TUCOWS INC /PA/ - Quarter Report: 2016 September (Form 10-Q)

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		September 30,				December 31,
		2016				2015
Assets
Current assets:
Cash and cash equivalents		$	10,498,296			$	7,723,253
Accounts receivable, net of allowance for doubtful accounts of $153,171 as of September 30, 2016 and $122,095 as of December 31, 2015			11,606,638				7,171,388
Inventory			1,502,433				903,775
Prepaid expenses and deposits			6,007,725				5,067,790
Prepaid domain name registry and ancillary services fees, current portion			49,735,226				44,708,041
Income taxes recoverable (note 7)			1,743,308				2,292,915
Total current assets			81,093,626				67,867,162
Prepaid domain name registry and ancillary services fees, long-term portion			11,184,655				11,040,929
Property and equipment			9,617,147				7,126,676
Deferred tax asset (note 7)			5,355,575				7,621,092
Intangible assets (note 5)			20,091,795				14,469,677
Goodwill (note 5)			21,005,143				21,005,143
Total assets		$	148,347,941			$	129,130,679
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable		$	4,036,804			$	4,166,135
Accrued liabilities			4,426,617				5,855,686
Customer deposits			5,227,879				5,136,909
Derivative instrument liability, current portion (note 4)			85,769				2,027,086
Deferred rent, current portion			20,854				19,463
Loan payable (note 6)			1,933,110				3,500,000
Deferred revenue, current portion			63,120,230				56,646,390
Accreditation fees payable, current portion			520,033				465,300
Income taxes payable (note 7)			1,447,970				444,053
Total current liabilities			80,819,266				78,261,022
Deferred revenue, long-term portion			15,246,462				14,947,639
Accreditation fees payable, long-term portion			114,962				118,480
Deferred rent, long-term portion			129,920				100,864
Loan payable, long-term portion (note 6)			8,547,808				-
Other liabilities (note 12)			1,073,500				1,459,960
Deferred tax liability (note 7)			4,827,192				4,876,691
Redeemable non-controlling interest (note 8)			3,073,642				3,036,598
Stockholders' equity (note 13)
Preferred stock - no par value, 1,250,000 shares authorized; none issued and outstanding			-				-
Common stock - no par value, 250,000,000 shares authorized;10,448,283 shares issued and outstanding as of September 30, 2016 and 10,685,599 shares issued and outstanding as of December 31, 2015			14,401,326				14,530,633
Additional paid-in capital			2,564,965				8,526,395
Retained earnings			17,595,108				4,381,849
Accumulated other comprehensive income (loss)			(46,210	)			(1,109,452	)
Total stockholders' equity			34,515,189				26,329,425
Total liabilities and stockholders' equity		$	148,347,941			$	129,130,679
Commitments and contingencies (note 11)
Subsequent event (note 16)

 

See accompanying notes to unaudited consolidated financial statements 

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		Three months ended September 30,								Nine months ended September 30,
		2016				2015				2016				2015
Net revenues (note 10)		$	49,064,327			$	44,267,645			$	141,014,329			$	126,985,121
Cost of revenues (note 10)
Cost of revenues			30,846,668				28,718,613				89,445,493				83,767,472
Network expenses			1,287,620				1,421,279				3,925,377				4,138,213
Depreciation of property and equipment			278,746				324,166				976,419				803,737
Amortization of intangible assets (note 5)			13,421				11,532				36,485				26,988
Total cost of revenues			32,426,455				30,475,590				94,383,774				88,736,410
Gross profit			16,637,872				13,792,055				46,630,555				38,248,711
Expenses:
Sales and marketing			5,479,445				4,517,666				15,174,619				12,548,415
Technical operations and development			1,270,107				1,101,581				3,445,118				3,405,052
General and administrative			2,166,217				2,607,917				7,497,752				7,826,405
Depreciation of property and equipment			178,687				63,790				328,877				185,074
Amortization of intangible assets (note 5)			279,126				56,997				613,041				167,209
Impairment of indefinite life intangible assets (note 5)			2,866				18,550				27,745				68,848
Loss (gain) on currency forward contracts (note 4)			22,475				352,738				(96,993	)			681,988
Total expenses			9,398,923				8,719,239				26,990,159				24,882,991
Income from operations			7,238,949				5,072,816				19,640,396				13,365,720
Other income (expense):
Interest expense, net			(135,168	)			(78,959	)			(301,868	)			(161,136	)
Other income, net (note 12)			130,147				-				387,787				-
Total other income (expense)			(5,021	)			(78,959	)			85,919				(161,136	)
Income before provision for income taxes			7,233,928				4,993,857				19,726,315				13,204,584
Provision for income taxes (note 7)			2,492,649				1,834,400				6,476,012				4,926,189
Net income before redeemable non-controlling interest			4,741,279				3,159,457				13,250,303				8,278,395
Redeemable non-controlling interest (note 8)			(254,101	)			(91,283	)			(698,583	)			(162,750	)
Net loss attributable to redeemable non-controlling interest			254,101				91,283				698,583				162,750
Net income for the period			4,741,279				3,159,457				13,250,303				8,278,395
Other comprehensive income (loss), net of tax
Unrealized income (loss) on hedging activities (note 4)			(58,821	)			(724,336	)			516,406				(1,723,247	)
Net amount reclassified to earnings (note 4)			131,912				364,330				546,836				1,152,359
Other comprehensive income (loss) net of tax of $41,580 and $198,664 for the three months ended September 30, 2016 and September 30, 2015 and $585,943 and $321,879 for the nine months ended September 30, 2016 and September 30, 2015			73,091				(360,006	)			1,063,242				(570,888	)
Comprehensive income for the period		$	4,814,370			$	2,799,451			$	14,313,545			$	7,707,507
Basic earnings per common share (note 9)		$	0.45			$	0.29			$	1.26			$	0.75
Shares used in computing basic earnings per common share (note 9)			10,432,763				10,984,869				10,549,056				11,057,634
Diluted earnings per common share (note 9)		$	0.45			$	0.28			$	1.23			$	0.72
Shares used in computing diluted earnings per common share (note 9)			10,619,005				11,372,682				10,736,775				11,469,657

