UNITED STATES

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, 2005

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 0-28284

TUCOWS INC.

(Exact Name of Registrant as Specified in Its Charter)

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 by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act): Yes o  No ý

As of November 7, 2005, there were 71,878,822 outstanding shares of common stock, no par value, of the registrant, excluding 3,569 shares of common stock remaining in escrow as a result of an acquisition in April 2004.

TUCOWS INC.

Form 10-Q Quarterly Report

INDEX

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PART I.

FINANCIAL INFORMATION

Item 1. Financial Statements

Tucows Inc.

Consolidated Balance Sheets

(Dollar amounts in U.S. dollars)

See accompanying notes to unaudited consolidated financial statements

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Tucows Inc.

Consolidated Statements of Operations

(Dollar amounts in U.S. dollars)

(unaudited)

See accompanying notes to unaudited consolidated financial statements

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Tucows Inc.

Consolidated Statements of Cash Flows

(Dollar amounts in U.S. dollars)

(unaudited)

See accompanying notes to unaudited consolidated financial statements

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

1.  BUSINESS AND BASIS OF PRESENTATION:

Tucows Inc., a Pennsylvania corporation (referred to throughout this report as the “Company”, “Tucows”, “we”, “us” or through similar expressions), provides Internet services and downloadable software through a global network of service providers, including web hosting companies and other providers of services over the Internet. Tucows services include domain registration services, digital certificates, billing, provisioning and customer care software solutions, email and anti-spam services,  blogware and website building tools.

The accompanying unaudited interim consolidated balance sheets, and the related statements of operations 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 at September 30, 2005 and the results of operations and cash flows for the interim periods ended September 30, 2005 and 2004.

The accompanying interim 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.  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, 2004 included in the Company’s 2004 Annual Report on Form 10-K filed with the SEC on March 24, 2005.

We consider investments in highly liquid instruments purchased with an original maturity of 90 days or less to be cash equivalents. We maintain our cash balances in highly rated financial institutions. At times, such cash balances exceed the Federal Deposit Insurance Corporation limit.

Our short-term investments are invested in United States Treasury Bonds, Certificates of Deposit and Commercial Papers. These short-term investments are reported at cost, while any accrued interest on these investments is included in Other Income within Consolidated Statements of Operations, and under Accounts Receivable, on the Consolidated Balance Sheets.

The Company has elected to follow the intrinsic-value-based method of accounting as prescribed by Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees”, and related interpretations, in accounting for its employee stock options.  Under APB 25, deferred stock-based compensation is recorded at the option grant date in an amount equal to the difference between the market value of a common share and the exercise price of the option.  Deferred stock-based compensation resulting from employee option grants is amortized over the vesting period of the individual options, generally four years, in accordance with the accelerated measurement method in Financial Accounting Standards Board Interpretation No. 28.

Stock options granted to consultants and other non-employees are accounted for using the fair value method under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-based Compensation”.  Under this method, the fair value of options granted is recognized as services are performed and options are earned.

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The following table illustrates the effect on net income if the fair-value-based method had been applied to all outstanding and unvested awards in each period.

To determine the fair value of each option on the grant date in the three months ended September 30, 2005 and 2004 respectively, the following assumptions were used for the Company’s stock option plan:

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.  INVESTMENT:

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 not temporary has occurred.

The Company holds a 7% interest in Afilias, Limited (“Afilias”), a private company, which is a consortium of 18 domain name registrars.

3.  BASIC AND DILUTED EARNINGS PER COMMON SHARE:

The Company’s basic earnings per common share have been calculated by dividing net income by the weighted average number of common shares outstanding.

The diluted earnings per common share have been calculated using the weighted average number of common shares outstanding and potentially dilutive common shares outstanding during the periods.

Options to purchase 103,786 shares of common stock were outstanding during the three months ended September 30, 2005 (three months ended September 30, 2004: 1,634,698) but were not included in the computation of diluted income per common share because the options’ exercise price was greater than the average market price of the common shares during the period.  Options to purchase 105,213 shares of common stock were outstanding during the nine months ended September

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30, 2005 (nine months ended September 30, 2004: 1,065,438) but were not included in the computation of diluted income per common share because the options’ exercise price was greater than the average market price of the common shares.  The options, which expire in years 2006 to 2015, were still outstanding at September 30, 2005.

