of interest from potential customers. Increases across all of the volume metrics we track are obviously positive signs in our core business.

While gross margin continued to decline, it is now clear that this is a result of sales mix much more than pricing pressure. This is important as it holds the seeds of opportunity for 2009.

The domain portfolio line of business grew 135% on a year-over-year basis, with no large portfolio sale in either of these quarters. While we are generally pleased with growth, revenue generated by our Direct Navigation names continues to be impacted by the industry-wide downward pressure on advertising payouts from syndication partners such as Google and Yahoo. We expect to continue to experience pressure on yields. We have seen and will continue to see a material impact on large portfolio sales, and accordingly, we are taking a much more conservative approach and lowering our internal expectations for this business. Positive here is the demand for good, brandable and generic domain names is relatively unaffected, and we expect it will continue to grow as more mainstream marketers come into the market.

This is the segment we have focused on. Central to that strategy is the recently-launched Yummy Names, which allows direct access to the tens of thousands of high-quality names in our portfolio. Site is particularly oriented towards marketers. Internet presence has evolved to the point where today, one of the most important elements of any marketing campaign is a quality domain name. Yummy Names is really the first with this focus on marketers and will help us realize the value in our portfolio.

In the retail business, we saw continued growth year on year. Fourth quarter, we expect to commence the migration of our old retail brands -- Domain Direct, NetIdentity and IYD retail -- onto our new Hover brand and think this sets us up nicely for 2009.

As previously noted, in the third quarter, we sold the last of our retail web hosting customers.

In 2009, we are very focused on providing domain registration and e-mail through Hover in a way that takes the personal internet to a whole new level.

I'm also pleased to note, just last Thursday, we launched the beta of a new website, butterscotch.com. Butterscotch is a technology website for non-geeks. It is using video over the internet to help people get more out of technology in general and the internet in particular. Think Home & Garden TV or The Food Network for technology. It is being led by Andy Walker and Amber MacArthur, two longtime veterans of technology media, and the Tucows.com team. It will be very tightly linked with the existing Tucows.com software libraries, and over time, will become the brand that predominates for us in content. At the end of this transition, Tucows will simply be the name of the company.

I would also note -- in looking at the disposition of non-strategic assets -- we certainly looked at the software libraries. However, the opportunities were not sufficient. In parallel, I had been searching for new leadership and a new direction for what is, in our view, a valuable property with a loyal audience and a great niche. We were lucky enough to convince Andy and Amber to join us. The additional investment is minimal, and the incremental opportunity is exciting. The approach we are taking with Butterscotch is very consistent with our internal mission to make the internet easier and more effective. The launch has been well-received and we're very pleased with the early results. The team has done a great job. This is a soft beta with the full launch early in the new year, and I'd encourage all of you to go take a look at it at butterscotch.com.

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

Thanks, Elliot.

Net revenue for the third quarter of fiscal 2008 grew by just over 13% to $20.1 million from $17.8 million from the third quarter of last year. The increase was primarily the result of higher revenues from our traditional domain registration, domain portfolio and retail services categories, which were offset by lower revenues from our e-mail and content services.

Cost of revenues, before network costs, for the third quarter increased by 19% to $12.3 million from $10.3 million, primarily as a result of higher domain registration volumes and the higher registration fees were are paying the registries as a result of the price increases they implemented in October last year.

These increases were partially offset by a decrease in network costs of $540,000, primarily the result of the lower support contract and people costs we achieved with the closure and relocation of certain of our co-location facilities following the completion of the e-mail migration, as well as the lower depreciation we incurred now that certain of our older computer hardware have -- has been fully depreciated.

Gross margin for the third quarter was 27%, compared to 25% for the same quarter last year. The increase is primarily attributable to the reduction in network costs of roughly $500,000 I mentioned earlier, and the shift in the percentage contribution to gross margin we experienced from our service categories as our sales mix changes.

Looking at the gross margin contribution by service category, gross margin from domain name registration services for the third quarter decreased to $2.7 million from $3.2 million for the same quarter last year. While domain transaction volumes for the quarter were up on a year-over-year basis, as a result of the price reduction we announced when we changed to a cost + model in August of last year, our gross margin percentage for the quarter decreased to 20% from 26% for the third quarter of last year. As expected, the adoption of the new pricing structure has had a dampening effect on gross margins and profitability in the short term. We believe, however, that the new pricing structure has strengthened our competitive position as evidenced by the favorable trends in both new and renewal transactions that Elliot described earlier.

