Deutsche Bank 29th Annual Media, Internet & Telecom Conference

Mar 8, 2021

Welcome everybody to the next session at our media, Internet, and telecom conference. I'm Matt Niknam, comm infrastructure analyst here at Deutsche Bank, and we are very pleased to be joined by Ocean Communications CEO and founder, Dave Schaeffer. Dave, welcome back. Great to have you. Hey. Well, thanks, Matt. I'd like to always thank you and Deutsche Bank for a great venue. It's not Palm Beach this year, but it's still a good venue. We'll be back there next year. And I'd like to thank all of the investors on the call for their time and interest. We can't wait to be back in Palm Beach. So, yes, definitely looking forward to it. Maybe just to start, Dave, you guys recently reported 4Q results a couple weeks back. Maybe if you can talk about some of the highlights from 2020 and lay out the top priorities you have for Cogent in 2021. Yeah. Well, thanks again, Matt. Know, Cogent is a simple business. In many ways, it has not changed in twenty years, but the market around us changes. And probably the impact of COVID in 2020 had both positives and negatives for Cogent. You know, in our corporate business, we saw a significant slowdown in corporate customers adding secondary locations and purchasing virtual private network services from us. Partially offsetting that was the fact that at primary locations, corporate customers accelerated their purchase of one gigabit connections over our traditional 100 meg product, making it actually the one gigabit product, our largest seller. On our NetCentric customer base, it was primarily a series of tailwinds that came from the pandemic. We saw an acceleration in traffic growth and a acceleration in revenue growth actually above long term trend line. And as we look at 2021, you know, I'm hopeful that we're nearing the end of the impact of the pandemic. I think people are anxious to get back to a normal routine back into the center cities, and we expect our corporate growth to accelerate. I think a lot of IT departments are beginning to prepare for a return to office environment. And as we continue to see vaccination rates go up, I think many companies are expecting by the end of summer to at least have some employees back in offices, which I view as a very positive thing. On our Adccentric business, I think the acceleration in streaming will continue post pandemic. We still have a long way to go as the majority of video is still distributed linearly. But increasingly with more streaming choices, more packages, and more internationalization, we expect that business to continue to grow at trend line or slightly above where it has grown over the past few years. So what we're clearly hoping for 2021 is a reacceleration in top line growth. You know, our multiyear guidance is to have roughly 10% top line growth and about 200 basis points a year of margin expansion. I think as we look at 2021, we'll get much closer to that revenue growth rate than we were last year. We were at about half of that growth rate. And we will also, I think, do better on March expansion even though last year with a slower top line growth, we still delivered roughly 150 basis points of margin. So all in all, I think 2021 is a year of recovery. And for Cogent, we want to be in a position to serve our corporate customers and to continue to serve our NetCentric. That's great. Maybe we can follow-up on the revenue growth. So you alluded to it, I think, last year, obviously, about half of the long term target. But the growth did decelerate, I believe, over the course of the year, and the exit rate growth was closer to the low single digits. And so I'm wondering what gives you confidence that that 10% growth is achievable? And I guess more specifically, what needs to happen from both a macro perspective and more company specific within Cogent, to sort of reaccelerate that growth rate? So, first of all, the growth rate is what Cogent has historically accomplished over the sixteen and a half years as a public company where we've grown at a compounded organic growth rate of about 10.3% year over year. So it's not an aspirational target that we have not met, but rather a recognition of what we've done in the past. For us to achieve that growth rate, really three things have to occur. First, we need to return to a normalized corporate environment. We saw a similar downtick in corporate growth in o eight and o nine and a great recession. The difference was that downturn only lasted a couple of quarters. This time, the downturn is much broader and is probably going to end up lasting five, six quarters before we return to normal. Cogent's corporate business has grown at a historic growth rate of about 11 and a half percent, again, all organic. We think that will resume as companies refine their new office environment. Because our corporate product sold on a fixed connection basis, even if some of those employees are working remotely, they will still be cogent customers as long as they have a physical office at that location. Secondly, we may get some additional benefit from corporate customers who actually reduce their real estate requirements, allowing us to grow our addressable market in our footprint. And then third, for our corporate