Description

TCX has been written up twice before, primarily based on the value of their domain registration business. We think TCX has a business of greater value in Ting. In short, we see upside of $4-5 over the next 12-18 months and downside of $1.75-2. At the core of TCX is a highly predictable recurring revenue business with a number of industry catalysts on the horizon. Furthermore, Ting should grow 50-100% in 2014 with what we think are very attractive unit economics. TCX has done an outstanding job of allocating shareholder capital. In fact, not only has TCX repurchased 50% of the company via 7 Dutch tenders over the past 5 years, it has also invested in what we think is an extremely attractive asset Ting.

Tucows is a Toronto-based internet services company with operations in the United States and Europe. TCX’s business consists of three operating segments: wholesale, retail and portfolio.

TCX’s wholesale segment, the company’s largest, encompasses all services related to the registration, renewal, transfer and management of internet domain names. This primary business also creates a broad client base into which ancillary services are sold. These services include a white-label, hosted email solution and a billing, provisioning and customer care software solution for ISPs (plus a few other very small businesses).

TCX’s retail segment has two pieces to it: Hover and Ting. Hover sells internet domain name registration and email services to individuals and small businesses. Ting sells mobile phones and services to individuals and small businesses (much more on Ting later).

Tucows’s portfolio segment consists of YummyNames and Butterscotch. YummyNames houses TCX’s portfolio of premium names, which it monetizes via sale or lease agreements and by displaying pay-per-click advertising. Butterscotch is TCX’s content and download business. It sells banner and text advertising to software developers who rely on TCX for distribution.

There are three crucial players in the internet domain registration business: ICANN, the registries and the registrars. ICANN is a nonprofit established by the US government to keep the internet functioning, a big component of which involves maintaining unique identifiers. Registries (Verisign) own the rights to gTLDs (Generic Top Level Domains - .com, .org, .net, etc.), but ICANN does not allow them to sell these directly to the public. Instead, registries must do so via a registrar such as GoDaddy, eNom (Demand Media) or Tucows. A registrar is essentially a clearinghouse for domain names.

The domain industry is a $3+ billion business as a whole. GoDaddy is the largest player, but Tucows is a significant participant. The industry is profitable with solid growth prospects, reasonably high barriers to entry and an attractive working capital dynamic. Although it’s tough to isolate financials for this business as the company has been investing in Ting, TCX as a whole threw off $7.4 million in EBITDA in 2012, over 70% of which went to FCF. It has also grown nicely in recent years, with revenue increasing from $80 million in 2009 to over $120 million today (LTM).

Two Significant Catalysts

We see two significant catalysts on the horizon that could have a pronounced, positive impact on TCX’s valuation. First, ICANN is in the process of rolling out new gTLDs. TCX is participating in the rollout as a minority stakeholder in .store, .group, .tech and .online. These will essentially be higher-margin domains for TCX, as a portion of the pass through that would have previously gone to Verisign will instead stay with TCX. More importantly, the existence of thousands of new gTLDs should significantly increase overall transaction volumes. Let’s walk through a hypothetical example. You own and operate Bob’s Donut Shop and you already own bobsdonuts.com. Not only will you retain this listing, you will also buy bobs.donut, bobsdonut.restaurant and bobsdonut.shop. You will do so for two reasons: it will help you grow your web presence via SEO (Search Engine Optimization) and choosing to do nothing would enable a competitor to snap up these new domains and drive business to their store.

Demand Media’s CFO Mel Tang is enthusiastic about the impact of new gTLDs, noting these new strings will offer “infinitely more choice and allow for better branding and consumer discovery.” GoDaddy CEO Blake Irving is similarly optimistic. “The new domains are going to be viewed as an opportunity to have a better presence on the Web,” he noted in a recent Wall Street Journal interview. “We'll see a resurgence—not a gold rush, because that implies scarcity—but businesses will want to get names that matter to them, specific names.” One more note on donuts: eNom founder Paul Stahura just raised $100 million from a handful of VC and private equity firms in order to create Donuts, Inc. Donuts has put that money to work by registering 300 new gTLDs. Clearly some smart people believe the rollout of new gTLDs is going to make waves.

Looking beyond gTLDs, two major capital market events in the domain services industry could also move the needle at TCX. The first is Demand Media’s impending spin-out of eNom, which is a direct comp to TCX’s wholesale segment. We know a few details about this business. Demand Media’s management team believes it will grow at 8% to 10% “over the long run” and put up EBITDA margins in the “teens.” The company expects the transaction to close by early 1Q14 at the latest. The second is a potential GoDaddy IPO. Bloomberg puts GoDaddy’s top-line at about $1.4 billion and cites a rumored IPO valuation of “more than $6 billion.” KKR, Silver Lake and Technology Crossover Ventures bought a large stake in Go Daddy in July 2011, valuing the company at a rumored $2.25 billion (2x LTM sales) according to multiple sources. In the same interview referenced above GoDaddy’s CEO commented on the potential for an IPO, noting, “it's not off the table. We're growing at double digits [in terms of percentage] on the customer side, on revenue, on earnings, so the opportunity for us to have an IPO is quite good. The board is quite supportive of taking that direction, if that's what we want to do.”

