Tucows Inc. (TCX) Q4 2006 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to the Tucows Incorporated fourth quarter results conference call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions]. As a reminder, this conference is being recorded today Thursday, February 8th, 2007. And now, I would like to turn the conference over to Ms. Leona Hobbs. Please go ahead.

Thank you, operator. Good afternoon, everyone, and thank you for joining us for today's call. With me is Elliot Noss, our President and Chief Executive Officer; and Michael Cooperman, our Chief Financial Officer. Today, following market close, Tucows issued a news release reporting the Company's results for the fourth quarter and fiscal yearend 2006 ended December 31st, 2006. The news release and other information for investors is available on our website. 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.

Thank you, Leona. Good afternoon, and thanks for joining us today. Today's call will follow our usual format. I'll begin with an overview of the highlights for the fourth quarter and the fiscal year. Mike will then provide a detailed review of our financial results. And finally, I'll return to talk about a fairly significant evolution that has taken place here at Tucows and in the marketplace over the last year. But first with the financial highlights for the quarter. Our continued strong financial performance in the fourth quarter capped off a year of significant momentum across all aspects of our business. Revenue for the quarter grew to $17.2 million, another record, and a 36% increase over the fourth quarter of 2005. It was our 16th consecutive quarter of revenue growth adjusting for the onetime accounting transaction in the third quarter of 2004. Net income was $200,000, our 18th consecutive quarter of profitability, excluding integration costs that we incurred in the first half following the acquisition of Critical Path. Cash flow from operations for the quarter was also a record at $3.9 million, our 21st consecutive quarter of positive cash flow from operations, excluding our use of cash last quarter to fund changes in working capital. Net deferred revenue, or deferred revenue less prepaid registry fees, increased almost 12% compared to the same point last year. Advertising revenue was almost $1.4 million, an 8% increase quarter-over-quarter and an 80% increase year-over-year as we continue to see strong growth in our direct navigation business. On the cost side, I would like to note that during the fourth quarter we did begin to see some of the cleanup in the operating expenses that we talked about last quarter. Looking at our results for the fiscal year, revenue totaled $65 million, an increase of 34% over fiscal 2005. Net income was $2.2 million, and I'm very pleased to report that cash flow from operations for the year was $8.8 million. We exceeded our cash flow from operations target of $7 million to $8 million for the year. As you heard me describe on our last call, in the third quarter we benefited from a windfall of almost $2 million resulting from the sale of patents acquired under the Infonautics transaction in 2001. As discussed, we took the opportunity to use some of that windfall to address some operational issues following the migration of NetIdentity customers to our email platform, and thus we expected to fall towards the bottom end of the range, and use the windfall to fall within the $7 million to $8 million. Despite that, we were still able to just about reach the $7 million to $8 million range outside of the $2 million windfall. We exceeded our expectations, and we were certainly above the top end of that range. Also in the fourth quarter, we saw strong continued retention in our email and anti-spam, reinforcing the sticky nature of those services. Given that we're at the beginning of the fiscal year, one financial item that I do want to discuss this quarter is our approach to managing our Canadian dollar needs in 2007. Our goal with any foreign exchange hedging strategies is essentially to minimize risk from currency exposure. What we strive for more than anything else is certainty. Through the second half of last year, after four years of significant strengthening of the Canadian dollar -- in fact, the Canadian dollar appreciated by more than 50% versus the US dollar over that time -- the Canadian dollar did begin to weaken. We consider this an opportunity to provide ourselves with some cost certainty as it relates to 2007. The way we view it is to look at the given exchange rate and ask ourselves if we're very comfortable operating with certainty at that exchange rate for the remainder of the period. When we did this analysis in the last quarter of 2006 we clearly felt that we were comfortable, and accordingly, we covered our needs for Canadian dollars in 2007 through a series of forward contracts. The Canadian dollar has continued to weaken since that time. So while in our GAAP financial performance you will see that we're taking a loss on foreign exchange contracts, it's important to recognize that at the same time we are realizing commensurate benefits from that weakened Canadian dollar, primarily in terms of lower labor and other operating costs. In fact, that savings will be felt with respect to any Canadian dollar denominated cost that we incur. To give you a sense of the impact this is likely to have this year, as Mike will discuss, in the