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

Good afternoon, and welcome back to Citi's AppsEconomy Conference. For those of you I haven't had an opportunity to meet yet, I'm Mike Rollins, and I cover the communications services and infrastructure stocks for Citi. Just a few housekeeping items. Before we get started, I'd like to mention that we have disclosures available to the right of the video player as well as under the Disclosures tab for Citi if you're viewing this via Velocity. And also, if you're joining us today and would like to ask a question during our session, you can enter your question into the question box that will come to us, and we'll work to get that integrated into the discussion. So with those housekeeping details out of the way, I'd like to welcome back Cogent's CEO, Dave Schaeffer; and CFO, Sean Wallace, to our conference. Thank you for joining today.

Hey, Mike, thanks for hosting us always. Thanks, Citi, for a great venue. I wish I could be face to face with investors, but hopefully, this virtual form will be effective today. And with that, Mike, I'm here to answer any questions you or the investors have.

Great. Well, thanks. As tradition for this conference day, we'd like to start off just learning about your strategic and operating priorities for the coming year. So we'll start with that and then dig in from there.

Sure. So I am a person that kind of limits my all staff e-mails to the Cogent team. I actually would do one a year for the past 22 years on New Year's Eve, laying out goals for the next year, and this year was no exception. And our goals are to increase our sales force size, increase the efficiency of our sales force and to increase our footprint, both in multi-tenant office buildings and carrier-neutral hotels. We have some very specific quantifiable goals for the team, and I'm a strong believer that the team can't achieve maximum results without having a clear objective in front of them. Now clearly, all of this has been clouded and turned on end by COVID. The pandemic has lasted longer, has been more severe, and the path out of the pandemic has been lumpier than we expected. We're nearly 20 months into the pandemic, and if you had asked me back in March of 2020, we would definitely not be in this place today. We sent our workforce home the week of Christmas, going back to a remote work environment. Clearly, the Omicron variant and the level of contagion has increased materially. We do have a mandatory vaccine and booster policy for our team. But first and foremost, we place the health and safety of our workforce at the forefront. Now one exception we've made is for our newest hires. One of the lessons we've learned from 20 months of the pandemic is that new hires do need in-person training. So for those employees that have less than 1 year of tenure in the sales organization, they are still required to come into a physical office and participate in face-to-face training and additional online training. But our goals for the year are clearly to move beyond the pandemic, to resume our historic corporate growth rate and continue to see if our NetCentric growth can perform at historically high levels.

Great. Maybe just starting with the corporate side and what you were describing, anything new that you learn? You said you sent a lot of your people home. What are you seeing from the buildings that you serve in terms of the employee basis? And has decision-making slowed down once again? Or do you still see a recovering path for decision-making and sales opportunities in your corporate buildings?

Yes. So we have a corporate on-net footprint of just under 1 billion square feet of office space. That is concentrated in large, multi-tenant office buildings in the centers of major cities. We have the highest concentration in the Northeast, Chicago, Toronto and the Bay Area. Those markets have been the most impacted by COVID and have had the lowest occupancy rates in their buildings. In the South and in the Southwest, we have not seen the same kind of degradation. So as we look at our footprint, we see that most of the loss in customers is concentrated in between 300 and 400 buildings in those markets. We believe that we troughed and are through the worst of it. Our corporate growth rate, which has historically been roughly 2.4% sequentially for the past 20 years, had a brief downturn during the great recession in '08 and '09, but that downturn lasted only 2 quarters. The downturn of the pandemic has now lasted 6 quarters. The good news for us is that the past 3 quarters, we've seen the negative growth rate gets smaller each of those quarters. I think we are still a quarter or 2 away from returning to positive growth in the corporate business. In talking to our sales force and to customers, I think we're sensing from customers a level of fatigue. Their managements have told the IT departments to hurry up, get back to the office to be ready for a new hybrid work environment only to then see those plans be pushed out again. I think there are 3 major changes to corporate architectures that the pandemic has initiated. The first is larger connections at the primary location, a realization that high-speed, symmetric Internet connectivity is critical for a hybrid work environment. Secondly, I think companies have groomed their footprint, deciding which locations are no longer seminal to the organization and which locations will be needed for remote offices in the future even if some employees are working from home. And the third change is many companies have taken the lead from large companies like Citi or JPMorgan that had historically done their dynamic ad hoc VPN concentration in the data center, and we're seeing a real uptick in corporate companies taking a small footprint in a data center as an on-ramp to their corporate networks. That presents Cogent an additional, new corporate port opportunity with those customers. So I think as customers return to their offices, we've seen vacancy rates in cities such as New York over double during the pandemic, going from about 6% in New York City to about almost 17%. D.C. has gone from 8% to 17%, the highest in the city [indiscernible]. San Francisco is nearly 30%. So I think as employees start to get comfortable in returning to office, we'll see those vacancy rates go down. That presents an additional new opportunity for Cogent because Cogent is most likely to win those customers when a new decision needs to be made. And since 20% to 30% of the office space will be making a new Internet decision, that bodes very well for our corporate growth rate reaccelerating and perhaps even passing the historical average for a period of time until we settle down into kind of a new norm.

