XASE:TCX Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q

 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2012

OR

 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from           to          

Commission file number 1-32600

TUCOWS INC.
(Exact Name of Registrant as Specified in Its Charter)

Pennsylvania
 
23-2707366
(State or Other Jurisdiction of
 
(I.R.S. Employer
Incorporation or Organization)
 
Identification No.)
 
96 Mowat Avenue,
Toronto, Ontario M6K 3M1, Canada
(Address of Principal Executive Offices) (Zip Code)

(416) 535-0123
(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:  Yes x  No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T §232.405 of this chapter during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).Yes o  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o
 
Accelerated filer o
     
Non-accelerated filer o
 
Smaller reporting company x
(Do not check if a smaller reporting company)
   

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):  Yes o  No x
 
As of August 10, 2012, there were 45,497,497 outstanding shares of common stock, no par value, of the registrant.
 
 
 

 
 
TUCOWS INC.
Form 10-Q Quarterly Report
INDEX

PART I
FINANCIAL INFORMATION
     
Item 1.
Consolidated Financial Statements
1
     
 
Consolidated Balance Sheets as of June 30, 2012 (unaudited) and December 31, 2011
1
     
 
Consolidated Statements of Operations and Comprehensive Income (unaudited) for the three and six months ended June 30, 2012 and 2011
2
     
 
Consolidated Statements of Cash Flows (unaudited) for the three and six months ended June 30, 2012 and 2011
3
     
 
Notes to Consolidated Financial Statements (unaudited)
4
     
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
15
     
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
31
     
Item 4.
Controls and Procedures
32
     
PART II
OTHER INFORMATION
     
Item 1.
Legal Proceedings
33
     
Item 1A.
Risk Factors
33
     
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
33
     
Item 4.
Mine Safety Disclosures
34
     
Item 6.
Exhibits
34
     
Signatures
 
35

TRADEMARKS, TRADE NAMES AND SERVICE MARKS

Tucows®, Butterscotch®, EPAG®, Hover®, OpenSRS®, Platypus®, Ting® and YummyNames® are registered trademarks of Tucows Inc. or its subsidiaries. Other service marks, trademarks and trade names of Tucows Inc. or its subsidiaries may be used in this Quarterly Report on Form 10-Q (this “Quarterly Report”). All other service marks, trademarks and trade names referred to in this Quarterly Report are the property of their respective owners. Solely for convenience, any trademarks referred to in this Quarterly Report may appear without the ® or TM symbol, but such references are not intended to indicate, in any way, that we or the owner of such trademark, as applicable, will not assert, to the fullest extent under applicable law, our or its rights, or the right of the applicable licensor, to these trademarks.
 
 
 

 
 
 PART I.
FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Tucows Inc.
Consolidated Balance Sheets
(Dollar amounts in U.S. dollars)

   
June 30,
2012
   
December 31,
2011
 
   
(unaudited)
       
Assets
           
             
Current assets:
           
Cash and cash equivalents
  $ 4,511,561     $ 6,408,209  
Accounts receivable, net of allowance for doubtful accounts of $56,481 as of June 30, 2012 and $57,415 as of December 31, 2011
    4,917,015       3,880,184  
Prepaid expenses and deposits
    5,853,373       3,961,905  
Derivative instrument asset, current portion (note 7)
    97,718       -  
Prepaid domain name registry and ancillary services fees, current portion
    47,001,530       43,209,033  
Income taxes recoverable
    634,661       867,093  
Total current assets
    63,015,858       58,326,424  
                 
Derivative instrument asset, long-term portion (note 7)
    -       87,023  
Prepaid domain name registry and ancillary services fees, long-term portion
    13,105,851       12,600,154  
Property and equipment
    1,330,274       1,437,564  
Deferred financing charges
    100       2,300  
Deferred tax asset, long-term portion (note 8)
    6,743,137       6,880,377  
Intangible assets (note 5)
    16,953,335       17,482,590  
Goodwill
    18,873,127       18,873,127  
Total assets
  $ 120,021,682     $ 115,689,559  
                 
                 
Liabilities and Stockholders' Equity
               
                 
Current liabilities:
               
Accounts payable
  $ 1,547,897     $ 1,051,115  
Accrued liabilities
    2,498,804       2,081,968  
Customer deposits
    4,268,497       4,202,899  
Derivative instrument liability, current portion (note 7)
    340,835       781,027  
Loan payable, current portion (note 6)
    4,000,000       850,000  
Deferred revenue, current portion
    57,441,960       52,683,546  
Accreditation fees payable, current portion
    585,155       555,869  
Deferred tax liability, current portion (note 8)
    903,510       880,008  
Income taxes payable
    166,407       158,258  
Total current liabilities
    71,753,065       63,244,690  
                 
Derivative instrument liability, long-term portion (note 7)
    -       5,479  
Deferred revenue, long-term portion
    17,018,389       16,492,155  
Accreditation fees payable, long-term portion
    151,954       156,061  
Deferred rent, long-term portion
    39,687       26,487  
Deferred tax liability, long-term portion (note 8)
    5,289,900       5,345,700  
                 
Stockholders' equity (note 12)
               
Preferred stock - no par value, 1,250,000 shares authorized; none issued and outstanding
    -       -  
Common stock - no par value, 250,000,000 shares authorized; 45,484,997 shares issued and outstanding as of June 30, 2012 and 53,497,584 shares issued and outstanding as of December 31, 2011
    10,233,628       11,358,959  
Additional paid-in capital
    35,109,427       40,994,013  
Deficit
    (19,574,368 )     (21,933,985 )
Total stockholders' equity
    25,768,687       30,418,987  
Total liabilities and stockholders' equity
  $ 120,021,682     $ 115,689,559  
 
Commitments and contingencies (note 11)
 
See accompanying notes to unaudited consolidated financial statements
 
 
1

 

Tucows Inc.
Consolidated Statements of Operations and Comprehensive Income
(Dollar amounts in U.S. dollars)
(unaudited)

    Three months ended June 30,     Six months ended June 30,  
   
2012
   
2011
   
2012
   
2011
 
    (unaudited)     (unaudited)  
                         
Net revenues (note 10)
  $ 28,152,614     $ 23,045,923     $ 55,689,920     $ 45,601,130  
                                 
Cost of revenues:
                               
Cost of revenues
    20,120,211       16,224,936       39,387,336       31,920,076  
Network expenses (*)
    1,213,864       1,235,498       2,470,754       2,498,326  
Depreciation of property and equipment
    155,638       213,089       303,056       449,770  
Amortization of intangible assets (note 5)
    35,910       6,430       71,820       25,720  
Total cost of revenues (note 10)
    21,525,623       17,679,953       42,232,966       34,893,892  
                                 
Gross profit
    6,626,991       5,365,970       13,456,954       10,707,238  
                                 
Expenses:
                               
Sales and marketing (*)
    2,065,729       1,771,971       4,250,364       3,796,674  
Technical operations and development (*)
    1,105,575       1,231,593       2,218,720       2,430,829  
General and administrative (*)
    1,748,402       1,443,773       3,531,855       3,007,547  
Depreciation of property and equipment
    45,522       45,495       92,937       91,682  
Amortization of intangible assets (note 5)
    219,030       277,750       438,060       584,740  
Loss (gain) on currency forward contracts (note 2, note 7)
    383,838       (117,229 )     (178,271 )     (471,373 )
Total expenses
    5,568,096       4,653,353       10,353,665       9,440,099  
                                 
Income from operations
    1,058,895       712,617       3,103,289       1,267,139  
                                 
Other income (expense):
                               
Interest expense, net
    (54,513 )     (8,657 )     (95,482 )     (20,197 )
Other income (note 5)
    20,911       51,648       529,711       374,977  
Total other income (expense)
    (33,602 )     42,991       434,229       354,780  
                                 
Income before provision for income taxes
    1,025,293       755,608       3,537,518       1,621,919  
                                 
Provision for income taxes (note 8)
    329,295       189,949       1,177,901       328,314  
Net income and comprehensive income for the period
  $ 695,998     $ 565,659     $ 2,359,617     $ 1,293,605  
                                 
                                 
Basic earnings per common share (note 9)
  $ 0.02     $ 0.01     $ 0.05     $ 0.02  
                                 
Shares used in computing basic earnings per common share (note 9)
    45,912,458       53,444,841       47,003,016       53,441,276  
                                 
Diluted earnings per common share (note 9)
  $ 0.01     $ 0.01     $ 0.05     $ 0.02  
                                 
Shares used in computing diluted earnings per common share (note 9)
    49,449,430       55,796,435       50,203,163       55,784,998  
                                 
(*) Stock-based compensation has been included in expenses as follows:
                               
Network expenses   $ 6,329      $ 5,349      $ 12,375      $ 11,362   
Sales and marketing     20,149        19,127        42,931        44,460   
Technical operations and development     15,047        11,394        27,890        27,102   
General and administrative     21,571        17,529        42,365        44,806   
                                 
 
See accompanying notes to consolidated financial statements
 
 
 
 
2

 
 
Tucows Inc.
Consolidated Statements of Cash Flows
(Dollar amounts in U.S. dollars)
(unaudited)

   
Three months ended June 30,
   
Six months ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Cash provided by (used in):   (unaudited)     (unaudited)  
Operating activities:
                       
Net income for the period
  $ 695,998     $ 565,659     $ 2,359,617     $ 1,293,605  
Items not involving cash:
                               
Depreciation of property and equipment
    201,160       258,584       395,993       541,452  
Amortization of deferred financing charges
    700       3,700       2,200       8,100  
Amortization of intangible assets
    254,940       284,180       509,880       610,460  
Deferred income taxes
    (107,146 )     -       104,942       -  
Deferred rent
    5,931       7,019       13,200       13,964  
Acquisition of domain names
    -       -       (3,664 )     -  
Disposal of domain names
    7,301       7,896       23,039       21,091  
Gain on disposition of intangible assets
    -       -       (508,800 )     -  
(Gain) loss on currency forward contracts
    245,477       193,157       (456,366 )     305,861  
Stock-based compensation
    63,096       53,399       125,561       127,730  
Changes in non-cash operating working capital:
                               
