In the past, we’ve profiled a handful of microcap companies (FNET, KSW, LIMC, RMCF), either with discernible competitive advantages, particularly rational management, or an imminent catalyst for unlocking shareholder value.
We continue in that vein today by profiling Tucows, Inc. (TCX), an ICANN-accredited internet domain registrar based in Toronto that manages email services and over nine million web domains. Through its subsidiary Butterscotch.com, it also owns one of the oldest and most popular software download sites on the Internet. At present, its principal shareholders include: Lacuna, LLC, which controls 17.7% of outstanding shares (as of 3/23/09), Diker GP LLC (13.7%), and Fertilemind Capital Fund I, LP (5.7%).
About two-thirds of Tucows’ revenue derives from its wholesale domain registration services, being the third largest ICANN-accredited registrar in the world and the largest publicly traded. And like other domain registry servicers (e.g., Network Solutions, GoDaddy), its business model is characterized by non-refundable, up-front payments, which generate predictable, positive operating cash flows. More specifically, Tucows receives payment for the annual registration fee prior to providing the full cost of the service, yet it is required to book those payments and costs incrementally. Looking at its balance sheet, one sees what—at first glance—may appear to be a highly-levered, capital-intensive business with nearly $97 million in assets and $75 million in liabilities. Yet, the bulk of these assets and liabilities pertain to prepaid fees and deferred revenues for their domain registry business. In truth then, Tucows is a cash-rich and largely unlevered business that fills its checking account faster than its earnings statement would indicate. In a way, its revenue resembles an insurance premium—non-refundable, and paid up-front—and enables Tucows to keep its cost of capital very low and perhaps even negative.
However, it is not only the balance sheet that masks Tucows’ virtues. In 2008, Tucows took initial steps to divest non-strategic assets and concentrate energies on its most profitable businesses. This process has complicated its cash flow statements and masked its significant free cash flow growth. For example, in 2006, depreciation and amortization charges of $3.9 million were less than capital expenditures ($4.6 million); in 2008, depreciation and amortization charges of $4.8 million far exceeded capex ($2.1 million). Because Tucows has significant amortization expenses—deriving from the intangible assets of previous acquisitions (i.e., customer relationships)—it has far more cash coming into the company today than its reported earnings reveal.
Lastly, Tucows has raised more cash in the last year by liquidating its $7.5 million equity stake in Afilias and a portion of its domain name portfolio. In their second quarter results (coming out in mid-August), Tucows will book a $2 million pre-tax gain on a portion of its Afilias stake; an additional $2 million pre-tax gain will also follow later this year.
Perhaps most interesting though is where all that cash is likely to go. In the last year, Tucows has used some cash to pay down its long term debt, repurchased 4.2 million shares (about 6% of those outstanding) in a “Dutch Auction” tender offer in March 2009, and repurchased an additional 1.1 million shares in a second “Dutch Auction” tender offer in July 2009. And to date, Tucows has ample room remaining in its $10 million stock repurchase program. Though the future capital allocation decisions are difficult to predict, the chains of habit are not easily tossed aside.
All told, Tucows strikes me as a relatively low margin business with low (and perhaps negative) capital costs that has deployed its retained earnings profitably for shareholders in recent years. Though GoDaddy is the dominant player in the sector, Tucows has added customers and concentrated its business lines. If Tucows continues to divest its non-strategic assets and contain its costs, I would not be surprised to see them earn more than $7 million this year ($4.5 million from operations and $2.5 from after-tax sale of investments). With a market cap of $29 million (as of 7/30/09), management and the Board should have an opportunity to buy back shares quite cheaply.
That is, unless enterprising investors find it first.
Disclosure: I, or persons whose accounts I manage, own shares of Tucows at the time of this writing.