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

Welcome, everyone. I'm Ana Goshko from Bank of America, and welcome to our 2021 still virtual Leveraged Finance Conference. I'm thrilled to have Cogent with us and Dave Schaeffer, the company's CEO, Founder and many other illustrious titles as well. Apologies for a little bit of a late start here, but we're just getting ourselves organized. But without further ado, I'm going to turn it over to Dave. Thank you again so much for joining us this year. Any kind of opening comments before we kind of dive into our Q&A this morning?

Yes. So first of all, thank you for hosting us, and I apologize for technical difficulties for the investors. I'll try to get all of Ana's questions answered. Just thank the Bank of America for a great venue and all the investors for their time as they've taken time out of their busy day to hear a little bit about Cogent. With that, let's maybe just jump into your questions, Ana.

Okay. Well, great. Thank you so much. So I think that current environment, the pandemic and the back-to-office environment is -- has really been impacting your business. And I think that's really sort of top of mind for everyone. So let's jump into that topic to begin with. So you've cited pandemic-related headwinds to corporate demand that did result in negative growth. And then likewise, I think we all -- have all seen slow back-to-office momentum certainly in some of the bigger metropolitan markets. So both of these factors -- have both of these resulted in lower new sales and/or higher churn for you?

So the answer is actually yes to both. The pandemic has caused our corporate business to have 6 consecutive quarters of negative growth. To remind investors, over the past 16.5 years, as a public company, our corporate business has grown at an average of just under 11% year-over-year. We had 2 negative quarters of growth at the end of 2008 and beginning of 2009 with the financial crisis. The pandemic has been longer and deeper than that crisis. Many of our corporate customers have employees either working remotely or in a hybrid model and are still planning their return to office. If we look at office occupancy, we've seen roughly a tripling of vacancies in the buildings that we serve going from about 4% to 12% of the square footage. We have just under 1 billion square feet multi-tenant office space in the U.S. and Canada. Our corporate business is only in the U.S. and Canada. In that footprint, we've seen average number of employees entering the buildings range from anywhere from in the low-30% range in some cities such as New York and San Francisco to the mid-60s in cities such as Houston, Dallas and Miami. We are seeing most of our customers begin to have a clear vision of what their new work environment is going to look like. They are planning for employees to return to the office, either on a full-time or a hybrid basis. Many of those companies had initially hoped to get people back into the office in [ Labor Day ]. With the Delta variant, they pushed those clients out. I think with additional variants, those plans still remain uncertain, but we are seeing an increased level of activity from corporate customers planning their new office environment. In our corporate market segment, we sell 2 basic products to our customers: dedicated Internet access, which actually accounts for about 81% of revenues; and virtual private network services. Most of our customers actually increased the size of their Internet connection at their primary location. What they have done though is paired some secondary locations that may not reopen. And then the office to office connectivity or VPN services have really been the portion of our business that has been the most negatively impacted. As companies plan for their new work environment, we are seeing an increased volume of quotes and installs now beginning on VPNs. So our corporate growth rate has [indiscernible] at about a negative 2.5% sequentially, and it has been improving each of the past 3 quarters, and we expect that trend to continue. We're probably still a couple of quarters away from positive corporate growth.

Okay. That's all very helpful. So if we do evolve into a new normal with a distributed workforce working from home rather than in main and branch offices, what does that mean for network architectures and ultimately, your corporate demand? Is there more kind of a headwind on a prolonged basis potentially to come? Or is there a silver lining as -- up for you as companies design the potentially new network architectures?

