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

So good morning, everyone. Thanks for attending our fireside with Cogent Communications. My name is [ Jatin Joshi ] and I'm the Deutsche Bank High-Yield Telco Analyst. To my pleasure to be hosting Dave Schaeffer. Welcome, Dave. Thank you. He's the CEO of the company. I think we all, in the room, know that. He's very present and in front of investors at all times, and we appreciate him coming to our conference here as well. So Dave, welcome.

Well, thank you, [ Jatin ], thanks Deutsche Bank for a great venue, and I'd like to thank all the investors for taking some time on our day to hear a little bit about Cogent.

Fantastic. So obviously, we're going to talk about the Sprint acquisition, that's the most topical thing for the company right now. But before we get there, let's maybe talk about the corporate side a little bit in the core business. You had said in the Q2 press release that you had started -- during Q2 started to see a little bit of improvement in vacancy, lower vacancies and higher occupancy, Midway through quarter 3 at this point, have you seen that sustained? Do you -- are you seeing that there could be some runway here? Or is there still uncertainty out there?

Q3 is over, and we're in Q4.

Sorry, in the middle of Q4 -- beginning of Q4.

So just to remind investors, within Cogent, there are a kind of 3 pieces. There's the classic Cogent corporate business, where we sell Internet access and VPN services and approximately 1 billion square feet of multi-tenant office space in the central business districts of major cities. That represented roughly 60% of classic Cogent revenues. We also sell -- wholesale bulk Internet connectivity in 51 countries and 1,600 carrier-neutral data centers around the world. [ Jatin ] is talking about our corporate core business. That business had consistently grown prior to the pandemic at about 11% a year for 15 years. Since the pandemic it has been experiencing negative year-over-year growth, and it is now finally positive. So at its trough, that business went to negative 9% year-over-year growth is back to positive 1%. We are continuing to see improvements and those improvements come in 3 dimensions. Maybe the most important is customers' willingness to make a decision. During the pandemic, many companies put their IT reconfigurations on hold. Now the companies are back to whatever the new normal is, they're much more willing to make those architectural reconfiguration and buy more bandwidth. The second thing that's been a positive for our business is throughout the pandemic, the need for higher bandwidth applications has continued to increase. Companies continue to put more applications in a remote or cloud environment. They support hybrid workers who need an ad-hoc VPN and virtually all of the software that a modern company uses is sold as a service as opposed to a perpetual license on prem. All of this is driving the need for more bandwidth per capital. And then the final trend has been in its no surprise to people who walk on the down streets, central business districts of city saw a exodus and are now seeing employees return, but that pace of return is not consistent across all geographies. We are seeing vacancy rates decline, occupancy rates increase customers making decisions for all those reasons, we're back at about positive 1% growth in Q2, and I expect that trend to continue going forward.

Okay. That's certainly encouraging. Can you kind of -- you're talking about the customer mix on the corporate side. Can you just run through that again for the audience. Are you more -- you're in large buildings, but the average profile of your corporate customer is more in the SMB.

Yes. So Cogent's typical corporate customer would generally have 3 locations. They will have about 30 employees at each location and be occupying about 8,000 to 10,000 square feet at that location. Now we typically start that relationship by selling their primary location and on-net service and then we sell off-net services in addition to on-net at additional locations. So within our corporate segment, 20% of the connections are off-net. That means we buy a local loop from a third party. It's a building that does not have enough demand to justify the capital for us to build into. 40% of our corporate revenues come from off-net services. those corporate customers typically buy about 3/4 of their purchases are Internet access, about 1/4 of their purchases are VPN services. Those businesses are located in 1,850 skyscrapers that average [ 41 ] stories in height, 550,000 square feet and would typically house about 51 tenants pre pandemic. What we have seen is the vacancy rate in that footprint roughly tripled, the number of tenants declined to about [ 40 ]. We are seeing that number increase now as companies come back, but the new tenants tend to take smaller floor plans. In the long run, that should be a positive for Cogent because the same 550,000-foot building with each tenant taking 20% less space, will give us an addressable market of nearly 60 as opposed to the 51 businesses we had pre pandemic. Now Cogent also sells to large enterprise customers. This is a result of the Sprint acquisition. Those large enterprise customers typically have hundreds of locations. The majority of those locations are off-net. 97% of the revenues that Sprint was -- excuse me, 93% of the revenue of Sprint [indiscernible] driving were off-net, only 7% on-net as opposed to Cogent, which is 75% on-net, 25% off-net. So one of the ways we're improving the profitability of those enterprise customers is migrating them from off-net to on-net.

