TUCOWS INC TCX
February 22, 2013 - 7:49pm EST by
wan161
2013 2014
Price: 1.69 EPS $0.10 na
Shares Out. (in M): 40 P/E 15.4x na
Market Cap (in $M): 68 P/FCF 12.6x na
Net Debt (in $M): 4 EBIT 6 8
TEV ($): 71 TEV/EBIT 12.9x 9.5x

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  • S/O cannibalization
  • Self-tender
  • Internet

Description

Tucows Inc. (TCX US: $1.69)

 

I last wrote up TCX two years ago based on the company’s prodigious cash flow, modest valuation and habit of returning cash to shareholders in the form of Dutch auction self tender offers.  The shares have since more than doubled from $.78 to $1.70.  But the story is not over.  I believe TCX is entering a new, higher growth phase, while continuing generate free cash flow and maintaining the tradition of returning it to shareholders in a tax efficient manner.

 

From 2008 to 2010, TCX grew revenues from $78.5mm to $84.6mm, or 3.8% annual average revenue growth.  From 2010 to 2012, TCX revenues went from $84.6mm to $114,7mm, for average annual growth of 16.5% (14.8% from ’10 to ’11 and 18.3% from ’11 to ’12).  Before I explain what led to this growth, I’ll provide an overview of the business to refresh memories on what TCX does. 

 

Business:

Tucows, Inc. is a global provider of domain names and other Internet services.  The Company provides domain names, email and other services to resellers through its extensive reseller network and directly to consumers and small business through its retail and content groups.  Tucows is the world’s first domain wholesaler and has grown to become the largest wholesale domain name registrar.

 

TCX’s reseller network includes more than 13,000 web hosting companies, ISPs and other resellers in more than 100 countries.  This reseller network, called OpenSRS, manages over 14 million domain names and millions of email mailboxes.  Tucows is an ICANN accredited registrar. 

 

The Company’s sells domain names and email addresses directly to consumers and small business through its retail group known as Hover

 

Ting.com is the name of the Company’s mobile phone service provider in the U.S. market.  As it was launched in February 2012, this business did not exist when I wrote up TCX two years ago. It is now a fast growing unit with low upfront costs and minimal ongoing expenses.  It is EBITDA negative at the present time.

 

The YummyNames unit owns and operates premium domain names that generate revenue through advertising or resale.  These comprise tens of thousands of domain names owned by the Company – essentially a portfolio of names for sale and lease.  Revenue from this unit can be lumpy.

 

Finally, Butterscotch is Tucow’s Content group, offering an online video network which gives consumers entertaining video to demystify technology and the Internet.  Butterscotch operates two advertising supported websites, Butterscotch.com and Tucows.com.  Tucows.com is a popular software download site.

 

Beginning in the first quarter of 2012, Tucows reclassified its revenue streams into three distinct service offerings: Wholesale, Retail and Portfolio. The Wholesale segment comprises OpenSRS, which provides domain services and value-added services per above.  The Retail segment consists of Hover and Ting.com, which provide the sale of domain name registration, email services and mobile phone services to individuals and small business.  The Portfolio segment is made up of Yummy Names and Butterscotch, and generates revenue from advertising on the Company’s domain names portfolio and from the Company’s advertising supported Butterscotch websites (butterscotch.com and tucows.com), and revenue from offering names in the Company’s domain portfolio for resale and lease.

 

Here is a snapshot of revenue, revenue % by segment, revenue YoY growth, and gross margin in for the 9 months ended Sept. 30, 2012 by segment (I choose to present this time period because it is the most recent for which a 10-Q/ K is available with detailed breakdown):

 

                                    Revenue          % of                YoY %                        Gross

Segment                       $mm                Total                Growth                        Margin

Wholesale                    72.925             85.8%              16.6%              23.4%

Retail                           7.113               8.4%                85.6%              38.8%

Portfolio                      4.898               5.8%                13.3%              87.1%

Total                            84.936             100%               20.1%

The above gross margin figures are before network costs and network D&A.  Overall gross margin after all network cost/network D&A is 23.4%

 

Acquisitions

In the past two years the company made one acquisition.  This was the acquisition of EPAG Domainservices, a German company, for $2.4 million on August 1, 2011.  At the time of the acquisition, EPAG had an annual revenue run rate of about $3.5 million.  We can use this figure to calculate the approximate growth in 2011 and 2012 ex-EPAG: 11.3% in 2011 and 18.1% in 2012, or 14.7% per annum over the two year period, versus 16.5% including the acquisition of EPAG.  The point is, organic growth at Tucows has strengthened considerably in the past two years compared the to what is was when I last wrote up the idea.