fourth quarter of 2006, general and administrative expenses included a GAAP loss on forward contract of nearly $500,000 relating to the 2007 forward contract. However, assuming the dollar remains flat, we will regain that loss over the course of fiscal 2007. From our perspective, there were two important points here. First, losses of this nature are offset by taking the benefit of the weakened Canadian dollar to the bulk of our costs. Second, the currency environment for us is considerably more favorable now than it has been for any of the last five years; not just the absolute level of the Canadian dollar, but also in terms of volatility. On the operational front, one of the key highlights for the fourth quarter was the development of a new email platform. We set three goals for our email platform in general -- reliability, operational simplicity and ease of integration. Reliability is about customer satisfaction. Operational simplicity is about managing operating expenses and being price competitive. And ease of integration is about most effectively bringing on new business. We've recognized that in order to meet these long-term objectives, we needed to build our own platform. And as a result, we will be moving away from Critical Path as our supplier. The good news is this was not a starting from scratch exercise. Our offering will be mix of three things. First, there were important elements of provisioning software that we owned as a result of the acquisition of the Critical Path Hosted email assets. Second, we were able to take advantage of important components from our existing provisioning platforms. And third, as was virtually every massively scaled email system, there will be some important components from the open source software work. We wanted to provide a higher level of responsiveness reliability in anything that we've seen in the market today. And we built a system that makes reliability job working. We've been using this new system internally for the last month or so. And so far it has exceeded our expectations. We expected to be available to customers in our test environment sometime in March. The next big we forward, now that we've dealt with the backend, we'll be to address some of the usability issues so that the next advantage you'll see in our email service will be with respect to significantly enhanced webmail. In the next week or two, we will also be releasing our new anti-spam service. There are two specific benefits to us in the business. At the customer level, it will improve service. We will see catch rates improve plus positive decline and you'll also see a higher level of reliability and performance. And at the business level, you will start to realize the benefits of rationalizing the two separate older anti-spam systems that I talked about last quarter. One, which we operated historically, and the other as a result of the Critical Path acquisition. This will have a positive impact on both operating expenses and capital expenditures. In the short term, we expect to see the biggest and quickest beneficiary of our email and anti-spam systems to be the retail business in general and the net identity portion of that business in particular. Folks running our retail business are extremely eager to take advantage of the new system as soon as we will let them. And we feel that we will have a real and immediate impact on that business. And generalize from there we are now finally able to really begin to take advantage of some of the operational simplification in synergies that we should have started to see earlier. That will be everything from reduction in systems maintained. It's a reduction in the number of data center acquired. Sum up, we identified the challenge and we stepped up to it. The simplification of our operating environment as well as the realization of other efficiencies and most importantly the continued growth across all services will allow us to achieve our target of $10 million to $12 million in cash flow from operations in 2007. Before turning the call over to Mike, I would like to briefly discuss the share repurchase program that we announced at the beginning of January. Under the program, we will purchase up to $10 million of our common stock with the timing and exact number of shares to be at our discretion. We expect to fund the buyback from cash on hand and cash generated from operations. We do not intend to create a debt facility for these purposes. However, we don't preclude the possibility that if the stock price was what we consider to be an exceptional value, we would not then consider using debt. But again, that's not our expectation. We expect to be buying stock into the normal course, and we will file the appropriate documents shortly thereafter. So there will be visibility to what we are doing. When you look at this buyback, it's more tactical and strategic with two things driving our decision. First, we have a high number of shares outstanding for a company our size. And this is our preferred avenue of addressing this. Second, we do think that our stock is quite a good value at current levels. Moreover, we have had a number of acquisitions over the last little while in a market where there is a lot of capital chasing 2Q deals, meaning that on a relative basis, our stock is even more attractive to us. With that, I'll turn the call over to Mike to discuss the financial results in more detail. Mike?