Accounts receivable
    (22,102 )     104,241       (1,036,831 )     (1,128,564 )
Prepaid expenses and deposits
    (783,370 )     (702,002 )     (1,891,468 )     (1,223,649 )
Prepaid domain name registry and ancillary services fees
    (1,378,771 )     (1,749,343 )     (4,298,194 )     (3,749,582 )
Income taxes recoverable/payable
    (378,492 )     25,000       240,581       160,000  
Accounts payable
    (308,892 )     (50,074 )     605,077       203,823  
Accrued liabilities
    255,254       65,095       524,165       381,567  
Customer deposits
    (191,402 )     (166,270 )     65,598       (257,703 )
Deferred revenue
    1,460,816       1,938,868       5,284,648       4,257,267  
Accreditation fees payable
    (16,775 )     (14,391 )     25,179       21,792  
Net cash provided by operating activities
    3,723       824,718       2,084,357       1,587,214  
                                 
Financing activities:
                               
Proceeds received on exercise of stock options
    219,000       -       349,712       3,460  
Repurchase of common stock
    (1,591,743 )     -       (7,485,190 )     -  
Proceeds received on loan payable
    -       -       4,000,000       -  
Repayment of loan payable
    (311,667 )     (478,560 )     (850,000 )     (957,121 )
Net cash used in financing activities
    (1,684,410 )     (478,560 )     (3,985,478 )     (953,661 )
                                 
Investing activities:
                               
Additions to property and equipment
    (174,054 )     (162,068 )     (504,327 )     (491,026 )
Proceeds on disposition of intangible assets
    -       -       508,800       -  
Net cash provided by (used in) investing activities
    (174,054 )     (162,068 )     4,473       (491,026 )
                                 
Increase (decrease) in cash and cash equivalents
    (1,854,741 )     184,090       (1,896,648 )     142,527  
                                 
Cash and cash equivalents, beginning of period
    6,366,302       4,164,166       6,408,209       4,205,729  
Cash and cash equivalents, end of period
  $ 4,511,561     $ 4,348,256     $ 4,511,561     $ 4,348,256  
                                 
Supplemental cash flow information:
                               
Interest paid
  $ 54,655     $ 8,718     $ 95,831     $ 20,307  
                                 
Supplementary disclosure of non-cash investing activity:                                
Property and equipment acquired during the period not yet paid for
  $ 42,343     $ 67,068     $ 42,343     $ 67,068  
 
See accompanying notes to unaudited consolidated financial statements
 
 
3

 
 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

1. ORGANIZATION OF THE COMPANY:

Tucows Inc., a Pennsylvania corporation (referred to throughout this report as the “Company”, “Tucows”, “we”, “us” or through similar expressions), together with our consolidated subsidiaries, is a distributor of Internet services, including domain name registration, security and identity products, email, and mobile telephony services both through its global Internet-based wholesale distribution network of Internet Service Providers, web hosting companies and other providers of Internet services to end-users and through retail websites directly to end-users.

We were incorporated under the laws of the Commonwealth of Pennsylvania in November 1992 under the name Infonautics, Inc. In August 2001, we completed our acquisition of Tucows Inc., a Delaware corporation, and we changed our name from Infonautics, Inc. to Tucows Inc. Our principal executive office is located in Toronto, Ontario and we have other offices in the Netherlands, Germany and the United States.

2. BASIS OF PRESENTATION:

The accompanying unaudited interim consolidated balance sheets, and the related consolidated statements of operations and comprehensive income and cash flows reflect all adjustments, consisting of normal recurring adjustments, that are, in the opinion of management, necessary for a fair presentation of the financial position of Tucows and its subsidiaries as at June 30, 2012 and the results of operations and cash flows for the interim periods ended June 30, 2012 and 2011. The results of operations presented in this Quarterly Report on Form 10-Q are not necessarily indicative of the results of operations that may be expected for future periods.

The accompanying unaudited interim consolidated financial statements have been prepared by Tucows in accordance with the rules and regulations of the Securities and Exchange Commission (the “SEC”). Certain information and footnote disclosure normally included in the Company’s annual audited consolidated financial statements and accompanying notes have been condensed or omitted. These interim consolidated financial statements and accompanying notes follow the same accounting policies and methods of application used in the annual financial statements and should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto for the year ended December 31, 2011 included in Tucows’ 2011 Annual Report on Form 10-K filed with the SEC on March 26, 2012.

There have been no material changes to our significant accounting policies during the three and six months ended June 30, 2012 as compared to the significant accounting policies described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011.

In the prior period, the Company recorded the realized gain or loss upon settlement of currency forward contracts in “General and administrative expenses” and recorded the unrealized gain or loss in “Loss (gain) on currency forward contracts”. The Company has determined that both of these amounts are more appropriately classified in expenses as “Loss (gain) on currency forward contracts” and as a result a gain of $0.3 million for the three months ended June 30, 2011 has been reclassified from “General and administrative expense” to “Loss (gain) on currency forward contracts”, and a gain of $0.8 million for the six months ended June 30, 2011 has been reclassified from “General and administrative expense” to “Loss (gain) on currency forward contracts”. As a result of this reclassification, there was no change to previously reported net income, income from operations, net revenues, gross profit, reported cash flows or the amounts recorded in the consolidated balance sheets.

The Company recognizes the effects of events or transactions that occur after the balance sheet date but before financial statements are issued (“subsequent events”) if there is evidence that conditions related to the subsequent event existed at the date of the balance sheet date, including the impact of such events on management’s estimates and assumptions used in preparing the financial statements. Other significant subsequent events that are not recognized in the financial statements, if any, are disclosed to the notes to the unaudited interim consolidated financial statements.

3. ACQUISITIONS:

a.     Acquisition of EPAG Domainservices GMBH:

On August 1, 2011, Tucows (Germany) Inc. (“Tucows Germany”), one of the Company’s wholly owned subsidiaries, acquired 100% of the outstanding capital stock of EPAG Domainservices GMBH (“EPAG”), from QSC AG. EPAG, based in Bonn, Germany, is an ICANN-accredited registrar with over 400,000 domains under management and is notable for offering over 200 Top Level Domains (TLDs). Consideration for the acquisition of EPAG was approximately US$2.4 million (€1.7 million to purchase the shares and the settlement of a working capital adjustment of €0.25 million) through an all-cash transaction which was financed by utilizing the Company’s non-revolving, reducing demand loan facility in the amount of US$2.5 million. In August 2011, the Company repaid $1.0 million of this loan. The acquisition consideration is net of cash acquired of US$0.1 million and a loan receivable from EPAG assumed in the amount of US$0.1 million. In connection with the acquisition, the Company incurred approximately US$0.1 million of acquisition costs during the three months ended September 30, 2011 and recorded the expenses in the general and administrative expenses line in the consolidated statement of operations. These costs include legal and other professional services.
 
 
4

 

The Company has accounted for the acquisition of EPAG using the acquisition method as required in ASC 805, Business Combinations. As such, fair values have been assigned to the assets and liabilities acquired and the excess of the total purchase price over the fair value of the net assets acquired is recorded as goodwill. The Company has completed the final valuation of the fair value assessment of certain intangible assets during the quarter ended September 30, 2011. The goodwill represents business benefits the Company anticipates realizing from optimizing resources and access to additional domain name TLD’s. The goodwill is not expected to be deductible for tax purposes.

Purchase price allocation

The following table summarizes the Company’s purchase price allocation based on the fair value of the assets acquired and liabilities assumed on August 1, 2011:

Accounts receivable
 
$
587,595
       
Cash acquired
   
118,477
       
Prepaid expenses and deposits
   
468,523
       
Prepaid domain name registry fees
   
1,116,798
       
Property and equipment
   
29,198
       
Intangible assets
   
1,723,800
       
Goodwill
   
882,320
       
Total assets acquired
           
4,926,711
 
                 
Accounts payable
   
92,950
         
Accrued liabilities
   
140,658
         
Customer deposits
   
32,603
         
Deferred revenue
   
1,425,182
         
Income taxes payable
   
172,380
         
Deferred tax liability
   
552,000
         
Total liabilities acquired
           
2,415,773
 
                 
Purchase price
         
$
2,510,938
 
 
The intangible assets acquired include technology in the amount of $0.3 million, brand in the amount of $0.2 million and customer relationships in the amount of $1.2 million. The residual value from the purchase price has been allocated to goodwill. The technology is being amortized over two years, while the customer relationships and brand are being amortized over seven years.

The amount of EPAG’s revenues in Tucows’ Consolidated Statements of Operations and Comprehensive Income for the three and six months ended June 30, 2012 are set forth below:

   
Revenues for the three
months ended June 30,
   
Revenues for the six
months ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
                         
Actual
 
$
960,106
   
$
   
$
1,830,745
   
$
 
 
The amount of EPAG’s net income (loss) included in Tucows’ Consolidated Statements of Operations and Comprehensive Income for the three and six months ended June 30, 2012 are set forth below:

   
Net income (loss) for the three
months ended June 30,
   
Net income (loss) for the six
months ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
                         
Actual
 
$
(43,228)
   
$
   
$
23,098
   
$
 
 
 
5

 
 
The unaudited pro forma revenues and net income of the combined entity had the acquisition been consummated as of January 1, 2011 are set forth below:

   
Three months ended June 30,
   
Six months ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Supplemental Unaudited Pro Forma Information
                       
Total revenue
 
$
28,152,614
   
$
23,919,954
   
$
55,689,920
   
$
47,472,338
 
Net income *
 
$
695,998
   
$
497,219
   
$
2,359,617
   
$
1,162,383
 
 
*             Included within net income for the three and six months ended June 30, 2012 above are $87,240 and $174,480 of estimated amortization charges relating to the allocated values of intangible assets, respectively.

The unaudited pro forma financial information in the table above is presented for informational purposes only and is not indicative of the results of operations that would have been achieved if the acquisition had taken place at the beginning of the period presented or the result that may be realized in the future.

4. NEW ACCOUNTING POLICIES:

Recent Accounting Pronouncements Adopted

Comprehensive Income

The Company adopted Accounting Standards Update No. 2011-05, “Comprehensive Income” (Topic 220)—Presentation of Comprehensive Income (“ASU 2011-05”), effective January 1, 2012 and applied retrospectively, which requires an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of equity.

Fair Value Measurement and Disclosures

The Company adopted Accounting Standards Update No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards” (Topic 820)—Fair Value Measurement (“ASU 2011-04”), effective January 1, 2012 and applied retrospectively, which provides a consistent definition of fair value and ensures that the fair value measurement and disclosure requirements are similar between U.S. GAAP and International Financial Reporting Standards. ASU 2011-04 changes certain fair value measurement principles and enhances the disclosure requirements particularly for level 3 fair value measurements (as defined in note 14 below). The adoption of ASU 2011-08 did not materially impact the fair value measurements of our assets and/or liabilities.

