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

Good afternoon, everybody. Thank you very much for joining us. I'm Dave Barden. I head up U.S. and Canadian telecom and comm infrastructure research for Bank of America. Thank you for joining us. I'm really pleased to have with us today Dave Schaeffer, the Founder, Chairman and CEO of Cogent Communications to have a conversation. This is a very interesting day for this meeting to be happening. So I'm really looking forward to this conversation. But in order to set the table, there's also been a lot of other stuff going on. And I'm really pleased to have with us the host with the most, Jill Hall, who's our Head of SMidCap Strategy, to hopefully maybe set the table for all of us on a couple of topics. One, I think, is just the general craziness in the market. And then second is just how -- maybe small-cap [indiscernible] which has been maybe ignored in the shadow of the Mag 7 might have an opportunity to shine now that there seems to be a rotation going on. So I don't want to -- maybe I'll hand it over to you, Jill. Thank you so much for being a part of our conversation today, and I'll hand it off to you.

Yes, thank you so much for everyone for joining and for Dave for hosting, Dave and all of our other companies for joining. I'm Jill Hall, Head of Small and Mid-cap strategy. I also worked with Savita Subramanian on our overall U.S. equity strategy and quantitative strategies. So just wanted to hop on good mid-cap conference we've had going on the last day, continues tomorrow opportunity to hear from a lot of different companies. Feel free to reach out to me if I can help anyone with anything on the smaller mid-cap side, connecting you with other analysts, signing up for other sessions. Also just wanted to give, as Dave said, the market volatility, just give a couple of high-level comments on what's going on, opportunities within that, how this impacts mid-caps, TMT, et cetera. I'd say the overall volatility that we've seen, it's one could argue that by historical standards and some of the signals that we're looking at, it could have been expected. In that, we were sort of due for a correction. Even when you look at just S&P 500 back 100 years, typically, these 5% corrections happened about 3x a year on average, 10% correction happened about once a year. We haven't had a 10% pullback since last fall. Volatility typically picks up from July to November and election years. So usually, you see about a 25% rise in the VIX. We've also typically seen the yield curve be a good long lead signal of what volatility does, and that was suggesting volatility could bottom about midway through this year and then pick up. So all of that said, it could be a volatile near-term period for the market for several more months now. But with volatility that brings opportunities, and certainly, there is some uncertainty over the weakening macro data recently. Prior to that, we have seen obviously a big rally around expectations around Fed cutting, which is particularly relevant for small caps, given the rate sensitivity. So a lot of refinancing risk for smaller companies, a lot of rate sensitivity for longer-duration small caps and non-earners, I think now the focus has sort of shifted to fundamentals, not only given the macro, but given the fact that we're seeing a broader shift within the market in terms of -- as Dave pointed out, Magnificent 7 had been leading the profit growth story. They continued to surprise to the upside. Now you're starting to see growth for those companies slow down, and they're also investing a lot in CapEx, these big hyperscalers relative to their earnings. And now finally, earnings for the rest of the market are expected to pick up. And for large caps, the other 493 that started to happen. For small caps, the story has been pushed out of it. So I think what investors are now focused on is evidence of companies that can show that the profits are recovering [indiscernible] estimates or guidance, I think fundamentals will be a big focus. I think also relevant to TMT, as Dave said, number one, just this broadening out of the market. If profits broaden out, then performance theoretically should follow. And a lot of the MAG 7 stocks have become very crowded and expensive relative to the rest of the market and also small caps relative to large, a lot of these small caps and parts of TMT have been under-owned by investors. I think dividend stocks have also been sort of a stealth underperformer within small caps and often a way to hedge regime risk. So that's been another interesting one where as profits recover, dividends tend to follow and we were in a period for a long time where price returns kind of drove the market. But historically, dividends were a larger share of investors' total returns, and we think that could come back. So I think that's another relevant one for TMT. And we've now seen the S&P 600 small cap index have a higher dividend yield than the S&P 500 and kind of an investor focus on dividends even for small caps. So lots of cross currents going on. But bottom line, we think it will be a stock pickers market, and so we're really happy to be hosting this conference. And our analysts here, we have a cover about 1,000 small and mid-cap U.S. stocks. So definitely lots of opportunities for alpha within the small-cap index, even if we see the [indiscernible] near term. And so with that, I can turn it back to Dave and Dave. And if anyone has anything I can help with or questions on the broader Smid landscape, definitely don't hesitate to reach out to me. Thank you.