In some of the markets that weren't as hit -- as difficult as in the Northeast as you were giving examples of, are you actually seeing that rebound, where maybe some vacancies picked up and you saw that kind of rubber band snap back and the sales have gotten substantially better for Cogent?

We actually never saw the level of the trough as severe in those Southern markets. So while sales did slow somewhat, they did not ever go negative in those Southern markets, and now they're kind of continuing at historical levels. But because our footprint is concentrated in very large buildings, the average building on the Cogent network is about 550,000 square feet, I think most of those buildings are in the footprint that has been hit the hardest, and that's why our company-wide growth rate has turned negative for corporate growth.

And in terms of the ARPU, you talked over the last year about how customers are adopting, and you mentioned earlier bigger connections going to 1 gig. Is that still an opportunity that's driving up ARPU for your customers? And while maybe volume isn't as good right now, you're still seeing the benefits of a higher ARPU.

So the answer is yes. Virtually, all new customers are taking 1 gigabit connections, and one of the goals that I laid out this year was to increase the availability of 10 gigabit connections in our corporate footprint to about 40% of the footprint. That does require some upgrades to our metro transport rings and in-building routers. Those routers are in a normal equipment refresh cycle. So I think we will continue to see ARPU uplift in corporate on-net from the high propensity of 1 gig sales and the, I think, new customer realization that the incremental differential for 10 gigabit corporate on-net connection, if available, is probably worth it. So all in all, I think corporate on-net ARPUs are set to be stable to up going forward.

You mentioned earlier that one of the priorities for this year was to continue to increase the footprint, so the corporate buildings that you serve, the carrier hotels or neutral data centers that you serve. You take that perspective or objective with what you were talking about in terms of the equipment refresh to enable 10 gig. Should investors expect something different on the CapEx line for Cogent?

No. Our CapEx efficiency should continue historically as it has been. As a percentage of revenue, it's consistently come down. In absolute terms, it's been relatively flat. Probably the biggest challenge for us on CapEx has been supplier availability of equipment. Normally, we would buy equipment with 30-day delivery terms. Now we're placing orders 6 to 9 months out with equipment sometimes coming in at 30 days, sometimes coming in, in 12 months. So our vendors have experienced significant chip shortages. And on certain equipment, they've been unable to predict exact delivery gains. That has caused us to have CapEx be more volatile than we normally have it. It was up slightly in the third quarter and probably will be above fourth quarter norms, but not because of the footprint expansion. As we look at our footprint expansion, our multi-tenant office building expansion will continue to be muted at 2.5% to 3% of the footprint, 25 million to 30 million square feet. Since Cogent is really already in virtually all of the buildings, that makes sense. There are some new large buildings coming online. There are a few stragglers that we're adding, but I don't see an acceleration in our corporate on-net footprint growth rate. In our data center footprint growth rate, we, for the last couple of years, have been averaging about 100 carrier-neutral data centers a year. We have over 1,350 on-net. And as we look at the construction pipeline from our existing carrier-neutral relationships and new relationships, we think that number for '22 will be somewhere between 100 and 125, which will be at that continued elevated rate. The occupancy rate in many of these carrier-neutrals is declining. But it is, I think, Cogent's priority to be able to serve the widest carrier-neutral footprint of any provider in the world. It's why we have the largest footprint today as measured by third parties, over 400 more data centers on-net than any other provider. And we have more networks directly connected to us, approximately 7,500, than any other provider by at least several thousand. So I think our strategy of being available at the core of the Internet globally has allowed Cogent's NetCentric business to grow at these unprecedented rates. And as I mentioned earlier, with the need of many corporates to move that work-from-home VPN concentration into the data center, I think having this big data center footprint will allow Cogent's corporate growth rate to also have higher-than-historical average growth rates.

