Cogent Communications Holdings, Inc. Q1 FY2022 Earnings Call

Welcome to the Cogent Communications Holdings Incorporated First Quarter 2022 Earnings Conference Call and Webcast. My name is Hilda, and I will be your operator for today's call. As a reminder, this conference call is being recorded and will be available for replay at www.cogenco.com. A transcript of this conference call will be posted on the same website when it becomes available. Cogent's summary of financial and operational results attached to its press release can be downloaded from the Cogent website. I will now turn the call over to Mr. Dave Schaeffer, Chairman and Chief Executive Officer of Cogent Communications Holdings.

Thank you, and good morning. Welcome to our first quarter 2022 earnings conference call. I'm Dave Schaeffer, Cogent's Chief Executive Officer. With me on this call this morning is Sean Wallace, our former Chief Financial Officer; and Tad Weed, our returning Chief Financial Officer. I want to personally thank Sean, a long-time friend for his willingness to step in and act as our Chief Financial Officer while Tad was on medical leave. And now that Tad has fully recovered, after a brief transition period with Sean, he will be resuming the CFO duties. I'm excited to welcome Tad back as our CFO. Hopefully, you've had a chance to review our earnings press release. Our press release includes a number of historical quarterly metrics that are presented on a consistent basis. Our corporate business continues to be influenced by real estate activity in central business districts. Two key statistics, including the level of card swipes for security entrants into buildings and leasing activity indicate that during the first quarter, the real estate market and leasing activity in central business districts in which we operate continue to see improvement. During the quarter, leasing activity across major markets continued to increase and the return of workers to offices has accelerated. In the first quarter, our corporate business experienced the smallest decline since the beginning of the pandemic as gross conditions improved and net churn continued to decline. Adjusting for the negative effect of changes in the Universal Service Fund revenue, our corporate business was essentially flat in the quarter. While these improvements in our corporate business are encouraging, we continue to remain cautious in our outlook, given the uncertain economic environment and the continuing challenges of the pandemic. Our Netcentric business continues to benefit from continued growth in video traffic and streaming. For the first quarter, our traffic was up 8% sequentially and increased by 17% on a year-over-year basis. Our Netcentric business grew by 4.4% sequentially quarter-over-quarter and by 15.1% on a year-over-year basis. On a constant currency basis, our Netcentric business increased by 18.6% from the first quarter of 2021 and grew by 5.3% from the fourth quarter of 2021. Despite facing significant revenue headwinds this quarter from the negative impact of foreign exchange and the reduction in USF revenue, our first quarter total revenues increased sequentially by 1.3% to $149.2 million and increased by 1.6% on a year-over-year basis. On a constant currency basis, our revenue increased sequentially by 1.7% and 2.9% on a year-over-year basis. On a constant currency basis and adjusting for the negative impact of the decline in USF revenues from the change in USF tax rate, we experienced a sequential growth in revenue from the fourth quarter of 2021 of 2.1% and a year-over-year growth rate of 3.5%. We continue to operate an extremely efficient network. Our network serves a growing number of markets, carrier-neutral data centers, and multi-tenant office buildings and is able to support dramatic increases in traffic and revenue with a relatively fixed cost base. The performance of our existing customer base continues to be strong, despite the impact of COVID-19. Customer churn, bad debt expense, and days sales outstanding for the quarter for our corporate customers all fell for the second quarter in a row. Our days sales outstanding of 21 days equals the best in Cogent's history. Our bad debt expense as a percentage of revenues was the best since the first quarter of 2016. Both our on-net and off-net churn rates improved for the quarter. We believe these statistics demonstrate the strong credit quality of our customer base and the importance of Cogent services to these businesses. During the quarter, we returned only $1.3 million to our shareholders through our regular dividend. We did not purchase any stock in the quarter and have a total of $30.4 million authorized under our buyback program, which is authorized to continue through December 31, 2022. Our cash at Cogent Holdings is $107.6 million at quarter end. This cash is unrestricted and available to be used for both dividends and buybacks. Cash held at our operating company is $204.2 million. Our total consolidated cash and restricted cash is $311.8 million at quarter's end. Our gross leverage ratio declined to 4.94% from 5.02% in the last quarter. Our net leverage ratio remained unchanged at 3.58%. Our consolidated leverage ratio, as calculated under our indentures is 4.91% at quarters end. Our Board of Directors reflected on the strong cash-generating capabilities and investment opportunities in Cogent's business. As previously announced, we decided to increase our dividend sequentially by another $0.025 per share this quarter, raising our quarterly dividend from $0.885 per share to $0.88 per share per quarter. This increase represents the 39th consecutive sequential increase in our quarterly dividend, and our annual dividend growth rate is approximately 12.8%. Now for some expectations against our long-term objectives. Our targeted long-term EBITDA annual margin expansion guidance calls for an improvement of 200 basis points per year. Our targeted multiyear constant currency revenue growth rate is approximately 10%. Our revenue and EBITDA guidance are meant to be multiyear goals and are not intended to be used as specific quarterly or annual guidance. Now, I would like to ask Tad to read safe harbor language to give an update on COVID-19 and review some of our operating performance. Sean will provide some additional performance details later in the call. Tad?