Thanks, Jill. So I appreciate the insights and the comments and all the strategy work to do and being a part of this conference. So thank you for letting us do this. And so Dave, man of the hour. Thank you for being here. I really appreciate it.

Well, thank you, Dave, and thank you, Jill, both for boosting us and giving us this great form to chat with investors.

So Dave, there's a lot to talk about. Obviously, the results coming out on Thursday, everyone's interested in an update on the business. And I'm going to weave this all together, but I'm going to start with the question that's less about Cogent and more about the market. And so we have been watching one of your biggest competitors, Lumen, kind of unfolded story in the last couple of weeks in slow motion. First, kind of an AI quid pro quo type of deal with Microsoft, which is the CEO, Kate Johnson's Alma Mater, then on the [indiscernible] call, something about reserving 2 years' worth of fiber capacity, kind of suggesting that there was a deal that was brewing some reason why they believe they needed this much fiber capacity. And then the -- I guess, the surprise announcement, the culmination of this slow motion narrative last night was that there was a $5 billion -- and I'm not going to -- I've been dealing with people all day about the syntax. So I'm going to use the wrong precise word, but a $5 billion deal with unknown counterparty or counterparties to do something in [indiscernible]. And everyone on this call who has an interest in this as with the press release, [indiscernible] because I want to focus on your view, Dave. What -- A $5 billion fiber deal sounds like an awful lot. And some people might view it as transformative for the industry, might be a transformative for Lumen. And we'll talk a little bit in a second about what it means potentially for Cogent. But what do you -- when you wake up this morning and read what this is, what do you think it means?