4.  SUPPLEMENTAL INFORMATION:

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

5.  COMMITMENTS AND CONTINGENCIES:

Commitment obligations which existed at December 31, 2004 have been disclosed in the Company’s 2004 Annual Report on Form 10-K filed with the SEC on March 24, 2005.

6.  STOCKHOLDERS’ EQUITY:

The following table summarizes stockholders’ equity transactions for the nine months ended September 30, 2005:

On August 19, 2005, we sold 401,173 shares of common stock at $0.90 per share in a public offering. On August 31, 2005, the underwriters in the public offering exercised in full their over-allotment option to purchase an additional 2,889,250 shares of common stock at $0.90 per share. The public offering resulted in net proceeds, after underwriting, legal, accounting, printing and other costs, of $1,574,675.

7.  RECENT ACCOUNTING PRONOUNCEMENTS:

In March 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (“FIN 47”), which is an interpretation of Statement of Financial Accounting Standards (“SFAS”) No. 143, “Accounting for Asset Retirement Obligations.”  FIN47 clarifies terminology within SFAS 143 and requires an entity to recognize a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. FIN 47 is effective for fiscal years ending after December 15, 2005. We do not expect the adoption of this statement to have a material impact on our financial statements.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections.”  SFAS 154 replaces APB 20, “Accounting Changes” and SFAS 3, “Reporting Accounting Changes in Interim Financial Statements” and establishes retrospective application as the required method for reporting a change in accounting principle. SFAS 154 provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. The reporting of a correction of an error by restating previously issued financial statements is also addressed. SFAS 154 is effective for accounting changes and corrections of

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errors made in fiscal years beginning after December 15, 2005. We do not expect the adoption of this statement to have a material impact on our financial statements

In December 2004, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payment,” which requires companies to expense the fair value of employee stock options and other forms of share-based compensation. Accordingly, SFAS 123R eliminates the use of the intrinsic value method to account for share-based compensation transactions as provided under APB Opinion No. 25. Under SFAS 123R, we are required to determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. We currently use the Black-Scholes option-pricing model to value options for pro-forma financial statement disclosure purposes in note 1. The use of a different model to value options may result in a different fair value than the use of the Black-Scholes option-pricing model. We are required to adopt SFAS 123R in the first quarter of fiscal 2006. We are evaluating the requirements of SFAS 123R and anticipate that the adoption of FAS 123R will affect our results of operations to an extent similar to that as presented in its FAS 123 pro forma disclosure included in note 1.

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

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Some of the statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Risk Factors” and elsewhere in this Form 10-Q constitute forward-looking statements.

These statements involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from the information expressed or implied by these forward-looking statements. While we believe that we have a reasonable basis for each forward-looking statement contained in this Form 10-Q, we caution you that these statements are based on a combination of facts and factors currently known by us and projections of the future, about which we cannot be certain or even relatively certain. 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; and

•  Pending or new litigation.

In addition, you should refer to the “Risk Factors” section of this Form 10-Q for a discussion of other factors that may cause our actual results to differ materially from those implied by our forward-looking statements. As a result of these factors, we cannot assure you that the forward-looking statements in this Form 10-Q will prove to be accurate. Furthermore, if our forward-looking statements prove to be inaccurate, the inaccuracy may be material. In light of the significant uncertainties in these forward-looking statements, you should not regard these statements as a representation or warranty by us or any other person that we will achieve our objectives and plans in any specified time frame, if at all.

You should read this Form 10-Q completely. In some cases, you can identify forward-looking statements by the following words: “may,” “will,” “should,” “expect,” “intend,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue” or the negative of these terms or other comparable terminology. All forward-looking statements included in this Form 10-Q are based on information available to us as of the date of this Form 10-Q, and we assume no obligation to update these cautionary statements or any forward-looking statements.  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.

OVERVIEW

We provide Internet services and downloadable software through a global distribution network of more than 6,000 customers, or Service Providers, in more than 100 countries. We are an accredited registrar with the Internet Corporations for Assigned Names and Numbers, or ICANN, and we generate revenue primarily through the provision of domain registration and other Internet services to Service Providers who offer such services to their own customers in a process known as wholesale distribution

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Our distribution network of Service Providers is comprised primarily of web hosting companies, Internet Service Providers, or ISPs, and providers of other services over the Internet. These Service Providers typically provide their customers, the end-users of the Internet, with a critical component to enable their use of the Internet. End-users typically consist of individuals and businesses ranging from small businesses to large corporations.