And what percentage do you think of the current Sprint corporate base can move on that with reasonable CapEx?

We think we'll eventually be able to bring about half of that revenue on-net, and that's going to come in 2 locations. That's going to come from those customers that have offices and buildings that we're in for end use and for those customers buying services in data centers, Sprint was only connected to 24 carrier-neutral data centers, Cogent is connected to over 1,600. So it's very easy for us in those data centers to put those customers on-net.

And have you discussed the margin difference both in the legacy Cogent for the on-net versus the off-net and what the Sprint profile will look like? That looks like currently with the 97% off? And what kind of an improvement you'll get?

Yes. The on-net business is inherently much more profitable. It carries a 100% gross margin contribution and 95% EBITDA. In an off-net service, roughly 50% of the cost of that service goes to buy that local loop. So by definition, it's a 50% gross margin and about a 45% EBITDA margin contribution. In the acquired Sprint business, there was roughly 1,400 large enterprise customers and other customers are improving your margins with Cogent 3 ways. One, we're eliminating non-core products that were actually gross margin negative. Two, we are requiring those customers to only get connectivity to us via fiber, which would mean higher reliability and higher throughput and lower cost. And third, for those customers that operate in very exotic markets, we are assisting the customers in purchasing the loops themselves as opposed to have a Cogent purchase those off-net circuits, in places like China, which are regulatorily very burdensome. So in the acquired Sprint business, it was negative EBITDA of about 70% at acquisition. We believe over a 4-year period, we will be able to improve those margins and stabilize that business at approximately a 20% positive EBITDA margin. Cogent's EBITDA margins on a blended basis prior to the acquisition were approximately 39%. So much better because of a higher mix of on-net services. In our NetCentric segment, which is the third type of customer we sell to, that business is almost 90% on-net and only about 10% off.

Right. So we've talked obviously a lot about Sprint. As I said, it's very topical at the moment. You closed the deal on May 1 of this year. And what I wanted to sort of kick off with is I think there's probably naturally a bit of skepticism, right, of the value of what you bought. You effectively bought it for $1. And on top of that, you have an IP transit services agreement, where you're going to be getting in $700 million in cash payments over time. So maybe you could just give investors a little bit of the history of the assets we can understand it better, what you saw in the asset that T-Mobile or frankly, any other buyer did not see and why this deal makes sense?

Yes. So [ Jatin ], there are actually very different assets that we acquired, but they needed to be acquired together. The first of those is the physical network. It was a network built on railroad right of way with fiber buried -- direct buried 6 feet under the track to deliver long distance telephone services. 19,000 route miles of intercity fiber, 1,200 miles of metropolitan fiber and 485 [ fee ] simple owned buildings, of which 45 are large tandem switch sites. This network was built in the mid- and late 1980s at a capital cost of $20.5 billion. It was the country's first nationwide fiber optic network. At that time, all long distance was delivered by a fixed microwave by AT&T and MCI. MCI actually stood for Microwave Communications Inc. Sprint was a #3 player in that market, it realized it could not out brand or out market AT&T or MCI. So in 2002, it had agreed to sell itself to MCI for $129 billion. That deal was ultimately blocked by the Justice Department and the European regulators. At that point, Sprint elected to underinvest in its wireline business and pivot to become the country's first nationwide mobile phone operator. Again, remember for investors, at that time, there were 2 licenses, A and B license. The A license was always given to 1 of the 7 RBOCs and the B license was typically an entrepreneurial endeavor. And Craig McCaw was rolling those up, but he was very far from having a national footprint. McCaw eventually sold to AT&T Long Lines, the Bell companies eventually consolidated. Sprint did build a nationwide wireless footprint, but again, found itself with a higher cost of capital and out marketed by Verizon, AT&T and T-Mobile. Sprint sold itself to T-Mobile. At that point, the wireline business had atrophy to $1.1 billion in revenue and [ 0 ] in EBITDA. T-Mobile initially hired a consultant to figure out what to do with the business. They came back with the same answer that Cogent came up with, turn it into a wavelength network and turn the switch sites in the data centers. They attempted to do that and realize it was going to be too hard. They didn't have a management team focused on it. And it would not be material enough relative to their wireless business. At that point, in late 2019, they took a different tact. They hired a different consultant and did a wind-down analysis, said let's just shut this business down. And they concluded it would cost about $1.5 billion and could potentially damage the T-Mobile brand. At that point, Cogent stepped in, acquired the asset. And when we acquired it, we acquired 2 very different things. We acquired a physical network for $1 that we had appraised by KPMG in its current state at $1 billion. That network is solid. It's much like an empty building with no tenants. It needs to have a purpose. Our purpose is to connect that network to our metropolitan footprint, offload some of our IP traffic onto it and then use that excess capacity to sell wavelengths and/or fiber. The second thing that we acquired was a remaining enterprise customer base buying 28 products. Those customers were 1,396 of them, they were spending $560 million in revenue and it was cash flow negative $330 million, $300 million of negative EBITDA, $30 million of CapEx. And again, you can go look at this all in T-Mobile's public disclosures at the point of acquisition. We requested that T-Mobile shut down 24 of those 28 products. That process is underway. The deal did close sooner than we expected, it was about $480 million of revenue going to about $440 million. We are end of lifing those gross margin negative products as quickly as possible. We are going to retain those enterprise customers. We will consolidate network assets. We will rightsize headcount, and we will be able to turn that business into a roughly 20% positive margin business with no growth. The enterprise customer base will be buying 2 services, Internet access and VPN services. Those VPNs are typically delivered over MPLS. That's an integrated technology. We will support it, but we don't see a lot of growth there.

