Description

We believe Elliot Noss, the CEO of Tucows (“TCX”), has built one of the one of the best high quality compounders in small cap public equity. Simply put, Adjusted EBITDA per share has grown from $0.42 a share in 2011 to $3.00 in 2016 and we think $10+ in 2020. It is a result of a double barreled approach of aggressively repurchasing stock (120% of Adjusted EBITDA), while growing high incremental margin business Ting.  

A High Quality Business:

1. 31% ROIC

2. 40% ROE

3. 15% annualized 5-year Revenue Growth

4. 43% annualized 5-year EBITDA growth

TCX’s Ting also received a very strong review from  Consumer Reports survey as well as a Net Promoter Score (NPS) ahead of Amazon and slightly below Nordstrom. This is due to their unique focus of successfully executing against a strategy of low-cost leadership and exceptional customer service.

Given the trajectory TCX is on, we feel less than an 8x multiple of Adjusted EBITDA is far too low (43% 5 year CAGR on Adjusted EBITDA) and that TCX should trade for at least 12x+ given that we think EBITDA will grow at least 25% CAGR through 2020.  We believe TCX will likely invest approximately $150+ million in very high ROIC investments between the business and share repurchases through 2020.

TCX has three subscription businesses with industry leading renewal rates and a company culture of exceptional customer service and low cost leadership that resonates throughout all segments:

1. Domain Services (64% of revenues) - the world’s third largest domain registrar, with ~15 million domains, $125 million in revenue, and estimated 8-10% EBITDA margin.

2. Ting Mobile (34% of revenues) – A mobile virtual network operator (“MVNO”) with 220,000 accounts and $65 million in revenue with estimated has 25-30% EBITDA margins

3. Ting Fiber (2% of revenues) – An emerging fiber internet service provider of fast internet speed of 1000mbps which should have a 50-70% EBITDA margins.

Elliot Noss, the CEO, has been at the helm for 17 years and is the largest shareholder, owning 6.5% of the company. CEO Noss, has made one good decision after the next:

1. Repurchased 50% of the company at an average cost of ~2x 2015 EBITDA or $5.37 per share;

2. Internally launched Ting Mobile from 0 to 220,000+ accounts and 0 to 65M in revenue in less than 4 years while maintaining SAC 70% below the industry, without contracts, and what we estimate to be 25%+ EBITDA margins;

3. Two nice tuck-in acquisitions for Ting Mobile and Domains Business (PTel and Melbourne IT, respectively);

4. Now Ting Fiber with great strategy and very high cash on cash returns.  

5. In 2016, on a $270 million market cap, the company is willing to reinvest $55 million back into share repurchases and what should be very high cash on cash returns in their Ting Fiber segment.  

Our thoughts on why the stock is underfollowed & undervalued?

Start with an insane name: Tucows, yes, pronounced 2 Cows with a logo of 2 cows (impact knock off 3 multiple turns of EBITDA), add a Canadian HQ's but 100% US based (knock off 1 turns of EBITDA), add no roadshows or conferences (knock off 2 turns of EBITDA), and finish up with a 50% reduction in share count with 100%+ of EBITDA going to buybacks in 2015 and a $40M share repurchase plan set in place for 2016 year (knock off another 3x turns of EBITDA). Who knows for sure, but the recipe has led to virtually no incremental institutional following of what we think is in the early innings of a very attractive return trajectory. (Institution Ownership and Insiders own 45% of the shares while the public owns the other 55%)  

By 2020, we think TCX will increase revenue from $200 million to $325-375 million in 2020 while increasing EBITDA from $30-35 million in 2016 to $80-90 million by 2020. Currently, TCX trades at 9x 2016 EBITDA (8x if you include hidden assets). We believe TCX EBITDA should grow on a sustainable trajectory of 20-30% CAGR over the next 4 years and will continue to aggressively reduce share count. The share count has dropped from 22 million to 11 million and we expect that by 2020, the share count will likely be in the 7-9 million share range. This would result $10+ EBITDA per share in 2020. Currently at $29, we believe TCX Sum-of-the-Parts is worth $45-56 per share, a 67-107% upside.

