Well, good afternoon and welcome back to Citi's 2023 Communications, Media and Entertainment Conference. For those of you I haven't met, I'm Mike Rollins, and I cover the communication services and infrastructure categories within Citi. Before we get started, I'd like to just mention that we do have disclosures available at the registration desk and on the Citi Velocity page, from which you're streaming the audio. We're gonna work to get your questions into today's discussion. Of course, we have the microphones around the room, but we also have a questions box on the website. If you have a question, you can enter it in there. We're also gonna continue the tradition of live audience surveys that are completely anonymous.
We're just collecting up the responses, and you can access that through the placards and the information here on the table or on a box that's gonna come up on the website. With all those details out of the way, I'd like to welcome back to the conference Dave Schaeffer, Founder, Chairman, and CEO of Cogent Communications. Dave, it's great to see you.
Hey, Mike. Thanks for hosting me. I'd like to thank investors for taking time out of their busy day and as always, thank Citi for a great venue. I think rather than give any overview, focusing on Q&A is the best way to use our time, Mike.
Well, great. Well, you know, maybe we'll just start with a high level question, of your strategic and operating priorities for the coming year and if there are any notable changes from the past year which, you know, given the activity for Cogent over the last few months, looking forward to your update on this.
Yeah. So we do obviously have some significant work ahead of us in completing the acquisition of the Sprint GMG network. It's been nearly 17 years since Cogent has done an acquisition. You know, I was joking with one of my team members from actually the FirstMark acquisition, and I said, "If I had told you we were gonna acquire Sprint GMG, you know, 20 years ago when we acquired FirstMark, you probably would have quit in a heartbeat and thought I was delusional." You know, it was, you know, the largest wireline network in the world at one point, and a business that had, you know, $40 million or $40 billion of revenue and 70,000 employees at peak.
The business is much smaller today, but it's also a business that's, you know, lived with over 20 years of lack of attention. It's attrited in terms of its scale and its profitability. We have a definitive agreement to acquire that business from T-Mobile. We also have kind of core Cogent, we need to continue to re-accelerate our growth and return to the patterns that we've had in previous years. You know, Cogent has had a organic growth rate for 17 years, averaging 10% a year. You know, the pandemic hit, that growth rate decelerated to 3% a year. It has re-accelerated slightly to about 5% last quarter on a year-over-year basis, but still half of our trend line. We have two major strategic initiatives for 2023.
The first of those is to complete the acquisition of Sprint GMG, acquiring that business from T-Mobile, reducing the cash burn and repurposing the network to generate positive cash flow by converting the network into a pure optical network that will carry either Internet traffic on one pair of fibers or optical transporter wavelength services, sell off unused portions of the network. The second, you know, challenge for Cogent is to see our organic growth rate continue to improve. While our net-centric business has outperformed historical averages for much longer than we expected throughout the pandemic and continues to grow at substantially above historic rates, we are seeing finally an improvement in our corporate business, which is the larger portion of our revenue stream, 57% of revenues.
Rather than going from an 11% average grower declining to a -8% at the worst of the pandemic, and now at least back to being a 1% positive growth business, we feel encouraged, but we need to do much better. I think, you know, the market is improving, and we should be able to achieve those objectives this year.
Just going to introduce our first survey, which actually just follows on your comments on corporate. We'll see what our audience thinks. The first question: When will Cogent's corporate segment revenue return to sustained positive quarterly sequential organic growth? For Q 2022, 1 Q 2023, 2 Q 2023, second half of 2023 or 2024 and beyond. We'll let this brew and see the responses come in. Before we get there, and, you know, maybe just touching on one of the first priorities you mentioned, which is Sprint acquisition.
You've described a lot about how you're approaching this deal and the opportunities. To get back to positive cash flow in this business, to have this business grow through the products that you were describing, are there other underappreciated aspects of this in terms of capital and equipment that you're inheriting with this business or routes that you know, kind of hinted at earlier that maybe you could sell off? Like, what are some of the underappreciated aspects of this transaction?