Thank you, Dave, and good morning, everyone. This earnings conference call includes forward-looking statements based on our current intent, belief, and expectations. These statements, along with any other non-historical remarks made during the call, are subject to various risks and uncertainties, which may cause actual results to differ materially. For more information about the factors that could influence our results, please refer to our SEC filings. Cogent does not commit to updating or revising any forward-looking statements. If we mention non-GAAP financial measures, they will be reconciled to GAAP measurements in our earnings release, available on our website at cogentco.com. We continue to be affected by COVID-19, as many companies are, and the various responses by governments globally. This quarter, our workforce returned to the office environment in March. We would like to express our appreciation to all our employees, especially our IT department, for their hard work during these challenging times. We also thank our field engineers, contractors, billing and collection teams, and many other Cogent employees who are crucial to installing our new customers, maintaining and upgrading our network, and delivering excellent service. Our risks pertaining to COVID-19 and other factors are detailed in our 2021 annual report on Form 10-K and our upcoming quarterly report on Form 10-Q, which will be filed shortly after this call. Throughout this discussion, we will present various operational statistics. Sean and I will highlight some key trends, followed by remarks from Dave, after which we will open the floor for Q&A. Now, regarding corporate and Netcentric revenue and customer connections. We analyze our revenues by connection type—on-net, off-net, and non-core—and according to customer type, which includes Netcentric and corporate customers. Corporate customers typically purchase bandwidth from us in multi-tenant office buildings or carrier-neutral data centers, encompassing professional service firms, financial services firms, and educational institutions. Our on-net customers, who include streaming companies and content distribution providers, buy significant bandwidth from us. This quarter, our corporate business accounted for 57.7% of our revenues, declining 6.4% year-over-year to $86.1 million, representing a minimal sequential decline of 0.8%. This reflects an improvement from last quarter, where corporate revenue saw a 7.4% year-over-year decline and a sequential decline of 2.5%. As Dave mentioned, a decrease in the USF rate, specific to our corporate VPN connections, negatively influenced both our sequential quarterly corporate revenues by $0.5 million and year-over-year revenues by $800,000. The USF rate changes are unpredictable, but for the current quarter, it has decreased to 23.8% from 25.2%. As discussed previously, the slowdown in corporate revenues is attributable to reduced building occupancy in city centers due to the pandemic. Additionally, many corporate customers have delayed decisions on system upgrades and new network investments during the work-from-home period and pandemic-related challenges. This slowdown, combined with normal churn levels, has contributed to reduced corporate revenue over the past two years. However, we are beginning to see positive signs indicating that corporate buying patterns are showing signs of normalization as the decline in corporate revenue has almost halted. Sales of our largest product, the 1-gigabit DIA, have risen for the fourth consecutive quarter, and several larger corporate customers are starting to expand and reconfigure their networks. Our corporate churn has decreased, with most churn originating from older products such as the 100-megabit DIA and 100-megabit VPN. We continue to observe very low churn levels for our 1-gigabit connections. At quarter's end, we had 45,393 corporate connections, reflecting a slight decrease of 0.1% from the previous quarter and a 2.8% decline from the first quarter last year. These declines show improvement from the last quarter when corporate connections decreased year-over-year by 0.3% and sequentially by 3.7%. Our Netcentric business, which represented 42.3% of total revenues despite significant foreign exchange headwinds, grew by 4.4% quarter-over-quarter to $63.1 million and by 15.1% year-over-year. The fluctuations in foreign exchange rates have a notably negative impact on our Netcentric business both sequentially and year-over-year. On a constant currency basis, the Netcentric business saw an 18.6% increase year-over-year and a 5.3% increase from the previous quarter. Connections in this segment totaled 49,491 at quarter's end, marking a sequential increase of 2.5% and a year-over-year increase of 12%. The Netcentric business has benefited from strong demand for larger ports in select locations, with particularly strong demand from outside the U.S. Regarding revenue and connections by type, our on-net revenue for the quarter was $112.6 million, up 1.7% sequentially and 2.4% year-over-year. On-net customer connections increased by 1.1% sequentially to 81,627 and by 4.1% year-over-year. We provide these connections across 3,065 multi-tenant and carrier-neutral data centers. Off-net revenue was $36.4 million for the quarter, showing a minimal sequential increase of 0.2% but a slight year-over-year decrease of 0.9%. The integration of cost savings from lower local loop prices into our pricing for off-net customers influences our off-net revenues. Off-net customer connections also increased sequentially by 2% to 12,922 and by 5.8% on a year-over-year basis. Regarding pricing, consistent with historical trends, our average price per megabit for our installed customer base decreased this quarter, though at a slower rate than in previous years. The average price per megabit in new customer contracts increased to $0.18 from $0.17 last quarter. Our installed base's average price per megabit fell sequentially by 5.8% to $0.31 and declined by 18.6% year-over-year. We’ve seen success in selling larger connections, and this shift in connection type has impacted our average price per megabit significantly more than changes in ARPU. Speaking of ARPU, our on-net ARPU rose sequentially but fell year-over-year, primarily due to foreign exchange and USF revenue impacts. The on-net ARPU, which includes corporate and Netcentric customers, was $463 for the quarter, an increase of 0.8% from last quarter and a decline of 1.8% from last year. The off-net ARPU, mainly from corporate customers, was $948, down 1.4% sequentially and 6.4% year-over-year. We anticipate our off-net ARPU will continue to decrease as we leverage discounts to lower our local loop costs for off-net corporate customers. Our churn rates improved this quarter for both on-net and off-net segments. The on-net unit churn rate was 0.9%, down from 1% last quarter, while the off-net unit churn rate decreased to 1% from 1.1%. We have a dedicated sales group focused on retaining customers considering termination and may offer them pricing discounts to encourage them to stay or increase their service commitments. During the quarter, some Netcentric customers utilized our volume and contract term discounts, entering long-term contracts that resulted in an increase of over 2,400 connections and an additional revenue commitment of $21.3 million to Cogent. Regarding EBITDA, we reconcile EBITDA to our cash flow from operations in our quarterly press releases. Seasonal factors, including payroll tax resets, annual cost-of-living adjustments, seasonal vacation patterns, and annual benefit plan increases, impact our EBITDA and SG&A expenses. Our EBITDA decreased by $0.3 million sequentially, primarily due to these recurring seasonal increases, although it increased year-over-year by $1.6 million. Our quarterly EBITDA margin decreased by 70 basis points to 38.3%, but it rose by 50 basis points year-over-year. Our basic and diluted earnings per share was $0.02 for the quarter, affected by material items including unrealized gains and losses on the translation of our 2024 notes into USD and noncash interest expenses related to our interest rate swap. We recorded an unrealized foreign exchange gain of $24 million on our 2024 euro notes due to the fluctuations in the euro rate. Total unrealized gains on euro notes for the quarter amounted to $8 million. In terms of foreign currency, about 25% of our revenue is reported in U.S. dollars, with 17% coming from Europe and the remaining 8% from Canada, Mexico, Asia Pacific, South America, and Africa. Volatility in foreign exchange can significantly affect our reported revenue, euro note valuation, and overall financial performance. The quarter saw a material negative impact from foreign exchange fluctuations, with an estimated negative effect of $0.5 million sequentially and $1.9 million year-over-year. The average euro to USD rate for this quarter so far is $1.08, and we estimate a negative FX impact of $900,000 year-over-year if current levels persist. Our customer base remains well-diversified, with our top 25 customers accounting for about 6% of our revenues for the quarter. Now, I will turn the call over to Sean for additional performance detail.

