Cogent Communications Holdings, Inc. ($CCOI)

Hi, everyone. My name is Sebastiano Petti and I follow the communications sector here at JPMorgan. It is my pleasure to introduce Dave Schaeffer, Founder and CEO of Cogent Communications. Dave, thanks for joining us today.

Sebastiano, thanks for hosting me. I'd like to always thank JPMorgan for a great venue. And importantly, thank investors for taking time out of their busy day.

Well, so just to start us off here, looking back, you closed the Sprint fiber acquisition in 2023. You laid out a multiyear vision, which was to convert data centers, launch waves, migrate more traffic on-net and ultimately emerge as a structurally different company. Now that we're 3 years in, I mean, what has played out as expected? And maybe what has surprised you along the path?

Yes. So I think there are 3 different parts to that answer. The first one is the conversion of the Sprint network into a wave-enabled network has pretty much played out as we expected in terms of the conversion. We initially set out to wave-enable 800 data centers. There have been additional data centers brought online and today, we're in 1,107 data centers. I think the aggregate demand for those services turned out to be better than we expected and that there is a fourth incremental use case. That incremental use case is AI training. What has been disappointing has been the rate at which customers have actually accepted those waves. Two, with regard to the data center footprint, our initial plan was not to spend capital on the 482 buildings that we had acquired with a gross inbound power capacity of 230 megawatts. About 1.5 years into the acquisition, it became clear to us that the power that was in place was a scarce commodity. We announced a plan to convert 125 of those 482 buildings into data centers. Today, Cogent has a total data center footprint of 185 facilities, a total of 2.1 million square feet and about 213 megawatts of power. In that footprint, we identified 24 of the largest facilities for divestiture. We felt that we would not have the best business model to fill them up. We put those assets on the market, 10 of those facilities are under LOI to be sold, and we have another 14 that are earmarked for sale. Third, in terms of the acquired customer base from Sprint, we anticipated needing to groom unprofitable services, noncore services, locations that were served with some technology, other than fiber. I think the rate of decline in that business has been faster than we had initially expected, but our ability to improve margins and take costs out have also been better than expected. Cogent today operates on a global footprint. Its EBITDA margins absent the subsidies from T-Mobile or about half of what they were prior to the acquisition, but we've been able to demonstrate substantial margin expansion over the 2.5 years since the acquisition at an annual rate of about 800 basis points a year. We have said that our long-term margin expansion will continue but at a more moderate rate of about 200 basis points a year and should continue from the roughly 21% margins today until we resume margins above 40%.

Well, so great overview and definitely going to come back to a bunch of those topics. But just thinking about the last point there, just the guidance and our expectations over a multiyear basis, and the pullback in shares suggests some concern about the path forward. But again, you have, right, reiterated or reaffirmed your longer-term targets, not only on margin expansion, but also waves, as well as the deleveraging opportunity. Because what gives you the confidence in the long-term fundamentals of the business? And maybe what is the market missing?

Yes. So you are correct, Sebastiano. Our stock has not performed well over the past couple of years since the acquisition, and I think there is a concern among some investors around our aggregate leverage and our ability to refinance our 2027 debt. And I think we'll touch on that a little later in our discussion. But in terms of the aggregate demand for the services that Cogent sells, the backdrop has probably never been better. Our core products are Internet-based services. 84% of our revenues come from those services. We are the largest carrier of Internet traffic globally. We operate in over 1,920 data centers in 57 countries, 306 discrete markets. In that footprint, we have seen traffic growth reaccelerate to about 14% year-over-year from 10% year-over-year the last quarter. That acceleration is the beginning of AI inference and a new application driving growth off of a larger base. If you look at the Internet, over its 35-year history, it's experienced 5 previous episodic waves of growth. This is now the sixth wave of growth from a new application. Secondly, in our wavelength business, which is a brand-new business for Cogent, we have gone from 0% to 3% market share in about 1.5 years. Now that is still far from the 25% market share that we anticipate ultimately capturing. But our footprint is the most ubiquitous, our routes are unique our ability to provision is quicker, our reliability is higher, and our cost basis in our network is lower, giving us a competitive advantage. So what really gives me confidence in Cogent's long-term prognosis is our ability to expand margins due to on-net sales. Prior to the acquisition, Cogent was 76% on-net, 24% off. $1 of incremental on-net revenue carries 90% incremental margins. $1 of off-net revenues carry about $0.45 of incremental margin. And since the acquisition is closed, we have seen our product mix shift from 47% on-net back up to 62%. And in the most recent quarter, 83% of our sales were on-net. So I think the combination of top line revenue growth coupled with margin expansion and our moderate capital intensity when compared to other service providers, the competitive footprint that we have and our more efficient infrastructure gives us confidence that we'll return to a pattern of returning meaningful capital to equity. We have returned almost $2 billion to our equity holders. We have paused that substantially due to our need to delever. And I think that has compounded some of the volatility in our share price.

