Cogent Communications Holdings, Inc. Q2 FY2022 Earnings Call

Welcome to the Cogent Communications Holdings Second Quarter 2022 Earnings Conference Call. As a reminder, this conference is being recorded and it will be available for replay at www.cogentco.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. And now I would like to turn the call over to Mr. Dave Schaeffer, Chairman and Chief Executive Officer of Cogent Communications Holdings.

Thank you very much, and good afternoon to everyone. Welcome to our second quarter 2022 earnings conference call. I'm Dave Schaeffer, Cogent's CEO. And with me on this afternoon's call is Tad Weed, our Chief Financial Officer. Hopefully, you've had a chance to review our earnings press release. Our press release includes a number of historical quarterly metrics that we present in a consistent manner each quarter. Now for a quick overview of our results. In June, we issued a $450 million unsecured 2027 note, and we used a portion of that proceeds to redeem our €350 million unsecured notes that were due in 2024. We received net proceeds from this offering of $71 million, and we extended the average maturity of our debt by extinguishing our 2024 euro notes. We obtained an economic gain of $26 million from the difference between the euro to dollar rate at the date of issuance as compared to the euro to dollar rate at the date of settlement. We also eliminated a restrictive covenant provision in our euro-denominated notes that was 4.25 to one times EBITDA. This restrictive covenant limited our ability to transfer funds from our operating company to a holding company, and therefore, be available for both dividends and share buybacks. As of June 30, our cash held at Cogent Holdings was $66.6 million, and we had an additional $219.9 million that can now be transferred to holdings for a total of $286.5 million of unrestricted cash that's available for either dividends and/or buybacks. Cash held at our operating companies was $283.3 million, and our total consolidated cash and restricted cash was $349.8 million at end of quarter. Our gross leverage ratio was 5.22, and our net leverage ratio was 3.70. Our consolidated leverage ratio as calculated under our notes indenture was slightly lower at 5.21 at quarter's end. Our total revenues and our NetCentric revenues were materially impacted by the negative foreign exchange movement during the quarter and a significant strengthening of the U.S. dollar, in particular, against the euro. For the quarter, we had sequential negative foreign exchange translation of $1.4 million and a negative year-over-year of $3.4 million. The negative impact of foreign exchange on our revenues for the quarter - third quarter is expected to be even more significant. Our total revenues and corporate revenues are materially impacted negatively also by the change in USF or Universal Service Fund revenues in the quarter due to the reduction in the USF rate by the U.S. government. For the quarter, the negative impact of USF on our revenues was $0.3 million and a negative of $1.4 million on a year-over-year basis. The combined negative impact to our sequential revenues of foreign exchange and USF was $1.7 million sequentially and $4.8 million negative impact on a year-over-year basis. Our corporate business continues to be influenced by real estate activities in the central business districts of North American cities. Two key statistics, including the level of card swipes in buildings and leasing activities indicate that during the first half of 2022, the real estate market and leasing activities in the central business district in which we operate have seen some improvement, but have not yet returned to their pre-pandemic levels. Leasing activities across major markets and workers return to offices continue to improve, albeit slowly. On a U.S. GAAP basis, our corporate revenues declined by 1.1%, which was partially attributable to the change in USF rates. Adjusting for this negative USF impact, our corporate revenue decline for the quarter was 0.007% sequentially. We continue to remain cautious in our outlook for our corporate revenues given the uncertainty of the economic environment and the continued lingering effects of the pandemic. Our NetCentric business continues to benefit from robust growth in video traffic and streaming. For the quarter, our traffic was up 3% sequentially and increased on a year-over-year basis by 19%. On a U.S. GAAP basis, our NetCentric revenues grew by 0.3% and grew on a year-over-year basis by 10.2%. Adjusting for foreign exchange on a constant currency basis, our NetCentric revenues increased by 16.2% on a year-over-year basis and 2.5% on a sequential basis. On a U.S. GAAP basis, our second quarter total revenues sequentially declined by 0.5% to $48.5 million and increased on a year-over-year basis by 0.4%. On a constant currency basis, our quarterly revenues increased sequentially 0.4%, an increase on a year-over-year basis by 2.7%. On a constant currency basis and also adjusting for the change and negative impact in USF revenues, our sequential quarterly revenues would have grown 0.6% sequentially and 3.6% year-over-year, approximately equivalent to the rate of growth in the last quarter. Our EBITDA margins this quarter increased to 39.4%, which represents the highest EBITDA margin in the company's history. We're also encouraged by the fact that our sales force productivity numbers increased to 4.9 installed orders per full-time equivalent rep per month, up from 4.7 last quarter. This is actually the best sales force productivity that we've seen since the fourth quarter of 2018. During the quarter, we returned $41.9 million to our shareholders through our regular quarterly dividend. We did not purchase any stock during the quarter and have a total of $30.4 million available for buybacks under our program, which our Board has authorized to continue through year end. Our Board of Directors reflected on our strong cash flow generating capabilities as well as investment opportunities that the company has and decided again to increase our quarterly dividend sequentially by $0.025 per share in the quarter, therefore, raising our quarterly dividend from $0.88 per share to $0.905 per share. This increase represents the 40th consecutive sequential increase in our regular quarterly dividends, and our annual dividend growth rate today is 12.4%. Now for a few expectations against our long-term guidance targets. Our targets are meant to be long term. Our EBITDA, annual margin expansion is anticipated to be approximately 200 basis points a year. Our targeted multiyear constant currency growth rate should be approximately 10%. Our revenue and EBITDA targets are meant to be multiyear targets rather than looking at a specific quarter. And these targets assume that businesses will continue to return to their offices, albeit in a hybrid work model. This is not intended to be quarterly or annual guidance. Now I'd like Tad read our safe harbor language and provide some additional details on our operations in the quarter. Following that, we'll open the floor for questions and answers.