Testing Goodwill for Impairment

The Company adopted Accounting Standards Update No. 2011-08, Intangibles—Goodwill and Other (Topic 350)—Testing Goodwill for Impairment (“ASU 2011-08”), effective January 1, 2012, which allows entities to use a qualitative approach to test goodwill for impairment. ASU 2011-08 permits an entity to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If it is concluded that this is the case, it is necessary to perform the currently prescribed two-step goodwill impairment test. Otherwise, the two-step goodwill impairment test is not required. The adoption of ASU 2011-08 did not materially impact the carrying value of our recorded goodwill. The Company will perform its next annual goodwill impairment testing on December 31, 2012.
 
Recent Accounting Pronouncement Not Yet Adopted

In July 2012, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2012-02, Intangibles — Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment (“ASU 2012-02”) to allow entities to use a qualitative approach to test indefinite-lived intangible assets for impairment.  ASU 2012-02 allows an entity to first perform a qualitative assessment to determine whether it is more likely than not that the indefinite-lived intangible asset is impaired.   If an entity concludes that this is the case, it is required to determine the fair value of the indefinite-lived intangible asset and perform the quantitative impairment test by comparing the fair value with the carrying amount.   ASU 2012-02 is effective for annual and interim indefinite-lived intangible asset impairment tests performed for fiscal years beginning after September 15, 2012 and early adoption is permitted. We do not expect the adoption of ASU 2012 to materially impact the carrying value of our recorded indefinite-lived intangible assets.
 
 
6

 

5. INTANGIBLE ASSETS:

Intangible assets consist of acquired technology, brand, customer relationships, surname domain names and our portfolio of domain names. As reflected in the table below, these balances are being amortized on a straight-line basis over the life of the intangible assets, except for the surname domain names and portfolio domain names; which have been determined to have an indefinite life and which are tested annually for impairment.

A summary of acquired intangible assets for the three months ended June 30, 2012 is as follows:

   
Technology
2 – 7 years
   
Brand
7 years
   
Customer relationships
4 – 7 years
   
Surname
domain
names
indefinite
life
   
Direct
navigation
domain
names
indefinite
life
   
Total
 
                                     
Net book value, March 31, 2012
 
$
191,520
   
$
528,520
   
$
2,337,040
   
$
12,118,454
   
$
2,040,042
   
$
17,215,576
 
Sales of domain names
   
     
     
     
(2,596)
     
(4,705)
     
(7,301)
 
Amortization expense
   
(35,910)
     
(43,410)
     
(175,620)
     
     
     
(254,940)
 
Net book value, June 30, 2012
 
$
155,610
   
$
485,110
   
$
2,161,420
   
$
12,115,858
   
$
2,035,337
   
$
16,953,335
 
 
A summary of acquired intangible assets for the six months ended June 30, 2012 is as follows:

   
Technology
2 – 7 years
   
Brand
7 years
   
Customer relationships
4 – 7 years
   
Surname
domain
names
indefinite
life
   
Direct
navigation
domain
names
indefinite
life
   
Total
 
                                     
Net book value, December 31, 2011
 
$
227,430
   
$
571,930
   
$
2,512,660
   
$
12,120,077
   
$
2,050,493
   
$
17,482,590
 
Acquisition of domain names
   
     
     
     
     
3,664
     
3,664
 
Sales of domain names
   
     
     
     
(4,219)
     
(18,820)
     
(23,039)
 
Amortization expense
   
(71,820)
     
(86,820)
     
(351,240)
     
     
     
(509,880)
 
Net book value, June 30, 2012
 
$
155,610
   
$
485,110
   
$
2,161,420
   
$
12,115,858
   
$
2,035,337
   
$
16,953,335
 
 
As of June 30, 2012, the accumulated amortization for the definite life intangibles was $3.6 million.

During the six months ended June 30, 2012, the Company sold certain intangible assets with no book value for $0.5 million

6. LOAN PAYABLE:

The Company has credit agreements (collectively the “Amended Credit Facility”) with the Bank of Montreal (the “Bank”) that were amended on July 27, 2011, and which provide it with access to two revolving demand loan facilities, a treasury risk management facility and an operating demand loan.

Two Revolving Demand Loan Facilities

The Amended Credit Facility provides for $8.0 million in funds available through a demand loan revolving facility (the “DLR Loan”) and a demand loan revolving, reducing facility (the “DLRR Loan”, and together with the DLR Loan, the “Revolving Demand Loan Facilities”). Advances under the Revolving Demand Loan Facilities may be used to finance the repurchases of the Company’s common stock and for certain permitted acquisitions. The Amended Credit Facility provides that aggregate advances under the Revolving Demand Loan Facilities may not exceed $8.0 million and that no more than $2.0 million of such advances may be used to finance repurchases of the Company’s common stock (the “Share Repurchase Limit”). On December 13, 2011, the Company entered into a letter of acknowledgment with the Bank that provided for the waiver of the Share Repurchase Limit and permitted it to use any funds available under the Revolving Demand Loan Facilities to finance share repurchases through March 31, 2012. As of March 31, 2012, the Share Repurchase Limit was reinstated and the Company may now draw additional funds on the Revolving Demand Loan Facilities to fund share repurchases only to the extent that the outstanding balance of the Revolving Demand Loan Facilities does not exceed $2.0 million.

The DLR Loan accrues interest at the BMO U.S. Base Rate plus 1.25%. The Company may elect to pay interest on the DLRR Loan either at the BMO U.S. Base Rate plus 1.25% or LIBOR plus 2.50%. In addition, the Revolving Demand Loan Facilities are subject to an undrawn aggregate standby fee of 0.20% following the first draw, which such fee is payable quarterly in arrears. Outstanding amounts under the Revolving Demand Loan Facilities are payable on demand at any time, at the sole discretion of the Bank, with or without cause, and the Bank may terminate these loan facilities at any time.
 
 
7

 

Repayment of advances under the DLR Loan consists of interest only payments made monthly in arrears and prepayment is permitted without penalty. The outstanding balance under the DLR Loan as of December 31st of each year is to be fully repaid within 31 days of December 31st through an equivalent advance made under the DLRR Loan. Advances under the DLRR Loan will be made annually and solely for such purpose. Each advance under the DLRR Loan is to be repaid in equal monthly principal payments plus interest, over a period of four years from the date of such advance.

On July 28, 2011, the Company drew down $2.5 million on the DLR Loan to fund the acquisition of EPAG as more fully described under Note 3, Acquisitions. On August 11, 2011, the Company prepaid $1.0 million of this loan. On December 31, 2011, in accordance with the terms of the Revolving Demand Loan Facilities, the remaining balance under the DLR Loan was fully repaid by an equivalent advance made under the DLRR Loan. At June 30, 2012, the DLRR Loan was fully repaid.

During the period ended March 31, 2012, the Company successfully concluded a modified “Dutch auction tender offer”, which was funded from available cash and an advance under the DLR Loan in the amount of $4.0 million. Under the terms of the offer, the Company repurchased an aggregate of 7,570,236 shares of its common stock at a purchase price of $0.77 per share, for a total of $5,829,082, excluding transaction costs of approximately $64,000. At June 30, 2012, the outstanding balance under the DLR Loan was $4.0 million. 

Treasury Risk Management Facility 

The Amended Credit Facility also provides for a $3.5 million settlement risk line to assist us with hedging Canadian dollar exposure through foreign exchange forward contracts and/or currency options. Under the terms of the Amended Credit Facility, the Company may enter into such agreements at market rates with terms not to exceed 18 months. As of June 30, 2012, the Company held contracts in the amount of $20.2 million to trade U.S. dollars in exchange for Canadian dollars (Note 7).
 
Operating Demand Loan

The Amended Credit Facility also provides the Company with a $1.0 million operating demand loan facility to assist it in meeting its operational needs (the “Operating Demand Loan”). The Operating Demand Loan accrues interest at a rate of BMO U.S. Base Rate plus 1.25%. Interest is payable monthly in arrears with any borrowing under the Operating Demand Loan fluctuating widely with periodic clean-up, at a minimum on an annual basis. The Company has also agreed to pay the Bank a monthly monitoring fee of US$500 with respect to this loan. The Operating Demand Loan is payable on demand at any time, at the sole discretion of the Bank, with or without cause, and the Bank may terminate the Operating Demand Loan at any time. As of June 30, 2012, the Company had no amounts outstanding under the Operating Demand Loan.

General Terms

The Amended Credit Facility contains customary representations and warranties, affirmative and negative covenants, and events of default. The Amended Credit Facility also requires the Company to make annual cash sweep payments based on its audited financial statements provided. These cash sweep payments are applied solely to amounts outstanding under the DLRR Loan in inverse order of maturity. The Amended Credit Facility also requires that the Company comply with certain customary non-financial covenants and restrictions. In addition, the Company has agreed to comply with the following financial covenants at all times: (i) Maximum Senior Funded Debt to EBITDA of 2.00:1; (ii) Maximum Total Funded Debt to EBITDA of 2.50:1; and (iii) Minimum Fixed Charge Coverage of 1.25:1. Further, the Maximum Annual Capital Expenditures cannot exceed $3.6 million per year, which limit will be reviewed on an annual basis. As of, and for the period ended, June 30, 2012, the Company was in compliance with these covenants.

Scheduled principal loan repayments are as follows:

Remainder of 2012   $ -  
2013
 
 
750,000
 
2014
   
1,000,000
 
2015
   
1,000,000
 
2016
   
1,000,000
 
2017
   
250,000
 
 
 
8

 
 
7. DERIVATIVE INSTRUMENT ASSETS AND LIABILITIES:

The Company enters into foreign currency contracts to hedge a portion of the Company’s expected Canadian dollar requirements. All derivative financial instruments are recorded at fair value on our consolidated balance sheet. The fair value of our foreign currency contracts at June 30, 2012 was a net unrealized loss of $0.2 million as compared to a net unrealized gain of $0.5 million at June 30, 2011. The net unrealized gain is a result of fluctuations in foreign exchange rates between the date the currency forward contracts were entered into and the valuation date at period end.