Net Revenues

We generate net revenues primarily through the provision of domain registration and ancillary services. Additional revenue is generated from advertising and other services.

Domain registration and ancillary services

We generate revenues from the provision of Internet services on both a wholesale and retail basis. To date, the majority of net revenues has been derived from the sale of services provided as an accredited domain registrar. As of September 30, 2005, we offered registration services for the generic top-level domains, or gTLDs, .com, .net, .org, .info, .name and .biz and for the country code top-level domains, or ccTLDs .at, .be, .ca, .cc, .ch, .cn, .de, .fr, .it, .nl, .uk, .tv and .us.

We receive revenues for each domain registration or ancillary service processed through our system by Service Providers.

With respect to the sale of domain registrations, we earn registration fees in connection with each new, renewed and transferred-in registration and from providing provisioning services to Service Providers and registrars on a monthly basis. Domain registrations are generally purchased for terms of one to ten years. Payments for the full term of all services, or billed revenue, 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.

Ancillary services currently consist of digital certificates, billing, provisioning and customer care software solutions, email and anti-spam services, blogware and website building tools which are used by our Service Providers to create bundles of Internet services for their end-users. We earn fees when an ancillary service is activated. Ancillary services are generally purchased for terms of one month to three years. Payments for domain registrations and ancillary services are for the full term of all services 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.

On a retail basis, we offer Internet services directly to end-users through our Domain Direct division. These services include domain registration, email, blogware, hosting and website creation. Depending on the service offered, Domain Direct receives standard fees for its services that are published on its website. In addition, Domain Direct offers referral commissions based on a percentage of net registration revenues to participants in its affiliate program.

Advertising and other revenue

We also generate advertising and other revenue through our online libraries of shareware, freeware and online services presented at our website, www.tucows.com. Advertising revenue is generated from third-party advertisers and from software developers who rely on us as a primary source of distribution. Software developers use our Author Resource Center, or ARC, to submit their products for inclusion in our software libraries and to purchase promotional placement of their software in the library categories, as well as purchase other promotional services on a cost-per-click through or flat rate basis. Software developers are able to promote their software through advertising services including keyword search placements, banners, promotional placements, expedited reviews and premium data services. Revenue is also generated from companies who contract with us to provide them with co-branded content. Advertising and other revenue is recognized ratably over the period in which it is presented. We have in the past also entered into barter transactions, which are a component of advertising revenues. Barter transactions are the exchange of advertising space on our website for reciprocal space or traffic on other websites. Revenues and expenses are recognized from advertising barter transactions when the value of the advertising surrendered is determinable based on our historical practice of receiving cash for similar advertising. We did not undertake any barter transactions during the three or nine months ended September 30, 2005 or in the three or nine months ended September 30, 2004.

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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. Notes 1 and 7 to the unaudited consolidated financial statements for the three and nine months ended September 30, 2005 includes further information on the significant accounting policies and methods used in the preparation of Tucows’ consolidated financial statements.

The preparation of financial statements in conformity with U.S. GAAP 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 recoverability of investments, 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:

•  Domain registration fees on both a wholesale and retail basis and ancillary services; and

•  Advertising and other revenue.

With respect to the sale of domain registrations, we earn registration fees in connection with each new, renewed and transferred-in registration and from providing provisioning services to Service Providers and registrars on a monthly basis. Domain registrations are generally purchased for terms of one to ten years. Payments for the full term of all services, or billed revenue, 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.

We also generate advertising and other revenue through our online libraries of shareware, freeware and online services presented at our website, www.tucows.com. Advertising and other revenue is recognized ratably over the period in which it is presented. To the extent that the minimum number of impressions we guarantee to customers is not met, we defer recognition of the corresponding revenues until the guaranteed impressions are achieved.

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 establish reserves for possible uncollectible accounts receivable and other contingent liabilities which may arise in the normal course of business. 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 reserves may be required.