Thank you, Dave. Good morning, everyone. This earnings conference call includes forward-looking statements that reflect our current intentions, beliefs, and expectations. These statements, along with any that are not historical facts, are subject to various risks and uncertainties, and actual results may vary significantly. For more details on those risks, please refer to our SEC filings. Cogent has no obligation to update or revise forward-looking statements. If we discuss non-GAAP financial measures, these will be reconciled to the corresponding GAAP measures in our earnings releases available on our website at cogentco.com. We, like many companies, continue to be affected by the COVID-19 pandemic and related governmental responses globally. The risks associated with COVID-19 and other risks are elaborated in our annual reports on Form 10-K and quarterly reports on Form 10-Q. We evaluate our revenues based on network connection types—on-net, off-net, and noncore—and categorize our customers as either NetCentric or corporate. Corporate customers generally purchase bandwidth from us in large multi-tenant office buildings or carrier-neutral data centers and typically include firms in professional services, finance, and education. In contrast, NetCentric customers, which include streaming and content distribution services as well as access networks, purchase significant bandwidth from our carrier-neutral data centers. Our corporate business accounted for 57.4% of our revenues this quarter, with corporate revenue declining 5.9% year-over-year to $85.2 million and a sequential decline of 1.1%. A reduction in the USF tax rate, applicable to our corporate VPN connections, negatively impacted corporate revenue growth by $0.3 million sequentially and $1.4 million year-over-year. We ended the quarter with 45,103 corporate customer connections, reflecting a 0.6% sequential decline and a 1.5% year-over-year decline. Our NetCentric business made up 42.6% of our revenues this quarter and despite significant foreign exchange challenges, it grew by 0.3% sequentially to $63.3 million and 10.2% year-over-year. The foreign exchange volatility severely impacted our NetCentric revenue both sequentially and annually. However, on a constant currency basis, NetCentric revenue was up 16.2% year-over-year and 2.5% sequentially. At the end of the quarter, we had 50,674 NetCentric customer connections, showing a 2.4% sequential increase and a 10% growth year-over-year. On revenue by network type, our on-net revenue was $112 million, which reflected a 0.6% sequential decrease but a 0.8% rise year-over-year. Our on-net customer connections grew by 0.8% sequentially to 82,277, with a 4% year-over-year increase, served across 3,095 on-net multi-tenant office and carrier-neutral data center buildings. Our off-net revenue was $36.3 million, representing a 0.3% sequential decline and a 1.1% year-over-year drop. Off-net revenues were negatively affected by our strategies to lower local loop prices, which subsequently lowered ARPU. Our off-net customer connections rose by 1.8% sequentially to 13,160, with year-over-year growth of 6.2%. We serve these customers in around 8,000 off-net buildings, primarily situated in North America. Regarding pricing, consistent with historical trends, our average price per megabit for our installed base and new customer contracts decreased this quarter. The average price for our installed base dropped by 6.2% sequentially to $0.29 and by 18.7% year-over-year, a better decline rate than our historical average. For new contracts, the average price fell 15% sequentially to $0.15 and 15.9% year-over-year. We are successfully selling larger bandwidth connections, which affects our connection mix and lowers average pricing without significantly impacting ARPU. Our on-net ARPU fell sequentially by 1.5% to $455, while the off-net ARPU decreased by 2.2% to $927. Our churn rates for both on-net and off-net connections remained stable, with on-net churn at 1% this quarter and off-net churn at 1.1%. To minimize customer turnover, we have a dedicated sales team that encourages customers contemplating service termination to remain, sometimes offering pricing discounts as incentives. This quarter, several NetCentric customers committed to long-term contracts for over 2,460 customer connections, increasing their revenue commitments by $23.3 million. Our EBITDA increased both sequentially and year-over-year by $1.3 million, although foreign exchange negatively impacted this growth by the same amount. Our quarterly EBITDA margin rose sequentially by 110 basis points to 39.4% and year-over-year by 70 basis points. Our basic and diluted income per share was $0.24 for the quarter, influenced by foreign exchange fluctuations related to our euro notes until their retirement on June 30. Losses from debt extinguishment and changes in the market valuation of our interest rate swap contributed to fluctuations in net income and per share results. This quarter, we reported a foreign exchange gain on our euro notes of $23.5 million, compared to previous quarters, with a non-cash charge of $7.5 million related to the interest rate swap fair value increase and an $11.9 million loss from extinguishing euro notes. Approximately 25% of our revenue is generated outside the United States, with about 16% from Europe and 8% from Canada and other regions. Recent foreign exchange rate volatility severely affected our quarterly revenue and EBITDA, translating impacts into our financial results. We anticipate similar negative results for the third quarter. Current average euro to U.S. dollar rates are $1.02 and $0.77 for the Canadian dollar. If these rates remain consistent through the third quarter, we project an FX negative impact of $1.1 million for sequential revenues and $3.8 million year-over-year. Our top 25 customers represent about 6% of total revenues, indicating a diversified customer base. Our quarterly capital expenditures fell by 4.6% to $17.3 million due to supply chain uncertainties, prompting a shift in our purchasing schedule for network equipment. Our finance lease IRU obligations, covering long-term dark fiber leases, amounted to $254.2 million at quarter's end, with principal payments decreasing by 10.7% sequentially to $5.2 million. At the end of the quarter, our available cash totaled $349.8 million, which includes $37.8 million of restricted cash linked to our interest rate swap agreement. Our operating cash flow was $34.4 million, down by $15 million from last quarter, partly due to $16.8 million in semiannual interest payments made this quarter. Our gross debt at par, including finance IRU lease obligations and reflecting the extinguishment of euro notes, stands at $1.2 billion, with net debt at $854.4 million. Our gross debt to adjusted trailing EBITDA ratio is 5.22%, and net debt ratio is 3.7%. We have an interest rate swap agreement aligned with our $500 million 2022 notes, transitioning fixed interest obligations to variable rates based on SOFR. At quarter-end, the fair value of the swap increased, necessitating a restricted cash balance to cover the net liability. Our total cash savings from the swap agreement since its inception amounts to $1.8 million. Lastly, our bad debt expense represented only 0.4% of revenues compared to 0.2% last quarter. Our days sales outstanding for worldwide accounts receivable was 22 days this quarter. We appreciate our billing and collection team for their exceptional work in servicing and collecting from our customers. Now I will turn the call back over to Dave.

