Cogent Communications Holdings, Inc.
Q2 2014 Earnings Call Transcript

Published: 7 Aug 2014

[Operator:]

Good morning, and welcome to the Cogent Communications Holdings' Second Quarter 2014 Earnings Conference Call. As a reminder, this conference 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.

[David Schaeffer:]

Yes. Thank you, and good morning. Welcome to our Second Quarter 2014 Earnings Conference Call. I'm Dave Schaeffer, Cogent's Chief Executive Officer. With me on this morning's call is Tad Weed, our Chief Financial Officer. We're relatively pleased with our results for the quarter, and we are optimistic in the strength and outlook of our business for the remainder of 2014. During the quarter, we experienced sequential revenue growth, EBITDA margin expansion. Sales rep productivity, again, was far above our historical averages. We returned a total of $25.8 million to our shareholders through a combination of dividends and stock buybacks during the quarter. This $25.8 million includes our regularly reoccurring dividend of $7.9 million or $0.17 a share and an additional $17.9 million paid under our return of capital program through stock buybacks. The $17.9 million in stock buybacks allowed us to purchase slightly over 522,000 shares of our common stock in an average price of $34.27. During the first 6 months of this year, we've purchased almost 1 million shares of our stock for $32.1 million at an average price of $34.61. So far, this quarter through yesterday, we've purchased an additional 131,000 shares of our common stock for a total of $4.4 million at an average price of $33.82 a share. Yesterday, our board authorized an additional $50 million for our stock buyback program. We now have a total of $59.3 million available for buybacks under our program, which was extended through February 2016. We remain confident about the cash flow-generating capabilities of our business. As a result, as we indicated in our press release, we've announced a significant increase -- actually, the largest ever -- in our quarterly dividend, raising that dividend from $0.17 per share to $0.30 per share, our eighth consecutive and largest sequential increase in our quarterly dividend. This third quarter regularly scheduled dividend will be paid on September 19, 2014, to holders of record as of August 29, 2014. Since we have returned more than $10.5 million of capital to our shareholders in the second quarter by purchasing $17.9 million worth of common stock, we will not make a special payment of a dividend in the third quarter of 2014. As a reminder, under our return of capital program, in addition to our regularly quarterly dividends, we are committed to returning, at minimum, $10.5 million to our shareholders each quarter through buybacks or a special dividend or a combination of both. We will continue to evaluate the market and use a combination of stock buybacks and special dividends under our return of capital program. Our return of capital program is planned to continue until our net debt-to-EBITDA, as adjusted, reaches 2.5

[Thaddeus G. Weed:]

Thank you, Dave, and good morning, everyone. This second quarter 2014 earnings report and this earnings conference call discuss Cogent's business outlook and contains forward looking statements within the meaning of Section 27A and 21E of the securities act. 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. You should also be aware that Cogent's expectations do not reflect potential impact of mergers, acquisitions, other business combinations or financing transactions that may be completed after today. Cogent undertakes no obligation to release publicly any revision to any forward-looking statement made today or otherwise update or supplement statements made on this call. Also, during this call, if we use any non-GAAP financial measures you will find these reconciled to the GAAP measurement in our earnings release and on our website at cogentco.com. I'll turn the call back over to Dave.

[David Schaeffer:]

Yes, hey, thanks, Tad. Now for some highlights from our second quarter results. Hopefully, you've had a chance to review our earnings press release. As within previous quarters, our press release includes a number of historical quarterly metrics. These metrics will be added to our website. Hopefully, you will find the consistent presentation of these metrics helpful and informative in understanding the financial results and trendings in our business. Our second quarter 2014 revenue was $94.6 million. Our revenue's sequential growth rate for the quarter was 1.8%, better than the 1.5% sequential growth rate we achieved for the comparable period last year, Q1 2013 to Q2 2013, but was less than the sequential growth rate we achieved from Q4 2013 to Q1 2014. Seasonal fluctuations in usage contributed to lower growth rates, and the quarter was similarly impacted last year. Our recent sales organization initiatives and the significant expansion of our sales organization are beginning to generate results. We evaluate our revenues based on product class, on-net, off-net, noncore, which Tad will cover in greater detail. We also evaluate our revenues base on the type of customer purchasing services. We classify our customers into 2 major groups

[Thaddeus G. Weed:]