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		Three months ended September 30,								Nine months ended September 30,
		2016				2015				2016				2015
Cash provided by:
Operating activities:
Net income for the period		$	4,741,279			$	3,159,457			$	13,250,303			$	8,278,395
Items not involving cash:
Depreciation of property and equipment			457,433				387,956				1,305,296				988,811
Amortization of debt discount and issuance costs			8,298				-				8,298				-
Amortization of intangible assets			292,547				68,529				649,526				194,197
Impairment of indefinite life intangible asset			2,866				18,550				27,745				68,848
Deferred income taxes (recovery)			926,733				(53,085	)			1,630,076				(1,019,254	)
Amortization of deferred rent			13,783				7,370				30,447				17,917
Disposal of domain names			4,760				2,866				25,581				20,551
Other income			(128,820	)			-				(386,460	)			-
Loss (gain) on change in the fair value of forward contracts			(20,114	)			99,052				(292,133	)			160,394
Stock-based compensation			195,439				128,575				585,854				378,228
Change in non-cash operating working capital:
Accounts receivable			(1,623,719	)			262,149				(4,435,250	)			(994,889	)
Inventory			(217,741	)			(123,047	)			(598,658	)			(281,491	)
Prepaid expenses and deposits			419,939				1,000,287				(939,935	)			(892,105	)
Prepaid domain name registry and ancillary services fees			(1,271,948	)			149,905				(5,170,911	)			(2,068,871	)
Income taxes recoverable			363,244				1,152,410				1,553,524				1,935,426
Accounts payable			681,303				195,002				(1,993	)			202,578
Accrued liabilities			(581,495	)			406,920				(1,429,069	)			1,517,453
Customer deposits			(943,579	)			(199,695	)			90,970				253,223
Deferred revenue			1,666,291				140,850				6,772,663				3,185,946
Accreditation fees payable			14,059				(20,621	)			51,215				11,425
Net cash provided by operating activities			5,000,558				6,783,430				12,727,089				11,956,782
Financing activities:
Proceeds received on exercise of stock options			48,376				189,914				107,672				737,369
Payment of tax obligations resulting from net exercise of stock options			(76,537	)			-				(318,770	)			-
Excess tax benefits from share-based compensation expense			268,565				312,091				714,764				1,400,793
Repurchase of common stock			-				(9,977,495	)			(7,180,257	)			(18,179,176	)
Proceeds received on loan payable			10,989,583				-				16,989,583				3,500,000
Repayment of loan payable			(9,062,500	)			-				(9,500,000	)			-
Payment of loan payable costs			(383,463	)			-				(516,963	)			-
Net cash provided by (used in) financing activities			1,784,024				(9,475,490	)			296,029				(12,541,014	)
Investing activities:
Additions to property and equipment			(2,091,368	)			(710,342	)			(3,923,105	)			(2,051,124	)
Gross proceeds from the waiver of rights to .online registry			-				-				-				6,619,832
Remaining payment for the acquisition of Ting Virginia, LLC., net of cash of $21,423 (note 8)			-				-				-				(357,493	)
Acquisition of intangible assets (note 5)			(74,400	)			-				(6,324,970	)			-
Net cash provided by (used in) investing activities			(2,165,768	)			(710,342	)			(10,248,075	)			4,211,215
Increase in cash and cash equivalents			4,618,814				(3,402,402	)			2,775,043				3,626,983
Cash and cash equivalents, beginning of period			5,879,482				15,300,762				7,723,253				8,271,377
Cash and cash equivalents, end of period		$	10,498,296			$	11,898,360			$	10,498,296			$	11,898,360
Supplemental cash flow information:
Interest paid		$	93,560			$	78,988			$	260,506			$	175,290
Income taxes paid, net		$	927,826			$	512,954			$	2,507,699			$	2,457,225
Supplementary disclosure of non-cash investing and financing activities:
Property and equipment acquired during the period not yet paid for		$	89,860			$	63,499			$	89,860			$	63,499

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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 provider of retail mobile phone service and fixed Internet access as well as a global distributor of Internet Services, such as domain name registration, digital certificates and email. The Company’s Internet Services are distributed through its global Internet-based distribution network of Internet service providers, web hosting companies and other companies that provide services 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. Our common stock is listed on NASDAQ under the symbol “TCX” and on the Toronto Stock Exchange under the symbol “TC”.

 

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 September 30, 2016 and the results of operations and cash flows for the interim periods ended September 30, 2016 and 2015. 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, 2015 included in Tucows' 2015 Annual Report on Form 10-K filed with the SEC on March 9, 2016.

 

The Company has reclassified certain prior period income statement amounts and related notes to conform with current period presentation. As a result of these reclassifications, there were no changes to previously reported Income from operations, Net income, Earnings per share, or on previously reported Consolidated Balance Sheets or Consolidated Statements of Cash Flows. 