Thanks, Tad. I'd like to highlight some of the strengths of our network, our customer base and our sales force. We achieved excellent revenue growth in our NetCentric business. On a year-over-year, NetCentric revenue growth was 10.2% and 16.2% on a constant currency basis. We continued to be a direct beneficiary of the increase in over-the-top video and streaming traffic, particularly in international markets. At quarter's end, we were connected to 1,409 carrier-neutral data centers and 53 Cogent data centers, more than any other carrier as measured by third-party research. The breadth of our coverage enables our NetCentric customers to optimize our networks and reduce latency. We expect to continue to widen our lead in this market as we plan to connect an additional 100 carrier-neutral data centers to our network each year for the next several years. At quarter's end, we were connected directly to 7,685 autonomous systems or unique networks that comprise the Internet. This collection of ISPs, telephone companies, cable companies, mobile operators and regional carriers provide us access to the vast majority of the world's broadband subscribers and mobile phone users. At quarter's end, we had a dedicated sales force of 197 professionals focused solely on the NetCentric market. We believe this group of professionals is the largest group of salespeople focused on this market segment. Now for a few comments on our corporate business. We are seeing positive trends in our corporate business. But in a work-from-home environment that is becoming established as part of people's normal work routine, we believe corporate customers will continue to upgrade their Internet infrastructure, particularly supporting larger connections to improve the user experience of their remote workers. Our corporate customers are aggressively integrating some of these new applications to become part of their working environment, such as including video conferencing in all aspects of employees' jobs. This usage will require high bandwidth connections both inside and outside of the premise. Our aggressive push towards lowering the cost of bandwidth and providing greater coverage has begun to boost corporate demand for our robust bidirectional and symmetric one gig and now 10 gig connections. Our corporate customers are also increasing their purchases of redundant connections in carrier-neutral data centers to help support the ad hoc virtual private networks that their remote workers need. Now for a few comments on our sales force. We continue to experience improvement in our sales force productivity due to our training as well as managing out underperformers. On a sequential basis, our total pre head count did slightly decline from 479 reps to 477, and our full time equivalents declined from 453 to 449. Both of these declines were more moderate than we've seen in other periods during the pandemic. On a year-over-year basis, our total sales rep head count decreased by 88 and our full-time equivalent rep in total decreased by 62. Our sales force was working remotely for the majority of the first quarter and only returned to a Cogent sales office on March 1st. Our sales force turnover numbers are improving. They were 5.9% per month. That is a significant reduction from the 6.9% per month in the previous quarter and a peak during the pandemic of a turnover rate of 8.7% as a percentage of the sales force per month at the peak. The factors that contribute to the increase in our sales force productivity have been better training and in-office attendance. This 4.9 is a material improvement from the 4.7 we experienced in Q1. So in summary, we remain optimistic about our unique position in serving small and medium businesses in the central business districts of major cities. We have a total of 1,826 multi-tenant office buildings directly connected to our network, supporting approximately one billion square feet of rentable office space. We remain concerned about the slower pace of office leasing as well as tenants returning, but we are seeing a number of key indicators that are showing signs of improvement whether it be workplace reentry or declines in the rate of increase in office vacancy and a heightened level of new lease signatures. While these remain below pre-pandemic levels, they are substantially improved over the past 18 months. We're encouraged that many tenants are indicating a return to office in 2022, and therefore, the commercial office leasing market should continue to improve. We are optimistic with the combination of our sales teams being in office and the return to a more normalized environment for our customers. We believe this will benefit our sales organization and allow us to sell tenants who have deferred or delayed network upgrade decisions. Many companies are establishing long-term network architectures that incorporate a hybrid work policy. This is a positive for Cogent. As certain corporations elect to downsize their office space requirements in multi-tenanted office buildings, this actually provides an increased addressable market opportunity as those spaces begin to be re-tenanted with new organizations. We believe the benefit from this opportunity will allow us to sell more services to more tenants as landlords aggressively strive to fill the vacant office space in U.S. and Canada. Our targeted multiyear constant currency growth rate remains 10% and our long-term EBITDA margin expansion target is 200 basis points. This is in line with our long-term historical averages. But during the pandemic, we've been operating at about half of that level. We expect to see a continued but, unfortunately, a gradual improvement to these long-term targets. We have extended the average maturity of our debt, eliminated restrictive covenants that were included in our euro notes. And as of June 30, we have substantially more cash available at holdings of a total of $286.5 million that is available to benefit our shareholders. While we did not repurchase any stock in the quarter and have $30.4 million remaining, we felt that the decision the Board took to increase our dividend for yet a 40th consecutive quarter to $0.905 per share for the quarter, representing a 12.4% growth rate in our dividend is consistent with our belief that our business is continuing to grow. Our consistent dividend increases demonstrate the long-term optimism we have in our business. Now I'd like to open the floor for questions.