Thanks, Tad. I also want to just take a moment to thank Dave for his trust and for providing me this position. It has been a great experience for me. I also want to thank the entire Cogent team. This is a fine company with a strong dedicated management team. And as a shareholder, I look forward to watching the continued progress in the future. Let's talk about capital expenditures. Our quarterly capital expenditures increased by $2.8 million sequentially and increased by $2.7 million year-over-year. Our capital expenditures were $18.1 million this quarter compared to $15.3 million for the fourth quarter of 2021 and $15.4 million for the first quarter of 2021. Supply chain uncertainty is causing us to shift our typical purchasing schedule for network equipment. These anticipatory investments are designed to ensure that we have satisfactory inventory levels of network equipment to accommodate our growth plans. We do continue to anticipate a reduction in our total capital expenditures for fiscal 2022. Finance leases and finance lease payments. Our finance lease IRU obligations are for long-term dark fiber leases and typically have initial terms of 15 to 20 years or longer and often include multiple renewal options after the initial term. Our finance lease IRU fiber lease obligations totaled $245.2 million at March 31, 2022. At quarter end, we had IRU contracts with a total of 297 different dark fiber suppliers. Our finance lease principal payments were $5.9 million for the quarter, primarily due to purchases of dark fiber in international markets, compared to $5.7 million for the first quarter of 2021 and $6.2 million for the fourth quarter of 2021. Our finance lease principal payments combined with our capital expenditures were $24.0 million for this quarter compared to $21.5 million last quarter and $21.2 million for the first quarter of 2021. Cash and operating cash flow. As of March 31, 2022, our cash and cash equivalents and restricted cash totaled $311.8 million. For the quarter, our cash decreased primarily from an increase in our quarterly dividend payment. Our $30.3 million of restricted cash is tied to the estimated fair value of our interest rate swap. Our cash flow from operations was $49.4 million for the quarter compared to $47.1 million for the first quarter of 2021 and $36 million for the fourth quarter of 2021. Our quarterly cash flow from operations increased by $13.4 million sequentially and increased by $2.3 million on a year-over-year basis. Our cash flow from operations this quarter represented the largest cash flow from operations in Cogent's history. Debt and debt ratios. Our total gross debt at par, including our finance lease IRU obligations, was $1.1 billion at the end of March, and our net debt was $822.7 million. Our total gross debt to trailing last 12 months EBITDA as adjusted ratio was 4.94% at March 31, 2022 and our net debt ratio was 3.58%. Our total gross debt to trailing last 12 months EBITDA as adjusted ratio was 4.94% at March 31, 2022, and our EUR 350 million notes are reported in U.S. dollars and converted to USD at each month-end using the month-end euro to USD exchange rate. The unrealized foreign exchange gain on our euro notes was $8 million this quarter or $0.17 per share compared to an unrealized gain of $8.8 million last quarter or $0.19 per share and an unrealized gain of $18.9 million for the first quarter of 2021 or $0.41 per share. Our swap agreement in restricted cash and noncash interest expense. We are a party to an interest rate swap agreement that modifies our fixed-interest rate obligations associated with our $500 million 2026 notes to a variable interest rate obligation based on the secured overnight financing rate or SOFR. We recorded the estimated fair value of the swap agreement at each reporting period, and we incurred noncash gains or losses due to changes in market interest rates. As of March 31, 2022, the fair value of the swap agreement increased to a net liability of $30.3 million. We are required to maintain restricted cash balances with the counterparty equal to the net liability. We recorded noncash interest expense of $21.3 million this quarter related to the increase in the estimated fair value of this interest rate swap agreement. The settlement payments under the swap agreement are made in November and May. Under our initial settlement payment, we achieved a net cash savings of $0.6 million for the period from the swap agreement inception date in August 2021 to October 31, 2021. Under the settlement period made on May 4, 2022, we achieved a net cash interest savings of $1.2 million for the period from November 1, 2021 to April 30, 2022. Our cumulative cash interest savings in the swap agreement totals $1.8 million. Bad debt and days sales outstanding. Our bad debt expense as a percentage of our revenues was our best performance since the first quarter of 2016. Our bad debt expense was only 0.2% of our revenues for the quarter compared to 0.5% last quarter and 0.6% in the first quarter of 2021. Our days sales outstanding, or DSO, for worldwide accounts receivable matched our corporate record low DSO of 21 days for the quarter. We want to thank and recognize our worldwide billing and collections team members for continuing to do a fantastic job in serving our customers and collecting from our customers during very challenging times. I will now turn the call back over to Dave.

