My name's Philip Cusick. I follow the comm services and infrastructure space, as well as media here at JPMorgan. Thank you for joining us. I'm pleased to welcome again, I don't know how many times, Dave Schaeffer, founder and CEO of Cogent Communications. Dave, thanks for joining us.
Hey, Phil. Thanks for hosting me. I'd like to thank JPMorgan for a great venue. I'd like to thank all the investors in the room for their interest in Cogent.
You and I have discussed the pandemic's impact seems to be diminishing in the U.S., and I think you said last week that you expect flat to up sequential growth in corporate. Can you sort of dig into what you're seeing right now in your customer base?
Yeah. Cogent's customers are divided into 2 major groups. 58% of our revenues come from selling to corporate end users. These businesses are located in multi-tenant office buildings in the central business districts of major North American cities. We're primarily selling those customers Dedicated Internet Access and VPN services to connect that office to other offices. That segment of our business, prior to the pandemic, had performed consistently well, growing sequentially at about 2.5% a quarter for the past decade or 11% year-over-year. During the pandemic, we experienced 8 sequential quarters of decline in that business, the worst that the company has seen. In the most recent quarter, Q1, we experienced effectively flat growth in that corporate segment. Our corporate customers use the internet to support their business. They are not internet service providers or content companies.
They're actually located in the second segment of our business, our NetCentric segment, which is 42% of revenues, has performed quite well. In our corporate business, we have seen the number of sales interactions with customers materially increase over the past 3 or 4 months. We have seen the timeframe from proposals issued to orders signed shrink. As a result of these leading indicators and the fact that many of our corporate customers have decided that they're ready to return to office, at least in a hybrid model, we think that our, the worst of our corporate performance is behind us, and we should see positive growth in that segment of our business going forward. We also believe it's probably a few quarters before we see that 2.5% sequential growth return.
Churn is one piece of this. You know, we've all read about increasing vacancies in some of the major markets. Why doesn't that impact you?
In our footprint, the average building that we serve is 41 stories tall, 550,000 sq ft. Prior to the pandemic, those buildings had 51 discrete businesses in them. Cogent today serves 14.4 of those 51 businesses. We have seen the vacancy rate in that footprint go from 6% to 16%. Now, we're starting to see renewed leasing activity in our footprint as well. The leases tend to be smaller, about 20% smaller than pre-pandemic level lease sizes for new tenants. We also see the landlords giving substantial tenant concessions that have reduced the effective rent in those buildings. What we have seen in previous real estate downturns is that tenants migrate from B and C buildings into the A buildings as they become more affordable, and the vacancy rates in those buildings remain the lowest in the market.
We think that trend will continue in this case, coupled with the fact that of the approximately 10 billion sq ft of multi-tenant office space nationwide, we think about 10% of that space will ultimately be converted to residential uses. That will tighten the market up materially. Cogent today serves 1 billion sq ft of on-net office space in our MTOB footprint, and we have the ability to sell off-net in roughly another 4.5 billion sq ft, where we utilize last mile services from other providers.
Does it make sense that if I were kind of in data space that I would have cut off my communication services quite a while ago?
I think that's right, Phil. I think, you know, our unit growth actually was positive for the first time in 2 years this quarter. Our revenue growth was effectively flat in our MTOB footprint. I think most of the churn is behind us. Those companies have groomed their networks, and for two years, companies have put off their buy decisions and their re-architecture of their networks. What we are seeing is companies say, "We are now back in our office, maybe a hybrid model, maybe only 3 or 4 days a week." We now need to modernize our network to do three things to support new applications, cloud-based services, SaaS-based services. 2, to allow our remote workers to have a highly resilient, adequately sized connection to our office on a permanent basis.
Third, we're increasingly seeing our corporate customers add an incremental connection in a data center as a secondary point of aggregation for those remote workers. I think most businesses are assuming that for the foreseeable future, some portion of their workforce will be remote. If they have groomed their real estate portfolio and shrunk their footprint, that has occurred at this point.
If I think about your addressable market, you used to have, can't remember what you said, 51 on average tenants in a building. You'd serve 14.5 of them. As their average lease size shrinks, your potential tenancy probably goes higher.
That's correct. If the trends that we are seeing continue, and third-party leasing data from companies like Cushman & Wakefield and JLL have supported this, that we should see the average tenant count in our footprint go over 60, about 20% higher than where it is today.
Do you care if a customer tends to have 5,000 sq ft or 20,000 sq ft? They tend to take the same amount.