Great. Thank you very much. Our first question comes from the line of Gregory Williams with Cowen. Gregory, go ahead.

Great. Thanks for taking my questions. First one is just on corporate. Dave, you've noted in the past that you'd want to get to the 2%, 2.5% sequential growth target, the historical target in the next few quarters. Has that changed since you're now noting a little bit of concern about office leasing trends? And the second question is just on your appetite for debt and increasing that. So I understand with this debt raise you did here, while it's nice to be paying in euros, and you now refied it at a much higher rate. I understand that you're lifting some of those restrictive debt covenants. With those debt covenants removed or at least a lot more flexible, I was hoping you'd give us sort of a new range or a new target of how high you'd be comfortable taking your debt levels up now that you're at 2.7 times? Thanks.

First of all, let me discuss the corporate growth rate. We have identified three factors affecting corporate activity in central business districts. Initially, during the pandemic, numerous businesses closed permanently, which increased the vacancy rate in those buildings and significantly harmed our corporate growth rate. Secondly, the remaining tenants in those buildings were hesitant to make decisions about their networks for the post-pandemic period, primarily due to uncertainty about when the pandemic would end. The third and most challenging factor to comprehend has been that some tenants are choosing to vacate properties even after their leases expire. While the rise in vacancy has slowed, we have not yet seen a reversal or a decrease in vacancies. To achieve a 2.5% sequential growth rate in corporate, we will need to see positive net absorption of vacancy rates and tenants returning to occupy signed leases. Our focus is less on the monetary value of those leases or their duration, although those aspects are crucial for landlords. While the rate of decline has slowed, we have not observed a positive turnaround in net absorption. Although we had hoped to see that improvement in the second half of this year, we lack complete visibility on it. We are noticing some signs of progress, as the pace of corporate declines seems stable compared to last quarter, but improvement has not yet occurred. At minimum, we expect to be several quarters away from recovery. We are optimistic about initial indicators like tours, card swipes, and some leases, but considerable effort is still required to return the buildings we serve to their historical occupancy levels. Now, regarding your question about debt, we maintain a net leverage range that includes all aspects, including capital leases, at 2.5 to 3.5 times EBITDA. Currently, we are at 3.7, which we do not consider alarming at this stage. This situation significantly influenced the Board's decision to raise the dividend by $0.025. We recognize that over time, EBITDA growth needs to align with dividend growth. Historically, our EBITDA has grown faster than our dividends, but since the pandemic, it has not. We continue to monitor this situation and are committed to maintaining our dividend growth policy. We anticipate that we will remain above 3.5 for several more quarters, but the Board is comfortable with our current level and has not changed the official range yet. We believe we will return to 3.5 or lower within the next year.

Thanks, Dave.

Thank you. We will queue up our next question. Our next question is by Frank Louthan with Raymond James.

Hey, guys. It's Rob on for Frank. So obviously, Dave, you just talked to the outlook for corporate with respect to the rate of vacancies and then re-absorption beyond that. Just pivoting to Internet traffic growth, what did traffic growth look like during the quarter? You might have addressed this earlier. And is there any reason that Internet traffic volumes might potentially be able to return to where they were like about a year or two ago? Like what's the outlook on traffic growth going forward? Thanks.