Yeah. I'm gonna give you kind of three answers to that question, Michael. The first one is the physical fiber itself. There's 19,000 route mi of inner city fiber and 1,300 mi of metropolitan fiber. The cross-section or fiber strand count ranges from 24 to 144 fibers, depending on the city pairs in question. The fact that the fiber was buried 6 ft deep rather than a more modern network that would typically be 24 in below grade, and the fiber was encased in an armored jacket, means that our network, while nearly 40 years old, has had fewer cuts than networks that are half its age. Most of the fiber in the ground today, inner city, was deployed in the late 1990s, early 2000s.
This network was deployed in the mid-1980s, it has better loss characteristics and fewer splices than those more modern networks. The second thing that I think is underappreciated is the fact that the network was built with single-mode fiber 28 or SMF-28. Common fiber in the early 1980s, it was argued that that fiber would become obsolete as transmission speeds increased. The first commercial networks were Async 565 or a 0.5 Gbps networks. The SMF fiber actually performed very well up to about 40 Gbps . When many companies were anticipating migrating to 100 gig, the fiber manufacturers, Corning, Lucent at the time, Sumitomo, were all pushing non-zero dispersion-shifted fiber, and that was what was deployed in the late 1990s and early 2000s.
As it turns out, no equipment vendor was able to make a non-coherent 100 gig transmission system work. All of the vendors, whether it be Ciena, Infinera, Cisco, Lucent, now Nokia, Fujitsu, NEC, all migrated to a coherent transmission technology. Coherent did not work on the non-zero dispersion-shifted fiber and actually performed better on the single- mode 28 fiber that was deployed. What is old is new again. New networks are all being deployed with SMF-28, and that will continue to be the standard, I think, for the foreseeable future as we're moving to 400, 800 gig and 1.2 Tb per wavelength networks. The second thing that I think is underappreciated in the Sprint network is the fact that the routes are unique to Sprint. Over 90% of the routes, no other provider shares the right of way.
While the endpoints are all the major North American endpoints, because this network was designed to connect all 168 LATAs together to allow for tandem switching in each of the Sprint facilities. Because of that ubiquity, but the uniqueness of routing for many of the purchasers of wavelength services, that diversity has tremendous value. I think the third asset that we are acquiring that is underappreciated are the 1,300 pieces of fee simple real estate that was owned by Sprint and now T-Mobile. Now, these can range from shelters along railroad tracks that are just amplifier sites all the way up to 100,000 sq ft data centers. There are 47 significant facilities that comprise about a little over 400,000 sq ft of raised floor space and have over 150 MW of conditioned power.
These facilities are suitable for data center conversion. Today, Sprint is generating less than $1 million a year on colocation and power within their facilities. We are going to repurpose those facilities, increase Cogent's data center footprint from 54 facilities that we own today and 604,000 sq ft to just under 1.1 million sq ft and increase total power from 69 MW to over 220 MW. I think it gives us a very large data center footprint, probably makes us probably the third largest operator of data centers in the country.
Are those facilities, do they really just connected by the Sprint network or do they have some degree of network density that creates a network effect?
The answer is yes and no.
Okay.
The network was built primarily for voice initially, it always has connectivity to the Sprint backbone, and typically the two competitive carriers that would be in the facility are AT&T and Verizon. Those two companies do not serve the wholesale market in any significant scale, we are in the process of building fiber from those Sprint facilities to Cogent facilities in each market. We have outlined the need to spend approximately $50 million of one-time CapEx in order to tie the networks together. By doing so, we will increase the number of endpoints where services can be sold. Today, Sprint is only interconnected to 24 carrier-neutral data centers in North America. Cogent is connected to over 800 carrier- neutrals.