We actually prefer the 5,000 sq ft tenant because that means there can be more discrete businesses within the building. Our connection is sold to corporate customers on an all-you-can-eat model. The customer can buy either a 100 megabit, 1 gigabit, which is the most common product. Increasingly now we're seeing some customers even migrate to 10 gigabit connections. That is part of the reason why our corporate on-net ARPU actually increased sequentially in the quarter after kind of an average decline rate, even pre-pandemic, of about 3%-4% per year.
What's the average price increase in that order of magnitude speed?
When you move from 100 megabits to a gigabit, it's typically a $200 a month upcharge. To move from a gigabit to 10 gigabits is typically a 4x increase in that 1 gig price.
Do you expect that difference to come down as more and more people take 10 gigs?
You know, I think the 10 gig product for corporate customers will remain relatively rare just because the average corporate customer at peak is only using about 18% of their current connection. There is a subset of our customer base in which this represents such a de minimis cost, they're literally looking for the best connection money can buy. I would think that the differential will decline as the number of customers adopting a 10 gig product increases, but I think that's probably a couple of years out.
You've got more potential customers, higher average-
Sale price.
Sale price. Then you were saying that many customers. How many are taking that second connection to the head of the business?
There's gives and takes. I would say that a significant, but not majority of our corporate customers are now adding another connection for VPN concentration. 30 or 40% of the base is either has done it or is currently receiving quotes to do that. The headwinds, however, have come from customers grooming their locations. Cogent's corporate customers would buy Dedicated Internet Access in a multi-tenant office building. From that initial sale, there were 2 potential expansion opportunities. One, to sell internet access at another location. The other would be to sell an office-to-office VPN. I think in both of those cases, I think that market has shrunk permanently because of the pandemic. Companies have groomed locations within the same MSA.
If they're gonna have a hybrid workforce, they would prefer to do it from one location as opposed to maintain two or three within the same market. Then secondly, pre-pandemic, many of our customers were already in the process of migrating their office-to-office private networks off of MPLS to one of the over-the-top technologies, SD-WAN or virtual private line service or VPLS. A small percentage of those customers previously were comfortable in just using the internet. After two years of just using the internet for their remote workers, probably 40% of our customers are now saying that just internet connectivity alone is sufficient for office-to-office connectivity. The difference is there's no additional security or encryption that's done at the endpoint as opposed to through the network.
Okay. Not a pure sort of increase from 1 to 2, but some increase in the average number of connections customers are taking.
That's correct.
Okay. You mentioned the 18%. What is happening in terms of traffic within the corporate customer base? Leaving the other side, for later.
Corporate customers represent 58% of our revenues, but less than 5% of our traffic. Those customers typically use the internet to support some other business. Legal is our biggest vertical. Financial services are our second biggest vertical, and it's really any business that's located in a skyscraper. Consulting companies, engineering, architectural firms are examples of customers. They are continuing to see about a 25% per year growth in traffic on their networks, primarily driven by the migration of storage and compute to remote locations, either private or public cloud, and the increasing pervasiveness of a SaaS software as opposed to a premises license software product.
Okay. As we've seen, COVID cases coming back in the last few weeks and fears about recession and inflation over the last few months, have you seen any pause in corporate buying?
We have not as of yet. I mean, we remain cautious. We continue to monitor, you know, our sales activity, our conversion rates, and the overall growth in corporate revenues. Three very different questions in that one. First of all, you know, many of our IT departments we interact with have been through 2 false starts with Delta and Omicron. I think virtually all of them now are ready to move on and do two years’ worth of upgrades that they've been putting off and re-architect their network. I think the idea of recession is real. It impacts smaller businesses. We have experienced, even through the financial crisis, very little bad debt and very little customer turnover due to inability to pay because the building owners have done a good job of vetting our customer base.
Usually, the buildings we're in are the most expensive real estate in any market, and as such, the tenants tend to be pretty creditworthy. The final part of your question is about inflation. While, you know, I heard the presentation this morning, and I know some companies are hopeful that telecom prices can go up, that's counter to 30 years of history and technology change. The product we sell is internet access. What we produce are interface routed bit miles connected to other networks, and the cost of producing those bit miles has been falling and will continue to fall due to technological advances. Oftentimes I get asked, what is Cogent's ultimate differentiator? It's really our ability to capture those improvements in technology more effectively than any of our competitors, trying to get more into cash flow and lower capital intensity than any of our competitors.
While I'd love to sit up here and tell you prices are going up, that's just a fantasy.
All right. I thought that was interesting. Let's switch to NetCentric. I wanna start with, you know, we've seen two years of massive growth in NetCentric traffic. A lot of businesses that saw massive pandemic-driven growth, including streaming companies, have started to see a rolling over of demand.
