Tucows Inc. (TCX: Amex) is a classic money spinner – a free cash-flow generating machine with top-line growth that efficiently returns cash to shareholders through share repurchases and dutch auction self tenders.  TCX has been cash flow positive for the last eight years and has over $80 million in revenue growing 3 – 4% per year.  The company trades at just 6.0x trailing EBITDA, 6.6x trailing EBITDA minus CapEx (low CapEx needs), and has a free cash yield of 15.9%, All with steadily growing revenues, EBITDA and free cash flow.

The Company has kept a good handle on costs, with SG&A, operations & development, and non-cost of sales D&A as a percent of sales declining over the past few years.  EBITDA has grown from 5.4% of sales in FYE 2008 to 8.2% of sales in LTM Q3-10, and EBITDA has grown 62% in that time, from $4.2mm in FYE 2008 to $6.82mm in LTM Q3-10.  EBITDA minus CapEx has grown even faster, from $2.09mm to $6.14mm.  Note that I do not add back stock-based compensation in my EBITDA calculation.  I believe stock-based compensation should be recognized as a legitimate expense, even if it is “non-cash” since the shareholders end up paying for it in the form of dilution.

More details are provided below, but first I will talk about the business of Tucows.

Introduction:

Tucows, Inc. 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 10,000 web hosting companies, ISPs and other resellers in more than 100 countries.  The reseller network, called OpenSRS, manages over 10 million domain names (over 5% of all domains on the net) 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. 

YummyNames is the TCX unit that oversees tens of thousands of domain names owned by the Company – essentially a portfolio of names for sale and lease (many of which generate advertising revenue). 

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.

Tucows, a Pennsylvania corporation headquartered in Toronto, files with both SEDAR and the SEC, and trades on Amex and on the Toronto Stock Exchange.  It has additional offices in Starkville, MS and in London, United Kingdom. 

Here is a snapshot of revenue, revenue % by unit, revenue YoY growth, and gross margin in Q3 2010 by unit:

                                    Revenue          % of                YoY %                        Gross

Unit                             $mm                Total                Growth                        Margin

Open SRS                    18.151             85.7%              6.6%                21.2%

YummyNames             1.248               5.9%                -29.9%             85.6%

Hover                          1.148               5.4%                4.7%                66.9%

Butterscotch                 0.632               3.0%                36.9%              98.1%

Total                            21.209             100%               3.5%

The above gross margin figures are before network costs and network D&A.  Overall gross margin after all network cost/network D&A is 23.2%

More details on the four units follows:

OpenSRS

OpenSRS provides its reseller network with domain services, email services and other services.  Domain services accounts for over 96% of OpenSRS revenue.  Domain services allows Tucows to add to its domain portfolio by purchasing names registered through the company upon their expiration.  Domain registrations are usually purchased for a term of one to 10 year, with the majority having a one-year term.  Payment for most domain registrations is made up front at the time of activation.  This results in a deferred revenue entry on right side of the balance sheet and a prepaid domain name registry entry on the left side of the balance sheet.

OpenSRS Email Service accounts for less than 1% of OpenSRS revenue and provide resellers with hosted email solutions that can be customized to their branding for the end user. 

Other Open SRS Services consists primarily of SSL (secure socket layer) certificates, but also includes blogware and website building tools that the resellers use to create bundles of Internet services to the end customers, and includes the Company’s Platypus billing software.  This software is offered to ISPs and allows for the provision of billings, provisioning and customer care solutions.

YummyNames

YummyNames is Tucows’s Domain Portfolio Group. Through this unit the Company manages tens of thousands of domain names.  Tucows earns revenue from its portfolio of domain names by displaying advertising on them.  In addition, many are offered for resale via Tucows’s reseller network and other channels.  Included in the Domain Portfolio are over 40,000 domains that are the basis for the Company’s Personal Name Service that allows over two-thirds of American to purchase a domain or email address based on their name.  For example, Tucows owns the domain name smith.net in its Domain Portfolio group.  Anyone named Smith who wants a personalized email address can get yourname@smith.net and yourname.smith.net as their personal web site for a price, assuming it is available.

The Company’s domain name portfolio is categorized into four classifications: Gems, Premium Names, Direct Navigation Names and Surnames.

Gems have the highest potential resale value, generate significant advertising revenue, or are brandable.  They can be worth $10,000 to $50,000.  Examples include tool.com, backs.com and veggies.com.  Premium Names are domains that could act as brands for businesses acting at those domains, and could be worth $1,000 to $5,000.  Examples include KansasGolf.com and FixYourFeet.com.  Direct Navigation names have nominal brand value but do generate advertising revenue from pay-per-click ads the Company places on these sites.   Surnames are domain names related to last names mentioned above. 

Hover

Hover offers individual and small business domain registration, email and other Internet services.  Hover does not provide web hosting, but instead connects domain names to websites though a DNS forwarding system.  This allows users to create short, easy to share links from a domain name to any web page on the Internet.

Butterscotch

Butterscotch is Tucows’s Content group, which generates advertising revenue though two websites, one of which is Tucows.com, one of the oldest and most popular software download sites on the Internet (founded in 1993).  Tucows.com offers reviews of and links to about 40,000 shareware, freeware, and demo software packages available for download. 

