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

So our next session is with CEO and Founder of Cogent Communications, Dave Schaeffer. Thank you for joining us, Dave.

Hi, Dave, thank you for hosting me. Thank BofA for a great venue, and thank investors for taking the time to hear about us.

So I mean, there's a lot going on in the world. Some of it has to do with fiber-to-the-home, some of it has to do with fiber to AI, and everything has to do with fiber, and that seems to be your wheelhouse. So I wanted to -- let's start with Lumen was here earlier. We spent some time talking about the $5 billion contract that they signed, part with Microsoft and a handful of other players. And they're attributing the win and really the emergence of an entirely new business model to the conduits that Jim Crow put in the ground 20 years ago, giving them a huge time-to-market advantage in what is a foot race between all the hyperscalers to kind of build the AI engines of the future. And the question has risen, why not AT&T, why not Verizon, why not Zayo or why not Cogent? Is this a piece of business that you looked at? Or was it -- were you passed over because Lumen's conduit network was just so clearly advantaged in delivering what the hyperscalers need to get?

So there's actually an opportunity that we did look at and engage with Microsoft, who is a transit customer of Cogent and a customer that we've had a very long relationship with as their primary transit provider and respectfully passed on the business. So in your opening statement/question, there's probably at least 3 different questions embedded. The first one is we are a strong believer in fiber as a technologically superior medium. The Internet was conceived really before fiber optic networks were deployed, and the Internet was agnostic to the underlying transmission media. But as the bit volumes increased on the public Internet, fiber became the only medium that would, in fact, support volumes. And Cogent built its original network of 61,000 route miles of intercity fiber and 18,000 route miles of metropolitan fiber by buying dark fiber from 328 different suppliers pre-acquisition of Sprint. And Lumen was one of those suppliers. In fact, we bought 12,900 miles from them. And we bought a single pair of fibers, we then deployed equipment that resembled a corporate land on a global architecture and then interconnected that to the highest traffic locations and productized that network solely to deliver Internet service. That level of specialization allowed Cogent faster provisioning times and a much lower cost structure. We survived when nearly 1,600 other institutionally funded telecom service companies failed around us. And it was because of that laser-focused strategy on the Internet as the only network that would matter and the belief that you had to be the lowest-cost producer per interface-routed bit mile and then you had to have the lowest cost of revenue acquisition. But maybe most importantly, with the advances in technology, you need to capture more of that technology efficiency than your competitor. And those guidance principles were at the heart of Cogent's model. We have the opportunity to actually announce 2 years ago at this conference to acquire the Sprint network. The Sprint network was built in another time and for another purpose. It was the first nationwide fiber network. It was built entirely to carry long-distance voice. And that initial network had a capacity of 0.5 gigabit per pair of fibers. Today, on a single pair of fibers, we can support over 10 terabits with existing technology. And that's continuing to improve. The cost to move a bit a mile has fallen at a compounded rate of 80% per year. On the Sprint network, it had basically been dormant for a decade as Sprint exited the wireline telecom business, and in their enterprise business, only 7% of their customers use the Sprint network. 93% were completely off-net to the network. What we realized was we could solve a problem for T-Mobile and taking over that money-losing enterprise business, shrink that business, exit certain noncore products, rationalize the cost structure, stabilize that business and make it marginally profitable. So take a business that was burning $1 million a day and turn it to a marginally profitable business producing probably about $80 million or $90 million a year of positive EBITDA. But the real upside for Cogent was taken over that fellow fiber optic network. Now that network turned out to be a little different than the network Lumen has in three respects: one, its long unique right of way. 90% of the network that Sprint has, no one else is on those right of ways. Two, because it was the first fiber optic network to be built, it was built differently than the way Lumen's empty conduit network that Jim Crow designed was built. It was, in fact, a armored network, putting bronze jacket buried 6 feet under the middle of the railroad track versus most of the conduit networks that are 2 feet deep along public highway right of way. The third attribute that is different is the type of fiber. So the fiber that was deployed was SMF 28, first generation of fiber. And it was thought in the late '90s that, that fiber would be obsolete as everybody needed to move to higher transmission speeds. And that, in fact, would have been correct if all of the transmission technology remained noncoherent. So you could talk to Ciena or to Corning or Nokia, any of -- Sumitomo, any of the fiber vendors or the equipment vendors. The movement from 0.5 gig to 40 gigs per wave and the move from 1 wavelength to roughly 80 wavelengths was all done with noncoherent optics. And at the time, it was believed that you had to switch to a different type of fiber, nonzero dispersion shifted fiber. The most prevalent of those was Corning LEAF, the second most prevalent of those was Lucent Truewave. Those were the 2 brands that were most widely deployed in North America. And that fiber turned out to actually be not very good for coherent transmission technology. So when the marketplace demanded 100 gig per wavelength, all of the equipment vendors globally switched their optics from noncoherent to coherent. When that happened, the nonzero dispersion shifted fiber actually performed worse than the original SMF-28. So Jim Crow's thesis was correct, but it was correct for a different reason. The fiber he put in turned out to be obsolete in a couple of years versus fiber that was a decade earlier continuing to still be manufactured and employed today. Now it is true that the brand new SMF-28 bought today, you can go still buy that at Corning, is slightly different. It has better optical purity and slightly lower loss. So you'll gain about 1/10 of a db per kilometer on the newer fiber versus the older. But the #1 reason why the fiber underperforms is actually splice cuts. So each time the fiber is cut and spliced back together, there is loss in that fiber. And we, as a buyer of fiber from Lumen, can absolutely attest that on a per mile basis, there are over twice as many splices on the Lumen fiber today than there are on Sprint fiber just because of how it was physically deployed. So I do think there is a need for SMF-28, I also believe that AI will generate more demand. But I also think there's an arithmetic problem, and that is how many fibers you actually need to do what you want to do? We are the largest carrier of Internet traffic in the world. We carry a 1/4 of the world's traffic. We do that on one pair of fibers. We are utilizing roughly 30% of the lit capacity in that fiber and have the cable of increasing that lit capacity by at least a factor of 10. So why would I need hundreds of fibers? Now AI is a different use case. It's moving large data sets from location A to location B, and that can require very large amounts of transport, but probably not more than the global Internet. So a long answer to your question, but I think the ability to have an extra conduit is really an insurance policy against having the wrong type of fiber. And for that -- to that point, actually Verizon owns an empty conduit on the Lumen network. They got that from XO. Carl Icahn litigated that and the courts ruled that they have the right to populate that. Verizon chose not to bid on this business. AT&T chose not to bid on this business. And the primary reason for that is as part of the deal with Microsoft, you had to build new fiber, brand-new de novo builds at very low IRRs. And when we looked at it in totality, we just said, thanks but no thanks.

