TUCOWS INC /PA/ - 10-Q Quarterly Report

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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2002

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 0-28284

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

Pennsylvania
(State or Other Jurisdiction of Incorporation or Organization)

23-2707366
(I.R.S. Employer
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 ý No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). : Yes o No ý

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:

Class		Outstanding at November 5, 2002
Common Stock, no par value		64,626,429

TUCOWS INC.
Form 10-Q Quartely Report
INDEX

PART I
FINANCIAL INFORMATION

		Page
Item 1	Financial Statements
	Consolidated Balance Sheets as of September 30, 2002 (unaudited) and December 31, 2001	3
	Consolidated Statements of Operations (unaudited) for the three months and nine months ended September 30, 2002 and 2001	4
	Consolidated Statements of Cash Flows (unaudited) for the three and nine months ended September 30, 2002 and 2001	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2	Management's Discussion and Analysis of Financial Condition and Results of Operations	10
Item 3	Quantitative and Qualitative Disclosures about Market Risk	33
Item 4	Controls and Procedures	34
PART II OTHER INFORMATION
Item 1	Legal Proceedings	35
Item 6	Exhibits and Reports on Form 8-K	36
Signatures		37
	Chief Executive Officer Certification	38
	Chief Financial Officer Certification	39
	Exhibit Index	40

Item 1. Financial Statements

Tucows Inc.
Consolidated Balance Sheets
(Dollar amounts in U.S. dollars)

			September 30, 2002 (unaudited)			December 31, 2001
Assets
Current assets:
	Cash and cash equivalents		$	7,421,668		$	4,814,189
	Restricted cash (note 7)			839,750			—
	Accounts receivable, net of allowance for doubtful accounts of $210,000 at September 30, 2002 and $276,579 at December 31, 2001			374,035			817,990
	Promissory note, secured and bearing interest at the rate of 6% per annum due on October 31, 2002			1,121,480			—
	Prepaid expenses and deposits			1,637,059			2,041,927
	Prepaid domain name registry fees, current portion			11,146,638			10,034,413

		Total current assets		22,540,630			17,708,519
Restricted cash (note 7)				225,000			—
Prepaid domain name registry fees, long-term portion				3,531,857			2,599,962
Property and equipment				1,747,828			3,691,390
Investments				353,737			1,367,072
Intangible assets				—			222,222

Total assets			$	28,399,052		$	25,589,165

Liabilities and Stockholders' Deficiency
Current liabilities:
	Accounts payable		$	1,249,357		$	1,958,744
	Accrued liabilities			2,554,406			2,242,858
	Customer deposits			2,021,196			1,951,336
	Obligations under capital lease, current portion			—			58,772
	Deferred revenue, current portion			18,494,147			18,444,280
	Deferred gain on disposition of Electric Library subscription assets			1,121,480			—

		Total current liabilities		25,440,586			24,655,990
Deferred revenue, long-term portion				5,744,877			4,270,341
Obligations under capital lease, net of current portion				—			52,387
Stockholders' deficiency:
	Preferred stock—no par value, 1,250,000 shares authorized; none issued and outstanding			—			—
	Common stock—no par value, 250,000,000 shares authorized; 64,626,429 shares issued and outstanding at September 30, 2002 and December 31, 2001			8,540,687			8,540,687
	Additional paid-in capital			49,992,129			49,992,129
	Deferred stock-based compensation			(224,309	)		(346,000	)
	Deficit			(61,094,918	)		(61,576,369	)

		Total stockholders' deficiency		(2,786,411	)		(3,389,553	)

Total liabilities and stockholders' deficiency			$	28,399,052		$	25,589,165

See accompanying notes to condensed consolidated financial statements

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

			Three months ended September 30,						Nine months ended September 30,
			2002			2001			2002			2001
Net revenues			$	8,879,281		$	8,200,917		$	28,286,001		$	21,779,959
Cost of revenues				5,413,730			5,929,612			17,645,243			14,500,083