And so as we -- moving to the corporate -- sorry, the NetCentric segment, off of your comments there, Dave, does that competitive position that you outlined give you a reinvigorated opportunity to become the #1 share firm in that Internet transit NetCentric arena? I think in the past, you referred to yourself, I think, as the #2 player.

Yes. And I believe our market share is rising. Clearly, we would like to be #1. We have benefited from the fact that well over 70% of our traffic stays on-net. That means 7 of 10, 7.5 out of 10 bps, go from a Cogent customer to a Cogent customer. While the ultimate goal would be 100% of the Internet, that's not realistic because then Cogent would be the entire Internet, and I do think diversity makes sense from most customers. But our market share gain is continuing. Lumen has been the largest player, primarily through multiple acquisitions. They have deemphasize transit as a product. We do not see them as a significant competitor in the market, and they are losing market share. The #3 player in the market, Telia, recently went through a divestiture from the parent company. There's been a lot of turnover in their organization, and they are also migrating away from transit. So with that, we think Cogent's market share will continue to increase. And I sincerely hope by the time we're talking next year, I could report that we're #1 in the market.

In this segment, you've had outsized growth over the past year. I think if my memory serves correct, it's been in the low 20s percent year-over-year over the last 9 months. And curious what you're seeing in terms of how sustainable that elevated growth could be for Cogent. And maybe an update in terms of whether it's the internationalization, whether it's the -- just acceleration of video, what you're seeing in terms of the drivers.

So as I think about our NetCentric business, it has always been a lumpy business with an average year-over-year growth rate of about 9%. The last 3 quarters at about 20% growth is the best 3-quarter growth string that we have had. There are really, I think, 3 drivers that drive that revenue growth. First is traffic growth. Second is the location of that traffic. And the third is, is that traffic going to be 2-sided or 1-side? The one thing that I did not mention specifically is the rate of decline in pricing. While I know there's been a lot of talk in all industries around inflation, technology is inherently deflationary. The Internet has been able to lower the price per bit at about 23% per year for the past 20 years. We have followed that same price decline curve, yet our margins have expanded while our competitors' margins have contracted because the architecture and platform that we have used is far more efficient than that of our competitors. So as I look forward, I think Cogent will continue to drive down that 23% price decline curve. Pricing its service is generally at a 50% discount to our competitors, gaining market share and delivering outsized growth. While we may have several more quarters of this extraordinary growth driven in large part by the acceleration in streaming because of the pandemic, over the long term, we think the NetCentric growth rate at about 9% is the right thing for the company to anticipate and investors to model. In the short term, we may do better than that simply because we're getting a disproportion of share. More of that share is international, and more of that is 2-sided traffic. And our customer mix has skewed more towards midsized customers rather than all growth coming from the very largest customers.

Earlier, you were talking about the sales force, the importance of hiring and having that in-person training and development. The last quarter, you were talking about some of that churn you experienced in the sales force. Where are you in that process of stabilizing and growing the sales force? And has that elevated turnover impacted your ability to execute on fourth quarter sales?

So first of all, our model has historically had high sales force turnover. Before the pandemic, we were averaging about 5.7% of the sales force turning to over a month. When we went to remote, our turnover rate actually declined. It declined because it was harder for our managers to effectively manage and terminate underperforming reps. When we returned to the office, we implemented a mandatory vaccine policy coupled with mandatory return to office. Some employees did not agree with one or both of those programs. Secondly, we were able to identify the deficiencies in some of those moderately tenured reps and managed them out. Our turnover rate rose to 8.7%. So an over 50% increase from an already elevated level. I think our sales force turnover rate is going to come down because of the in-person training that we've put in place. Omicron has been a challenge because while on one hand, we want to keep our employees safe and allow them to work remotely in a highly infectious environment, we also have to balance that with the experience of low success rates with remote workers. This is a delicate balancing act. I think our sales force will grow. Our sales force productivity will increase. I think when we look at the fourth quarter, investors should expect trends very similar to that which they saw in the third quarter. And I do feel that the NetCentric business is continuing to outperform. The corporate business is underperforming averages but at a less traumatic rate, and our sales force turnover is declining as we have learned on how to manage and train those employees in a hybrid environment.