Thank you, Dave, and again, good morning, everyone. I'd also like to thank and congratulate the entire Cogent team for the results and hard work and their efforts for this quarter. And I'll begin my discussion by providing additional details on our revenue by product class, just on-net and off-net. Our on-net revenue was $70.4 million for the quarter, which was a sequential increase of 1.9% and an increase of 12.3% from the second quarter of last year. About 90% of our new sales for the quarter were for our on-net services. Our on-net customer connections increased by 3% sequentially and increased by 17.4% from the second quarter of last year. We ended the quarter with over 37,400 on-net customer connections on our network in our 2,057 on-net buildings. Our off-net revenue was $23.9 million for the quarter, which was a sequential increase of 1.5% and an increase of 5.6% from the second quarter of last year. Off-net customer connections increased by 4.6% sequentially and by 16% from the second quarter of last year. We ended the quarter serving over 5,400 off-net customer connections in over 4,100 off-net buildings. Our noncore revenue was about $400,000 and represented less than 0.4% of our revenue and about 400 customer connections. Statistics related to ARPU, average revenue per unit. Our on-net and off-net ARPUs declined from the first quarter. Our on-net ARPU for Corporate and NetCentric customers combined was $649 for the first quarter and decreased by slightly less than 2%, 1.9%, to $637 for the second quarter. Our off-net ARPU, which includes predominantly Corporate customers, was $1,516 for the first quarter and declined by 2.2% to $1,482 for the second quarter. Churn rates. Our churn rate for on-net customers improved during the quarter, and our off-net churn rate was flat. Our on-net churn rate was 1.1% and improved last quarter and improved to 1% this quarter. Our off-net churn rate was 1.5% for the first quarter and was the same 1.5% for this quarter. EBITDA and gross margin. Our EBITDA, as adjusted, margin percentage for the quarter increased sequentially and increased over the prior year quarter despite the legal fees. Our EBITDA, as adjusted, margin for the quarter increased by 80 basis points from the first quarter sequentially and increased from the second quarter of last year by 90 basis points. Our EBITDA, as adjusted, margin was 34.5% for the second quarter of last year, 34.6% from the first quarter of this year and increased to 35.4% for the current quarter. Our EBITDA adjusted for the quarter was $33.5 million, which was an increase of 4.3% from the first quarter and a 13% increase from the second quarter of last year. As Dave mentioned, we spent $1.2 million on legal fees defending net neutrality during this quarter and these legal fees, obviously, as they hit SG&A, have materially impacted our EBITDA margins. If you adjust for these legal fees, our EBITDA margin would have been 36.7% this quarter, which would have been an increase of 220 basis points over the second quarter of last year and would have increased by 200 basis points over the first quarter of this year. If you adjust for the $2 million in legal fees we incurred during the first 6 months of this year, our EBITDA, as adjusted, margin would have been 36% for the 6 months of this year, which would have been 200 basis points in line with our guidance, over 34% for the first 6 months of last year. Our gross profit margin increased by 140 basis points from the second quarter of last year and was unchanged from the first quarter. Our gross profit margin was 56.9% from the second quarter of last year and increased to 58.3% for the current quarter. Our on-net revenues continue to carry nearly 100% incremental direct gross profit margin, and our off-net revenues continue to carry a 50% incremental direct gross profit margin. Variability in our EBITDA and gross margin expansion can and does occur. If you examine our quarterly metrics for the last 37 quarters included in each of our press releases since we became a public company, you will notice unevenness in our quarterly margin expansion, both gross and EBITDA margins, and this can occur due to seasonal and other factors which can vary from quarter to quarter, including the timing and scope of our network expansion activities, our sales organization expansion and, recently, our legal activities. Seasonal factors that impact our SG&A expenses include the resetting of payroll taxes in the U.S., the cost of our annual sales meeting held in January and the annual cost-of-living increases and the timing of our audit and tax and other professional services. These changes typically increase and did increase our SG&A expense in the first quarter from the fourth quarter of last year. We typically experience a sequential decline in SG&A from the first to second quarter. If you adjust for the $1.2 million legal fees we incurred in the second quarter related to defending net neutrality, our SG&A expenses, in fact, did decline as expected from the first to second quarter of this year. Despite quarter-to-quarter variability, our long-term margin trend has demonstrated that our business model generates increasing EBITDA margins. Details on interest expense, which includes the new notes. Interest expense for the quarter resulted from interest that we incurred starting on April 9, 2014, on our new $200 million senior unsecured notes, interest on our $240 million of senior notes, interest on our $92 million of convertible notes through June 20, 2014, when those notes were repaid and, finally, interest on our capital lease obligations. Our interest expense for the quarter was $11.3 million last quarter and increased to $13.8 million for this quarter. The details of that $13.8 million of interest expense for this quarter are as follows

[David Schaeffer:]

