Cogent Communications Holdings, Inc. Q3 FY2024 Earnings Call

Good morning and welcome to Cogent Communications Holdings Third Quarter 2024 Earnings Conference Call. As a reminder, this conference call is being recorded and it will be available for replay at www.cogentco.com. A transcript of this conference call will be posted on Cogent's website when it becomes available. Cogent Summary of Financial and Operational Results is attached to the spectrum. These can be downloaded from the Cogent website. I would now like to turn the call over to Mr. Dave Schaeffer, Chairman and Chief Executive Officer of Cogent Communications Holdings. Please go ahead, sir.

Thank you and good morning to everyone. Welcome to our third quarter 2024 earnings conference call. I'm Dave Schaeffer, Cogent's Chief Executive Officer, and with me on this morning'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, which we present on a consistent basis every quarter. I'd like to take a moment to address some of the expected cost savings that we've been able to achieve. We are continuing to make substantial progress in realizing cost savings and synergies from the acquisition of the Sprint Global Markets business. Based on the difference between our monthly cost run rates in May of 2023 and September of 2024, we have realized $165 million of these savings, which is approximately 75% of our targeted $220 million in annual cost savings. These cost savings were initially expected to be achieved in their entirety by May of 2026. Our combined Cogent business had a very good quarter. Our total revenue was $257.2 million for the quarter. Our revenue results for the quarter were impacted by the continued grooming of low margin off-net connections, the continued elimination of non-core products and low margin business, as well as the reduction in revenues from the commercial services agreement that we have with T-Mobile. Revenues under our commercial services agreement with T-Mobile decreased sequentially by $1.8 million to $4.1 million for the quarter from $5.9 million for Q2. Revenue from a low margin resale customer contract, which was acquired in the Sprint acquisition that we intentionally terminated, was classified as on-net revenue and enterprise revenue and declined by $3.5 million sequentially. Excluding these impacts, our total revenue would have increased by $2.1 million or approximately 0.7% sequentially. Our non-core revenues also declined by another $500,000 to $4.1 million for the quarter. Our wavelength revenues increased sequentially by 45.8% to $5.3 million and an increase of 76.7% on a year-over-year basis. Our IPv4 leasing revenue increased sequentially by 11.8% to $12.8 million and increased 31.5% on a year-over-year basis. Our network traffic for the quarter increased by 8% sequentially and 19% on a year-over-year basis. Our EBITDA increased sequentially by $8.7 million and our EBITDA margin increased sequentially by 350 basis points to 13.9%. Our EBITDA as adjusted was $60.9 million, with an EBITDA as adjusted margin of 23.7% for the quarter versus $106.2 million and 40.8% for Q2 of 2024. The sequential change was due to the scheduled reduction of $41.7 million in payments under our IP Transit Services Agreement with T-Mobile but was partially offset by an $8.7 million sequential increase in EBITDA. In accordance with our IP Transit Service Agreement with T-Mobile, we received payments for the quarter totaling $25 million. This compares to the payments that we received in the previous quarter of $66.7 million. The payments for this quarter are three monthly payments of $8.3 million. An additional 38 monthly payments of $8.3 million per month will continue through November of 2027. These payments are included in our EBITDA as adjusted. We continue to realize cost reductions from the acquired expense base. Our SG&A decreased by $4.9 million sequentially or 7.5%. Our SG&A as a percentage of revenue also decreased to 23.4% from 25% last quarter. Our cost of goods sold increased by $5.3 million from the last quarter due primarily to two major expenses: the additional costs involved in converting former Sprint switch sites in the Cogent data centers that were not capitalized, and certain vendor contract termination costs. The primary contract that was terminated was a tri-party agreement. This was the first opportunity we had to buy out of that agreement and to end that relationship. However, over the course of the year, on a year-over-year basis, our cost of goods sold still decreased by $12.1 million or 7%. Our gross debt to trailing twelve months EBITDA as adjusted ratio was 4.94 for the quarter, and our net debt ratio increased from 3.14 last quarter to 4.13 primarily due to the reduction in IP transit payments from T-Mobile. We ended the quarter with $316.1 million of cash and cash equivalents on the balance sheet. Our sales force productivity improved from 3.8 installed orders per rep per month in Q2 to 4 orders per rep per month in Q3. In conjunction with the Sprint acquisition, we hired a total of 942 employees in May of 2023. At quarter's end, 635 of these employees remain with Cogent. Our wavelength business improved materially. We have now sold wavelength services in slightly over 200 locations, and by the end of 2024, we expect to offer wavelength services in over 800 locations with a much more rapid provisioning cycle. We have a backlog and funnel of over 3,400 unique wavelengths. Our Sprint acquisition materially expanded our data center footprint. As of September 30, we have partially reconfigured 43 of the acquired facilities and added them to our network. Our Board of Directors reflected on the progress that we have made and decided to increase our quarterly dividend by $0.01 per share, raising our quarterly dividend from $0.985 per share to $0.995 per share. This increase represents the 49th consecutive increase in our regular quarterly dividend, with a 4.2% annual dividend growth rate. We expect the combined business of Sprint and Cogent to continue to achieve long-term average revenue growth of between 5% and 7%. Our revenue and EBITDA guidance are intended to be multi-year and not to be used as specific quarterly or annual guidance. Our EBITDA is adjusted, and leverage ratios are impacted by the $700 million that we receive under the IP Transit Agreement with T-Mobile. Now I would like to ask Tad to read our Safe Harbor language and provide some additional operating performance metrics for the quarter before we open up for questions.