And Dave, a question I've asked you in the past is when you've gotten into situations where revenue has been a little more uncertain, you've taken some opportunity to be a little more creative with the products but to a very limited degree. So a bunch of years back, you did a little bit more in data center. Recently, coincidently or not with the timing of the pandemic, you have a platform, an exchange platform that you've been creating for peering or interconnection in your own footprint and for your own geographic reach. Can you talk a little bit about how you're thinking about trying to leverage your footprint of all of these dense corporate buildings and carrier hotel data centers and if we're going to look at that differently in the future in terms of the opportunities to introduce new products or new services?

So I take a fairly simplistic view of the business when I talk to the Board, and I say we have this great asset. Our job is to maximize revenue out of this asset. I am not religious about products, services or technologies. I want to sell customers what they want on our footprint that will allow us to generate free cash flow from the sales. We have really expanded our transit portfolio in 3 distinct tranches. We added VPN services back in 2006. Those remained relatively muted until 2014 when we were able to migrate from rapid spanning tree to a VPLS platform and have risen to be about 16% of revenue. Secondly, we have a number of data centers that are co-resident with our sales offices and the hubs of our network. They tend to be relatively small, 54 data centers, about 600,000 square feet of race for space and about 70 megawatts of power. All of these data centers were taken over from failed operators. We did not construct any ourselves. We derive a little over 3% of our revenue from space and power sales in our data centers, and we offer both our NetCentric and corporate customers a lower cost, easy on-ramp to the Cogent network. The third and final expansion was the establishment just about a year ago of an exchange platform, allowing companies to not use transit but to exchange IP traffic over our global footprint without a fixed commitment. That's a materially superior method of exchange when compared to the point exchanges like DE-CIX, AMS-IX or LINX. It's often compared to some of the private exchange footprint. But our reach is more ubiquitous, lower cost. We have seen traffic materially increase on that. It is still de minimis relative to our transit traffic and revenue. Roughly 81% of Cogent's revenues still come from selling Internet access. And the reason we have been so focused on the Internet, it is where our competitive advantage lies. It is where the customer demand is. If you look at the marketplace of failed Internet providers and telecom providers, they all thought the inevitable trend of everything moving to the Internet. The Internet is more ubiquitous, lower cost, easier to use and more application-rich than any other platform. So I think where we sit today, Cogent's future still lies with the Internet, but the supplemental products will help us drive incremental revenue on our network even though they place a de minimis load on the network. I feel very good about the footprint we have, the products that we have and the addressable market. What I don't feel good about is our corporate customers' uncertainty around when and how they're going to return to work. And in talking to these IT departments, I've come away with the understanding that they're just fatigued. They hurry up, deploy an architecture, get ready for back to office only to see it delayed again, and that's very frustrating for these companies.

One of the points you've made before is the breadth of vendors that you have from which you're leasing network elements to create the global Cogent experience. But within that diversity of vendors, are there any critical connections or elements that you have to manage through over the next few years and just given the consolidation that's taken place in the category?

So we have over 285 diverse vendors. Our largest vendor by mileage is Lumen, but we have 9 years remaining on that agreement at no charge, and then we have negotiating rights going forward to extend. In every one of the links, there are alternatives. In fact, in some cases, we have activated alternate links because they were more optimal in terms of quality of fiber and the latency of the given route. I think we have no particular concerns of any vendor. Probably largest number of product orders is Zayo, lot of small segments and metro markets. But they account for only a few percent of our total mileage, and those agreements run for another 18 or 19 years under fixed terms. In almost every instance, we have alternate solutions. We are in a golden age of fiber availability. Even incumbent companies such as AT&T and Verizon are now considering selling dark fiber, which would have been unthinkable earlier on as they are deploying capital to meet their 5G backhaul requirements. We have seen 3 major catalysts to fiber deployment, one being overbuilding in metro markets to compete with cable, the Ziplys, the consolidators of the world, the Brightspeeds that will be coming out of Lumen. All of those overbuilders make dark fiber available. The second catalyst has been the cellular backhaul builders, those companies that justify their capital deployment solely on providing backhaul with significant surplus fiber. Crown Castle would be a great example in that market, Zayo to a lesser extent. And then third, there are a number of smaller business-centric overbuilders that have emerged as well, the Unitis and Windstreams of the world. The Segra was in the smaller regional players, FiberLight here in the U.S. and dozens of these providers across Europe and even in Asia. So I feel very comfortable that there is ample fiber available. Costs will actually come down due to the competitive nature of multiple providers being available in almost all footprints. And with advances in wave division multiplexing, we have shown that with a very thin footprint, we can carry virtually all of the world's Internet traffic.