Got it. So we'll get to the numbers again as to what the trajectory is going to be to get it from what the current run rate is, which I think you said is negative $180 million to 20% margin. But before we get to that, let's talk about wavelengths a little bit. What is -- before we get to what it is, I want to ask you about what we need to -- what you need to do to get the network ready to sell the wavelength product. But from your perspective, can you describe the wavelength market, the way you see it, the size, the players and the competitors you're going to be going up against, the demand drivers, and essentially, how do you plan on inserting yourself into that market, which is currently, I believe, dominated by aluminum?

Yes. So let's, first of all, start with what we're going to be selling, what is the product. So the Internet is the most ubiquitous, easiest to use and cheapest way to move data around. However, there are 3 attributes of a wavelength network that will justify a premium from customers. One, it's deterministic. You know exactly how long it takes to get from point A to point B. Two, it's well suited for very large file transfers and three, it's totally secure.

[indiscernible] just -- could you explain the deterministic part of it.

It just means you know where point A and point Z is and you know the exact path, the Internet was designed to survive a nuclear attack. There is no concept on the Internet of end-to-end connectivity. When you type something in on your computer, the only thing that compute does as it knows what the next router is where it's sending the packet. The Internet dynamically real-time optimizes how that packet gets from its origin to its destination and back by a series of those next hop determinations. If it's inside of your network, it's known as IGP, internal gateway protocol. If it's between networks, it's BGP or border gateway protocol, and that's how packets move. The average packet goes to about 8.5 routers between origin and destination. And 2 endpoints may end up with dozens of different physical paths between them based on traffic at that instant in time. A deterministic route says, "I have a fixed circuit from location A to location Z. It never varies, and I know exactly how many milliseconds. And there is no restriction on packet size going down that route. So the customers for those services, those deterministic services are content producers, regional access and large corporates. Cogent already has relationships with virtually all of those potential customers.

When you say content producers, you're effectively talking about hyperscalers...

Hyperscalers, some CDNs, some hosting companies. But really think of companies like Amazon, Microsoft, Google, anyone doing AI, anyone doing large data replication would be the customer base. And they tend to want to move very large files on a fixed schedule which is not conducive to the Internet. So for those customers, we will compete with Lumen, Zayo and others. What Cogent will have as an advantage, 90% of our routes are unique to us, meaning the physical path to fiber is on is not shared. That's not true of our competitors, who oftentimes are along railroads or pipelines that are shared. Secondly, we will have more endpoints on-net because we sell transit today and more end points than anyone else by physically interconnecting the networks. Third, because we are designing this network solely to deliver wavelengths, we can optimize it to be able to provision those much more quickly. We anticipate being able to deliver a wavelength and 800 endpoints. Any permutation of those 800 can be delivered in a 2-week window. That is not where the market is today. Today, it's more like 350 locations and 3 to 6 months to provision. And then finally, because we have an asset that we paid $1 for we will be able to have very aggressive pricing. Remember, we were paid $700 million in the form of a transit agreement to take over a money-losing enterprise business. We will probably spend $400 million of that $700 million, stabilizing that business. To your question about the trajectory to positive EBITDA, it was negative [ 300 ] of signing. It was down to negative [ 190 ] at closing within a year of closing. So the run rate in May of '24 will be negative [ 80 ] by May of '25, it will be breakeven. And by midyear '26 should be about a 20% margin business. through all of those restructuring efforts that I described.