Although TCX hasn’t done much in the way of M&A recently, opting instead to repurchase shares (more on that later), it did buy Germany-based EPAG from QSC AG for $2.4 million in August of 2011. TCX paid 1.2x sales for EPAG, which was operating at a loss. The same multiple on TCX’s non-Ting business yields a $2.80 stock. We would be surprised but not shocked to see more M&A from TCX in the near-term, as the company already has a nice growth bet in Ting. Furthermore, with TCX trading at less than 1x sales and given a history of buybacks, we think M&A would be hard to justify from an opportunity cost standpoint. The conversation around M&A is much more interesting when you consider TCX as the target rather than the acquirer. With GoDaddy contemplating coming public and eNom operating independently, TCX could come into play.

Valuing the Domain and Content Businesses

It’s worth noting that TCX’s legacy business features several high-quality attributes, most notably a sticky customer base. CEO Noss touched on this during the company’s 3Q10 conference call, identifying TCX’s core competitive strength as, “our ability to build and maintain long-term customer relationships.” He offered a similar comment on the 3Q11 conference call, calling domain services, “a very sticky business.” In addition to a recurring revenue stream, TCX’s legacy business is also relatively insensitive to the economic cycle. Noss stressed this fact in early 2009, when shares were trading for $0.35: “The good news especially in the current economic environment, is not only that our domain registration business represents the largest component of our gross margin, but also that it is a recurring revenue stream that is generated by large volumes of low-cost transactions. It is a milk-and-eggs type of business, one that involves the type of buying decision that shouldn't be significantly impacted by the economy.” Finally, the domain services business is very efficient from a working capital perspective. Sales stay out thirteen days, inventories turn every two and TCX pushes payables out six days, creating a nine day cash conversion cycle. Although FCF can be lumpy from quarter to quarter, the business consistently produces a healthy amount of cash on an annual basis.

We use a simple DCF to value TCX’s legacy business. We expect assume a mid-single-digits growth rate, with the introduction of new gTLDs potentially providing considerable upside. Looking at its historical profitability, we think the company should be able to manage 9% EBITDA margins as the business grows (see below).  We apply an 8x multiple to our FY2017 EBITDA estimate and discount back at 12%. This gets us to a fair value of $1.85.

Historical EBITDA Margins

Before moving on to Ting, we would also note that there is somewhat of a “hidden asset” at TCX. This asset is the company’s portfolio of owned domain names, which consists of tens of thousands of “brandable” domains and a thousand or so much higher-priced “gems.” The company continuously and opportunistically refreshes this portfolio by monitoring the 180,000 domains that expire out of its managed wholesale business each month. Although we estimate only $1 million or so is generated by the sale and lease of these domains each year, much more revenue comes from the pay-per-click ads the company places on each property. It’s a nice revenue stream on an ever-green assets base that requires no maintenance CapEx, and we think it could be worth a decent amount of money to either a strategic or financial buyer.

What is Ting Worth?

Ting is one of a handful of fast-growing operators (alongside Republic Wireless, Simple Mobile, etc.) that have prompted industry watchers to declare a second coming of the MVNO, the first having been somewhat of a disaster. Previously “The Big Four” worked against MVNOs rather than with them. Ten years ago the growth strategy was simple: build a brick and mortar store and new subscribers will come to you. MVNOs brought little to the table in this operating environment and many went out of business.  A lot has changed since then. With the US wireless penetration rate now exceeding 100% (according to CTIA, the largest wireless industry trade group), land-grab opportunities are all but gone. Now carriers have to grow by stealing subscribers from other networks. Furthermore, brick and mortar stores are expensive to lease, renovate and staff. MVNOs offer a solution to both of these challenges.

Sprint has been a leader as far as recognizing the value proposition MVNOs provide to carrier partners in today’s saturated wireless market. "It's a good strategic play for us," Sprint Wholesale president Matt Carter said in a recent interview with Fierce Wireless, adding, "it's another army to help us garner more subscribers on the network." A November 2011 article from Bloomberg BusinessWeek noted that “the wholesale business has emerged as Sprint’s main generator of new subscribers.” Since 2011, Sprint’s focus on the wholesale channel has only intensified.