Okay, thanks, Tad. I'd like to take a moment and speak about sales force activity and productivity. We began the second quarter of 2014 with 317 sales reps and ended the quarter with 337 sales reps, a net gain of 20. We hired 69 reps in the quarter, and 49 sales reps left the company during the quarter. Our monthly rep turnover or churn rate was 5% in the second quarter, much better than our improving long-term historical average, which is now down to 6.5% due to continued improvements in our sales force turnover. We began the second quarter of 2014 with 303 full time equivalent reps and ended the quarter with 310 full time equivalent sales reps. Productivity on an FTE rep basis for the second quarter was, again, 5.9 installed customer connections per full time equivalent rep per month. This rate of organic rep productivity is significantly better than our long-term historical averages, which have traditionally been approximately 4.6 customer connections per full time equivalent rep per month. As a reminder, our sales rep productivity rates are not based on contract signing but rather are based upon actual completed and installed customer orders once they begin generating revenue. Cogent's scale. Our size and scale of our network continues to grow. We added 33 buildings to our network and have, today, over 2,050 buildings on our network. Our network consists of 27,300 metro fiber miles and 57,600 miles of intercity fiber. The Cogent network is one of the most interconnected in the world where we directly connect to over 5,200 networks, of which approximately 40 are settlement-free peers. The remaining networks that connect to Cogent are our customers. We are currently utilizing approximately 29% of the lit capacity on our network. We routinely augment capacity on parts of our network to maintain low utilization rates. We currently serve only 23% of the potential Corporate customers in our on-net footprint. We serve less than 1% of potential off-net customers in our footprint, and we serve approximately 14% of our potential NetCentric customers available to us in our addressable markets. We have a well-diversified revenue base with low revenue concentration. No one customer represents more than 2.3% of our revenues in the second quarter, and our top 25 customers represent less than 8.3% of our revenues. We believe our network has substantial available capacity to accommodate our growth plans. So in summary, we believe that Cogent is a low-cost provider of Internet access, transit services and other IP services, and our value proposition to our customers remains unmatched in the industry. Our pricing strategy has continued to attract many new customers, resulting in above-average sales force productivity, increased volumes, increased revenue commitments from existing customers. Our business plan remains completely focused on the Internet and IP services and provides a necessary utility to our customers. We expect our annual revenue growth and EBITDA margin expansion to be consistent with our annualized rates of 10% to 20% total revenue growth and greater than 200 basis points of EBITDA margin expansion, excluding the onetime extraordinary legal fees that we've explained related to our positions on net neutrality. For 36 out of 37 quarters as a public company, we have produced organic sequential revenue growth, and we are encouraged by the cash flow generating performance of our business. We continue to be very encouraged by the results of our sales initiatives, our sales force productivity and our order pipeline. Certain of our last mile access network peers continue to be reluctant to upgrade their peering connections to us. Unlike other organizations, we believe in and are completely supportive in an Open Internet and true strong net neutrality. We're incurring a material legal expense to defend these principles, spending approximately $4 million this year on defending net neutrality, of filings that we have prepared and are continuing to prepare for the Federal Communications Commission, the Department of Justice here in the U.S. We also talk to state's attorney generals and the Directorate General for Competition in Europe. We like and are confident in our network reach, our product set, our addressable market and the operating leverage that we have achieved. In short, we continue to like our business. We feel that we have an underserved, ample addressable market in our on-net footprint, allowing us to grow our revenues at our historical growth rates. We are committed to providing annualized top line revenue growth of 10% to 20% and expanding our EBITDA margins and generating increasing free cash flow for our equity holders. We are opportunistic about the timing of purchase of our common stock. Our board has authorized an additional $50 million for stock buybacks. Through yesterday, our buyback program, we have purchased 1.4 million shares of our common stock for a total cost of $40.7 million. We now have a total of $59.3 million remaining under our authorization for buybacks, which now has been extended and runs through February 2016. Our Board of Directors approved another and our most significant increase in our regular quarterly dividend to $0.30 per share per quarter. This dividend will be paid to our shareholders on September 19, 2014. This dividend increase demonstrates our continued optimism regarding the cash flow generating capabilities of our business. We have strengthened our balance sheet through reorganization and the issuance of $200 million of unsecured notes. We are committed to returning an increasing amount of capital to our equity shareholders on a regular basis and migrating towards our targeted net debt target of 2.5x EBITDA by no later than the end of 2016. With that, I'd like to now open the floor for questions.

[Operator:]

[Operator Instructions] And our first question comes from the line of Colby Synesael of Cowen and Company.

[Colby Synesael:]

Great. I have two questions, one on revenue and one on margin. So on revenue, we've seen a slowdown in the off-net business the last 2 quarters, and it looks like it's being driven predominantly by a reduction in ARPU. I was wondering if you could talk about what's going on there and how we should think about growth going forward for that particular part of the revenue business. And then as it relates to the margins, the last 2 quarters, we've seen a bump-up in what you guys call gains on asset-related transactions, which was $2.7 million this quarter. Can you just remind us, a, what that is? How much of it is actually cash versus noncash? And what's the likelihood of that being sustainable on a go-forward basis as well?

[David Schaeffer:]

Yes, sure, Colby, thanks for the questions. Let me start with the off-net question. First of all, our sequential rate of off-net growth did accelerate this quarter from 0.3% last quarter to 1.5% sequentially. We have seen continued ARPU declines in off-net because of our ability to secure lower-cost loops that we then pass on to our customers. To remind investors, our off-net products typically carry a 50% gross margin. So our pricing strategy is to take the best price that we can achieve on that off-net loop and then effectively double it for the value we add by converting that loop into an Internet connection. We do anticipate a continued pacing of acceleration in our off-net revenue growth, particularly as we are able to shorten some of the install times on these off-net loops. As our providers have given us better pricing, they have not yet shortened their install periods, but we are working with them to shorten those install periods. So we expect both unit growth and continued ARPU decline, but the results should be an even faster pace of sequential growth in that off-net business next quarter and the quarter after. Our long-term historical trend in that business has been to grow at about 5% sequentially. And I do believe we will be able to continue to see the improvement from the 1.5% towards that historical growth rate.

[Colby Synesael:]

And to that point, Dave, are you still expecting then total revenue growth to get to the midpoint of your range? You've talked about 10%, 20%, getting to somewhere around the 15% type [ph] rate by the fourth quarter. I think the way you think about that is 3.75% on a sequential basis in the fourth quarter. Is that still your top line target for this year?