 

              During the three months ended September 30, 2016, the Company identified an immaterial error that affects the classification of certain marketing program costs. Prior to the third quarter of fiscal 2016, the Company recorded the cost for certain marketing credits as Sales and marketing expense which should have been recorded as a reduction in Net revenue. The Statement of Operations and Comprehensive Income and supplemental financial information presented here correctly reflect these marketing credits as a reduction in Net Revenues for all current and comparative periods.  This resulted in a decrease in Net Revenues, and a corresponding decrease in Sales and marketing expenses of $0.3 million and $0.9 million for the three months and nine months ended September 30, 2015. For the nine months ended September 30, 2016, Net revenues and Sales and marketing expenses reflect a reduction of $1.1 million for the reclassification of credits for the first six months of fiscal 2016. The Company has evaluated the effect of the above misstatement on its consolidated financial statements for the current and prior periods in accordance with the guidance provided by SEC Staff Accounting Bulletin No. 108, codified as SAB Topic 1.N, “Considering the Effects of Prior Year Misstatement When Quantifying Misstatements in the Current Year Financial Statements,” and concluded that the current and prior periods were not materially misstated. These corrections have no impact on previously reported Income from operations, Net income, Earnings per share, or on previously reported Consolidated Balance Sheets or Consolidated Statements of Cash Flows. 

  

  

There have been no material changes to our significant accounting policies and estimates during the nine months ended September 30, 2016 as compared to the significant accounting policies and estimates described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2015, except for the adoption of Accounting Standard Update No. 2015-17, Income Taxes (Topic 740).

 

The Company's most significant accounting policies are revenue recognition, property and equipment and derivative financial instruments and are included below:

 

(a) Revenue recognition

 

The Company’s revenues are derived from domain name registration fees on both a wholesale and retail basis, the sale of domain names, the provisioning of other Internet services and advertising and other revenue. Amounts received in advance of meeting the revenue recognition criteria described below are recorded as deferred revenue. 

 

   

The Company earns registration fees in connection with each new, renewed and transferred-in registration and from providing provisioning of other Internet services to resellers and registrars on a monthly basis. Service has been provided in connection with registration fees once the Company has confirmed that the requested domain name has been appropriately recorded in the registry under contractual performance standards.

 

Domain names are generally purchased for terms of one to ten years. Registration fees charged for domain name registration and provisioning services are recognized on a straight-line basis over the life of the contracted term. Other Internet services that are provisioned for annual periods or longer, are recognized on a straight-line basis over the life of the contracted term. Other Internet services that are provisioned on a monthly basis are recognized as services are provided. 

 

For arrangements with multiple deliverables, the Company allocates revenue to each deliverable if the delivered item(s) has value to the customer on a standalone basis and, if the arrangement includes a general right of return relative to the delivered item, delivery or performance of the undelivered item(s) is considered probable and substantially in the control of the Company. The fair value of the selling price for a deliverable is determined using a hierarchy of (1) Company specific objective and reliable evidence, then (2) third-party evidence, then (3) best estimate of selling price. The Company allocates any arrangement fee to each of the elements based on their relative selling prices. 

 

Revenue generated from the sale of domain names, earned from transferring the rights to domain names under the Company’s control, are recognized once the rights have been transferred and payment has been received in full.   

 

The Company derives revenues from the provisioning of mobile phone and fixed Internet access services primarily through its Ting website. These revenues are recognized once services have been provided. Revenues for wireless services are billed based on the actual amount of monthly services utilized by each customer during their billing cycle on a postpaid basis. The Company’s billing cycle for each customer is computed based on the customer’s activation date. As a result, the Company estimates the amount of revenues earned but not billed from the end of each billing cycle to the end of each reporting period. In addition, revenues associated with the sale of wireless devices and accessories to subscribers is recognized when title and risk of loss is transferred to the subscriber and shipment has occurred. Incentive marketing credits given to customers are recorded as a reduction of revenue. 

 

 

The Company also generates advertising and other revenue through its online libraries of shareware, freeware and online services presented on its website. Advertising revenue includes revenue derived from cost per action advertising links we display on third party websites who provide syndicated pay-per-click advertising on OpenSRS Domain Expiry Stream domains and the Company’s Portfolio Domains. In addition, the Company uses third party partners to derive pay-per-click advertising on the Tucows.com website. Advertising revenue is recognized on a monthly basis based on the number of cost-per-action services that were provided in the month. 

 

Impression based advertising revenue and other revenues are recognized ratably over the period in which it is presented. To the extent that minimum guaranteed impressions are not met, the Company defers recognition of the corresponding revenues until the guaranteed impressions are achieved. 

 

In those cases, where payment is not received at the time of sale, additional conditions for recognition of revenue are that the collection of the related accounts receivable is reasonably assured and the Company has no further performance obligations. The Company records costs that reflect 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. 

 

The Company establishes provisions for possible uncollectible accounts receivable and other contingent liabilities which may arise in the normal course of business. Historically, credit losses have been within the Company’s expectations and the provisions the Company has established have been appropriate. However, the Company has, 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.

 

 

(b) Property and equipment

 

Property and equipment are stated at cost, net of accumulated depreciation. Depreciation is provided on a straight-line basis so as to depreciate the cost of depreciable assets over their estimated useful lives at the following rates:

 

 

The Company reviews the carrying values of its property and equipment for potential impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If the estimated undiscounted future cash flows expected to result from the use of the group of assets and their eventual disposition is less than their carrying amount, they are considered to be impaired. The amount of the impairment loss recognized is measured as the amount by which the carrying value of the asset exceeds the fair value of the asset, with fair value being determined based upon discounted cash flows or appraised values, depending on the nature of the assets.