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Product development costs

We account for the costs of computer software developed or obtained for internal use in accordance with the American Institute of Certified Public Accountants Statement of Position 98-1: Accounting for the Cost of Computer Software Developed or Obtained for Internal Use, as more fully described in Note 2 to our audited consolidated financial statements for the year ended December 31, 2004. Our policy on capitalizing internally developed software costs determines the timing of its recognition of certain development costs. In addition, this policy determines whether the cost is classified as development expense or depreciation of property and equipment. Management reassesses these judgments on an ongoing basis. Changes in management’s assessment could impact the recognition of development costs in our accounts.

Valuation of intangible assets, goodwill and long-lived assets

Our business acquisitions typically result in goodwill and other intangible assets, which affect the amount of future period amortization expense and possible impairment expense that we may incur. The determination of the value of such intangible assets requires management to make estimates and assumptions that affect our consolidated financial statements. In addition to annual evaluation of the carrying value of goodwill, we review our identifiable intangibles, long-lived assets and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors that we consider important that could trigger an impairment review include the following:

•  a significant underperformance relative to expected historical or projected future operating results;

•  a significant change in the manner of our use of the acquired asset or the strategy for our overall business; or

•  a significant negative industry or economic trend.

When we determine that the carrying value of intangibles, long-lived assets or goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure any impairment based on a projected discounted cash flow model using a discount rate determined by management to be commensurate with the risk inherent in our current business model. Management will base its estimates in preparing the discounted cash flows on historical experience and on various other assumptions, including current market trends and developments, ongoing customer developments and general economic factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily available from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Accounting for income taxes

We account for income taxes under the asset and liability method in accordance with Statement of Financial Accounting Standards No. 109. 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 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 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, resulting in a reduction in net income or an increase in net loss in the period when such determinations are made.

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Accounting for stock based employee compensation

We account for stock based employee compensation arrangements in accordance with the provisions of Accounting Principles Board, or APB, Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations, and comply with the disclosure requirements of Statement of Financial Accounting Standards No. 123, “Accounting for Stock Based Compensation,” or SFAS 123. Under APB Opinion No. 25, compensation cost, if any, is recognized over the respective vesting period based on the difference between the deemed fair value of our common stock and the exercise price on the date of grant. The determination of the volatility, expected term and other assumptions used to determine the fair value of stock options granted under SFAS 123 for footnote disclosure purposes involves subjective judgment and the consideration of a variety of factors, including our historical stock price and option exercise activity to date.

In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123R, “Share Based Payment,” or SFAS 123R, which requires companies to expense the fair value of employee stock options and other forms of share based compensation. Accordingly, SFAS 123R eliminates the use of the intrinsic value method to account for share based compensation transactions as provided under APB Opinion No. 25. Under SFAS 123R, we are required to determine the appropriate fair value model to be used for valuing share based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. We currently use the Black Scholes option pricing model to value options for pro-forma financial statement disclosure purposes. The use of a different model to value options may result in a different fair value than the use of the Black Scholes option pricing model. We are required to adopt SFAS 123R in the first quarter of fiscal 2006. We are evaluating the requirements of SFAS 123R to assess what impact its adoption will have on our financial position and results of operations.

RESULTS OF OPERATIONS FOR THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2005 AS COMPARED TO THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2004

NET REVENUES

Total net revenues for the three months ended September 30, 2005 decreased to $12.1 million from $12.4 million for the three months ended September 30, 2004.

Total net revenues for the nine months ended September 30, 2005 increased to $35.9 million from $33.2 million for the nine months ended September 30, 2004.

During the three and nine months ended September 30, 2005, no customer accounted for more than 5% of billed revenue, and one customer accounted for 12.2% of accounts receivable at September 30, 2005. Subsequent to the quarter end, substantially all of the amounts, owed by this customer were collected. Significant management judgment is required at the time of recording of revenue 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 our outstanding receivables to be fully collected.

Domain name and ancillary services

Net revenues from domain name and ancillary services for the three months ended September 30, 2005 decreased by $100,000, or 0.6%, to $11.3 million from $11.4 million for the three months ended September 30, 2004 as a result of our reported revenue for the three and nine months ended September 30, 2004, which included the recognition of deferred domain name revenue of approximately $1.1 million that was recognized as a result of one of our resellers becoming an accredited registrar and transferring all of its domain names from our tag to its own tag.  The impact of the transfer of these names, which included a large number of multiple year registrations, resulted on our having no future obligations in connection with these names.  As a result, we recognized all deferred revenue previously recorded relating to these names during the quarter ended September 30, 2004.  The customer continues to be a customer of ours, using our OpenHRS platform for its registration needs.

