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

Welcome to day 2 of the Bank of America 2023 Leveraged Finance Conference. I'm Ana Goshko. I cover technology and telecom credits. And we're thrilled to have Cogent Communications with us this morning. Dave Schaeffer, the company's Chief Executive Officer, Founder and Chairman. So thank you.

Well, Ana, thank you for hosting me. I'd like to thank all the investors who got up early to pay attention to Cogent. And as always, thank Bank of America for a great event.

Okay. Great. So Dave, we got a lot of moving pieces right now in the business. Most of those moving pieces are associated with the Sprint wireline asset acquisition, the company recently completed. But a lot to cover, but what -- since this is a credit and debt-focused audience, I did want to clarify some issues on debt structure first, get it out of the way. So when you first announced the agreement to acquire the Sprint wireline asset, I recall that you said the intent was from bond indenture perspective to keep the Sprint assets in an unrestricted subsidiary. And I think the intent at that time was to insulate the credit from any negative EBITDA of the acquired assets. But I also think the last time you publicly spoke about this might have been at this conference a year ago. So I just wanted to clarify what structure was ultimately put in place with those assets, the business and the kind of restricted unrestricted group with regard to the debt?

Absolutely happy to answer that question, Ana. So the publicly traded company is Cogent Holdings. Holdings has no debt. Underneath Holdings, there are 2 operating entities. In Cogent Group, which is where our debt resides, Cogent's operations exist to all employees, all customer relationships, all revenue sit within the group entity. When we acquired the GMG business from T-Mobile, we've bifurcated that business in order to ensure that bondholders would not be disadvantaged. So all of the operations of the acquired business reside in group. That means all of the customer relationships, all of the revenues, all of the employees and most importantly, for the creditors, the stream of payments, $700 million from T-Mobile over a 54-month period, all sit within group. Next to group, a sister company that is unrestricted only owns the physical assets, the 482 pieces of simple real estate, the dark fiber, meaning the 19,000 route miles of intercity fiber and the approximately 1,200 miles of metro fiber as well as approximately 4,600 miles of IRU fiber, leased fiber that a large portion of that is governed by an out-of-market uneconomical lease that we called out specifically, that liability and the assets with no revenue sit within Cogent infrastructure. Cogent Group is purchasing an IRU from the infrastructure entity as it migrates traffic off of the Lumen fiber and migrates it on to the Sprint fiber as well as an IRU to facilitate the sale of wave line services. We will also be leasing space in those 482 buildings only on an as-needed basis. So rather than burden group with any undue liabilities, we kept those liabilities segregated. Hopefully, that clarifies it. So all the customers, all the revenue stream, all the employees are in the operating entity that is the borrower. And in the sister subsidiary, only physical assets and uneconomic liabilities.

Okay. That is helpful and that's clarifying a little tough if you really want to be pure about trying to figure out what the kind of credit metrics are for the debt to kind of parse between the 2. Over time, as you are able to get out of these economic leases because they basically just expire and you're able to reduce cost. Is there a plan to basically merge the entity so you don't have this kind of separation of the assets, which I think you believe are worth at least $1 billion, right, from the debt holder group.

So the physical assets were appraised by KPMG at $1.150 billion. Subtracted from that appraisal amount was $147 million or roughly $150 million for the uneconomic leases that we were forced to acquire. So the net value in that infrastructure entity are tangible assets that today have no revenue associated with them, only cost of $1 billion. As we monetize those physical assets and that will occur in 3 primary ways. One, we will sell or lease dark fiber and generate revenue against that liability and at least bring that asset into compliance and at least breakeven. One of those customers will be Cogent Group but there'll be other third-party customers. The second relationship will be as we repurpose those buildings for data centers, we will become a tenant for a small portion of that footprint, where we will operate a data center business. But equally important, there will be substantial power and space available to other data center operators to lease from us on a wholesale basis. We have not built that wholesale revenue stream into our models and projections at this point because we're just too uncertain about how deep that market is. And then third, there is a small amount of metro fiber most of which is not relevant to Cogent and that may also be eventually sold off or monetized. So the idea is to get the infrastructure entity at least to a breakeven level on its own. As it becomes cash flow generative, we will have 2 options: do we decide to somehow borrow against that entity with a Sempra credit or do we elect immersion. We have not yet made that decision. But today, those assets are actually cash flow negative and they're being funded with cash from the holding company. So cash that we would move from the restricted payments bucket in the creditor up to holdings that could be used for buybacks or dividends, now have a third use, which is they are down flowed into the infrastructure company to absorb the carrying cost of those assets.

Okay. That's helpful. So maybe to move now to the kind of consolidated picture. And if you don't mind, just for the audience, I think it would be helpful just to sort of do a small recap of where you are with Cogent Classic, as we call it, and then the acquired Sprint Wireline business. So Cogent Classic, which sells Internet access to corporate and net-centric customers, it has been facing some headwinds from the pandemic and post-pandemic corporate office vacancies. But nonetheless, was run rating about $225 million of annualized EBITDA, I think, before the Sprint Wireline acquisition. 2022 cash flow after finance lease equipment installation payments was about $50 million. Does that sounds about right?