At June 30, 2012, the Company had the following outstanding forward exchange contracts to trade U.S. dollars in exchange for Canadian dollars:

Maturity date
 
Notional
amount of
U.S. dollars
   
Weighted
average
exchange rate
of U.S. dollars
   
Fair value
 
                   
July – September, 2012
   
5,100,000
     
0.9855
     
(163,215)
 
October – December, 2012
   
5,100,000
     
0.9855
     
(173,130)
 
January – March, 2013
   
6,000,000
     
1.0277
     
33,987
 
April – May, 2013
   
4,000,000
     
1.0385
     
59,241
 
Total
 
$
20,200,000
     
1.0085
   
$
(243,117)
 
 
The Company does not apply hedge accounting and, therefore, for the three and six months ended June 30, 2012, the Company recorded a loss of $0.4 million and a gain of $0.2 million, respectively, on currency forward contracts in its consolidated statements of operations and comprehensive income. For the three and six months ended June 30, 2011, the Company recorded a gain on currency forward exchange contracts of $0.1 million and $0.5 million, respectively.

8. INCOME TAXES

For the six months ended June 30, 2012, the Company recorded a provision for income taxes of $1.2 million on income before income taxes of $3.5 million, using an estimated effective tax rate for our 2012 fiscal year. Comparatively, for the six months ended June 30, 2011, the Company recorded a provision for income taxes of $0.3 million on income before taxes of $1.6 million, using an estimated effective tax rate for its 2011 fiscal year adjusted for certain foreign exchange losses for which it did not anticipate obtaining a current tax benefit in that fiscal year.

The effective tax rate for the six months ended June 30, 2012 differs from the effective rate for the comparative period ended June 30, 2011 as a result of the change in temporary differences during the period in respect of deferred tax assets that were recognized in the fourth quarter of 2011.

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the years in which those temporary differences become deductible. Management considers projected future taxable income, uncertainties related to the industry in which it operates, and tax planning strategies in making this assessment. During the fourth quarter of 2011 the Company released the remaining valuation allowance of $3.6 million.

The Company follows the provisions of FASB ASC Topic 740, Income Taxes to account for income tax exposures. The application of this interpretation requires a two-step process that separates recognition of uncertain tax benefits from measurement thereof.

The Company had approximately $0.2 million of total gross unrecognized tax benefit as of June 30, 2012 and $0.2 million of total gross unrecognized tax benefit as of December 31, 2011, which if recognized would favorably affect its income tax rate in future periods. The unrecognized tax benefit relates primarily to prior year Pennsylvania state franchise taxes and other insignificant U.S. state taxes as well as unrecognized tax benefits for 2011 research and development tax credits. The Company recognizes accrued interest and penalties related to income taxes in income tax expense. The Company did not have significant interest and penalties accrued as of June 30, 2012 and December 31, 2011, respectively. The Company believes that it is reasonably possible that all of the unrecognized tax benefit will decrease in the next twelve months as it is anticipated that the U.S. tax authorities will finalize their review of prior taxes owing in Pennsylvania within the period, certain other prior year state tax returns will be filed and the 2011 Canadian research and development claim will be assessed.
 
 
9

 

9. BASIC AND DILUTED EARNINGS PER COMMON SHARE:

Basic earnings per common share has been calculated by dividing net income for the period by the weighted average number of common shares outstanding during each period. Diluted earnings per share has been calculated by dividing net income for the period by the weighted average number of common shares and potentially dilutive common shares outstanding during the period. In computing diluted earnings per share, the treasury stock method is used to determine the number of shares assumed to be purchased from the conversion of common shares equivalents or the proceeds of option exercises.

The following table is a summary of the basic and diluted earnings per common share:

   
Three months
ended
June 30,
2012
   
Three months
ended
June 30,
2011
   
Six months
ended
June 30,
2012
   
Six months
ended
June 30,
2011
 
Numerator for basic and diluted earnings per common share:
                       
Net income for the period
 
$
695,998
   
$
565,659
   
$
2,359,617
   
$
1,293,605
 
Denominator for basic and diluted earnings per common share:
                               
Basic weighted average number of common shares outstanding
   
45,912,458
     
53,444,841
     
47,003,016
     
53,441,276
 
Effect of outstanding stock options
   
3,536,972
     
2,354,594
     
3,200,147
     
2,343,722
 
Diluted weighted average number of shares outstanding
   
49,449,430
     
55,796,435
     
50,203,163
     
55,784,998
 
Basic earnings per common share
 
$
0.02
   
$
0.01
   
$
0.05
   
$
0.02
 
Diluted earnings per common share
 
$
0.01
   
$
0.01
   
$
0.05
   
$
0.02
 
 
For the three months ended June 30, 2012, outstanding options to purchase 546,000 common shares were not included in the computation of diluted income per common share because all such options had exercise prices greater than the average market price of the common shares.

For the six months ended June 30, 2012, outstanding options to purchase 558,250 common shares were not included in the computation of diluted income per common share because all such options had exercise prices greater than the average market price of the common shares.

During the three months ended June 30, 2012, 1,115,304 common shares were repurchased and cancelled under the terms of our stock repurchase program announced in November 2011.

During the three months ended March 31, 2012, 7,570,236 common shares were repurchased and cancelled under the terms of a modified Dutch auction tender offer announced in December 2011.

The computation of earnings per share and diluted earnings per share for the three and six months ended June 30, 2012 includes reductions in the number of shares outstanding due to these repurchases. No common shares were repurchased during the three and six months ended June 30, 2011.

10. SUPPLEMENTAL INFORMATION:

The following is a summary of the Company’s revenue earned from each significant revenue stream:

   
Three months ended June 30,
   
Six months ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
OpenSRS :
                       
Domain Services
  $ 21,667,630     $ 18,219,726     $ 42,775,606     $ 35,760,108  
Value-Added Services
    2,588,983       2,208,173       5,277,701       4,473,931  
Total OpenSRS Services
    24,256,613       20,427,899       48,053,307       40,234,039  
                                 
Retail
    2,298,285       1,278,365       4,147,880       2,473,420  
Portfolio
    1,597,716       1,339,659       3,488,733       2,893,671  
    $ 28,152,614     $ 23,045,923     $ 55,689,920     $ 45,601,130  
 
No customer accounted for more than 10% of the Company’s revenue for the three and six months ended June 30, 2012 or the three and six months ended June 30, 2011. Significant management judgment is required at the time revenue is recorded to assess whether the collection of the resulting receivables is reasonably assured. On an ongoing basis, we assess the ability of our customers to make required payments. Based on this assessment, we expect the carrying amount of our outstanding receivables, net of allowance for doubtful accounts, to be fully collected.
 
 
10

 

As of June 30, 2012, one customer accounted for 10% of accounts receivable. As of June 30, 2011, two customers accounted for 24% of accounts receivable.

The following is a summary of the Company’s cost of revenues from each significant revenue stream:

   
Three months ended June 30,
   
Six months ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
OpenSRS :
                       
Domain Services
  $ 18,011,032     $ 15,101,335     $ 35,631,091     $ 29,674,211  
Value-Added Services
    536,781       506,842       1,043,932       1,019,549  
Total OpenSRS Services
    18,547,813       15,608,177       36,675,023       30,693,760  
                                 
Retail
    1,356,514       418,571       2,286,274       837,864  
Portfolio
    215,884       198,188       426,039       388,452  
Network, other costs
    1,213,864       1,235,498       2,470,754       2,498,326  
Network, depreciation and amortization costs
    191,548       219,519       374,876       475,490  
    $ 21,525,623     $ 17,679,953     $ 42,232,966     $ 34,893,892  
 
11. COMMITMENTS AND CONTINGENCIES:

The Company is involved in various legal claims and lawsuits in connection with its ordinary business operations. The Company intends to vigorously defend these claims. While the final outcome with respect to any actions or claims outstanding or pending as of June 30, 2012 cannot be predicted with certainty, management believes that their resolution will not have a material adverse effect on the Company’s financial position.

12. STOCKHOLDERS’ EQUITY:

The following unaudited table summarizes stockholders’ equity transactions for the three month period ended June 30, 2012:

   
Common Stock
   
Additional
Paid in
         
Total
Stockholders’
 
   
Shares
   
Amount
   
Capital
   
Deficit
   
equity
 
                               
Balances, March 31, 2012
   
46,221,465
   
$
9,952,314
   
$
36,700,388
   
$
(20,270,366)
   
$
26,382,336
 
                                         
Exercise of stock options
   
378,936
     
504,375 
     
(285,375
)    
     
219,000
 
Repurchase and cancellation of shares – Normal Course Issuer Bid
   
(1,115,304)
     
(223,061)
     
(1,368,682
)
   
     
(1,591,743)
 
Cancellation of Restricted Stock Awards
   
(100)
     
——
             
     
 
Stock-based compensation
   
     
     
63,096
     
     
63,096
 
Net income for the period
   
     
     
     
695,998
     
695,998
 
                                         
Balances, June 30, 2012
   
45,484,997
   
$
10,233,628
   
$
35,109,427
   
$
(19,574,368)
   
$
25,768,687
 
 
The following unaudited table summarizes stockholders’ equity transactions for the six month period ended June 30, 2012:

   
Common Stock
   
Additional
Paid in
         
Total
Stockholders’
 
   
Shares
   
Amount
   
Capital
   
Deficit
   
equity
 
                               
Balances, December 31, 2011
   
53,497,584
   
$
11,358,959
   
$
40,994,013
   
$
(21,933,985)
   
$
30,418,987
 
                                         
Exercise of stock options
   
673,153
     
611,777 
     
(262,065)
     
     
349,712
 
Repurchase and cancellation of shares – Dutch Auction
   
(7,570,236)
     
(1,514,047)
     
(4,379,400)
     
     
(5,893,447
)
Repurchase and cancellation of shares – Normal Course Issuer Bid
   
(1,115,304)
     
(223,061)
     
(1,368,682)
     
     
(1,591,743)
 
Cancellation of Restricted Stock Awards
   
(200)
     
     
     
     
 
Stock-based compensation
   
     
     
125,561
     
     
125,561
 
Net income for the period
   
     
     
     
2,359,617
     
2,359,617
 
                                         
Balances, June 30, 2012
   
45,484,997
   
$
10,233,628 
   
$
35,109,427
   
$
(19,574,368)
   
$
25,768,687
 
 
 
11

 
 
On January 23, 2012, the Company announced that it successfully concluded a modified “Dutch auction tender offer” that was previously announced on December 15, 2011. Under the terms of the offer, the Company repurchased an aggregate of 7,570,236 shares of its common stock at a purchase price of $0.77 per share, for a total of $5,829,082, excluding transaction costs of approximately $64,000. The purchase price and all transaction costs were funded from available cash and an additional advance under its Amended Credit Facility from the Bank in the amount of $4.0 million. All shares purchased in the tender offer received the same price and all shares repurchased were immediately cancelled. As a result of the completion of the tender offer, as of January 23, 2012, the Company had 46,047,053 shares issued and outstanding.