Okay. So maybe let's step back and understand three big trends in our industry. The first is the deployment of fiber as a replacement for other transmission medium. And back in the late 1990s and early 2000s, literally several $100 billion of capital was deployed that facilitated the Internet but resulted in little actual revenue, created tremendous economic growth enabled what we know now as the public Internet and facilitated the burgeoning of dozens of business models and applications that have transformed society. AI is building off of that. So AI is possible because of the huge amounts of data that recollected at virtually no cost over the Internet. And then the ability to process that data through large language learning models to create predictive pattern develop. That is effectively what AI is today. And that has the ability to drive another leg of productivity improvement and a transformation across Society. The second key issue has been the migration of all services in telecom to over the top using one common IP network. And then the third trend has been the proliferation of fiber to endpoints to be able to allow everyone to take advantage of the full capabilities of the Internet. I think the announcement that you're referring to from one of our competitors, leverages all of these trends, it may not result in a significant amount of profitability but will further enable the deployment of AI, large language models. Because of the constraints of power and data center space, the training of these models occurs in a distributed fashion. Many of the hyperscalers are, in fact, building proprietary data center or data center campuses where they can get affordable land and available power. I think a key component of this announcement is going to be the construction of new fiber from existing end points of preexisting fiber backbones to these brand-new developed sites. Cogent has chosen not to participate in that market because there is too much monopsony power on the part of those hyperscalers, who are constructing these facilities. You spend tens of millions, maybe hundreds of millions of dollars building fiber to these newly constructed data centers with only one customer in those facilities and what an opportunity to harness additional revenue streams. I think a key component of these announcements has been the fact that one company decided to hire another company to outsource that construction utilizing their existing [indiscernible]. The second will be the purchase of fiber that is surplus along the existing routes that are in place today and are unused. So selling off excess inventory whether that is going to generate significant operating free cash flow is yet to be seen. So Cogent is the largest carrier of Internet traffic in the world. We carry approximately 25% of global Internet traffic. We do that over a network where we have purchased fiber from 328 different suppliers around the world. Just as any hyperscaler to go out and purchase that capacity. With the advances in wave division [indiscernible] a large number of fibers to have virtually unlimited throughput and support any of these AI training applications. Our model has been to purchase that fiber to connect to major traffic aggregations. We connect to 1,680 carrier-neutral data centers in 54 countries around the world. This allows us to access roughly 98% of global Internet traffic. What we have chosen not to do is develop extensions of that network into these proprietary locations, where whole of the market power resides with the purchaser, and there is only one customer. So where we sit in this ecosystem is two places. One, we're connecting those 1,680 data centers. We're carrying a 1/4 of the world's Internet traffic, and we are connected to over 8,100 other networks that may know the Internet that gives as a unique position in helping aggregate that traffic for these training models. The second place that we participate is we, about 15 months ago, acquired the Sprint Global Markets Group network. It was a 19,000 route mile intercity fiber network that had been built at a capital cost of $20.500 billion between 1982 and 1991 to carry long-distance voice. That network had been maintained but had become unoccupied, as Sprint shut down its long distance voice business, the network quickly became a liability. We were paid $700 million in cash over 54 months to take over that network from T-Mobile. What we're doing is repurposing that network to provide optical transport services. So Cogent had historically only sold Internet-based services. Optical transport services have 3 characteristics that the Internet cannot replicate. They have defined, wait and see, they have defined endpoints and they are completely secure. Those attributes are valued by companies that are doing large amounts of data replication. The cost to move those bets, however, is more expensive, generally 2x to 2.5x more per bit-mile than just using the public Internet. We are entering a market to sell wavelength services or optical transport. What makes our services may be different than what Lumen has announced is we took a former voice network are in the process of re-engineering that network and making it so it can provide any data center to any data center, optical transport capability and being able to provision that with a 2-week interval. That puts us in a very unique position. We have begun selling those services. So they are analogous to the transport services that Lumen announced with two key differences. One, the endpoint; and two, at least from what appears to be what has been indicated in the cryptic press releases that this is a dark fiber sale and they're looking for the counterparty to light that fiber. Hopefully, that background, David, was helpful and you're kind of framing this question.

No. Thank you, Dave. So I think that I had a follow-up question, and I think that the answer is in that answer, but I just wanted to maybe fine-tune it a little bit, which was that, your perspective and in the press release, Lumen talks about how the majority of the $5 billion is going to be both received and spent in the first 3 to 4 years of the relationship with whoever it is or whoevers it is. And so I guess I agree with your idea that a lot of this is going to be building new stuff to new places that these places may not even exist yet. And that's why it takes 3 or 4 years to build this stuff, which wouldn't take if these places existed. But the question I'm getting is when you acquired Sprint and you mapped out a number, we'll get to these things in a bit. But you mapped out a number of opportunities that the Sprint asset brought to you when you talked about one of them is the lit wave opportunity. And you size that opportunity to $2 billion today. I guess the question I've been getting today has been, does this fiber deal represents an evolution of the marketplace, which is where people no longer waves, they want full fibers, and then does that diminish your opportunity set? Or does this fiber deal potentially represent an expansion of the market. And maybe it's not the way market is necessarily, but it's an expansion of the market. It's not cannibalistic, it's additive. I think I know the answer, but I just wanted to clarify.