Butterscotch.com offers television-like shows and video tutorials designed to visually teach users about technology and the Internet. 

These sites have over 3,600 videos and over 300,000 software and mobile listings and articles.  Butterscotch also provides custom video production services for technology manufacturers and ISPs.

Acquisitions

While the Company has made a number of small acquisitions in the past, things on the M&A front have quieted down in the past few years, with the last deal being the purchase of Innerwise, Inc., in July 2007 for $11.4mm.  There is a large noncash amortization of intangibles charge on the income statement as a result of amortization of these acquisition-related  intangibles ($1.44mm in 2009; $1.48mm in 2008).

FX Exposure and Hedging

The Company’s revenues are principally in U.S. Dollars while a significant portion of expenses are in Canadian dollars.  The company hedges this exposure with currency forward contracts.  The Company accounts for the fair value of these derivative instruments within the balance sheet as a derivative financial asset or liability and the corresponding change in fair value is recorded in the consolidated statement of operations each quarter under mark-to-market accounting.  While in some years the gains and losses from currency contracts shown on the income statements seem large, they are non-cash charges/credits as can be seen by the corresponding items on the cash flow statements.

Major Shareholders

The two largest shareholders as of the date of the most recent annual meeting proxy (dated August 9, 2010) were Lacuna, LLC with 14.0% and Diker GP with 16.1%.  A representative of Lacuna is on the board of directors of the Company.  Directors & officers own shares and exercisable options (within 60 days) accounting for 22.3% of shares.  The CEO, Elliot Noss owns shares and exercisable options for 5.0% of shares. 

Repurchase of Company Shares

The Company has a 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 23.2 million or ~30% 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:

The above repurchase costs exclude transaction costs.

CapEx

The Company has stated that it envisions Capex to stay in the current range for the foreseeable future.  2009 CapEx was $0.808mm while LTM Q310 CapEx was $0.674mm.  The Company’s CapEx needs are quite low at 1% of sales or less.  This contributes to the strong free cash flow generation.

Valuation

As can be seen on the Historic Financial Data & Valuation Metrics table below, for the LTM Q3-10 TCX trades at 0.49x revenues, 6.0x EBITDA, 6.6x EBITDA minus CapEx and 6.3x free cash flow, for a whopping 15.9% FCF yield.  These metrics point to a cheap, underfollowed stock.

While there are few publicly traded comps, I’ve managed to find a few along with some acquisitions in the space to compare with TCX’s trading multiples.

Register.com

In August 2010, Web.com (ticker WWWW) bought Register.com from Vector Partners for $135mm.  at the time Register had $84.9mm Q4x4 run rate revenues and $22.6mm of EBITDA (LTM 6/30/10), though this EBITDA was somewhat inflated because restrictive debt covenants necessitated a cutback of marketing expenditures.  This excerpt is from WWWW’s conference call to discuss the deal:

“Register.com's adjusted EBITDA margins have admittedly been running higher in recent periods because of restrictions on its ability to invest in the business due to the nature of debt covenants they had in place. And its recent revenue run rate is essentially flat on a year-over-year basis in spite of facing two significant headwinds: the difficult economy and these investment restrictions. We believe there is an attractive opportunity to both rejuvenate Register.com's overall source of revenue flows in addition to gaining leverage for our combined company.” 

Register.com was purchased for 1.59x revenues and 6.0x inflated EBITDA compared to TCX’s .49 and 6.0x on the same metrics.  Interestingly, Register.com was taken private by Vector Partners in August 2005 at .86x trailing revenues and 10.0x trailing EBITDA.   Including dividends paid to the sponsor, Vector made about 2.5x its equity on the deal.

Web.com

Since WWWW acquired Register.com just 6 months ago, trailing data is not meaningful, but based on street estimates, WWWW trades at 8.9x 2011 EBITDA and over 2.0x revenues.

Indom & Group NBT

On December 14, 2010, Group NBT Plc (NBT LN) bought Indom, a French domain name registrar, for Eur16.9mm cash (there was Eur2.3mm net cash on the B/S), or an EV of Eur14.6mm.  Indom had 2009 revenues of Eur 6.6mm and was slightly profitable, with 2009 profit before tax and amortization of Eur0.5mm, so the EV/Revenue paid was 2.2x. 

NBT is Europe’s leading specialist domain name management company and one of the UK’s largest providers of website hosting services.   NBT trades at the following trailing multiples: EV/Revenues: 2.15x; EV/EBITDA: 9.6x. 

Conclusion

Tucows is a well-run microcap cash-generating machine with a growing top line, and faster growing EBITDA and free cash flow trading at a modest valuation.  The stock’s FCF yield of 15.9% is one of the highest I’ve come across lately.  The cash the company generates doesn’t just pile up in the bank, inaccessible to shareholders.  It is returned to shareholders - used to buy back shares - at a rapid pace (five Dutch auction self tenders since Feb ’09).   After the financial market bubble burst in 2007/2008, the company was buying back shares at an average of $.32 per share in 2008.  In the last Dutch Auction the Company held in October 2010, the price per share paid was up to $.70 and shares are trading in the market at $.78 per share, reflecting the success of the Company operationally and in returning its ample cash generated to shareholders.

Catalyst – Continued revenue, EBITDA, and free cash flow growth and continuation of share repurchases though open market purchases and Dutch auction self tenders.