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Net revenues from domain name and ancillary services for the nine months ended September 30, 2005 increased by $2.4 million, or 7.9%, to $33.4 million from $31.0 million for the nine months ended September 30, 2004, primarily as a result of increased volumes from new and existing customers, as well as the additional revenue earned as a result of the April 2004 acquisition of Boardtown Corporation.

During the three months ended September 30, 2005, the number of domain names that we processed increased by approximately 100,000 to approximately 1.0 million new, renewed and transferred-in domain name registrations, compared to the three months ended September 30, 2004. During the nine months ended September 30, 2005, the number of domain names that we processed increased by approximately 200,000 to approximately 3.0 million new, renewed and transferred-in domain name registrations, compared to the nine months ended September 30, 2004.   These increases were due primarily to our continuing to compete aggressively to attract new clients and retain existing customers to protect our current market share and improve our competitive position.  These actions have resulted in our average selling price declining, which has partially offset the impact of the increased transaction volume on our revenue and profitability.  We may face continued pricing pressure in order to remain competitive, which would adversely impact our revenues and profitability.

The renewal rate for domain name registrations increased to approximately 69% for the three months ended September 30, 2005 compared to approximately 65% for the three months ended September 30, 2004.

During the three months ended September 30, 2005, revenue from domain names, including Domain Direct, comprised 86% of total revenue, compared to 87% for the three months ended September 30, 2004. During the three months ended September 30, 2005, revenue from ancillary products comprised 8% of total revenue, compared to 6% for the three months ended September 30, 2004.

During the nine months ended September 30, 2005, revenue from domain names, including Domain Direct, comprised 86% of total revenue, compared to 89% for the nine months ended September 30, 2004. During the nine months ended September 30, 2005, revenue from ancillary products comprised 8% of total revenue, compared to 5% for the nine months ended September 30, 2004.

While we anticipate that the number of new, renewed and transferred-in domain name registrations will incrementally increase, the volatility in the market could affect the growth of domain names under our management.  During the three months ended September 30, 2005, the total number of domain names under our management increased by approximately 100,000 to approximately 4.7 million. In addition, as of September 30, 2005 we provided provisioning services to 6 registrars on a monthly basis (6 registrars at September 30, 2004) who use our technical systems to process domain registrations with their accreditation. As of September 30, 2005, we managed approximately 849,000 domain names (approximately 252,000 at September 30, 2004) on their behalf.

Deferred revenue from domain name registrations and ancillary services at September 30, 2005 increased to approximately $37.3 million from approximately $36.6 million at June 30, 2005.

Advertising and other revenue

Advertising and other revenue for the three months ended September 30, 2005 decreased by approximately $256,000, or 26%, to approximately $724,000 compared to approximately $980,000 for the three months ended September 30, 2004.  This decline in revenue was primarily the result of the improved efficiency that users are experiencing as a result of the significant redesign of our software download website that we completed during the second quarter of 2005. While the improved navigability and usability of the website is enabling users to more readily find the software download that best addresses their needs and is resulting in a steadily improving ratio of downloads per visit, it has also enabled users to find their desired download more readily which has resulted in a decrease in the number of searches, the number of times users click on paid placements and the number of times users click on syndicated pay-per-click results. We expect the growth rate for advertising and other revenue to continue to be impacted over the short-term. However, over the long-term we expect that the improved navigability and usability will result in increased traffic to the website, which will generate additional advertising and other revenue that we believe will offset this decline in revenue.

Advertising and other revenue for the nine months ended September 2005 increased by approximately $200,000, or 9%, to approximately $2.4 million compared to approximately $2.2 million for the nine months ended September 30, 2004.  The increase was predominantly the result of growth in advertising revenue from third party advertisers, which was partially offset by a decrease in advertising revenue as a result of the improved efficiency of the redesigned website described above.

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During the three months ended September 30, 2005, revenue from advertising and other revenue comprised 6% of total revenue, compared to 8% for the three months ended September 30, 2004. During the nine months ended September 30, 2005, revenue from advertising and other revenue comprised 7% of total revenue, compared to 7% for the nine months ended September 30, 2004.

COST OF REVENUES

Cost of revenues includes the costs associated with providing domain registration and ancillary services, advertising and other revenue and network costs.