Gross profit				3,465,551			2,271,305			10,640,758			7,279,876
Operating expenses:
	Sales and marketing(*)			926,098			1,522,296			2,831,851			5,292,725
	Technical operations and development			866,061			1,411,193			2,883,770			4,054,074
	General and administrative(*)			914,248			912,277			3,230,594			2,850,088
	Depreciation of property and equipment			378,913			631,024			2,273,587			2,462,042
	Amortization of intangible assets			—			1,325,700			222,222			3,189,146
	(Gain) loss on change in fair value of forward contracts			530,381			—			400,488			—

		Total operating expenses		3,615,701			5,802,490			11,842,512			17,848,075

Loss from operations				(150,150	)		(3,531,185	)		(1,201,754	)		(10,568,199	)
Other income (expenses)
	Interest income (expense), net			21,299			(156,428	)		60,164			(157,184	)
	Gain on disposal of Electric Library subscription assets (note 3(b))			725,237			—			725,237			—
	Gain on disposal of Liberty Registry Management Services Inc.			—			—			1,955,443			—
	Loss on disposal of Eklektix Inc.			—			—			(44,304	)		—
	Write down of investment in bigchalk.com			—			—			(1,013,335	)		—

		Total other income (expenses)		746,536			(156,428	)		1,683,205			(157,184	)

Income (loss) before provision for income taxes				596,386			(3,687,613	)		481,451			(10,725,383	)
Provision for income taxes				—			—			—			—

Net income (loss) for the period			$	596,386		$	(3,687,613	)	$	481,451		$	(10,725,383	)

Basic and diluted earnings (loss) per share			$	0.01		$	(0.07	)	$	0.01		$	(0.20	)

Shares used in computing basic and diluted earnings (loss) per common share				64,626,429			56,574,253			64,626,429			53,297,131

(*): Stock-based compensation has been included in operating expenses as follows:

	Sales and marketing		$	27,707		$	27,707		$	82,218		$	82,218
	General and administrative		$	13,302		$	13,303		$	39,474		$	39,474

See accompanying notes to condensed consolidated financial statements

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

			Three months ended September 30,						Nine months ended September 30,
			2002			2001			2002			2001
Cash provided by (used in):
Operating activities:
	Net income (loss) for the period		$	596,386		$	(3,687,613	)	$	481,451		$	(10,725,383	)
	Items not involving cash:
		Depreciation of property and equipment		378,913			631,024			2,273,587			2,462,042
		Amortization of intangible assets		—			1,325,700			222,222			3,189,146
		(Gain) loss on change in fair value of forward contracts		530,381			—			400,488			—
		Write down of investment in bigchalk.com		—			—			1,013,335			—
		Stock-based compensation		41,009			41,010			121,692			121,692
		Gain on disposal of Electric Library subscription assets		(725,237	)		—			(725,237	)		—
		Gain on disposal of Liberty Registry Management Services Inc.		—			—			(1,955,443	)		—
		Loss on write-off of Eklektix Inc.		—			—			44,304			—
	Change in non-cash operating working capital:
		Accounts receivable		(51,270	)		(930,753	)		271,613			(724,661	)
		Prepaid expenses and deposits		296,718			258,292			233,754			(456,489	)
		Prepaid domain name registry fees		(481,381	)		491,973			(2,321,352	)		(2,717,198	)
		Accounts payable		(192,794	)		(501,500	)		(371,943	)		(1,235,813	)
		Accrued liabilities		387,166			(1,868,244	)		(354,102	)		(1,183,757	)
		Customer deposits		(224,762	)		362,955			84,455			380,962
		Deferred revenue		634,973			1,784,512			3,609,422			4,464,134

	Cash provided by (used in) operating activities			1,190,102			(2,092,644	)		3,028,246			(6,425,325	)

Financing activities:
	Proceeds on issuance of promissory notes			—			2,500,000			—			2,500,000
	Repayment of promissory note			—			(2,500,000	)		—			(2,500,000	)
	Proceeds on rights issue			—			—			—			2,999,973
	Loans payable			—			(3,800,000	)		—			—
	Proceeds received on exercise of stock options			—			—			—			24,396
	Repayments of obligations under capital leases			(65,588	)		(5,821	)		(111,160	)		(5,821	)