 

Additions to the fiber network are recorded at cost, including all material, labor, vehicle and installation and construction costs and certain indirect costs associated with the construction of cable transmission and distribution facilities. While the Company’s capitalization is based on specific activities, once capitalized, costs are tracked by fixed asset category at the fiber network level and not on a specific asset basis. For assets that are retired, the estimated historical cost and related accumulated depreciation is removed.

 

(c) Derivative Financial Instruments

 

During the three and nine months ended September 30, 2016 and the year ended December 31, 2015 ("Fiscal 2015"), the Company used derivative financial instruments to manage foreign currency exchange risk. The Company accounts for these instruments in accordance with Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 815, “Derivatives and Hedging” ("Topic 815"), which requires that every derivative instrument be recorded on the balance sheet as either an asset or liability measured at its fair value as of the reporting date. Topic 815 also requires that changes in the derivative financial instruments’ fair values be recognized in earnings, unless specific hedge accounting and documentation criteria are met (i.e. the instruments are accounted for as hedges). The Company recorded the effective portions of the gain or loss on derivative financial instruments that were designated as cash flow hedges in accumulated other comprehensive income in the accompanying Consolidated Balance Sheets. Any ineffective or excluded portion of a designated cash flow hedge, if applicable, is recognized in net income.

 

 

For certain contracts, the Company has not complied with the documentation standards required for its forward foreign exchange contracts to be accounted for as hedges and has, therefore, accounted for such forward foreign exchange contracts at their fair values with the changes in fair value recorded in net income.

 

The fair value of the forward exchange contracts is determined using an estimated credit adjusted mark-to-market valuation which takes into consideration the Company's and the counterparty's credit risk. The valuation technique used to measure the fair values of the derivative instruments is a discounted cash flow technique, with all significant inputs derived from or corroborated by observable market data, as no quoted market prices exist for the derivative instruments. The discounted cash flow techniques use observable market inputs, such as foreign currency spot and forward rates.

 

3. Recent accounting pronouncements:

  

Recent Accounting Pronouncements Adopted

 

On January 1, 2016, the Company adopted Accounting Standards Updates ("ASU") No. 2015-16, Business Combinations (Topic 805), No. 2015-05, Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement and Nos. 2015-03 and 2015-15, Interest - Imputation of Interest (Subtopic 835-30). The adoption of these Accounting Standards Updates did not have a significant impact on the consolidated financial statements.

 

On January 1, 2016, the Company elected to early adopt Accounting Standard Update No. 2015-17, Income Taxes (Topic 740), which simplifies the presentation of deferred income taxes, such that deferred tax liabilities and assets be classified as non-current on a balance sheet. The impact of the change on the consolidated balance sheet at December 31, 2015 is the reclassification of $3,243,718 from the deferred tax asset, current portion to deferred tax asset long-term portion.

  

 

Recent Accounting Pronouncements Not Yet Adopted

 

In August 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-15 which addresses eight cash flow classification issues, eliminating the diversity in practice. This ASU is effective for annual and interim reporting periods beginning after December 15, 2017, with early adoption permitted. The retrospective transition method, requiring adjustment to all comparative periods presented, is required unless it is impracticable for some of the amendments, in which case those amendments would be prospectively applied as of the earliest date practicable. The Company is currently in the process of evaluating the impact that the adoption of ASU No. 2016-15 will have on its consolidated financial statements.

 

In June 2016, the FASB issued FASB ASU No. 2016-13, Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which changes the impairment model for most financial assets. The new model uses a forward-looking expected loss method, which will generally result in earlier recognition of allowances for losses. ASU 2016-13 is effective for annual and interim periods beginning after December 15, 2019 and early adoption is permitted for annual and interim periods beginning after December 15, 2018. The Company will apply ASU 2016-13 on January 1, 2020. The Company is currently in the process of evaluating the impact that the adoption of ASU 2016-13 will have on its consolidated financial statements.

 

In March 2016, the FASB issued ASU No. 2016-09, Compensation – Stock Compensation (Topic 718) (“ASU 2016-09”). The areas for modification under ASU No. 2016-9 involve several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. This guidance is effective for annual and interim reporting periods of public entities beginning after December 15, 2016 (January 1, 2017 for the Company). Early adoption of the standard is permitted as of the beginning of an interim or annual reporting period. Dependent upon the specific amendment, the implementation of the amendments in ASU 2016-05 are to be made on a prospective, retrospective or modified retrospective basis after the date of adoption. The Company is currently in the process of evaluating the impact that the adoption of ASU 2016-09 will have on its consolidated financial statements.

 

In March 2016, the FASB issued ASU No. 2016-05, Derivatives and Hedging (Topic 815) (“ASU 2016-05”). The amendments in ASU 2016-05 clarifies the effect of derivative contract novations on existing hedge accounting relationships whereby a change in the counterparty to a derivative instrument that has been designated as the hedging instrument under Topic 815 does not, in and of itself, require dedesignation of that hedging relationship provided that all other hedge accounting criteria continue to be met. This guidance is effective for annual and interim reporting periods of public entities beginning after December 15, 2016 (January 1, 2017 for the Company). Early adoption of the standard is permitted as of the beginning of an interim or annual reporting period. The implementation of the amendments in ASU 2016-05 are to be made on a prospective or modified retrospective basis after the date of adoption. The Company is currently in the process of evaluating the impact that the adoption of ASU 2016-05 will have on its consolidated financial statements.