[David Schaeffer:]

Yes. So our target continues to be improvement in our sequential growth rate. This quarter, our sequential growth rate was lower because of the seasonality that we anticipated, and we've tried to convey that to the market. But we do see more salespeople, more productivity per rep and relatively constant rates of price declines on our on-net services. In fact, we've seen some moderation in that rate of price decline, and in the off-net, continuing to see acceleration and growth. So we are clearly committed to getting to the midpoint of our guidance of 10% to 20%. We will not deliver that midpoint for this year, but we'll be within the guidance range and we'll be on a run rate by the end of the year that will get us to a midpoint which needs to be at about 3.5% sequential growth. I do want to touch on your margin question as well, Colby. We have been able to sell some of the equipment that we deem as obsolete on our network. We have commitments from purchasers to take more of that equipment over the next several quarters. So we have abeen able to achieve an extraordinary gain for the past couple of quarters through these equipment exchange programs. We're replacing that equipment with more modern equipment. And we expect that to continue for at least the next several quarters, so the remainder of this year and, actually, into early next year. So it's not...

[Colby Synesael:]

Any color on -- is the 2.7% a good number for us to be thinking about? Because it's obviously having a pretty big impact in terms of how we're modeling it. So any color on some numbers or parameters around that would be helpful.

[David Schaeffer:]

Yes, I think for the next 2 to 3 quarters, that type of run rate is very reasonable.

[Operator:]

And our next question comes from the line of Mike McCormack of Jefferies.

[Scott Goldman:]

It's Scott on for Mike. Dave, maybe a follow-up to that last question just on overall revenue. I mean, I guess, as we look at sales force productivity, you've been running at a much higher level now for probably 4, 5, 6 quarters now. So just wondering, with productivity where it's at, yet revenue growth still sitting towards the lower end of that range, sort of what are the next steps from here to sort of get you that revenue acceleration if you're already getting sort of the sales force productivity levels you're looking at? And then just maybe thinking on net neutrality. Obviously, you guys are incurring a lot of legal fees for that. But I wonder if you could give us the latest update or latest thinking on where you think Washington or the regulators are on that, what you think the most likely outcome is. And then maybe we've seen AT&T and Verizon, I think, since the last quarterly call, sign deals with Netflix. I don't think that necessarily impacts you, but if you could just give us a sense for if there's any impact from those deals on that front.

[David Schaeffer:]

Sure, okay. A lot of questions there, Scott. Let's start with the revenue growth rate. So this quarter, we saw a relatively slow growth in our NetCentric business, growing it only 0.1% sequentially, whereas the Corporate business performed much better. That was due to the fact that we typically see seasonal slowdown in the rate of traffic growth. This year was no different than the pattern over the past 4 or 5 years. Whereas with any seasonal trend, that will end, then we'll start to see a re-acceleration on a sequential basis in traffic growth. Actually, beginning in the latter part of this month, the schools go back and people start to spend more time consuming media. We also continue to see growth in the sales force. So just on a quarterly basis, we went from 317 quota-bearing reps to 337. We also saw an increase in full-time equivalents. Productivity continues to remain elevated, and we actually think that there's some initiatives that are in place that are going to either-- even further improve that productivity per rep. So to get us to the midpoint of our guidance on revenue growth, we really need 3 things to happen. One, we need all parts of our business growing effectively. That is our Corporate on-net business; our off-net business, which I just touched on, on the last question; and then finally, our NetCentric business. And I do believe that all of the pieces are in place for us to be able to get to that improved revenue growth. There's no one magic bullet here, but rather a series of initiatives that have allowed us to improve the productivity and continue to hire and reduce turnover. In all of those areas, I think we have more room for improvement, but we will be able to demonstrate consistent, sequential improvement. Now to the net neutrality question. We are based in D.C. I wish I could read the regulator's mind. I will say that we, I think, made tremendous progress in bringing the real net neutrality to bait into the public arena, and we've done that in conjunction with some of our customers like Netflix. In the past, I think many of the local ISPs like AT&T and Verizon have chosen to define net neutrality very narrowly by only addressing traffic inside of their network and using what is a giant loophole in that definition to, in fact, retard the quality of traffic that their customers were receiving by failing to upgrade the connections to the Internet, not only to coach them, but to every other backbone in the world as well. We've seen the SEC move from, first, stating they were not going to look at peering to now including peering in their analysis and launching a formal investigation into these types of interconnection agreements and whether or not they are being done on an arm's length basis. The actual process of lobbying was much more complicated and expensive than we originally anticipated and has been exacerbated by the fact that not only are we dealing with a Notice of Proposed Rulemaking and a general policy change, there are 2 large high-profile M&A transactions in the market that are involving the Department of Justice, and providing information to the DOJ related to those transactions has been very time-consuming. I believe there will be relief in 2 areas. One, I believe, on a general policy basis, there will be a need for carriers to deliver the service that they have promised their customers. And transparency, which is a hallmark of Tom Wheeler's administration, has become, I think, paramount. And I think the combination of transparency, coupled with mandatory service obligations, will ensure a net neutrality policy that includes interconnection. Secondly, with regard to the various M&A in the industry, I believe the DOJ will impose conditions that will ensure that companies who sign up for a net neutrality commitment are truly committed to that. I do know that even the President commented, which is a little unusual for the Commander-in-Chief to comment on a policy issue that is this archaic [ph], but he wanted to look at these "fast lane transactions" and wasn't sure that they fit with his understanding of net neutrality. It is true that Netflix under duress has signed some direct interconnection agreements with Comcast, Verizon and AT&T, yet their traffic and commitment to us continues to increase. But I think they are just emblematic of what is an attempt by these ISPs to use interconnection and exert their monopoly power. And I think we've been successful -- unfortunately, we haven't, maybe, had quite as much support from others as we'd like, but we've been successful in getting regulators to focus on these issues.