On March 16, 2012, the Company announced that it was reinstating its previously announced stock buyback program, which initially commenced on November 15, 2011 and which was temporarily suspended when the Company undertook its Dutch auction tender offer. Under this buyback program, the Company may repurchase up to 3,840,000 shares of the Company’s common stock over the 12-month period that commenced on November 15, 2011. The Company repurchased 1,115,304 shares under this program during the three and six month periods ended June 30, 2012.

13. SHARE-BASED PAYMENTS

(a)    Stock options

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model, consistent with the guidance on stock compensation. Because option-pricing models require the use of subjective assumptions, changes in these assumptions can materially affect the fair value of the options. The assumptions presented in the table below represent the weighted average of the applicable assumption used to value stock options at their grant date. The Company calculates expected volatility based on historical volatility of the Company’s common shares. The expected term, which represents the period of time that options granted are expected to be outstanding, is estimated based on historical exercise experience. The Company evaluated historical exercise behavior when determining the expected term assumptions. The risk-free rate assumed in valuing the options is based on the U.S. Treasury yield curve in effect at the time of grant for the expected term of the option. The Company determines the expected dividend yield percentage by dividing the expected annual dividend by the market price of our common shares at the date of grant.

During the three months ended June 30, 2012, stock options to purchase 504,000 common shares were granted. No stock options were granted during the three months ended June 30, 2011.

During the six months ended June 30, 2012, stock options to purchase 549,000 common shares were granted. No stock options were granted during the six months ended June 30, 2011.

The stock options granted during the three and six months ended June 30, 2012 expire on various dates through 2019.

Details of stock option transactions for the three months ended June 30, 2012 and June 30, 2011 are as follows:

   
Three months ended
June 30, 2012
   
Three months ended
June 30, 2011
 
   
Number of
Shares
   
Weighted
Average
exercise price
per share
   
Number of
Shares
   
Weighted
Average
exercise price
per share
 
Outstanding, beginning of period
   
8,458,699
   
$
0.57
     
8,254,749
   
$
0.56
 
Granted
   
504,000
     
1.38
     
     
 
Exercised
   
(378,936)
     
0.58
     
     
 
Forfeited
   
(59,250)
     
0.74
     
(17,625)
     
0.69
 
Expired
   
(14)
     
0.49
     
     
 
Outstanding, end of period
   
8,524,499
   
$
0.62
     
8,237,124
   
$
0.55
 
Options exercisable, end of period
   
6,864,749
   
$
0.55
     
6,972,124
   
$
0.53
 
 
 
12

 
 
Details of stock option transactions for the six months ended June 30, 2012 and June 30, 2011 are as follows:

   
Six months ended
June 30, 2012
   
Six months ended
June 30, 2011
 
   
Number of
Shares
   
Weighted
Average
exercise price
per share
   
Number of
Shares
   
Weighted
Average
exercise price
per share
 
Outstanding, beginning of period
   
8,746,041
   
$
0.57
     
8,272,249
   
$
0.56
 
Granted
   
549,000
     
1.35
     
     
 
Exercised
   
(673,153)
     
0.52
     
(7,250)
     
0.48
 
Forfeited
   
(97,375)
     
0.78
     
(27,875)
     
0.71
 
Expired
   
(14)
     
0.49
     
     
 
Outstanding, end of period
   
8,524,499
   
$
0.62
     
8,237 124
   
$
0.55
 
Options exercisable, end of period
   
6,864,749
   
$
0.55
     
6,972,124
   
$
0.53
 
 
As of June 30, 2012, the exercise prices, weighted average remaining contractual life and intrinsic values of outstanding options were as follows:
           
Options outstanding
   
Options exercisable
 
 
Exercise
price
 
Outstanding
Number
   
Weighted average exercise price per share
   
Weighted Average remaining contractual life (years)
   
Aggregate intrinsic value
   
Number
exercisable
   
Weighted average exercise price per share
   
Aggregate intrinsic value
 
$  0.31  -  $
0.48
   
3,136,074
   
$
0.38
     
1.1
   
$
2,272,845
     
3,136,074
   
$
0.38
   
$
2,272,845
 
 $  0.56  -  $
0.75
   
3,898,425
   
$
0.66
     
3.8
     
1,727,088
     
2,784,675
   
$
0.63
     
1,295,050
 
 $  0.80  -  $
1.38
   
1,490,000
   
$
1.04
     
3.7
     
233,830
     
944,000
   
$
0.85
     
231,580
 
             
8,524,499
   
$
0.62
     
2.8
   
$
4,233,763
     
6,864,749
   
$
0.55
   
$
3,799,475
 
 
Total unrecognized compensation cost relating to unvested stock options at June 30, 2012, prior to the consideration of expected forfeitures, was approximately $782,000 and is expected to be recognized over a weighted average period of 2.9 years.

The Company recorded stock-based compensation of $62,923 and $53,202 for the three months ended June 30, 2012 and 2011, respectively.

The Company recorded stock-based compensation of $125,207 and $127,374 for the six months ended June 30, 2012 and 2011, respectively.

The Company has not capitalized any stock-based compensation expense as part of the cost of an asset.
 
(b)   Restricted stock awards
 
During the three and six months ended June 30, 2012, no restricted stock awards were granted to any employees of the Company.

Restricted stock awards generally vest annually over a four year period. Holders of restricted stock may not sell, assign, transfer, pledge or otherwise dispose of an unvested stock. Unvested shares of restricted stock are held in escrow by the Company until the holder’s interest in such shares vests.

Holders of restricted stock have full stockholder rights with respect to any shares of Company stock issued to the participant under a stock award, whether or not the holder’s interest in those shares is vested. Accordingly, the holder has the right to vote such shares and to receive any regular cash dividends paid on such shares.

Total unrecognized compensation cost relating to unvested restricted stock awards at June 30, 2012, prior to the consideration of expected forfeitures, was approximately $500 and is expected to be recognized over a weighted average period of 0.8 years.

The Company recorded stock-based compensation associated with restricted stock awards of $173 and $197 for the three months ended June 30, 2012 and 2011, respectively.
 
 
13

 

The Company recorded stock-based compensation associated with restricted stock awards of $354 and $356 for the six months ended June 30, 2012 and 2011, respectively.
 
14. FAIR VALUE MEASUREMENT

ASC Topic 820, “Fair Value Measurements and Disclosures” establishes a valuation hierarchy for disclosure of the inputs to valuation used to measure fair value. This hierarchy prioritizes the inputs into three broad levels. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities. Level 2 inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument. Level 3 inputs are unobservable inputs based on the Company’s own assumptions used to measure assets and liabilities at fair value. A financial asset or liability’s classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement.

The following table provides a summary of the fair values of the Company’s derivative instrument assets and liabilities measured at fair value on a recurring basis at June 30, 2012:

   
June 30, 2012
 
   
Fair Value Measurements Using
   
Assets at
 
   
Level 1
   
Level 2
   
Level 3
   
Fair Value
 
                         
Derivative instrument asset
 
$
   
$
97,718
   
$
   
$
97,718
 
Total Assets
 
$
   
$
97,718
   
$
   
$
97,718
 
                                 
Derivative Instrument liability
 
$
   
$
340,835
   
$
   
$
340,835
 
Total Liabilities
 
$
   
$
340,835
   
$
   
$
340,835
 
 
The following table provides a summary of the fair values of the Company’s derivative instrument assets measured at fair value on a recurring basis as at December 31, 2011:
 
   
December 31, 2011
 
   
Fair Value Measurements Using
   
Assets at
 
   
Level 1
   
Level 2
   
Level 3
   
Fair Value
 
                         
Derivative instrument asset
 
$
   
$
87,023
   
$
   
$
87,023
 
Total Assets
 
$
   
$
87,023
   
$
   
$
87,023
 
                                 
Derivative Instrument liability
 
$
   
$
786,506
   
$
   
$
786,506
 
Total Liabilities
 
$
   
$
786,506
   
$
   
$
786,506
 
 
The carrying values of cash and cash equivalents, restricted cash, accounts receivable, accounts payable, accreditation
fees payable, customer deposits, loan payable and accrued liabilities approximate their fair values due to the relatively short periods to maturity of the instruments.  The fair value of these financial assets and liabilities is determined using Level 3 inputs.

15. RECLASSIFICATION

Certain of the prior periods’ comparative figures have been reclassified to conform with the presentation adopted in the current period.

 
14

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
 
This Quarterly Report on Form 10-Q contains, in addition to historical information, forward-looking statements by us with regard to our expectations as to financial results and other aspects of our business that involve risks and uncertainties and may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as “may,” “should,” “anticipate,” “believe,” “plan,” “estimate,” “expect” and “intend,” and other similar expressions are intended to identify forward-looking statements. The forward-looking statements contained in this report include statements regarding, among other things, the Company’s foreign currency requirements, specifically for the Canadian dollar; the number of new, renewed and transferred-in domain names we register as our business develops and competes; the effect of a potential global top level domain (“gTLD”) expansion by the Internet Corporation for Assigned Names and Numbers (“ICANN”) on the number of domains we register and the impact it may have on related revenues; our belief that the market for domain name registration will trend upward gradually and may be affected by market volatility; our belief that, by increasing the number of services we offer, we will be able to generate higher revenues; the revenue that our parked page vendor relationships may generate in the future, the effectiveness of our intellectual property protection, including our ability to license proprietary rights to network partners and to register additional trademarks and service marks; the potential impact of current and pending claims on our business; our valuations of certain deferred tax assets, our expectation to collect our outstanding receivables, net of our allowance for doubtful accounts; our expectation regarding fluctuations in certain expense and cost categories; our expectations regarding future revenue from our patent assignments; our expectations regarding our unrecognized tax benefit and the timing or completion of certain audits of our US tax returns; our expectations regarding cash from operations to fund our business; our expectation regarding increased competition due to the introduction of new gTLDs by ICANN; the impact of cancellations of or amendments to market development fund programs under which we receive funds; and our belief that a slowing economy may lead to a decrease in advertising spending. These statements are based on management’s current expectations and are subject to a number of uncertainties and risks that could cause actual results to differ materially from those described in the forward-looking statements. Many factors affect our ability to achieve our objectives and to successfully develop and commercialize our services including:

 
Our ability to continue to generate sufficient working capital to meet our operating requirements;

 
Our ability to maintain a good working relationship with our vendors and customers;

 
The ability of vendors to continue to supply our needs;

 
Actions by our competitors;

 
Our ability to achieve gross profit margins at which we can be profitable;

 
Our ability to attract and retain qualified personnel in our business;

 
Our ability to effectively manage our business;

 
Our ability to obtain and maintain approvals from regulatory authorities on regulatory issues;

 
Pending or new litigation; and

 
Factors set forth under the caption “Item 1A Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011.