Thanks, Elliot. As Elliot explained, we carry the momentum we experienced across all areas of our business throughout 2006 into the fourth quarter, which enabled us to exceed our target of $7 million to $8 million in cash flow from operations to the year. It also contributed to our 16th consecutive quarter of revenue growth as well as another quarter of strong cash flow from operations and continued growth in our deferred revenue balance. Net revenue for the fourth quarter increased 36% to $17.2 million from $12.7 million for the corresponding quarter of 2005. Net revenue from domain registration and other Internet services increased by $3.9 million or 33% to $15.8 million from $11.9 million for the fourth quarter of 2005. Contribution to total revenue from other Internet services for the quarter increased to 24.2%, up 9.3% in points from 14.9% for the fourth quarter of 2005. Revenue from domain registrations, which you will recall as of third quarter excludes demand reg, was up 16% year-over-year, however, accounted for only 67.7% of total revenue, down more than 11 percentage points from 79% for the fourth of last year. The primary driver for the shift in revenue mix from domain registration to other internet services revenue is primarily the result of the contribution from hosted e-mail services. Revenue from other Internet services, excluding Domain Direct, accounted for 18% of revenue compared to 7.6% for same quarter of last year. Revenue from advertising and other content sources for the fourth quarter increased 80% to $1.4 million from $772,000 for the fourth quarter of fiscal 2005. Please remember that advertising and other content source revenues include the contribution of direct navigation revenue, which accounted for $538,000 of this growth. Excluding direct navigation revenue, advertising and other content source revenue grew 10% compared to the fourth quarter of last year. Advertising and other revenue as a proportion of total revenue increased to 8.1% from 6.1% for the fourth quarter of 2005. Cost of revenues for the fourth quarter increased to $12 million from $8.3 million for the fourth quarter of last year, primarily as a result of an increase in network costs of $1.9 million, $2.4 million from $529,000 for the forth quarter of last year. Cost of domain registrations, which now exclude Domain Direct, as a proportion of total of revenues, fell by 15 percentage points to 70% from 85% for the corresponding quarter of fiscal 2005. While the cost of other internet services, which now includes Domain Direct, grew slightly to 9.1% of the total cost of revenues from 8.5% for the fourth quarter of last year. These changes were a result of a shift in revenue mix away from domain registrations and the increase in network costs. Gross margin for the quarter was 30%, down from 34% for the fourth quarter of 2005 and 33% for the third quarter of 2006. The year-over-year decrease is primarily attributable to the higher network costs to support and manage our expanded Internet service offering most notably to support our hosted e-mail platform as well as a decline in domain registration gross margin to 27.7% from the 29.1% achieved in the fourth quarter last year. This decrease in domain registration gross margin was in line with our expectations, and as I commented last quarter, is a result of the competitive environment in the domain registration industry. Operating expenses for the fourth quarter, increased by $1.3 million to $5 million, or 29% of net revenue. From $3.8 million or 30% of net revenue for the same quarter of fiscal 2005. As I have done in the past, to assist you in understanding our operating expenses. I would discuss them in terms of core operating expenses and other operating expenses. As a reminder, we define core operating expenses as those cost relating to ongoing sales, marketing, development and administrative costs. For the fourth quarter, these expenses increased by $511,000 or 40% to $4.1 million, compared to $3.6 million for the fourth quarter of last year. The primary contributor to this increase was increased people costs of $455,000 relating to our ongoing commitments to stabilize and extend our hosted email services. As a percentage of net revenue, however, core operating expenses for the fourth quarter decreased to 25% from 30% for the fourth quarter of last year. Other operating expenses for the fourth quarter increased to $876,000, compared to the fourth quarter of last year, primarily to three reasons. Let me begin with foreign exchange. As Elliot mentioned, our objective in managing our exposure to the Canadian dollar is to minimize foreign exchange risks, by achieving some certainty with regard to our cost. Accordingly, when the Canadian dollar began to weaken towards the end of 2006, we cease the opportunity to do just that for 2007. And cover that estimated 2007 Canadian dollar needs, through a series of forward contracts. Who is purchasing these contracts, however, the Canadian dollar has continued to weaken, which is reflected as a loss on the change in the fair value of these contracts of $497,000 for the fourth quarter. Please remember, that these losses will reverse, as these contracts mature over the course of fiscal 2007. And the fair market value of the remaining outstanding contracts (inaudible). Second, as a result of having adopted FAS 123(R), accounting for stock-based compensation for fiscal 2006, we incurred a charge for stock-based compensation of $86,000 that we did not incur in the fourth quarter of fiscal 2005. And third, depreciation and amortization increased by $220,000 to $331, 000, as a result from higher depreciation related to the new computer equipments and higher amortization, resulting from the acquisitions we have made in the current and prior years. Adjusted net income which we have previously referred to as adjusted EBITDA for the fourth quarter increased 6% to $1.2 million from $1.3 million for the same quarter last year. The decline in adjusted net income was primarily the result of the nearly $0.50 million loss we incurred on the change in fair value of the Forward Exchange contracts that I mentioned earlier. Net income for the fourth quarter was $156,000 or less then $0.01 per share compared to $1 million or $0.01 for the fourth quarter of last year. Turning to the balance sheet, cash, short-term investments, and restricted cash at the end of the fourth quarter increased to $7.3 million from $3.8 million at the end of the third quarter of 2006 and decreased from $19.2 million at the end of the fourth quarter of last year. The increase in cash compared to the end of the third quarter of 2006, was primarily the result of the generation of cash-flow from operations of $3.9 million in the fourth quarter. And I would reiterate that excluding the impact of the $3.3 million we used during the third quarter to fund changes in working capital, which we discussed in details during the last quarters conference call. This is our 21st consecutive quarter of positive cash flow from operations. Deferred revenues for the quarter reached another record level at $45.1 million up 19% from $37.9 million at the end of the fourth quarter of fiscal 2005 and up 1% from $ 44.7 million at the end of the third quarter of 2006. In closing, our financial performance in the fourth quarter, capital for another year of solid growth throughout our business and strong cash generation. We continue to build a strong financial foundation upon which to achieve future growth and drive long-term value for our shareholders. I would now like to hand the call back to Elliot.

