Elliot Noss - President and CEO Michael Cooperman - CFO

Thanos Moschopoulos - BMO Capital Markets David Shore - Research Capital Aram Fuchs - Fertilemind Capital

Thank you, operator. Good afternoon, and thanks for joining us today.

With me is Michael Cooperman, Tucows Chief Financial Officer. As per our usual format for these calls, I'll begin with a brief overview of our financial performance and some of the operational highlights for the third quarter of 2009.

I'll then turn things over to Mike for a detailed review of our financial results, and then I'll return for some concluding comments before opening the call up to questions. Third quarter saw the continuation of our solid financial performance in 2009.

Revenue totaled $20.5 million, up a couple of percentage points from both the third quarter of last year and the second quarter of this year. We've delivered a solid financial results, driven by our focus on strengthening the competitive position and improving our overall cost structure.

Next, I'm pleased to report that in September, we've received the third and final payment related to the sale of our stake in Afilias which contributed $2 million in cash during the quarter. That brings the total compensation for our Afilias stake to over $7 million.

In addition, cash EBITDA for Q3 was over $1.5 million, bringing cash EBITDA for the year-to-date to just over $5 million, that's before including the benefits of our successful Canadian dollar hedging strategy. It is now clearly the case, and, as I have noted in the past, 2009 looks a lot more like 2007 than 2008.

Cash EBITDA is a non-GAAP measure, but I use it here as net income for the quarter includes a large gain in currency contracts and the one-time gain from Afilias sale. With cash flow from operations, there were balance sheet items, which had a negative impact of approximately $1.5 million and provisional payments made for 2009 income taxes in the amount of almost $900,000.

Mike will speak to each of these items in more detail a little later. Turning to our OpenSRS domain service, a strong focus on wholesale domain registration continues to payoff.

We saw continued growth in both new and renewal domain registration transactions. New registrations were up just over 3% on year-over-year basis and renewals were up 10%.

This growth in both new and renewal transactions pushed domains under management up by 6% compared to a year ago to more than 9 million. It also contributed to year-over-year growth in domain services revenue of 9%.

When reporting the strong first quarter, I noted a softening in the overall market in the early part of Q2 a trend we saw, continue through the second and third quarters. Now, however we are seeing strengthening in the market in early Q4 that we find encouraging.

We feel the softening, we correctly identify them has been replaced by the strengthening we are now starting to see. Again, new registrations are perhaps the best leading indicator of performance and we continue to outperform the market.

We are winning new customers and in fact the pace of these wins is accelerating. We see our customers growing their businesses and margin is holding steadier than we've seen in a long while.

The third quarter saw continued reliability and efficiency in our email service. We are seeing more customer wins and are now quite confident that with the last of the three big customers that moved primarily to larger portals players are off the platform, we'll be well positioned to start growing email again.

Well, to really mention the digital certificates business; we are the largest SSL wholesaler in the world, which is a great testament to our customer’s willingness to buy other services from us. Q3 was a record quarter for SSL.

Active certificates at the end of the quarter were 38,000 and unit sales were over 8,000 in the quarter, our best quarter ever in a 13% increase over last year. Another real highlight of the quarter was the strong performance from YummyNames, our domain portfolio group.

Most importantly, there was nearly a $0.25 million in brandable domain name sales. The number of brandable domain name transactions has shown great progress through September and continue to accelerate in October.

We expect this to be helped further as we finalize the deal to list our domains in the buydomains.com and afternic.com market places and distribution networks, which we view as the best buy now marketplaces in the secondary market. Again, those brandable domain name sales are the segment we view as more strategic.

When we add inventory from our expiry stream, this is the type of name we focus on. These brandable domain name sales are up from almost nothing at the beginning of last year to where they are today.

In summary, a good quarter with nice progress in all our key strategic areas. I’d turn the call over to Mike to walk through our financial results in detail, Mike?

Thanks, Elliot. Net revenue for the third quarter of fiscal 2009 was $20.5 million up slightly from $20.1 million for the third quarter of last year, and $20 million for the second quarter of this year.