Got it. Then I want to come back to the on-net in a minute here. But you alluded to it and just kind of going back to the data center sale, help us maybe think about the time line. So on the first quarter call, you spoke about the nonbinding LOI for the 10 data centers within potential or expected close in early summer. So again, walk us through the time line, when should we expect a binding agreement when maybe 8-K details on the counterparty and proceeds big area of focus for folks out there.

Yes. So we initially elected to convert the data centers in June of '24. By July '24, we had our first LOI. And then earlier this year, that LOI fell apart based on the counterparty requiring financing. We had another counterparty at the table that stepped in for a larger percentage of the portfolio. This is a well-capitalized 22-year-old infrastructure fund that manages $35 billion globally. They have completed their due diligence. We have negotiated a purchase and sale agreement. Once that agreement is fully executed, you will see an 8-K from Cogent that will outline who the counterparty is, which 10 data centers, the exact purchase price and the anticipated closing date. We are still quite confident that we will close this in early summer.

Got it. And remind us of the intended use of proceeds from there, especially regarding 2032 notes and the planned issuance of new secured notes.

Yes. So just to remind investors, the public company, Cogent has no debt at the holding company level. Underneath of that, since 2010, we added high-yield debt at the operating entity, Cogent Group. And we operated up until the Sprint acquisition with that corporate structure. With the addition of the Sprint network, we created a sister subsidiary Cogent infrastructure that holds the physical assets acquired from Sprint and also funds the associated burn with that asset. The data centers that are being sold exist at Cogent infrastructure outside of the borrower group. We have committed to bondholders to take the proceeds of these first 10 data centers and entirely contribute them into the borrowing group, Cogent Group, and not increase our restricted payments capacity. We will then use a significant portion of those proceeds to repurchase some of our current secured debt provided that secured debt continues to trade below par. After we have done that, we would then enter the market and issue new secured debt in order to replace the 2027 unsecured debt. In order to facilitate that, we are gathering a consent from the vast majority, more than 65% of our current secured bonds are held by companies that have agreed to allow us to increase our secured capacity, allowing us to refinance the entire unsecured tranche with secured capital, which should lower our cost of capital.

And are those the same as you think about the seeking consent from the secured bondholders to refinance the 2027 notes with secured paper. Are those the same bondholders that are likely to participate in the new deal? I mean, I guess what -- maybe any color on that?

I can't speak to each fund, but what I can say is the group of holders that represent more than the majority of our secured debt also hold a majority of our unsecured debt which will be called when there is no make-whole after June 15. They have indicated to us verbally that they would likely want to participate in that new offering. But we will work with a bank, potentially JPMorgan or some other bank in order to go to a broad marketing campaign and determine whether or not to allocate the new offering to the current holders or new holders.

Okay. And as we think about cash proceeds coming in from the data centers from this LOI, are there any material tax considerations or other deductions we should kind of be aware of? Just trying to think about what the proceeds could look like and your expectations around cash that you received?

You know what, we expect our cash tax leakage to be fairly minimal. While Cogent has approximately USD 1.1 billion in non-U.S. NOLs, predominantly in Europe, our U.S. NOLs are much more limited at about $140 million. We also will be spending capital this year and will be beneficiary of bonus depreciation accounting for that. The combination of our NOLs and our capital expenditures this year, coupled with our current interest load and our ability to avoid any 163J limitations, I believe, will allow us to receive the vast majority, if not all of these proceeds tax-free, except for some local jurisdictions, which may not follow federal guidelines.

Understood. And after the data center sale and the debt repayment, talking about using the vast majority or a substantial amount of the proceeds, do you have an anticipated leverage ratio in mind? Or where do you expect things to kind of shake up?

So we have said that the company will continue to focus on delevering until its net leverage falls to 4x. We are today at 6.7x. Without disclosing the exact proceeds of the data center sale, this will be a material step in closing that gap between the 6.7 and the 4.0. We also will expect to continue to delever with the growth in underlying EBITDA. If you look at the approximately 10 quarters since we closed the transaction with T-Mobile to acquire Sprint, our underlying EBITDA has grown at a little bit over $5 million a quarter sequentially. Now while that is not a perfect straight line, some quarters can be up $10 million next quarter could be up $1 million. The average is slightly over $5 million. We anticipate our EBITDA to continue to grow at a similar or even better rate as the mix of on-net versus off-net traffic improves and as we return to total top line growth due to the complete attrition of the Sprint revenues that are negative or low margin.