Thank you, Dave. And good morning, everyone. This earnings conference call includes forward-looking statements. These statements are based on our current intent, belief, and expectations. These forward-looking statements and all other statements that may be made on this call that are not historical facts are subject to a number of risks and uncertainties, and actual results may differ materially. Please refer to our SEC filings for more information on factors that could cause actual results to differ. Cogent undertakes no obligation to update or revise forward-looking statements. If we use non-GAAP financial measures during the meeting, you will find them reconciled to GAAP measures in our earnings releases, which are posted on our website at cogentco.com. Some comments on corporate and net-centric revenue and customer connections. We analyze revenues based on network connection type, which is on-net, off-net, wavelength, and non-core. We also analyze revenues based on customer type, classifying customers into three types: net-centric, corporate, and enterprise customers. Our corporate business represented 45.2% of our revenues for the quarter, and our quarterly corporate revenue decreased by 3.5% year-over-year and sequentially by 2.8%. The sequential decrease was primarily due to the grooming of low-margin off-net connections and the elimination of non-core products. Our net-centric business represented 35.7% of our revenues for the quarter and decreased by 3.2% year-over-year but grew sequentially by 0.8%. Our enterprise business represented 19.1% this quarter at $49.1 million, with a decrease of 18.2% year-over-year and sequentially by 1.4%, primarily due to the reduction in non-core and low-margin revenues. Revenue from a low-margin resale customer we acquired in the Sprint acquisition that we intentionally terminated declined sequentially by $3.5 million. If you exclude this impact from this cancellation, our enterprise revenue would have increased sequentially by $2.8 million or by 5.6%. Our on-net revenue was $136.5 million for the quarter, which was a year-over-year increase of 5.8% but a sequential decrease of $4.3 million or 3%. The decline in on-net revenue under our commercial services agreement with T-Mobile, and the cancellation of that low-margin resale customer negatively impacted our sequential on-net revenue results by an aggregate total of $5.7 million. Excluding these impacts, our on-net revenue would have increased sequentially. Our revenue from wavelengths was $5.3 million, a 45.8% sequential increase and a 76.7% year-over-year increase. Our non-core revenue was $4.1 million for the quarter, a sequential decrease of $500,000. Our average price per megabit for our installed base decreased sequentially by 8.5% to $0.23 and 23.9% year-over-year. The average revenue per IPv4 address sold was materially higher at $0.49 per address for the quarter, a 63.3% increase from an average of $0.30 for the base of all addresses at the beginning of the quarter. Our DSO was 32 days for the quarter versus 26 days last quarter. Our bad debt expense was $4.5 million and 1.8% of our revenues for the quarter. These increases were largely due to some collection issues associated with a large former Sprint customer that we since resolved after quarter-end. And with that, I will turn the call back over to Dave for some final remarks.

Thanks, Tad. I'd like to highlight a couple of strengths in our network customer base and sales force. We continue to experience substantial traffic growth in our net-centric IP business. At quarter's end, we were in 1,627 carrier-neutral data centers and 95 Cogent-owned data centers, bringing that total to 1,722 facilities. This breadth allows our net-centric customers to optimize their networks and reduce latency. We have a presence in 56 countries globally for these services. Our sales force productivity is dependent on managing underperforming reps and training those that remain to make them more successful. Our sales force turnover rate was 6.7% per month for the quarter, down from a peak of 8.7% during the height of the pandemic, but still slightly above our historical average of 5.7% per month. We expect to continue to widen our lead in the market, projecting the addition of over 100 carrier-neutral data centers to our network each year for the next several years. We remain optimistic about our unique position in serving small and medium-sized businesses with our IP-based services located in central business districts of major North American cities, with over 1,870 multi-tenant office buildings directly connected to our network. We are excited about the continued growth opportunities to our large enterprise customer base and are enthusiastic about our optical transport business and the addition of wavelength services to our portfolio. With a significant wavelength backlog and a funnel of over 3,400 wavelength opportunities, we remain focused on completing the integration of the Sprint Network and the Cogent Network. We will continue to make efforts to monetize our IPv4 addresses and excess data center capacity. Now, I'd like to open the floor for questions.