We're actually very encouraged by the traffic growth that we saw. Traditionally, the summer months on a sequential basis are slower than the winter months. We grew sequentially in the second quarter by 3%, and our year-over-year growth actually accelerated to 19%. These are very positive signs. We're seeing that growth come mostly from international markets. We saw our NetCentric revenues were a direct result of this growth, grew at 10.2% year-over-year on a stated basis and 16.2% on a constant currency basis, so far above the long-term average growth rate of 9%. I know that many investors were concerned because some of our content delivery customers had called out slower traffic growth as part of the reason why their businesses were not performing as well as investors expected. We have over 200 content delivery networks and thousands of proprietary networks continuing to use our network. So we feel pretty good and have been actually pleasantly surprised to the upside for the past several quarters on how well our NetCentric business has performed and we actually expect this outperformance to continue at least for the foreseeable future.

Got it. Very helpful. Thanks, Dave.

Thank you. Our next speaker - our next question and answer is from Nic Del Deo with MoffettNathanson. Go ahead, Nic.

Hey. Afternoon, guys. Thanks for taking my questions. Tad, a couple of questions ago, you noted that you think you need to see vacancy rates decline to get corporate growth back to normal. If I think back to when your corporate unit was growing at much faster rates, vacancy rates bounced around and I don't think that was ever really thought of as a key driver of the business. I think the driver was improving your share of connections in the building you serve. So the way you tied corporate growth to vacancy trends almost makes it sound like share gains aren't part of the story. I mean, shouldn't you be able to grow the corporate business even if vacancy rates stay flat via share gains? And maybe just help me understand that disconnect or if I'm interpreting something incorrectly?

So share gains are our primary way of growing our corporate business. You are absolutely correct. However, our addressable market shrank by over 10% when the average vacancy rate went from 6% to 18%, where it is today nationwide in CBDs. Some cities actually have CBD vacancy rates of nearly 40%. Those are probably the most extreme. Downtown San Francisco is probably the worst example. But I think with that level of vacancy in the building, many tenants are just reluctant to make a switch. They don't know if they're going to stay or not, are they're going to move to a different building, are they going to downsize. And I think we just need to see a stable environment and one that's maybe a little more normal than what we've historically seen. I do believe that most of Cogent's growth will come from capturing incremental customers in the building. But we've always stated that there are three windows in which we can win customers. That has not changed. When a customer moves into the building, when the customer's IT infrastructure is re-architected or when a customer experiences a failure from their incumbent provider. These three factors remain the key reasons why people will consider a new Internet provider. And I think with a lack of new tenants coming in and these vacancy rates, a lot of tenants are reluctant to take a multiyear commitment for new bandwidth.

Okay, okay. That's helpful. On the NetCentric side, obviously, you've talked about NetCentric returning to a more normal pace for some time. So it's not surprising that it's tapering off. If I look at the sequential constant currency growth rate, it did step down quite a bit from what we've seen over the last 1.5 years. Obviously, that's volatile. It's hard to forecast. Should we think of this as a more normal sequential growth rate going forward? Or is this an anomaly and you think it could still kind of bounce up and down and take longer to taper to your target growth rate?

Well, I think it will definitely have some sequential volatility. And typically, we see a pickup in traffic, and therefore, corresponding NetCentric revenue in the latter part of the third quarter, throughout the fourth quarter and throughout the first quarter and then slowing down again in the second quarter. And that's been a historic trend both pre-pandemic and during the pandemic. We've said that over time, we expect our NetCentric growth to converge to about a 9% annualized rate. We're obviously at least 50% above that today. It's a little hard for us to tell how much more of the internationalization of streaming will continue because many of the markets are still relatively nascent. We've seen, I think, a level of maturity in the U.S. and Canada for streaming. That doesn't mean it's not growing. It just means the growth rate has slowed materially. That same trend has not happened in the developing world. And if it continues to follow the same trajectory as the U.S. and Canada did, we'd probably have three or four years of elevated growth. But again, we just don't have enough data to be comfortable to tell investors expect 15%, not 9% growth for the next three to four years.

Okay. Thank you.

Thank you. Our next question comes from the line of Timothy Horan with Oppenheimer.

Thanks, guys. So Dave, customers are kind of frozen. They're not really upgrading or changing their networks if they might move. But they're not really moving yet. So churn is relatively low. And new tenants aren't really coming in yet. Do you think that recession kind of extends out this frozen period, maybe this will last two or three years more or another 12, 18 months? Or what gives you the confidence with the dividend increase that this will reverse in a few more quarters?

Yeah. So two different points. So the first one is, in previous recessions, with the exception of the financial crisis of '08, '09, we were not materially impacted in terms of our corporate growth rate. What we typically see is tenants use recessions to upgrade their offices at the same or lower rent by migrating from B and C buildings into A buildings. And we've experienced that in our customer base. If you look at third-party data, whether it's JLL, CoStar, Cushman & Wakefield, for previous recessions, that's always been the case. Now if we have a recession, it is most likely not going to be as impactful as 2008, 2009. And for that reason, we don't believe that the rate of economic growth is really material to our corporate growth rate. It's really the aggressiveness of the landlords to lower the rents in the most expensive buildings to reduce the vacancy rates. And they typically have had more flexibility in doing that in previous recessions. We think that will continue. We also think that at the lower end of the market, we're continuing to see supply be converted to residential. So I think part of the reason why, even though the world has migrated mostly to a hybrid work environment, that we're seeing the rate of vacancies plateau. That doesn't mean it's a V. It means it looks more like a U. But it has at least stabilized. In terms of the dividend, we feel very comfortable in raising $0.025 today. We've got the outperformance of our NetCentric business. We have the expansion in margins and the best EBITDA performance in the company's history. The percentage of our business that is NetCentric has kicked up throughout the pandemic from roughly 40% of total revenues going into the pandemic to today being approximately 47% of revenues. So as long as that increases as a share and it continues to increase at an outpaced rate, we feel comfortable in our ability to generate more cash. As I stated earlier, it's absolutely necessary that our dividend growth rate and our EBITDA growth rate eventually converge. We think that with the high percentage of on-net in our NetCentric business, we'll continue to see further margin expansion and acceleration in EBITDA growth even without a material reacceleration in corporate on-net. We do think corporate on-net and off-net for corporate customers will improve, but we also are realistic that the rate of improvement is not as aggressive as we would have thought even two or three quarters ago.

