Cogent Communications Holdings, Inc. (CCOI) Earnings Call Transcript & Summary

Good morning. This is the conference call for Cogent Communications at the 28th Annual Media, Internet & Telecom Conference for Deutsche Bank. Gentlemen, you may start.

Okay. Thank you, operator. This is Matt Niknam, communications analyst at Deutsche Bank. We are very pleased to be joined by Cogent Communications Founder and CEO, Dave Schaeffer. Dave, thank you for joining us in what is a very, very turbulent day in the market. Much appreciated, Dave.

Well, thank you, Matt, for hosting me. Welcome back to Deutsche Bank. And I apologize to everyone on the call for being a couple of minutes late. But Matt, I know you have some questions for us.

Yes, yes. So I'm going to jump right into the Q&A. Just for the purpose of everyone who is on the line, this session will go a little over 30 minutes through the top of the hour. So I'm just going to jump right into it. Dave, the business in totality actually saw reaccelerating top line growth last quarter. I think you grew just under 7% on a constant currency basis. Your long-term targets still are calling for roughly 10% growth on an annual basis. So maybe just to start, what gives you the confidence that 10% top line growth is achievable? And maybe what needs to happen from a macro perspective and within the business to get there?

Sure. So a couple of points, Matt. First of all, over Cogent's 15-year history as a public company, we have averaged 10.3% top-line growth, and we've had a fair amount of volatility in that over that 15-year period. So I firmly believe the 10% target is achievable. The second point is that our business has 2 discrete addressable markets. 69% of our revenues come from selling to corporate end users. That Corporate business has grown consistently at about 11.7%. Last quarter was very typical of our growth, and the business grew sequentially at about 2.5% and about 10.5% year-over-year. So pretty much in line. That is a very granular business. There is no customer concentration, and there are some significant drivers to that growth. As businesses continue to migrate away from premise-based computing and licensed software to SaaS and cloud, they need more bandwidth, and the Cogent product allows them to benefit from greater throughput over a more secure and a quicker installed connection. For our Corporate customers, we are giving them 30 to 60x the throughput, we're installing 9x faster, and the service is 3x more reliable than comparable services. With that, and the transition to cloud and SaaS, we think that we can roughly double the penetration in our on-net footprint. Today, in Corporate's 960 million square foot addressable market for Cogent, we have approximately 15.2 customer connections per building out of -- or excuse me, customers, and 23.2 connections per building out of the 51 potential customers in those buildings. We think we can increase that as well as add additional buildings to our footprint. From that Corporate on-net connection that is typically a DIA connection, the relationship can be expanded 2 ways: We can sell to additional locations Internet service or VPN services. So with this increase in demand in our on-net footprint, we think our off-net business and our VPN business will also grow at similar historic rates or just under 12%. The improvement in our growth really came from the inflection in our NetCentric business. To remind investors, our NetCentric business is the sale of bulk Internet connectivity and carrier-neutral data centers to either access networks or content producers. We expect that business to average about its historical trend line of 9% growth. In fact, it has been underperforming, and even last quarter, only grew 0.1% on a year-over-year basis, but did grow 2.5% sequentially. Now that business has been impacted by regulatory issues, by customer concentration, and the fact that roughly half of the NetCentric revenues are outside of the U.S., significant FX. But with the advance of a number of new over-the-top video providers, we feel pretty comfortable that we'll see a reacceleration in that NetCentric business, allowing Cogent's total revenues to grow in line with historical averages of 10%.

Okay. Okay. Maybe we'll jump -- I'm going to start on Corporate, and then we had a couple of questions to follow-up on NetCentric as well. So Corporate, a little over 2/3 of your revenue right now. You've picked up investments in sales. I guess firm-wide, the number of quota-bearing reps, I think, were up 13% last year. It's a little bit above the 7% to 10% rate you've typically done. What's the driver behind this? And is this fair to assume this, in turn, will drive a reacceleration in growth as these sales reps become more productive?