Probably by the time the transaction closes, late summer, early fall, we'll have virtually all of those 800 facilities available for the sale of services off of the Sprint backbone. That's really important because that allows us the greatest footprint for the sale of wavelengths of any carrier in North America. Because we have a larger third-party data center footprint than any other provider, this should help us gain market share quickly.
Great. Let's see what the survey results were. In terms of when the corporate segment revenue will return to sustained positive quarterly sequential organic growth rates. There's a lot of words in there. 0 for 4Q, 25% for 1Q 2023, roughly 50% for the second half of 2023, and 25% in 2024 and beyond. You know, you mentioned earlier some of your observations about how the corporate market, it may be improving. If you could share more thoughts of what's happening in that segment and, you know, what you're seeing in terms of pipeline sales and the types of engagement with these corporate buildings that you connect to.
Cogent today connects to about 1,850 skyscrapers in North America. That represents over 1 billion sq ft of net rentable office space. There is a total North American inventory of about 9 billion sq ft. We're in just under 12% of the market. The vacancy rate at our footprint pre-pandemic was approximately 6%. That vacancy rate skyrocketed to 18%. It improved slightly at the end of 3rd quarter to 17.7%. We anticipate continued but slow improvement in that vacancy footprint. But I think it's probably a 4-5-year process before we get back to pre-pandemic levels. In most recessions, it's usually new business formation that mops up excess supply. I do believe this time is different.
We have seen studies and have specific examples of buildings that both we're in and we've looked at, where buildings were being repurposed for either residential or hospitality. It's estimated that approximately 10% of the market, or about 900 million sq ft, will be converted. That will dramatically tighten the occupancy levels. Secondly, we've seen rents fall, what is normally the pattern is tenants take advantage of those lower rents and more desirable buildings and move upmarket, away from suburban B and C buildings to CBD A buildings. All of the third-party studies, Newmark, CBRE, Cushman & Wakefield, JLL, all support that, we're seeing that as well. I think the underlying occupancy is improving. The second factor is customers' desire to modernize their networks. Many customers have procrastinated or postponed network modernization for 3 or 4 years because of the uncertainty of the pandemic.
Pre-pandemic, companies would design their networks where 97% of employee workdays were anticipated to be in the office, 3% were anticipated to be remote. The new design standard that companies are migrating to are 60% of workdays in office, 40% in a remote environment. That has profound implications. It means you need a bigger connection at your primary aggregation point. Two, it means more of your compute and storage is moved off-site. Three, it's more likely that you will need a second hardened aggregation point, oftentimes in a data center, which is a brand-new opportunity for Cogent. On the negative side, many companies are reducing the number of offices that they are occupying. We just saw the headline today from Salesforce.com where they're cutting sales force by 10%, but they're also reducing the number of offices.
Rather than shrink the offices they remain in, they're just eliminating non-core locations. That, I think, is the more common pattern. I think when companies 5 years ago thought about office-to-office connectivity, they needed to have a highly secure VPN, usually based on MPLS. Today, because they've now lived with an ad hoc VPN for remote employees for the past 2 years using the Internet, I think most companies are now willing to accept an internet-based VPN or just naked internet connectivity for their office-to-office communications. You know, there's both pluses and minuses for Cogent, but when we package these things together, what we have seen is growth in our sales force. It was actually the fastest growth in a single quarter in the company's history in the third quarter. We've regained about half of the net number of salespeople we lost during the pandemic.
We expect to continue to see improvement in fourth quarter and first quarter. Hopefully by mid-year, we'll be back at pre-pandemic sales force levels. We'll continue to grow from there in the latter part of the year, returning to that annualized 7%-10% sales force growth number. Secondly, we have seen the number of proposals issued per rep accelerating. I think that means customers are now ready to make decisions. The third thing is we've seen the gestation period of those proposals shrink. We're seeing a more rapid decision cycle. All in all, we're seeing good recovery. I'll comment now on the survey. We did return to positive growth in the fourth quarter.