Very good. Just two other maybe brief. Are you seeing any change in pricing in the corporate side? Inflation has ticked up a lot and the prices have been down a lot. Have you seen any change in trajectory there?

So we live in the industry that inflation forgot. We are in the business of selling a deflationary service. As Tad mentioned, the rate of decline in the average price per megabit actually did moderate some. I think part of that is the fact that more of those megabits sold have tended to be in more expensive markets outside of the developed world, which I think has distorted that a little bit. We are a huge beneficiary of substantial improvements in technology, both wave division multiplexing and optically interfaced routers. We think those trend lines will continue for the foreseeable future. Our equipment vendors support that prognosis. So we feel pretty good. On the operation side, clearly, our expenses are rising just like all other businesses. We have been able to expand margins even though we have passed on some of those inflationary pressures and been able to increase our employee salaries, remain competitive in the market, and obviously, take advantage of market conditions for office rents, for other services that we buy. We are also fortunate that most of our power purchases are fixed and are not susceptible to wild market fluctuations. We have had some increases in power, and we've been able to pass those on to our customers. So all in all, we think that inflation will not impact our ability to grow our EBITDA. Thank you.

Thanks.

Thank you. Our next question comes from the line of Walter Piecyk with LightShed Partners.

Thanks. Hey, Dave. You mentioned in the prepared comments - you mentioned in the prepared comments about some long-term deals on NetCentric. Typically, when those companies enter into long-term deals, they're asking for price reductions. But that also gives you some good visibility in terms of the growth of that line. Can you give us some kind of qualitative comments on the kind of puts and takes of those long-term deals?

Yeah. Sure, Walt. And by the way, you can go back to transcripts for the past decade, and we have that same section in every one of them and we quantitatively give how many customers and what their contract value increase was. So a NetCentric customer is accustomed to buying services on a metered basis. We offer discounts for fixed commitment and fixed term. So what a customer will typically do is buy a number of ports. They will typically commit to 50%, 60% total port capacity, and they will be running at approximately the same level. As time goes on, they may either add additional ports or they may start to run over their committed capacity, in which case they then pay a premium, a higher price per megabit. Customers understand that market prices have declined at about 23% per year for like volumes. Because most NetCentric customers enter into a three year contract to get the lowest initial price, usually about halfway through that contract the customer is experiencing two things. One, they haven't gotten a reduction in price, and two, they're utilizing more than their committed capacity and are paying the penalty rate on that first traffic. What they will typically do at that point is come back to us, say, we'll sign a new three year contract, recast the 18 months that are left to 36 months, will take more ports, more total commitment and a lower price. We expect that to happen routinely with NetCentric customers, and we then factor that into their next three year contract commitment. That is the most common pattern for these re-pricings.

I would just add. For us to accept that new commitment, so a customer is pricing - asking for a change in term, the total contract value for the new contract must be greater than the remainder on the original contract for us to accept that.

And there's a second governor, which is the salesperson only gets a commission if there is an increase in the monthly spend. So there's kind of both an internal control mechanism and a customer control mechanism.

Thank you for that. I want to also go back to Nick Del Deo's question because I think your response to that was a bit more cautious than the kind of outlook that you provided really since this pandemic started. And then I want to kind of, I guess, put that in the context of long term, you're expecting EBITDA growth and - well, not long term. You said at some point. I don't know what the time frame is, but I think you were non-specific about it. But you're going to converge the EBITDA growth rate with the dividend growth rate, which obviously is under pacing at the moment, as you already highlighted. I think you've gotten some stuff wrong in the past. Obviously, everyone gets stuff wrong in terms of understanding when things don't go as we expect them to. But given how cautious you were to Nick, if we don't really know the time frame of when those can converge, then it seems like there's a possibility that you can't get leverage down below 3.5. So let's put that aside. You're willing to stick this out. At what point do you not stick it out? Like is 4.0 the benchmark? Or the bogey is 4.5? At what point does the Board say, you know what, we're tired of waiting for this convergence. And 4.0 or 4.2 or 4.5 or 5, like 7, like there's got to be a number. Are you willing to take leverage to 9 times?