Year-over-year increase was achieved, despite the expected declines in email and other revenues, and was primarily the result of higher demand services and YummyName’s revenue. Cost of revenues before network costs for the quarter increased by just over 10% or $1.3 million to $13.6 million from $12.3 million for the same quarter of last year.

Network costs for the quarter decreased by $781,000 or 32% to $1.7 million from $2.5 million for the third quarter of last year. The decrease is primarily attributable to the lower co-location costs stemming from the closure and relocation of our US-based co-location facilities completed in September of last year as well as the restructuring we implemented in November 2008.

It was also attributable to lower network depreciation and amortization costs, which decreased by $300,000 compared to the same quarter last year, primarily as a result of certain of our older computer hardware being fully depreciated and not requiring replacement. Gross margin for the quarter decreased to 25% from 27% for the third quarter of last year, largely the result of a shift in sales mix to a higher proportion of domain registration services, as well as the impact of the 7% registry price increase that was levied by some of the domain registries in October of last year.

Even negative impacts on gross margin were partially offset by the lower network costs that I discussed a moment ago. Gross margin from our OpenSRS service, which includes domain services, email services, and other wholesale services, was $4.2 million or 25% of net sales, compared to $4.7 million or 29% of net sales for the third quarter of last year.

Gross margin from domain services was $2.8 million, up slightly from the same quarter of last year. As a percentage of our domain services revenue, gross margin decreased to 18.4% from 19.5%, reflecting our success in increasing revenues from higher volume, lower price customers as well as the impact of the 7% registry price increase I mentioned earlier.

Gross margin from email services decreased to 739,000 from $1.4 million for the third quarter of last year. The decline was primarily the result of the two factors that we have discussed at length on previous calls.

Termination of relationships to several non-strategic enterprise customers acquired from Critical Path that were not a strategic fit for our business and the loss of the three media portal companies who made the decision to bundle the email requirements into largest supply contract. The last of these customers is expected to complete their migration during the current quarter.

Gross margin percentage for emails services was 88%, down marginally from 89% for the third quarter of last year. Gross margin for YummyNames, our domain portfolio services category, increased by $0.5 million to $1.6 million, compared with $1.1 million for the same quarter of last year.

This increase primarily reflects the timing of larger portfolio sales of domain names while as the improved performance we are currently experiencing with auction initiatives. These increases have been partially offset by decrease in the delivery of third-party advertisements on Parked Pages of 300,000.

Decrease resulted from the impact that our sale of domain names has had on the names we have available for advertising purposes as well as the general economic conditions resulting in a generally store advertising environment. Gross margin percentage for YummyNames increased to 88% of net sales, compared to 86% for the third quarter of last year.

Gross margin for Hover, our retail services group, decreased to $711,000 from $1.5 million from the third quarter of 2008. This decrease primarily resulted from the impact on current period revenues of the sale of the remainder of our retail hosting assets, part way through the third quarter of last year and impact on current period revenues of the sale of the remainder of our retail hosting assets, part way through the third quarter of last year and our decision to reclassify certain retail customers acquiring the IYD acquisition that did not meet our definition of retail customers to OpenSRS.

Revenue was also impacted by our decision to deemphasize new customer acquisition while transitioned our retail customers from our DomainDirect, NetIdentity, and IYD Services to other. Gross margin percentage for other fell to 59% from 73% for the third quarter of last year.

The decrease was largely the result of the impact of the recognition of deferred revenue as a result of the sale of our remaining hosting customers in September 2008 in our last year’s gross margin. Gross margin for Butterscotch our content services group decreased slightly to $436,000 from $497,000 for the same quarter last year.

This decrease is primary a result of contraction in the yields from our syndicated user feeds and lower revenue from our resources center, which partially offset by an increase in advertising and video revenue. As a percentage of net revenue, gross margin decreased from 99% to 95%.

Total operating expenses for the third quarter of fiscal 2009, decreased by $3.9 million or 62% to $2.4 million or 12% of net revenue from $6.4 million or 32% of net revenue for the corresponding quarter of last year. Breaking this down a little further, co-operating expense which we define as those expenses relating to ongoing sales, marketing, development and administrative costs, decreased by $198,000 or 19% $3.8 million from $4.9 million for the same quarter last year.

