Fallen Angel: Tucows Inc.

The recent sharp turbulence in the stock market, due to the mortgage crisis, has unfairly punished many non-financial microcaps. Tech play Tucows Inc. (AMEX:TCX) is one such example.

Headquartered in Toronto, Tucows is primarily in the unglamorous, but profitable business of providing domain name registration and related Internet services to Web hosting companies and Internet service providers. Except for a one quarter hiccup in 2006, Tucows has posted 27 quarters in a row of positive cash flow from operations. In addition to managing over 8 million domain names and millions of email boxes for 9,000 service providers, Tucows owns a portfolio of 150,000 “high value” domain names. Tucows acquired the core of this domain name portfolio through its 2006 acquisition of NetIdentity for $18 million in cash and securities.

As part of this deal, NetIdentity shareholders, which included billionaire Mark Cuban, ended up with a minority ownership stake in Tucows. In mid-August, investment firm Lacuna, LLC bought out Cuban’s 6.9 million share position in Tucows for $0.50 a share.  Cuban had been a Tucows shareholder even before the NetIdentity deal. Interestingly, two of Lacuna’s principals were previously NetIdentity executives. While the recent exit of Cuban from Tucows has weighed on the stock, Lacuna’s deep knowledge of the domain name and Web services sector shouldn’t be ignored. After a series of follow-on open market buys by Lacuna, the investment shop now holds a nearly 15% ownership stake in $28 million market capitalization Tucows.

For the second quarter ended June 30, Tucows reported revenue of $20.5 million, down slightly from $20.8 million a year ago. Tucows noted that last year’s second quarter results included an “atypically large” sale of a block of domain names for $3 million.  With this in mind, net income declined to $2.2 million, or $0.03 a share, from $3.2 million, or $0.04 a share, a year ago. Deferred revenue increased 11% to $54.4 million.  For the quarter, Tucows generated $3.68 million in EBITDA, compared with $4.57 million a year ago. Quarterly cash flow from operations rose 9% to $2.58 million from $2.36 million.  Tucows ended June with a net debt position of approximately $4 million on its balance sheet.  For 2007, Tucows posted revenue of $74.6 million, $8.7 million in EBITDA and $2.67 million, or $0.04 a share, in net income. For 2008, Tucows expects to post year-over-year growth in revenue, profitability and cash flow.

With Tucows shares down approximately 50% year to date and investment shop Lacuna emerging as a major new shareholder, pressure is on management to perform.  Tucows claims that its expenses will decline next quarter, due to technology infrastructure changes.  Tucows has also hinted at the sale of non-core assets, such as its namesake Tucows.com software download website. Lacuna likely believes the market is undervaluing the Tucows domain portfolio.  It’s also worth noting that Tucows approved a stock buyback program in May.  On the downside, Tucows operates in a low-margin, highly competitive business that is subject to regulatory risk.  

Turning to valuation, using a market capitalization of $28 million, the market is valuing Tucows at a meager three times last year’s $8.7 million in EBITDA.  Through the first half of this year, Tucows has generated $4.2 million in EBITDA with expectations of cash flow growth this year.

For medium to lower-risk oriented investors, Tucows looks like a microcap “fallen angel” worth considering. While Tucows is certainly not a glamorous tech play, it has been unfairly punished amidst the recent market malaise.  A snap back to the $0.60 level seems a decent possibility.       

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