There are three parts to your question, and I'll provide three answers. Firstly, I don't have the ability to predict when we will return to normal. At the beginning of the pandemic, I believed everyone would work from home for a few weeks and then return to the pre-pandemic routine. Now, after 2.25 years, we are still in a changed environment characterized by supply chain challenges, price fluctuations, and a major shift in the employer-employee relationship. The balance of power has shifted from employers to employees due to the pandemic, leading to a more prevalent hybrid work model. I cannot say whether this change will be permanent or temporary. However, I've noticed that the timeline for returning to historical norms has taken longer than anticipated. Consequently, I have been clear that we believe our corporate business has reached its lowest point, and we feel confident about this assessment. Earlier, I indicated that we were two to three quarters away from a normal return. Although another quarter has passed and we have more data, the results remain largely unchanged, leading me to conclude that the pace of returning to a normal work environment is slower than I initially predicted. Therefore, it is essential for customers to feel empowered to make architectural decisions. We perform well when engaging with prospects, winning 50% of our on-net proposals. However, customers must be ready to focus on their architectural plans. Reflecting on your firm's evolution during the pandemic, it’s uncertain whether you will return to an office, and this uncertainty extends across many tenants in our buildings, creating a more cautious climate. While we are successfully acquiring business and improving our sales effectiveness, these are positive indicators. Additionally, our NetCentric business has exceeded our pandemic expectations for an extended period and is comparatively more profitable due to a higher percentage of on-net engagements. Together, these factors indicate an expected growth in EBITDA. Looking at Cogent's historical performance since going public, we've seen a 10% top-line growth and a 15% EBITDA growth rate during that period. Currently, top-line growth is around 3.5% to 3.6% this quarter, with EBITDA growing at about 5%. While these numbers are considerably slower, we believe improvements are on the horizon, which gives us confidence in our ability to increase our dividend. We continue to keep a close eye on the dividend moving forward. Our balance sheet shows substantial liquidity and ample incremental borrowing capacity, reaffirming our confidence in growing the dividend. The pace of this growth may vary, but we will monitor the situation as it develops. Overall, we feel very optimistic about generating more free cash flow each quarter.

The last part of that question, Dave, was whether there comes a time when your leverage ratio leads you to slow down or stop growing the dividend. I appreciate your confidence and the indicators you see for a turnaround, but we are facing greater uncertainties than ever regarding the economy, inflation, and various other factors. I could argue that the conversion of office spaces to residential is going to extend beyond just small markets, yet I see the rental prices my child is facing and the costs associated with new residential construction in New York City and many other cities. The future is uncertain. The core question is, at what point does the Board decide that a leverage ratio of 4 times is adequate, or perhaps 4.5? It seems we can agree that a leverage of 10 times is likely too high, but I am trying to understand what the acceptable number is.

Our indentures have specific limits; we cannot exceed 6 times gross leverage and 4 times secured leverage. These terms are contractual, and we are currently well below these limits. The real issue regarding the business's capacity to sustain high leverage levels hinges on the cost of debt capital. Our debt costs are significantly lower than those of our competitors and below historical averages. While the Board doesn’t have a specific trigger point for reducing dividend growth, it is a topic of regular discussion at our meetings, considered alongside other factors. We also have $350 million on our balance sheet, but we only need about $60 million to $70 million to operate the business, allowing us to return excess cash. With our covenants modified, this cash is now unencumbered, and we expect to continue returning excess cash for the foreseeable future. However, I can’t provide a specific number because one does not exist.

Yeah, that’s fine. All right, Dave. Thank you.

Thanks, Wal.

Thank you. We will queue in our next question. Our next question comes from David Barden with Bank of America.

Thank you for your patience. I appreciate the good question. First, I'd like to discuss our sales force hiring and productivity. Dave, are we maximizing productivity with our current sales team, and how is the recruitment process going? I recall that returning to the office impacted retention negatively, and I’d like to delve into that a bit more. My second question is about Lumen and AT&T citing rising wholesale prices as an issue. People are speculating about who might benefit from this—could it be Cogent? I'd love your perspective on this. Lastly, I’d like to mention a notable short seller who has published a short thesis on the data center industry, which could negatively impact Cogent and its connectivity opportunities. I assume you're aware of this, so I’d be interested in your thoughts on the potential short-term disruptions in the data center sector caused by cloud providers. Thank you.