customers, we will see a resumption of a VPN replacement cycle using either SD WAN or VPLS to replace the MPLS legacy networks that are rigid, expensive, and antiquated. The second major point I want to touch on is our NetCentric growth. There, it is much more a volume based business. We sell to about 7,300 access networks around the world as well as selling to approximately 5,000 content publishers. In that market space, we are selling a fungible undifferentiated commodity and winning business based on price. That business has averaged a 9% growth rate, but actually before the pandemic, it actually slowed down to a growth rate of only about 2% year over year. We are now starting to see a reacceleration of that growth driven in part by the acceleration in people streaming versus consuming video linearly. We think those trends will continue, and that business should be able for the next decade to be able to deliver growth rates in line with historic averages. So if our two thirds of our revenue are growing at 11%, a third of our revenue at nine, will be right within our targeted growth rate. I think the third point is where are offices going to reopen for the corporate customer? And I think that is really a tale of three different fact patterns. Primary offices where our relationship begins I think will remain intact and continue to stay in place even if a portion of the workforce works from home. The second type of office are remote offices within the same metropolitan market. I tend to think that small set of those remote offices may end up shrinking. We may see companies eliminate two or three offices in the same metropolitan market in order to, you know, allow people to telecommute partially and then come into the main office on a more limited basis. And then finally, for those offices in remote cities, I think they will remain in place. There's no substitute for having a physical presence in a remote market. Now those offices will require a combination of dedicated Internet and VPN services. So when I look at the kind of changing landscape of work, I feel Cogent is very well positioned to benefit from those trends. And then on the NetCentric side, the trends that were accelerated in the pandemic have been long term trends and will continue for a long time. So I'm not expecting us to grow better than we have in the past, but rather in line with historical average, about twice as well as we did last year. Got it. And when we think about then maybe let's drill down into the corporate segment. And you had mentioned growth north of 10%. And obviously, we've seen that moderate and slow as well. But when we think about the reopening and we think about some of the commentary I think you conveyed on the last call, how should investors think about the trajectory for growth in the corporate segment at least near term given that this is, as you mentioned, gonna take five to six quarters for us to sort of get back out of this slowdown? And I guess more specifically, what sort of visibility do you have towards the sequential improvements that you talked about in corporate segment revenue, in the first quarter? Yeah. So I think the first point is we're four quarters in to the pandemic. So I think we're two thirds to three quarters of the way through. Secondly, we have seen a number of leading indicators improve. Those indicators are number of phone calls connected each day by the corporate sales force, number of emails, the number of new opportunities created, the number of opportunities moving through the sales funnel. All of those are leading indicators that will show that corporate activity probably troughed at the August or in September and has been sequentially improving. You know, on a kind of headline basis, you see that in part as an improvement in our sales force productivity while still below long term averages better than we were doing earlier in the pandemic. And I think companies are reevaluating what their IT infrastructure will be, and that's a net positive for us. There are really three windows when a customer is right to be sold, when they move into a building, when their current provider fails, or when they change their IT infrastructure. And I think the pandemic has caused all IT departments to reevaluate their infrastructure and figure out, you know, what does that new IT infrastructure look like. And it probably will contain more cloud based services, more SaaS, and probably some portion of the employee base working from home. And if those things are true, those will be net positives for Cogent. They will require those companies to have more reliable and greater Internet connectivity. And for our Internet service, one of the key differentiators is that our service is completely symmetric, meaning up and down are equivalent. And that really gives us a leg up on our competition. So when I look at all of these very specific sales leading indicators, it appears, you know, our corporate business, which normally rose at about 2% plus a quarter and declined last quarter at about 2% sequentially as trough. Got it. And so maybe I want to go into the sales cycle comments as well. Because I think over the last year, you have talked about lengthening sales cycle, customers a little bit more hesitant. And so