 

 

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). The standard requires lessees to recognize the assets and liabilities that arise from leases on the balance sheet. ASU 2016-02 requires the recognition on the balance sheet of a lease liability to make lease payments by lessees and a right-of-use asset representing its right to use the underlying asset for the lease term. The new guidance will also require significant additional disclosure about the amount, timing and uncertainty of cash flows from leases. The new guidance is effective for annual and interim reporting periods beginning after December 15, 2018 (January 1, 2019 for the Company). The amendments should be applied at the beginning of the earliest period presented using a modified retrospective approach with earlier application permitted as of the beginning of an interim or annual reporting period. The Company will adopt this guidance in the first quarter of fiscal 2019 and is in the process of evaluating the impact of the adoption of ASU 2016-02 will have on its consolidated financial statements. 

 

In January 2016, the FASB issued Accounting Standards Update (“ASU”) 2016-01, Financial Instruments – Overall (Subtopic 825-10) which relates to the recognition and measurement of financial assets and financial liabilities. ASU 2016-01 requires that all equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) be measured at fair value with changes in fair value recognized in net income. The new guidance requires the performance of a qualitative assessment for equity investments without readily determinable fair values. The update also requires an entity to present separately in other comprehensive income, the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017 (January 1, 2018 for the Company). Earlier adoption is not permitted. The Company is in the process of evaluating the impact that the adoption of ASU 2016-1 will have on its consolidated financial statements.

  

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) ("ASU 2014-09"), which is a comprehensive revenue recognition standard that will supersede nearly all existing revenue recognition guidance under U.S. GAAP.  The new standard provides a single principles-based, five-step model to be applied to all contracts with customers, which steps are to (1) identify the contract(s) with the customer, (2) identify the performance obligations in the contracts, (3) determine the transaction price, (4) allocate the transaction price to the performance obligations in the contracts and (5) recognize revenue when each performance obligation is satisfied. More specifically, revenue will be recognized when promised goods or services are transferred to the customer in an amount that reflects the consideration expected in exchange for those goods or services.  ASU 2014-09 was set to be effective for interim and annual periods beginning after December 15, 2016. On July 9, 2015, the FASB voted to defer the effective date by one year, such that the new standard will be effective for the Company for the interim and annual reporting periods beginning after December 15, 2017 (January 1, 2018 for the Company). In March 2016, FASB issued ASU No. 2016-08 clarifying the implementation guidance on principal versus agent considerations. In April 2016, FASB issued ASU. No 2016-10 providing further guidance on identifying performance obligations and licensing. In May 2016, FASB issued ASU. No 2016-12 providing guidance related revenue recognition and consideration received. Early adoption of these standards is permitted but not before the original effective date. Companies can transition to the standards either retrospectively or as a cumulative-effect adjustment as of the date of adoption. The Company does not intend to adopt the standards early and is currently in the process of evaluating the impact that the adoption of ASU 2014-09, ASU 2016-08, ASU 2016-10 and ASU 2016-12 will have on its consolidated financial statements and the selected method of transition to the new standard.

 

4. Derivative instruments and hedging activities:

 

Foreign currency forward contracts

 

In October 2012, the Company entered into a hedging program with a Canadian chartered bank to limit the potential foreign exchange fluctuations incurred on its future cash flows related to a portion of payroll, rent and payments to Canadian domain name registry suppliers that are denominated in Canadian dollars and are expected to be paid by its Canadian operating subsidiary. As part of its risk management strategy, the Company uses derivative instruments to hedge a portion of the foreign exchange risk associated with these costs. The Company does not use these forward contracts for trading or speculative purposes. These forward contracts typically mature between one and eighteen months.

 

 

The Company has designated certain of these transactions as cash flow hedges of forecasted transactions under ASC Topic 815. For certain contracts, as the critical terms of the hedging instrument, and the entire hedged forecasted transaction, are the same, in accordance with ASC Topic 815, the Company has been able to conclude that changes in fair value and cash flows attributable to the risk of being hedged are expected to completely offset at inception and on an ongoing basis. Accordingly, unrealized gains or losses on the effective portion of these contracts have been included within other comprehensive income. The fair value of the contracts, as of September 30, 2016, is recorded as derivative instrument assets and derivative instrument liabilities.

 

As of September 30, 2016, the notional amount of forward contracts that the Company held to sell U.S. dollars in exchange for Canadian dollars was $5.0 million, of which $4.3 million met the requirements of ASC Topic 815 and were designated as hedges (September 30, 2015 - $31.0 million of which $26.4 million were designated as hedges).

 

As of September 30, 2016, we had the following outstanding forward exchange contracts to trade U.S. dollars in exchange for Canadian dollars:

 

 

Fair value of derivative instruments and effect of derivative instruments on financial performance

 

The effect of these derivative instruments on our consolidated financial statements as of, and for the nine months ended September 30, 2016, were as follows (amounts presented do not include any income tax effects).

 

Fair value of derivative instruments in the consolidated balance sheets

 

 

 

Movement in Accumulated Other Comprehensive Income ("AOCI") balance for the three months ended September 30, 2016:

 

  

 

Movement in Accumulated Other Comprehensive Income ("AOCI") balance for the nine months ended September 30, 2016:

 

 

 

Effects of derivative instruments on income and other comprehensive income (OCI) for the three months ended September 30, 2016 and September 30, 2015 are as follows:

 

  

 

Effects of derivative instruments on income and other comprehensive income (OCI) for the nine months ended September 30, 2016 and September 30, 2015 are as follows:

 

 

In addition to the above, for those foreign currency forward contracts not designated as hedges, the Company has recorded a loss of $39,401 upon settlement and a gain of $20,114 for the change in fair value of outstanding contracts for the three months ended September 30, 2016, in the consolidated statement of operations and comprehensive income. The Company has recorded a loss of $0.1 million upon settlement and a loss of $0.1 million for the change in fair value of the foreign currency forward contracts not designated as hedges for the three months ended September 30, 2015, in the consolidated statement of operations and comprehensive income.