	Cash provided by (used in) financing activities			(65,588	)		(3,805,821	)		(111,160	)		3,018,548

Investing activities:
	Additions to property and equipment			(160,710	)		(337,310	)		(608,767	)		(2,308,524	)
	Decrease (increase) in restricted cash—being margin security against forward exchange contracts (note 7)			131,250			—			(1,064,750	)		—
	Net proceeds on disposal of Electric Library subscription assets			455,649			—			455,649			—
	Investment in Afilias Limited			—			(158,031	)		—			(253,737	)
	Proceeds on disposal of Liberty Registry Management Services Inc., net of cash disposed			—			—			938,889			—
	Proceeds on disposal of Eklektix Inc., net of cash disposed			—			—			(30,628	)		—
	Acquisition of Infonautics Inc., net of cash acquired			—			8,833,431			—			8,833,431
	Deferred acquisition costs			—			313,098			—			—

	Cash provided by (used in) investing activities			426,189			8,651,188			(309,607	)		6,271,170

Increase in cash and cash equivalents				1,550,703			2,752,723			2,607,479			2,864,393
Cash and cash equivalents, beginning of period				5,870,965			2,281,865			4,814,189			2,170,195

Cash and cash equivalents, end of period			$	7,421,668		$	5,034,588		$	7,421,668		$	5,034,588

Supplemental cash flow information:
	Interest paid		$	12,304		$	143,736		$	23,932		$	181,400
Supplemental disclosure of non-cash investing and financing activities:
	Common stock issued on the acquisition of Infonautics, Inc.		$	—		$	8,489,000		$	—		$	8,489,000
	Value assigned to Infonautics, Inc. outstanding option on acquisition of Infonautics, Inc.			—			44,000			—			44,000
	Promissory note receivable on disposal of Electric Library subscription assets			1,121,480			—			1,121,480			—

See accompanying notes to condensed consolidated financial statements

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BUSINESS AND BASIS OF PRESENTATION:

Tucows Inc., a Pennsylvania corporation (the "Company" or "Tucows"), provides Internet domain name registration and other Internet services through its global distribution network of Internet service providers, web hosting companies, web designers, value added resellers and other providers of Internet services to end users (sometimes collectively referred to as "MSP's").

The accompanying unaudited interim condensed consolidated balance sheets, and the related statements of operations and cash flows reflect all adjustments consisting of normal recurring adjustments and other adjustments appropriate in the circumstances that are, in the opinion of management, necessary for a fair presentation of the financial position of Tucows and its subsidiaries at September 30, 2002 and the results of operations and cash flows for the interim periods ended September 30, 2002 and 2001.

The accompanying interim condensed consolidated financial statements have been prepared by the Company without audit, in accordance with the rules and regulations of the Securities and Exchange Commission (the "SEC") and do not include all information and notes normally provided in annual financial statements. Except for derivative financial instruments, which have been accounted for in the manner described in the following paragraph, these interim financial statements follow the same accounting policies and methods of application used in the annual financial statements and should be read in conjunction with the audited financial statements and notes thereto of the Company for the year ended December 31, 2001 included in the Company's 2001 Annual Report on Form 10-K filed with the SEC on April 1, 2002.

The Company follows Statement of Financial Accounting Standard No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133"). SFAS No. 133 and Statement of Financial Accounting Standard No. 138, which amended SFAS No. 133, establishes accounting and reporting standards for derivative instruments and hedging activities. SFAS No. 133 requires that all derivatives, including foreign currency exchange contracts, be recognized in the balance sheet at their fair value. Derivatives that are not hedges must be recorded at fair value through earnings. If a derivative is a hedge, depending on the nature of the hedge, changes in the fair value of the derivative are either offset against the change in fair value of underlying assets or liabilities through earnings or recognized in other comprehensive earnings until the underlying hedged item is recognized in earnings. The Company has not complied with the documentation standards for its derivative financial instruments to be accounted for as hedges and has therefore accounted for such derivative financial instruments at their fair value, with any changes in the fair value accounted for through the statement of operations.