Thanks, Sean. I'd like to highlight a couple of strengths about our network, our customer base, and our salesforce. Our Netcentric performance details are as follows. As I stated earlier, we saw an acceleration of revenue growth in our Netcentric business during the last 3 quarters. Our Netcentric year-over-year growth rate was 15.1% and 18.6% on a constant currency basis. We are a direct beneficiary of increased over-the-top video and streaming services, particularly in non-U.S. markets. I would like to highlight some important trends and statistics that we believe demonstrate the strength of our Netcentric business. At quarter's end, we were connected to 1,383 carrier-neutral data centers and 54 Cogent data centers, more than any other carrier globally as measured by independent third-party research. The breadth of our coverage enables our Netcentric customers to better optimize our network and reduce their latency. We expect that we will continue to widen our lead in this market as we project to connect over an additional 100 carrier-neutral data centers per year to our network for the next several years based on the construction pipeline of anticipated new data centers. At quarter's end, we directly connected to 7,625 networks. This collection of ISPs, telephone companies, cable companies, mobile operators, and other carriers provided us a vast majority of the world's broadband subscribers and mobile phone users directly connected to Cogent's network. At quarter's end, we had a salesforce of professionals solely focused on the Netcentric market for the sale of transit. We believe this group of professionals is one of the largest and most sophisticated sales teams focused on this market in the industry. In our corporate business, we are seeing some positive trends. As the work-from-home environment becomes established as part of the way people work, we believe our corporate customers will continue to look to upgrade their Internet access infrastructure to support larger capacity connections to ensure high-quality corporate access for work-from-home employees. Our corporate customers are aggressively integrating new applications that become part of a remote work environment, such as video conferencing. These usages will require high-capacity connections both inside and outside their premises. The aggressive push towards the lower cost of bandwidth and greater coverage has begun to boost our corporate demand for our robust 1-gigabit and now 10-gigabit corporate products. Corporate customers are increasingly buying connections in carrier-neutral data centers to supplement their corporate local area network connections and provide redundancies to support ad-hoc VPNs that are necessary for working from home. Now for a few comments on our salesforce and its performance. We experienced improvement in our sales productivity from our continuous training, as well as managing out underperforming sales reps. On a sequential basis, our total rep headcount did decline to 479, and the number of full-time equivalent sales reps declined to 453 at quarter's end. Our year-over-year rep headcount decreased by 68, and our full-time equivalent number of reps decreased on a year-over-year basis by 69. Remember, our sales team was working remotely for the majority of the first quarter, only returning to the office for in-person management and training on March 1 in the U.S. and even later in some of our international offices. Our salesforce turnover rate was 6.9% per month for the first quarter, a slight drop from the 7.0% per month we experienced in the fourth quarter and is primarily a result of a more disciplined approach to managing out underperformers. Many of these individuals have been hired remotely and never received the intense mentoring and training that can only occur within an office environment. These factors contributed to a rebound in our salesforce productivity to 4.7 orders installed per full-time equivalent per month, a 12% increase sequentially from the 4.2 orders per month per full-time equivalent rep in the previous quarter. We believe our salesforce has been able to accomplish a great deal under some very challenging circumstances throughout the pandemic. In the first quarter of 2022, our sales team was able to achieve its best sales performance in our company's history. We want to thank the entire salesforce and our entire sales team for all they've accomplished and look forward to continued improvements in sales efficacy and the size of the salesforce throughout 2022. In summary, we remain optimistic about our unique position in serving small and medium-sized businesses located in the central business districts of major cities in North America, where we have 1,824 multi-tenant office buildings directly connected to our network, representing approximately 1 billion square feet of rentable office space. Currently, key indicators for office activity, including workplace reentry and leasing activity do remain below pre-pandemic levels. However, they are many encouraging signs that companies are returning to the office. Employees are returning and many new leases are being signed to really bring down vacancy rates in our footprint. We are optimistic that with the combination of in-office sales teams and a return to a more normal office environment, we will benefit from selling tenants services that have deferred or delayed upgrade decisions to their networks for nearly 2 years. Many companies are establishing a long-term network architecture that is designed to support a hybrid workforce with greater flexibility. We will benefit from this opportunity to sell our services to new tenants as landlords aggressively work to fill vacant space in their office buildings in the U.S. and in Canada. Our customer churn, our bad debt, and DSOs are all better than our historical norms. We believe these statistics represent the strong credit quality of our customer base and the increasing importance of our service to the operation of their businesses. Our targeted multiyear constant currency long-term revenue targets of 10% and our long-term EBITDA expansion rates of approximately 200 basis points in margin per year, remain a very achievable goal in this improving environment. Our Board of Directors has approved our 39th consecutive sequential increase in our regular dividend, increasing our dividend by $0.025 a share to $0.88 a share in the quarter. This increase represents a 12.8% annual growth rate in our dividend. Our constant currency dividend increase demonstrates the optimism of the increasing cash flow capabilities from our business. While we did not repurchase stock in the first quarter, we do have $30.4 million available at quarter's end in our buyback program that's in place until the end of 2022. Again, I'd like to just personally thank Sean, a 25-year friend who stepped in and really helped Cogent in a time of need. It gave Tad the time needed to fully recover. And this has just been a great working experience. The team has worked together well. And I think Cogent is in the best place because of this collaborative effort. Now I'd like to open the floor for questions.