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 recorded as prepaid domain registry fees. Costs of revenues for ancillary services consist of fees paid to third-party service providers and are recognized ratably over the periods in which the services are provided. We have minimal direct cost of revenues associated with our advertising and other revenues. Therefore, the gross profit margin on advertising revenue is approximately 100% and, accordingly, any increase or decrease in advertising and other revenue represents an increase or a reduction of our gross profit of the same amount. Network costs include personnel and related expenses, including bandwidth and co-location expenses to support the supply of all our services. Bandwidth and co-location expenses are composed primarily of communication and provisioning costs related to the management and support of our network.

Cost of revenues for the three months ended September 30, 2005 and the three months ended September 30, 2004 remained flat at approximately $7.7 million primarily as a result of the higher costs attributable to higher volumes of domain registrations and ancillary services and the November 2004 change in nature of the ICANN accreditation fee. Included in the cost of revenues for the three months ended September 30, 2004 is approximately $800,000 of non-cash prepaid cost of goods recorded during the quarter ended September 30, 2004 that arose as a result of one of our resellers, as more fully described under Net Revenue above, becoming an accredited registrar and transferring all of its domain names from our tag to its own tag with the result that we no longer have any future obligations in connection with these names. 

Cost of revenues for the nine months ended September 30, 2005 increased by approximately $1.8 million, or 9%, to $22.5 million from $20.7 million for the nine months ended September 30, 2004. The increase was primarily the result of higher costs attributable to higher volumes of domain registrations and ancillary services, and as a result of the November 2004 change in nature of the ICANN accreditation fee. This increase was partly offset by the recognition of the non-cash prepaid cost of goods recorded during the quarter ended September 30, 2004 of approximately $800,000 that arose as a result of one of our resellers, as more fully described under Net Revenue above, becoming an accredited registrar and transferring all of its domain names from our tag to its own tag with the result that we no longer have any future obligations in connection with these names. 

Registry fees, the primary component of cost of revenues, are paid in full when the domain is registered. Registry fees are recorded as prepaid domain registry fees and are recognized ratably over the term of provision of the service. Ancillary service costs and ICANN accreditation transaction fees are generally paid either monthly or quarterly. Services provided over periods longer than one month are recognized ratably over the term of provision of the service. Effective November 1, 2004, ICANN’s members voted to change the basis whereby registrars pay their variable accreditation fee to a transaction based fee of $0.25 per domain year registered. As this fee is now being charged as a transaction fee, we are no longer expensing this fee to sales and marketing, but are allocating it to cost of goods sold and are recognizing it ratably over the term of provision of the service. We anticipate that cost of revenues will continue to increase in absolute dollars primarily as a result of continued growth in domain registration and ancillary services.

Prepaid domain registration and ancillary services fees at September 30, 2005 increased by approximately $0.5 million, to approximately $25.4 million from approximately $24.9 million at June 30, 2005.

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Cost of revenues includes the costs of network operations. These costs for the three months ended September 30, 2005 increased by $100,000, or 17%, to $400,000 from $300,000 for the three months ended September 30, 2004, primarily as a result of additional bandwidth and people costs, primarily as a result of increased headcount and hours of operation.

Network operations for the nine months ended September 30, 2005 increased by $100,000, or 11%, to $1.0 million from $900,000 for the nine months ended September 30, 2004, primarily as a result of additional people costs, primarily as a result of increased headcount and hours of operation.

The cost of network operations is comprised primarily of communication costs, equipment maintenance, and employee and related costs directly associated with the management and maintenance of the network. We expect communication costs to increase as our network expands geographically and network activity increases.

SALES AND MARKETING

Sales and marketing expenses consist primarily of personnel costs.  These costs include commissions and related expenses of our sales, product management, public relations, call center, support and marketing personnel.  Other sales and marketing expenses include customer acquisition costs, advertising and other promotional costs.

Sales and marketing expenses during the three months ended September 30, 2005 decreased by approximately $220,000, or 16%, to approximately $1.2 million compared to approximately $1.4 million during the three months ended September 30, 2004.

The decrease was primarily the result of a decrease in ICANN fees, which decreased by approximately $152,000 due to this expense now being  included under cost of goods sold (as discussed under cost of revenues above).