This list of factors that may affect our future performance and financial and competitive position and also the accuracy of forward-looking statements is illustrative, but it is by no means exhaustive. Accordingly, all forward-looking statements should be evaluated with the understanding of their inherent uncertainty. All forward-looking statements included in this document are based on information available to us as of the date of this document, and we assume no obligation to update these cautionary statements or any forward-looking statements except to the extent of any obligations under the Securities Exchange Act of 1934 or the Securities Act of 1933. These statements are not guarantees of future performance.

We qualify all the forward-looking statements contained in this Form 10-Q by the foregoing cautionary statements.
 
 
15

 

OVERVIEW
 
Our mission is to provide simple useful services that help people unlock the power of the Internet. We accomplish this by reducing the complexity our customers’ experience as they acquire, deliver or use Internet services such as domain name registration, email and other services.
 
Our primary distribution channel is a global network of more than 12,000 resellers in more than 100 countries who typically provide their customers, the end-users of the Internet, with a critical component for establishing and maintaining an online presence. Our primary focus is serving the needs of this network of resellers by providing superior services, easy-to-use interfaces, reseller-oriented technology, and agile development processes. We seek to provide superior customer service to our resellers by anticipating their business needs and technical requirements. This includes providing easy-to-use interfaces that enable resellers to quickly and easily integrate our services into their individual business processes, and offering brandable end-user interfaces that emphasize simplicity and visual appeal. We also provide “second tier” support to our resellers by email and phone in the event resellers experience issues or problems with our services. In addition, we provide proactive support to our resellers by monitoring all services and network infrastructure to address deficiencies before our resellers or their customers are impacted.

We believe that the underlying platform for our services is one of the most mature, reliable and functional reseller-oriented provisioning and management platforms in our industry, and we continue to refine, evolve and improve this platform for both resellers and end-users.

Our principal place of business is located in Canada. We report our financial results as one operating segment with three distinct service offerings – Wholesale, Retail and Portfolio. Our chief operating decision maker regularly reviews our operating results on a consolidated basis, principally to make decisions about how we utilize our resources and to measure our consolidated operating performance. To assist us in forecasting growth and to help us monitor the effectiveness of our operational strategies, our chief operating decision maker regularly reviews revenue for each of our service offerings in order to gain more understanding of the key metrics driving our business. Accordingly, we report revenue in the following service areas:

Wholesale, primarily branded as OpenSRS, derives revenue from its Domain Service and from providing Value-Added Services. The OpenSRS Domain Service manages over 13 million domain names under the Tucows ICANN registrar accreditation and for other registrars under their own accreditations. Value-Added Services include hosted email which provides email delivery and webmail access to millions of mailboxes, Internet security services, publishing tools and reseller billing services. All of these services are made available to end-users through a network of over 12,000 web hosts, Internet service providers (“ISPs”), and other resellers around the world. In addition, we also derive revenue from the bulk sale of domain names and advertising from the OpenSRS Domain Expiry Stream and the Marketing Development Funds we receive from vendors from time-to-time to expand or maintain the market position for their services.

Retail, primarily our Hover and Ting websites, derives revenues from the sale of domain name registration, email services and mobile phone service to individuals and small businesses. Retail also includes our Personal Names Service – based on over 42,000 surname domains – that allows roughly two-thirds of Americans to purchase an email address based on their last name.

Portfolio generates advertising revenue from our domain name portfolio and from our two large advertising-supported websites, butterscotch.com and tucows.com. We also generate revenue by offering names in our domain portfolio for resale via our reseller network and other channels.

Our business model is characterized by non-refundable, up-front payments, which lead to recurring revenue and positive operating cash flow.

For the three months ended June 30, 2012 and 2011, we reported revenue of $28.2 million and $23.0 million, respectively. For the three months ended June 30, 2012 and 2011, the OpenSRS Domain Service accounted for 77% and 78% of our total revenue, respectively.

For the six months ended June 30, 2012 and 2011, we reported revenue of $55.7 million and $45.6 million, respectively. For the six months ended June 30, 2012 and 2011, the OpenSRS Domain Service accounted for 78% and 79% of our total revenue, respectively.

 
16

 
 
KEY BUSINESS METRICS

We regularly review a number of business metrics, including the following key metrics to assist us in evaluating our business, measure the performance of our business model, identify trends impacting our business, determine resource allocation, formulate financial projections and make strategic business decisions. The following tables set forth, the key business metrics which we believe are the primary indicators of our performance for our wholesale OpenSRS domain service for the periods presented.

Total new, renewed and transferred-in domain name registrations:

   
Three months ended June 30,
   
Six months ended June 30,
 
   
2012 (1)
   
2011 (1)
   
2012 (1)
   
2011 (1)
 
   
(in ‘000’s)
   
(in ‘000’s)
 
Total new, renewed and transferred-in domain name registrations
    2,330       2,081       4,766       4,091  
 
 
(1)
For a discussion of these period to period changes in the domains provisioned and how they impacted our financial results see the Net Revenue discussion below.

Domain names under management:

   
As at June 30,
 
   
2012 (1)
   
2011 (1)
 
   
(in ‘000’s)
 
Domain names under management:
           
Registered using the Tucows Registrar Accreditation
    10,774       9,771  
Registered using our Resellers’ Registrar Accreditations
    3,101       1,373  
Total domain names under management
    13,875       11,144  
 
 
(1)
For a discussion of these period to period changes in domains under management and how they impacted our financial results see the Net Revenue discussion below.

OPPORTUNITIES, CHALLENGES AND RISKS
 
The increased competition in the market for Internet services in recent years, which the Company expects will continue to intensify in the short and long term, poses a material risk for the Company. As new registrars are introduced, existing competitors expand service offerings and competitors offer price discounts to gain market share, the Company faces pricing pressure, which can adversely impact its revenues and profitability. To address these risks, the Company has focused on leveraging the scalability of its infrastructure and its ability to provide proactive and attentive customer service to aggressively compete to attract new customers and to maintain existing customers.
 
Our direct costs to register domain names on behalf of our customers are almost exclusively controlled by registries such as Verisign and by ICANN. Verisign provides all the registry services operations for the .com, .net, .cc, .tv and .name domain names. ICANN is a private sector, not-for-profit corporation formed to oversee a number of Internet related tasks, including domain registrations for which it collects fees. The market for wholesale registrar services is both price sensitive and competitive, particularly for large volume customers, such as large web hosting companies and owners of large portfolios of domain names. We have a relatively limited ability to increase the pricing of domain name registrations without negatively impacting our ability to maintain or grow our customer base.
 
In 2007, we entered into contractual agreements with Verisign for the supply of domain names. These agreements were automatically renewed in February 2012 until February 2017. Under the agreements, effective January 15, 2012, Verisign increased their domain name fees to $7.85 for .com and $5.86 for .net. Mandated registry price increases such as these will adversely increase our service costs as a percentage of our total revenue.
 
In 2009, our contractual agreement with ICANN was amended to extend the terms of the agreement through June 30, 2014. Under the agreement, ICANN charges a $0.18 fee for each year that a domain name is registered in the TLDs that fall within its purview. In addition, ICANN has approved a framework for the significant expansion of the number of gTLDs in 2012. The New gTLD Program's goals include enhancing competition and consumer choice, and enabling the benefits of innovation via the introduction of a wide range of new gTLDs. We believe that such expansion, once completed, will result in an increase in the number of domains we register and related revenues in 2013. In addition, we believe that the new gTLD Program could also provide us with new revenue opportunities in 2013, which include operating the back-end infrastructure for new TLD registries and/or owning one or more TLDs in our own right.
 
 
17

 
 
From time-to-time certain of our vendors provide us with Market Development Funds to expand or maintain the market position for their services. Any decision by these vendors to cancel or amend these programs for any reason, may result in payments in future periods not being commensurate with what we have achieved during past periods.

Sales of domain names from our domain portfolio have a negative impact on our advertising revenue as these names are no longer available for advertising purposes. In addition, the timing of larger domain names portfolio sales is unpredictable and may lead to significant quarterly and annual fluctuations in our Portfolio revenue.

Our revenue is primarily realized in U.S. dollars and a major portion of our operating expenses are paid in Canadian dollars. Fluctuations in the exchange rate between the U.S. dollar and the Canadian dollar may have a material effect on our business, financial condition and results from operations. In particular, we may be adversely affected by a significant weakening of the U.S. dollar against the Canadian dollar on a quarterly and an annual basis. Our policy with respect to foreign currency exposure is to manage our financial exposure to certain foreign exchange fluctuations with the objective of neutralizing some or all of the impact of foreign currency exchange movements by entering into foreign exchange forward contracts to mitigate the exchange risk on a portion of our Canadian dollar exposure. We may not always enter into such forward contracts and such contracts may not always be available and economical for us. Additionally, the forward rates established by the contracts may be less advantageous than the market rate upon settlement.

Net Revenues

Wholesale - OpenSRS Domain Service

Historically, our OpenSRS Domain Service has constituted the largest portion of our business and encompasses all of our services as an accredited registrar related to the registration, renewal, transfer and management of domain names. In addition, this service fuels other revenue categories as it often is the initial service for which a reseller will engage us, enabling us to follow on with other services and allowing us to add to our portfolio by purchasing names registered through us upon their expiration.

With the acquisition of EPAG Domainservices GmbH (“EPAG”) in August 2011, we now offer registration services for over 200 TLDs.

