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

All right. We're going to go ahead and get started with our next session. This is Matt Niknam, communications infrastructure and data networking analyst here at Deutsche Bank. And we are very pleased to welcome Cogent Communications CEO, Dave Schaeffer, to our Annual Tech Conference. Dave, welcome.

Matt, thank you. Thank Deutsche Bank for hosting us, and I would like to thank all the investors on the call for their time.

So Dave, maybe just to start from a high level, can you talk about your top priorities for Cogent as we close out the year and begin thinking about 2021?

Yes. So the world has changed with the pandemic, and I think we've adapted to the new world order. The most profound change for Cogent was taking our entire workforce and going to work from home. We anticipate that continuing well into next year. We are looking forward as a vaccine is distributed, the therapeutics improve to bring people back to the office. So we have 38 physical offices around the world, where our sales team sit. We have been able to pivot to a remote hiring structure as well as remote management of the sales force. And we continue to monitor our sales force productivity and efficacy. I think different segments of our business have been impacted differently by the pandemic. On our NetCentric business, we saw a significant uptick in traffic growth as people work from home and streaming accelerated, I think those trends will continue into 2021 and will help us improve the growth rate of that portion of our business. In our corporate business, which is 70% of our revenues, I think they are both positive and negative effects from the pandemic. We have seen a significant acceleration in the sale of gigabit connections to our on-net corporate customers, which has resulted in higher ARPU as those corporate locations are concentrating employees as those employees work from home and construct an adjunct of VPN in order to connect into their corporate networks. Where the headwinds have been is in branch offices, we have seen for many of these companies a decline in their need for either dedicated Internet access or permanent VPNs in these branch offices. I think until those offices begin to reopen, that portion of our corporate business will be slower. And we've adapted our sales force and their targeted focus is to those realities of the marketplace. We do anticipate continued growth even though GDP remains challenged. Cogent continues to outperform on both growth and on margin expansion. Maybe I'll pause for a second, Matt, and let you jump into some more specific questions.

Yes, sure, sure. So why don't we -- I'm going to maybe start with corporate because that is 70% of the business. It had been growing sort of double digits, low double digits for some time. But obviously, in the last couple of quarters, we've seen a little bit of a deceleration. And I think in the most recent quarter, growth was about 5%, somewhat flattish sequentially. And so maybe, Dave, can you help us think through how much of this decel is more sort of macro and pandemic-related versus maybe more company-specific sales force type issues? And then secondly, how should investors think about the trajectory for year-on-year growth in the interim as some of these macro concerns linger?

Yes. So 70% of Cogent's revenues come from selling to end users. Our sales always begin with an on-net corporate location that is located in the central business districts of major cities in a skyscraper. At that location, we are selling the customer dedicated Internet access. From that initial sale, there are really 3 ways that relationship can develop. The first is we've satisfied the customer's requirement, and there's no further relationship. The second would be to sell a branch office Internet connectivity, which may be either on-net or off-net. And then finally, to sell a VPN service between offices. We today have about 25% of the potential customers in the building as Cogent customers, meaning 3/4 of our addressable market do not yet buy from us. We have seen an uptick in the need for greater Internet connectivity at that location. So for our corporate on-net customers, there are traditionally 3 windows of opportunity to sell to them. When they move into the building, when their current provider fails or they change their IT infrastructure. The pandemic has brought a fourth catalyst, which is as employees work from home, they need more bandwidth at their firewall to concentrate those customers. So our corporate growth rate for the past 15.5 years has organically grown at 10.5%. In fact, we have had sequential growth every single quarter for the past 64 sequential quarters in this business. Our corporate on-net growth rate did decelerate from that 10.5%, down to about 9% in the most recent quarter. Where the big shortfall in our corporate growth rate has been is in the off-net component. Off-net are those branch offices where we would sell either Internet or VPN. VPNs represent 25% of our corporate business. As companies work from home and shutter those branch offices, they need connectivity at the main office, do not need connectivity to those branch offices. So we've seen a dramatic reduction in VPN sales. And as a result, our off-net business actually was negative in the quarter on a year-over-year basis, resulting in a little over 5% total corporate growth on a year-over-year basis. I think as the economy begins to reopen, we will see these branch offices also reopen, and we will see an uptick in that off-net business and those secondary locations as well as the need for dedicated VPN services. We also think in our on-net corporate footprint, our growth should continue at long-term historical rates, which is slightly over 10%, 10.5%. We did see a bit of a slowdown because of the pandemic and the fact that many companies were uncertain about where their business was going. But I think over the next few quarters, companies are adjusting to the new reality and beginning to realize that improving their Internet connectivity is critical to their business. So we do see our corporate business continuing to grow albeit slightly below the double-digit growth rate that we've historically had for the next several quarters, but then begin to revamp.