Gross margin from domain portfolio services increased to $1.1 million from $380,000 for the same quarter of 2007. While we are pleased with this growth, we believe that the contributions of both portfolio sales and Parked Pages programs were impacted by the effect that the slowdown in the economy has had on advertising spending and that they will continue to be impacted for the foreseeable future.

Gross margin for e-mail services decreased to $1.4 million from $1.6 million for the corresponding quarter of last year. As we've discussed on previous conference calls, the decrease resulted primarily from our losing enterprise customers that we acquired as part of the Critical Path asset acquisition. We have since moved on to suppliers that are probably more appropriate for their needs.

Gross margin from retail services increased to $1.5 million from $1 million for the same quarter last year. The increase is primarily attributable to the recognition of $384,000 of deferred revenue as a result of the sale of our remaining hosting customers in September of 2008 and, to a lesser extent, from the sales -- on the changing sales mix as a result of our having exited the retail shared hosting services market.

Gross margin from other services decreased marginally to $1.2 million from $1.3 million for the third quarter of last year. This decrease primarily reflects the slower advertising through our website and the reduction we have been seeing in the yield from our syndicated Google fees.

Total operating expenses for the third quarter increased by 26% to $6.4 million, or 32% of net revenue, from $5.1 million, or 29% of net revenue, for the same quarter of last year.

Core operating expenses -- which I will remind you that we define as costs relating to ongoing sales, marketing, development and administrative costs -- were relatively unchanged on a dollar basis compared to the same quarter of last year at $4.7 million, and decreased as a percentage of revenue -- 23% compared with 27% same quarter last year.

Other operating expenses for the third quarter were $1.7 million, or 8% of net revenue, compared to $340,000, or 2% of net revenue, for the third quarter of last year. The increase is primarily the result of the following three factors.

First is the impact of foreign exchange. As we've discussed on previous calls, a large portion of our costs are in Canadian dollars. During the third quarter, we recognized a loss on foreign exchange transactions of $683,000, which includes a loss on the change in the fair value of foreign exchange contracts which were still outstanding at the end of the quarter of $526,000. This compares to the recognition of a gain on foreign exchange transactions of $370,000, which includes a gain on the change in the fair value of the foreign exchange contracts of $62,000 in the third quarter of last year.

Second, as part of the completion of our migration to our new e-mail platform, we disposed of some of our older computer hardware at co-location facilities that were no longer -- that we no longer intend to deploy and incurred a net loss on disposition of $500,000.

Third, in the third quarter of last year, we incurred transitional costs of $244,000 related to the IYD acquisition.

Adjusted net loss for the third quarter of fiscal 2008 was $93,000, compared to adjusted net income of $1.1 million for the third quarter of fiscal 2007. Net loss for the quarter was $71,000, or less than $0.01 per share, compared with a net loss of $311,000, or less than $0.01 per share, for the corresponding quarter last year.

Turning to the balance sheet. Cash and restricted cash at the end of the third quarter was $2.7 million, a decrease of $3.5 million from $6.2 million at the end of the third quarter of last year, and a decrease of $200,000 from $2.9 million at the end of the second quarter of this year. The decrease compared to the second quarter of this year is the result of several factors, including cash used in operations of $107,000; additions to property and plant and equipment, primarily related to our hosted e-mail environment, of $627,000; and the repayment of $479,000 of our bank loan.

These uses of cash were partially offset by the $921,000 generated by the sale of our remaining retail shared hosting accounts during the quarter.

As Elliot mentioned in his opening remarks, subsequent to the quarter-end, we sold our ownership position in Afilias for $7.4 million, which immediately generated $3.2 million in cash. The remaining $4.2 million is payable in two equal installments in June and December next year and are conditional on Afilias having sufficient distributable reserves at that time.

Deferred revenue at the end of the third quarter was $54.4 million, up 9% from $49.8 million at the end of the third quarter of last year and unchanged from $54.4 million at the end of the second quarter of this year. A lack of growth compared to the second quarter of this year was impacted by the reversal of the $384,000 of deferred revenue generated by our retail shared hosting assets following their sale during the quarter.

Over the last year, we have implemented a number of initiatives designed to capitalize on the opportunities inherent in all components of our business, including the change in pricing structure on domain registrations, the launch of Yummy Names, migration of our e-mail customers a new platform and the consolidation and branding of our retail business, to name a few. We are beginning to see the financial benefits of some of these changes to our business and expect this to continue in 2009.

While we continue to expect 2008 revenue and profitability to increase compared to last year, we will fall short of our objective to grow cash flow from operations (inaudible) the reasons that Elliot discussed.

Fundamentally, however, the ability of our business to generate cash from operations remains strong. Our cash position has been significantly strengthened as the result of the sale of our stake in Afilias and the sale of our shared retail hosting assets, which has put us on a firm financial ground during a challenging economic environment.