I appreciate everyone staying late to listen to our answers. It's important that we address your questions. Starting with the sales force, the rate of decline in our sales force has significantly slowed down. From Q4 to Q1, we reduced our sales team by 12%, but from Q1 to Q2, we only lost two net salespeople. Since the pandemic began, we have hired at record levels, with no shortage of applicants. We've had peak hiring months where we added over 60 new salespeople to our quota-bearing sales force, which consists of about 500 people, totaling 650 in the organization. Some individuals prefer not to work in an office or to be vaccinated, which contributes to turnover, although lower productivity is a primary reason. It’s encouraging that we have returned to nearly our 15-year average for productivity, something we haven't achieved since Q4 of 2018. Our turnover rate rose from an average of around 5.2% to 8.7%, but it decreased last quarter to 6.9% and has declined again this quarter, which we find encouraging. We believe the sales force will continue to grow from here; it has stabilized and is now increasing. We aren't facing any challenges with the sales force. Regarding productivity, it results from having people in the office, learning from training in a remote setting, and improving the work environment. We are optimistic about our sales force's ability to drive additional revenue growth without raising subscriber acquisition costs. On the topic of wholesale pricing, I was skeptical of a comment made by a large carrier. We source off-net circuits and serve nearly 13,000 off-net customers using 90 different suppliers, with at least two providers in almost every instance. We only offer off-net services delivered via fiber, and we have observed a 6% to 7% compounded reduction in the prices for these wholesale loops, which we expect to continue, especially due to various fiber overbuild projects funded by private equity and incumbent carriers. Therefore, we are not increasing prices for our wholesale customers and are experiencing lower purchasing prices. Regarding Mr. Chanos' short thesis on data centers, we serve around 1,450 data centers operated by several hundred carriers, and we are connected to more equinoxes, interactions, and core sites than any other carrier. We have a limited data center footprint typically linked to our sales offices and network equipment, as we chose not to invest capital in building that market. Data center valuations are high, but many have not consistently shown returns above their cost of capital, often attributing this to perpetual growth. There is significant substitution by hyperscale cloud options, instances of technological obsolescence, oversupply, and competition. We observe that several data centers we serve go out of business quarterly, with about five or six closing down. Interestingly, after we cease service, a new operator often takes over soon after. I can't speak to the long-term profitability of data center operators, but I do know there is strong industrial demand for space and power in facilities connected to the Internet, which is what we provide. The operator doesn't concern me as much as the customers in those facilities, and that aspect of our business has grown beyond our typical trend, particularly in our NetCentric segment, and we expect this growth to continue, potentially for longer than we initially anticipated at the start of the pandemic.

That's great. Thanks, Dave.

Thank you. Our next question comes from the line of Michael Rollins with Citi.

Hi. Thanks for taking the question. One follow-up and one question. So the follow-up would be, Dave, you did mention the goal to build 100 data centers annually for the next few years. What's the implications for CapEx on that type of a build plan? And then secondly, on the subject of tax. Where are you today in terms of the tax position and when you start paying material cash taxes? And does the proposed tax changes in D.C. have any influence on that timing or your expectations? Thanks.

Yeah. So let me take the data center one first. We have a pretty robust funnel of actual building addresses and facilities that are under construction, both by existing operators and new operators and feel that the 100 a year is very realistic. It's about the pace we did last year. We are probably going to do less multi-tenant office buildings, not because the market is not recovering quickly enough, but because even before the pandemic, our MTOB expansion had materially slowed as we had reached the targeted buildings that we wanted to. Now there are several new buildings coming on in major markets, and we will go to them. But that MTOB footprint expansion has slowed over the past year from about 7% to about 2% a year as measured by square footage. The data center number has been pretty consistent. With that, we think that our total CapEx will be in line with last year. It came down on a sequential basis, both in terms of straight CapEx and principal payments on capital leases. We think that in our CapEx guidance, the 100 data centers a year are very achievable without a change in CapEx. Now to your tax question. Cogent still has slightly over $1 billion of NOLs. However, only about $40 million of those NOLs are in the U.S. The majority of those NOLs are in international markets with the largest concentration in our holding company in Luxembourg that holds many of our European subsidiaries. We believe we will be subject to a 15% minimum tax due to the BD calculation independent of a new statutory 15% minimum. So over the next year or two, we will become a cash taxpayer, but we believe we will be able to utilize our international NOLs not paying taxes outside of the U.S. but then being effectively caught by the foreign indirect tax capture at 15%. So I think as investors kind of model Cogent in out years, I think that's a pretty good outcome. It's not perfect, but it's surely better than paying at a 21% or a higher rate.

Thanks.

Thank you. And now for our final question. Our final question comes from the line of Brandon Nispel from KBCM. Your line is now open.

Hey, thanks. It's Evan on for Brandon. Do you think you could talk a little bit about your thoughts around the share buybacks and maybe what conditions would need to exist for you to start thinking about starting that? Thanks.

Yeah. Sure. So it first starts with our return to - return of capital question. And I think that's the question that Walt was focused on. He phrased it as a dividend question. But it's really a question about are we committed to continuing to return increasing amounts of capital to shareholders. The answer is unequivocally yes. The rate of growth of that is something that we will evaluate, but we are absolutely committed to returning increasing amounts. Now the mechanism of return today is mostly dividends, in part because we have not seen the level of volatility that told us suspending the dividend and using a buyback was more effective. We have been able to classify the majority of our dividend as a return of capital, therefore, getting a tax advantageous result for the dividend recipient. As a result of that, we have decided to use dividends more than buybacks. We consider that every quarter. We've returned $1.1 billion in total. Roughly $230 million of that has been through buybacks and about $850 million of that has been through dividends. I think at this point, it will probably remain dividend focused. But again, we'll evaluate each and every quarter based on market conditions.

Okay. Thanks.

Thanks.

Thank you. No more questions. I would like to turn it back over to Dave for closing remarks.

Well, thank you all very much for staying late. We normally do this in the mornings, but we needed to accommodate some schedules. So hopefully, this was not too inconvenient. We thank everyone for their attention, and we're available to do any follow-up calls. Take care. Talk to you soon. Bye-bye.

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.