We have a question from Phil Cusick from JPMorgan.

I guess 2, if I can, starting with corporate sales trends. Can you talk about trends through the first quarter and in April sort of month-to-month and the potential for corporate revenue to grow, excluding USF in the second quarter? And then second, I think Akamai was talking about slowing traffic globally. Anything you're seeing in the Netcentric business to that angle, both overall and at peak periods? And what you think about the impact on revenue there?

Yes. Thanks, Phil, for both questions. First of all, in terms of our corporate sales funnels, they had continued to build over the past 6 months, although many corporate customers who clearly needed service and were engaging with the salesforce were not ready to make that final purchase decision due to uncertainties, first from the Delta variant and then from Omicron. I think most of our corporate customers now have a much clearer view on what their future networks will require and that we will be living with some level of COVID for the foreseeable future. As a result of that, virtually all of our customers have some hybrid work component to their network architecture. They are now ready to upgrade their networks to support that, meaning at their primary location, increasing connectivity and extending contracts. It also means that they will add an alternate VPN concentration point typically in a carrier-neutral data center, where there is still some uncertainty as around branch office locations. Many of these secondary locations still remain unoccupied. Some will be permanently closed. Others may return with a hybrid work environment. So for that reason, our secondary sales of DIA in those locations have lagged as well as our VPN services. Those VPN services are delivered by either SD-WAN or VPLS and are meant to be permanent office-to-office connectivity. Well, that market is not permanently impaired; there is not the same level of clarity around network architecture for those VPNs. So there's a bit more of a lag. In terms of trends that we've seen in April, they continue to be strong. We continue to see customers ready to sign contracts for the products and services that I've just described. While we do not give specific quarterly guidance, it does appear that the improvements that we saw throughout the term of the first quarter, sequentially getting better on a month-to-month basis from January to February to March, are continuing into April. As a result of that, we are encouraged that with the only 0.1% sequential revenue decline in corporate revenues in the first quarter when adjusting for USF and FX, we should see a stable and hopefully growing revenue stream from corporate. I want to caution investors we are still probably several quarters away from that robust kind of 2.2%, 2.5% sequential corporate growth rate that we had experienced for nearly a decade prior to the pandemic, but we are seeing good consistent improvement and should expect that to continue throughout the year as companies are back in offices, signing new leases and kind of adapting to the new world order. Now pivoting to your second question on Netcentric. Typically, summer months see a slowdown in traffic growth, I think that on a sequential basis, we'll probably continue to see that trend play out. We saw it throughout the pandemic. Secondly, we saw a benefit from growth outside of the developed world. I think the rest of the world's Internet traffic growth rates are still substantially above the developed world. It is still being driven primarily by over-the-top video. Cogent benefits in really two ways. One, we sell to the majority of those video producers, those companies that are distributing that content. But secondly, we have over 7,600 access networks around the world that buy their upstream from Cogent. As a result of this, our effective price per megabit is actually increasing, even though our headline price may continue to decline at historical rates due to the fact that we're getting paid by both the sender and receiver. In the case of the content delivery network that you mentioned, they only get paid by the sender and typically have to pay the receiver to connect to them. So we have a very different market dynamic and in fact, we sell to virtually all of the third-party CDN operators as well as proprietary CDN networks for content publishers.

Our next question comes from Brett Feldman from Goldman Sachs.

Yes, Dave, kind of a multipart question around inflation and how you're thinking about managing the impacts on your business. And the 2 things I was hoping you could expand upon are, first of all, how inflation impacts your cost structure, I think that your biggest cost is really your salesforce. And so if you can maybe expand upon what you're seeing in terms of wage growth there and whether you have an opportunity to mitigate that? And then on the pricing side, to what extent at all do you think you have an ability to revisit or maybe even raise price for your customers if you were to experience sustained upward pressure on your cost structure?