 

The Company has recorded a loss of $0.1 million upon settlement and a gain of $0.3 million for the change in fair value of the foreign currency forward contracts not designated as hedges for the nine months ended September 30, 2016, in the consolidated statement of operations and comprehensive income. The Company has recorded a loss of $0.3 million upon settlement and a loss of $0.2 million for the change in fair value of the foreign currency forward contracts not designated as hedges for the nine months ended September 30, 2015, in the consolidated statement of operations and comprehensive income. 

 

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5. Goodwill and Other Intangible Assets:

 

Goodwill

 

Goodwill represents the excess of the purchase price over the fair value of tangible or identifiable intangible assets acquired and liabilities assumed in our acquisitions.

 

 

Goodwill consists of the following:

 

 

The Company’s goodwill relates 90% to its Domain Services operating segment and 10% to its Network Access Services  – Other Services operating segment.

 

Goodwill is not amortized, but is subject to an annual impairment evaluation.

 

Other Intangible Assets:

 

Intangible assets consist of network rights, 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 direct navigation domain names, which have been determined to have an indefinite life and which are evaluated at least annually for impairment.

 

A summary of acquired intangible assets for the three months ended September 30, 2016 is as follows:

 

 

 

A summary of acquired intangible assets for the nine months ended September 30, 2016 is as follows:

 

 

The following table shows the estimated amortization expense for each of the next 5 years, assuming no further additions to acquired intangible assets are made:

 

  

As of September 30, 2016, the accumulated amortization for the definite life intangible assets was $6.6 million.

 

With regard to indefinite life intangible assets, as part of our normal renewal process we assessed that certain domain names that were acquired in the June 2006 acquisition of Mailbank.com Inc. and that were up for renewal should not be renewed. Accordingly, for the three months ended September 30, 2016, domain names, with a book value of $2,866 (three months ended September 30, 2015 - $18,550) were not renewed and were recorded as an impairment of indefinite life intangible assets. For the nine months ended September 30, 2016, domain names, with a book value of $27,745 (nine months ended September 30, 2015 - $68,848), were not renewed and were recorded as an impairment of indefinite life intangible assets.

 

On April 1, 2016, the Company acquired the international reseller channel from Melbourne IT Limited for consideration of $6.0 million, excluding legal and registry related transaction costs of $0.2 million. The acquired assets were funded through a $6.0 million advance under the 2012 Demand Loan Facilities on March 31, 2016. These assets have been assigned to Other Intangible Assets, Customer Relationships and are being amortized over 7 years. 

 

6. Loan payable:

 

On August 18, 2016, the Company entered into a secured Credit Agreement (the “2016 Credit Agreement”) with Bank of Montreal (“BMO” or the “Administrative Agent”) and Royal Bank of Canada (collectively with BMO, the “Lenders”) to establish a credit facility (the “2016 Credit Facility”) that refinanced and replaced the Company's prior credit facility with BMO.

 

2016 Credit Facility

 

The obligations of the Company under the 2016 Credit Facility are secured by a first priority lien on substantially all of the personal property and assets of the Company.

 

The 2016 Credit Facility has a five-year term. Under the 2016 Credit Facility, the Company has access to an aggregate of up to $75 million in funds (inclusive of a $15 million accordion facility described below) that are available as follows:

●

a $5 million revolving credit facility (“Facility A”);

●

a $15 million revolving reducing term facility (“Facility B”); and

●

a $40 million non-revolving facility (“Facility C”).

  

 

Borrowings under the 2016 Credit Facility accrue interest and standby fees at variable rates based on borrowing elections by the Company and the Company’s Total Funded Debt to EBITDA as described below. The purpose of Facility A is for general working capital and general corporate requirements, while Facility B and Facility C support share repurchases, acquisitions and capital expenditures associated with the Company’s Fiber to the Home program (“FTTH”).

  

The repayment terms for Facility A require monthly interest payments with any final principal payment becoming due upon maturity of the 2016 Credit Facility. Under the repayment terms for Facility B, at December 31st of each year, balances drawn during the year that remain outstanding will become payable on a quarterly basis commencing the first quarter of the following year, for the period of amortization based on the purpose of the draw. For Facility C, each draw will become payable beginning the first full quarter post initial draw for the period of amortization based on the purpose of the draw. The amortization periods for Facility B and Facility C are based on the purposes of the draws as follows: draws for share repurchases are repaid over four years, draws for acquisitions over five years and draws for FFTH capital expenditures over seven years. The 2016 Credit Facility includes a mechanism that is triggered based on the Company’s Total Funded Debt to EBITDA calculation at the end of each fiscal year. If Total Funded Debt to EBITDA exceeds 2.0:1 at December 31 of each year during the term, the Company is obligated to make a repayment of 50% of the Excess Cash Flow as defined under the agreement.

 

At September 30^th, 2016, there was no outstanding balance under Facility A (December 31, 2015 – nil), $6.0 million outstanding under Facility B (December 31, 2015 – nil) and $5.0 million outstanding under Facility C (December 31, 2015 – nil).

 

In addition, under the terms of the 2016 Credit Facility, the Company has the option, based on 60 days prior written notice and subject to approval by the Banks, to increase the size of Facility C by up to $15 million. 