As a percentage of revenue co-operating expenses decreased to 18.5% from 23.4%. The decreases can be attributed to three main factors.

First, the reduction in people-related cost of just $0.5 million primarily the result of the restructuring we undertook last November. Second, continued success we are having in our focus on controlling cost, in particular professional fees, which were $200,000 lower and net bank fees, which were also $200,000 lower as a result of the initiative we introduced in January of this year to recover some of our payment processing fees.

Third, the favorable impact of foreign exchange. As we have discussed in the past, the significant portion of our expenses are incurred in Canadian dollars Thus the weakening of the Canadian dollar related to the US dollar during the quarter when compared to the same quarter last year has had a positive impact on cooperating expenses.

Other operating income for the quarter was $1.4 million, compared to other operating expenses of $1.7 million in the same quarter last year. The $0.3 million change in other operating expenses can be attributed to these factors.

First, we recognized the significant gain on foreign exchange of just over $1.9 million inclusive of a mark-to-market gain of just under $1.9 million. This compares to a loss on foreign exchange in the third quarter of 2008, of $683,000 inclusive of a mark-to-market loss of $526,000.

I would like to highlight that the mark-to-market accounting process has resulted in a derivative instrument asset related to foreign exchange gains on our balance sheet at the end of September of $1.9 million. This asset will reverse in future accounting periods as we undertake mark-to-market assessments of our outstanding foreign exchange contracts and at that time will result in recognition of significant non-cash losses and foreign exchange in those periods in which these forward contracts unwind.

I will note that these losses will have a significant non-cash impact on the bottom line next year. Second, we reported a foreign exchange gain of $49,000 during the third quarter, as compared to a foreign exchange loss of $200,000 during the third quarter last year.

Third, during the third quarter last year, we incurred a loss on disposition of computer equipment of $0.5 million that was not incurred this year. Net income for the third quarter of 2009 increased to $5.1 million, or $0.07 per share, compared with a loss of $71,000, or less than a $0.01 per share, for the same last quarter.

There were a number of notable items that favorably impacted net income for the third quarter of this year. First, net income included other income of $1.9 million, generated by the receipt of the third and final payment in the sale of equity stake in Afilias last year.

Second, as I noted earlier, we recorded a gain on the value of our foreign exchange contracts also in the amount of $1.9 million. Third, as we are no longer subject to state taxes in certain jurisdictions, given the change in jurisdictions in which we now operate, we have reassessed the tax rate at which our deferred tax liability should be carried at and have reduced our deferred tax liability by $497,000.

Turning to the balance sheet. Cash and cash equivalents at the end of the third quarter of this year increased to $8.2 million, from $2.7 million at the end of the third quarter of last year, the $7.4 million at the end of the second quarter of this year.

The increase in cash of $731,000 from the second quarter of this year is attributable to the receipt of $2 million as the third and final payment from the sale of our Afilias investment. This increase was partially offset by our repaying $479,000 on our bank loan, our investing an additional $281,000 in acquiring fixed assets, and our using $570,000 to repurchase our shares under the second modified Dutch tender auction offer.

Cash flow from operations for the third quarter was $82,000, and, as Elliot mentioned, reflects a significant change in non-cash working capital, which was primarily impacted by three factors. First, new payments from customers did not arrive in time for quarter end and resulted in banking receivable payments amounting to $0.5 million shortly after the quarter end.

Second, we had made payments of $1 million to certain of our suppliers to comply with new payment terms we had agreed to with them. Third, as we’ve explained on prior calls, this is the first year that we have recorded a provision for income taxes, and, during the quarter, made provisional payments to the receipt of totaling $875,000.

Combined, these factors impacted cash flow from operations during the quarter by approximately $2.3 million. Deferred revenue at the end of the third quarter was $56.5 million, up $3.9 million from $54.4 million at the end of the third quarter of last year, down slightly from $50.9 million at the end of the second quarter of this year.

To conclude, our financial results for the third quarter continued to demonstrate the strength of our overall business, the continued success in improving our overall cost structure. Against the backdrop of a challenging macroeconomic environment and weakness in the Internet services market, a strong competitive position has enabled us to grow demand service component of our business in each quarter of this year.