Got it. And you read it. So as we think about reaching the 4.0 leverage target, in the past, you talked about before reaccelerating or revisiting capital returns. How do you think about -- or how are you -- what are the factors, I guess, that determine the pace and form of future returns, buybacks versus -- sorry, Dave, versus dividend?

So Cogent actually began returning capital to equity in 2007. It continued that capital return program entirely through share repurchases til 2010. At that point, we actually added high yield to our balance sheet, we had no debt previous to that, other than our capital lease obligations. As we had grown our EBITDA, we implemented a return of capital or dividend program. We also continue to supplement that with buybacks. We had a dividend and we grew that dividend for 52 sequential consecutive quarters. With the capital that was necessary to repurpose the Sprint network and the decline in our top line growth rate, we decided to reduce that dividend to a minimal level of $0.02 per quarter or $0.08 a share a year. That dividend has mostly been counted as a return of capital. So therefore, has been tax efficient for the recipient. We also have continued to do some episodic buybacks. In aggregate, we bought 10.3 million shares back at about $23 a share. In hindsight, we should have waited because the shares have traded below that, but no one can be perfect in their timing. We also have returned approximately $1.7 billion through the dividend, of which the vast majority was treated as return of capital. As we approach 4x net leverage, we will commit to continuing to return capital to shareholders and whether the mechanism is buybacks or dividends, it will be highly dependent on market price of Cogent securities at that time.

Understood. Understood. So going back to just top of the funnel with the on-net commentary you touched on earlier. So with on-net plus waves was up, I believe, 9% in the first quarter and have been improving each of the last, I think, 3 quarters. As we're thinking about the drivers of growth, you talked about AI and some of these other things, maybe you can double-click on that for us and how much of this improvement is organic relative to the migration of the Sprint network, the Sprint off-net traffic on that?

So the migration of Sprint traffic from off-net to on-net occurred within the first several quarters of the acquisition and was a key driver in our ability to expand margins very quickly. When we acquired Sprint, it was 93% off-net and only 7% on. The Sprint business represented 42% of of the revenues of the combined company. In that transition, we did improve margins, but subsequently, the margin improvement has come from continued cost reductions and synergies, but also from our ability to sell a much greater percentage of on-net than off-net. And on a going-forward basis, we anticipate more than 100% of our growth to come from Cogent's organic sales. Now how can it be more than 100% because the Sprint revenue, which represents today, 16% of the combined company's revenue, down from 42% is continuing to decline. As it becomes a smaller and smaller part of our business, it becomes easier for us to have total top line growth. Finally, the Sprint revenues have contributed some margin to Cogent, but their margin contribution is far below the average of the Cogent margin contribution. So without the payment subsidy from T-Mobile, our margins are around 21%. When we add that subsidy in, we're at around 31%. That subsidy will continue for just under 2 more years or about $200 million more in payments from T-Mobile. As those subsidies wane, we expect to be able to continue to grow our underlying margins. And while our margins will expand meaningfully and our aggregate reported EBITDA will expand there will be in '28, a flattening of our rate of margin -- or rate of EBITDA growth due to those subsidy payments lapping.

Okay. And so the combination -- so I guess what gives you the confidence in achieving that? This year, I believe you talked about being able to expand margins over 200 basis points, which is -- 200 is the longer multiyear kind of target, but within 2026, it's -- do you think you can do better than that? Is this a function of just this accelerating on-net mix shift? Is there any -- help us think about any other kind of cost takeout opportunities that are maybe near term that we should be focused on as well?

Yes. I think there are actually 4 drivers of that ability to grow margins. The first and most significant is the growth in on-net versus off and that relative improvement in margins. Two, our ability to take the remaining Sprint business and price it appropriately. So each product has an acceptable level of margin. Third, we have still a small amount of synergies to be achieved from the acquisition. And those synergies will actually expand as we are successful in divesting of the unproductive data centers that I had mentioned earlier. And then finally, we are still spending capital on integration work. Many companies stop when they get the easy parts of integration done, and then they wait literally years before they're able to show the savings. We have, I think, had the discipline to continue to focus on the hard parts of integration, and that's allowed us to continue historically raising our margins after that first year.

And then thinking about going back to just revenue real quick. In the first quarter, I believe revenue declined, you called out, I think, some large enterprise customers had canceled the month-to-month services. Acknowledging, I guess, the unpredictability of month-to-month contracts, should we anticipate sequential revenue growth from here? I mean that was something we've been talking about the last several quarters. So as you think about the on-net versus off-net mix that we just kind of described, do you anticipate continued sequential revenue growth from here?