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

Thanks, Mike.

We all know the difficulties in the macro environment right now. Over the longer term, we believe that our priority should be on generating cash and, over time, on returning capital to shareholders through share buybacks or through dividends. In the short term, the economic environment puts a significant premium on cash, tempering the above point to some extent.

I stated earlier that our three largest e-mail customers will be leaving over the next couple of quarters. I also stated that we would generate less cash than we did last year. Obviously, neither of these are good news. Anyone listening to conference calls over the last few weeks knows there are many negative announcements in the broader business environment. That makes this no less difficult.

On the other hand, there are many positives from this year. Product launches of Butterscotch, Hover and StoreFront; brand launches of OpenSRS and Yummy Names; smooth e-mail migration and the cost savings that generates for 2009.

On top of that, there are three things that I wish to talk about specifically for 2009.

First, the OpenSRS domain registration business. We have seen solid and accelerating gains in volume in this quarter. We have a full pipeline and are seeing continued momentum with customers. We think the data demonstrates that we have strengthened our competitive position. The only cloud there is, is that the gross margin decline was greater than we anticipated. It is now clear to us that this is the result of continuing changes in our sales mix rather than increasing pricing pressure. This sets us up in 2009 to focus on additional market segments. You will see some of that with the StoreFront launch later this month. You will see a number of additional elements added in 2009 that will drive additional volume. We will take this business to a new level.

The second thing is continued cash generation. An extremely large portion of our revenue comes from low-priced subscription services. When a domain name has been renewed three years in a row, chances are very high that it will renew again. Renewals make up the vast majority of our domain name transactions. In addition, Tucows has a demonstrated history of cost control and execution. We have managed through a number of cycles. We know how to put our heads down and grind. We will continue to generate solid cash from this business.

Lastly, the Afilias transaction and others will allow us to buy back our own stock. In times like this, the safest thing to do is to bet on what you know, and we know the value in our own company and our own people. This will allow us to generate a solid return for shareholders, which is what they deserve.

These will be tough economic times, but we consider ourselves fortunate to have the business, the business model and the people that we do, and to have always had a conservative inclination which makes adjusting to turbulence much easier. We expect 2009 to be a good year for Tucows.

With that, I'd like to open the call to questions. Operator?

Thank you. (OPERATOR INSTRUCTIONS.) Your first question comes from Thanos Moschopoulos from BMO Capital Markets. Please go ahead.

Hi. Good afternoon.

Hi, Thanos.

Hi, Elliot. To begin with, just on your comments regarding the margin in the domain registration business, I'm not quite sure I understand what you mean by mix. Could you just provide more color on that?

Sure. The additional volumes that we're seeing are being driven by a greater contribution from our larger customers -- customers that are at lower prices.

Okay.

And so that's just having the effect of driving down the blended number.

Okay.

And we think that provides some openings going forward.

Okay. Now as far as the ongoing pricing pressure in that market, has it been accelerating in recent weeks, just given the downturn and perhaps more overall pressure on people to be more aggressive, or has it been in line with the ongoing decline you've seen over the long period?

Yes. Nothing outside there. I think that, certainly, the fact that the vast majority of our customers, like us, sell bread and milk, not cars and refrigerators. And so I think that those are things that are a little bit less impacted. There's no question that there's an impact. There's an impact everywhere. I think it's also the case that we're dealing with services that are relatively quite low-margin right now. So while we won't be surprised if we see a little more pressure, we're not quite seeing that yet.

Okay. On the e-mail front, you mentioned how your expectation now is for -- I believe it was $4 million in revenue for 2009? Is that correct?

That's right.

Okay. So presumably -- you're at about a $6 million run rate currently, so presumably, does that mean that we're going to have more of a drop-off in the near term and that you're anticipating growth to get us to the $4 million for '09? Is that accurate?

No. You'll see a trend down sort of through -- it really depends on the specific migration plans of the customers, and so it's tough to predict. I said on the call we expect, by the end of Q1, all three will be gone. It could stretch into Q2 as well. You're talking about very big companies and, as you can imagine, everybody's plans are in flux. So we're a little bit sort of at their -- not at their mercy, but we're -- we have to wait and see what their specific plans are. But you'll see it -- the best way to think about it, Thanos, is it'll drift down through the middle of next year and then start to pick up from there.

Okay. I guess another way to rephrase the question is the three customers together -- were they about a $2 million run rate or were they more than that and then you're still going to have some residual revenue as they do the migration over the year and that's how we get to the number for next year?