is it fair to assume based on that commentary that maybe that's changed or improved for the better at all in recent months? Yeah. I think three things there. One, at the very beginning of the pandemic, install cycles widened, but those have since collapsed and are back down at our historical norms, which is to deliver on net services at an average of about nine days, to deliver off net services depending on part of which loop vendor, but in about sixty days, both well within our service level agreement targets. The second thing that's changed is companies at the beginning of the pandemic were really paralyzed. They did not know what they were going to do, what the end looked like, and what their infrastructure was going to look like. The only thing that was happening early on in the pandemic was this massive shift from fast a Internet access or a 100 meg connections to gigabit. While that continues, there's now kind of a second thing that's going on, which is companies are really evaluating what their new infrastructure need is. And as a result of that, they're having more conversations and the sales cycles are shortening. I think the third factor is that as people physically go back to the office, they real IT departments really wanna make sure that bandwidth is not going to limit those employees affected. And I think that's a additional contributor to accelerating sales cycles. You know, we close about 40% of the proposals that we write. I actually think with this return to office trend, we're starting to see those close rates improve slightly. And so you referenced also the sort of upward migration to the OneGate product in recent quarters. And I believe now it's taken a greater share of connections And so I'm wondering how meaningful of a tailwind can this be to top line growth? And do you sense this sort of upward migration and sort of some of the tailwinds we talked about from a macro perspective could offset some of the pressure you've seen and may continue to see from lower off net sales? You know, I do think they're roughly able to offset one another. You know, the off net portion of our corporate business are the smaller, more diffuse branch offices, and those are probably the last offices that will be repopulated. So I think we'll see some drag in that corporate off net footprint coupled with the fact that off net has a more significant ARPU decline than on net because our loop costs have actually been coming down for those off net locations coupled with contract firms like that. The $200 a month uptick from gigabit sales is more than sufficient to offset that, and it's why we feel that our corporate aggregate growth rate, even with these branch office headwinds from off net, should be able to return to you know, 11% growth. The mix shift that will come from a greater percentage of corporate revenues being on net versus off also has a tailwind effect on our ability to expand margin. And it's part of the reason why our gross margins, even last year, were so exemplary even though the revenue growth was about half of trend line. So I'm going to pause here. I just should have mentioned upfront. If anybody on the webcast wants to ask a question, you can just type it into the portal. I'll see it. I'll relay it over, on the live q and a. So feel free to do so if you'd like. And, Dave, maybe while we're on the topic of corporate, one other one, I guess, picture from the corporate business, is can you talk about the addressable market for that segment? Where are you today in terms of market share? And what gives you the confidence that there's still meaningful room ahead for growth and increased penetration and share gain from Cogent within that domain? Yeah. So if we look at our average corporate building, we have 1,792 buildings at the end of twenty twenty. We had 976,000,000 square feet, which represents about 11% of all office space in North America. There are 51 discrete tenants in those buildings. We have approximately 25% market share measured by tenants. However, there are also more incorporated businesses than there are tenants. Sometimes there could be two companies or even three companies, you know, cohabitating in an office. By that measure, we're more like 15% penetrated. As companies continue to need more connectivity to support those SaaS remote workers and cloud based services, that becomes the catalyst for us to continue to sell. We think it is very reasonable that over time in our footprint, we can reach a roughly 50% penetration rate. So our corporate on net business should more than double from where it is today by increasing penetration and modestly at a two to 3% per year expansion of the footprint. The buildings that we go into tend to be the most expensive in a given market. They tend to have the most creditworthy tenants, and they tend in times of economic stress to lower rents but remain heavily occupied and most of the vacancies end up in the suburban campus environment. Got it. Got it. Let's pivot, to the NetCentric business. So this business, I think it's now about 35% of your revenues, obviously, a bigger beneficiary of recent events, accelerating traffic growth, as you mentioned, recently returned to double digit top line growth, from a revenue perspective. And so from