Business Overview

Tucows is a Toronto based Internet services and telecommunications company with operations in North America and Europe. Tucows consists of three stable businesses that are each a low-cost provider for utility like services with 100% recurring revenues, low churn, and best-in-class customer service. Through its legacy domain services business, Tucows operates the world’s third largest domain registrars selling domains wholesale to resellers under the brand “OpenSRS”, selling retail to individuals and small businesses under the brand “Hover”, and holds a portfolio of domains under the brand “YummyNames”. In February 2012, TCX entered the telecommunications industry under the brand “Ting”, as a mobile virtual network operator (“MVNO”), leasing the wireless network infrastructure from Sprint and T-Mobile and reselling the service to customers under Ting’s operations. TCX’s entrance into this new market was met with much skepticism; an internet domain registrar to invest in building an MVNO?? However, TCX’s legacy business was successful because if offered best-in-class customer service, competitive pricing, and a robust billing and services management platform. The exact same combination enabled Ting Mobile’s rapid growth and popularity. For the second straight year, Ting beat all of the major cellphone carriers in the Consumer Reports survey of U.S. Cellphone Providers and was the highest rated MVNO with the best customer service. In 2014, TCX once again decided to pursue another growth business by leveraging the Ting brand and operational base to become a fiber optic provider. TCX’s first move into the fiber initiative was through the acquisition of 70% interest in an independent regional Internet service provider under the brand Blue Ridge Internet Works in Charlottesville, Virginia.  So far, Ting has entered into three towns Westminister, MD, Charlottesville, VA, and Holly Springs, NC. They just announced their fourth market for consideration, Sandpoint, ID with plans to add 1-3 new markets in 2016 and increasing into more markets, 4-6 per year, as the flywheel gains traction. Looking back, TCX’s bets have paid off all while keeping a tight focus on bottom line profitability: LTM EBITDA growth at 46%. As we go forward, more and more of TCX’s revenues will shift into Ting Mobile and Ting Internet/Fiber which are higher margin businesses that will prepare TCX with substantial FCF dry powder to deploy into share buybacks, acquisitions, or reinvestment back into current business segments.

Three Stable Businesses

TCX divides their operations into three business segments:

1. Network Access – Other Services (“Ting Internet/Fiber”)

2. Network Access –Mobile Services (“Ting Mobile”)

3. Domain Services

1. Wholesale (“OpenSRS Domain Services” & “Value-added Services”)    

2. Retail (“Hover”)

3. Portfolio (“YummyNames”)

Ting Internet/Fiber

Ting Internet/Fiber will be providing households with fast internet speeds of 1000mbps with one of the lowest costs at $89/month for consumers and $139/month for businesses.  In some cases, TCX will build the fiber themselves and own the fiber network infrastructure, where in other cases, TCX will be working with municipalities who have built or are building their own fiber networks, which will be less capital intensive than the former. Banks are comfortable lending for investments in infrastructure and construction. Given TCX’s EBITDA, we believe the company could borrow 2x or maybe 3x EBITDA, which implies access to capital of potentially $60-$90M. Noss states it will cost approximately $2,500 to light up a house (initial capex) and gross margin will be around $1,000 per home. For the 2016 year, Noss expects to add 2-4 markets in 2016 (4-6 markets going forward) and will spend around 15M in capex for 2016 fiber initiatives. The gigabit movement is gaining traction with AT&T, Comcast, Google, Fairpoint, Windstream all adding markets. Although internet access is essentially a utility, we have high confidence on management’s execution to be the provider of choice when entering new towns and delivering the best service to customers.

“Growing customer demand, advancing technologies and pro-investment municipal policies that lower construction costs have accelerated our recent network deployments,”  - AT&T, April 2016

http://www.bloomberg.com/news/articles/2016-04-25/google-gets-beaten-to-the-punch-by-at-t-on-super-fast-broadband

“We're looking to be promiscuous around these fiber opportunities, because what we know we do best in the world is that customer experience, customer service, fair and transparent pricing and productizing. And so we want to make that available across as many networks as possible.” – Ting Virginia M&A Call 12/2014 – Elliot Noss

This extremely sticky business is one with high barriers to entry involving coordination with government officials at the local level and high upfront costs. Unlike Ting Mobile, Ting Internet is an extremely capital intensive business with high initial capital investment in return for a consistent stream of cash flows in the future. Using accelerated depreciation (writing off 50% of capex in year 1 and 1/15th annually), Ting Fiber will be able to shelter cash flows from taxes with high depreciation and interest charges. Using the assumptions below, we constructed a DCF for Ting Internet to reach a value between $7-12 per share. Ting (Fiber) Internet division should generate 90-95% in gross margin, 50-70% EBITDA margins, and provide significant cash flow margins in the years to come.

Ting Fiber comp, Allo communications, was acquired by NNI for 17.2x EBITDA and 4.1x sales in November 2015.

CEO quote “…the current performance reminds me of 2012, 2013 when we were investing in Ting Mobile. We are able to grow the business while investing in and launching a completely new revenue stream in a way that made the investment INVISIBLE AND PAINLESS to investors. Right now and for the next bit, we are investing in Ting Internet; and much like the last time, the investors who recognize this are likely to be well-rewarded.”