At the same time we are gradually realizing the benefits of the improvements we have made to other service categories, positioned them for future growth. As a result, we remain confident in our ability to consistently generate cash flow from operations and realized value for our shareholders.

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

Thanks, Mike. At our year end call in February, I stated that we would be aggressive in returning capital to shareholders.

As announced on our last call, we initiated our third modified Dutch auction tender. Under this offer, which commenced on August 20th, shareholders have the opportunity to tender their shares at a price ranging from $0.52 to $0.60 per share.

Our intention was to repurchase up to 5 million shares. The resulting tenders by shareholders were such that we purchased just under 785,000 shares at $0.60 for a total dollar investment in our part of approximately $470,000.

On the positive side, the results are indicative of the loyalty of our shareholders and their belief in our business going forward. Before the tender was first announced, our shares were trading in the mid $0.40 range.

In aggregate, we've now purchased a total of 6.1 million shares through our Dutch tender offers this year, reducing our number of shares outstanding by more than 8%. Total shares outstanding now are just over 67 million.

While we are not announcing another tender on this call, we are continuing to evaluate next steps here and most importantly, we remain committed to a strategy that returns capital to shareholders and is focused on seeing the value that Tucows best realize. Looking ahead to 2010, we expect to continue to grow our business and generate solid cash flow but we know that our results will be impacted by a few factors First for some time we have saying that direct navigation names are non-strategic and it was our objective to bring consistency to bulk sales of this class of names.

We have been successful in this regard and now have regular bi-monthly disposition of these names under a subcontract for a consistent amount of money. In addition, in 2009 we were able to sell the bulk of our backlog of these names.

This resulted in nearly a $1.5 million of revenue generated that will not be repeatable in 2010, much, but not all of this will be replaced by increased volume in the sale of brandable sales. Second, over a $1.5 million in revenue from email in 2009 arose from the three large media portal customers who moved as part of broader alliances.

We do expect new customers to replace some of that revenue. Third the change in our tax status, as Mike had discussed on the two previous conference calls this year, in 2010 we will be fully taxable.

We did have a low effective rate in 2009, however, that rate will increase significantly in 2010. In closing, we feel about the business.

We expect growth to come from a number of different places and we continue to improve the efficiency of the business. We are looking forward to 2010.

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

Just starting off with I guess the last point that was made on the tax rate, can you just remind us what tax rate, which we are looking for in 2010?

Roughly 34.5%.

Are you referring to that’s the reported tax rate on the income statement, right?

Sorry, I didn’t catch that, Thanos.

You are referring to the reported tax rate on the income statement, correct?

That’s right.

Elliot, you made a comment earlier about, you are seeing signs of an uptick, and in the past few quarters with downturn in the economy, we really haven’t seen much of an impact on your business, you have shown remarkable resilience during that time. So, how should we think about what impact or affects you will see as the economy starts to recover, where would that likely show up?

We think that that place where we did see a macro impact was in the broader domain name market. If you look at the registry results, that get reported, there were some pretty significant breaking of growth, or in some cases even decline in the registrations year-on-year and a couple of those quarters, but we were able to kind of keep growing into that.

It certainly muted our growth, and you have seen very simple things. Unless some times the people had a comment on that, they have let them let go.

That kind of activity is the margins. We really saw the start of October distinctly different from September, if that starts to pick up.

So where that will live for us is in the new registrations and probably the renewal transactions as well. So we think it will help mostly around the domain registration results.

It could help a little bit with email as well as our customers start to feel a little bit healthier about things. They could be more open to outsourcing and picking up new cost.

Just talking about sort of the use of cash going forward, you clearly have the Dutch auctions in recent quarters. Any thoughts or what's your current thinking as far as potential for dividend?

Well, I think I'll go back to my general statement there, which is I think that's not something we would in any way consider as long as we felt the stock was undervalued. I think still looking at where we are valued relative to, and I never liked that as you know, I never to like hope too much evaluations, but I'm still pretty comfortable that the stock is quite attractively valued.

Turning to the domain sales, I just want to be clear on the comments that you made about the non-repeatable business. So if you could just kind of elaborate on the comments you made there?