Right. So at their peak, those three customers were more than a $2 million run rate -- closer to 3. One of them has been drifting down and we've been backfilling, and the other two -- we're still seeing full revenue from, and so that'll be the drop-off kind of from here to the trough.

Okay. And you mentioned you're confident that these issues are unlikely to recur with the rest of your base. Is that just because of the customer type?

Yes. It's very much a function of customer type.

Right.

These are much larger companies, and e-mail was a small part of a large strategic relationship for all three.

Okay. Can you comment then how the sales cycle is progressing as far as trying to close new business for the e-mail side now that the migration's complete?

Yes. So I think that the challenge there is that we compete -- first of all, I would say, "Okay" or "Fine." We've got a reasonable pipeline. We've got things that are coming out the other end of the pipeline. The challenge there is that we compete with non-consumption, and as the economy gets worse, often for us, when you're competing with do-it-yourself, it feels to the customer like it'll cost them a little bit more money going forward. So that's certainly a bit of a drag.

Okay. Okay. And then on the Butterscotch side, you said no significant start-up costs associated with that?

Yes. It's -- there's a few extra people --

Right.

But not much beyond that. And I'd love you to kind of dig in and give me your feedback.

Okay. Alright. I'll pass the line for now. Thanks.

Thanks.

Your next question comes from Alex Grassino from Laurentian Bank Securities. Please go ahead.

Hi, gentlemen. Could you give me a little bit more color on where you see CapEx going, going forward, because it jumped up to $600,000 this quarter. You expect that to revert back down?

Yes. CapEx next year will be more in the $1.5 to $2 million range.

Okay, so (inaudible). Okay. And just a general idea of where you see gross margin as a whole going in 2009.

That's a tough one to answer because it's going to be very much determined by the mix, and I don't think that I -- or Mike has really drilled down on that. It could be, for instance, a positive if blended gross margin is going down -- if the reason that it's going down is because we're having a significant growth in domain name transactions, for instance.

Okay. Perfect. And in terms of exploring divestiture of non-core assets, are you more or less finished now or are you still sort of looking at refining what you have at this point?

Yes. I think the big stuff has pretty much happened. We -- if we were speaking 6 months ago or 12 months ago, I might have talked about more potential for a large domain name portfolio sale, for instance.

Okay.

That market has really been negatively impacted.

Okay. Perfect. Alright. That's all I have for now. Thanks.

Great. Thanks.

Your next question comes from David Shore from Research Capital. Please go ahead.

Thanks. Elliot, that's a great segue for me. Can you talk more about the premium domain market and kind of what you're seeing there and what you think that business looks like sort of over the next year or so?

Sure. And so we're definitely seeing softness in those Long Tail direct navigation portfolio-type names. We're not really seeing the same kind of softness around the brandables. Now those are obviously a much smaller number of transactions and they're much bigger price tags. You look out in the market in what I'd call the wholesale market there -- those are professionals who are trading with each other. There, there might be a bit of softness because for those professionals, their purses get filled with a lot of that parking revenue -- the direct NAV revenue. But we -- what we see from marketers -- for instance, with the Yummy Names launch and some of the follow-on discussions -- is there, there's value. And for them, they're looking at the value of a generic -- a semi-generic -- a brandable name relative to what search traffic costs or relative to very, very large advertising budgets. So we don't think that through '09, we'll see a negative impact around valuations in those categories. And in fact, we think it's such an early stage in that market that if we do a good job of reaching marketers and bringing them into the market, we think we can see continued growth there nicely.

Okay. Thanks. That's it for me.

Great. Thanks.

(OPERATOR INSTRUCTIONS.) Your next question comes from Aram Fuchs from Fertilemind. Please go ahead.

Yes. It's Aram Fuchs, Fertilemind Capital. I was wondering -- you've been at the premium domain business for a while. I was wondering if you can talk about which channels are working well to attract the end user -- those marketers you talk about. Is it the auctions or some relationship with agencies? If you can give us that landscape, that would be --

Sure. So right now, the auctions are not great. They were probably better 12, 18, 24 months ago. And I'm sure, as things come back a bit, they may get a little bit more useful. The work -- the thing that yields the most in terms of direct leads or sales right now is actually the network of brokers that are out there who maintain contacts sort of broadly across industry. Those are the relationships that probably will contribute the most this quarter. And when it comes to the agencies, that's really just hard work at this point. So that's Bill Sweetman, who runs that group -- who I think you've met -- just going and giving seminars and talks, appearing at conferences and speaking and doing sessions for people. And so that's really just bringing in buyers in onesies and twosies.

Great. Thanks for your time.

Thanks.

There are no further questions at this time. Please continue.

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

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