The results of operations for any interim period are not necessarily indicative of, nor are they comparable to, the results of operations for any other interim period or for the full fiscal year.

2. ACQUISITION OF INFONAUTICS, INC.:

On August 28, 2001, Tucows Inc., a Delaware corporation, which later changed its name to Tucows (Delaware) Inc., finalized the acquisition of Infonautics, Inc., a Pennsylvania corporation ("Infonautics"). In connection with the acquisition, for accounting purposes, all of the outstanding shares of Tucows (Delaware) Inc. were exchanged for 51,685,432 shares of Infonautics common stock. The acquisition of Infonautics has been accounted for as a reverse purchase acquisition as the former stockholders of Tucows (Delaware) Inc. acquired a majority of the outstanding shares of common stock of Infonautics and controlled the combined group of companies as a result of the acquisition. The accompanying condensed consolidated financial statements of the Company reflect the historical results of the predecessor entity, Tucows (Delaware) Inc., and the consolidated results of operations of the Company subsequent to the acquisition date of August 28, 2001.

The following supplemental pro-forma information is presented to illustrate the effects of the acquisition on the historical operating results for the three and nine months ended September 30, 2001, as if the acquisition had occurred at the beginning of that period. No pro-forma information is required for the three and nine months ended September 30, 2002 as all the relevant entities are included in these condensed consolidated financial statements for the full nine months.

	Three months ended September 30, 2001			Nine months ended September 30, 2001
	(unaudited)			(unaudited)
Net revenues	$	9,056,000		$	25,991,000
Loss for the period	$	(4,343,000	)	$	(13,748,000	)
Loss per share	$	(0.07	)	$	(0.21	)

3. DISPOSITIONS:

a): Liberty Registry Management Services Inc. ("Liberty RMS"):

On March 25, 2002, the Company sold all of the outstanding shares of Liberty RMS, which was a wholly owned subsidiary, and certain technology required to provide registry services, to Afilias Limited. Liberty RMS owned and operated the back-end registry services for the.info registry. Total consideration received consisted of cash proceeds of $977,000 and a receivable of $87,000. The Company has recorded a gain on the disposition of Liberty RMS of $1,955,443. The Company is also entitled to additional contingent consideration of up to $1 million based on certain future performance criteria. The amount the Company may earn from the future consideration cannot be estimated at this time and no amounts have been recognized. Any amounts receivable based on these criteria will be recorded when determinable.

b): Electric Library subscription assets and Encyclopedia.com services:

On August 16, 2002, the Company sold all the assets and certain liabilities associated with its search and reference services, Electric Library and Encyclopedia.com, to Alacritude, LLC ("Alacritude"). Total consideration received consisted of cash proceeds of $500,000 (including an intellectual property license fee of $100,000) and a promissory note receivable of approximately $1.1 million. This resulted in a gain on the disposition of these assets in the amount of approximately $1.8 million. As Tucows is accounting for the assets sold to Alacritude using a cost recovery method, Tucows has deferred approximately $1.1 million of the gain. This has been recorded on the balance sheet as a deferred gain on disposition of Electric Library subscription assets, and will be recognized when payment of the promissory note receivable has been received. The remainder of the gain, in the amount of approximately $725,000, has been recognized as a gain at September 30, 2002.

The promissory note bore interest at 6% per annum and was due on October 31, 2002. The note was secured by a first priority security interest in all of Alacritude's assets and certain securities owned by Alacritude's Chairman and Chief Executive Officer. On October 30, 2002, the Company received repayment of this promissory note in full.

4. INVESTMENTS:

Investments over which the Company is unable to exercise significant influence are recorded at cost and written down only when there is evidence that a decline in value that is other than temporary has occurred.

The Company holds a 7.38% interest in Afilias Limited ("Afilias"), a private company, which is a consortium of domain name registrars.