Sure. So over the couple of few years that we were sort of taking the [exit] from our expiry stream, we built up a bit of a backlog of those direct navigation names and you remember those are the names that are really valued on a multiple of revenue based on their traffic, not for in any way their value to a company who might want to name themselves or use the name line of business and we are really focused on those brandable names.

Now through this year, we've been very successful at kind of selling our excess inventory that we had around direct navigation names. So now we are getting to the point where what we are really doing is, we are monetizing that inventory as it comes in.

So, we kind of burden through some of that backlog or excess inventory. I mean you'd almost think about it, if we were a classic business, we had built up excess inventory in a certain line or certain goods that we then shows to run down on because it wasn't what we are emphasizing.

At the same time underneath that the folks in the YummyNames business unit have really done a strong job building up around those brandable sales. So, the direct navigation sales that will still go on, but at a suddenly reduce rate to last year, around the number that I have talked about and we will be filling in with some of those brandables and I think over time you will continue to see growth around that business unit, but this is really, almost an inventory adjustment.

Okay, guys. That’s very clear.

In the YummyNames revenues you had this quarter of the $1.8 million, how much would have been in bulk sales.

This quarter I want to say, Michael, correct me if I’m wrong. I’m going to say 350,000 or so, maybe 400,000.

Well remember, when you are saying bulk I’m thinking now what I’ll call non-repeatable bulk. So, 350,000 to 400,000.

Okay. I got you.

So, I mean rather large transactions.

Well, not really. We have a quite regular transaction stream that in the kind low six figures every month or really a transaction of every 60 days that includes a couple of those.

That’s pretty regular and it does change a little bit, each 60 days period based on names that flow through, but we have now seen, I want to say three or four of those and they are pretty consistent transaction to transaction.

Okay. On the OpEx side, we should rethink about any significant changes there, now especially?

No, certainly as we are looking forward something we would actually started to do really in the last half of 2009 is to spend a little bit more money on marketing and when I say that, that’s primarily in terms of, not very many but a couple of few, and when you are really seeing that is as we’ve done so much of the platform work that we did, both in the OpenSRS business also in the Butterscotch and Hover business. Remember that works behind us and you kind of you have done the backend.

Now, we can start to focus a little more on the sales and marketing side against the things that we’ve built and put in place. So it’s a little bit more of a spend but really, you’ve noticed a long time, what I say that its not really in very appreciable numbers.

Product wise may be you could layout sort of what the next, year or two, will there be additional things that would be interesting in the portfolio. Give us some thoughts on that?

I think that as we are looking forward, the things that we’re playing with on the roadmap, are things that really extend from domain names and emails. So we think that there are some additional pretty closely related services that we will be able to supplement with.

I think that in other words what you would you hear there is, there is no kind of whole new category, that we see brining in but we do see some additional revenue opportunities through 2010 on some very closely related ancillary services. In addition, we are still big believers that there is some nice upside with the personal name service that we are really focusing on nailing that on the retail side of the business in Hover, and then taking what lessons we learned there, and to the extent that we are able to crack the code there rolling some of that learning back into wholesale.

We think we've got an amazing service with that personal name service, that email address, that's first name and last name dot.com that are ORG. We think it's still a real opportunity, and it's right at the intersection of domain names and email.

So we think there is a lot of opportunity than what we have in front of us.

As far as those of the things you'd be developing in-house I would assume?

That's right.

Any changes competitively, many guys being sort of more aggressively pricing or anything like that?

No. I think that there is probably two comments I'll make there.

One, you've heard me talk in the past about the fact that we are more focused on the wholesale segment than really in our view any of our competitors on a company level. For Tucows, the company, wholesale services to hosting companies and ISPs is what we do at our core and we think that that focus.

So competitively as others maybe have other things that are interesting them, that focus pays off and plays out well competitively. In terms of price, we really said about to try and be the low cost suppliers.

So when I say low cost, I'm not talking about low price, but to be the most efficient and effective supplier in the industry and the one who can live with the [finest] oxygen and I think we have done a great job of getting ourselves there. So I hope that our competitors are worried more about us there than we are worried about them.

I was wondering if you could be a little bit more specific on net increase in accounts payable, what was the purpose for it?

Are you talking about the payables?

Yes.