That sounds right.

Okay. Great. Okay. And then on May 1 of '23, you acquired the Sprint Wireline business. And effectively, T-Mobile is paying you $700 million to offset the negative EBITDA, negative free cash flow and the expense in CapEx that is going to take you to get that to breakeven, right? And then that $700 million payment from T-Mobile, so you get $350 million the first year, so it's $88 million a quarter. And then the final $350 million is going to be over 42 months. So then that's going to drop to about $17 million a quarter after the first year. So the beginning -- I mean, the middle of '24.

I show more about $24 million a quarter.

Sorry, you're right. Times 3. You're right. 8 times 3. Okay. So simple math in third quarter, you reported $131 million of EBITDA, about $57 million, plus or minus, I think, was legacy Cogent. You got $88 million from T-Mobile. So then we back into the Sprint business, there was a negative of about $13 million, right? But then you also have a benefit because you reclassify the lease, to finance the lease, there's about a $13 million benefit. So really -- and you also had some other uneconomic finance lease payments. So I think what we're trying to back into here is where you stand today, how negative is the Sprint business from a cash flow perspective. I think it seems about $100 million or so. But so -- if you could clarify that. And then the bigger question, obviously, is how do you get that [Audio Gap]?

Really complicated, but it is not that complicated. So let me clarify at least 4 different points that you raised. First, the Cogent Classic business we sold 3 basic products. Internet access was accounting for 81% of revenues, 16% of revenues were [ VPN ] services and 3% of revenues were [indiscernible]. That business was operating on a 61,000 route mile intercity fiber and outwork and 18,600 miles of -- round miles of Cogent fiber as well as 55 Cogent-owned data centers that comprise approximately 620,000 square feet and about 69 megawatts of power. That business had not done any acquisitions for 18 years and had organically grown every quarter since going public in 2005 at a compounded rate of about 10% with an average of 220 basis points a year of EBITDA margin expansion. In the last full quarter as a stand-alone business, we were doing slightly over an annualized rate of $600 million in revenue with 39% EBITDA margins to about $240 million of EBITDA in that classic business. Because of the pandemic, the growth rate in that business had decelerated from 10% to approximately 5%. And our margin expansion was also decelerated to about 100 basis points a year. That business was slowly improving as companies return to office. That improvement is continuing in that classic business. We have reported all of our metrics for that business in a consistent manner with no reclassifications or changes in reporting for 18 years. We acquired 2 things from T-Mobile. They were really 2 separate transactions but they were tied together. We cannot do one without the other. The Sprint Global Markets business was the nation's first wireline nationwide fiber optic network that was designed to carry voice. That network was built between 1982 and 1989 at a capital cost of $20.500 billion. It was designed solely to carry voice. The second thing that we acquired was an operating business serving predominantly large enterprise customers. That business had been ignored and not focused on for over 15 years. The revenue has declined from $40 billion to $565 million and the business went from $16 billion of positive EBITDA to negative $300 million when we signed the agreement to purchase that business from T-Mobile. In that transaction, we paid $1 for the physical network. 93% of the revenues that were in the operating business never touched the Sprint network. The Sprint network was basically a fallow dormant asset that had been sitting in place for nearly 15 years with no capital investment. Maybe what best summarizes it is the fact that across those physical buildings that I described, there were 22,500 cabinets or racks, full-size racks, 8 feet tall of telephone switch equipment that hadn't been in service for nearly 15 years, but had never been removed. We paid $1 for that asset. The operating business had shrunk to just under 1,400 customers buying 28 products. In our due diligence, we determined that 24 of the 28 products were actually gross margin negative. As part of the transaction, T-Mobile prior to closing, began a cost reduction program that included end-of-lifing those products. So between signing and closing -- so deal was signed in May of '22, the deal close -- excuse me, September of '22, closed in May of '23. In that period, T-Mobile spent over $500 million in operational burn and reduced the revenue stream from $565 million to $490 million. The EBITDA burn was reduced from $300 million to $190 million. We have said that we will further reduce that burn over the 12 months subsequent to closing by an additional $110 million, getting us to an $80 million annualized negative EBITDA 1 year after closing. We do that basically with 3 major tools: one, the consolidation of networks and the migration of traffic from off-net to on-net; two, the elimination of uneconomic customer relationships that was begun under T-Mobile and is continuing; and third, the SG&A savings through headcount rationalization and facilities rationalization. That will continue for the next 2 years. So a total of 3 years post closing until we are able to get that stabilized business of $450 million in revenue that we acquired to a positive 20% EBITDA margin. So we will spend about $400 million of the $700 million we are getting from T-Mobile in that integration and subsidization phase as we turn that business around. At the simplest level, a shareholder or a bondholder can look at Cogent and say, we issued no debt, we issued no stock and our aggregated EBITDA went from $240 million to $520 million annually. Our margins increased from 39% to 47.7%, with no additional debt or equity being issued. That is because of the stream of payments from T-Mobile. They will step down from $29 million a month to $8.3 million a month in June of '24 and continue for the next 42 months for payment subsidies spread over a total of 54 months. Another way to look at it is, Cogent's EBITDA margins went without the payments from T-Mobile, went from 39% down to approximately 20% because of the acquired businesses burning cash, but off of a revenue scale that was 80% larger. Then adding in the payment stream from T-Mobile, the EBITDA increases to $131 million in the last quarter. Over the long run, we will be operating a business that combines 3 components. One, a classic Cogent business. It will be all reported as a unified company, but that business will be a significant portion of our business. The second thing that we will be doing is taking the physical assets that I described earlier that today are fallow and monetizing them through dark fiber sales, facilities leases. And then finally, adding a new product, optical transport. It is a market that's adjacent to where Cogent is, but it's a market that we have never participated in either as a buyer or a seller. It is about a $2 billion addressable market. In that market, we have 4 distinct competitive advantages. We have more end points on-net than any other provider. Our routes are completely unique. Over 90% of them are on right of way that is not shared with any other provider. Third, we have very accurate detailed engineering maps that give us the location of the network within 1 meter. This was not a roll-up. This was not an amalgamation of acquisitions, but rather it was an organically built network by one owner for over 40 years. And then finally, we have a $1 cost basis, which will give us the ability to sell at whatever price it takes to gain market share. We are very encouraged by the initial response to selling transport services, we do have a significant amount of reconfiguration work that needs to be completed over the next 13 months or so. But at that point, we will have fully integrated the networks. On a reported basis, Cogent has always reported consistently. There are 2 changes to our reporting metrics. One, we've added a third type of customer we never had, enterprise. So now Cogent has corporate customers, NetCentric, which are basically wholesale, hyperscalers and access networks. And now we have very large enterprises, Fortune 1000 companies as customers. The other thing is every dollar of revenue at Cogent has always been reported 4 ways: customer type, I've just explained; geography, U.S., rest of the world; on-net, meaning it's entirely on our network, no third parties; or off-net where we buy a loop from another provider; and then by product. So Cogent historically had 3 products now has 4. So it still sells Internet access, still sells VPN services, still sells colocation and now has optical transport as a fourth product. Any on-net service, which our NetCentric business, is 90% on-net and our wavelength business or transport business is a 100% on-net, carries a 100% gross margin and 95% EBITDA contribution. So the real upside is our ability to take a portion of that dark fiber and repurpose it into a very efficient optical transport network.