[Operator:]

And our next question comes from the line of Barry Sine of Drexel Hamilton.

[Barry M. Sine:]

First, just a quick number question, I may have missed it. Did you give the number of customers per building in on-net? And then more of a policy question, I guess, for Dave. If you could comment on what you're seeing in your business and industry-wide in terms of elasticity of demand. You guys give very good visibility in terms of price per megabit, and then you also talked about traffic growth. It looks to me as if price reductions aren't having quite the impact that they would have had in past years on stimulating traffic growth and then, therefore, stimulating revenue.

[David Schaeffer:]

Sure, thanks for the questions, Barry. So first of all, on the customers per building, we do disclose that. We -- in our corporate buildings, we have 1,424 corporate buildings, representing slightly over 770 million square feet connected to our network. We, today, have 11.7 customers per building. We also have 633 carrier-neutral buildings connected to our network, housing over 720 unique data centers on our network. We have about 26.5 customers per facility in those carrier-neutral facilities. With regard to the elasticity question, there's been a number of third-party studies done around the size of the Internet and the growth rate of the Internet. The Internet's just grown over the past 5 years in traffic volume at about 29% per year. I think the consensus growth rate for the next 5 years is about 26% in unit volume, so relatively consistent with what we have seen. There has generally been about a 20% to 25% price reduction per megabit in the market. We believe those trends will continue. We think the dollar value of that NetCentric market remains relatively constant at about $1.5 billion. I know there have been some other studies pegging the market at about $2 billion. And with that, our growth is coming by gaining market share and it's a result of us being the most cost-effective solution, that's why the largest customers connect to us and why our traffic growth rate over the past 9 years has actually been a little bit over double the rate of the market growing at roughly 57%. So our NetCentric growth rate of about 12% in revenue over that 9-year period is the result of our rate of price decline of about 23% and the rate of traffic growth on our network of 57%.

[Operator:]

And our next question comes from the line of Michael Bowen of Pacific Crest.

[Michael G. Bowen:]

David, I apologize if I missed this, but I think you have given this over the last couple of quarters. How many reps today are hitting 100% of their quota? I'm not sure whether you can give that by month or just sort of quarter. Secondly, can you remind us how big Netflix is now today as a percentage of your revenue? I think it was 2.5% last quarter, but I may be mistaken on that. Lastly -- or thirdly, with regard to the sales hires, can you give us any feeling as far as -- so you have 5.9 as far as rep productivity. How can we look at that on a normalized basis? Obviously, you're adding a lot of reps here. When you start to get to the end of this program, what do you think a long-term rep productivity figure will be? And then last thing with legal expenses, since these were extraordinary, was there any thought to adding this back to adjusted EBITDA?

[David Schaeffer:]

Yes, sure. Let me take each of these questions. I'm going to give to Tad the EBITDA question at the end. First of all, approximately 27% of our sales force in the quarter achieved quota. It's actually above the roughly 21% that has been our long-term average. And that's particularly encouraging as the average tenure of our rep is actually lower because we've done so much hiring. In fact, our sales force, in the past 12 months, has grown by 28%. So we have kind of a younger sales force, one that continues to mature. And what we see is rep productivity continues to improve sequentially to about month 30 of a reps' tenure, at which point it kind of plateaus. Our average rep is substantially below that. So I think we have significant room for those reps to continue to mature, particularly as we've been able to reduce our turnover rate in the sales force, and we're continuing to run initiatives to reduce that even further. In terms of productivity, we're, today, about 1/3 above what our long-term historical run rate is, and we've been there now for a year. I think we're going to be in a position to kind of set a new bar for what the new normal is in another couple of quarters as the sales force growth rate-- I think starts to slow a little bit. We'll continue to grow the sales force, but we won't at the kind of rapid pace that we have. That will have a result of improving margins and allowing the sales force to season, and I think the new normal will be above the 5.9. I just don't know yet how far above that. I just want to be honest, we need more data to answer that question clearly. And then with regard to Netflix, Netflix was about 2.5% of our revenues in Q1, dropped slightly to 2.3% of revenues in this quarter. They continue to be our largest customer, and we expect their growth rate to reaccelerate, particularly as their business-- number of hours of viewership per day tends to be very seasonal. And while they've launched some initial services in Europe, I think their biggest rollout in Europe is not going to come until the end of this month. Now I'd let Tad to take the legal cost question.