Cogent supports two types of NetCentric customers. That is a global business. We operate in 1,450 data centers in 51 countries around the world. We sell to 7,600 regional access networks that distribute our bandwidth to their end users. These could be companies as large as China Telecom, Jio in India, China Mobile, are examples of Cogent's upstream customers. They're buying upstream from us to get their customers to the internet. On the other side, we sell to about 5,000 content generating companies, whether it be Facebook or Netflix or Google or Amazon, who are pushing applications to customers. We saw a material acceleration in the transition from linear television to streaming during the pandemic.
Going into the pandemic, about 18% of video consumption in the developed world was on streaming, meaning 82% was delivered either via linear television broadcast or through DVDs and storage medium. Today, about 44% of all content that is consumed is streamed to the customer. It's significant acceleration. We've also seen the growth of streaming be much more international than domestic. A phenomenon that started in the U.S. with Netflix has expanded globally, and now we've also seen a broadening of the customer base. The average price per megabit of internet service, this is the headline price that we sell at. This is a metered service where we're charging by the usage has fallen for 20 years at a compounded rate of 23% per year. In this most recent quarter, it was very similar. It fell by 22%, not a material change.
What has changed is the effective price per megabit. We are seeing three things help Cogent's revenues grow at the best rate in the company's history during the pandemic. The first of those is a broadening of the customer base. Rather than sell just to a handful of names, we're selling to dozens of names, different business models, different streaming platforms. 2, a majority of that growth is outside of the U.S. Today, about 55% of our total traffic is outside of the U.S., and that allows us, in some cases, to charge a higher price per megabit. The third, and maybe the most important factor, has been the increase in traffic that we are getting paid by both the sender and receiver. When a party connects to the Internet, there are two mechanisms to exchange traffic. One is transit.
That is the product we sell. We sell to CDNs, we sell to hosting companies, to FAANG teams who are pushing content out, and we sell to access networks who are pulling content down. The second mechanism of connection is peering. In a peering connection, you only connect to your local portion of the Internet, not the entire Internet, and only one party collects revenues. Today we have 24 peers. We have seen the percentage of traffic that goes customer to customer grow to 73% of traffic. 27% of traffic we get paid on one side, meaning we get paid either by the sender or the receiver, and we hand it off to one of our peers. In the other 73% of the cases, we're getting paid both by the sender and receiver. As a result, our NetCentric revenue growth has accelerated materially.
In fact, in Q4, we had the best NetCentric quarter in the company's history, growing over 25% year-over-year. In Q1, we continued to grow at better than 18% on a year-over-year basis. Now, the long term average growth rate for our NetCentric business is about 9% year-over-year. Going into the pandemic, that business was actually underperforming trend line, only growing at between 3% and 4% per year. The pandemic has been very beneficial to that business. We do believe that NetCentric growth over the next year or so will moderate back to kind of the pre-pandemic average in high single digits.
What evidence have you seen so far of that? I mean, obviously 25-18, a lot of the comping issues.
Yeah. We clearly had Net neutrality issues that impacted growth of the entire internet in 2015 and 2016. Those issues were predominantly resolved in 2017. What we have seen during the pandemic are a few things. One, this internationalization. A much larger portion of the world now has better connectivity with either LTE or even 5G in some cases. Secondly, we've seen a lot more local content being produced. Third, we've seen a continued desire by vertically integrated telecom and cable companies not to try to build out a global network, but rather to buy transit. It is just cheaper to buy from someone of our scale than to try to do it yourself.
In terms of competitive landscape, on the NetCentric side, we typically compete with Lumen and the former international portion of Telia, the Swedish incumbent now named Arelion and NTT. The four of us control over 75% of the market. Cogent's the second largest participant in that market with just under 25% market share.
Can I ask you a little bit off topic, but as a D.C. resident and telecom longtime expert? Well, it increasingly looks like the FCC might be stuck at a 2-2 split for a long time, maybe through this administration.
I don't know if you wanna tell Gigi that. She's still hoping to get her position appointed. It does appear we have a bit of a stalemate. Even with the FCC acting, I don't think that would be a final resolution on net neutrality because it is such a politically divisive issue. Ultimately, I think for a final resolution, it would require legislative action, which I think is virtually impossible in this environment. I think we have de facto adoption of net neutrality. The history was that the FCC abdicated its oversight of the internet under the Trump administration. The Obama administration had classified as communication service. The Trump administration reclassified it as an information service. At that point, a number of states adopted their own net neutrality rules. The most aggressive of those was California.
They were challenged by a consortium of local access networks. They lost at the first level. They lost at the appeals court, and they lost en banc in the appeals court, so they lost 15 to 0. At that point, they withdrew their litigation. With the establishment of the California rules, there is a de facto national net neutrality rule today, and I think that's kind of where we're going to be. Whether, Commissioner Sohn is appointed or not, I think we have net neutrality through the state actions.