Thanks for both questions, Brett. I'm going to actually take them in reverse order. While I would love to be able to say we have pricing power, that is not realistic. We are in the technology business. The underlying technologies that we utilize of wave division multiplexing and optically interfaced routers continue to improve and are nowhere near reaching their technical limitations. So we see the cost of production of our service continuing to decline due to these advances in technology and our ability to optimize utilization of our global fiber infrastructure. Now short term, we are absolutely experiencing equipment delays, and it is causing an increase and inefficiency in our capital deployment. So when we replace equipment in our network, our typical model is to take existing equipment at the core of the network and move it to more peripheral locations, putting the newest generation equipment in the densest parts of the network. That still is our model. But typically, that equipment is not a unitary box, but rather a chassis with multiple cards. What we've experienced is that we order the complete configuration, the chassis and all the requisite cards, the chassis and 3 quarters of the cards show up and then the last 25% have some kind of supply chain issue. Therefore, we're stranding capital on our warehouse shelves until that final component can come in. This has made our capital expenditures more lumpy, but we think these are transitory events. These are not permanent situations. In talking with our current equipment vendors and their competitors, we think all of them feel that this issue will get resolved. The market remains sufficiently competitive, and as a result, the cost of production is declining and the competitive pressures mean prices will come down. We capture that efficiency better than any of our competitors and anticipate our capital as a percentage of revenues to continue to decline, as well as our margins to continue to expand. Now with the wage piece, I'm going to let Tad touch on that.

So as I mentioned in the prepared remarks, our CPI adjustments typically all occur in the first quarter. So you're seeing any impact of CPI adjustments that we have and primarily in the first quarter of this year. With respect to wages, we did have the annual COLA increase. That was all included in the wage adjustments for the first quarter. We do not make interim adjustments to wages with exceptions for promotions. Most of our contracts, if they do have a CPI clause, have an embedded cap in that CPI clause. So in short, any impact of inflation on our cost is essentially reflected in our first quarter amounts. I don't know if you want to add anything to that.

I think in terms of our employee base, Cogent has always offered a very robust entry-level package for our sales reps. Even in a tight labor market, we have a surplus of resumes and applicants. We have a very well-developed training program. But as we've shared both internally with our salesforce and externally, it is a hard job to telesale to the volumes that we require to be successful and not all reps succeed. We really hope that now we're back in the office for good that we'll be able to continue to lower that turnover rate. But we feel that the reps that are here at Cogent as well as those that we're hiring, we're extremely competitive and don't feel that there's any material wage pressure.

Our next question comes from Walter Piecyk from LightShed.

Dave, given the rising interest rate environment, do you have any different leverage targets that you're considering?

So we have been always focused on our absolute lowest cost of capital. That's why we looked at the euro-denominated debt. We are considering the possibility of monetizing that unrealized gain that we made. And I wish I could say I was smart enough to know the future of currency movements; I wasn't, but we'll take it when we can get it. I think we may do that. We may look at extending some of our maturities. In terms of aggregate leverage, we are very comfortable in where we are at. We have a great deal of flexibility. We remain under-levered relative to many of our peers. We have the two pillars of a great business, which is growing revenues throughout a very challenging environment; we continue to grow and continued margin expansion. With that, we feel comfortable that while we are slightly ahead of our targeted range at 2.5x to 3.5x at 3.58x levered, we're well within a comfort zone. Even in a rising interest rate environment, we feel that our cost of debt capital is substantially below the equity cost of capital, and therefore, a levered balance sheet makes sense.

So does that comfort allow you to have the comfort to go to 4x by maintaining the dividend growth rate that you've been consistent at in the last many quarters?

Well, I can comment on the past 39 quarters because they've already occurred, and that is a rarified club of companies that have that level of dividend growth pace and consistency. In terms of the future, I fully anticipate being able to do that. I cannot make a promise. We're going to continue to monitor the situation. But based on the fact patterns as they exist today, we have a great deal of confidence in our ability to generate increasing amounts of free cash. Then the decision will be to evaluate market conditions and determine whether we should accelerate buybacks or continue to accelerate the dividend.

Aside from buybacks because that would obviously accelerate or increase the leverage even faster. I guess this is kind of a circular question I'm trying to get to, but if your comfort level is 3% to 3.5%, that's fine. That's where you are today. But if your dividends take you to 4x, so you're above the stated 3.5% comfort level, your comfort level going to 4% as interest rates rise. Is that what I should understand?

Our range is 2.5% to 3.5%. Although we haven't officially changed that, we have maintained a level of 3.58% for the past two quarters. We are stable at this rate and feel comfortable exceeding 3.5% for some time. We will assess this based on the cost of capital and growth rate. As our growth rate returns to historical levels, this concern will no longer apply.

Sure. But if it doesn't, you're basically allowing your leverage to increase at a time when rates are rising quickly; but whatever. So let's move on to the second point. These are just numbers; it's basic math, right? Can we discuss the salesforce? The salesforce has clearly been a focus area for corporate growth. I think maybe Tad was focused on this as well. You're essentially back to 2018 levels. Some of the points you mentioned in your prepared remarks are similar to what we heard last quarter. What should we anticipate regarding the trajectory of the salesforce? Is it just going to keep declining? If that is the case, how should we assess your ability to return to growth in the corporate sector?

Our salesforce productivity has improved significantly from 4.2 to 4.7 installed orders per full-time equivalent sequentially. However, we are still below the long-term average of 5 orders per representative, indicating there is room for further improvement. Additionally, two-thirds of the quarter was spent with our team working remotely, which is less effective compared to having them in the office with training and management support. Our turnover rate has eased slightly but remains high at 6.9% per month, significantly above the long-term average of 5.2%. We anticipate this number will decrease as more employees return to the office. Most of the recent departures are individuals hired during the pandemic and trained remotely. We are confident that now that we have returned to in-person work, we will continue to hire at a good pace and see a reduction in our turnover rate, leading to an increase in our salesforce and productivity. Furthermore, our addressable market for corporate opportunities has temporarily decreased by about 10%, with occupancy rates dropping from around 94% to approximately 85%. As buildings get re-tenanted, typically with smaller tenants in terms of square footage, our total addressable market will expand, benefiting a larger salesforce. We plan to grow the salesforce and boost productivity.