With respect to the sale of domain registrations, our pricing structure for domain names provides visibility into the various fees that make up the cost of a domain name by breaking out the cost of the registry and ICANN fees separately from our management fee. Effective January 2012, registry fees for the .com and .net registrations were increased by the registry to $7.85 and $5.86, respectively. The management fee provides our resellers with access to our provisioning and management tools to enable them to register and administer domain names and access to additional services like WHOIS privacy and DNS services, enhanced domain name suggestion tools and access to our premium domain names. We earn fees in connection with each new, renewed and transferred-in registration and from providing provisioning services to resellers and registrars on a monthly basis. Domain registrations are generally purchased for terms of one to ten years, with a majority having a one-year term.

Wholesale – OpenSRS Value-Added Services

We derive revenue from our hosted email service through our global distribution network. Our hosted email service is offered on a per account, per month basis, and provides resellers with a reliable, scalable “white label” hosted email solution that can be customized to their branding and business model requirements. The hosted email service also includes spam and virus filtering on all accounts. End-users can access the hosted email service via a full-featured, multi-language AJAX-enabled web interface or through traditional desktop email clients, such as Microsoft Outlook or Apple Mail, using IMAP or POP/SMTP.

We also derive revenue from other Value-Added Services primarily from provisioning SSL and other trust certificates. In addition, we derive revenue from the bulk sale of domain names and advertising from the OpenSRS Domain Expiry Stream.

Other services included in Value-Added Services include web publishing tools, special discounts on 3rd party services and fees we receive from time-to-time from vendors to expand or maintain the market position for their services. In addition, we provide billing, provisioning and customer care software solutions to ISPs through our Platypus billing software.

Retail – Hover

We derive revenues from Hover’s sale of retail Internet domain name registration and email services to individuals and small businesses.

Retail - Ting

We derive revenue from Ting’s sale of retail mobile phone services to individuals and small businesses.
 
 
18

 

Portfolio

We derive revenue from our portfolio of domain names by displaying advertising on the domains and by making them available for sale or lease. When a user types one of these domain names into a web browser, they are presented with dynamically generated links that are pay-per-click advertising. Every time a user clicks on one of these links, it generates revenue for us through our partnership with third-parties who provide syndicated pay-per-click advertising (“parked page vendors”).

Our parked page vendor relationships may not continue to generate levels of revenue commensurate with what we have achieved during past periods. Our ability to generate online advertising revenue from parked page vendors depends on their advertising networks’ assessment of the quality and performance characteristics of Internet traffic resulting from online advertisements rendered on their websites. We have no control over any of these quality assessments. Parked page vendors may from time to time change their existing, or establish new, methodologies and metrics for valuing the quality of Internet traffic and delivering pay-per-click advertisements. Any changes in these methodologies, metrics and advertising technology platforms could decrease the amount of revenue that we generate from online advertisements. In addition, parked page vendors may at any time change or suspend the nature of the service that they provide to online advertisers. These types of changes or suspensions would adversely impact our ability to generate revenue from pay-per-click advertising.

Portfolio names are sold through our premium domain name service, auctions or in negotiated sales. The size of our domain name portfolio varies over time, as we acquire and sell domains on a regular basis to maximize the overall value and revenue generation potential of our portfolio. In evaluating names for sale, we consider the potential foregone revenue from pay-per-click advertising, as well as other factors. The name will be offered for sale if, based on our evaluation, the name is deemed non-essential to our business and management believes that deriving proceeds from the sale is strategically more beneficial to the Company.

Portfolio names that have been acquired from third-parties or through acquisition are included as intangible assets with indefinite lives on our consolidated balance sheet.

We also generate advertising and other revenue through two ad-supported content sites, butterscotch.com and tucows.com. These sites primarily derive revenue from banner and text advertising. In addition, their revenue is derived from software developers who rely on us as a primary source of distribution. Software developers use our Author Resource Center to submit their products for inclusion on our site and to purchase promotional placements of their software.

Critical Accounting Policies
 
The following is a discussion of our critical accounting policies and methods. Critical accounting policies are defined as those that are both important to the portrayal of our financial condition and results of operations and are reflective of significant judgments and uncertainties made by management that may result in materially different results under different assumptions and conditions. Note 2 to the consolidated financial statements for the year ended December 31, 2011 includes further information on the significant accounting policies and methods used in the preparation of our consolidated financial statements.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate the application of these estimates, including those related to the useful lives and valuation of intangible assets, valuation of goodwill, fair value measurement of assets and liabilities, product development costs, revenue recognition and deferred revenue and accounting for income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual amounts could differ significantly from these estimates.

Revenue recognition policy
 
We earn revenues from the following services:
 
 
·
Wholesale (Domain Service and other Value-Added Services);
 
·
Retail (Hover and Ting)
 
·
Portfolio (Domain Portfolio monetization and sales).
 
 
19

 
 
With respect to the sale of domain registrations and other Internet services, we earn registration fees in connection with each new, renewed and transferred-in registration and from providing provisioning services to resellers and registrars on a monthly basis. We also enter into revenue arrangements in which a reseller may purchase a combination of services (multiple element arrangements). When a standalone selling price exists for each deliverable, we allocate revenue to each deliverable based on the relative selling price of each of the deliverables. The standalone selling price is established for each deliverable by the price charged when that deliverable is sold separately by the Company which is vendor specific objective evidence (“VSOE”). For arrangements where the Company does not sell the deliverable separately, the selling price is determined based on third party evidence (“TPE”), which is the price at which a competitor or third party sells the same or similar and largely interchangeable deliverable on a standalone basis. In instances where VSOE and TPE do not exist, the Company uses an estimated selling price for the deliverable, which is the price at which a company would transact if the deliverable were sold by the vendor regularly on a standalone basis. Payments for the full term of all services are received at the time of activation of service and where appropriate are recorded as deferred revenue and are recognized as earned ratably over the term of provision of service. This accounting treatment reasonably approximates a recognition pattern that corresponds with the provision of the services during the quarters and the year.

Revenue from the sale of domain names consists primarily of amounts earned for the transfer of rights to domain names that are currently under the Company’s control. Collectability of revenues generated is subject to a high level of uncertainty; accordingly revenues are recognized only when payment is received, except where a fixed contract has been negotiated, in which case revenues are recognized once all the terms of the contract have been satisfied.

We also generate advertising and other revenue through tucows.com and butterscotch.com as well as advertising revenue from our OpenSRS expired domain names and our domain name portfolio. Advertising and other revenue is recognized ratably over the period in which it is presented. To the extent that the minimum number of post-presentation impressions we guarantee to customers is not met, we defer recognition of the corresponding revenues until the guaranteed impressions are achieved. Revenue is also generated from vendors who are seeking to expand or maintain their services market position and is recognized once all the conditions have been met.

Changes to contractual relationships in the future could impact the amounts and timing of revenue recognition.

In those cases where payment is not received at the time of sale, additional conditions for recognition of revenue apply. The conditions are (i) that the collection of sales proceeds is reasonably assured and (ii) that we have no further performance obligations. We record expected refunds, rebates and credit card charge-backs as a reduction of revenues at the time of the sale based on historical experiences and current expectations. Should these expectations not be met, adjustments will be required in future periods.

We record provisions for possible uncollectible accounts receivable and contingent liabilities which may arise in the normal course of business. The allowance for doubtful accounts is calculated by taking into account factors such as our historical collection and write-off experience, the number of days the customer is past due and the status of the customer’s account with respect to whether or not the customer is continuing to receive service. The contingent liability estimates are based on management’s historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the reported amounts of liabilities and expenses that are not readily apparent from other sources. Historically, credit losses have been within our expectations and the reserves we have established have been appropriate. However, we have, on occasion, experienced issues which have led to accounts receivable not being fully collected. Should these issues occur more frequently, additional provisions may be required.

Valuation of intangible assets, goodwill and long-lived assets

Goodwill represents the excess of purchase price over the fair values assigned to the net assets acquired in business combinations. Finite life intangible assets, related to the acquisition of EPAG in August 2011, are being amortized on a straight-line basis over periods of two to seven years, and consist of technology, brand and customer relationships. Finite life intangible assets, related to the acquisition of Innerwise, Inc. in July 2007, are being amortized on a straight-line basis over periods of five to seven years, and consist of brand and customer relationships. Indefinite life intangible assets, acquired in the acquisition of Mailbank.com Inc. in June 2006, consist of surname domain names and direct navigation domain names.

Goodwill and indefinite life intangibles are not amortized, but are tested for impairment annually or more frequently if circumstances indicate potential impairment, through a comparison of fair value to carrying amount. Goodwill is tested for impairment annually at the same time every year, and when an event occurs or circumstances change such that it is reasonably possible that impairment may exist. We review goodwill and indefinite life intangibles at least annually for possible impairment in the fourth quarter of each year as more fully described under the caption “Critical Accounting Policies” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011.

With regards to property, equipment and definite life intangible assets, we continually evaluate whether events or circumstances have occurred that indicate the remaining estimated useful lives of our definite-life intangible assets may warrant revision or that the remaining balance of such assets may not be recoverable. We use an estimate of the related undiscounted cash flows over the remaining life of the asset in measuring whether the asset is recoverable. There was no impairment recorded on definite-life intangible assets and property and equipment during the three and six months ended June 30, 2012 or during the three and six months ended June 30, 2011.
 
 
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Determining the number of reporting units and the fair value of a reporting unit requires us to make judgments and involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates, future economic and market conditions, and determination of appropriate market comparables as more fully described under the caption “Critical Accounting Policies” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011. We base our fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain. The long-term financial forecast represents the best estimate that we have at this time and we believe that its underlying assumptions are reasonable. However, actual performance in the near-term and longer-term could be materially different from these forecasts, which could impact future estimates of fair value of our reporting units and may result in a charge to earnings in future periods due to the potential for a write-down of goodwill in connection with such tests.

Any changes to our key assumptions about our businesses and our prospects, or changes in market conditions, could cause the fair value of our reporting unit to fall below its carrying value, resulting in a potential impairment charge. In addition, changes in our organizational structure or how our management allocates resources and assesses performance, could result in a change in our operating segments or reporting units, requiring a reallocation and updated impairment analysis of goodwill. A goodwill or intangible asset impairment charge could have a material effect on our consolidated financial statements because of the significance of goodwill and intangible assets to our consolidated balance sheet. As of June 30, 2012, we had $18.9 million in goodwill and $17.0 million in intangible assets.

