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

So once again, everyone, thank you for coming out and special thanks to Dave Schaeffer. Dave, great to see you again. It's good to be covering the space and get reconnected with you and Cogent. So thank you once again for attending our conference.

Well, thank you. Hey, Ana. Welcome back to telecom from software. Hopefully, it's a little more exciting. And as always, I want to thank Bank of America for a great venue, the opportunity to present. And I'd like to thank all the investors for taking time to hear a little bit about what we're doing.

Yes. Absolutely. Look, given a chance to catch up on what's Cogent, what's happening at Cogent and yourself has certainly made it more interesting for me as I've ramped back up on the space. So I want to start by going back to last quarter and then maybe connecting some things to some previous guidance you gave about the full year exit rates. So if we can start on the wavelength business, and I'm going to paraphrase my interpretation, and then please correct me if I'm wrong. But the installations in 2Q came in below Street expectations. You said that, yes, but the backlog, right, is very large and installations were lower because customers accepting delivery was less than you expected, and that was due in part because they're so conditioned to not expect -- or to not get delivery in the time frame that you were delivering, right? But I think your commentary remained positive or you reiterated your exit rate expectation for the business for 2025. And I hope that I caught all that right. If I didn't, please correct me. So can you take that as a question and just kind of fill in what I've missed and connect the 2Q with the exit rate for 2025?

Yes. So the wavelength business is a new business for Cogent and also a new business with the Sprint network and Sprint assets. So when we announced the acquisition of Sprint 3 years ago actually at this conference when it was still in L.A., our plan was to wave-enable the former Sprint long-distance network, and we laid out a time line and a path to do that. Probably the biggest disappointment during that process was our inability to sell a significant number of wavelengths between large data centers. So when we initially laid out a target of connecting 800 data centers, we said that would take us almost 2 years to complete post closing. In fact, we did it in 17 months. And during that process, we concentrated our initial work on the largest data centers. While we did sell a small number of wavelengths and installed them, the vast majority of the wavelength demand tended to be from smaller data centers to larger data centers. And at the end of 2024, we had fully enabled 802 sites to be able to deliver waves at 1 of 3 speeds, 10 gig, 100 gig and 400 gig and do that delivery in 30 days. This is an industry where waves have traditionally been installed on an as-needed bespoke basis with generally 4 to 6 weeks to get a firm quote and then another 2 to 3 months for install with a significant number of waves that are quoted never installing due to issues with the service provider and their network availability. In Q1, we installed a significant number of waves, but virtually all of those waves were installed at the very last day of the quarter. And for that reason, there was a significant disconnect between our revenue and our unit number of wave installs. We have not yet implemented a forced billing model, even though we have the right to do that for customers. Because we are a new entrant in the market with less than 1% market share, we have treaded lightly on pressuring customers. In the second quarter, we installed significantly more waves than we ended up recognizing revenue for. And I believe that, that gap will close over the next several quarters as we validate for customers our ability to actually meet the delivery windows that we have laid out. Even with that, albeit from a very small base, our revenue in the wave business grew sequentially 27% and 149% year-over-year. Now our run rate in Q2 was a little above $36 million annually. And while the company does not give annual guidance in validating the reasons for the acquisition, we laid out a series of multiyear targets that included growing the wavelength business to $500 million in a period that would be 5 years post closing, and that would result in mid-2028 doing $500 million in wave revenue. We have built a significant funnel of wave opportunities. When we announced the transaction, we were expecting to sell to 3 customer bases: international carriers, regional carriers and content distributors. A fourth group of buyers emerged, which quite honestly was not anticipated in September of 2022, which is AI training. And we think that will drive incremental growth for the aggregate market and help accelerate our ability to meet our revenue targets. We have issued a number of KPIs that are designed to give investors some points to measure Cogent's progress. But ultimately, the only KPI that should matter is our GAAP reported revenue. And I think over the next year or 2, we will migrate away from these qualitative KPIs and focus on those GAAP numbers. We expect the cadence of installs to pick up, and we expect the lag between install and customer acceptance to shrink. We believe that the experience we've had in selling high-capacity Internet and data centers is indicative of what we expect in the wavelength market. So while it is true the unit numbers were below expectations, the revenues were not materially below what we expected.

Okay. And just to boil it down how I'm thinking about it, Dave, is you laid out that customers were conditioned to you said kind of 4 to 6 weeks for delivery and then sometimes it was never delivered. And so one thought that I had asked you last quarter was, do you think maybe that these customers were just over-purchasing, right? Just that would be a rational thing to do if their experience was that it takes a long time and sometimes it's never delivered. And then have you seen an improvement in installations, right? Have you seen an improvement in customer acceptance this quarter versus 2Q? Because I think to hit your target for your exit rate, you would have had to do something like 1,000 installs a quarter in 3Q and 4Q. So have you seen improvement? And is my hypothesis about customers overbuying, is that on or off base?