At first glance, it might seem odd for an internet domain registrar to invest in building an MVNO. We think it actually makes a lot of sense. At the end of the day, Tucows’s legacy business was successful because it offered top-level customer service, competitive pricing and a robust billing and services management platform. The exact same combination enabled Ting’s rapid growth and popularity. Ting’s value proposition is twofold. First, a unique, pay-per-use pricing scheme—the idea is simple, by paying for only what they use, subscribers save money. Ting claims 98% of people would save money with Ting. The second piece is customer service. Tucows was built as a customer-oriented business, and Ting reflects this culture. Look at reviews for Ting and check out the company’s Facebook page—lots of very happy subscribers. Ting’s disruptive pricing leads to low customer acquisition costs. A superior user experience drives lower churn. The result is a very high cash-on-cash return.

Given limited information, it’s tough to value Ting. In order to do so, we’ve had to make a series of major assumptions with regard to ARPU, customer acquisition costs and churn. Looking at public comps, we feel comfortable assuming 3% monthly churn, which is over double AT&T and Verizon, 60 bps higher than Sprint and about in line with T-Mobile. On the most recent conference call Noss offered up a qualitative assessment of Ting’s churn rate, saying “we're still very happy with where the churn numbers are.” From an ARPU standpoint, we model $35 per month. All four major carriers are over $43, with Verizon leading the pack at $47. We like our number because it reflects Ting’s value proposition as a cost leader and because we feel it leaves room for upside. On the most recent conference call, CEO Elliott Noss said, “customer acquisition costs remain well below the $100 mark.” We model $85. Add all this up and the result is very compelling. Then consider the fact that Ting is also growing like crazy.

Ting added 9,000 net new subscribers from 1Q13 to 2Q13.Total accounts increased 56% YoY. We don’t expect Ting to single-handedly disrupt Verizon and AT&T. We expect it to remain a niche product. Even then the opportunity is enormous—0.1% penetration of the US wireless market equates to a $200 million top line. Additionally, the investment phase in Ting is almost over, as the company has guided for Ting to switch from consuming cash to contributing cash in the fourth quarter of this year.

We think the runoff value of Ting is about $0.55 per share today. Combine this with the legacy business at $1.85 and you get today’s share price. We believe Ting’s fair value is somewhere north of $2.65 today. We get there by computing the expected lifetime value of each Ting subscriber (net of an estimated customer acquisition cost) using the assumptions detailed above. We see this business adding 30,000 net subscribers this year, which seems reasonable given that the company added 9,000 in the last quarter alone (a seasonally weak quarter in the industry, we would add). We place a 10x multiple on this business and net it against the NPV of all estimated operating expenses, which we have growing for the foreseeable future (albeit at a much slower rate than the company’s subscriber base). Acknowledging the many assumptions required in order to put a dollar value on Ting, we are most comfortable thinking about it as having very little downside and a lot of optionality. We expect Tucows to break out more granular detail around Ting in the not-too-distant future, as we estimate this unit already comprises more than 10% of the top line.

Solid Management with Aligned Interests

It’s worth briefly noting that TCX’s management team has an impressive track record when it comes to capital allocation. (For readers seeking more detail we would point to VIC user wan161’s February write-up.) Since 2010, management has deployed $25 million to repurchase almost 28 million shares for an average price of $0.90 in seven different buyback programs. The numbers speak for themselves.

Management thinks and acts like a shareholder for good reason—they own almost 20% of the company. Elliot Noss, who has been with Tucows for over fifteen years, personally owns 2.7 million shares. Michael Cooperman, TCX’s CFO, owns another 770,000. The Board of Directors owns a combined 4.75 million shares. We think quite highly of Mr. Noss in particular and would encourage readers to check out the following two series of videos: http://tucowsinc.com/investors/investorvideos.php and https://ting.com/blog/ask-an-exec/. (The former is targeted specifically at investors and the latter is an ongoing Q&A on Ting.)

There are many unknowns with regard to Ting. Management’s track record of preserving and creating shareholder value increases our level of comfort as we try to handicap how successful Tucows will ultimately be in building out this business. We’re confident Elliot Noss and his team will make smart decisions as they grow Ting and believe our downside / runoff estimate could look laughable a few years down the road.

Conclusion

In closing, we think TCX’s legacy business is conservatively worth $1.85 per share. If this business can grow meaningfully (perhaps on the back of new gTLDs) or more operating leverage kicks in, it should be worth more. Regardless, the impending eNom spinout at Demand Media and a potential GoDaddy IPO should bring more attention to TCX’s business and valuation.

We think Ting is worth $0.55 in runoff. However, we don’t expect to see Ting in runoff. Instead, we expect continued growth and positive cash flow starting in 2014. If this happens, we think Ting is worth $2.65. Adding back TCX’s legacy business, we see fair value of $4.50 today, or approximately 90% upside.

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