[Thaddeus G. Weed:]

Sure. We have consistently reported EBITDA as adjusted since, I guess, our June 2005 initial report as, essentially, when we really became public after going through the filing process with the SEC. And that is reconciling EBITDA as adjusted to operating cash flow and then adding back gains or losses on asset-related transactions. But we intended on this call to at least provide those amounts so investors can understand the impact of that. But moving the target of EBITDA adjusted and continuing to change that definition, I don't think we'll -- we don't intend on playing that game here. I know others can do that. But we have consistently reported EBITDA adjusted the same way for whatever it is, 37 quarters, and don't intend on changing that. But we do want people to understand the impact of these legal costs on SG&A and our results.

[Michael G. Bowen:]

And a quick follow-up. To get to that $4 million estimate for total legal cost, I think you said you spent $2 million in the first half, do you anticipate all $4 million this year? Or do you think it will bleed into 2015?

[Thaddeus G. Weed:]

We believe that is the number for this year.

[David Schaeffer:]

Right. And it will actually be a little heavier in the third quarter and a little lighter in the fourth. As I had said earlier, we're responding to some civil inquiries for data, as well as responding to the first round of comments and replies on the Notice of Proposed Rulemaking, so we're probably on the heaviest phase now. And these expenses are both legal and for economic analysis, necessary for the DOJ in their antitrust analysis.

[Operator:]

And our next question comes from the line of James Breen of William Blair.

[James D. Breen:]

Just a couple of questions on the traffic growth, and then just some of the puts and takes on EBITDA. Is the frame of reference -- can you just talk about the seasonality and traffic growth you've seen from first to second quarter of the last couple of years, and how that's differed this year, if it has? And then secondly, on the EBITDA adjustment, can you go through the onetime adjustments? There was obviously the gain for $2.7 million. I know there was another adjustment for about $10 million on the loss side. The $10 million number, obviously, seemed large. It was the largest you've had over the last several quarters. Can you just talk about what makes that up and how that would be going forward?

[David Schaeffer:]

So I'm going to let Tad take the EBITDA one. I think you're maybe looking at a different number there, Jim. But let me take the traffic one first. Seasonally, our rate of sequential traffic growth declines substantially, Q1 to Q2, Q2 to Q3. That's been the pattern now for the past 9 years. We report those numbers consistently every quarter. The 52% year-over-year growth rate is somewhat slower than we've experienced in the past couple of quarters, but very much in line with the long-term average of 57%. Typically, Internet services are consumed in the northern hemisphere, and when people are outside, they're spending less time online. And today, the primary use of the Internet is for video distribution, and they're just watching less minutes of long-form content and consuming less bits. We absolutely expect to see a sequential improvement in traffic growth slightly Q2 to Q3, as we get the pick up at the end of August and September, and then you tend to see a very significant rate of traffic growth, Q3 to Q4, Q4 to Q1. That's been the pattern historically. So there is really no difference this year than other years. And I'm going to let Tad take the EBITDA questions.

[Thaddeus G. Weed:]

Sure, yes. I'm not sure of the $10 million number you're quoting. But simply, our EBITDA is -- or our gross margin for the quarter was $55.1 million, so that's revenue minus cost of goods sold. SG&A was $24.3 million. Deduct that, and then add back the asset gain of $2.7 million. So that's how you get to the EBITDA adjusted of $33.5 million.

[James D. Breen:]

Yes, I was looking at the -- in the chart you gave, there was a number for changes in operating assets and lability.

[Thaddeus G. Weed:]

That's just reconciling it to cash flow as SEC asked us to do, but you can also reconcile it back to the income statement like I just did. That's the mechanics of having to reconcile it to the cash flow. It has to do with the change quarter-to-quarter. Since last quarter, we had a large interest expense payment, you wind up having that impact as you perform that exercise.

[James D. Breen:]

And then as I look at the cash flows, net cash provided by operating activities was around $28 million for this quarter, up from last quarter. Is there seasonality to that as well? Do you tend to see a stronger second quarter there?

[Thaddeus G. Weed:]

It depends on the timing of interest payments. So the answer to that is yes. We have our senior note interest payments are made in February and August. So when those payments are made, the operating cash flow is less, so you see that impact. And you'll see that impact going forward as we begin to pay interest on the new notes, and that will begin in October.

[James D. Breen:]

Okay. And then just lastly on the dividend, obviously, a big increase this quarter. I guess, how do you think about the dividend in terms of the absolute size? Do you think about it from a yield standpoint? And should we continue to see the increase even though it's such a large increase this quarter?

[David Schaeffer:]

So first of all, Jim, we expect our business to continue to improve, and we will be able to revisit our dividend every quarter and intend to continue to increase it, maybe not at this pace. So we have laid out a target of getting to 2.5x leverage. We're at slightly below 2 today. And when investors did the arithmetic, even at the low end of our guidance and with the low end of our margin expansion, they were having a hard time understanding how we were going to return the capital, even with the guarantee of $10.5 million above the dividend every quarter. We listen to those concerns. A number of investors came to our annual meeting and spoke directly with the board. And I think what the board said is they wanted to show that we're willing to use both mechanisms in a balanced way. Last quarter, we spent nearly $18 million in buybacks and only $8 million on dividend. So the idea was to take the dividend up, so we're really trying to accommodate both dividend investors, as well as those investors who like the compounding nature of buybacks. Buybacks are used episodically, and we're committed to continuing to shrink the share count. We bought back over 8 million shares over the years, and we expect to continue to buy back stock. But I think the idea of this large dividend was trying to just balance the way of returning capital.