 

Borrowings under the 2016 Credit Facility will accrue interest and standby fees based on the Company’s Total Funded Debt to EBITDA ratio and the availment type as follows:

 

If Total Funded Debt to EBITDA is less than 1.00, then:

●

Canadian dollar borrowings based on Bankers’ Acceptance (“CDN$ Bankers’ Acceptance Borrowings”) or U.S. dollar borrowings based on LIBOR (“US$ LIBOR Borrowings”) will be at 2.00% margin;

●

Canadian dollar borrowings based on Prime Rate (“CDN$ Prime Rate Borrowings”), U.S. dollar borrowings based on Prime Rate (“US$ Prime Rate Borrowings”) or U.S. dollar borrowings based on Base Rate (“US$ Base Rate Borrowings”) will be at 0.75% margin; and

●

Standby fees will be at 0.40%.

 

If Total Funded Debt to EBITDA is greater than or equal to 1.00 and less than 2.00, then:

●

CDN$ Bankers’ Acceptance Borrowings or US$ LIBOR Borrowings will be at 2.25% margin;

●

CDN$ Prime Rate Borrowings, US$ Prime Rate Borrowings or US$ Base Rate Borrowings will be at 1.00% margin; and

●

Standby fees will be at 0.45%.

 

If Total Funded Debt to EBITDA is greater than or equal to 2.00, then:

●

CDN$ Bankers’ Acceptance Borrowings or US$ LIBOR Borrowings will be at 2.75% margin;

●

CDN$ Prime Rate Borrowings, US$ Prime Rate Borrowings or US$ Base Rate Borrowings will be at 1.50% margin; and

●

Standby fees will be at 0.55%.

 

      Prior to the Company entering into the 2016 Credit Facility, the Company had credit agreements (collectively the “Amended Credit Facility”) with BMO that were amended on November 19, 2012, and which provided it with access to two revolving demand loan facilities (the “2012 Demand Loan Facilities”), a treasury risk management facility, an operating demand loan and a credit card facility. In connection with the 2016 Credit Facility, the Company repaid its outstanding indebtedness of the 2012 Demand Loan Facilities. With the settlement of the outstanding indebtedness, the 2012 Demand Loan Facilities and the operating demand loan were simultaneously terminated and the outstanding balances were fully repaid through advances on the 2016 Credit Facility. The Company continues to have access to the treasury risk management facility and credit card facility.

 

  

In connection with establishing the 2016 Credit Facility, the Company incurred $0.5 million of fees paid to the lenders and debt issuance costs which have been reflected as a reduction to the carrying value of the loan payable and will be amortized over the five-year term of the credit facility. For the three and nine months ended September 30, 2016, the Company amortized $8,298 as interest expense (three and nine months ended September 30, 2015 - $0).

 

 

 

Treasury Risk Management Facility

 

The Amended Credit Facility also provides for a $3.5 million settlement risk line to assist the Company 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 September 30, 2016, the Company held contracts in the amount of $5.0 million to trade U.S. dollars in exchange for Canadian dollars.

 

General Terms  

   

The 2016 Credit Facility contains customary representations and warranties, affirmative and negative covenants, and events of default. The 2016 Credit Facility 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, which are to be calculated on a rolling four quarter basis: (i) maximum Total Funded Debt to EBITDA Ratio of 2.25:1 until March 31, 2017 and 2.00:1 thereafter; and (ii) minimum Fixed Charge Coverage Ratio of 1.20:1. Further, the Company’s maximum annual Capital Expenditures cannot exceed $22 million per year, which limit will be reviewed on an annual basis. In addition, funded share repurchases are not to exceed $20 million, or up to $40 million so long as the total loans related to share repurchases do not exceed 1.5 times of trailing twelve months EBITDA. As at and for the period ending September 30, 2016, the Company was in compliance with these covenants.  

 

7. Income taxes

 

For the three months ended September 30, 2016, the Company recorded a provision for income taxes of $2.5 million on income before income taxes of $7.2 million, using an estimated effective tax rate for the fiscal year ending December 31, 2016 (“Fiscal 2016”) adjusted for certain minimum state taxes. Comparatively, for the three months ended September 30, 2015, the Company recorded a provision for income taxes of $1.8 million on income before taxes of $5.0 million, using an estimated effective tax rate for the 2015 fiscal year.

 

For the nine months ended September 30, 2016, the Company recorded a provision for income taxes of $6.5 million on income before income taxes of $19.7 million, using an estimated effective tax rate for Fiscal 2016 adjusted for certain minimum state taxes. Comparatively, for the nine months ended September 30, 2015, the Company recorded a provision for income taxes of $4.9 million on income before taxes of $13.2 million, using an estimated effective tax rate for its fiscal year ending December 31, 2015.

 

In assessing the realizability of deferred tax assets, the Company 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. The Company considers projected future taxable income, uncertainties related to the industry in which we operate, and tax planning strategies in making this assessment.

 

 

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 $0.1 million of total gross unrecognized tax benefit as of September 30, 2016 and as of December 31, 2015, 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. 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 at September 30, 2016 and December 31, 2015, respectively.

 

8. Acquisitions:

 

On February 27, 2015, Ting Fiber, Inc., one of our wholly owned subsidiaries, acquired a 70% ownership interest in the newly formed Ting Virginia, LLC and its subsidiaries, Blue Ridge Websoft, LLC (doing business as Blue Ridge Internet Works), Fiber Roads, LLC and Navigator Network Services, LLC (the “BRI Group”) for consideration of approximately $3.5 million. The Company advanced in escrow $3,125,000 during the year ended December 31, 2014, and paid the remaining purchase price of $357,493 during the year ended December 31, 2015. Ting Virginia, LLC was an independent Internet service provider in Charlottesville, Virginia, doing business primarily as Blue Ridge Internet Works. The BRI Group provides high speed internet access, Internet hosting and network consulting services to over 3,000 customers in central Virginia. The purchase price was primarily satisfied through an advance under our 2012 DLR Loan facility.

