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

Great. Let me start by reading a quick disclaimer. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. I'm Jonathan Greenberg, Investment Banking Managing Director. And I'm here with Dave Schaeffer from Cogent. Dave, thanks for coming back to San Francisco.

Hey, well, Jon, thank you for hosting me. As always, I want to thank Morgan Stanley for a great venue, and I'd like to thank the investors who stayed around to hear a little bit about Cogent.

Yes. Thank you for staying into the evening. I feel like we should all be sharing a couple of cocktails together. But maybe we'll focus on the business to start.

Fair enough.

So let's just start with broader industry trends. Cogent manages 25% of global Internet traffic, which is a pretty impressive number. Traffic is growing around 10% annually. And so how do you think about the surge in demand of traffic and how that influences your business over time?

Yes. So the Internet is roughly 35 years old. And during that period, it's grown at a compounded rate of about 23% a year. So slightly higher than today's current growth rate. But the base keeps getting larger and eventually, it becomes more and more challenging to maintain the same percentage growth rate. I think the Internet actually has decades left of continuous growth. But if we look over that 35-year period, there have been at least 6 discrete technologies that each 1 has adopted has driven a wave of growth. We are in a transition period from streaming video being the primary driver of traffic growth to now being AI. We're in another 1 of those inflection points. Internet traffic growth is defined by 3 inputs, the number of people using the Internet, the number of minutes a day they use it, and most importantly, the bit intensity per minute. And we have seen streaming growth grow in the past 5 years, starting at the beginning of the pandemic, streaming represented about 18% of all video consumption in the developed world. Today, it's at 34% -- 54%. So we've seen this really S-shaped curve, a very rapid adoption of over-the-top video, professionally produced, displacing linear television. That trend will continue, but we're seeing a maturation of that trend. On a going-forward basis, we have not yet really seen AI inference be widely integrated in applications and to various business processes. I think as that matures, we will see a reacceleration from the 10% back up probably even above the long-term trend line, which has been the pattern as each new technology gets implemented. And then over a 5- to 10-year period as that technology matures, we start to see things revert back to that [ mid-20% ] type growth rate.

So a surge in demand over this period of time that we've also seen falling prices, which you have historically been very price sensitive in terms of pricing your product. How does that influence your pricing strategy going forward and your positioning in terms of competing for this traffic?

So at an investor conference, I wish I could say that we've reached a point of price stability but that would not be a true statement. Price per bit has fallen also at about 23% per year, keeping that total addressable market in dollar terms flat. I think that price compression will continue perpetually into the future. There was adequate competition both at the end user level and at the backbone level. Now the real advantage that Cogent has that is sustainable is its network architecture. The core founding principle of Cogent was to build a network focused entirely on the Internet and have the absolute lowest cost of production of an interface-routed bit mile. And when someone uses the Internet, they don't think about what they're doing. They just click on a website and expect something to come back. And what, in fact, a service provider delivers is it gives you an interface to plug into, it routes your bit typically through about 8.5 routers between origin and destination. It typically ultimately traverses a little under 2.5 networks between origin and destination, and travels about 2,800 miles. Ironically, over the 35-year history of the Internet, that has not materially changed. It's isolated some. And what we've seen is 2 factors: more content being cached locally. So therefore, packet travel distances should go down. But offsetting that is the fact that the Internet has become much more global. So 25 years ago, 85% of all bits on the Internet either originated or terminated in the U.S. Today, that's about 31%. So that globalization has roughly canceled out the localization of content. With all of those engineering data points, how does that translate into pricing and the ability to grow the market size. The 2 underlying technologies that drive the ability to drive down price are wave division multiplexing and optically interface routers. Over that long-term period, those 2 technologies have been on a rapid price performance improvement curve. Cogent's maybe most important competitive advantage has been its architecture. We capture more of those advances in optronics and in routing more effectively than legacy Internet service providers. We can keep some of that as profit and pass some of that on to customers. So Cogent's market advantage has been the fact that we typically price at a 50% discount to the market average. And that has, in fact, contributed to us being the largest carrier of Internet traffic globally.

So increase in demand falling prices, obviously, the ticket is to take share. Maybe can you talk about -- you just talked about how you take share, but maybe some of the share gains you've seen relative to some of the competitors in the landscape?