In addition, personnel costs decreased by approximately $58,000 primarily as a result of no accrual being made for the 2005 at risk incentive compensation plan, or the 2005 At Risk Plan in the three months ended September 30, 2005. Under the 2005 At Risk Plan, the personal and net income performance bonus of each executive officer is paid partially in recognition of an individual’s achievement of established objectives and partially in acknowledgement of our net income performance. During the three months ended September 30, 2004, we recorded a provision of approximately $162,000 in connection with the fiscal 2004 at risk incentive compensation plan, or the 2004 At Risk Plan, as management had assessed that it was more likely than not that we would exceed the performance thresholds that the compensation committee had set for fiscal 2004. No accrual has been recorded for fiscal 2005 as management has determined that at this point in time it is not likely that we will exceed the performance thresholds set by the compensation committee for senior managers and executive officers in our 2005 At Risk Plan.  This decrease was largely offset by incremental personnel costs of approximately $104,000 during the quarter. Travel expenses for the three months ended September30, 2005 decreased by approximately $25,000 as a result of slightly less travel undertaken during the quarter.

Sales and marketing expenses during the nine months ended September 30, 2005 remained flat at approximately $3.7million compared to the nine months ended September 30, 2004. Included in these expenses was increased people costs, including contractors, of approximately $324,000 (includes a cost of approximately $62,000 relating to a severance payment), related to ongoing initiatives to improve customer service, product management and expand our sales reach.  Also included in sales and marketing expenses is an increase of approximately $67,000 primarily related to travel incurred as a result of efforts to extend our sales reach. The increase was partly offset by a decrease in ICANN fees of approximately $438,000, which, effective November 2004, is included under cost of goods sold (as discussed under Cost of Revenues above) and by our not recording an accrual for senior managers and executive officers under the 2005 At Risk Plan.

We believe that sales and marketing expenses will continue to increase, in absolute dollars, as we adjust our marketing programs and sales strategies to meet future opportunities in the marketplace.

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TECHNICAL OPERATIONS AND DEVELOPMENT

Technical operations and development expenses consist primarily of personnel costs and related expenses required to support the development of new or enhanced service offerings and the maintenance and upgrading of existing infrastructure.  This includes expenses incurred in the research, design and development of technology that we use to register domain names and ancillary services and to distribute our digital content services.  Editorial costs relating to the rating and review of the software content libraries are included in the costs of product development.  In accordance with the American Institute of Certified Public Accountants Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, costs incurred during the application development stage are capitalized and primarily include personnel costs for employees directly related to the development project.  All other costs are expensed as incurred.

Technical operations and development expenses for the three months ended September 30, 2005 increased approximately $361,000, or 33%, to approximately $1.5 million from approximately $1.1 million for the three months ended September 30, 2004.

The increase was primarily the result of people related costs including contract and outside service costs, which increased by approximately $310,000 and reflects our ongoing commitment to enhance and extend our OpenSRS platform.  No accrual was included under technical operations and development expenses during the three months ended September 30, 2005 for at risk compensation under the 2005 At Risk Plan compared to approximately $58,000 of at risk compensation under the 2004 At Risk Plan included under technical operations and development expenses during the three months ended September 30, 2004.

The amount of capitalized personnel costs for employees directly related to the application development stage of development projects decreased by approximately $26,000, which contributed to the increase in technical operations and development expenses. Also included in the increase in technical operations and development expenses is an increase of approximately $25,000 primarily related to travel expenses incurred in furthering the integration of our North American development teams.

Technical operations and development expenses for the nine months ended September 30, 2005 increased approximately $888,000, or 27%, to approximately $4.1 million from approximately $3.3 million for the nine months ended September 30, 2004.

The increase was primarily the result of people related costs including contract and outside service costs, which increased by approximately $835,000 (includes a cost of approximately $100,000 relating to a severance payment) and reflects our ongoing commitment to enhance and extend our OpenSRS platform.  No accrual was included under technical operations and development expenses during the nine months ended September 30, 2005 for at risk compensation under the 2005 At Risk Plan compared to the approximately $58,000 of at risk compensation under the 2004 At Risk Plan included under technical operations and development expenses during the nine months ended September 30, 2004.

Also included in the increase in technical operations and development expenses is an increase of approximately $55,000 primarily related to travel expenses incurred in furthering the integration of our North American development teams.

The amount of capitalized personnel costs for employees directly related to the application development stage of development projects increased by approximately $2,000, which partly offset the increase in technical operations and development expenses. We expect technical operations and development expenses to increase slightly, in absolute dollars, going forward as our business continues to grow and as we further develop our applications and services.

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GENERAL AND ADMINISTRATIVE

General and administrative expenses consist primarily of compensation and related costs for managerial and administrative personnel, fees for professional services, public listing expenses, rent and other general corporate expenses.

General and administrative expenses for the three months ended September 30, 2005 decreased by approximately $568,000, or 41%, to $821,000 from $1.4 million for the three months ended September 30, 2004.

The decrease in general and administrative expenses resulted from in decreases in people related costs including contract and outside service costs, of approximately $281,000. These decreases were primarily due to no accrual being made for at risk compensation under the 2005 At Risk Plan during the period. During the three months ended September 30, 2004, approximately $286,000 of at risk compensation under the 2004 At Risk Plan was included under general and administrative expenses.

Professional fees accounted for approximately $190,000 of this decrease as costs for advice obtained in connection with the evaluation of cross border corporate structures and the protection of our intellectual property were incurred during three months ended September 30, 2004. In addition, directors and officers liability insurance, investor relations, conferences and seminars and other expenses accounted for an additional $43,000 of the decrease in general and administrative expenses.

These decreases were partially offset by an increase in provision for doubtful accounts of approximately $39,000 and increases in facility costs, business and state taxes and other miscellaneous expenses of approximately $46,000 during the three months ended September 30, 2005 compared to the three months ended September 30, 2004.

We also recorded a foreign exchange gain of approximately $294,000 for the three months ended September 30, 2005 compared to approximately $154,000 for the three months ended September 30, 2004.

General and administrative expenses for the nine months ended September 30, 2005 increased by approximately $62,000, or 2%, to $3.4 million from $3.3 million for the nine months ended September 30, 2004.

The increase in general and administrative expenses generally reflects the more sophisticated infrastructure needed to support the constantly evolving needs we experience as the size and scope of our business continues to grow. This resulted in increases in provision for doubtful accounts of approximately $98,000, increases in facility costs of approximately $94,000, and increases in public listing expenses, professional fees, telephone and supplies totaling approximately $97,000 (includes an incremental cost of $95,000 related to an outside management consultant).

These increases were partially offset by decreases in people costs, including contract and outside services of approximately $90,000. These decreases were primarily due to no accrual being made for at risk compensation under the 2005 At Risk Plan during the nine months ended September 30, 2005. During the nine months ended September 30, 2004, approximately $286,000 of at risk compensation under the 2004 At Risk Plan was included under general and administrative expenses.

Directors and officers’ liability insurance, business and state taxes travel and other miscellaneous expenses decreased by a total of approximately $124,000 during the nine months ended September 30, 2005 compared to the nine months ended September 30, 2004. We also recorded a foreign exchange loss of approximately $241,000 for the nine months ended September 30, 2005 compared to a foreign exchange gain of approximately $228,000 for the nine months ended September 30, 2004, reflecting the continued strengthening in the Canadian dollar.

We expect general and administrative expenses to continue to increase, in absolute dollars, as our business continues to grow and the impact of a higher Canadian dollar, more fully described in the risk factors above, is recognized.

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DEPRECIATION OF PROPERTY AND EQUIPMENT

Property and equipment is depreciated on a straight-line basis over the estimated useful life of the assets.

The increase in depreciation for the three months ended September 30, 2005 compared to the three months ended September 30, 2004 was primarily due to the acquisition of additional computer hardware, purchased to increase production capacity to meet additional customer demands.

The decrease in depreciation for the nine months ended September 30, 2005 compared to the nine months ended September 30, 2004 was primarily due to certain of our older computer software being fully depreciated and not requiring replacement.

We expect that depreciation of property and equipment will increase, in absolute dollars, as we continue to enhance and add functionality to our service offerings.

AMORTIZATION OF INTANGIBLE ASSETS

Amortization of intangible assets consists of amounts arising in connection with the acquisition of Boardtown Corporation in April 2004.  The technology, brand and customer relationships purchased are amortized on a straight-line basis over seven years, while the non-competition agreements entered into with the former owners of Boardtown Corporation are amortized on a straight-line basis over three years.

OTHER INCOME