So our stated goal is to grow the sales force between 7% and 10% a year. In 2018, we actually missed that goal and only grew at about 4.5%. So in 2019, we added additional recruiting resources and accelerated our sales force growth to 13%. Roughly 72% of the sales force focuses on the corporate market, 28% of the sales force focuses on the NetCentric market. We believe that there is sufficient addressable market that we can continue to add salespeople for the next 7, 8 years, consistently at that rate and still not be able to reach all of our potential customers. Now the reality is, for the Corporate rep, most of the time they call an opportunity, that opportunity is not ripe for a sale because they're either under a contract or they're content with the bandwidth that they have. But there are really 3 catalysts that can cause a Corporate customer to reconsider their bandwidth purchases and switch to Cogent, that is when they move to a new location, or when their IT infrastructure changes and they deploy a cloud-based computing platform or software-as-a-service. When Cogent is able to get to a decision-maker in that window of opportunity, we actually close half of the sales that we propose. That is a phenomenal close rate for a outbound telemarketing effort. And we need additional sales resources to be able to get in front of all those customers when these increasing trends of cloud and SaaS occur. We think that the Corporate business will continue to be driven almost exclusively by the fact that customers no longer can support these higher bandwidth applications on a copper-based infrastructure and need fiber all the way to the premise. And the fact that Cogent has prewired the building with fiber to every floor gives us a competitive advantage both in quality of service as well as speed of provisioning. Now for the 28% of the sales force that is focused on the NetCentric market, that is a different marketplace. First of all, it's a service that's sold on a unit basis. We benefit from the fact that customers end up needing more bandwidth as their businesses grow. We are able to grow generally about twice as fast as the market by doing 2 things: one, by winning new customers who have previously not purchased from Cogent; and then two, getting growth rates faster than the market from our customers. And that can occur 1 of 2 ways, either the customers that we choose have a growth rate faster than the average, and we've seen that with a number of OTT players in the past; or we can also get a larger share of wallet from those customers. So for the NetCentric sales team, this is much more of a consultative sale. We need to show the engineering data to our customers and the value that we can deliver to them. As well as the fact that we are guaranteeing to undercut any other provider by 50% is why Cogent has grown to become the second largest carrier of Internet traffic in the world. Approximately 95% percent of our bit volume comes from our NetCentric customers. So we think the investment that we made in our sales force in 2019, which did increase our SG&A and depressed margins where we only experienced 70 basis points of year-over-year margin expansion, was a transitory event. And in fact, our gross margins improved by 190% year-over-year, which is better than our long-term trend line. But we do expect the entire business to continue to deliver about 200 basis points a year of EBITDA margin expansion as our margins will expand from the approximately 37% today to a long-term stable state of 50% EBITDA margins.

Okay. Okay. On the Corporate side, I mean, you referenced a 50% sort of win rate when you're able to get on the line with this decision-maker and there is a decision to be made. Maybe just to expand on that, can you talk a little bit about the competitive landscape right now? Have there been any changes? Are you seeing maybe the incumbents fighting more aggressively to retain that share? And then secondly, any impacts to the business from what's been maybe a more evolving or fluid macro environment so far this quarter?

Yes. So a few things. First of all, our sales process to Corporate customers is constant outreach to those customers until they are in the market for more bandwidth. We typically have seen the incumbents deemphasize the enterprise portion of their businesses; in fact, they deemphasize their entire wireline business. Most of the incumbents have chosen to shrink their sales force and rely heavily on channel to reach customers. Cogent has approximately 99% of its revenue base from direct sales, only about 1% through channels. So we're growing our sales force while the incumbents are deemphasizing the products and reducing their sales force. For the customers, the incumbent oftentimes is trying to sell a bundle of services. What the customer wants is better Internet connectivity. Our tag line is SMART PEOPLE BUY DUMB PIPES. Most incumbents want to sell value-added services and additional products. That is very different than the Cogent model; in fact, it's where the market is headed. And for those reasons, we continue to gain market share. We've seen cable become more aggressive up in competition with telcos, but cable competition has been aimed more at smaller businesses and suburban office park buildings. So in our off-net footprint, we do see a lot of competition between cable and telcos. In our on-net footprint, which is central business district skyscrapers, it's almost exclusively the incumbents. And there, the incumbents typically have not modernized their plant in order to offer our service. So they not only need to bring fiber to the building, but they need to reconstruct the riser so they can bring fiber to every floor, and oftentimes it's prohibitively expensive to install a customer on an upper floor. So if you're a business on the 30th or the 40th floor of a high-rise building, you can expect install fees that can cost, on average, $1,000 a floor, making it prohibitively expensive and also taking a long time to install. So we have seen a more benign competitive landscape in our on-net footprint. In our off-net footprint, we have seen more alternatives, which has actually helped Cogent as well as allowed us to compete. And the way it helps is we purchase those local loops from third parties and the cost of those loops has come down. So in understanding our business, roughly 80% of our connections to Corporate customers are on-net, about 20% are off-net. If you measure that business by revenue, 60% of the revenue is from on-net Corporate services and 40% of Corporate revenues come from off-net services. Hopefully, that was helpful, Matt.