Ting Mobile

Ting Mobile was internally created in 2012 and in three years, Ting has one of the best unit economics in the industry, low churn, low CAC, high LTV, and the highest overall rating in the history of the Consumer Reports survey. Ting Mobile’s customer acquisition costs are under $100 and the average revenue per user is $37, the lowest among top 7 carriers. This segment has been growing rapidly from 0 to 65M in revenues and now makes up 34% of TCX revenues. The first quarter of 2016 benefitted from a one-time uptick in net additions due to a competitor, PlatinumTel Wireless (“PTEL”), shutting down their service and Ting being one of their few recommended providers. Backing out PTEL’s net adds, signs of slower growth were apparent in second half of 2015 into 2016, but was met with lower churn of 2.39% in 1Q16. Ting Mobile ended the 1Q16 with 141,000 Subscribers and 221,000 mobile devices under management. The following table exhibits the top 7 carriers’ statistics along with Ting Mobile:

Ting’s competitive advantages are its usage based pricing model, giving customers optionality to opt into cheaper plans, its excellent customer service, no hold time when you call, but most importantly, strategy execution in maintaining churn at low levels and consistently looking for growth opportunities. 11% of customer additions come through a customer referral program and Ting is very active with grassroots marketing, hosting webcam hangouts, publishing articles, and constantly keeping in touch with and updating customers. In Q3 of 2015, Ting announced two big partnerships with Kroger and Staples to distribute Ting SIM cards at ~2,000 retail locations across the US, which should help drive more credibility and awareness in Ting.

An example of TCX’s quirky culture:

“Grab a Ting GSM SIM for just $1 and get free priority mail shipping (Only valid while our CFO is on vacation, or while supplies last)”

Check out customer feedback of TCX on Facebook:

“So I showed my husband your video the other day and while I was laughing, he was looking at me like I was crazy. Fast forward to today.... I had him call your customer service as we are thinking of switching to Ting, and when he hung up with your customer service he looked at me with a shocked look on his face and said... now that's what Customer's Service is suppose to be like! Your Customer Service alone made him want to switch! “

Ting Mobile - No hold times:

https://www.youtube.com/watch?v=vV_l9ZoBfOI

With churn at ~2.5%, the average stay is around ~3 years and LTV is $1000+. Historically on average, the quarterly revenue per device is $80 and the device per subscriber is 1.5. Modeling out 6,000 net adds per quarter going forward, we calculate revenues for Ting Mobile to be 75M in 2016, 86M in 2017, and around 100M in 2018. With 25-30% margins, we calculate Ting Mobile to contribute $21M in 2016, $26M in 2017, and $30M in 2018. To value the business at  the midpoint of historical 9-14x multiple of EBITDA at 12x seems very reasonable to us for a subscription based business with 3 year average length of stay (~2.5% monthly churn), 15 to 1 ROI on Lifetime value/Subscriber acquisition cost, and what we estimate to be 25-30% EBITDA margins. With these assumptions, Ting Mobile is worth $25, $30, and $35 in 2016, 2017, and 2018 respectively.

Domain Services

Tucows’ core domain registrar business is a cash cow with no/low growth managing around ~15M domain names while cross selling value-added services. The business generates above $110M annually for the past 4 years and continues to be a very predictable and sticky business with extremely high renewal rates at record levels near 80% and rivaling that of industry leaders.

Recently starting 2Q16, TCX acquired the International Reseller Channel of Melbourne IT (everything outside of Melbourne IT’s domestic markets of Australia and New Zealand).

“In total, the deal added 1.6 million domain names under management that generate $13 million in annual revenue and $2 million in gross margin. For which we paid $6 million. We expect to generate a little bit of operating synergy from the acquisition, but given that we didn't acquire any operations, there isn't much more on the expense side than a few hundred thousand dollars. There are some additional service opportunities that we will explore, in that we offer a much broader range of CCTLDs and new gTLDs.” – Elliot Noss 1Q16 Transcript

This acquisition should add $13M to the topline and $2M to the bottom line due to operating synergies which will increase revenues to ~$125M with $9-10M in EBITDA. TCX Domain Services Comps trade around 1-2x Sales and 10-20x EV/EBITDA. Conservatively, we use the lowest EV/Sales, Rightside at 0.9x and Melbourne IT’s 1.3x. Using EV/Sales between 0.9x-1.3x on TCX 2016 Domain Services 2016 Revenue of 125M, we reach a valuation between $10-$15.