 

Ting Fiber Inc. and the selling shareholders (the “Minority Shareholders”) also agreed to certain put and call options with regard to the remaining 30% interest in Ting Virginia, LLC retained by the Minority Shareholders. On the second anniversary of the closing date, Ting Fiber, Inc. may exercise a call option to purchase an additional 20% ownership interest in Ting Virginia, LLC. Contingent upon the exercise of the call option by Ting Fiber, Inc., the Minority Shareholders may exercise a put option within 7 days following the exercise of the call option by Ting Fiber, Inc., to sell their remaining 10% ownership interest in Ting Virginia, LLC. The consideration to be exchanged for the shares acquired or sold under the options shall be $100,000 per percentage point of the additional equity interest acquired.

 

In addition, on the fourth anniversary of the closing date, the Minority Shareholders may exercise a put option under which Ting Fiber, Inc. shall be obligated to purchase the Minority Shareholders’ remaining interest for $120,000 per percentage point of the additional equity interest acquired.

 

The Company has determined that the put options described above are embedded within the non-controlling interest shares that are subject to the put options. The redemption feature requires classification of the Minority Shareholders’ Interest in the Consolidated Balance Sheets outside of equity under the caption “Redeemable non-controlling interest”. The present value of the liability at the acquisition date was $3,000,000 and is being accreted to the estimated liability amount using a discount rate of 5% over a period of four years from the acquisition date. During the three and nine months ended September 30, 2016, this amount was increased by $12,398 and $37,044, respectively, ($12,199 and $24,349 for the three and nine months ended September 30, 2015, respectively) to $3,073,642, to reflect the present value of this Redeemable non-controlling interest as at September 30, 2016.

 

 

The purchase consideration is comprised as follows:

 

 

The following table represents the finalized purchase price allocation based on the fair values of the assets

 

 

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 share equivalents or the proceeds of option exercises.

 

 

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

 

 

For the three months ended September 30, 2016, outstanding options to purchase 76,750 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 nine months ended September 30, 2016, outstanding options to purchase 95,950 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 September 30, 2016, no common shares were repurchased and for the nine months ended September 30, 2016, 308,416 common shares were repurchased and cancelled under the terms of our stock repurchase program announced in February 2016.

 

During the three and nine months ended September 30, 2015, 398,000 and 637,502 common shares were repurchased and cancelled under the terms of our stock repurchase program announced in February 2015.

 

During the nine months ended September 30, 2015, 193,907 common shares were repurchased and cancelled under the terms of a modified Dutch auction tender offer announced in December 2014 and concluded in January 2015.

 

The computation of earnings per share and diluted earnings per share for the three and nine months ended September 30, 2016 and 2015 include reductions in the number of shares outstanding due to these repurchases.

 

10. Segment reporting:

 

(a)     We are organized and managed based on three operating segments which are differentiated primarily by their services, the markets they serve and the regulatory environments in which they operate and are described as follows:

 

1.       Network Access - Mobile Services - This segment derives revenue from the sale of mobile phones and telephony services to individuals and small businesses through the Ting website. Revenues are generated in the United States.

 

2.       Network Access - Other Services - This segment derives revenue from the provisioning of high speed Internet access, Internet hosting and consulting services. Revenues are generated in the United States.

 

3.       Domain Services – This segment includes wholesale and retail domain name registration services, value added services and portfolio services. The Company primarily earns revenues from the registration fees charged to resellers in connection with new, renewed and transferred domain name registrations; the sale of retail Internet domain name registration and email services to individuals and small businesses; and by making its portfolio of domain names available for sale or lease. Domain Services revenues are attributed to the country in which the contract originates, primarily Canada.

 

The Chief Executive Officer is the chief operating decision maker and regularly reviews the operations and performance by segment. The chief operating decision maker reviews gross profit as a key measure of performance for each segment and to make decisions about the allocation of resources. Sales and marketing expenses, technical operations and development expenses, general and administrative expenses, depreciation of property and equipment, amortization of intangibles assets, impairment of indefinite life intangible assets, loss (gain) on currency forward contracts, other income (expense), and provision for income taxes, are organized along functional lines and are not included in the measurement of segment profitability. Total assets and total liabilities are centrally managed and are not reviewed at the segment level by the chief operating decision maker.

 

 

Information by operating segments, which is regularly reported to the chief operating decision maker is as follows:

 

 

(1)

Network access includes Mobile Services and Other Services. Other Services includes the provisioning of high speed Internet access, Internet hosting and network consulting services.

 

 

(1)

Network access includes Mobile Services and Other Services. Other Services includes the provisioning of high speed Internet access, Internet hosting and network consulting services.

 

 

 

(1)

Network access includes Mobile Services and Other Services. Other Services includes the provisioning of high speed Internet access, Internet hosting and network consulting services.

 

 

 

(1)

Network access includes Mobile Services and Other Services. Other Services includes the provisioning of high speed Internet access, Internet hosting and network consulting services.

 

 

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

 

 

During the three and nine months ended September 30, 2016 and 2015, no customer accounted for more than 10% of total revenue. As at September 30, 2016 and 2015, no customer accounted for more than 10% of accounts receivable.

 

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

 

 

(d)           The following is a summary of the Company’s property and equipment by geographic region:

 

 

 

(e)           The following is a summary of the Company’s amortizable intangible assets by geographic region:

 

 

 

(f)           The following is a summary of the Company’s deferred tax asset by geographic region:

 

 

 

(g)           Valuation and qualifying accounts: