Cogent Communications Holdings, Inc.
Q4 2016 Earnings Call Transcript

Published: 23 Feb 2017

[Operator:]

Good morning and welcome to the Cogent Communications Holdings Fourth Quarter 2016 and Year-End 2016 Earnings Conference Call. As a reminder, this conference call is being recorded and it will be available for replay at www.cogentco.com. I would now like to turn the call over to Mr. Dave Schaeffer, Chairman and Chief Executive Officer of Cogent Communications Holdings.

[David Schaeffer:]

Okay. Good morning and thank you all for joining us on the call today. Welcome to our fourth quarter 2016 earnings conference call. I'm Dave Schaeffer, Cogent's CEO. Along with me on this morning's call is Tad Weed, our CFO. We were very pleased with our results for the quarter and for the year and remain optimistic in the strength of our business and the outlook for full-year 2017. We achieved our annual revenue growth on a constant currency basis goal, and we grew at 10.8% year-over-year, and our quarterly revenue growth on a constant currency basis quarter-over-quarter from last year was 10.2%. For the quarter, we achieved our year-over-year traffic growth of 37% and a sequential increase in traffic from the third quarter of 11%. Our sales force productivity increased by 7% from the third quarter to 6.1 units of installed services for per full-time equivalent rep per month, a productivity rate that's significantly above our long-term historical average of 5 units per full time equivalent rep per month. Excluding the impact of a $2.9 million SG&A charge in the quarter related to a settlement of a class action wage and hour claim for certain of our current and past sales representatives, our EBITDA increased by $2.8 million, or 7.5%, from the third quarter of 2016, and an increase of $5.2 million, or 15.1%, from the fourth quarter of 2015. Our cash flow from operations increased by 48.4% sequentially to $33.9 million and increased by 28.8% for the year to a record of $108 million. Both of these numbers represent records in cash flow for the company. During the quarter, we returned $18.2 million to our shareholders through our regular quarterly dividend. As we posted on our website, 78.7% of our $68.2 million in total dividends in 2016 should be treated as a return of capital and therefore tax deferred, and 21.3% should be treated as taxable dividends for U.S. federal income tax purposes. During the fourth quarter of 2016, we purchased 80,000 shares of our stock under our buyback program at a cost of $2.8 million, at an average price per share of $35.11. At the end of the year, we had a total of $43.3 million available under our stock buyback program which has been authorized by our board to continue through the end of this year. In December, we issued $125 million of senior secured notes, adding capital to our balance sheet. Our gross leverage at the end of the quarter was 4.73 times EBITDA, and our net leverage was 2.90 times at year-end. We ended the year with a total of $274.3 million of cash on our balance sheet. Of this cash, $142.6 million is held at our holding company, Cogent Holdings, and is completely unrestricted and available for use for dividends and buybacks. We continue to remain confident in the growth potential and cash flow generating capabilities of our business. As a result, we have, as indicated in our press release, announced yet another increase in our quarterly dividend. We are increasing our dividend by $0.02 a share quarterly from $0.40 per quarter to $0.42 per quarter. This actually represents the 18th consecutive quarterly increase in our regular quarterly dividend. Throughout this discussion, we will highlight several operational statistics that we feel are important. I will review in greater detail these operational highlights and trends. Tad will provide some additional details on our financial performance. And then, following the prepared remarks, we'll open the floor for questions-and-answers. I'd now like to turn it back over to Tad to read our Safe Harbor language.

[Thaddeus G. Weed:]

Thank you, Dave, and good morning to everyone. This earnings conference call includes forward-looking statements. These forward-looking statements are based upon 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 the factors that could cause actual results to differ. Cogent undertakes no obligation to update or revise forward-looking statements. If we use any non-GAAP financial measures during this call, you will find these reconciled to the GAAP measurement in our earnings release which is posted on our website at cogentco.com. I'll turn the call back over to Dave.

[David Schaeffer:]

Okay. Thanks, Tad. Hopefully, you've had a chance to review our earnings press release. Our press release includes a number of historical quarterly metrics. Now, I'd like to take a moment and talk about expectations against guidance targets. We anticipate our full-year revenue growth for 2017 over 2016, on a constant currency basis, will be within our long-term guidance range of 10% to 20%. On a constant currency basis, our revenues increased by 10.8% for full-year 2016 over full-year 2015. Excluding the impact of a total cost of $3.1 million in our class action wage and hour settlement, our SG&A charge that we incurred in this most recent quarter, our EBITDA as adjusted margin, would have increased by a 140 basis points to 34.4%. Our gains on equipment transactions for 2016 were $7.7 million as compared to $5.4 million of equipment sale gains for 2015. We anticipate our equipment sale gains for 2017 will continue but will be slightly less than that of 2016, and we will return to our long-term trend and guidance of 200 basis points year-over-year of EBITDA margin expansion as adjusted. Our revenue and EBITDA guidance are intended to be long-term goals and are not intended to be used as specific quarterly guidance. Our EBITDA, as adjusted, is impacted by amounts such as equipment gains, seasonality, and certain SG&A expenses, and the legal fee spent in our defense of net-neutrality. Now, Tad will cover some additional operational and financial details from our quarterly results.

[Thaddeus G. Weed:]

Thank you again, Dave, and good morning to everyone again. I'd also like to thank and congratulate the entire Cogent team for the results we achieved and their continued hard work and efforts during another very busy year and a very productive quarter and year for the company. We analyze our revenues based upon product class which is on-net, off-net, and non-core, and we also analyze our revenues based upon customer type. We classify all of our customers into two types

[David Schaeffer:]

Again, thanks, Tad. I'd like to take a moment and speak to the scale and scope of our network. Our network continues to grow. Today, we have over 860 million square feet of multitenant office space in North America on-net. Our network consists of over 29,500 metro fiber miles and over 57,200 intercity route miles of fiber. The Cogent network is one of the most interconnected networks in the world. We directly connect with over 5,940 networks. Approximately 30 of these networks are settlement-free peers; the remaining 5,910 networks are Cogent transit customers. We are currently utilizing approximately 29% of the lit capacity in our network. We routinely augment capacity along sections of our network to be able to maintain these low utilization rates. We added another Cogent-controlled data center to our network, representing 32,000 square feet of raised floor space. Cogent now operates 52 Cogent data centers with an aggregate total of 595,000 square feet, and these centers are operating at an average utilization of 30%. Our sales rep turnover decreased substantially in the quarter, and was 3.8% for the quarter, far less than our long-term average of 5.9%. We ended the year with 422 quota-bearing sales reps, the most in our history. Cogent remains a low-cost provider of Internet transit and dedicated Internet services. Our value proposition in the industry remains unparalleled. Our business remains completely focused on the Internet and IP connectivity and data center colocation services. These services are a necessary utility for our customers. We expect our annualized constant currency revenue growth to be consistent with our historical rates, and be within the 10% to 20% constant currency range; and our long-term EBITDA as adjusted margins should expand at approximately 200 basis points per year. We've incurred material legal and economic analysis fees in our fight for net neutrality. We spent $400,000 in the fourth quarter of 2016 and $3.3 million for the full-year 2016 in support of this effort. That is lower than our expenditures in both 2014 and 2015. We expect these fees to continue to decline. We do, however, expect that we will spend some monies in 2017, but at a lower level than 2016. Our board of directors approved yet another increase in our regular quarterly dividend $0.02 a share, bringing that quarterly dividend to $0.42 a share. These dividend increases demonstrate our continued optimism, as well as the continued actual increase in the cash flow capabilities of our business. We remain opportunistic about the timing and purchase of our common shares. At the end of the quarter, we had $43.3 million remaining under our current buyback program, and that program remains in effect for the end of the year. We are committed to returning increasing amounts of capital to our shareholders on a regular basis. With that, I'd like to open the floor up for questions.

[Operator:]

And our first question comes from Colby Synesael with Cowen and Company. Your line is now open.

[Colby Synesael:]

Great. Thank you. Two if I may. First up on CapEx; CapEx is little bit higher in the quarter than we were anticipating, about $4 million or so. I was wondering if you could share with us your expectations for CapEx in 2017, including cap leases and any potential vendor financing that you may use during the year. And then also, the $2.9 million, the settlement you mentioned it was $3.1 million I think in total thus far; is there anything out that we should expect or is that really the end of it? And I guess, just more broadly, any other potential onetime things going on that could impact 2017? Thank you.

[David Schaeffer:]

Sure. Thanks for both questions, Colby. Let me go ahead and start with the CapEx question. We anticipate that our CapEx for both capital lease payments and straight capital, whether that capital is CapEx or installment sale capital, will decline in 2017 to a lower level than 2016. Our capital spending was slightly higher in the fourth quarter than we had originally anticipated, in large part because of the refurbishment and bringing online of the additional data center. That data center was in Seattle. We had had customer demand for that market, and quite honestly, our sales office in that market was very small and needed to be expanded. So, we opportunistically took advantage of that. And we were able to get a substantial portion of that capital expenditure, even though it's recorded as CapEx by us reimbursed by the landlord as we took over that center, that was originally a corporate facility that had been vacant. So, we expect our general capital expenditures to continue to decline both for CapEx as well as principle payments on capital leases. Now, with regard to our wage and hour settlement claim, this has been an ongoing issue for several years for Cogent. We have disclosed this to shareholders and it was a series of class actions that were brought around the country by employees who claimed that they were not exempt employees, but should be treated as hourly employees. That goes against industry standards. We felt strongly that these employees are exempt employees and would not be covered under the Fair Labor Standards Act as hourly employees. We actually prevailed in litigation in several states and won. In the State of California, we had two adverse rulings. The first of those rulings were that these employees could in fact form a class. We believe there were enough differences between the employees that they should not be a class. Secondly, our employees are governed by arbitration agreement. And under well-settled federal law that has actually been adjudicated to the Supreme Court, these arbitration agreements should inoculate the company from the ability of employees to form a class. The District Court and the Appeals Court, the Ninth District Court in California ruled against us. In light of those two adverse rulings but still feeling confident in our position, we felt that we're absolutely right, we made an economic decision rather than to substantially ramp-up our legal spending to just go ahead and settle the claim. So, as Thad indicated, we had originally reserved $200,000 for legal. It looked like our legal was going to mushroom to several million dollars with that Appeals Court ruling going against us. We still feel we are right on the issue. This does put this to an end and we have gone ahead and reclassified all Cogent sales people in the U.S. as hourly employees. While we think that is wrong, that is a further inoculation against any future actions. There are no other material legal actions and we do not anticipate any other unique or onetime charges going forward. So, hopefully that answered your question.

[Colby Synesael:]

Great. Thank you.

[Operator:]

Thank you. Our next question comes from Nick Del Deo with MoffettNathanson. Your line is now open.

[Nick Del Deo:]

Hey, Dave. Good morning.

[David Schaeffer:]

Hi, Nick.

[Nick Del Deo:]

Hi. So, I saw that Dyn recently put out its Baker's Dozen list for 2016. You guys are one of the top, as usual. But the associated commentary noted that you lost Apple as a customer in the quarter, but picked up a lot of new business in Asia. Are those observations correct, first? And if so, how should we think about the relative revenue contribution to those factors?

[David Schaeffer:]

So, two things. First of all, we have continued to grow our Asian customer base. We have network points of presence in Hong Kong, Tokyo, and Singapore. We also have increased our sales to Asian carriers, both in Europe and North America. And today, we're actually ranked as the third largest Asian provider in the world. Apple has been a customer of Cogent for a long time. They continue purchase services from us. I don't want comment on specific changes in their network architecture, any specific customer, but we continue to be the leading transit provider for every major content provider globally, and we will continue to do so. Some of these companies have been in the process of building their own content delivery networks. In some cases, that will reduce the amount of transit purchase; in some cases, it actually increases it. But we've actually had a couple of our larger customers get a little bit concerned about us mentioning their name. So, we're trying to steer away from specific names.

[Nick Del Deo:]

Okay. Fair enough. And then, maybe one clarification based on Colby's question. Should we anticipate any change in your ongoing SG&A because of the settlement and reclassifying the employees? So, for example, by having to rejigger pay policies or anything like that on a go-forward basis?

[David Schaeffer:]

The answer is, no, we do not expect any change in SG&A or employee compensation. What we had to do is, rather than treat employees as exempt employees and therefore give them a annual salary and a commission plan, we had to take their average compensation, divide it into a 40-hour week, and effectively pay the employee the same thing but on an hourly basis, and then put a reporting system in that will inoculate us from employees working more than 40 hours a week. And in particular in the State of California, it's a two-part test, it's not only 40 hours a week, it can't be more than 8 hours in any given day. So, we're very conscious of that. We put in place a monitoring system. There really was no real wage and hour claim here, it was just a classification and it all hinged around the question about how much time the employee spent out of the office versus in the office on the phone. We still feel strongly that they do fit within the definition of an exempt employee, but rather than fight to be right, it was cheaper to go ahead and settle.