a high level, can you talk about your expectations for the Net Centric business in '21 and how we should think about revenue growth trending alongside what we've seen in terms of a recent acceleration, in terms of traffic growth? Yes. So our NetCentric business is almost exclusively volume based. The key application that's driving volume growth remains streaming video. And we're seeing three things that benefit that business. One, more minutes a day being streamed. Two, the number of streamers is diversified, helping us achieve a higher effective price per megabit. And third, a acceleration in the internationalization of that streaming business. Like many tech trends, they begin in The United States and are then exported around the world. I think streaming is a great example of that. And we are seeing services like Disney Plus, Peacock, Hulu, Amazon Prime, all capturing user share. And while Netflix remains the dominant player in the market, there is more diversity and more choice, and many subscribers are electing to take more than one package. We view all of these as positives for us. You know, I often get asked the question, how can I predict traffic? And the answer is, I really can't in the sense that it's totally usage based. But over time we have continued to garner market share because of our aggressive pricing model and capture a disproportionate share of bits and therefore a disproportionate share of revenue growth. When we look at the underperformance of the NetCentric business, it was really attributable to three discrete causes: the loss of mega upload, port congestion by companies violating net neutrality, and then finally customer growth coming from a limited number of customer. Those three onetime events are behind us, and we think returning to NetCentric growth, you know, barring some kind of exogenous tailwind or headwind, should allow us to grow at our historic average. And in fact, we overachieved that average last quarter, growing 15.3% year over year and FX adjusted 10.9%. And so when we sort of pull that apart and think about the growth, one of the interesting things you mentioned was internationalization, of the Internet. So I don't know if there's any way to do this, but can you help us think about traffic and revenue growth trends you're seeing between The US and international markets and how those two compare in terms of driving this reacceleration we're seeing in terms of top line growth in that, Cedric? Yes, sure. So the Internet was very much a U. S. Phenomenon when it got started. You know, 85% of global Internet traffic was in The U. S. When Cogent got started in the year February. Today, that's only about 30% of global traffic. So there are approximately 4,900,000,000 end users globally of the Internet. There are 7,400,000,000 people in the world, so there is still room for 50% more growth in subscribers. Now clearly, there'll be some people too old, too young. But for the most part, you know, we've still got probably another five to ten years of subscriber growth ahead of us. But then within that, what we are seeing is a change in how people use the Internet internationally. Most of the developed world, that's US, Canada, Japan, you know, Western Europe, has been predominantly fixed line. There are 900,000,000 fixed line subscribers. But with the migration to either LTE or five g in the developing world, those 4,000,000,000 wireless only subscribers are seeing their unit volumes go up rapidly. And while they may not get the resolution, to watch video on a large, you know, 75 inch flat screen, you know, they can do a lot on their handheld device. And most of the video consumption in the developing world is mobile. Now mobile's got a very long way to go. Globally, mobile only accounts for about 3% of global traffic, yet it accounts for 80% of the user. Mobile's growth rate is over double that of fixed line. So all of that is driving increased penetration of streaming video. And with Cogent having more access networks in more countries as its customers than anyone else in the world, we're disproportionately a beneficiary of that. And related to that, in the past, most of our traffic was a one-sided customer payment. Two years ago, half of our traffic, we got paid by one side, and then we got paid on both sides in 50% of the cases. In 50% of the cases, we peered that second side of traffic with no revenue. Last year in 2020, we were up to 67% of the cases where Cogent was getting paid by both a sender and a receiver. This is a net positive for our business and should continue going forward. Okay. Okay. And so let's let's now pivot. You had mentioned Salesforce, and I wanna dig into this a little bit because I noticed productivity per sales rep, which had been trending downward, to start 2020, ticked back up. We got back to about 4.2, this past quarter. And so can you help us think about the drivers here? And I guess, in particular, can you talk a little bit about sales force turnover as well? Because I did notice that picked back up, in the fourth quarter. So maybe we can touch on that, and I've got a couple of follow ups. Maybe we can start there. Yeah. So, when the pandemic hit, Cogent had to quickly pivot from sales offices around the world where our 750 sales professionals, 