Accounting for income taxes

We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. We apply a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if on the weight of available evidence it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit that is more than 50% likely to be realized upon settlement.

Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate based on new information that may become available. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made.

As we account for income taxes under the asset and liability method, we recognize deferred tax assets or liabilities for the anticipated future tax effects of temporary differences between the financial statement basis and the tax basis of our assets and liabilities. We record a valuation allowance to reduce the net deferred tax assets when it is more likely than not that the benefit from the deferred tax assets will not be realized. In assessing the need for a valuation allowance, historical and future levels of income, expectations and risks associated with estimates of future taxable income and ongoing tax planning strategies are considered. In the event that it is determined that the deferred tax assets to be realized in the future would be in excess of the net recorded amount, an adjustment to the deferred tax asset valuation allowance would be recorded. This adjustment would increase income in the period that such determination was made. Likewise, should it be determined that all or part of a recorded net deferred tax asset would not be realized in the future, an adjustment to increase the deferred tax asset valuation allowance would be charged to income in the period that such determination would be made.

On a periodic basis, we evaluate the probability that our deferred tax asset balance will be recovered to assess its realizability. To the extent we believe it is more likely than not that some portion of our deferred tax assets will not be realized, we will increase the valuation allowance against the deferred tax assets. Realization of our deferred tax assets is dependent primarily upon future taxable income. Our judgments regarding future profitability may change due to future market conditions, changes in U.S. or international tax laws and other factors. These changes, if any, may require possible material adjustments to these deferred tax assets, impacting net income or net loss in the period when such determinations are made.

 
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RESULTS OF OPERATIONS FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2012 AS COMPARED TO THE THREE AND SIX MONTHS ENDED JUNE 30, 2011

NET REVENUES

The following table presents our net revenues, by revenue source:

   
Three months ended June 30,
   
Six months ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
OpenSRS :
                       
Domain Services
  $ 21,667,630     $ 18,219,726     $ 42,775,606     $ 35,760,108  
Value-Added Services
    2,588,983       2,208,173       5,277,701       4,473,931  
Total OpenSRS Services
    24,256,613       20,427,899       48,053,307       40,234,039  
                                 
Retail
    2,298,285       1,278,365       4,147,880       2,473,420  
Portfolio
    1,597,716       1,339,659       3,488,733       2,893,671  
    $ 28,152,614     $ 23,045,923     $ 55,689,920     $ 45,601,130  
Increase over comparative period   $ 5,106,691             $ 10,088,790          
Increase  - percentage
    22 %             22 %        
 
The following table presents our revenues, by revenue source, as a percentage of total revenues:

   
Three months ended June 30,
   
Six months ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
OpenSRS :
                       
Domain Services
    77 %     78 %     78 %     79 %
Value-Added Services
    9 %     10 %     9 %     10 %
Total OpenSRS Services
    86 %     88 %     87 %     89 %
                                 
Retail
    8 %     6 %     7 %     5 %
Portfolio
    6 %     6 %     6 %     6 %
      100 %     100 %     100 %     100 %
 
Deferred revenue from domain name registrations and other services at June 30, 2012 increased to $74.5 million from $66.8 million at June 30, 2011. Included in this increase is an amount of $2.2 million pertaining to EPAG, which was acquired on August 1, 2011.

No customer accounted for more than 10% of revenue during the three and six months ended June 30, 2012 and June 30, 2011. At June 30, 2012, one customer accounted for 10% of accounts receivable, and as of June 30, 2011, two customers accounted for 24% of accounts receivable. Significant management judgment is required at the time revenue is recorded to assess whether the collection of the resulting receivables is reasonably assured. On an ongoing basis we assess the ability of our customers to make required payments. Based on this assessment, we expect the carrying amount of our outstanding receivables, net of allowance for doubtful accounts, to be fully collected.

Wholesale

For the three months ended June 30, 2012, Wholesale revenue increased by $3.8 million, or 19%, to $24.3 million when compared to the three months ended June 30, 2011, primarily as a result of OpenSRS Domain Service revenue increasing by $3.4 million or 19% to $21.7 million. For the six months ended June 30, 2012, Wholesale revenue increased by $7.8 million, or 19%, to $48.1 million when compared to the six months ended June 30, 2011, primarily as a result of OpenSRS Domain Service revenue increasing by $7.0 million or 20% to $42.8 million. These increases resulted primarily from our success in attracting customers with increased transaction volumes, the contribution from the EPAG acquisition that we completed during the third quarter of last year and the impact of our passing on the 7% registration fee increase implemented in January 2012 for registration fees paid to certain registries.

In addition, Value-Added Services increased by $0.4 million or 17% to $2.6 million when compared to the three months ended June 30, 2011and by $0.8 million or 18% to $5.3 million when compared to the six months ended June 30, 2011. These increases resulted primarily from the sale of domain names and advertising from the OpenSRS Domain Expiry Stream and increased digital certificate sales.

During the three months ended June 30, 2012, the number of transactions from all new, renewed and transferred-in domain name registrations that we processed increased by 0.2 million transactions to 2.3 million when compared to the three months ended June 30, 2011. During the six months ended June 30, 2012, the number of transactions from all new, renewed and transferred-in domain name registrations that we processed increased by 0.7 million transactions to 4.8 million when compared to the six months ended June 30, 2011. While we anticipate that the number of new, renewed and transferred-in domain name registrations will continue to incrementally increase in the long term, the volatility in the market could affect the growth of domain names that we manage.
 
 
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In addition, new TLDs, including new IDN TLDs, ccTLDs and gTLDs, are being introduced by ICANN in 2012. We cannot assess the impact, if any, the introduction of these new TLDs will have on our revenues and results of operations. See “Item 1A Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011.

As of June 30, 2012, the total domain names under our management increased by 1.0 million to 10.8 million, when compared to June 30, 2011. This increase includes the 0.4 million domains that were added through the acquisition of EPAG. In addition, we provide provisioning services on a monthly basis to accredited registrars who use our technical systems to process domain registrations with their own accreditation. As of June 30, 2012, we managed 3.1 million domain names on behalf of other accredited registrars, an increase of 1.7 million compared to the 1.4 million we managed as of June 30, 2011. The increase is attributable to one of our accredited registrars transferring 1.8 million domain names they were directly managing under their own accreditation onto our platform.

Retail

The increase in net revenues from Retail for the three months ended June 30, 2012 as compared to the three months ended June 30, 2011 increased by $1.0 million to $2.3 million. This increase reflects the impact of Ting’s mobile device sales made during the quarter as well as the success that Hover’s marketing initiatives and improved website are having on our ability to attract new customers and retain existing ones.

The increase in net revenues from Retail for the six months ended June 30, 2012 as compared to the six months ended June 30, 2011 increased by $1.7 million to $4.1 million. This increase reflects the impact of Ting’s mobile device sales made during the six months ended June 30, 2012 as well as the success that Hover’s marketing initiatives and improved website are having on our ability to attract new customers and retain existing ones.

Portfolio

For the three months ended June 30, 2012, Portfolio revenue increased by $0.3 million, or 19%, to $1.6 million when compared to the three months ended June 30, 2011. For the six months ended June 30, 2012, Portfolio revenue increased by $0.6 million, or 21%, to $3.5 million when compared to the six months ended June 30, 2011. These increases primarily reflect the impact from the sale of domain names from our domain name portfolio. The increase in portfolio sales primarily reflects the timing of portfolio domain name sales and may not be repeatable in future quarters. The market for monetization of domain names is rapidly evolving and there is no guarantee that we will be able to continue to acquire the same caliber of names for our portfolio from future expiring domains or that names we acquire in future will provide the same revenue impact as we have experienced from past acquisitions. In addition, the revenue we derive from our Portfolio is driven by general macroeconomic factors that affect Internet advertising. Our advertising revenues are typically sensitive to economic conditions and tend to decline in recessionary periods and other periods of economic uncertainty.

COST OF REVENUES

Wholesale

OpenSRS Domain Service

Cost of revenues for domain registrations represents the amortization of registry fees on a basis consistent with the recognition of revenues from our customers, namely ratably over the term of provision of the service. Registry fees, the primary component of cost of revenues, are paid in full when the domain is registered, and are initially recorded as prepaid domain registry fees. This accounting treatment reasonably approximates a recognition pattern that corresponds with the provision of the services during the period. Market development funds that do not meet the criteria for revenue recognition under ASC 605-50 “Customer Payments and Incentives”, are reflected as cost of goods sold and are recognized as earned.

Value-Added Services

Costs of revenues for Value-Added Services include licensing and royalty costs related to the provisioning of certain components of related to hosted email, fees paid to third-party service providers, primarily for trust certificates and for printing services in connection with Platypus. Fees payable for trust certificates are amortized on a basis consistent with the provision of service, generally one year, while email hosting fees and monthly printing fees are included in cost of revenues in the month they are incurred.

Retail

Costs of revenues for our provision and management of Internet services on a retail basis include the amortization of registry fees on a basis consistent with the recognition of revenues from our customers, namely ratably over the term of provision of the service and includes the amortization of registry fees payable to renew the domains in our surname portfolio. Registry fees, the primary component of cost of revenues, are paid in full when the domain is registered, and are recorded as prepaid domain registry fees.
 
 
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Portfolio
 
Costs of revenues for our Portfolio represent the amortization of registry fees for domains added to our portfolio over the renewal period, which is generally one year, the value attributed under intangible assets to any domain name sold and any impairment charges that may arise from our assessment of our domain name intangible assets. As the total names in our portfolio continue to grow, this cost will become a more significant component of our cost of revenues. Payments for domain registrations are payable for the full term of service at the time of activation of service and are recorded as prepaid domain registry fees and are expensed ratably over the renewal term.

Costs of revenues for our larger ad-supported content sites (tucows.com and butterscotch.com) include the fees paid to third-party service providers, primarily for digital certificates sold through our content sites and content license fees.

Network costs

Network costs include personnel and related expenses, depreciation and amortization, communication costs, equipment maintenance, stock-based compensation and employee and related costs directly associated with the management and maintenance of our network. Communication costs include bandwidth, co-location and provisioning costs we incur to support the supply of all our services.

The following table presents our cost of revenues, by revenue source:

   
Three months ended June 30,
   
Six months ended June 30,
 
   
2012