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

Good afternoon, and welcome to the Bank of America Leveraged Finance Conference and to our session with Cogent Communications. I'm Ana Goshko, Bank of America's Credit Analyst, covering telecom and technology, and I'll be moderating our discussion today. And we are very pleased to have with us Dave Schaeffer, Cogent's long-time Chairman, President, CEO, Founder; and also Sean Wallace, Cogent's CFO, who is not so long time at the company. So happy to have Sean with us. A quick note to the audience. You have a tool through which you can submit questions. So feel free to do that throughout our discussion, and I'll be checking that. And with that, let's get started. So Dave and Sean, thank you so much for being with us.

Just by way of introduction, I wanted to maybe start with Sean and just having joined Cogent in May, I'm eager to hear any kind of comments you have on your experience and your impressions to date.

That's an interesting question. I've thought about it quite a bit. And I think there are 2 answers. There was a perception that I saw when I came to the place and was evaluating the role, and I was very enamored by the company's discipline around allocation of capital. And when I say that, I mean this is a company that has unbelievable cost controls. I mean nobody has a secretary in the company, Dave fly a coach out to Singapore. We reuse equipment well beyond its useful life. We have returned capital to shareholders in a very disciplined, transparent basis. And I think of all the companies that I've known as a banker over 25 years, it's probably one of the most disciplined allocators of capital I've ever seen. But I think -- and I'll embarrass Dave a little bit more because he's sitting next to me, in terms of -- the management team at Cogent has made a series of discrete choices around its technology, around its products, its sales force that candidly have given them a competitive advantage that is -- it's really incredible. If you think about this company has gone from basically 0 around the turn of the century, being one of the 3 largest ISPs that runs the largest network in the world, it has Net Promoter Scores on a service level that are unlike any I've seen at the telecom company, indeed most companies. It has performed and become a multibillion-dollar enterprise in a very, very short time frame, as a result of great choices that they made at the beginning and the discipline, not to get tied into acquisitions, not to increase the number of products and everything else. And it really is amazing when you peel back the onion and begin to see more and more things about the cost advantage of this company and the choices that they made and the choices they continue to make to continue to perform. It's obviously been a challenging time for us, and I call it the 2 terrible Cs, COVID and CRM. But this is an incredibly resilient business. It's -- the management team, I am clearly the youngest in terms of tenure, but everyone has been here 15 or 20 years. And it's an exciting place because the internet continues to grow, technology continues to evolve, and I think we're in the cusp, and we're on a very important part of this mission-critical internet service that, candidly, most of our clients can't live without. So it's -- those are my 2 observations: incredible discipline around allocation of capital; and incredible foresight into making really hard choices around the products, technology and what it uses. And the benefits have been pretty material to the shareholders, and let's not forget the bondholders as well.

Okay. Great. That's a great introduction. And then so just one more question for you. Do you have any specific goals for your contribution to Cogent?

I think I fill very big shoes. I'm bigger than Dave physically, but I fill very big shoes in terms of his ability. He has been unbelievably transparent, dedicated to shareholders and bondholders, I hope to be the same. I hope I can do half as well as he can. He's just -- he's incredibly smart. He's incredibly open and he's unbelievably generous in his time and effort to make people understand the story. So I hope, if I can do 50% of that, I'll be thrilled. The only other thing I'd say is we want to be very transparent around the financial strategy of the company. And I think there are 3 things that we want you to know. We're going to probably have a cash on the balance sheet of around $400 million, plus or minus $50 million. We're going to be very liquid. We don't think we need a revolver because of that liquidity. We're going to have debt-to-EBITDA on a gross basis, around 5x, plus or minus a half, and net debt-to-EBITDA of 3x plus or minus a half. We will bounce around that level, but we will be pretty much around those levels, and we will continue to grow our dividends in line with our growth in free cash flow and incremental debt capacity. We define incremental debt capacity as change in EBITDA times 5x. And we think those metrics, the amount of liquidity we have, the leverage levels and the growth in our ability to pay dividends should make bondholders very, very comfortable that we're going to be transparent around our performance and transparent around our responsibilities, pay interest in principle to the bondholders who have supported us over these many years.