So two very different questions. We have seen zero cancellations before install. So that indicates that customers were not overbuying, but rather were caught off guard, in part because they were conditioned by our competitors to believe that we could not install and that the quality of our service would not be what it has turned out to be. I think the fact that we have installed in 428 unique locations at the end of the quarter and have installed services now for several hundred unique customers is helping us get the opportunity to bid on a larger portion of those customers' backlog of orders. There are approximately 9,000 waves per month that come out of contract with the installed suppliers because most of the waves are going through a capacity migration from 10 to 100 gig and a small segment from 100 to 400. That means there is a new buy decision required in each of those waves as they come out of contract. So I feel that the breadth and depth of our funnel is a good proof point that we will hit metrics that we have laid out both in the near term and most importantly, in the longer term. So I think that we will continue to see the differential between install and customer acceptance shrink. But the sample set is too small, and we are too early in the wave business. What is maybe a little hard for investors to fully understand is while this business is important and it is the main justification of acquiring the assets from Sprint from T-Mobile, it is a brand-new start-up in the public arena. So within Cogent, waves represent less than 2% of our revenue. It is a brand-new product set and one that we have to demonstrate credibility with customers. I think the fact that our ARPUs went up and our discounting has not been as extreme as we expected it to be at this point is also a good indication of our ability to capture market share while maintaining price discipline.

Okay. I'd like to double-check sometimes that I'm hearing or understanding things correctly. So what I hear is that the longer-term opportunity is as large or larger than you thought when you initially did the Sprint transaction. There are a lot of customers coming off contract that create new growth opportunity for Cogent, right? That hasn't changed. Maybe some of the near-term metrics or KPIs or commentary that you gave to be helpful when you closed the deal are less relevant and might slip a little bit because it's a newer business, and it's hard to project growth and slope of growth early on in new business. But the longer-term outlook is intact and still very positive. Is that -- am I encapsulating all that correct?

I think you are, Mike.

Okay. Okay. I just want to make sure I understood.

And again, in understanding Cogent, there are really three pieces to the thesis. The first piece is understanding the business that existed prior to the acquisition. And that business was impacted negatively by the pandemic. And while it has recovered...

The legacy on-net, off-net business.

It is the Corporate and NetCentric services sold both on-net and off-net. It is selling Internet-based products that were 2 primary services, either dedicated Internet or VPNs over the Internet. But 100% of Cogent's revenues pre-acquisition of Sprint were coming from Internet-based services. We had a very small IPv4 business, very small colocation business both linked to the sale of Internet, but we did not sell transport services or wavelengths. When we acquired Sprint, we acquired from T-Mobile a large enterprise, multiservice managed services company that was delivering mostly VPNs and Internet access almost exclusively off-net and was losing $1 million a day. That business was declining at 10.6% a year for the 3 years prior to the acquisition. We were paid $700 million over a 54-month period to take that business. We have received about 60% of those funds to date, and T-Mobile will make the remaining payments between now and the end of Q1 2028. That business was burning $1 million a day. We accelerated the rate of revenue decline. We purged unprofitable services, we cut costs, and we were able to get that business to neutral, not yet profitable but neutral, and took out approximately $220 million of direct costs associated with that business. That business is still selling to a customer base that is in decline. Every enterprise service provider globally is shrinking. We are no different, although we now have mitigated that rate of decline and it's probably in the low single digits, 1% or 2%. And the primary reason for doing the acquisition was the acquisition of a $20.5 billion asset that was sitting idle. It was the actual long-distance network of Sprint: 482 buildings, 1.9 million square feet, 230 megawatts of inbound power and 19,000 route miles of intercity fiber and 1,200 route miles of metropolitan fiber, all idle. Our thesis was that we had three significant competitive advantages in repurposing that asset. We had a metro network that would enhance the value of that long-haul network, we had a sales force that would help us sell services on that network, and we had the technical know-how to be able to repurpose that network for one and only one purpose, and that is to sell wavelengths. So a considerable difference between us and the major competitors in the wavelength market is we have built a network from the ground up to sell wavelengths. It is a business that Cogent was never in, and we are very pleased with the progress we've made in the wave enablement of the network at or ahead of schedule. We are very pleased with the aggregate level of demand for our services in the locations that we have chosen to serve. And while the pacing of revenue growth may not be exactly what investors modeled or expected, in general, we feel that the opportunity is larger than we expected. And it's important to remember, the opportunity was greatly derisked by the payment stream from T-Mobile. Because we have cut the burn on the acquired business to 0, the remaining net present value of payments due from T-Mobile is $244 million. So effectively, we have a windfall but we also have optionality on a new addressable market.