 

Cause of Growth

Excluding the acquisition of EPAG, the factors impacting growth include attracting customers with increased transaction volumes, fee increases (which were accepted by customers), returns from the investment of market development funds provided by vendors to expand or maintain the market position for their services, (all in the Wholesale segment), success of marketing initiatives and improved website for attracting new customers and the impact of Ting’s mobile device sales (in the Retail segment), and the timing of portfolio domain name sales (in the Portfolio segment).

 

The factors impacting the Wholesale segment listed above are a result of the an increase in the total domain names under management by the company which, in turn, is the result of success in attracting new customers and better quality customers i.e., customers with higher transaction volumes.  This comes from targeting the right customers and being successful in acquiring those customers, both borne out of the Company’s fruitful marketing efforts.

 

The factors impacting the Retail segment are also a result of the company’s successful marketing efforts and the introduction of a new service, Ting.  In the nine months ended September 30, 2012, Ting contributed $1.7 million to revenues versus zero in the same period of 2009.  This upward trend in Ting revenues is expected to increase as more consumers come to appreciate Ting’s value proposition. 

 

The Portfolio segment’s sales are lumpier and growth is harder to predict, though the recent trend has been positive.

 

In June 2011, ICANN introduced new gTLDs (global top level domain names) such as .apple, for example.  The sale of these gTLDs began in Jun 2012.  The Company believes the expansion of new gTLDs will result in an increase in the number of domain names the Company registers and related revenues.  The Company has paid $0.7 million in application fees for four domain strings under ICANN’s new gTLD Program and expects the delegation of operator rights for each gTLD to be commenced in 2013.

 

Another factor that can help revenue growth and profitability in the future is the announcement on November 30th, 2012 that Verisign and the US Department of Commerce had come to an agreement that allows Verisign to continue to operate the .com domain for another six years.  What’s different this time is that Verisign no longer has the right to four price increases of 7% over the term of the agreement, as it did in the past.  This is positive for registrants and in turn will be positive for TCX.

 

Repurchase of Company Shares

The Company has continued its history of buying back a large number of its own shares, both as normal course issuer bids (normal share buybacks in the market) and as Dutch auction tender offers.  In 2010 alone TCX repurchased 13.7 million, or ~20% of its shares outstanding at the start of the year.  Since January 1, 2007, TCX has repurchased over 37.2 million or nearly half of its shares outstanding at the start of 2007.

 

The CEO has stated that the Company continues to believe share buybacks, in-market or in the form of Dutch auctions, are an excellent means to return the Company’s substantial cash flow to shareholders and create shareholder value.

 

The CEO has said that the reason TCX remains a publicly traded Company is due to three reasons: 1 – public company options are preferable to private company options; 2 – it’s easier for shareholders to get into and out of their investment, and 3 – being public makes returning capital to shareholders much easier and more effective than if TCX were a private company.  TCX manages the cost of being a public company well, mitigating the downside to be being public. 

 

The table below summarizes the repurchase of shares since 2007:

 

Tucows Inc. - Repurchase of CommonShares January 1, 2007 to January 4, 2013

       
 

2,007

2008

   

2009

   

2010

2011

 

2012

 YTD 2013

Announce Date

2007

2008

12Feb09

26May09

20Aug09

14Dec09

16Feb10

09Sep10

01Nov11

15Dec11

16Mar12

13Nov12

Completion Date

2007

2008

23Mar09

14Jul09

02Oct09

21Jan10

09Sep10

19Oct10

15Dec11

19Jan12

15Nov12

04Jan13

Type

Market

Market

Dutch

Dutch

Dutch

Dutch

Market

Dutch

Market

Dutch

Market

Dutch

 

Purchases

Purchases

Auction

Auction

Auction

Auction

Purchases

Auction

Purchases

Auction

Purchases

Auction

No. of Shares

2,616,600

849,760

4,185,769

1,103,824

784,643

6,341,470

3,409,300

3,913,670

23,765

7,570,236

2,371,204

4,114,121

Cost (USD$)

2,452,766

272,444

1,716,132

496,721

470,786

4,439,029

2,423,807

2,739,569

18,442

5,829,082

3,286,751

6,171,182

Price/share paid

$0.94

$0.32

$0.41

$0.45

$0.60

$0.70

$0.71

$0.70

$0.78

$0.77

$1.39

$1.50

Shares Outstanding December 31, 2006: 75,978,502

             

Shares Outstanding January 4, 2013: 40,215,688

               

 

Over 14 million shares have been repurchased and retired by the company since my last write=up two years ago. 