Thanks, Mike. Most important development for Tucows in 2006 was the evolution of hosted email as a clear second pillar for the Company. In fact before 2006, email made an insignificant contribution to the Tucows business. In 2006, the contribution split between domain registration and email was roughly two-thirds, one-third. And certainly, we expect growth in hosted email to continue to exceed growth in domain registration going forward. 2006 saw three acquisitions either directly or indirectly related to our hosted email service. We've developed a new platform that sets up technically for the future we envision. We had important customer wins through the course of the year. And all of that is an addition to the biggest asset that we bring to the table in terms of addressing this market, which is the strongest set of customer relationships with web hosting companies and ISPs in the world. 2006 was a very interesting year for e-mail, in terms of the competitive landscape. It is the case today. The best providers of e-mail in the world are those that provide free e-mail. There are also high-end corporate e-mail services. None of those are delivered with very few exceptions by or through service providers. And service providers are the companies that provide support at the customer level, but the small business and individuals that actually use e-mail. 2006 was a very important year for e-mail as a service more broadly. I’ve been in this industry for over a dozen years now. And for the first time ever, I’ve heard power users -- people that I would consider experts, agree with me and lament that e-mail is in many respects broken. What these people are referring to is a degradation in reliability, a degradation in deliverability and a degradation in the user experience. All of this is caused to a great extent, but the massive increase expand and efficiencies. As well as the huge additional demand put on e-mails systems by today storage requirements and webmail requirements. At the same time, e-mail has become and is by far the most important communications tool in the world today, even more important than the telephone. All of this, our evolution at the company level, the evolution in the competitive landscape. The evolution in peoples’ experience with e-mail combines to create a huge business opportunity that we are uniquely positioned to address over the next couple of years. With that I would like to open the call for questions. Operator?

[Operator Instructions]. Our first question comes from the line of Thanos Moschopoulos with BMO Capital Market. Please go ahead.

Hi. Good afternoon.

Hi, Thanos.

Elliot, first on the OpEx size, so to clarify the 500,000 loss per month, the foreign exchange contract that was in the G&A line?

Right.

Okay. So that means on a sequential basis in Q4 relative to Q3 we saw a resizable decline in sales and marketing as well as SG&A taking that out. Would that primarily be due to bit of currency?