Lower IRR for you because you don't have a conduit and you don't have a deal Corning to get all this fiber, and perhaps reasonable IRRs for Lumen who's in a different asset position?

So IRRs are IRRs. We have plenty of access to fiber if we need it. There's no shortage of fiber in the world today. Corning, the old Alcatel, now Nokia fiber or Sumitomo, you call any of them, get as much as you want. There's no shortage here. It's just like coffee in the Bank of America coffee pot. It doesn't run out, it's bottomless.

Good analogy, I like that one, Dave.

There's plenty of it there. In theory, it can run out, but it's not going to run out during this conference. The issue was that you had to build brand-new build, not where you have conduit, but to new data centers where there is only one customer, Microsoft. And Microsoft has enough monopsony power along with other hyperscalers to drive those IRRs down to low single digits. They typically fund about half of the build upfront, and they expect you to fund the other half. This is not all that dissimilar to the business that got Crown Castle in building small cells. There was this huge meeting a few years ago. Everybody's got to build to every small cell with huge bundles of fiber. And because we're only 3 or 4 potential customers, they forced the builds to accept these low IRRs that then did not generate a sufficient return. That's not the only issue with that fiber business in Crown Castle, but that was a contributing factor. We have been disciplined for 25 years. Sometimes the best deal you do is the deal you say no to.

Well, you went a lot of years saying no to lots of deals before you got the Sprint deal. I want to talk a little bit more about that. But to your point, the -- we had Crown Castle here yesterday. They're looking at all options with respect to the fiber business that they have after Elliott got involved and catalyzed a strategic review of all that. Is there anything about that business that interests you?

So there is real value, but that value is very low, in our opinion. We look at companies that made up that business, whether it be fiber tower or light tower or some of the other businesses that got rolled up into that. There is a -- it's about a $2 billion business. About half of it looks like a more traditional CLEC and other half is, in fact, a fiber business. I think their basis is such that there is not a market clearing price that we would be interested in. Is there some value? Yes. Is there a value that would it be all acceptable to the seller that we could get comfortable with? I don't think so. So again, we're going to spend our time elsewhere.

So Uniti was here yesterday, and they're going to buy Windstream. And Kenny Gunderman said that they're looking at all options with respect to maximizing share price value for themselves, presumably that -- on its face, they're looking at something their managed services business, which probably doesn't sound like a Cogent type of business to be interested in. But they have a fiber-based services business in second and third tier markets. There's probably some assets at Windstream that could be merged into that. Is anything about that of interest to a Cogent?