Okay. Great. Okay. So kind of launching more generally into our discussion. I did want to start on the pandemic impacts. And I know, Dave, you've talked about this on the earnings calls and -- but kind of from where you stand today, if you look at the end market demand and the company's sales performance this year, has there been a net tailwind or a net headwind to the business as a result of the pandemic?

So first of all, I want to thank you for inviting us to the conference again, Ana. And also for all the investors staying with us late in the day. So I appreciate that opportunity and Bank of America has been a great supporter of the company over the years. To directly answer the question, it's been a headwind. But it's not quite that simple. We have a long-term average growth rate over a 15.5 year period of organically growing at 10.3%. We're growing now at about half of that rate. For the last 6 years, the primary underperformance in the business was coming from the 30% of our revenue that is coming from our NetCentric customers. That business is characterized by unit volume growth at about twice the rate of the Internet's volume growth rate or in the mid-40s and price declines of about 23% per year in line with the industry, with Cogent being the price leader. The pandemic has been a positive to that business and has reaccelerated growth to about 9% year-over-year and may actually continue to accelerate growth beyond that. The primary driver of that growth has been the shelter-in-place orders, the spike up in streaming video content and the revenue that we derive from the 7,200 access networks around the world that buy their upstream from Cogent and the nearly 5,000 content publishers who are pushing more applications and content to end users. So that 30% of our business has been a net beneficiary. Now turning to the 70% of our revenues that come from our Corporate customers. There are 2 different answers, and it depends on where the customer is located. In our Corporate on-net business, where we're selling at primary locations, we have seen a slight benefit from the fact that businesses, as they've sent employees home to work, have needed increased symmetric bandwidth to support those work-from-home VPNs. And we have seen an uptick in new customer wins and also an uptick in existing customers buying bigger pipes. Two quarters ago, we saw a shift where customers were starting to buy more 1 gig connections than 100 meg, which have been the company's core product. What we've seen more recently is almost a complete switch where all new customers at those primary locations are buying gigabit connections, and that results in an ARPU uplift of $200 a month. So for those primary locations in multi-tenant office buildings in the central business districts of major North American cities, the pandemic has been a positive, even though there are no employees in those offices. The negatives have come from the secondary locations that those same businesses have remote employees. Those offices are shutter. They're a combination of on-net and off-net and they buy 2 products, Internet access and VPN services. That business has basically ground to a halt and probably will remain challenged over the next 6 to 9 months until a vaccine is widely distributed and people start to return to offices. So the net impact of these 3 different trends has been a deceleration in our total top line growth from that 10%, down to low single digits, call it, 4%, 5%. But the mix shift that has occurred with a greater percentage of sales coming from on-net services has actually allowed us to remain very close to our 200 basis point year-over-year margin expansion. In fact, last quarter, we saw our EBITDA margins expand 150 basis points on a year-over-year basis, while at the same time we were growing at less than half of our projected growth rate. Our contribution margins have ticked up from being in the mid-40s to the low 60s, which has been beneficial to our business. So net-net, we have seen a number of positive trends in our business, and compared to other companies in the pandemic, I think, we're doing much better.

Okay. Great. That was very helpful. And you preempted a couple of the follow-up questions I had. But -- so it sounds like with regard to kind of a rebound or normalization in the business, you're looking effectively to the summer of 2021, as many other businesses are because that's really dependent upon ramp in the vaccinations. But -- and secondly, have -- the answer to this question simply may not be knowable yet, but I'd love to hear your perspective. With the popularity of work-from-home and the potential that office footprints could be scaled down more permanently, could this be more of a secular headwind for your business post-pandemic?