Our next question comes from James Breen from William Blair.

Dave, just following up on that point, can you just talk about the discussions you've had on the real estate side? Are they starting to see some re-leasing of the space to sort of boost that 50 average tenants up to the maybe 60% range as we come out sort of the back end of the pandemic?

Thanks for the question, Jim. So I'm going to actually speak with two halves. I myself have a fairly substantial real estate portfolio only here in D.C., but also I talk to others in the industry in other markets. I think we've seen a significant increase in tour activities up to levels that equal pre-pandemic levels. Now tours take a while to convert to leases, but we're also seeing leasing activity accelerate probably back to 60% of pre-pandemic levels from a trough of about 20% of pre-pandemic levels at the worst. The third point is that most tenants are taking smaller footprints. The nature of their office configuration is changing, and their leases tend to be shorter in term. So while the vacancy rates remain around 15% to 16% across our CBD office footprint. I think over the next several quarters, that vacancy rate will decline, and the number of tenants per building will continue to increase. Leasing is a bit of a lagging indicator. Companies have demonstrated that they're now committed to a hybrid environment and a return to the office. As a result, we're seeing good leading indicators to say our corporate total addressable market will actually be better post-pandemic than it was pre-pandemic.

Our next question comes from Nick Del Deo from MoffettNathanson.

Sean, congratulations on the new role. Really appreciate all your help over the last couple of years. Tad, it's great to hear you're fully recovered and nice to hear your voice again. Kind of turning to questions. There are a few metrics that we can look to, to measure the return to office trend. Dave, I think you called out bad swipes and leasing activity. Do you view those as the metric that most strongly correlates to the outlook for the corporate segment? Or is it more dependent on things we can't quantify, like customers understanding their needs and their comfort signing deals and things like that?

I believe it's a mix of factors. We observed an increase in all our leading indicators in the corporate market last fall, which included more outreach and more proposals being issued. However, customers were hesitant to finalize and sign those orders. After navigating multiple cycles of working from home and returning to the office due to Omicron, nearly all companies we engage with now express commitment to their current path and readiness to convert proposals into orders. The decision cycle, which had been lengthy, is now shortening. This trend positively influenced our performance this quarter and is likely to continue benefiting us in the upcoming quarters. Understanding these leading indicators is crucial for assessing the total addressable market. Currently, there are still three times as many vacancies in our portfolio compared to normal levels. To illustrate, out of our 1 billion square feet, there exists an additional 100 million square feet of vacancy, which is equivalent to all office space in a city the size of Philadelphia, where every office building is completely vacant. That's a significant figure. Presently, landlords have adjusted their rents and have become flexible with lease terms, no longer insisting on 10- or 15-year commitments. Consequently, companies are more willing to enter into these new agreements. I believe we will start to see a reduction in office vacancy rates. It may take several years for the office market to fully recover. Another significant factor affecting office space is the trend of converting offices to residential units. While this doesn't usually affect our Cogent buildings due to their size and type, nationwide, it's expected that about 10% of North America's office inventory will transition to residential. This change stems from over a decade of underinvestment in housing, where we have been producing around 300,000 to 400,000 fewer units annually compared to pre-financial crisis trends. One of the most straightforward solutions is to repurpose existing office buildings into apartments or condominiums, and we are witnessing a significant amount of this occurring. This trend is tightening the market, and with landlords showing flexibility in our Class A buildings, we're seeing many tenants from B and C buildings, who would have never considered us before, now entering our space.

Our next question comes from Frank Louthan from Raymond James.

This is Rob on for Frank. So one of the CDN providers on their call earlier this week said they're seeing the rate of growth in traffic flow slow. Would you say that you're seeing something similar? And what do you think the overall growth rate of Internet traffic looks like for the full year?

Yes. Our growth rate at 17% year-over-year is actually below our long-term multiyear trend. The base is getting larger. The 8% sequential growth rate for us was pretty much in line with averages. We continue to gain share. I do think global Internet traffic growth accelerated during the pandemic, and it has slowed now to kind of mid-double digits, low teens, and that's below kind of the 15-year trend line, but that's after a year or two of being above trend line. One of the key drivers was the fact that during the pandemic, the streaming transition accelerated; I think it's now more normalized. I think it may actually reaccelerate a little bit if we do see a recession. Video consumption is a classic inferior good, meaning if people have less disposable income, they spend more time watching television. Secondly, streaming tends to be more cost-effective than any of the linear applications. I think while we've seen some slowdown, we may have the ability to see some reacceleration a little later in the year.

Our next question comes from RBC Capital Markets.

So we're taking the questions. I guess, first, you've spoken in the past by corporate customers upgrading from 100 megabit to 1 gigabit or 10 gigabit. I was just wondering if that rate of conversion is staying stable, accelerating, or slowing down, I'm trying to figure out if there's a base of customers that will stay at that 100-megabit service and how much more room there is for Cogent to continue to benefit from that trend?