Yes. Yes, very much so. And so I'm going to shift to NetCentric, which makes up, I guess, the other sort of 30% to 33% of your business. So this past quarter, I think one of the bigger highlights was the NetCentric business returned to pretty modest -- but admittedly, you're back to growth on a constant currency basis for the first time since late 2017. And I know this is a business that has pretty consistently seen pricing pressure. And it's been no secret, I think you continue to sort of reference and remind investors that pricing per megabit will continue to move lower. But as we think about traffic growth, and some of the strength you've seen there, what are some of the bigger -- I mean, I know you talked about video, but if you can maybe help us think about what's helping you drive traffic and grow traffic faster than the broader marketplace? And then secondly, your expectation for some of these newer OTT products, how does that factor into your expectations for traffic growth in 2020?

So I think 3 things, Matt. First of all, we have the most ubiquitous footprint of on-net data centers where our NetCentric customers can buy from us of any provider globally. We have over 1,200 carrier-neutral data centers that are directly on the Cogent network in 45 countries. Secondly, we are the most interconnected network in the world with direct connectivity to over 6,950 other networks, of which less than 30 are settlement-free peers, meaning over 6,900 networks are Cogent transit customers, giving us greater reach and greater number of networks that we connect to. And then finally, because this is a commodity, we undercut any other provider in those facilities by 50%. And that's allowed us to gain market share and grow in what is a relatively static addressable market of about $1.5 billion globally. We focus on transit, whereas the other providers sell it in conjunction with other services. We have a network that is more efficient at producing interface-routed bit miles, which is really the service that we sell. And we do that in a way that is more effective than others because of our architecture: the way in which we built our network, the way we deploy the technology, and the way we can capture the efficiencies of new technologies as they're deployed. So I often get asked the question, when will transit prices stop falling? And the answer is probably not for decades because of the advances in wave division multiplexing and optically interfaced routers. So it's much like Moore's Law, which has a 53-year history of a 55% per year price performance improvement. Optically interfaced routers have improved at about 40% per year. Optical transport wave division multiplexing has actually improved at an even faster rate of about 80% per year for the past 35 years. Our architecture allows us to capture that more effectively. So when new applications are developed that utilize a lot of bandwidth, they tend to choose Cogent because that bandwidth is a significant cost to that business model. OTT is a great example. So whether it be YouTube or Netflix, we were their major provider and continue to be a significant provider to them as they get their business models off of the ground initially and then grow those models. So there is now a second wave of professionally produced, over-the-top video that is designed to be a streaming replacement for linear television. We will benefit by selling transit to virtually all of those new services. And then conversely, our approximately 6,900 access networks that buy from us also will be consuming more bandwidth as their customer bases spend more minutes a day streaming video. In fact, in about 70% of the cases for our NetCentric customers, we are getting paid by both sides, both by the sender and the receiver. In about 30% of the incidences, we only get paid by one side, which is typically the other side going to a peering partner. This efficiency of customer to customer allows us to further lower prices and build a competitive moat that is difficult for other networks who are not as well connected to compete with us. So Cogent continues to see its margins expand, its capital intensity decline, yet it's selling transit services at a 50% or greater discount to any other provider in the market. And it's that virtuous cycle that has allowed us to continue to gain market share.

And if I could just follow-up. I know we're still sort of maybe a little over 2 months into the quarter. But in theory, one of the reasons we've seen stocks like Netflix, their "stay at home stocks" run up is this presumption that you've got more people at home, more people theoretically streaming, watching video on their computers. Any color you can share that you've shared to date on traffic trends just in light of what's gone on over the last couple of months?