600 quota bearing reps went every day to work from home. That transition was challenging. We had to get everyone laptops. We had to get them cell phones, and they had to begin to do their outbound telemarketing in a remote environment. We did very well at that. The second thing we had to do is start hiring new reps because we do earn about 5% sales per month. You know, this is a, you know, outbound telesales model which requires high activity, and not everyone is successful at that. In the first part of the pandemic, we did a good job of hiring, decent job of managing, and a poor job of managing out underperformer. We became more aggressive in the third quarter and fourth quarter of managing out those underperforming reps. That will continue. We also think that our sales force will be able to return to an office environment hopefully by the end of summer, early fall. And there is a benefit to having managers and colleagues directly in the same office as opposed to working remotely. It also makes training easier. So we feel pretty good about, one, the underlying demand backdrop, and then two, our ability to have sales enough salespeople to go after that market, and three, those salespeople to increase their productivity. So we did get we understood that it was in large part, you know, because we were carrying some underperforming reps, and we managed them out. You know, if we step back and look at 2020, we grew our entire sales force 4% in a year. We grew our full time equivalents at 8%. Our stated long term goal is to grow the sales force at between 710%. So we did reasonably well against that goal even though we had to hire remotely and train remotely as we can get back to a physical hiring and a physical training environment. We think that's an added benefit to getting us back to our long term average productivity of about 5.3 or below that today per rep per month of installed orders and to get our Salesforce turnover in line with long term turnover rates of just over 5% per month. And so what inning are we in right now in terms of this managing the underperformers process? Because I assume the way I understand it is there were maybe newer reps brought in, you know, and I guess tougher to sort of manage them out if they're underperforming. And so these are shorter tenured reps, the way I understand it, that are being managed out. But I'm trying to better understand how I guess, what inning are we in in terms of this process? Yeah. I think just like with the pandemic, we're probably in the seventh inning at this point. You know, we have a pretty good process in place for hiring, training, managing, and managing out underperformers, but it's still all remote. The real benefit comes when we can get those people back into the office. Got it. Got it. Let's, let's talk a little bit about, margins. So I think you had mentioned, obviously, the longer term target of about 200 bps year on year margin expansion. I think you did, you know, pretty close to that. By my numbers, it was about 130 basis points of expansion, last year despite growth being less than half of the long term target. And so as I think about an improving or inflection trend for the corporate side, more of a mix towards on net versus off net, at least in the interim, and we think about the continued strength in NetCentric, which is primarily on net as well, what is the sort of expectation, if any, in in terms of margin? Because I would think that sets you up pretty positively to maybe accelerate the rate of improvements in adjusted EBITDA margins in 2021? I'm just curious to get your thoughts there. Yes. Again, our guidance, both in terms of revenue growth and margin expansion, It's not meant to be this year or rather multiyear in nature. I think that we are in a good place. We saw our gross margins expand by a 100 plus percent basis points. And really, we should get the SG and A uplift when those reps become more productive. We also have the tailwind of a greater percentage of sales being on net versus off. So in our corporate business, the mix is roughly 60% on, 40% off. In an eccentric business, it's 93% on, 7% off. So we get the benefit of selling more NetCentric and more on net corporate, which carries much better contribution margin. Our contribution margins on that are 100% gross margin contribution, $0.95 of EBITDA. And I think we are in a position to see revenue growth revert back to historic norms and with that achieve at least the type of margin expansion we've done again over the past twenty one years where we have grown margins since going public sixteen point five years ago at two ten basis points a year average. And then so now let's pivot to capital allocation. I know it's a very popular topic with Cogent. And so maybe I'll start first with leverage. I'm just wondering, you know, in the past, you've talked about targeting leverage between two and a half to three and a half turns. I believe last quarter, you were closer to the upper end of that at about 3.4 turns. And so I'm thinking with leverage where it is, with interest rates rising, how do you approach leverage today? And does that backdrop imply incremental shareholder returns could moderate until you see maybe more meaningful reacceleration in growth? So a few