[Nick Del Deo:]

Sure. Okay. That makes sense. Thanks, Dave.

[David Schaeffer:]

Thanks, Nick.

[Operator:]

Thank you. Our next question comes from Scott Goldman with Jefferies. Your line is now open.

[Scott Goldman:]

Hey, good morning, Dave. Couple questions, if I could. I guess to follow up on some of the previous questions. Just maybe you could help us parse out the margin expansion opportunity in 2017. I think, historically, you've talked about half coming from gross margin, half coming from SG&A. Gross margins have been relatively flat, I think, of late, so just wondering if that's still the view on how we should think about the margin expansion and whether or not changes in net-neutrality and asset gains play a role? You expect them to play a meaningful role in the 200 basis points in 2017. And then secondly, a lot of chatter, I guess, of late around cable competition. And obviously, I think AT&T embarked a few years ago on delivering fiber to multitenant office buildings, talks of Charter doing the same. Wondering if whether you're seeing any change in cable competition and how you think that your value proposition against what cable may be delivering? Thanks.

[David Schaeffer:]

Yeah. Sure. Well, thanks for the questions. Let me start with the margin question. We have historically over a 15-year period delivered slightly better than 200 basis points a year of margin expansion. And roughly half of that expansion has come from gross margin expansion and half has come from SG&A efficiency. If we look at this most recent year, our gross margin expansion was depressed. It actually was negative because of the inclusion for a full-year of USF [Universal Service Fund] fees, which carry no contribution margin and are a direct pass-through. So, we would have seen a gross margin expansion of about 70 basis points as opposed to the negative 20 basis points. So, we believe that the operating leverage of the business continues to flow through on the gross side. Our gross margins have also been depressed by the rate of network expansion, the COGS associated with new fiber routes, new buildings on-net, and in particular, new Cogent data centers. We did add one data center. It was a fairly large one in the Pacific Northwest this most recent quarter, but the pace at which we've been adding them has been slower than it had been over the past several years, and we expect that to continue. So, as a result, we expect our gross margins to expand at roughly 100 basis points a year. Now, to the SG&A efficiency, that comes from the efficiency of the sales force. As we have seen, their productivity has continued to increase. It also comes from the growth in our scale and our ability not to increase our overhead. And as a result of that, we expect our SG&A efficiency to also contribute roughly 100 basis points a year of margin expansion getting us to that 200-basis-point margin expansion. We will have a bit of headwind this year, as we indicated, that our asset sales which count in EBITDA as adjusted will actually be lower. Even inclusive of that headwind, we feel comfortable that we'll return to our 200 basis points year-over-year margin expansion. So, the operating leverage has shown through the business in the record cash flow. We did take a significant SG&A hit in this quarter for the wage and hour settlement that, again, I still feel is wrong, but it was the right business decision to make. And we do not anticipate any of these additional expenses. And then finally, with the regulatory environment, I think two things. One, we have contracts in place and are completely congestion-free with seven of the eight providers that were historically blocking traffic. We don't believe that there will be a significant change on regulation, even though there is a lot of noise around that, and I think there will be a lot of titular changes, but not functional changes in net neutrality rules. But, we're actually governed by contract. And as a result of that, our expenditure on these legal expenses will decline substantially in 2017 and probably, hopefully, be eliminated by 2018. So, I think that will also help us on our margin gain. I'm going to now switch to cable and in your broader question, you'd mentioned one of the incumbent telcos and the competitive landscape as well. Cogent has 860 million square feet of On-net multitenant office space; just about 1,600 buildings. That's a small number of buildings but a large amount of square footage representing 9% of the market. And in that footprint, we are truly unmatched and our definition of on-net is actually very different than cable or telco and that we have full fiber infrastructure throughout the building and can distribute to every customer on every floor. We have 90 off-net providers. We only use fiber to connect off-net customers. So, we do not use Ethernet over copper, fixed radio, or any other technology. No coax, only fiber. We have approximately 325,000 on-net buildings that are in our off-net quoting tool. So, they're on-net for one of our 90 off-net providers. Those buildings, on average, are about one twenty-fifth the size of a Cogent building. In that footprint, we absolutely see cable and some incumbent telco competition, but those companies are typically focused on selling a bundle of services. They are still oversubscribing the services, and their services are not symmetric. You may have realized that at least in New York, the attorney general has filed suit against now Spectrum, a Cogent customer, formerly Time Warner Cable, for fraud, for misleading its customers, stating two things. One, they sold bandwidth knowing that they couldn't actually deliver it. So, the average customer was sharing a bandwidth with 325 customers in the State of New York. Secondly, the modems that were installed were incapable of supporting the bandwidth that was sold. And then finally, during the period of this investigation, there was a conclusive proof that there was poor congestion leading to the greater Internet and I'm not sure it's a badge of honor but Cogent was the most congested of those providers in Attorney General Schneiderman's litigation. As a result of all that, I think cable has proven itself to be an inferior product. It does compete with us, but we continue to win against it. And in fact, you saw our off-net growth rate continue at roughly 13% year-over-year which is historical rates. Hopefully that was a good answer to your question.