We have been very clear to investors, and I'm glad they listened to what we said, that we're uncertain if that's permanent and, you know, we're just straight up from here. I think things feel pretty good. I think we are going to continue to see improvements. After 2 and a half years of pandemic, I think we're realistic that the path is going to take longer and be bumpier than we expected. I think, you know, kind of the, you know, modal response at mid-year for sustained growth is both realistic and probably a little bit conservative.
Just to make sure we got all these details correct. You mentioned that you returned to positive growth in the fourth quarter?
We did.
Oh,
Fourth quarter of last year.
2022, you were positive.
Well, we were positive in third quarter.
Right. Yes.
Yes.
I want to make sure. Yeah.
That's very different than saying it's sustained.
Yes. Mid of 2023, you know, to you, seems reasonable for kind of a base expectation.
That's correct, Mike.
The other kind of curveball here is possible recession. Given all of your touch points into different parts of the economy, are you seeing any indicators on a change in consumption or behavior or payments, you know, around macro factors? How does a possible recession impact this recovery?
We are maybe not the best barometer. We have not seen any increase in bad debt, any material change in DSO. We have not seen any material business failures. Our corporate customer base is pre-vetted by the landlords who typically have the most expensive real estate in any given market. That vetting process insulates us from recession. In previous recessions, the corporate business continued to grow, with one exception, the very deep recession in Q4 of 2008 and Q1 of 2009. I don't think this recession will be nearly that pronounced and that abrupt, so I don't think it's going to have a material drag on our corporate growth rate.
I do think that with a rising interest rate environment and a high level of economic uncertainty, new business formation will remain low, and we should not look at that as a driver of increased occupancy. Rather, in this recession, occupancy rates are going to go up because of supply reduction.
Need to throw out the next survey question, we'll come back to this. You know, just kind of following on the discussion of the Sprint GMG acquisition. Question is, how do you view the pending acquisition of Sprint's GMG business for Cogent's ability to create value over a 1- to 3-year period? Positive, neutral or negative? We'll go to the polls on that. While that's kind of brewing, maybe flipping, just for a moment on net-centric. You mentioned, you know, net-centric's been performing well, relative to history. What's the likelihood that that continues to perform well, and are there any drivers there that investors should be mindful of?
While I maybe was more optimistic about our corporate rate of recovery, I have been equally guilty of being too pessimistic about the rate of sustained growth in the net-centric business. I think that business will continue to outperform for the foreseeable future. Initially, I thought we were benefiting from a surge in pull forward demand due to the pandemic and an acceleration in streaming. While the streaming companies themselves are struggling for profitability, aggregate number of minutes of video consumption continues to increase, and the greatest area of increase is international. We have a much stronger footprint globally. We also have a higher likelihood that we're getting a two-sided payment internationally than domestically. Our net-centric business has seen traffic growth in line with historic averages, but yet our revenue growth is 70% above the historic average since the pandemic has started.
You know, our average growth rate was about 9% a year. We entered the pandemic actually below average at about 3% net-centric revenue growth. That accelerated to a peak of over 25% year-over-year growth. It has moderated some to last quarter being just under 17% on a constant currency basis. Because 55% of that business is outside of the U.S., there is significant FX exposure. What we are seeing is the proliferation of streaming in 2 dimensions. 1, more end users. 2, many more choices. I was speaking to an investor earlier today, and he looked at the world from the streaming providers out to the customer and was trying to assess the health of that market.
I said, "While that may be an important way to look at the profitability of those streamers, the better way to assess the market is from the consumer in." What we have seen is the number of minutes of video consumed over the internet versus other delivery methods go from 18% of all video being streamed pre-pandemic to 44% today. That number will continue to rise. It will come from a wider number of players. It also will come from an increasingly large percentage of free services that are ad-based versus subscription. You know, I think there is no shortage of content. What is in short supply still are eyeballs to watch that content. As long as there is a war for those consumers, the consumer will win and traffic will continue to grow.