Yes. So there are three ways to move bits. The cheapest, most ubiquitous and easy to use is the public energy, that dominates the amount of traffic that is carried globally. And that will continue to grow because of the application agnostic nature as well as the efficiency of the internet that $2 billion North American wave network opportunity. It has been growing at modest single digit ranges. It is today about a $7 billion global market, about $3.5 billion is North America. And of that $3.5 billion, about $1.5 billion is metro wave. So basically, from 1 point within a given market, city to another and then about $2 billion is intercity. The third and most expensive or more expensive way is to buy wave lines. Now those attributes that I talked about earlier, may justify that incremental expense. And then there is a fourth and even more expensive way, which is to buy dark fiber. Now why would you buy that dark fiber? One, you may want to go to a site where none of those three other alternatives is available. Of course, nobody there, you can't connect to it, it's kind of useless to you. So you either have to build the fiber yourself or get someone to act as your construction outsourcer. That is what is happening in a lot of these new build environments. The second piece is once you connect to fiber that is already in place, do you want your own dedicated fiber as opposed to a wave line? And there, it's a question of control. It's a question of, are you comfortable with your counterparty's ability to maintain it and grow it in their financial capabilities? And then finally, do you view this as something as long-term strategy? And the answer probably varies among each of the hyperscale operators. There will be some of them that do elect to buy dark fiber on backbone routes. But there's nothing new in this press release that's been going on for 20 years. Just as Cogent has gone out and bought its backbone fiber. Well, we bought roughly 72,000 route miles of fiber, and we own 19,000. So we operate 91,000 route miles of intercity fiber. But that kind of shows that there's plenty of inventory out there and plenty of existing counterparties that want to sell it. And most of those counterparties have lost tremendous amounts of capital generating virtually no return on their deployed capital. In fact, in many cases, those companies have gone bankrupt once or even twice and are still struggling, which is why that inventory is readily available. So I think there our buyers out there, but there are also a lot of sellers in the market. I think what we feel with wavelengths is a segment of the market that wants those three attributes of a dedicated network, but want them on a flexible, scalable and ubiquitous feature set and location inventory as opposed to going out and buying dedicated routes for 20 or 30 years, obligating ourself to large maintenance payments without necessarily having a lot of confidence that the counterparty that you're paying those payments to continue to provide those services.

Got it. So you don't want to stay right here right now, Dave, that you're about to jump into AI fiber and have the stock go up 300%?

Well, first of all, I have no idea of what the term AI fiber means. I know what a fiber is, I have a sample in the room next to me. And the fiber basically comes in two different varieties. You had the initial deployments of single-mode fiber that were deployed in the 80s and 90s. It was then replaced by non-zero dispersion-shifted fiber that became popular in the late '90s and early 2000s. And now, all of the fiber that is being deployed has reverted back to that standard single mode fiber. And the reason for the two different types of fiber was the optronics that send signals down that fiber. Initially, all of the signals were asynchronous. They then standardize on a noncoherent [indiscernible]. That technology did not maximize the optical spectrum in the fiber itself. And in the mid-2000s, the market transition to coherent transmission. With coherent, the non-zero dispersion-shifted fiber turned out to be sub up and the difference is, am I sending the information down the fiber is a coherent law of information, who am I sending it in coherently as a set of disciplined joint houses rather than a single coherent transmission. And the non-shared dispersion shifted fiber was developed specifically to prevent traumatic dispersion, the spreading out of the signal. So think of it as you look at like through a Prism and the colors bleed together, but they kind of bleed out even further. What is happening in a non-zero dispersion-shifted fiber is the fiber has a certain topology and a chemical injected intuit that compresses that optical signal back together pushing that dispersion together. When you put a coherent signal in that, it actually works very poorly. It actually does the exact opposite of what you want to do. It takes a single coherent ball of information and distort it or spreads it out when it doesn't want to distort or disperse on its own. So it is for this reason that the fiber that's been deployed since 2006, 2007 has all been back to standard single mode. And today, when you get the largest throughput on that fiber, it is all done with single-mode fiber and coherent optics.