[James D. Breen:]

And given the cash balance at the end of this quarter, how much more cash -- if we were to start today or at the end of the second quarter, how much more cash do you think you need to give back in order to hit those leverage ratios?

[David Schaeffer:]

Okay. So we have today about $350 million -- just under $350 million on the balance sheet. If we work over the next 10 quarters, which is basically the timeline we've laid out, we need to distribute about $450 million in cash to hit our targets. So the $0.30 a share is only a part of what we need to do to get that cash back.

[Operator:]

And our next question comes from the line of Tim Horan of Oppenheimer.

[Timothy K. Horan:]

Just a quick clarification on the cash, Dave. What do you think is the right cash level to kind of run the business at? And then, Dave it sounds like the whole net neutrality issue -- or sorry, the Netflix issue here with the direct peering, is this largely behind, at this point, in terms of a financial, maybe volume impact, is that kind of what you're thinking and saying? And I guess from the buying growth perspective, you're obviously doing more like 90% last year and it's still at 50%. Is that primarily a result of the whole net neutrality disagreements? Or is there something else going on?

[David Schaeffer:]

Sure, Tim. So let me take the cash one first. Our belief is that kind of the minimum level to run the business is to have about 6 weeks of revenue run rate as a minimum of liquidity. We're far, far above that. And we are committed to returning capital, even our pacing and getting to the 2.5. We're going to still have excess liquidity on our balance sheet. And I think what the board has said to management is that, "Let's get to the 2.5%, that's a reasonable goal, and then we'll revisit it and determine whether or not we need to return even more capital to shareholders at a faster pace. But you kind of set a goal, get to the goal before you set the next goal." So we're quite comfortable that we've got a good problem in that we're generating free cash, as Jim pointed out in his question, $28 million from operations, and we're doing it at an increasing rate and we're also returning it at an increasing rate, but maybe not quite fast enough. With regard to the Netflix and direct connect agreements, we, today, have 8 peers out of the 5,200-plus networks that connect to us that have been recalcitrant and refusing to upgrade their connectivity. And that has impacted a portion of our revenues, basically, about -- if you think about outbound traffic, it represents about 1/4 of our revenues, 18% of it going to those 8 networks, the other 82% going to other networks, which are not constrained. Netflix continues to grow with us. They have only entered these direct agreements because they've had no other alternative, and I think in every case, after they've entered them, they've come out and kind of spoken about why they think strong net neutrality is important and these agreements were not negotiated in a competitive market but rather in a monopolistic situation. Now with regard to traffic growth, our long-term trend has been to grow about double the rate of the market. We're continuing to do that at the 52%. There tends to be some lumpiness to that growth rate. It tends to be related to end-user connectivity, broadband speeds and most importantly, the nature of the content that people are using. I think as you look at third-party studies like telegeography that have indicated kind of this 26% annual growth rate for the next 5 years that actually ties closely to the Cisco Visual Indexing Number, all of those things feel about right for us, and we think we'll continue to grow at about double the rate. Now I think there'll be some quarters where we're growing year-over-year 80% or 90%, other quarters where we're back down around 40% or 50%. But long term, we expect to grow at least double the rate of the market. And we continue to be the most aggressive pricer in the market, and we generate the best margins. And with that, more and more networks choose to connect to us than anyone else in the world, and that's going to continue. So I don't think this temporary abuse of market power, where these networks are refusing to upgrade, has a material long-term impact on the Internet. And quite honestly, it's part of the reason why we feel so strongly. We don't take it lightly to spend $4 million on legal and economic analysis. I'm very much a person who likes direct up gratification, and it's a little hard for me to see that, but I also understand that it's critical to innovation, new business models and the long-term survivability of the Internet. And quite honestly, there's not a lot of other people standing up to do it. I would have much preferred to have ridden someone's coattails than spend $4 million of our shareholders' money, but I think it's been a good investment. And as I commented on earlier, we've moved the needle quite a bit and now including these discussions in both the merger reviews, as well as the general net neutrality notice of proposed rulemaking, where originally, both of those venues were not going to consider this interconnection. And it benefits Netflix, but it benefits every other content producer as well and, ultimately, the real winner is the consumer.

[Operator:]

And our next question comes from the line of Michael Rollins of Citi Investment Research.

[Michael Rollins:]

Just a couple for you. First, I was wondering if you can comment a little bit on Windstream's opco/propco structure? Does that at all have any interest to you? I know you have NOLs today, but in the long run, once those NOLs are exhausted, does that interest you at all in terms of creating a more tax-efficient structure for your business? And then secondly, just in terms of the operations. As you look at the incremental margin performance, particularly at the gross profit line, are you seeing any changes in the business model and in terms of how that translation should work? And how should investors think about that over, maybe, the next 1 to 2 years?