I actually don't have perfect visibility to that, but I would say that if I had to guess, it will actually be a secular tailwind, and let me explain why. Our footprint is very selective. We're in 11% of all multi-tenant office space in North America, but the buildings we serve do not look like typical office buildings. The average office building in America is less than 10,000 feet with 2.1 businesses located in that building. Our average building is over 550,000 square feet with 51 discrete businesses. It tends to be the most expensive real estate in any given market. What we have seen in multiple recessions, as rents have come down, vacancies have spiked up in the suburbs and in the B and C buildings, and the A buildings remain very highly occupied. What I think is going to happen post-pandemic are really 3 things: One, I think there will be a hybrid work-from-home model. So some employees may elect to work part-time or even permanently from home. Two, in the offices, that employees go to, the open floor plan will be replaced with doored offices, the return of the private office. And third, I think some of those companies may end up taking less aggregate square footage, both in their primary location and may elect to shutter some of those branch offices in the suburbs. I don't believe if the branch offices are in remote markets they will be shuttered. But as a result of shrinking their footprint in that central business district, we actually may see the tenant count in the building go up. So today, the average tenant in the buildings that we serve takes about 10,500 square feet. The average Cogent customer takes about 8,000. So we tend to have slightly smaller customers in those buildings. But if we see the tenant count go from 51, say to 65, that increases our TAM by nearly 30% and that, I think, will be a tailwind to our corporate on-net business. And the fact that those companies will have a percentage of employees working remotely, the need for a symmetric non-oversubscribed gigabit connection will increase. And usually, we are uniquely positioned to be able to serve those customers because we have prewired the building with fiber, cable cannot come in and compete based on the asymmetry of their plant as well as the cost to wire the building. And the Telco remains committed to a legacy product portfolio and has historically been reluctant to convert to be a dumb pipe business such as Cogent.

Okay. Very interesting. I have numerous follow-ups, both on the kind of growth outlook and on the margin as well. But I think you mentioned the -- kind of CRM challenges this year. And I know also that -- you've mentioned just some challenges generally with the sales force, as Cogent has gone work from home. And really, the sales force and the sales process, from my perspective, as I look at Cogent, a constant process of optimization. So could you talk about, one, the CRM kind of a deployment this year, what the challenges have been? And once you get through that, is that going to make you more efficient? And then also just the challenges you've faced with regard to the work-for-home.

Sure, Ana. I'm going to take those in reverse order. So in March, we quickly pivoted from working in 38 offices around the world to 100% of our 1,100 employees and 600 quota-bearing salespeople working from home. We needed to get them all equipped with laptops, softphones, and we had to adapt all of our monitoring tools to be able to manage them. We did that in pretty short order. The second thing we had to do is change our sales training and sales management tools to work remotely. We were very successful in getting those implemented in about 6 weeks. The third thing that we ended up needing to do is figure out how to hire new salespeople. Our model has always had high sales force turnover. As a result, we needed to figure out how to hire someone without ever seeing them face-to-face, and how to get them to log into our network and understand our processes remotely. And anyone who's ever worked in any company knows there's a lot of benefit from going into the office on the first day and have some individuals show you where the lunch room is, how the phones work, how to log into the network. And all of that had to be done remotely. We did a good job at that. Where we probably did not focus enough attention on is how to manage out underperforming reps remotely. And we saw our sales force productivity to grade, and we quickly took steps to put better monitoring, more objective standards to be able to manage out those underperformers in a remote environment. I think Cogent now has all those issues behind it. The second thing we did is we looked at our customer relationship management software. And we have been strong believers in commercially off-the-shelf packages. For the first, roughly, 12, 13 years of Cogent's existence, we used Siebel, which then became Oracle's CRM platform after Siebel was acquired by Oracle. They failed to invest in that platform and modernize it, and we switch to a SaaS-based service, Salesforce. And for 5 years, we were using Salesforce, we found the deficiencies that we were living with became more pronounced than the pandemic. And it was very difficult for our people to switch remotely back and forth between Salesforce and the other tools that we, as a company, use to quote and be able to provision services. So we developed a home-grown system, which was kind of against my first instincts because we are not a software company. We implemented that in July, the slowest month of the year, and we're able in the months of July and August to work out any bugs and transition issues, and we've seen sequential improvement in Salesforce efficacy in August, September, October and now November. So I think those issues are behind us, and we think the integration to our quoting tools, to our service delivery tools, to our databases and the ability to work in one unified environment is making salespeople more productive. And ultimately, the demand landscape impacts productivity as well. Our NetCentric reps have never been more productive in the company's history. Our corporate reps have had their challenges because of the issues that I've described in the pandemic. But in aggregate, we are seeing improvements in our sales force productivity, and I think the CRM, coupled with the market environment are accounting for those improvements.