So I think the 100 megabit to gigabit conversion is substantially complete. There are always some technological laggers who aren't going to change; if it's not broke, don't fix it mindset. But what we've actually seen is a pretty significant increase in corporate customers actually now asking for 10-gigabit connections. While I don't think those connections are necessarily needed at this time, the average corporate customer uses about 11% of their bandwidth at peak. But we are seeing companies, particularly those that are less price sensitive, looking to move to those 10-gigabit connections. That represents an even bigger step up in differential than moving from 100 megabits to gigabit. As a result, I think we may see some ability to see our corporate on-net ARPUs go up.

Okay. Can you share what the percentage difference is between 100 megabits and 1 gigabit? Just to understand the magnitude.

That’s correct.

No, what percentage magnitude differential between those two?

Okay. So today, probably about 10% of our base is at 100 meg and about 89%, 90% is at 1 gig; and less than 1% today is at 10 gigabit. But as I said, we're seeing an accelerating rate from a small base of people that actually do want to go to 10 gigabit.

Okay. How much more in terms of pricing, how much greater is the ARPU for a 10-gigabit service versus the 1-gigabit?

Generally, about a 5x to 6x increase in price.

Got it. Okay. Great. And then secondly, can you talk about any differences in headcount changes and productivity trends specifically between the Netcentric versus the corporate salesforces?

So when I actually touch on headcount for the entire company in productivity. It was a real milestone for the entire company to have the highest revenue per employee in our history at $604,000 per employee than our sales and operations. That's better than companies that are 20x our size. While it declined, it declined only very modestly, and our national account managers that focus on multisite customers also has declined much more gradually. The bulk of the turnover has been in the lowest entry level, and it was really those individuals that we hired during the pandemic that never became fully productive.

So is it fair to say then that the average tenure of your salesforce has actually increased then with the attrition of the more new entrants?

It actually has. So our average tenure of the salesforce increased by another 10%. During the entire pandemic, our average sales tenure actually increased by about 20% as a result of almost all the turnover being of very untenured reps.

Our next question comes from Brandon Nispel from KeyBanc Capital Markets.

Okay. Great. Dave, a question for you. As we look at the corporate growth, excluding USF, this quarter, you guys sort of got to flat, maybe slightly grew sequentially. Should we expect that to continue throughout the rest of the year? And do you think you can finish the year actually growing that business on a year-over-year basis? Secondly, gross margins were down 90 basis points this quarter year-over-year. It's been several quarters in a row now of gross margin compression. What's really causing that? And what should we expect for the remainder of '22?

I'll address your questions in reverse order. Regarding gross margin, the impact comes from our international expansion and lower occupancy in new markets until those markets are fully ramped up. We believe this is a temporary situation, as our experience has shown that markets we entered 2 or 3 years ago reached similar gross margin profiles to our more established Cogent network. The fast pace of new market expansion affects our overall gross margins. As for your first question about corporate, I mentioned earlier that we don't provide precise quarterly guidance. However, I do believe that we've moved past the peak of our corporate churn and sales challenges, and we should see ongoing improvement. Whether this will be sufficient for year-over-year growth is uncertain, as I lack the data for an accurate prediction, but I do anticipate continued improvement throughout the year.

Our next question comes from Tim Horan from Oppenheimer.

Dave, could you share your strategy regarding raising and refinancing debt, and what you expect the overall cost to be in the near future? Additionally, I wonder if your salesforce might be contributing to the churn because they're not earning enough from leasing activities, which seem relatively low. Can you also discuss the compensation structure for your salesforce? Are they earning more now compared to before the pandemic, especially considering inflation?

Yes. So two very different questions. Let me take the debt strategy question first. I do think we're in a rising interest rate environment for the next couple of years. There's probably heightened capital markets volatility. As a result of that, I think we would like to extend maturities. We would also like to monetize that $24 million FX gain that Tad mentioned. It is likely that we will pull our euro-denominated debt and put in place probably a U.S.-denominated issue of longer duration that will raise our interest rate, but the cash savings that we monetize will more than cover that for several years. I think longer term, we're back to a low interest rate environment. So I do think this is not a permanent new normal, but rather a response to a number of exogenous shocks to the system that have created really unprecedented inflation. To your question about salesforce, we typically give a rep a 3-month bridge, so they get their full commission payment for 3 months, then they're just on their base salary and their variable. Across the organization, we're roughly about 2/3 salary, 1/3 variable. Our total comp package is actually one of the most aggressive in the industry, where we give reps accelerators for the length of time that they've been at Cogent, as well as we give accelerators for different levels of certification and that we give raises based on tenure. You get both more variable and more base the longer you've been here. That's part of the reason why our average tenure continues to increase. Really, the reps that we've been turning over are those that are very early in their career and have never achieved the funnel building necessary to be successful. It was unfortunate; we did the best we could in a remote environment. I think now we're back in person in the office. We're going to see that turnover rate come down. We are not losing reps to competitors; that's not the issue. It's really more of we're losing reps who just never could ramp and meet our expectations.

That is our last question. I would like to turn the call over to Mr. Schaeffer for final remarks.

Well, again, I want to thank everyone. I was expecting a little shorter call, but I'm glad everyone was engaged. Again, I hope you all join with me in thanking Sean and wishing him well in his new venture. He's been a great asset to Cogent. So thanks a lot. We're glad to have Tad back right next to me and in this seat. Take care, everyone. Bye-bye.

Ladies and gentlemen, this concludes today's conference. We thank you for participating. You may now disconnect.