Kenny is an old friend. There are really 3 businesses, and there have been multiple processes that have been public and disclosed around divestiture of each of these businesses. And at least to date, none have come to fruition.

Are you in that sport somewhere?

I doubt we would be in that mix. For Kenny, I think there are -- there was a natural reason to bring Windstream and Uniti back together as the lease structure was not sustainable as constructive. There is the old PayTech business, McLeod, that has morphed into a managed services business. Most of the revenue is not connectivity based but rather value-add services. That's the exact business that, when we acquired Sprint, we're trying to kill as fast as possible because it's gross margin negative. And I don't believe there's value in a telecom service provider marking up third-party services. Second, there is a dark fiber business. That's the primary Uniti business, and some of that is inside of Windstream as well. Some of that is resale of Lumen IRUs that they had that they could resell some that were as part of the settlement when CenturyLink and Level 3 merged and some of their own builds, particularly some along the coast in the Southeast, in South Carolina. And then there is a third business is kind of their national wholesale business. And I think they're subscale out of their footprint. I think they've looked to divest in many different flavors both when Elliott controlled Windstream and Uniti. And I think we're more an observer than a participant.

Okay. Let's talk about the deal that you did do, which is the Sprint deal. And I would say that I kind of look at it as having 3 parts, basically. I'm sure you look at it differently. But one part of the deal was, let's get the cost cutting done. Let's get this thing from loss-making to breakeven to maybe making, as you said, a modest amount of profitable EBITDA. And that's on track. It seems to be on track.

That's deal -- that's aspect number one. We're in agreement, by the way.

Aspect number two was the creation of new business opportunities, specifically wavelengths, but also maybe dark fiber.

And data centers.

And then I was going to part three. Part two is kind of the new core business things. And then part three was kind of the hidden value stuff, whether it's IPV4 data centers, maybe dark fiber is in there too. And so it seems like the surfacing of value in the hidden value has been a positive surprise with the ABS that you did for the IPV4. And I think just making people aware that IPV4 is a thing, which I don't think many people did before we started doing our calls on that. But that the wavelength business has been just way behind schedule. And it was weird to me because you know so much more about this business than anybody that your expectations for this wavelength business were so much higher than what you've been able to deliver. And the line of sight to when you will be able to deliver on the promises that you thought you were prepared to make a year ago is still fuzzy. And so let's start out with that wavelength business. Why did you make the promises you made? Why can't you fulfill those promises? And when will you hit those goals?

Okay. So the network that we acquired was not a wavelength network. It was basically a dormant network. When I announced the transaction at your conference in September of '22, we said it would take us about 1.5 years post-closing to convert that network. So there's no real surprise. We closed in May of '23 and we will complete the conversion of that network to making it a wave-optimized network at the end of this year. We're still on track to do that. That conversion has three key components: one, the physical interconnection of the network to; two, meaning extending the Sprint network to the metropolitan networks. The Sprint network typically ended 10 or 15 miles outside of a metropolitan market. And then at that point, there was a connection to the ILEC in that LATA for voice termination. That was what it was built for. Well, because we want to sell wavelengths, we got to get the network extended into the data centers. That physical effort at 110 locations is complete and was completed in February of this year, actually a little ahead of when we thought we would get that component on.

What percentage of people listening, do you think would know what a LATA is?