Okay. Great. That's super helpful, a lot. We've got actually just a few minutes left. And I did want to take all of this and shift to the issue of capital allocation. And then again, since we're at a debt conference. So we did start out, I think some people walked in late talking about how there is a separation of some of the Sprint wireline assets into an unrestricted subsidiary versus a restricted subsidiary for all of the payments. But nonetheless, from the public information that we have to work with, we really do look at leverage on a consolidated basis. So 2 questions. So one, right now on an LQA run rate of about $525 million of EBITDA, company's leverage is 4.8 gross, 4.4 net. But when these T-Mobile payments start stepping down, once you pass the first year mark, do you expect leverage to initially increase? Or will you be on a glide path where you'll be able to maintain or lower leverage over time? And then the second part of this question is really on the dividend. So you currently have a dividend that annualizes to about $180 million a year and that is in excess of your free cash flow. So if you could just comment on the dividend, your outlook for dividend sustainability and then basically the overall capital allocation policy on the credit versus the shareholder return.

So first, let me start with the leverage. Your numbers were correct. Pre-acquisition both with an LTM test and using [Audio Gap], we actually delevered last quarter by roughly 1.5 turn both net and gross. Over the next 3 quarters where we will have the full effect of the acquisition calculated, that delevering will continue. So Cogent has gross debt of approximately $1.4 billion, approximately a little over $1 billion of high yield in 2 tranches: secured and unsecured, and then finance lease obligations that count as debt of about $400 million including that uneconomic finance lease. We will have EBITDA of approximately $500 million during that period. So we're going to be on an LTM basis delevered down to a gross leverage of probably somewhere around 2.5x, which is the low end of our guideline and we will be on a net basis, even below that because of cash on the balance sheet. It is true that our EBITDA will step down as the T-Mobile payment is down, but that will be offset by the improvement in operating deficits from the restructuring work in the enterprise acquired business and the sale of wavelength services. So for the next 5 years, we anticipate our EBITDA to remain relatively constant at between $400 million and $500 million against a total debt load that will actually come down. With that, we have raised our dividend for 45 sequential quarters consecutively. Today, that rate of increase is at about 4.5%. We will continue to return capital to shareholders through either a combination of raising the dividend or supplementing that with share buybacks. Our goal is to operate comfortably in a net leverage range of between 2.5x and 3.5x EBITDA. After the T-Mobile payments end, we anticipate the business doing at least $1.5 billion in revenue from the $1.1 billion run rate today and EBITDA of about $500 million with top line growth of 5% to 7% on a combined basis and about 100 basis points a year of margin expansion, which tells us in even this interest rate environment, we have a very prudently capitalized balance sheet.

With that, we're out of time. Dave, it's a pleasure, as always. Thank you for making the effort and spending time with the investors at our conference.

Well, thank you for hosting me. Thank you, all.