points. One, most more of our leverage increase came from the fact that the euro denominated notes had to be marked to a higher value because of the appreciation of the euro against the dollar. That was a $19,000,000 headwind in the quarter. In fact, when we refinanced our unsecured debt, we lowered the interest rate from five and seven eighths to four and three eighths, lowering our cash cost. Similarly, we have a callable third offering that's a five and three eighths that we're evaluating refinancing and lowering the interest rate, which I think would have a meaningful impact. Secondly, we have excess cash on the balance sheet. We have far more cash than the company needs to operate, and our goal is to gradually disgorge that cash through a combination of buybacks and dividend. Last quarter, we did supplement our dividend with $4,200,000 of buyback. In total, since 02/2006, Cogent has returned $895,000,000 to shareholders. Roughly $230,000,000 of that has been through the buyback program and about $665,000,000 through our dividend program. We have 34 consecutive sequential quarters of growing the dividend sequentially. Our dividend growth rate last quarter was 14.4%. Historically, since starting the dividend in 2012, we have grown the dividend at a compounded rate of about 16%. We have also, during that period, grown free cash flow at a similar rate. We feel very comfortable that we're going to be able to return increasing amounts of capital to our equity holder. And and adjusting for that, you you mentioned the euro denominated notes has to be marked higher, and that drove about 19,000,000. So where where would you say sort of normalized leverage is right now adjusting for that? And is there sort of a comfort level in terms of where you'd like to be, particularly with the uptake the uptick in, interest rates of late? Yes. So two points. First of all, that was just the one quarter movement. There was movement to prior quarters as well. So in aggregate, we've had almost $80,000,000 of movement in the euro against the dollar to impact our leverage. We had initially targeted a range of two and a half times. When we became close to that, we raised that range to two and a half to three and a half times EBITDA. We know that we have a very durable existing revenue stream and a consistent growth rate. Let's put this in perspective. We grew just under 5% in a world where GDP was contracting at probably 5% or 6%. So I think we have been very durable and when compared to other wireline companies, more durable. So I think we have the ability to take on more leverage if needed. To your comment on interest rates, while the ten year has moved up over the past three months, high yield spreads have actually compressed some. So the high yield index remains near historic record. Still, in absolute dollars, if we did something, we'd be lowering our interest rates. And it's not clear to me with the efforts globally in a synchronized manner of all the central banks that we are gonna see any kind of permanent increase in interest rates in the short to medium term. You know, I think that, you know, there is a lot of stimulus going into the economy. The economy is benefiting from the back inizations and the optimism of reopening, but there's still a lot of economic damage that was caused by the pandemic that has not yet been fully dealt with. Understood. And if we tie this all together, it's gonna be my last question. What do you think is most misunderstood by the street about the cogent story, and where do you see the potential for upside surprise over the next six to twelve months? So having done this for a long time, I've become a bit gated because every business over the long run should be measured by a simple consistent yardstick, which is DCF per share and the growth rate and that discounted free cash flow per share. I think cogent is misunderstood because many investors look at us on an EBITDA multiple and may say, oh, Cogent works expensive. But when they look at us on a growth adjusted free cash flow multiple, we actually look very inexpensive. So Cogent is, I think, misunderstood because it's lumped in with a bunch of wireline telecom companies that sell legacy products at negative revenue growth and negative operating. Again, throughout the pandemic and, you know, even before, we continued extraordinary top line growth and exemplary margin expansion. So when you put that together, you know, we're really not a wireline telecom company. You know, we look at some of the other companies in your coverage universe more in the data center space or tower space, much more capital intensive than Cogent and lower organic growth rates, yet create a substantially higher valuation. We just got lumped into a neighborhood that's not a good neighborhood. And, you know, the only thing we could do is run our business. Guys like you and your colleagues that pick what peer universe you compare us to. Understood. And I think with that, we will end it there. We're just about out of time. So, Dave, on behalf of myself, everyone at DB, thank you for joining us. And we are really looking forward to doing this in person in Palm Beach next year. All right. Thanks a lot, Matt. Thanks, everyone, for taking time. We'll talk soon. Bye bye. Thanks. Bye.