May 9, 2017: Tucows CEO Elliot Noss Explains the Impact of the eNom acquisition and Deferred Revenue on Earnings
Hello. I thought it made sense this quarter to do a video talking about the impact of deferred revenue on our results for this quarter. I should note that I 'm talking about the first quarter of 2017.
If you've read the press release or if you listened to the conference call or read the script afterwards you would have heard me talk about a 4.8 million dollar impact from deferred revenue so I wanted to explain that a bit to help you all understand it in a little more detail and possibly save you from having to track me down for a deeper explanation.
How Accounting Works With Domain Names
First I want to talk about how the accounting works for domain names with deferred revenue.
When we sell a domain name we recognize it pro rata over the life of the domain. Typically, to take the simplest example, we sell at a domain name for $12. We sell it in January. In January we will recognize a dollar of revenue and we will defer $11 recognizing another dollar each month throughout that year's registration. Now in addition we also will be pre-paying the registry fee.
Let's imagine the registry fee was nine dollars for the year. So we'll be recognizing seventy-five cents in cost in January and then each month pulling a dollar to revenue and seventy-five cents into cost over the life of the registration.
How Deferred Revenue is Treated at the Accounting Level
Now the first thing that complicates this quarter is the way the deferred revenue is treated at the accounting level with transactions.
When a company acquires another company that has a deferred revenue asset of their balance sheet, essentially the deferred revenue gets wiped out and reset to zero. It's a simple way to think about it. So when we bring over that eNom book of business, we don't bring over all of the deferred revenue.
That deferred revenue gets re-evaluated and in this case there was a reduction of about eight million dollars.
Now that eight million dollar reduction is an accounting exercise obviously taken on by accounting professionals. That eight million dollar reduction is the totalnegative impact that we will have from the eNom transaction and that impact will take place overwhelmingly in 2017.
Refilling the Balances of eNom's Deferred Revenue
What we're essentially doing in the first quarter is we are refilling the balances of that deferred revenue. Now I'm just going to talk about the eight million dollars revalued.In January we are essentially putting that money back in, stocking up the balance for the remainder of the year, and pulling out 1/12 of that amount.
In February, when you're doing it, you will be recognizing both the February and the January and pushing the rest out. Over a year, that washes out.
As you can see in January it's going to have the biggest impact because in January you're only pulling in the one month and deferring the 11. But by time that same thing is happening in December you've got all those previous months where you've already stopped you deferral asset that you're pulling out into so the impact is by far the biggest in Q1.
Purchase Price Accounting
Now the second thing that complicates this is what's called purchase price accounting. I don't purport to explain it but it is a one-time charge in the amount of 1.4 million dollars that again takes place in Q1 and is part of the eight million dollars. That we are allowed at an SEC level to talk about in relation to EBITDA.
The rest of it, the other 3.4 million in the quarter we are not allowed to talk about because of the third complication.
Treatment of EBITDA for Companies that Sell Subscription Services
In May 2016, the SEC changed the way that they advised companies to talk about adjusted EBITDA. In particular the SEC was concerned that companies who sold a subscription service were in their EBITDA calculations and treating their sales as if they were the sales of a product.
Typically when you have a subscription service you recognize the revenue ratedly over the period of subscription. You know from what I've said above that that's what happens with domain names but unlike most subscriptions with a domain name once you pay upfront there is no right-of-return. The bulk of that work is done on our part right at the time we sell the domain name.
Put that aside because we're not debating the accounting treatment, we're just trying to understand it a little better. But because of that concern of the FTC's concern about subscription services, they strongly advise companies that that they should not bring deferred revenue amounts into adjustment of EBITDA calculations.
We had always included the amount of net deferred revenue in our adjusted EBITDA calculations. We did that through Q1 of 2016. When this change was made, we talked about it and we went along with the change and reported it on the basis of the new standard.
OpenSRS a Very Large, Slow Growing Business
Now because open SRS is a very large, very mature, relatively slow growing business, that change didn't really have a material impact on our adjusted EBITDA. It might have had a couple few hundred thousand dollar impact per quarter which we were very comfortable with. So we complied with the change.
But that change now, with the acquisition of eNom and with the way that the accounting treats deferred revenue, when you bring over balances with an acquisition has a meterial impact. The impact of deferred revenue is 4.8 million dollars in the quarter. That 4.8 million dollars really has an impact on adjusted EBITDA as we reported it under the old approach back in Q1 2016. In Q2 and going forward with the new approach only 1.4 million of the 4.8 million can be applied to adjusted EBITDA.
The Way We Run the Business Historically is on a Cash Basis
I know this is becoming convoluted but I'll ask you to bear with me and maybe watch the video a couple times if you need to. The point is that the way we run the business is on a cash basis. There's about a 4.8 million difference between the adjusted EBITDA number we report and the way that we have historically reported adjusted EBITDA prior to Q2 2016.
The total difference for 2017 will be 8 million dollars and you'll see that runoff.
To summarize, that impact I've talked about EBITDA on an apples-to-apples basis - going from 30 million dollars in 2016 going to 50 million dollars in 2017.
I've also talked on both the about the fact that the 50 million dollars EBITDA would be impacted by this change in the SEC approach would be more like in the 42 million dollar range. So you will see the 6.2 million we reported this quarter as relating to the 42 million number. If you wanted to compare it to the 50 million figure you'd add back that deffered revenue.
But most importantly that washes out through the year so in 2018 all of this will have washed through.
Summary of the Four Factors Affecting the Numbers
If we were to assume and this is just an assumption for strictly expository purposes which is the furthest thing from guidance, we would have assumed that we grew the business on a cash basis the way we have historically thought about it from 2017 to 2018 by 20%, the change in the this approach and the new way that the SEC would like us to talk about it, would have us go 30, 42, 60.
Using the old approach 30, 50, 60.
Of course the big difference in 2016 to 2017 is that eNom is coming.
So I hope that helps you understand both of the what and the why. Again you have the combination of deferred revenue treatment in domain names, purchase price accounting, the way that the deferred revenue is treated with acquisitions, and a change in SEC policy or at least guidance that really leads to a somewhat convoluted explanation.