Do you mean the decrease in payables, like the use of cash in payables?

Right.

So there was a change in the ICANN contracts that created an incentive to significantly accelerate the payments and it was part of a number of changes in the new RAA or Registrar Accreditation Agreement with ICANN, and so it created a little bit of a change in the ICANN [theme], which is something that we passed along to our customers that we flow through on our pricing, and it required us to pretty significantly accelerate the payments. So that’s something where you catch up once and then you are in a pretty new steady stream cycle.

Then I was wondering retail declined a little bit sequentially and in the context of our statement of trying to crack the code in personal names in Hover. I was wondering how far along are you cracking that code and when do you think retail, I’m assuming that we would see that an increase in sales in retail, first, and then you could share what you did with your wholesale customers?

That’s right. So there is probably two comments I will comment there.

One, the sequential number is not really a big dollar number that’s primarily driven by renewal patterns. Still overwhelmingly the revenue in that business is with most retail businesses that have been round a while as renewals.

So that’s big driver there. In terms of the stuff we are doing for personal names, I am wondering if you would have seen this as an old Domain Direct customer, we’re doing things like learning how to cross-sell to domain holders, the personnel names.

We are working on a number of places where we are going to enter into new affiliate relationships. That effort really started in earnest around July, August.

So we are not seeing that yet. We are seeing a kind of learning and may be separately we can go into deeper dive on some of the boring details there, I think you would find some of it interesting.

That will start to bear fruit in the coming months, but at this point its really about, kind of building that, here’s what a small tweak looks like. Some place you might see that Aram.

Where you might have basically seen it, is in some of the things we are doing with the part pages.

Right, but there seems to have been, you don’t think this would be sort of step function, where once its done, you would see some sort of quick result worthwhile.

No I don’t think it would be step function at all, in fact I think it would be a slow and accelerating growth. Once you find kind of one vein you can mind then inside of that vein you can start to optimize conversions.

Optimize copy, optimize landing pages, all of those various pieces. So I think its something that is more like a snowball, than a step function.

Right and then Butterscotch and the content business, can you just give little more detail on where you are getting sales in Butterscotch and how the base tucows.com business is doing there?

Sure. So there was a couple of things they were first of all before I talk about probably three comments I'll make.

Well let me start with sales in Butterscotch, I think that we are now starting to see some progress around some of the corporate video work we've been doing. We had in the quarter, our first couple of repeat customers, large corporate customers that we've done some corporate video fort them, so they have come back to second time.

We've added a couple of new customers. There again its very snowball like and Q3 is the worst quarter in the year especially in that business, that has the July, August month typically very bad for advertising.

More impressively the traffic on the Butterscotch side both in terms of the site proper and the growth of its YouTube channel had been very, very impressive and one of the things that that's now its been a bit of a halo effect who have for the first time in the long time, we've actually seen the old tucows.com traffic start to tick up and that was a very encouraging sign for us. So if you have been watching or sort of looking at the site you will be seeing slightly more kind of cross traffic driving slightly more integration and that's really bearing fruit.

The traffic driven from Tucows to Butterscotch and from Butterscotch to Tucows, been pushing it both ways has actually nearly tripled, kind of Q3 over Q1 and it’s a non insignificant number. I didn't want to sort to talk about in the body here of the call, I don't want to talk about traffic numbers because they don’t translate directly in to revenue so quickly, but we're really seeing impressive traffic growth there and in the ways that we would like to, which is kind of that core pieces of being to build this video business, using that base that all base of Tucows.com customer really does seems we are playing out well.

Are you seeing any synergy or pull-through from your wholesale customers and domains and email today and they want the video content for their customer service or any other type, please?

There has been a couple of very good discussions there and we have got the making of the first couple of deals there. One thing you will see there if you look in the Hover help section now, there is over a 100 almost a 150 Butterscotch like tutorials that are produced with the same people and that’s giving us great demo showcase for those wholesale customers and they see it and they like it.

I think you will see our use of that internally and some of the synergies there accelerating. We think that we could doing a much better job on helping people to understand the benefit of personal names or premium names using video that we are doing today for example.

Great. Thanks everybody and we look forward to seeing you all next quarter.