Okay. Great. I have a couple of questions here submitted from the audience just around capital intensity. So I guess, how do you target your capital expenditures? And then there is a question, I know you don't really provide guidance, but for an outlook on what your CapEx budget might be for 2021, 2022. And I think it all kind of goes to the free cash flow profile of the company. So I mean how do you target sort of -- is it EBITDA less CapEx that's a target metric for the company? But generally, what is the capital expenditure budgeting process like and the outlook as well?

So first of all, capital expenditures at Cogent show up 2 places on our cash flow statement. We want to be totally transparent about that. It is both CapEx, which is traditional capital as well as the principal payments on capital leases. That number has been declining, both as a relative percentage of revenue and in absolute terms for the past several years. It was $57 million in 2019, and it will be a similar number in 2020. As we think, going forward, that number should continue to decline modestly. Our expenditures are really for 3 different purposes: one, to expand the footprint to new markets. Today, we operate in 47 countries, 208 markets around the world, and we do buy fiber to serve those new markets. We talked about, on the last earnings call, buying some fiber to connect, for example, São Paulo to Rio, terrestrially in Brazil or fiber to go deeper into Mexico to more secondary markets. We do that on a kind of risk return analysis basis. We look at the total depth of the market, the cost of the infrastructure and our expected paybacks. The second place we spend fiber is to expand our network in the markets we're in. That could be additional metro fiber or adding buildings, whether it be data centers or multi-tenant office buildings in North America. And the third place we spend capital is the maintenance of the network, equipment that wears out. And as Sean says, we have a program to be very thoughtful about getting as much economic life out of equipment as possible. We constantly take equipment from the densest parts of the network and move it into more peripheral parts of the network. That maintenance number is pretty consistent at about $35 million a year and that includes adding capacity to existing network segments. And the way we can do that is the technology is continuing to improve rapidly with wave division multiplexing, improving at about an 80% per year price performance curve and optically interface routing improving at about 40% per year. So I think what investors should think about is our multiyear guidance, 10% top line growth. That's in a non-COVID environment, but that's a very reasonable growth rate that's in line with our 15-year historical average. The second thing being about 200 basis points a year of margin expansion. I mentioned 150 basis points we did during the pandemic with lower revenue growth. But on average, Cogent has averaged 210 basis points a year of margin expansion. And third, this moderating capital intensity, which results in cash flow growth of about 20% per year. And as Sean said, our goal is to use our balance sheet prudently to return capital to equity and only use leverage when appropriate, and we are in a low interest-rate environment. We have a very durable revenue stream that's been proven throughout the pandemic, throughout the great financial crisis, throughout dot-com meltdown. Cogent slipped through 3 crises and had consistent growth and low churn. And finally, we have a product that's increasingly important to our customers. So we continue to grow when most other companies in our sector have negative top line growth. And it's been around the discipline that Sean mentioned, a product and focus. So we feel pretty comfortable that having that kind of roughly 3x net leverage and 5x gross leverage is very prudent, knowing the predictability and durability of our business.