Yes. So as companies decide how many days a week employees are going to be in the office and 3 things are happening with their office layout. One, they're generally shrinking those floor plates. That is actually a positive for us. We serve slightly over 1,800 skyscrapers in North America. In those buildings, there's approximately 550,000 square feet and pre-pandemic, there were 51 tenants. If each tenant shrinks it's floor plate, we would see the total number of tenants actually go up. That is a positive for Cogent. We sell our services to corporate customers on a flat, unmetered basis. So more tenants would actually improve our addressable market. Secondly, we have seen our corporate customers take advantage of lower rental rates, more tenant concessions and actually begin to extend leases. In the past, when there had been a downturn in commercial real estate, our market segments tended to be the most immune because the landlords had the flexibility to increase tenant concessions and lower rents and maintain much higher occupancy rates. In fact, we're seeing that in this downturn as well, where the vacancy rate in our footprint is about 40% below the national average. The second thing is, I think most companies are expecting to have employees in the office, at least some of the time, to collaborate and ideate among themselves. I think that's going to lead to more meeting rooms, and it's going to lead to the continuation of doored offices but probably on a more shared basis as opposed to dedicated to one individual all week all. And then I think the third thing that is changing is the way in which VPNs for remote workers are concentrated. The most midsized and smaller companies do that VPN concentration through their firewall. Large organizations such as Bank of America would have that function located in a carrier-neutral data center. I think with a permanent hybrid work environment, we'll see a large number of our corporate customers elect to move that VPN concentration function to a more hardened environment. That actually is an incremental opportunity for Cogent to sell a service that it previously had not sold, an internet port in a data center to that corporate customer. And then in terms of remote offices, those offices, I think, fall into 2 different categories. Those offices that are located in the same metropolitan area will typically be consolidated. And that intra market VPN service will probably not be a major product going forward. However, for inter market VPNs, i.e., locations in remote setting, so I'll use again a Bank of America with headquarters, maybe in New York and Charlotte, but then major work presences in L.A. and San Francisco, in Texas or Miami, they would still have those remote locations and still need an inter-office VPN for that. So I think long term, the impact of a hybrid work environment will be [ meaningful ] or slightly positive to our business.

Okay. Thanks. Well, that's super interesting. And there's a lot that's to be seen yet. So thank you for that. So switching to NetCentric. NetCentric demand, it really did benefit from the pandemic, but what's the outlook now? Are you seeing signs of demand growth slowing after the surge?

So first of all, I wish I could say I was so smart that when I wrote the Cogent business plan 22 years ago, I was going to have these 2 business segments that hedge each other in times of [ pandemic ]. This is just some luck that it ended up working out this way. But our NetCentric business has actually surged through the pandemic, and we've delivered the 2 best quarters in the company's history in terms of year-over-year growth in the NetCentric business over the last 2 quarters. There are really 4 things going on concurrently. One, an increase in bit volume driven by streaming. 2, a broadening of the streaming providers' markets. So therefore, more of those bits are coming internationally and they're coming from more different streaming providers instead of one or 2 very concentrated provides. We have benefited by being able to get paid on both sides because of the ubiquity of Cogent's network and over 1,350 carrier-neutral data centers in 50 countries and a direct connectivity to over 7,600 networks around the world, we have the greatest footprint and the highest level of connectivity, allowing us to get a much larger percentage of our traffic where we're getting effectively double [ confidence on ] increasing the effective yield per bit. And the fourth and final factor is prices on a nominal basis are going to continue to decline. The technology that drives price per bit reduction, that is wave division multiplexing, optical transport and optically interfaced routing are still on price decline curve similar to historic trends. So over the next decade, we expect the average price per bit to fall at about the same rate it has historically, 23% per year. Packaging these 4 factors together, we've been able to deliver better growth rates. Our long-term growth rate in our NetCentric business is about 9% year-over-year, not the 30% that we delivered last quarter. I think we should expect that growth rate to bridge forth to more historical norms, and over the next year or 2, go from its abnormal growth rate today to something more normalized in that 9% to 10%.

Okay. Thank you for that. So switching to salesforce. So salesforce is one of the key engines of Cogent. And I think during the height of the pandemic, you did comment on kind of a lag in productivity as that salesforce initially had to do work from home. So, one, wanted to see if you've gotten productivity back to where you want it. And then let me set you up for the follow-on questions, 2, with current labor shortages, are you having trouble attracting and retaining salesforce?