You know, maybe taking a step back, if you look at just your market shares in both corporate and net-centric, you know, given the value proposition that you provide, they're not very high in terms of share. I think in the corporate building, it's in the teens of unique customers. I think you said before in the net-centric business it's, what, mid-twenties was that?
24%.
Yeah. Is a recessionary environment and one in which, as you were describing, customers seem to be pursuing digital transformations maybe more quickly post-pandemic. Is this the catalyst or catalysts to really accelerate the opportunity to gain share?
You know, I wish that was the case, Mike. I'm not sure it is. I think we sell a necessary utility to businesses. The businesses that we sell to, their internet spend as a percentage of their total spend is de minimis. I don't view this as a major cost center. It delivers a tremendous amount of value. While Cogent prices its corporate services at parity to our competitors, we win due to the superiority of the service. The speed of installation, the quality once installed, and the aggregate amount of throughput. I think those drivers will continue for our corporate segment. What will accelerate growth is customers feeling some degree of certainty around their future network requirements. Our biggest competitor is not another provider. It's not the realization that their networks need to be modernized. It's actually the fear of doing it at the wrong time.
Either it's just not convenient or the world is changing. I think as people, CIOs, MIS managers, kind of come to grips with the new reality, our corporate business will accelerate. On the net-centric side, historically, recessions have been a positive. Unemployment rates go up, people have more time on their hands. They use an unlimited service that's a low cost service, such as residential broadband, more intensely. I think this will continue to accelerate the trend away from linear television and probably bodes well. I think the real driver is lowering the total percentage of consumers' spend on entertainment and giving them greater choice. That's really where streaming wins and linear cannot compete.
Back to the survey. We ended up with a low sample size on this one, so instead of revealing the results, I'm gonna ask the question this way. What have you heard in terms of concern from investors about the deal? How do you respond to those concerns?
I would say the number one concern is you're taking over someone else's problem. It's an old, obsolete network, and no one pays you $700 million unless there's something wrong with it. The answer is, there is something wrong with it for its current owner. It is not strategic, there is no management focus on it, and they have no desire to enter into the market segments that Cogent is going to repurpose that network to serve. I think we were the ideal partner because of our track record of repurposing assets, our ability to take and add value and monetize things in a way that maybe others have not. I have no delusions. The network that was built by Sprint for long distance to connect those 168 tandems is completely obsolete.
That network today needs to be used for modern technology and modern services. That means IP transit and optical transport services. We intend to do that. In addition to that, we are committed to selling off non-core assets. I think the early concerns have been abated as investors thought that there really are customers for the repurposed network.
Last question for us goes to capital allocation. After slowing the pace of sequential dividend growth over this past quarter, what are the factors that would lead the board to sustain or accelerate dividend per share growth versus the factors that could lead to either a further deceleration in the growth rate or a cut in the aggregate dividend per share?
Cogent's corporate business, which represents 57% of organic Cogent's revenues, had decelerated in the pandemic, and that deceleration lasted longer than we anticipated. We also saw a rising interest rate environment. With those two factors, it made sense to stop the slow creep up in net leverage. By reducing the growth rate and the dividend from $0.025 a share sequentially to $0.01 a share, we actually get to the point where we start to naturally de-lever. That does make sense. Two things would motivate the board to increase the pacing of the growth in the dividend once again. That would either be a re-acceleration in the corporate business or a decline in interest rates. Since both of those are not certain at this time, taking that more modest growth rate made sense. Again, I'm gonna defend Cogent's growth and dividend policy.
We have 41 sequential quarters of growing the dividend. There have actually only ever been 7 public companies in history that have that long of a track record of growing its dividend. We remain under-levered in a recurring revenue business model, and our average cost of debt still hovers around 5%. When we put those factors together, I think we have a very prudent capital structure.
Dave, thank you for joining us today.
Thank you, Michael. Thank you all in the room. Thank you on the webcast. Take care.