So the rate of revenue decline has moderated every quarter sequentially for the past 5 quarters, each quarter being less than the quarter before. Secondly, that revenue decline was caused entirely by the Sprint customer base. And the organic Cogent revenues actually grew 28% in the 10 quarters since the acquisition. It is really a question of will the Cogent revenue growth dwarf the rate of decline and the Sprint revenues. The Sprint revenues are today a much more de minimis portion of our total base at only 16%. But we are not giving a specific target, but I would anticipate the rate of decline to continue to moderate and may turn positive over this quarter or the next several quarters.

In the aggregate?

In aggregate.

Okay. Understood. That's great. And then moving to waves. So Waves installs slowed in the first quarter to the slowest -- to the lowest pace, I think, since the second quarter of 2025. You touched on customer acceptance issues, but also I believe there were some supply chain constraints as well. Maybe help elaborate on those and help us think about your anticipated -- when do conversion rates within the funnel, which we don't talk about anymore, when should conversion rates begin to improve?

So let me touch on supply chain issues 2 ways. One, their impact on Cogent; two their impact on customers. Cogent has built out a wave-enabled network over the entire Sprint footprint. We today have nearly 30,000 route miles of intercity wave network connecting over 110 markets. We also have over 21,000 route miles of metro fiber in those markets allowing us to connect to 1,107 carrier-neutral data centers. The line systems, ROADMs and transponder shelves to deliver waves across that footprint are fully installed. We have an adequate supply of pluggable optics to add incremental wavelengths to that network. And what makes our network unique is the flexibility of being able to go from any data center to any data center. So across that footprint, there's actually a combination of 10 to the 2,800 power of permutations of possible wavelengths ordered. We have sold wavelengths to date to 492 unique customers. We have sold those wavelengths into 581 of the 1,107 facilities. We actually installed more wavelengths in the quarter than we recognized revenue on. And many of our customers have had a number of constraints impacting their ability to accept those waves. Those constraints can range from limitations on power and the data centers in which they operate, their access to server equipment due to memory shortages and their access to pluggable optics. So whether it be our IP-based services or our wavelengths customers still need something to plug those services into. And we have seen a number of supply constraints impact all of our customers.

Understood. And I think in an earlier session today, Verizon talked about AI infrastructure and -- something a topic that also came up last week, but talked about AI infrastructure as an opportunity for them. This is consistent with some of the channel checks we've done as well. But have you seen -- is there increased interest from the likes of AT&T, Verizon and others as well that's causing some pressure, whether it be on demand or pricing within the waves market?

So I would actually say the majority of the incremental use has come from hyperscalers. If you looked at the wave market historically for the past 15 years, there have been 3 major customer segments: regional networks looking to connect their networks together, international networks looking to extend their network and content distribution of information usually by hyperscalers. The fourth use case, which has been the incremental driver has been the need to move data from one data center where data is stored to another data center where power is available for AI training. That has created a significant incremental demand on wavelength traffic. For Internet transit, we have actually seen transfer traffic accelerate in part because the data that is collected over the Internet now has incremental value for training, whereas before it was discarded. So if we look at the 35-year history of the Internet, only about 20% of data transmitted was over stored, 80% was discarded. Now that ratio is inverted and over 80% of data transmitted is now being stored and used for training. And we are now approaching the benefits of the AI training with inference. And inference means using those large language models that were developed in these large facilities, distributing them closer to the edge at the perimeter of the network. And then in an Agentic AI environment, 2 things are true. Total Internet usage by end users increases; and two, the directionality of that traffic changes to be much more symmetric as opposed to the asymmetry we've seen over the past 15 years.

Got it. And then just a quick follow-up on that. Just you modestly walked back maybe the mid-2028 time line on waves and reaching the 25% market share. But you still see that, I think, as the longer-term kind of target. But maybe help us why is 25% still the right number? And I guess despite the slower ramp perhaps.

So we operate in a fairly concentrated market. For metropolitan waves, the market is dominated by AT&T and Verizon. For intercity waves, the market is dominated by Lumen and Zayo. Cogent has 5 discrete competitive advantages, more endpoints, faster install, unique routes higher reliability on a per route mile basis and lower prices. We believe those competitive differentiations will allow us to replicate the market share that we have in global transit. We are the largest carrier of transit globally, carrying just under 2 exabytes a day of information. representing about 25% of all global traffic.

Well, Dave, I think that's a great place to end it. Thank you for your time today, and thanks, everyone, for joining us.

Thank you, Sebastiano.