So I'll take them in the order on what you asked. To protect our workforce, we quickly pivoted to remote work in March of 2020. In October of '21, in the U.S., we have returned to the office. We have some limited voluntary returns in Canada, Europe. But in Asia, we're still working remotely. We needed to quickly adapt all of our systems [indiscernible]. We successfully did that. Going into the pandemic, we had about a 5.7% per month churn rate [ for sales percentage and are historical average ] going into the pandemic. So even if things remain as they were pre-pandemic, we need to continue [indiscernible]. We are at about 600 direct quota-bearing employee. Different than most telecom companies, over [ 99% ] of our revenues are from our direct salesforce and only 1% from channel or [indiscernible] partners. That's very different than the industry average, which is sharing between 30% and 40% of sales coming from third party. So we relied heavily on an outbound telesales model, and we needed to recruit. We quickly ramped up our training and onboarding, and we're doing a pretty good job and we [ increased ] headcount. But we saw productivity decline and the reason for that decline was [indiscernible] while being trained adequately, not getting the mentorship and drive that they would get in an office environment. We saw our productivity numbers decline, and our salesforce turnover rate increase. As we have returned to the office, we have seen a decline in our turnover rate and an increase in our sales retention productivity numbers. So we are encouraged. Now to the second part of your question in terms of labor market. We have continued to have ample supply of candidates. Our base compensation is $80,000 per year for an entry-level salesperson. Typical candidate will have a college fee, soft major and probably about a 2.7, 2.8 grade point average [indiscernible]. An $80,000 office job for someone with that profile is pretty desirable. The challenge is getting those people productive. And we do know that in an office environment, if we have a manager and a trainer on site with those reps, their productivity [ climbs ]. So we've seen our productivity bottom and improve over the last several quarters, and we expect our salesforce productivity to continue to improve. We also believe that we will see a reduction in our salesforce turnover. A number of that is critically short on today is that, of the sales people that were hired or most of those from April of 2020 till today, 69.5% of those individuals [ no longer with ] the company, meaning they never got to productivity levels necessarily. So we think by getting people back into an office at Cogent, we have 40 offices globally where there are 70 sales [indiscernible] manager and typically where teams share a learning manager designed as a full-time framework. This model has allowed us to develop rapidly and have the lowest cost of revenue acquisition.

Okay. Thank you for that. I also wanted to ask you about competition. Could you talk about what you're seeing now in the competitive environment for both Corporate and NetCentric? And in particular, I know that you recently talked about a dedicated team for the NetCentric business to kind of head off some churn there, which is sort of surprising because you would think that the NetCentric business is kind of so critical to your customers that there would be somewhat of a natural kind of barrier to exit there.

Yes. So we always divided our salesforce between Corporate and NetCentric. The usage patterns by practices for each customer segment are very different. And our Corporate salesforce, they are focused on either very small companies [ such as entry-level ] position focuses on businesses with 3 or less locations or senior corporate position focuses on businesses that have more colocations and are [ likely to provide ] VPN services along with an Internet connectivity path. In the NetCentric salesforce, there are 2 groups. There are salespeople for [indiscernible] globally for either access networks or content generators. And then we have a smaller team that focuses on our 500 charges and accounts. In our each of these segments, we have different compensation packages and different incentives. The majority of our salesforce product is actually on the corporate side because sales tend to be less technical and the customers don't have as prolonged of a pattern of additional business. On the NetCentric side, we do have some churn, that churn is typically from businesses going out of this being purged. On the access side, our business is very stable. Once we develop a relationship, we generally maintain that relationship. And our goal is to constantly increase the percentage of business that present of those customers. However, our NetCentric customers anticipate a 23% per year price reduction, and they also anticipate, as their volumes grow, getting the volume threshold price discount. So we do have a team that helps those customers in those situations to reach to the next year, perhaps ship percentage of traffic that they send to Cogent. Cogent has consistently grown its NetCentric business faster than the market in large part because of our pricing volume. Just again to remind investors, the NetCentric business is a meter business sold on a usage basis, and Cogent under-budgets competitors by 50%. It's that progressive pricing that has allowed us to become the second largest supplier. In terms of competition on the Corporate side, it's typically some company and it's a more suburban [indiscernible] basis. On the NetCentric side, we have seen a continued decrease in competitive pressure as [indiscernible] the largest players, [ particularly deemphasize ] this product. [ Helio Swedish ] incumbent, third largest player in the market has sold business and NTT has [ deemphasized ] the segment as well. So I think part of Cogent's outperformance on the second side has been our gain in market share from [indiscernible].

Okay. I hate to say it Dave, but we're actually already out of time. It's always so fascinating to hear about your insights into both Cogent business and the industry. So thank you so much for being with us. I know that investors also had the chance to meet with your management team today during the one-on-one meeting. So we really appreciate that. So thank you so much for being with us. And next year, we are already committed to being back in Florida for this conference. So I'm already extending the invitation to you now, and hopefully, we'll expect to see you in Florida next year.

Absolutely. Looking forward to being back in person. Take care and stay safe everyone.

Okay. Thank you.