So one question on capital allocation. So as you look out over time and you look at the trajectory that the dividend has been on, does the eventual migration to be a cash taxpayer change the slope of that line for Cogent? And where are you on that journey in terms of tax efficiency?

So we have been, I think, an efficient allocator of capital, returning over $1 billion to our shareholders, roughly $230 million through a buyback program that shrunk the float by about 20% and about $670 million through a consistently growing dividend that's grown for 37 consecutive quarters sequentially. Our dividend growth rate today is about 13%. It is well aligned with the growth in our cash flow. As we think about our tax policy, we have constantly looked at our non-U.S., non-expiring tax assets and have tried to use those more efficiently. While I don't think Cogent will be a 0 cash taxpayer, I do believe that Cogent will be paying taxes at a substantially lower rate than the 21% corporate rate because of our ability to utilize those international NOLs, no taxes in those regions and relatively low FDII or GILTI taxes in the U.S. With nearly $1 billion of non-expiring NOLs, we think we have a very long runway to being a low taxpayer. While we have considered alternate corporate structures such as [indiscernible], we think that we should utilize our existing NOLs before taking any more aggressive tax strategy.

And going back to the question of just capital allocation and dividends versus buybacks, and you've kept a significant cash balance now for quite some time on the balance sheet, any thoughts on how to maybe use that balance more efficiently? Or do you find it serves the company well to keep a larger cash balance just for whatever could come up in the future?

So while I give myself a good grade in allocating capital for the company, I give myself a poor grade in being a macro market commentator. I would have expected major market dislocations that would have allowed us to disgorge that cash quickly through a very effective buyback program. While markets have increased volatility, they continue to trade at historical levels, whether it be the NASDAQ, S&P or Dow, all at all-time highs within a couple of percent of those all-time highs. That's just not an optimal environment to be using a buyback strategy. We think the dividend program is appropriate and is methodical. The cash balances are meant for those opportunistic periods to buy back stock. While I can't predict when a correction will come, I am absolutely confident that at some point it will. And the negative carry of weighting, i.e., carrying that cash balance with a relatively low cost of debt, has been fairly benign. Now again, I have 2 assets to optimize. One is the network. The other is the balance sheet of the company. The balance sheet of the company is strengthened by the underlying growth trajectory and operating leverage in the business. That's why I think we are in such an envious position when compared to virtually any other company in the telecom sector. And maybe I've been too patient in that allocation of excess capital, but it is the goal to eventually reduce those cash balances and get the share count to efficiently use those cash balances by concentrating future earnings.

Are you ready for a rapid fire 3 questions within 3 minutes?

Boy, as long-winded as I am, Mike, 3 minutes is tough for one question. But I'll try to get them. I'll be like Joe Biden, maybe a one-word answer.

All right. First question, why should investors buy your equity?

The DCF per share is dramatically undervalued.

Second question, is inflation a net opportunity, net neutral or net risk for your business model and financial performance?

Probably a net neutral. We operate in a deflationary sector. That sector will continue to be deflationary going forward. So even if there is general inflation, the price of Internet services are coming down.

Okay. And then third question is given that this is the AppsEconomy Conference now, what application can fundamentally change demand for connectivity and data consumption over the next few years? And at Cogent, you have particular insight into some of these trends.

So first of all, the Internet is as limited as the 5 million global users and their ability to publish applications. I have a great deal of faith in human ingenuity. I think we are on the cusp of moving into an augmented and virtual reality, use of the Internet. So the video experience will become much more immersive, much more interactive, not possible in a unicast broadcasting world but absolutely possible in a bidirectional Internet world. And as fiber gets deployed closer to end users, I think we will see the explosion of augmented reality and virtual reality. Whether it's metaverse or something else, it's yet to be determined. But I think the user interfaces will get better. Consumers will want it. They will spend more hours using it, and the bit consumption per unit of time will go up astronomically.

Dave, Sean, great to see you. Thank you for your time.

Hey, thanks, guys. Thanks, everyone, for staying late and hearing us.