Thank you. Our first question comes from Jim Schneider at Goldman Sachs.

Good morning. Thanks for taking my question. I was wondering, Dave, if you could maybe just comment on the wavelengths business for a moment. Clearly, you had a nice uptick sequentially in revenue. Does that reflect getting better improvement on provisioning than you would have expected maybe a quarter ago? And then maybe kind of comment on what you said about the backlog. I think you mentioned up to 700 sequentially on the backlog, but also some of these may not be installed. So maybe talk about the rate of backlog growth we could expect in the next few quarters and whether you would expect to write down any of that backlog if you determine you can't provision it.

Yes. So three different questions, Jim, thanks for them. First of all, we substantially increased the number of endpoints that we could deliver wavelength services. We are quite confident that while we ended the quarter at 657 sites, by year-end that number will be over 800 sites. In order to provision a wavelength rapidly, all intermediate sites need to be optimized for that wavelength implementation. Our goal is to achieve those wavelengths install windows down to about two weeks from today, about 90 days. Some customers in our backlog have significant needs for wavelengths, and we've diverted some resources away from the network optimization program to provision these wavelengths. Most customers have been tolerant of that and have continued to affirm their interest in those wavelengths. However, if some of those orders have been sitting for six or seven months, some customers may not accept them when we actually go to provision, and we'll have those discussions. As far as building the funnel, we believe the rate of funnel expansion will materially accelerate into next year. As we demonstrate success in delivering wavelengths, we establish more credibility with buyers. They see that we can meet provisioning windows, the quality of service meets or exceeds industry standards, and our pricing remains competitive. So we feel optimistic that in 2025 we will see a material ramp in the growth of our wavelength business, targeting $500 million in wavelength sales within five years, representing a 25% market share in North America, similar to our IP transit market share.

That's very helpful. Thank you very much. And as a follow-up, I wanted to ask about the network cost side. I think you cited some individual items converting the Sprint sites and vendor termination costs. On a go-forward basis, maybe in Q4, as we head into a run rate for 2025, how should we think about where those overall cost of revenues line, where does that settle out?

They will indeed improve for three reasons. One, we continue to eliminate unprofitable products, including low margin off-net circuits and any non-core products we can remove once the customer is out of contract. Secondly, we had a substantial one-time expense associated with buying out a complicated contract that we inherited. While we cannot disclose the exact settlement amount, it was considerably above the revenue we received from it. We expect these one-time expenses to be unique, though some smaller contracts will appear in 2025. The third item is as we accelerate the marketing of our wholesale data center space, we have been conducting numerous tours with potential customers. We've had to conduct preparatory work that cannot be capitalized, which has raised our cost of goods sold. We expect to see a reduction in these costs over the next couple of quarters as we complete these preparations.

Thank you very much.

Thanks, Jim.

Thanks for taking my questions. Dave, your on-net revenue was down quarter as you mentioned that contract that was terminated had a $3.5 million impact, but it still would have been down $2.8 million excluding this. So just trying to understand the color here as well as the size and cadence of future uneconomical contracts going forward. More color there would be great. And the same-store sales on corporate would be helpful. Second question, just on the data center sale process you mentioned, could they sell for less than the $10 million per megawatt marker? But it sounds like you're putting the CapEx into it for the next few quarters, so as to then command a $10 million per megawatt price. Thanks.

So first, on the on-net revenue decline, two major contributors were a sequential decline of $1.8 million in our commercial services agreement with T-Mobile—those services are low margin—and the second being the reduction in that contract which resulted in a $3.5 million revenue stream but even more in costs. We anticipate some smaller opportunities going forward, but the reduction in these contracts has been predicated on our efforts. For corporate, our core corporate products continue to perform well, while we are still grooming two types of corporate services: non-core services and low margin off-net services. That process will likely continue for several quarters due to contracts acquired through the Sprint acquisition. On the data center side, we looked at recent market prices and established our price points accordingly. We are seeing greater interest in leasing these facilities rather than outright sales; however, we remain open in negotiations as the market will dictate. The amount of capital we're spending is minimal relative to the opportunity at hand, whether we achieve $10 million, $9 million, or $11 million per megawatt out of these sites, it will still be a great outcome for us.