[Scott Goldman:]

Yeah. No, that's very helpful. Just one quick follow-up on that. So, are you seeing any cable competition in the 1,600 buildings that you mentioned earlier?

[David Schaeffer:]

We do not, and I think there are three reasons for that. One, the cable plant tends to be in other geographies. Two, they have been unwilling as cable operators to enter into license agreements with the building owner and pre-wire the building speculatively, and therefore, when they come in to compete with us if they are in the area, they have to use the tenant's right of entry and have to home run to each tenant. With the average cost of construction being about $1,000 a floor, or the average Cogent building being 41 stories tall, so the average tenancy is in the middle of the building on the 20th floor, that creates a non-recurring charge to the customer of about $20,000 by the cable company, which makes them uncompetitive. Finally, the cable operators, both residentially and to their business customers, have been very reluctant to sell just Internet; they want to sell a bundle of services. And increasingly the customers want just that dumb pipe. And for all those reasons, we see no significant cable competition in our on-net footprint.

[Scott Goldman:]

That's great. Thanks so much, Dave. Appreciate it.

[David Schaeffer:]

Okay. Thanks, Scott.

[Operator:]

Thank you. Our next question comes from Frank Louthan with Raymond James. Your line is now open.

[Frank Garreth Louthan:]

Great. Thank you. Can you give us an idea on the sales force? The quota-bearing heads are up, but can you give us an idea of what the mix is between NetCentric and the Corporate side? NetCentric growth was a little slower than we were looking for. What's the possibility of ramping that sales force up and is that sort of the key component to getting that rate of growth higher?

[David Schaeffer:]

So, first of all, Frank, our NetCentric growth in the quarter accelerated on a year-over-year basis. It was 5.5% last quarter, it was 6.1% year-over-year this quarter. That 6.1% also include some FX headwinds. So FX adjusted, that NetCentric growth on a year-over-year basis was actually about 6.3%. So, that's a fairly material acceleration in NetCentric growth. We clearly have work to do. We're not at our long-term average of 10% growth. Our Corporate business continues to perform at historic levels and productivity remains high. As we look at the sales force, it is still dominated by Corporate reps. Corporate reps make up roughly 305 of the 422 total reps. We are continuing to hire additional NetCentric reps globally, both here and in Europe. I think we'll continue to see improvement in that NetCentric business. The NetCentric business is highly susceptible to FX, as over half of that business, now 51% of that business, is outside of the U.S. And then secondly, there is seasonality in that business. So, while understanding the Corporate business on a sequential basis makes a lot of sense, because there is very little seasonality, looking at that NetCentric business on a year-over-year basis is probably the most meaningful way to measure it. And quite honestly, we're very pleased with the improvement in performance and the rebound in growth. Remember, we had a number of major last mile networks who did substantial damage to the Internet, knowingly, willingly, and were I think chided for it and now some are actually facing litigation for it and it takes awhile for that to recover, but we feel pretty pleased with the rebound in the NetCentric business and we also are adding more sales reps and probably a disproportionate number of those hires are NetCentric versus Corporate.

[Frank Garreth Louthan:]

Got it. Okay. Thank you.

[Operator:]

Thank you. I'm showing no further questions at this time. I would like to turn the call back over to Mr. Schaeffer for closing remarks.

[David Schaeffer:]

Well, again, I want to thank everyone for following Cogent, their questions, and the support. We feel very good about the progress in our business. And we'll talk to you on our next earnings call for Q1. Take care, everyone. Thanks.

[Operator:]

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Everyone, have a great day.