The Company also holds an 11% interest in bigchalk.com, inc. ("bigchalk"), a private company. Until the disposal of all the assets and certain liabilities associated with its Electric Library subscription and Encyclopedia.com services to Alacritude on August 16, 2002, Tucows paid bigchalk content

royalties and technical service fees for content provided to Tucows' Electric Library site, which amounted to approximately $166,000 for the three months ended September 30, 2002, and approximately $952,000 for the nine months ended September 30, 2002. At September 30, 2002, approximately $166,000 was owed to bigchalk for these content royalties and technical service fees and is included within accrued liabilities. During the quarter ended June 30, 2002, the Company reviewed the carrying value of its investment in bigchalk. Based on this review, Tucows believes that a decline in the value of this investment that is other than temporary, has occurred and has recorded a write down in the amount of $1,013,335 against the carrying value of this investment. The carrying value of this investment at September 30, 2002 was nil.

5. BASIC AND DILUTED (LOSS) EARNINGS PER SHARE:

The Company's basic (loss) earnings per common share for the three and nine months ended September 30, 2002 and 2001 has been calculated by dividing net earnings by the weighted average number of common shares outstanding.

The diluted (loss) earnings per common share exclude the effect of potentially dilutive shares when their effect is anti-dilutive. As all options to purchase common stock had exercise prices greater than the average market price of the common stock for all reported periods, they have been excluded from the computation of diluted earnings per share. Therefore, for all reported periods, basic and diluted (loss) earnings per share are equal.

6. SUPPLEMENTAL INFORMATION:

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

	Three months ended September 30,				Nine months ended September 30,
	2002		2001		2002		2001
	(unaudited)				(unaudited)
Advertising and other revenue	$	296,354	$	379,573	$	1,058,982	$	1,538,076
Domain name and ancillary services		8,118,966		7,417,338		24,598,634		19,837,877
Electric Library subscription		463,961		404,006		2,628,385		404,006

	$	8,879,281	$	8,200,917	$	28,286,001	$	21,779,959

7. COMMITMENTS AND CONTINGENCIES:

The Company has been named as a defendant in a lawsuit filed in the Superior Court in the Province of Ontario, Canada. The lawsuit alleges that the Company defamed the plaintiff when the Company warned its customers about the plaintiff's business practices. Tucows does not believe that the lawsuit has merit and has retained local counsel to represent the Company in the proceedings. The Company does not believe it will be liable for any damages and accordingly has not accrued any amounts at September 30, 2002.

The Company has been named as a co-defendant with other entities in the industry in two class action lawsuits filed in the Superior Court, County of Los Angeles, U.S.A. The lawsuits allege that the defendants were engaged in unfair competition under state laws because they conducted an illegal lottery enterprise through the pre-registration of.biz generic top-level domains. The Company believes that the cases are without merit and has retained local counsel to represent the Company in the proceedings. The Company does not believe that it will be liable for any damages and, accordingly, has not accrued any amounts at September 30, 2002.

On July 2, 2002, an action was commenced in the District Court for the Eastern District of Pennsylvania alleging that the Company has defaulted on several payments incurred by Infonautics prior to its acquisition by the Company in August 2001. Infonautics had contested these claims but the

matter was never resolved. The Company does not believe that the lawsuit has merit and intends to defend this claim vigorously.

To manage its exposure to foreign exchange rate fluctuations, the Company has entered into a series of forward foreign exchange contracts ("Contracts") whereby U.S.$375,000 is converted into Canadian dollars on a semi-monthly basis until the end of December 2003 at an average foreign exchange rate of 1.5430. The notional principal of the outstanding Contracts at September 30, 2002 is $11.3 million. As margin security against these Contracts, the Company has placed $1.1 million into secured term deposits, which mature on a monthly basis in line with the Contracts and has been reflected as restricted cash on the balance sheet. As these Contracts do not meet the criteria to be accounted for as a cash flow hedge, the Company has recorded these Contracts at their fair value with a charge to the Consolidated Statement of Operations of $530,381 and $400,488 for the three months and nine months ended September 30, 2002, respectively.

8. RECENT ACCOUNTING PRONOUNCEMENTS:

In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 141, "Business Combinations" ("SFAS No. 141") and SFAS No. 142, "Goodwill and Other Intangible Assets" ("SFAS No. 142"). The new statements