Got it.

Yes, absolutely.

Hey guys, it’s Dave Barden. Hey Dave and Tad, thanks for taking the question. So I guess I have two. The first is a housekeeping question, I guess related to IPv4. And we’ve been seeing that IPv4 leasing volumes be growing at kind of like in the 5%, 6% range, and you raise prices and now it’s kind of growing at the 1% range. Could you kind of talk a little bit about Dave, your kind of senses to the price elasticity in that market right now? We’ve been looking at some of the brokerage sites and prices have been falling and just interested in your updated view there. And then second, Dave, at the risk of having you talk the rest of the call, I just wanted kind of your latest thoughts. Lumen earlier this week kind of made the case that the current physical internet is too small, too slow and not secure enough for the emerging AI opportunity and that they’re really in the sweet spot and that they’re going to excel in the AI world and that the puck is moving away from where the Cogent’s of the world are operating. If you could give me your retort to that, I’d love to hear it. Thank you.

Yes, let me take the IP address space question first. The demand remains robust. When we implemented a price increase, there was some shock to customers who were in negotiations but had not signed contracts at lower prices. Most of that is behind us, and I think you will see volumes continue to increase. The market is bifurcated for small block sales, where prices have fallen, but for larger block sales, prices have held firm. We possess the largest block ever issued on a single basis and have significant leverage there. I don’t see a demand elasticity problem currently. As for the public Internet and AI bandwidth needs, it's been said for years that the public Internet is dying, but we continue to see growth. The Internet continues to increase, and our network traffic has shown an 8% sequential growth and 19% year-over-year growth. AI's possibility stems from the vast amount of data collected over the Internet. There is still ample capacity on our network, and while some models require defined latency and more security, we are prepared to deliver that through our wavelength services. The cheapest way to move bits remains the Internet, followed by wavelengths, and finally dark fiber as the most expensive.

I appreciate it, Dave. Thank you.

Thanks, Dave.

Thanks, Dave, first for reducing the prepared remarks. That's a nice improvement for this quarter. I think we got some additional synergies there.

Thank you, Walt.

So on the CapEx, none of this is speculative, meaning that you see the market in front of you. You spend the CapEx now, and then we start to see first sales in the second half of next year? Or have these guys specifically contracted saying you do X, we're going to pay Y? Or have there already been sales that we can look at?

There have not yet been sales. We have letters of intent from multiple parties, but we have not executed any. We were not initially planning to monetize these assets, but as we sensed the acute need for power, we started to convert those facilities. I believe that we will have transactions that can be announced before mid-next year, but we still have work to do on our part to prepare the facilities.

I understand that. Thanks.

Absolutely.

Hey, thanks, guys. Dave, you said that the number of switch sites that you're planning to convert into data centers has increased. How does that break out between retail sites you're planning to keep versus larger locations that you're considering selling or leasing, both in terms of number of locations and the megawatts? I’m interested specifically in the sites you think you can sell or lease wholesale.

Currently, we believe 21 of the 48 facilities we are converting are suitable for wholesale monetization, representing 88 megawatts of protected power out of a total of 169. We expect that number may go up by another 10 or so megawatts and five locations. Our view is that our current understanding will evolve as we listen to what customers want.

Okay, that's helpful. It sounds like there is more interest in long-term leases than outright sales. If that develops, would you be inclined to sell the stabilized leased facilities, probably at a market multiple if you're looking to sell that income stream or if it's better to keep it inside the business?

Yes, we would evaluate that. There may be an intermediate step, allowing us to securitize this revenue stream for liquidity before potentially selling that business.

Thanks, guys. I have three questions. First, what dictates the timing of you announcing a sale or lease of data center capacity? Do you have any customers that want to buy the whole portfolio? Second, I know you don't typically give guidance, but can you provide a range of possible EBITDA margins for next year, considering these changes? Lastly, can you remind us when you increased the IPv4 pricing and how much? Can you do so next year?

We are in discussions with certain counterparties who may be interested in the entire portfolio, but we want to ensure that we are prepared. We expect to see progress over the next couple of quarters. As for EBITDA margins, we don't provide guidance, but we do expect continued improvement in underlying EBITDA. The IP price increases were two-phased, initially on new sales and then for 25% of the installed base in September. We will likely increase prices on another significant portion of the installed base by year-end. We anticipate continued growth in our IP leasing revenue. Thank you all very much for your questions. I even received a compliment from Walt about shortening the script, which is quite the achievement. Thank you, and take care. We'll talk soon. Bye-bye.

The meeting has now concluded. Thank you all for joining, and have a pleasant day. You may now disconnect.