So Dave, I'll assume that everyone -- thank you for all that, by the way. That's helpful context for the industry dynamic. I'm assuming that everyone on the call here at the conference knows a little bit about what Cogent is all about. I guess, one of the things, Dave, one of your core businesses, the corporate connectivity business, you've told this story, it was growing 10%, it got hit by the pandemic. It's been kind of leveling out and coming back. We've been experiencing or finding the new normal with return to work. And all of a sudden in the last 3 days, we're not talking about the possibility of recession. So could you give us an update on kind of what -- how the Cogent Corporate business has been developing and give us a picture of if we were worried about a recession, should we be worried about this unit again?

So Cogent prior to acquiring Sprint, only sold Internet-based services and it had two customer bases. It had corporate end users and other service providers are netcentric or wholesale business to other service providers represented 97% of our traffic but only 48% of our revenues. And that business tended to be fairly volatile when Netflix came along and everybody started streaming, that business grew at double-digit rates. And then when we reached saturation on that application, at levels off, grows at much more modest rates than the next application drives growth. The much more stable business for Cogent up until the pandemic was our end-user corporate business. So in the U.S., the end market for business Internet connectivity is about $9 billion. It's actually been relatively static for the past 15 years. Cogent focused on the best part of that market. We went after any business that was located in a skyscraper in the central business districts of a major North American city. We connected 1 billion square feet of sky scrapers to our network that represented about 1,860 buildings. So we start with a universe of approximately 4.1 million commercial buildings in the U.S. and Canada. Of those 4.1 million , 3 million of them are single tenant buildings that don't make sense. Then we looked at the remaining roughly 1 million buildings and realized that we needed to pick the largest of those buildings, but also buildings that have a diverse customer base. So the average building we connected to is approximately 41 stories tall, 550,000 square feet and had 51 discrete businesses in it prepandemic. These buildings tend to be located in the downtowns of major metropolitan markets. We were growing that business at 11% year-over-year for 15 consecutive years by taking market share. Customers switch to us in those buildings because our service was installed 9x faster than our competitors, we were 3x more reliable once we install and we were delivering 30x to 60x the throughput. A great store. The pandemic hit, and we went from being an 11% year-over-year growing business in that segment to negative 9%. With us coming out of the pandemic, we have recovered but only partial. That business today is growing in between 2% and 3%, not the 11% it was growing the store. We have picked the best builds in the best markets. We have weathered several other recessions, the [indiscernible] recession, the great financial recession. And in both of those cases, our corporate business continued to grow. The pandemic was different. People's work patterns changed. Many companies are reevaluating their aggregate real estate footprint for office workers, but that business is continuing to improve slowly. And I think even if we go into a recession, that improvement will continue, albeit maybe not as quickly as we went down, the events of COVID were a shock to the system. A recession that we would enter into now would probably take longer and be more diffuse. Finally, the buildings that we connect to tend to be the most recession proof. They tend to be the best buildings in a city, the sky scrapers in the Downtown, the Class A buildings and the tenants that are in those buildings tend to be fairly well vetted by the landlords and much more recession-proof. So I think our corporate business is going to continue to improve as companies' IT budgets continue to get squeezed and a recession does that to all expenses, companies constantly look to shift to greater value, more throughput, the reliability, lower prices. Those are positives for Cogent's corporate business.

Great. Thank you, Dave. And just to check in, the other side of the house, the traditional house, the netcentric business, had very strong boost as we saw the stream wars take a troll on the media industry, it had a big benefit to the connectivity business. Now there's kind of some, I don't know, I don't want to say stagnation in the streaming business, but there seems to be some plateauing and rising churn and some question marks among some of these players about how committed they want to be and should there be consolidation in the industry? What is the -- we know where the netcentric business has come from, where do you think it's going with the margin?