Probably those are as old as you and I. But it's local access trading area. In the Bell parlance, the country was divided into about 168 LATA. And within a LATA, you can make a local phone call. And if you cross the LATA, you had to pay a toll. And when the AT&T was broken up, the LATAs were parsed out to different operating Bell companies. There's one exception to that rule, which was in a few states, there were intra-LATA tolls allowed in very large LATAs, mostly in Texas. And needless to say, since the voice business has gone, the concept of the LATA is gone. But back to what we have to do. The second key component is the reconfiguration of our metro networks to support wavelengths. We are busily doing that. We have to reconfigure about 12,500 miles of fiber and about 100 markets around the country to have wavelengths go to data centers and IP go to both data centers and multi-tenant office buildings. And then third, we have to deploy 2 sets of equipment. We have to deploy transponder shelves in 800 data centers and we need to deploy ROADMs at the physical intersection of the long haul in the metro network. Think of that ROADM as a traffic cop that directs wavelengths to the correct location. And we're probably about 80% of the way through that implementation. When we got started, we knew that there was a lot of pent-up demand, there was a lot of frustration with the current wavelength supplier base. We hurried up and got about 65 large data centers ready to accept wavelengths. We would still be forced to provision those wavelengths the same way that our competitors would want, a bespoke one-off custom basis. It would typically require 6 field visits turn up a get their way. But we thought we would have enough demand, large data center to a large data center, to do that, What turned out to be the case as we had plenty of demand, but the demand was at one end in those large data centers, but most of the demand had the second hand in a smaller data center. And the amount of manual effort to go in and custom build those wavelengths to each of those smaller data centers with just too daunting and it would have put at risk our entire network optimization program. So we made a conscious decision to build a backlog allow some of that business to fall away and to focus on the network optimization. So today, if you buy a wavelength from any competitor, it will generally take 90 to 120 days to be installed and it will require those 6 site visits and generally,somewhere between 30 and 60 days of custom engineering to be designed in a total installation window of 3 to 4 months. Transit services, which is how Cogent had defined its original business, worked very similarly. 25 years ago, if you went to a data center to buy transit, the biggest port you could buy was a DS3. That was a 45-megabit port. The cost was $300 a megabit at that time, and it would take you about 90 days to get it installed. Cogent came to that market, lowered the price to $10 a megabit, 97% discount to the market, and we cut the provisioning time from 90 days to 9. No we're not magicians the way we did that is designed a network that was optimized to sell high-capacity Internet services. And we walked away from every other product and service including wavelengths, including MPLS. That turned out to be the right decision. When we looked at the Sprint network, we said we can the exact same thing by taking that dark fiber and optimizing it for wavelengths. We will be able to provision a wavelength from any data center in North America to any data center in 2 weeks. The number of permutations are 799, so it's 800 minus 1, divide it by 2 factorial. That's gazillions of potential permutations where those waves can go. No one can preprovision all of that capacity. But what we could do is build a base network that will allow us to turn up a wave with 2 field deployments, one at each end, and then automate all of those internal steps. We will win market share based on the ubiquity of our coverage, the uniqueness of our routes, the speed of our provisioning. And at the end of the day, we'll do what it takes on price. I have no doubt we will hit the forecast that I gave at your conference 2 years ago that said by May of '28 in the wavelength business, we will be at a run rate of $500 million. Yes, we are behind getting there because we did not sell big data center to big data center because that's not where the demand was. But in aggregate, we know that we will serve the entire market.

So that's super helpful. So to the answer to that question is then you kind of misunderstood where the demand was going to be. Why is the demand looking like it does and not the way you thought it would look?

So I think most companies use the Internet for large data center to large data center because there's plenty of Internet capacity and the cost per bit mile is 2.5x cheaper than using a wavelength, where if you're at a small data center in a secondary market, there may not be enough Internet connectivity with enough reliability to get you to that major aggregation point. So if you're in Racine, Wisconsin at a data center and you need to get to 350 Cermak in Downtown Chicago, which is the largest aggregation point in Chicago, you probably use wavelengths to do that because there's just not enough Internet connectivity in Racine. If you were at 350 Cermak and you want to go to 1950 Stemmons in Dallas, the largest aggregation point in the South, South Central country, you would end up using Internet to do that. But if you were in Lubbock, Texas wanting to go to either Dallas at 350 Cermak or 56 Marietta in Atlanta, you're probably going to want a wavelength for that. That's just where the market is. Remember, we had no market experience. So just like you mentioned, the hidden value parts of the business, we baked into our financial guidance. And again, it's multiyear. It's not specific annual guidance. We said we will be doing $1.5 billion in revenue. We're doing $1.1 billion now. That will be in May of '25. We're doing $350 million run rate of EBITDA today. We'll be doing $500 million of EBITDA. And we will be on a path to continue to grow at between 5% and 7% with about 100 basis points a year of margin expansion. That's what we said 2 years ago. That's where we are today. And we will do that through growth in all of these segments, but not included in that is dark fiber, IP address sale or wholesale data centers. I do want to touch on something you said about IP address space, and I think that's a misconception. Prior to the acquisition of Sprint, Cogent already was the third largest owner of address space in the world and had 28 million. All of the addresses that we have leased came out of Cogent inventory, not out of hidden inventory that came out of the Sprint acquisition. We did get an additional 9.9 million addresses all unleased in that acquisition. It's also public knowledge that T-Mobile sold 2 million addresses prior to the acquisition closing. It was simple calculus. They could have sold all 12 million that they had and they would have just had to write a bigger subsidy check to us. We knew what the addresses were worth. That was a trade-off in a negotiation that determined the ultimate $700 million subsidy payment. So it's not like there was some hidden gem that we didn't know about or T-Mobile didn't know about. Now what was surprising to us and was an upside surprise is the demand for data center space. We went into this -- and again, go read the transcript of the initial announcement. We said we were going to take 45 of the 482 switch sites that we acquired from Sprint and convert those into data centers. But we said they will look like Cogent data centers. That means they would have 10,000 to 12,000 square feet at about a megawatt of power. And we would sell 1 or 2 racks at a time to corporate customers. Prior to the acquisition, Cogent had 55 of those facilities and 634,000 feet of [ raised 4 ] and 69 megawatts of power. We've actually uncovered 3 more that makes sense. We're actually converting 48, not 45 that originally set out. But what we found was there was an extra 1 million square feet and an extra 100 megawatts of power that we can't use. There's a lot of demand in the market. We're rapidly converting that, enabling that to be sold, and we've started conversations with people to buy it. That is hidden value we had not anticipated. And then on the dark fiber piece, we knew how many fibers that were along the 19,000 route miles of intercity and 1,200 miles of metro. The fiber count ranges from 24 strands to 144 depending on the segment. We will generally use 6 strands to run our business. That means there's a lot of extra fiber on every route. We have not started to sell that because we need the resources that would provision that dark fiber to focus on getting this wavelength project complete. Once that's done, we're going to monetize it. So we will be willing to sell that dark fiber when we've got all of this foundational wavelength work done. Did that fully answer?