So Internet services represent over 85% of Cogent's revenues. We were founded solely on the premise that the Internet would be the only network that mattered. And each of our relevant addressable markets we offer compelling value to the customer. In the end user market where today Cogent has about 1.1 billion square feet of multi-tenant office space, we offer an Internet connection that is typically installed 9x faster than a competitor. It's more reliable once installed, 3x more reliable and then it delivers 30x to 60x the symmetric throughput for price parity. That has allowed us to gain a 35% market share and 11% of all office space in North America. The bad news for Cogent is that the other 89% of the market is not economically serviceable. The cost to extend fiber to those facilities, the cost of revenue acquisition and the aggregate size of those buildings do not justify the investment to bring fiber into the building and up the riser. So we do have an off-net business where we rely on others to deploy that fiber. But there, our competitive advantage is much lower. And then for our wholesale or NetCentric business. We connect to 1,902 data centers in 307 markets across 57 countries, far more footprint than any other ISP. We do that over our own fiber network that is comprised of roughly 93,000 route miles of terrestrial fiber intercity and another 33,000 route miles of metropolitan fiber. In that footprint, we connect to what are effectively supermarkets for bandwidth, and we offer our service at a 50% discount. That has allowed us to capture market share. And I think going forward, we continue to see companies who used to compete in that market withdraw. So a decade ago, there were probably 25 legitimate global carriers. Today, there's probably 6 or 7. And eventually, I think this market will stabilize with less than 5 players.

Let's transition to the waves side of the story. This was a key focus of the Sprint transaction that you did a few years ago. You've said that Cogent has less than 2% of that market today, and you think there's opportunity to build that to 25%. Maybe talk about the progress you're seeing in that piece of the business and what it's going to take to get to that 25% target.

So first of all, for investors, let me differentiate between a wavelength and Internet service. Internet service is the connectivity you make when you connect between networks. You use optical transport, but you use routing and interface and interconnectivity to other networks. The Internet is not a single thing, it's an amalgamation of tens of thousands of networks, creating a web of paths that bits can flow across and those bits flow on a routed basis. The Internet is the easiest to use, cheapest and most ubiquitous connectivity. But there are certain characteristics that customers value that the Internet cannot replicate, security, large package transmission and most importantly, predictable latency with a defined path. That's where a wavelength comes in. We had never been in the wavelength business until 2023. When we had the opportunity to acquire Sprint, we really did 2 concurrent acquisitions at the same time. We acquired an operating business, selling a combination of 3 services. Internet access, MPLS VPNs and a series of noncore products to a number of non wholesale customers, retail customers, either large enterprises or larger midsized businesses. That business that we acquired was burning almost $1 million a day of cash, and we struck a deal with T-Mobile to buy that business and be paid $700 million. And we have ripped cost out of that business, eliminated products, directly shrunk the customer base and turned it into a marginally profitable business. But the real reason we did the transaction was we got to buy the dormant Sprint LD voice network for $1. We are repurposing that network to sell wavelengths. Sprint had never sold wavelengths, Cogent had not sold wavelengths. We spent over 2 years connecting that network to 1,096 data centers in North America. It's architected solely to deliver wavelengths. We can provision a wavelength between any of those data centers any permutation whatsoever, and there's over 10 to 2,800 power of permutations across that footprint. And we can do that in 30 days or less. That product is much better than what you can buy from legacy providers who sell wavelength services as excess capacity on their network. The total addressable market for waves globally is about $7 billion, $3.5 billion of that is in North America. The North American market is further split between local, which is dominated by the incumbent phone companies and cable companies that local market is about $1.5 billion, and then a $2 billion intercity data center to data center market. That is what we are focused on. Today, Cogent drives about 4% of its revenues from that business, and we grew 100% year-over-year. And maybe most importantly, we are still a big player in that market. We have 2% market share, as you pointed out, Jon. And for us to gain market share, we have to go to wavelength customers. It is a relatively concentrated customer base, and we need to show them a compelling value proposition. Why should I use Cogent versus 1 of the 2 or 3 legacy providers? And on that front, we actually have a 5-pronged value proposition. We have more data centers, faster provisioning, unique routes, higher reliability and lower price. A little bit different than in the Internet business, each route is custom priced based on its distance and the wavelength side. We have been able to use our advantages to quickly gain a foothold in that market, and we need to grow from here. But our competitors are saddled with a network architecture that is less efficient than what we have in delivering those wavelengths.

What should investors take away from this with respect to what you're seeing in the sales pipeline and the current backlog? And you mentioned your time to install is much faster or time to provision. And so how should they think about that translating into results in the near to medium term?