Yes. So we saw a step function increase in the percentage of video that was streamed during the pandemic. We went into the pandemic with 18% of all video consumption being streamed. Today, we're at about 49% of all video stream. So almost half of all video globally is stream. We're also seeing streaming continue to gain market share, albeit at a slower rate, and we're seeing the globalization of what happened in the U.S. and Western Europe being pushed into more peripheral markets. So even though there has been a slowdown in these more developed markets, we're continuing to see strong growth in streaming globally. Cogent's growth is global. We serve access networks and streaming providers in 180 countries. Now we always have physical assets in 54, but whether it's China Telecom or China Mobile or China Unicom, all of them connect to us outside of China were prohibited by Chinese law to actually have network inside of China. And on the other side, we sell to virtually every major streaming platform, whether it be Disney or Netflix or [indiscernible] majorly baseball or the NFL or probably hundreds of names you haven't heard of whether it's CBS or NBC, all of them buy some upstream from Cogent. I do think the current revenue models of some of those streamers are challenged, streaming growth down the studio barrier to entry that had existed for nearly 100 years, and also allow for the intermediation of the aggregate, that has put tremendous pressure on the Media business. There will be winners and losers. I don't want to sound callous, but we at Cogent are somewhat different to that. I think our netcentric business, which in revenue terms, is growing about 10% or 11% a year, better than its long-term average, better than we were doing prepandemic, is continuing to grow at these elevated rates. And what we are seeing is 3 things: more people streaming; two, spending more minutes a day using those three main applications. And then three, as part of the war for those eyeballs, we're seeing the quality of that streaming increase. I have billability to comment on the quality of the content, but I can't comment on the quality of the transmission signal where we're seeing much higher resolution, much faster action content that all requires much higher video encoders and therefore, more bits. So as we move to a world of live event streaming, we will see yet another lag off and the growth stream.

Dave, I just got a question from a client, and I want to kind of shift gears as quick as I can to maybe wrap up on some of the new opportunities like data centers and IPV4. But have you seen any deleterious effect from the [indiscernible] exercises that you undertook so far this year, I think, with Tata and NTT.

So with Tata, we actually fully restored harmonious peering connections. Cogent is the most interconnected network in the world. We run over 29,000 BGP sessions. We directly connect to over 8,100 networks. We only have 23 peers. We buy no transit. As we gained market share in Asia, two of our global peers began to constrict our access to their customer base. So the group peering connections with us in Europe and in North America, but not in Asia. We took a different approach with each of the two companies you mentioned. With Tata, we actively selectively depaired their BPO customer base. The pressure from that ended up forcing them to honor their peering agreement with us and they established multiple peering connections throughout Asia, inclusive of Indian routes. And today, there are no issues. We've restored full connectivity to their BPO customers. And we, in fact, got a full routing table for our customer base globally. NTT has taken a slightly different approach to its Japanese household customers, they have been willing to allow those customers to suffer and get some optimal connectivity to the Internet. As a result of that, we never had connectivity in Asia with them. They continue to have ample connectivity to us in North America, but we've removed their connectivity in Europe. So now for a residential Japanese customer, if they are looking to get content, NTT has to bring that request but all the way to the U.S., grab that content and carry it all the way back to Japan, whereas if they allowed us in their Asian theater, we would carry that traffic and exchange that traffic locally. We have not had any similar breakthrough with NTT. NTT is relatively irrelevant to global traffic, much like of the access networks, the only other major access network that's taken this strategy is Deutsche Telecom, whether it be BT or Orange or Telefonica, we have very harmonious relationships, but those two companies have been willing to allow their residential end user customers to receive suboptimal traffic. From Cogent's perspective, this is a de minimis impact on our global traffic volumes.

Dave, I wanted to say thank you so much for the time. I wanted to talk a little bit a lot more stuff, but I know that for all those that want to talk about all the stuff that I know that you know that we didn't get to. The conference call is going to be out 8:30 a.m. on Thursday for the second quarter results. So we'll have a lot more to talk about data center sales, IPV4, dark fiber, anything we hear on the Lumen call tonight, that's relevant. So I want to thank everybody for being a part of this. I want to thank Jill for organizing the conference, and Dave, thank you for being a part of again this year, we appreciate it.

Thank you very much, Dave, and I promise to answer every question on our earnings call.

And you always do.

Take care, all. Bye-bye.