Does that put you in a better or worse position than if there was actually action by the FCC?
You know, I think like all participants in this industry, we would like to see kind of a permanent set of rules in place at the federal level. You know, much like in the auto industry, when there were no federal emission rules and California passed the first auto emission standards, they became the de facto standards for the country, and we still live with California emission rules. I think we're in the same place with Net neutrality. I think we're satisfied with the level of regulatory protection we have.
Okay. You know, you have been a regular dividend increaser. But leverage is running above your allowed target at this point by the board. Yet you continue to pay dividends. The market has been a lot more volatile than we've seen in a long time, and your own stock is trading below where we've seen in quite a while. How does that make you think about one, what the appropriate leverage is? Two, do you wanna go out and sort of be opportunistic with the stock price?
Cogent has returned over $1 billion of capital to its shareholders through a combination of buybacks and dividends. Roughly $250 million in buybacks. We've bought back about 20% of our float. We've now had 39 consecutive sequential quarters of dividend growth. We have a leverage target of between 2.5 and 3.5x EBITDA. For the past 2 quarters, we've been running at 3.58, so we're slightly above the top of the range. We actually have excess cash on the balance sheet with over $300 million, and we've been clear that our ultimate goal is to slowly disgorge that cash to investors. We have, I think, preferred dividends over the last several years, in part because of our ability to characterize the dividend as a return of capital.
Last year, 79% of our dividend was returned to shareholders as a return of capital and reducing their basis. We feel that either mechanism of returning capital is appropriate, but the important point is to return capital. The board has looked at the temporary shock that COVID caused to our business. Our total growth rate is half of what it was going into the pandemic. It's under 5% versus almost 10% pre-pandemic. Our rate of margin expansion fell from 200 basis points a year to 100 basis points a year. We believe that is temporary. As our business normalizes, as the world returns to a new normal, not the normal that existed before the pandemic, we feel that we will resume our long-term growth rates of about 10% for the total business and 200 basis points of margin expansion.
We will naturally de-lever. We also know that we are still in a low interest rate environment, even though interest rates are rising. It is appropriate to keep leverage on our balance sheet. We have been willing, at different points in our history, to use different mechanisms of return of capital. We had a convert outstanding and bought back virtually all of that convert at 45 cents on the dollar in 2008. When, you know, the market has sold off, we have looked at either purchasing debt or stock and have done both opportunistically. As we go forward, I think the board looks at three things. First, is the business able to produce increasing amounts of free cash flow? They feel very comfortable in the ability to do that, having been through the COVID period.
The second question is the level of leverage appropriate? While we have that stated goal of 2.5-3.5 times, we think that we're within a close enough cushion of that it is appropriate. The third question, which is the one I think investors care about, is what's the mechanism of the return of capital? You know, I'm lucky I own about 10% of Cogent, and I've tried to be a good allocator of capital. I'm gonna pivot between whichever mechanism creates the highest return for shareholders. I think in a very volatile market, that actually makes sense.
Certainly volatile. Then finally, this sort of goes to the same point a little bit. We've known each other more than 15, not quite 20 years. You're 65 this year. How long do you wanna run this business and what's the succession strategy if you don't wanna run it anymore?
That's a very fair question, Phil, and we're both showing our age, although I think I've got a couple of years on you. I didn't have any gray hair when I started. I'd even say I didn't have much before the pandemic, and I've got a little bit more now. All truth to the side, you know, I've been a very lucky guy. I founded seven companies. You know, I'm very happy in running Cogent. I think the board has been pleased with the results operationally. You know, we have outperformed, I think, virtually every other company in the telecom sector in terms of organic growth and margin expansion and growth in cash flow in a very difficult, very commoditized segment. You know, I think I've got a few years left in me. I plan on continuing to run the company if the board supports that.
At some point, we will either look internally or bring someone in from the outside when I think it's better for someone else to run it. At this point, I'm comfortable in continuing to do this. I will say it was easier doing these conferences from my desk on Zoom than it was, you know, getting up in the morning at 4:00 A.M. to fly up here. That's part of the job. You know, we're pretty comfortable. When I look across my team, I've had a great deal of stability. In my 9 direct reports, they have an average tenure in the company of 18 years. A couple of us are getting on the older side and probably will transition.
We've had our general counsel retired a couple years ago, and his deputy, who'd been at Cogent for 16 years, stepped right into his shoes. We do have a pretty strong bench across the board.
Good. Stick closely with Dave, thank you for coming.
Thank you very much, Phil.
Appreciate the forward mic.