You know, when you say that I don't think we passed it out. But there is one such a big move over the back half of the year. You know, I think you're going to see little bit of that coming from currency. But you are also starting to see, you know, just a little bit cleaner operations. You know, I talked in last quarter about the fact that some of the integration cost that hung around.

Right.

And you know some of those are now started to come clean. You know, I think, I mentioned also last quarter. You know, I don't like to kind of hide those up. We said we're going to be through with that in the first two quarters. So we took that in as, you know, kind of a normal operating expense. And I just think you are starting to see some of those benefits there.

Okay. So in the near-term with this source of levels of operating expenditure will be kind of representative of what you would expect?

Yes.

Yes.

Yes. And would be just declining, I mean it's not continuous decline. I think you have to be comfortable that we're going to be getting, you know, that we are seeing that place were, you know, I go back to my old metric of build gross margin growing, a twice the rate of OpEx.

Right. Okay. As far as the new e-mail platform, have you [certainly] got a pause and trying to pursue the large new e-mail opportunities while preparing for the launch of the new platform or has that proceeded being parallel while your doing this?

You know, frankly, we did that through the fourth quarter at least. You know, as we were -- yes, we're pretty pristine with our customer relationships. And as, you know, for us we think the biggest opportunity was this and will continue to be with the huge existing set of customers that we have. So these are people traditionally or you know, in domain that we have relationship with already. And if we didn't have confidence and you know frankly, to fourth quarter we didn't. You know, so we were coming out the other side of this. We were slowing things down and putting them on a pause. And believe me that's a very, very difficult thing for a company to do.

Okay. I'll take some of the usual metrics that you disclose out. What were the -- at yearend the total domain for the management?

I've the -- total domains that we had in the management of end of the year was $5.9 million -- held directly and 1.7…

that's 1.8, 1.7 --1.8…

1.7 or 1.8 for, I'll just look it out.

Indirect…

Or indirect.

Okay. And the number of transactions?

Don't think we've reported that in a bit. Probably, that for the last two or three quarters.

All right. That wasn't the -- okay, I thought I had that consistently give you some of the…

We can price -- bring it up for you. I mean we have not, you know we've not.

Yes.

But if we can, we'll share it.

Okay. And then, Mike, you talked about -- we're seeing some of the ongoing margin compression in the domain registration business. Is that sort of proceeding kind of at the expected rate? Have there been any significant changes competitively or just sort of the ongoing competition we've seen over the past few quarters?

I am -- there's nothing new there. You know, you'll see that the numbers there actually came in towards the top end of -- you know, you'll remember hearing me say, looking at 2006, 12% to 15% in units, kind of 8% to 12% and 1 point or 2 down in margin and 8% to 12% in actual [built] gross margin actually lowers. And I think we came in at 14 and 11, so sort of towards the top end is exactly what we expected. You know, one of the other things that we're seeing there, Thanos, you know, you remember we talked in the past about the way over the last couple of years, we've started to price with our large customers --.

Right.

--which was to make sure that we, you know, loft in the current rate of business and provided a relatively speaking lower transaction cost on incremental business.

Great. That's fine.

That does create [certainty] for us and still capturing some of the upside.

Great.

You know, you're starting to see a number of those deals where we're actually seeing that incremental transactional business, which is much lower than the average margin.

Okay.

Yeah. And we're thrilled to keep it in the door, but its going to bring that blended number down.

Okay. As far as CapEx, I think you talked about how you'd expect '07 CapEx to be less than this year, so is that's all the case?

Yes. Absolutely.

Okay. And as far as the buyback, should we take that as an indicator that maybe in the near term, you're less focused in acquisition opportunities or you're still actually looking at things?

You know, I think no more or less active than we've being historically. You know, you've heard me say a couple of times that certainly with the two bigger acquisitions in 2006, those were things that we had been keeping an eye on in form or another for years.

That's great.

So I'm answering the phone when people are calling and they always are. But it is the case that, you know, we take integration serious. We definitely want to be simplifying operations, you know, after picking up some complexity last year. And you know, there is not a lot of value out there. You know, we think that on a relative basis, the buybacks looks to be just capital.