Yes. So a couple of points, Matt. First of all, the base of the Internet continues to get large, therefore, making the ability to have the same kind of percentage growth rates more challenging, although we've continued to grow at substantially faster rates than the Internet, the Internet continues to grow. The key driver is OTT. And I think with a lot of the concerns about group congregation and being outside, stay at home stocks, as you say, are a big beneficiary, and I do think people will be streaming. But what -- we've seen continuation of traffic growth so far in Q1 similar to Q4 of last year. We've even seen some acceleration beyond that. We consistently report our traffic numbers every quarter, and we will do so again when we report Q1 results, but the initial trends appear very encouraging for continued OTT adoption. Because it is a usage-based service, it's a little difficult for us to know exactly how well any one provider's OTT offering will be received in the market, or how many minutes a day consumers will use those services. But in general, we continue to gain share and continue to do quite well in terms of growing our share of OTT. And probably for the next 6 or 7 years, that will be the key application that drives growth. At the end of 2018, third parties concluded that approximately 64% of -- or excuse me, 84% of global video consumption was still linear and only 16% was over-the-top. I think probably over the next 5 years, those percentages will roughly invert, and we'll see 85% of video being streamed. And because of Cogent's connectivity, ubiquity and pricing, we'll get a disproportionate share of that business.

Got it. Got it. And so if we tie this together, you've got a business that is growing high singles; it could grow 10% over time. You talked about the margin expansion story and the 200 bps that you're targeting on an annualized basis to get to that sort of 50% target over time. You referenced briefly capital intensity. I think you've talked about capital intensity continuing to grind lower. And so what that does is it creates this consistent sort of growth in free cash flow. And it naturally sort of brings up the question, I know you get this fairly often, but what do you do with the cash, right? And how you're thinking about prioritizing sort of capital allocation. So maybe if you can help us think through your latest thoughts on pacing of shareholder returns in the context of leverage, and how you're thinking about that these days?

Sure, Matt. So, again, this a great problem to have. Most telecom companies are actually facing the inverse, which is declining revenues, shrinking margins and the need to reduce or eliminate returns of capital to shareholders. We have purchased about 20% of our float in the open market. I don't particularly love market volatility like we're having right now, but that does give us an opportunity to buy shares at times, taking advantage of volatile markets. Second, we have a dividend and now have grown our dividend for 30 consecutive quarters sequentially. We remain under-levered. We have about $400 million of cash on our balance sheet. On a net basis, we're were 2.86x levered. We have a recurring revenue business with a very sticky customer base and low churn rates. When you put all of those pieces together, we have the ability to return increasing amounts of capital to shareholders. The Board consistently looks at our return of capital strategy and decides whether or not we should accelerate buybacks, accelerate the growth rate in the dividend. And we've, on occasion, looked at special dividends, but probably don't see that as a great way to build long-term value. So it's something the Board consistently evaluates, and we'll address it each and every quarter. But we do have a stated goal that we will keep net leverage between 2.5 and 3.5x EBITDA. We have been delevering over the past couple of quarters. We're at the lower end of that range, and that may pressure the Board to be more aggressive in the rate of dividend increase.

Right. And I was going to say, maybe to follow-up on that, with where rates are right now and the stability in your business. I think you've talked about 2.5 to 3.5 is the range. But obviously, being below that and with EBITDA continuing to grow, one would think that if you sort of look at the puts and takes, there maybe is a little bit of an upward bias towards the pacing of quarterly dividend increases. So I'm just wondering if I'm thinking about that the right way.

Well, you're thinking about it the right way. What I don't want to do is mislead investors and imply that a final decision has been made, other than our need to maintain the leverage targets where we've set them. Now to that end, we have our U.S.-denominated unsecured debt that's callable at par next month. It is highly likely that the company will then exercise that call. When it does, we will look at our various costs of capital. We did a unsecured, euro-denominated deal earlier in the year. That was our lowest cost of capital and probably will be still our lowest cost of capital. So we may elect to expand that facility. And then in 2021, our secured debt becomes callable at par, and we will look to expand that as well. We understand that we have a strategic asset in our balance sheet. It is underutilized, and we are committed to returning capital. So we're trying to balance all of these kind of Cogent-specific issues with the general macro volatility. And while interest rates have come in quite a bit, spreads have widened, and what we're trying to do is kind of balance those 2 forces and optimize our capital structure.

Understood. Understood. Dave, I think we are just about out of time. So on behalf of myself, thank you very, very much, and enjoy the rest of your day.

Hey, thanks, Matt. Thanks, everyone, for joining the call today.

Thank you.

Thanks.