No, that was good. I think I've gotten 4 questions and we're almost done. So the -- just quickly on the data centers. Can you tell us a little bit what is the cost from upfront perspective to do this conversion of these legacy central offices into data center space that can actually be used by people who need real data center space? And can you give us any concrete examples of assets that have transacted that we can kind of get a baseline for what this could be worth? I mean, data center by data center.

Okay. So the typical data center is a brick and block building of about 40,000 square feet sitting on 6 or 7 acres of land and in an industrial park that's 10 to 15 miles outside of downtown. That's what it physically looks like. There will be multiple Sprint long-haul fibers coming into that, and now there are multiple extensions from that facility to the metro footprint in that given market. In those facilities, there were 22,500 base or cabinets, 3-foot wide, 8-foot tall, full of telephone switches. DMS 250s, 5ESSs. People don't know what LATA are, they surely don't know what these are. And we are down to 6,000 still left. So we've pulled out the vast majority, 16,500. But we've got to continue to pull them out. We have to go in and test and recertify the battery systems, the fire systems, the alarm systems and the generators and all of the backup facilities. The good news is the serving power is in place. There's 230 megawatts of inbound power coming into these facilities. There's generation and transmission capacity in place. And then most important step is all of these facilities were designed to operate at negative 48 volts DC. So when you run a data center, all the power comes in off of the grid usually comes in high-voltage AC. You have an on-prem transformer that steps that down to 483 phase. That then comes into the facility, it gets inverted to DC, it charges a battery plant. And then there's a inverter that turns that back into AC 120. There's a transfer switch sitting between the generator and the batteries. So if there's an interruption to inbound power, the center runs off of the batteries, the generator kicks in and charges the batteries as opposed to the power grid charging the batteries. That's how pretty much every data center is built. In our facilities, there is -- that last step is missing. There is no rectifier to invert that power. We are deploying those now. So it's a combination of housekeeping, general cleanup, testing systems and getting these inverters in place. We are working on that. We've actually accelerated that. We thought we would do this over a 3 or 4-year period. We're now trying to do it in a 1-year period. And this is in response to the demand. There is not a single transaction completed today. I don't want to mislead you or misguide you on the likelihood of those. What I will say is we went out to 115 counterparties at the end of April. We had an additional 18 inbounds, so we've had 133 parties that we've spoken to. We have 58 of those parties in some kind of active negotiation or discussion. Some are interested in just one site, some are interested in multiple sites. And none of the sites are ready to plug a server. And by the end of the year, there will be a subset of sites. This work will not be complete at year-end, it will bleed into next year. Again, we have finite resources, but we're trying to get these marketable while there is this short-term strong demand. We priced our space either on a lease basis or a sale basis at about a 40% discount to where the market is. We are pricing these at a rental rate of $1 million a megawatt a year or a sale price, pretty simple, at $10 million a megawatt. And we'll see what the market says in response to that.

It's a great place to leave it, Dave. Good conversation. Thank you so much.

Thanks, Dave. Sorry we didn't get to more questions.

You got to -- this would take 3 days to [indiscernible]. I appreciate it, as always. Thank you.

All right. Thanks, Dave.

All right. Good.