Got it. Got it. And I'm going to get into margins later on in the discussion. But if I think about more on-net growth and off-net being the area where the pressure is, theoretically, you should see a little bit more of a lift, I would think on the margin front, despite some of the slower revenue growth?

That is correct. So in the most recent quarter, even though we only grew 5.1% we were able to deliver 290 basis points year-over-year of EBITDA margin expansion. Now approximately 80 of those basis points came from an accounting change in the requirement for us to capitalize maintenance on one of our larger IRU agreements. But even netting out that noncash impacting accounting change, we still grew our margins 210 basis points. Our long-term guidance is to grow revenues at approximately 10% and 200 basis points of margin expansion. We actually beat on the margin expansion with a lower growth rate. And that's in large part because most of the deceleration in growth was in the off-net business, which only carries a 50% gross margin and a 45% contribution margin as compared to our on-net business, which carries 100% gross margin contribution and a 95% incremental EBITDA margin.

Understood. Understood. While we're on the corporate side, so I think sales cycles is another area where you recently talked about some of these sales cycles lengthening, customers maybe being a little bit more hesitant given the current macro backdrop. So I guess, a, has this changed at all in recent weeks? And then b, how do you sort of assess the pandemic's impact on your customer base and sort of weigh the risk of either higher churn or higher bad debt expense?

Yes, I'm going to take those in reverse order, Matt. We are fortunate in that our customers have been pre-vetted by the landlords and the buildings that we have chosen to serve. So Cogent connects to approximately 1,800 buildings in North America that average 41 stories in height and about 550,000 square feet. That is not a typical building. And those buildings typically are the most exclusive in a given market and charge the highest rents. The landlords have selected businesses that are more financially able to withstand the pandemic than a traditional business. We have very little exposure to hospitality, to retail, to restaurants. These are the types of businesses that are really being negatively impacted. Our customer base is primarily law firms, financial services companies, consultants, traditional white collar businesses that are able to pivot to work from home. While we do have maybe a couple of retail customers on the first floor of the building, there's 40 more floors above it that are purely office. So we have actually seen our DSOs decline, our cash collections remain steady and our bad debt expense remain steady. And to remind investors, our DSOs are substantially better than other wireline telecom companies where we average about 25 days. We're actually below that at 23 in this last quarter. We expect to be able to see our customers pay their bills regularly. We monitor our cash collections daily. And since mid-March, we're running about 3.8% above where we were last year, even though revenue is up 5%. So we are seeing a slight lengthening of payment windows, but compared to companies that have a significant bad debt exposure, I think this is a nonissue for Cogent. Now to the sales cycle. I think when the pandemic first hit, a lot of companies were unsure how long it was going to impact them and exactly how it was going to impact them. I think after that initial period of shock, where there was binge buying to upgrade their connections. So we saw a material uptick in growth from mid-March through the end of April, early May. After that, we reverted back to a more normalized sales cycle where customers were going through their traditional due diligence on selecting a given provider and taking their time. I also saw that there was some uncertainty injected into the buying decision as companies were unclear. So they were willing to push out a buy decision, maybe stay month-to-month for another month or 2 with their legacy provider. I think those issues have pretty much subsided at this point. I think customers realize that we're going to be in a abnormal situation for probably the next year. And because of that, they're going to make the decision that will impact their business for the next year and one that they can live with after the pandemic is over. Our traditional customer buys a 3-year contract. And we expect to see corporate sales cycles begin to revert back to normal as kind of a new normal sets in.