Investors care about 3 things: Can you grow top line? Can you expand margins while you're growing top line and therefore produce an amplified amount of cash flow? And can you have a balance sheet that rationally allocates that cash flow between debt and equity? And I think on all 3 fronts Cogent is addressing those issues. With the acquisition of the Sprint customer base for 9 quarters we had negative top line growth. So for 18 years as a public company before acquiring Sprint, Cogent had a track record of 10.2%, organic growth on average over those 18 years. In the past 9 quarters, that went to negative 5.4% growth. We have now reverted to top line growth. So what investors need to take away from this is the totality of Cogent is now a growth company. Wavelengths are an important contributor to that. Any of our on-net products carry a similar contribution margin of 90-plus percent incremental EBITDA. For our office product, we're 35% penetrated. So there's only 65% of the market left on net to capture. And our transit business, we're 25% market penetrated. And in our wavelength business, we're only 2% penetrated. So as the total business grows, waves will be a disproportionate share of on-net growth. With that, we expect Cogent to report a top line growth rate of between 6% and 8% per year on a multiyear glide path. Secondly, we expect our EBITDA margins to expand because of this relative mix of on-net and off-net traffic by at minimum 200 basis points a year. Before Cogent acquired Sprint, we had an 18-year track record averaging 220 basis points a year of margin expansion. Post Sprint, we've actually averaged over 1,000 basis points a year, but that was coming mostly from cost cutting. Some of it was coming from on-net sales but the majority was coming from rationalizing the burn that we inherited. With most of that rationalization behind us, our growth going forward is going to come from new sales with a high percentage of the sales being on-net. In the fourth quarter of '25, we had 80% of our sales be on-net. We expect to continue to increase the percentage of the total base that is on-net. Wavelengths will contribute to that. And therefore, we should see EBITDA grow in mid- to low single-digit rates for the foreseeable future. And then finally, we have, I think, taken a number of steps to optimize our balance sheet. The acquisition of Sprint increased our leverage. We had 52 consecutive sequential quarters of growing a dividend. We had to reduce that dividend for the first time because our net leverage was above our comfort zone. We have committed to investors to get back down to 4x net leverage. And at that point, we can begin accelerating a return of capital again to shareholders. I think those are the important takeaways for an investor.

You did a good job covering some of my questions right there. I can come back...

Unless I didn't pique.

How are you thinking about balancing the need to invest in the network for future growth relative to debt reduction you were just talking about? And how do we think about capital allocation as well as return of capital longer term once you do get back there?

So oftentimes, Cogent gets viewed as a serial acquirer. Between 2001 and 2004, we looked at 121 targets. We bid on 19, and bought 13 of them and integrated them into the Cogent network. We ended up paying very little and actually netting cash. We paid $60 million, acquired $115 million of cash, $400 million of acquired preferences, $500 million of debt. We then restructured operationally and financially without a bankruptcy to emerge debt free. And then for 18 years, we did not do a single acquisition. We had looked at 850 targets in past. We chose to do Sprint because it was additive, and it was priced correctly where we felt that the challenge that T-Mobile had gave us the opportunity to derisk the acquisition with the $700 million payment stream. During that period, we returned $2 billion to shareholders. We bought back 22% of our float, and we implemented that dividend and grew that dividend for over 12.5 years successfully every quarter. We did use leverage to do that. And at the same time, we consistently expanded our footprint. Our business model is very capital efficient. We will need roughly $100 million in long-term average capital per year and another $40 million for principal payments on capital leases. We have debt service that we have to make on the roughly $2 billion of gross debt that we have. And then finally, there's a significant remnant leftover of cash that is available to shareholders. In the short term, we're going to use that along with asset divestitures to accelerate our delevering. But then we will begin to return capital again at an accelerated rate. We will continue to look at M&A, but I think it's unlikely in this environment that we will do anything and more likely that we will kind of continue to expand our footprint. We're in 57 countries and we consistently add both multi-tenant office space and data centers to the footprint in both existing markets and new markets. The most recent country we've done a significant expansion is in India. That is a regulatorily challenged market. It took us almost a decade to get the requisite licenses. But we do see that as a significant growth opportunity for the company. With a lot of geopolitical turmoil, it's not clear against this regulatory backdrop, there are that many more countries that welcome an open Internet. We will continue to add. We actually have Thailand on the map to come on-net probably in the next 60 days. So there are still some incremental markets. And then there are incremental cities. So recently, we extended in Japan from just Greater Tokyo to Osaka. So there will be these types of footprint expansions, and we'll typically add about 120 carrier-neutral data centers a year to the footprint. But I don't see M&A as a significant use of capital.

Not a use of capital, but you have been quite vocal about your intentions to monetize the data center portfolio. Maybe can you give us an update as to where those stand?