 

 

Valuation

As can be seen on the Historic Financial Data & Valuation Metrics table below, for the year ended December 31, 2012, proforma for the dutch self-tender completed on January 3th, 2012, TCX trades at 0.62x revenues, 9.7x EBITDA, 11.2x EBITDA minus CapEx and for a reasonable 7.9% free cash flow yield.  While these multiples are higher than the last time I wrote TCX up, it was a low growth story then.  Now it is a mid- teens growth story that continues to buy back its own shares at an aggressive rate.  The nearly 8% free cash flow yield is all the more impressive considering the extra working capital requirements that go with being a mid-teens top line growth company.

 

Tucows Inc.

 

 

 

 

 

 

Historic Financial Data & Valuation Metrics

 

 

 

 

 

 

 

FYE

 

 

FYE

 

 

FYE

 

 

(USD$ millions)

31Dec10

 

%

31Dec11

 

%

31Dec12

 

%

Revenues

84.579

 

100

97.065

 

100

114.727

 

100

Cost of Goods & Svcs

64.475

 

76.2

73.762

 

76.0

88.518

 

77.2

Gross Profit

20.103

 

23.8

23.303

 

24.0

26.209

 

22.8

Ops & Development, D&A

6.191

 

7.3

6.060

 

6.2

5.369

 

4.7

SG&A

10.098

 

11.9

13.539

 

13.9

15.312

 

13.3

Operating Income

3.815

 

4.5

3.703

 

3.8

5.528

 

4.8

Interest Expense

0.116

 

0.1

0.050

 

0.1

0.193

 

0.2

Other Expense (Inc.)

1.371

 

1.6

0.202

 

0.2

-1.094

 

-1.0

Pretax Income

2.328

 

2.8

3.451

 

3.6

6.428

 

5.6

Income Tax

0.211

 

0.2

-2.720

 

-2.8

2.004

 

1.7

Net Income

2.117

 

2.5

6.170

 

6.4

4.424

 

3.9

 

2.117

   

6.170

   

4.424

 

 

                 

 

Depreciation & Amort.

2.945

 

3.5

2.028

 

2.1

1.822

 

1.6

EBITDA

6.759

 

8.0

5.731

 

5.9

7.349

 

6.4

Capital Expenditures

0.589

 

0.7

0.851

 

0.9

0.997

 

0.9

 

               

 

Net Cash from Operations

6.769

   

5.885

   

6.343

 

 

Capex

0.589

   

0.851

   

0.997

 

 

Free Cash Flow

6.180

   

5.034

   

5.346

 

 

 

               

 

$mm shares repurchased

$9.602

   

$0.018

   

$9.116

 

 

No. of shares Repurchased

13,664,440

   

23,765

   

9,941,440

 

 

 

               

 

Shares O/S

           

40.216

 

*

Share Price

           

1.69

 

 

Equity Market Cap (EMC)

           

67.965

 

 

Debt

           

3.700

 

 

EMC + Debt

           

71.665

 

 

Cash

           

0.244

 

*

Total Enterprise Value (EV)

         

71.420

 

 

 

               

 

EV/Revenues

           

.62

 

 

EV/EBITDA

 

 

 

 

 

 

9.7

 

 

EV/(EBITDA - CapEx)

 

 

 

 

 

 

11.2

 

 

EV/EBIT

 

 

 

 

 

 

12.9

 

 

EMC/Pretax Income

 

 

 

 

 

 

10.6

 

 

EMC/Net Income

 

 

 

 

 

 

15.4

 

 

EMC/Free Cash Flow

 

 

 

 

 

 

12.7

 

 

Free Cash Flow Yield (%)

 

 

 

 

 

7.9%

 

 

Notes: 1 - Stock-based compensation is not added back above to derive EBITDA because I believe it is

 

incorrect to deduct a form of compensation from expenses to derive an artificially inflated EBITDA.

   

2 - * Shares O/S and Cash both reflect proforma repurchase of  4.1mm shares in dutch auction self tender

completed on January 4, 2013, after fiscal year end 2012.

             

 

Conclusion

Tucows is a well-run microcap cash-generating GARP story with a mid-teens growing top line offering a very reasonable FCF yield doing something few growth stocks do: returning cash to shareholders by buying back shares aggressively. The Company's strategy has worked extrmely well since I last wrote it up two years ago.  With the sustainable acceleration of top line growth since then and continued share repurchases, I expect the shares to perform very well during the next few years.

I do not hold a position of employment, directorship, or consultancy with the issuer.
Neither I nor others I advise hold a material investment in the issuer's securities.

Catalyst

Continued revenue growth from sustainable drivers and continuation of share repurchases though open market purchases and Dutch auction self tenders.   Continued execution of strategy that has worked so well since I last wrote it up two years ago.

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