Hidden Asset

The TCX Domain portfolio generates $5-7 million a year in domain sales/ad revenue  and generates 75-85% gross margins on a total domain portfolio that we think is worth $50 million + (current asking value is $95 million). This domain portfolio is built through TCX’s ability to pick through 140,000 domains a month that expire on their platform and buy them at expiration. Portfolio names are sold through our premium domain name service, auctions or in negotiated sales. The 70,000+ domain portfolio holds assets: backs.com, beagles.com, beautyqueen.com, botanist.com, chessmasters.com, congressmen.com, countryrock.com, designexperts.com, facevalue.com and tens of thousands more.

Godaddy and other large domain investors are driving M&A interest in bulk domain portfolio purchases. Godaddy bought Archeo Domain Portfolio for $35 million with an earn out and in early December bought another 70,000 domain name portfolio. Godaddy is buying domain portfolio’s to sell to their large customer base. The revenues for this segment are lumpy yet it is still a significant asset with high margins when sold:

We sorted and organized the asking prices of TCX’s high value domain portfolio on YummyNames that is currently for sale and found 29K domain names for a portfolio value of $95M.

TCX bought the surname business (Mailbank.com) for $17 million. (39,000 last names or 80% of the top 50,000 names, example: [email protected])

Undiscounted: Domains asking prices + Surnames business valued at cost= 95M + $17M = $112 million or $10+ per share.

Discounted: TCX Portfolio Business has generated on average 5.5M in the past 3 years of which 80%+ has fallen to the bottom line. If TCX were to monetize on the portfolio of domains they currently have today, selling off ~$5M annually of which $4M drops to the bottom line, we value the portfolio as an annuity stream between $30-40M, $3-4 per share.

Stock Repurchases/Buybacks

Since 2007, TCX has bought back stock every year with 8 modified Dutch Tender offers and shrunk the share count by more than 50%. The share repurchase has been a grand slam for investors as company’s average cost of just $5.37 per share. TCX repurchased $20+ million worth of stock in 2015, which represented approximately a 10% buyback. In February 2016, TCX nearly double its 2015 buyback allocation to up $40 million. The CEO has over the years stated a strong commitment to buybacks and we believe share count can be reduced in the following years between 7-9M shares which is $10-11 EBITDA per share in 2020.

Risks:

• Management could use their cash for poor acquisitions or an untimely buyback.

• Ting Fiber may not be able to enter into 4-6 markets annually due to timely government processes and logistical delays.

• With increasing data usage from smartphone users and cheaper and fatter plans from top 4 mobile carriers, it may get harder and harder for Ting to convince customers to pursue the MVNO route if these trends continue.

Disclaimer: This does not constitute a recommendation to buy or sell this stock. We own shares in this company, and we may buy or sell shares at any time without updating the board.

Catalyst

Conclusion/Catalysts

1. Can Ting Fiber Invest $100 million in capital by 2020? Our opinion: likely. Ting expects to add 4-6 cities a year, with a 5 year build out, 50% population penetration, $2,500 installation cost per home, $1,000 in gross margin per home per year. If $100 million is invested: $40-60 million in incremental EBITDA should flow out of Ting Fiber by 2020.

2. Can Ting Mobile grow 12% annually through 2020? Our opinion: likely.

3. Will TCX continue to aggressively buyback stock: Our opinion: probably.

IF A+B+C play out on the current $33-36 million base of TCX EBITDA….the 2020 EBITDA should be $100 million with a likely range between 7-9 million shares.

• Winning larger small cities: Ting is currently finalist for the build out of Boulder, Co Fiber Network. Boulder estimates the cost at $70-90 million to roll out Fiber to city (roll out is typically 5 years) or $16 million a year.

• https://www-static.bouldercolorado.gov/docs/20160616_Boulder_jsh-1-201607011633.pdf

• Page 28 Ting appear to be in a good spot. Google is out and Ting is the only company that covers two buckets on page 37.

• Continued aggressive reinvestment of capital $40 million + a year into extremely high ROIC investments (Fiber/business/Share repurchases) current ROIC is 32% and ROE is 40% without debt

• TCX could easily tap debt markets to roll out Fiber at 2-3x EBITDA (especially if they own the fiber) $60-90 million in access to capital.

Aggressive EBITDA Trajectory:

2011: $0.42 EBITDA per share

2016: $3.00 EBITDA per share [($30-$35M EBITDA)/10.5M shares]

2020: $10-11 EBITDA per share [($80-$90M EBITDA)/(7-9M shares)]

TCX Sum of the Parts (67-107% upside):

Ting Internet/Fiber: $7-$12

Ting Mobile: $25

TCX Domain Services: $10-$15

Total: $42-$52

Hidden Assets: $3-4 (Outright sale for $10M unlikely but possible)

Total Including Hidden Assets: $45-$56