Yes, sure, Jon. So when we acquired the Sprint network for $1, we effectively got 2 assets, 20,200 miles of dark fiber that was fallow, and 482 buildings that comprise 1.9 million square feet and had 230 megawatts of inbound power. This deal was announced in September of '22. There was no data center shortage problem. There was no constraints on power. Our original thought was we were going to take 45 out of 482, and put a small low power density data center in those buildings. By the beginning of '24, it became clear to us that the asset we had had significant value because of the inbound power. We canvassed a number of potential buyers, listen to what features they wanted to see. And in June of '24, we kicked off the 1 year, $100 million program to retrofit 125 of the 482 buildings. Of that retrofitting process, 24 of the largest buildings are beyond Cogent's ability to fill them up. So we decided to divest them. That project was completed at the end of June of '25. By beginning of August of '25, 6 weeks after the completion, we actually had our first deal to buy 2 buildings. And those 2 data centers went under LOI, the parties agreed on a price, and in the first quarter was supposed to close. When it came time to close, the counterparty did not renegotiate price but demanded that we provide vendor financing. We withdrew from the LOI, and we pivoted to 1 of our backup deals that people were conducting in the background. Earlier this week, we announced that we have signed a letter of intent. It is nonbinding, but we do believe it will close for 10 data centers and it is substantially higher than the $144 million in the first deal. We'll continue to work with that provider, and we will continue to work with other interested counterparties, some of which are backups to these multiple contracts for the remaining 24 facilities. And we feel comfortable that the quality of the facilities, their location and the aggregate demand backdrop presents us a great opportunity to take an asset that we have no basis in other than the capital we spent to modify them and sold them for a significant gain.

Sticking with the balance sheet for a second. You indicated earlier this week your intent to refinance the senior notes that are due in 2027. Maybe you also published a couple of slides. I think that went up on your website...

I'm going to quiz you on those slides, Jon.

Don't quiz me, let's provide it to the investors right now. But maybe if you could chat through how you're thinking about the refinancing and the structuring that you're doing?

Yes. So let me explain Cogent's organizational structure, which is necessary to understand the refinancing strategy. Cogent Holdings, the public entity has no employees and no debt. Underneath of it, since 2010, there's an operating company, Cogent Group, where all the employees, all the customers and where the debt sits. When we acquire Sprint, those customers went into that entity as well as the subsidy payments from T-Mobile. We also acquired the MT network that had a $140 million cash carry cost. We did not want to burden our bondholders with that. So we created a sister subsidiary, Cogent Infrastructure, no employees, no operations, just physical assets, the buildings and the fiber. That entity has been funded for the past 2.5 years by the restricted payments capacity generated at the borrower, Cogent Group. Cogent Group has 3 tranches of debt, $623 million of capital or finance leases, $600 million of secured debt, and $750 million of unsecured debt that matures in about 16 months. And what we are doing is taking the finance leases out of Cogent Group and moving them, leases, liabilities and assets over into Cogent Infrastructure through a series of asset realignment steps. And doing that, we removed $569 million of debt, most senior debt off of the balance sheet of the borrower. We also have committed to put the proceeds from this initial 10 facility data center sale into the borrower group when in fact the assets sit outside of the borrower group. These 2 steps were designed to free up incremental borrowing capacity and enhance the credit of the current bondholders. We will issue $750 million of most likely 7-year duration, secured debt and use those proceeds dollar for dollar to pay off the unsecured debt, and in doing so, extend our maturities. So the nearest date of maturity will be 6 years, the longest stated would be 7 years. The capital leases would not be in the borrowing group, and they have actually an average remaining life of nearly 21 years in them. So they're extremely long-dated matures.

Lots of initiatives underway, never a dull moment. I would characterize this, though, as a very optimistic conversation. Maybe any parting words for the investors with respect to your excitement for the business and what you're seeing going forward over this year and the years to come?

Yes. I think I have 4 messages to leave investors with. The first, Cogent is a stable business that's been around for 26 years, 21 of them is a public company. We've experienced significant stock volatility and bond volatility over the last year, but our business has been amazingly consistent. Two, we have reverted to top line growth after a 9-quarter period because of the acquisition of the Sprint customer base where we had negative growth. Third, we have demonstrated the ability to expand margins at an extraordinary pace through cost cutting and through product rotation. On a going-forward basis, we will continue to focus on on-net services and grow the profitability of the business. And third (sic) [ fourth ], with the balance sheet tools that we just described, we have an ample runway to ensure that we have ample liquidity to be in a position within a couple of years to be able to return capital again at an accelerated pace to our equity holders.

Great. Very clear. Dave, thanks for coming. We hope we'll see you next year.

Thank you very much. Thanks, everyone, for staying so late. Take care.

Have a good one.