[David Schaeffer:]

Okay. Thanks for the questions, Mike. So first of all, we're very fortunate that we're not a significant cash taxpayer today. There are some trivial amounts of state taxes that we pay, as certain states don't recognize federal NOLs, but we are not a material taxpayer. Secondly, we, I believe, have demonstrated, without a need to have a statutory requirement, to be committed to returning capital to our shareholders through dividends and buybacks. So I think the 2 primary benefits that they reap are one, tax efficiency; two, as a forcing mechanism to distribute cash. As we approach becoming a tax cash payer, and that will be several years or more off as we have a significant number of NOLs, we will consider a REIT. We've also done a lot of work at working at, perhaps, an MLP structure as a way to minimize tax and maintain flexibility. We are concerned if there would be a cash cost of an E&P purge and also want to be able to distribute all of the bases to our shareholders. As a reminder, last year, we were very conscious of tax efficiency and, in fact, 56% of our dividend was treated as a return of capital and, therefore, reduced investor's basis as opposed to being taxable. And clearly, the buybacks defer taxes by not being currently taxable. So the answer is we will consider it, but I don't think it's a near-term structure that makes sense for Cogent. In terms of the margin contribution question, we've delivered over long term a 48% EBITDA margin contribution. To get to that, we've had both improvements in direct cost of goods sold, so gross margins have improved as they did this year by over 100 basis points year-over-year, as well as our increased efficiency in our SG&A and, therefore, EBITDA margin expansion. I think we believe that over the long term, we can see our EBITDA margins go from the roughly 35% today to 50%. But it's going to take some time to get there, and we're going to get that from both gross and cost savings on the sales and marketing side, as well SG&A. So I think investors should consider for the next couple of years that roughly 50% contribution margin is a good way to think about our ability to expand margins.

[Operator:]

And our next question comes from the line of Frank Louthan of Raymond James.

[Frank G. Louthan:]

Just want to be clear as far as the dividend policy, so you're raising the dividend, you're also discussing sort of the capital return and then revisiting that at 2.5x leverage. I just want to be clear, when you reach that point, when you're at 2.5x leverage, is the dividend at that point going to be rethought as well? Or is this new rate of dividends the new floor on the dividend regardless of what you decide to do with additional capital raises? And then I've got a follow-up.

[David Schaeffer:]

Yes, so I think the dividend, as a recurring committed dividend, we take that seriously and fully intend for that to remain as a floor and, actually, expect it to continue to grow. So what we're talking about is the extraordinary returns, which are either buybacks or special dividends that allow us to purge cash to shareholders. But we feel very comfortable that the regular dividend that we put in place will continue to grow and will not be in jeopardy of either stagnating or being reduced. All we said at 2.5x is we are not certain that, that is the absolute appropriate level of leverage for the business. We just think it's an appropriate level considering where we're at today, and the board would reevaluate it going forward. But if there's flex, I would say the flex is in the special dividend and the rate of buybacks. Those would be the areas, but the dividend, I think one of my board members said it best when he said, when you commit to a dividend, it's like driving down a one-way street, you don't ever want to back up.

[Frank G. Louthan:]

Okay. Then the follow-up, how beneficial do you -- as you're selling more off-net, how beneficial do you think the cable mergers might be in getting some better pricing on special access for the off-net part of the business going forward?

[David Schaeffer:]

Sure. So we do buy ethernet loops from all of the major cable companies. The reality is when you subtract our on-net footprint, the remaining footprint, over 90% of our off-net spend actually goes to the incumbent carriers. There's just not the density of cable plant and the ability to buy the ethernet services on a symmetric basis non-oversubscribed. Remember, most of the cable plant is an HFC plant that share bus and cannot deliver the type of service that we're selling our customers. So they're selling an oversubscribed quasi-party-line-type service. That's different than what we sell. Any competition is good. It's allowed us, both through increased volume and the threat of competition, to drive down those off-net loop prices, which is reflected in the lower ARPU that was asked earlier.

[Operator:]

The next call comes from the line of Brian Hawthorne from Stephens

[Barry McCarver:]

This is Brian Sullivan [ph] for Barry McCarver. Just one, what would cause you to accelerate your ramp to the 2.5x leverage?

[David Schaeffer:]

If we saw a significant dislocation in the capital markets and the stock market, or in our stock, we would be a more aggressive buyer. We've been aggressive, we spent almost $18 million last quarter. We have, obviously, increased our authorization. And as I've pointed out, we still have far too much liquidity on the balance sheet. So we would get there quicker if it would seem like there was a sale in the capital markets. But it does seem at a 0 interest rate environment, we're not quite at an equity fire sale as of yet.

[Operator:]

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

[David Schaeffer:]

Just want to thank everyone. I apologize, it was a little longer, but we had some new topics, particularly these legal issues. And we feel very strongly about a true open Internet and the highest quality of service for our customers, and it's the reason why we're fighting so hard to make sure the Internet remains the engine of growth that it's been. So again, thank you, everyone, and we'll talk soon. Take care. Bye-bye.

[Operator:]

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Have a great day, everyone.