Okay. Fair enough. That's all. Thanks, guys.

Great. Thanks, Thanos.

[Operator Instructions] Our next question comes from the line of Madhu Kodali from Fertilemind Capital. Please go ahead.

Hi. This is actually Aram Fuchs from Fertilemind Capital. I was wondering if you can talk about your e-mail offering in the context of the competition from Google's Gmail and Google's web AppSphere demand --?

Sure.

And maybe if you can also talk about the calendar acquisition that you gave and where that fits in? Thanks.

Sure. I think that the way you want to think about relative to email, you know, you heard me say on the call, that in my view, the best providers of email currently in the market are some of the biggest, I certainly put are some of the biggest free services. And I certainly put Gmail in that category. You know, I don’t believe that there is a comparable service coming today, from the hosting or ISP market. That’s exactly where we want to take this. Now, you’ll always see a distinction between what Gmail is doing for instance. You know, as an example, same thing about Yahoo mail or Hotmail. And what we’re doing in, you know, the primary differentiator is going to be, that those are and will continue to be as supportive, unless you’re paying for it. For us, you know, we’ve reviewed that at a, you know, at a very reasonable price are included in a bundle services. The people are already paying for it. Today, they would prefer not to have advertising around their email. In addition the second, you know, I’ll have to say how it is important differentiator, is when it’s being delivered end-to-ends through our customer for the end-user. You’re also going to be able to make recourse to support. And people need help using internet services. And that is something again, that the Google's, the yahoo's, the Microsoft's in the world just don't do. I mean, it's not part of there business model, it's going to knock on them. And I don't want you to hear me saying that, you know, there is no room for free email services there of course, will continue to be a huge portion of the market serviced by those services. And I think there is much more room than is being experienced today for commercial e-mail services. You know, I think, with respect to the calendar, you know, that's one of the additional kind of usability and better user experienced developments that you have to see through the year. So, you know, we've now had some time to digest that. We get pretty deeply through the code. We know we want it to look like, I don't think you will see it in the first iteration. And that's just because we think that there is lower hanging fruit, you know, that we need to get to first. But we absolutely think calendaring is a really important part of that e-mail and communications experience.

Okay. Great, thanks you. And just one follow-up question. Is there any push, do you feel any push to integrate wireless plus e-mail onto your conventional corporate e-mail business?

I think that -- I'll speak of the user first. And I'll tell you that, you know, I don't like having multiple e-mail boxes that I access using multiple ways. For me -- as a user, my goal in communications would be to have a single means of access in all of my communications. So you know, I think that as it relates to the product development path, naturally it would make sense to me that there is something at a mobile level. It's what I would want as a user, and we try to be responsive to what users' needs are.

And then actually an unrelated question. There has been some M&A activity in the domain auction space and you have a service there. And I was wondering if you can comment on looking back on the development of the auction to what do you think we did right and wrong and what the prospects are of Tucows' auctions?

One of the things -- and if I recall correctly, you and I chatted something about this. You know, we felt really that auction specifically was not going to be the most important part of what we were doing in the secondary market going forward. You know, we really think the biggest opportunity for Tucows is in facilitating what I would call a more efficient to be in the marketplace. You know, we're now through [with all the] subsidiary a fairly large holder of names. We also feel most importantly here that we have, you know, if not the best, certainly one of the two or three best what I would call demand streams from small businesses for domain names. And a small business is looking for domain name. They are not necessarily looking for only a name that is available for registration for the first time. They are looking for a name. And we think there is a huge opportunity in bringing a lot of efficiency to that market. And it's -- you know, it's not one where we're going out and trying to conquer the world or really even go outside of our world. You know, we think that inside of the existing Tucows distribution network, there is a huge amount of small business demand for domain names in the primary and the secondary market. And we think if we do nothing more than fulfill the demand of sitting in our distribution channel, we'll be accomplishing some pretty big things.

Great. Thanks for your time.

Thanks.

Thank you. And at this time, it appears there are no further questions.

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

Thank you. Ladies and gentlemen, that concludes our conference for today. Thank you for your participation. And have a great day. You may now disconnect.