Let me thank you for the overview. My perception is that what investors in the market are reacting to is that you are in this phase where there is execution risk, tremendous opportunity, right, with the Sprint asset. But there's still execution risk and maybe some short-term metric shortfall, which is fine to be expected in most businesses that are making large strategic transactions or initiatives. But you're also doing that while carrying a debt load that net debt to EBITDA of what, 7 to 7.5x, depending on how you're calculating it and still paying out $200 million a year in dividend that at least today is not self-funded. I know you were saying that it's going to be covered because EBITDA is increasing the free cash flow. And so I think it's that perilous state that the market is at least in part reacted to. So the question in my statement is do you support cutting the dividend to at least remove one of the pressure points from the bear argument that some investors might be making even if the initial stock reaction could be negative at least puts the company on a more stable financial footing capital structure?

So Cogent has returned in excess of $2 billion to investors. We have a history of growing our dividend, and we have a track record of periodically enhancing that return of capital through share buybacks. Our leverage today is at about 6.6x net leverage. That is far above where Cogent is both comfortable with and where we have historically operated. So we have historically hovered around 3x leverage while we were consistently growing the dividend. With the onset of the pandemic and our continued dividend growth, our leverage actually ratcheted up to 4.2x above kind of its historical norms. And we slowed down the rate of dividend growth from $0.025 a share to $0.005 a share per quarter. We also rapidly delevered with the acquisition of Sprint from T-Mobile due to the front-end loading of the payment stream from them. So as a result, our leverage in the first year of the acquisition went from 4.2 to 2.7x net leverage. Now our leverage has ratcheted back up because those subsidy payments ratcheted down. The headwind that we faced was $104 million a year. In the first year, we were able to cut costs fast enough to stay ahead of that, and our EBITDA stayed effectively flat. So we were $352 million in 2023 and $348 million in 2024. While we are continuing to cut costs and for the 8 quarters that we have operated the combined company, we have averaged $5.2 million a quarter sequentially in underlying EBITDA improvement. So even though our top line on a combined basis was declining because of the acceleration of revenue burn off from the undesirable revenue streams, our EBITDA, not just our margin, but the absolute dollars of EBITDA were growing. We still have additional cost savings that we intend to extract from the combined company. We still have monies that we are spending on integration work that will taper off. We have the ability to both delever and continue to return capital, both in a dividend and a buyback. Now it is clear that the market, which is an important constituency here does not believe that or our dividend yield would not have spiked to the level it's at today. So one must observe what others think, whether it's correct or not, it's a fact. The market has spoken. Now we have a clear path to delevering. If we maintain the current return of capital profile, which includes both dividends and buybacks and dividends growing, with our growth in EBITDA, we should delever to 5x leverage from 6.6 over the next 6 quarters. Now that may not be sufficiently rapid because even at 5x, we are probably above what is optimal for Cogent. Now it's highly dependent on the interest rate environment, but we, I think, have a great deal of flexibility. Now the rate of revenue decline has moderated significantly for the combined company. Q4 to Q1 revenues declined $5.4 million sequentially. From Q1 to Q2, the rate of revenue decline was only $800,000. We have said that we will be revenue neutral sometime in Q3. Now also, I'll qualify that. I don't want people to leave with near-term guidance expectations. It may be insufficient to make us completely revenue positive for the quarter, but it will moderate. And beyond this quarter, we will inflect back to positive revenue growth. We also have a mix shift going on. We are installing much higher margin revenue than the revenue that we have intentionally disgorged. So as a result, we should be able to see the $5.2 million that we've sequentially improved probably do better on a going-forward basis. Now with all of that said, it is absolutely appropriate for the Board every single quarter to evaluate what and how much and in what mechanism we should return capital. If you read our press releases for the past 15 years, they've always included a statement that said the Board reviews this each quarter and evaluates it on a quarterly basis. But at this point in time, there is no plan to eliminate or change our return of capital strategy.

When does the Board meet next?

So the Board meets regularly between quarters to address many events and then always meets at least once a quarter. In general, our Board meets about 10 or 12 times a year.

Okay. That's very helpful. We have about 12 minutes left, so I want to pivot a little bit. Other areas to potentially address the debt and the balance sheet that have been discussed are sale of IPv4, right, where you continue to have a very large inventory there and/or data center asset sales, and that was discussed quite a bit last quarter. So maybe just take those one at a time, your thoughts on IPv4. I know that some of the market prices that we can track are certainly off a peak. And so what do you think your capacity is to raise capital from IPv4 sales? And why hasn't that happened yet?

So while the sale price has declined, the 2 major buyers of those addresses have not been active in the market for the past 1.5 years. While the market is broad, it's not very deep. The volume of total addresses transacted is far below our inventory. So we would be flooding the market without those buyers in the market.

Why do you think they haven't been in the market?

I believe they were very successful in building an inventory of addresses, and now they are in the process of monetizing them through leases. So the second thing that has happened...

Who are the other buyers though beyond those 2?

Primarily Amazon and Microsoft.

But beyond the 2, who are the primary buyer -- who are the other buyers?

Oh, there are hundreds of small buyers.