Okay. Great. So we're actually getting closer to running out of time, but I do want to throw 2 more questions in. So one, in terms of geographic expansion, are there particular areas of the world where you would still like to expand or go deeper into?

So 2 very different questions. Let's start with our multi-tenant footprint in the U.S. and Canada. We are pretty well complete with that expansion. We'll add probably 50, 60 office buildings a year as new skyscrapers get built, probably that's going to slow down a little bit because of the pandemic. Historically, North America has added about 60 skyscrapers a year to its inventory. We've actually seen a acceleration of data center builds, and we're adding close to 80 data centers this year and probably going to continue to add carrier-neutral data centers, as there is this proliferation of those facilities. Now to the physical reach, Cogent is in 47 out of 200 countries. We look at 3 things. We look at the aggregate demand in a country. We look at the ability to leverage existing infrastructure through the purchase of dark fiber. And finally, we look at the regulatory environment. We tried for nearly 8 years to go to Russia and gave up because we were convinced we could not enter the market without violating The Foreign Corrupt Practices Act. We're evaluating other markets in Africa, in Latin America and deeper into Asia Pac. But we do need a regulatory regime that supports an open internet. For example, we serve Hong Kong, but do not serve Mainland China. We are actually the primary upstream provider of the 3 incumbent operators in China. China Mobile, China Unicom and China Telecom, all buy upstream from Cogent. But we ourselves do not go into China because of the Chinese regulatory environment. India is somewhere in between Russia and China, it's a market that we're evaluating. We're evaluating some other middle eastern markets. When Cogent was founded 20 years ago, 85% of the internet originated or terminated in the U.S. Today, the U.S. is down to 33% of global Internet traffic. And at some point, it will be down to 4.5% because we're only 4.5% of the world's population. You have one more, Ana?

Yes, I do. So the final one. So really, Cogent was built to consolidation, but then you really haven't engaged in any material M&A for a long time, I think. Is that still the case? Or is there the potential for additional acquisitions, and why or why not?

So it's not for lack of looking. Between 2001 and 2004, we looked at 121 targets. We bid on 19 and bought 13 companies that we dismantled and took the assets to build Cogent. That was a means to an end to execute our business model with less capital than building organically. Since then, we have looked at nearly 800 incremental acquisition opportunities and have not done a single deal. And the reason has changed. We don't need physical assets, we need operating businesses that generate returns above our cost of capital. And this may be the scariest fact for investors. And looking at those 800 acquisitions, we have not identified a single target that would generate a 6% risk-adjusted return on capital. That's a pretty low hurdle rate, and it's driven by the fact that capital is inexpensive today. And even with that relatively inexpensive capital, we have not found targets to buy. So we're going to continue to look. But today, pretty much everything that we've looked at will not generate a return greater than our cost of capital. So our job is not to destroy value, it's to create value for our equity. And that's why when Sean said part of what attracted him to Cogent was our disciplined approach, it's not emotional, it's very empirical. Now I've had the good fortune to know Sean for nearly 25 years. He started by banking one of my previous companies, and he was much further along his career in, was managing companies and businesses much larger than Cogent. And I was fortunate to be able to convince him to come here and give us a hand. So capital allocations, one of the two most important things a management team can focus on. The other is running the business day-to-day efficiently. And we take both of those missions very seriously.

Okay. Well, we are really out of time now. We ran a little bit over, but it was worth it, as always. It's always a pleasure, Dave, to speak with you. We appreciate your time and for supporting this conference. Sean, welcome. And I hope to see you both next year in Boca Raton in Florida. And all the best to you and to Cogent in 2021.

Thanks a lot Ana.

Thank you, Ana.

We hope to see you in Boca as well, it's much warmer than it is here indeed. Take care.

Okay. Thank you, guys. Bye-bye.

Thanks. Bye-bye.