All right. If everybody can go ahead and please take their seats. We're gonna go ahead and get started with our next session. For those of you who don't know me, I'm Matt Niknam, Comm Infrastructure Analyst here at Deutsche Bank. We are pleased to be joined by a man who really needs no introduction. I'll give an introduction anyways. Cogent Communications CEO, Dave Schaeffer. Dave, welcome back.
Well, thank you, Matt, for hosting me. I'd like to thank Deutsche Bank for a great venue, and I'd like to thank investors for taking time to hear a little bit about Cogent.
Great. We've got lots to talk about. Maybe just to start, you recently reported fourth quarter results, closed out 2022. Sounds like you've got a very busy 2023 ahead. Maybe just to start, we can talk about some of your top strategic goals and priorities for the year.
Yeah. I think our number one goal is to complete successfully the closure of our acquisition with Sprint GMG or the T-Mobile wireline business to begin some of the cost reductions and increases in profitability in that business, as well as to begin to market wavelength services across that network and colocation services within the footprint we're acquiring. I think our second key objective is to see continued re-acceleration in Cogent's organic growth rate. You know, the pandemic was tough on us. You know, we went into it with a 10% working on a top-line growth rate for the past 17 years. Because of the impact on our corporate business, the growth rate decelerated to as low as a couple of %. Last quarter was back up to 5.7% year-over-year growth.
We're more than halfway back, but getting that business to continue to improve, probably our second strategic objective.
Okay, great. We usually talk about M&A at the end of the discussion, but we'll kinda flip it and start on M&A just given the Sprint GMG deal. Maybe just to start, if you can refresh us on the rationale and benefits from the Sprint GMG acquisition and talk about some of the synergies that the asset brings classic Cogent.
Yeah. What we are buying is the Sprint Global Markets business that is about a 40-year-old business. At peak, that business had $40 billion of revenue, 70,000 employees, and $16 billion of EBITDA. That's 20 years ago, and that's history. That asset has really been ignored for the past 20 years. It has shrunk to $560 million in revenue, negative $300 million in EBITDA, and approximately 1,320 employees. There are 1,400 customers buying a total of 28 products. 24 of those 28 products are actually gross margin negative. We are acquiring a business that is both declining and burning cash.
We're being paid by T-Mobile through the sale of transit services to T-Mobile, which at this point they may not use, $700 million, $350 million in the first 12 months, and then the next $350 million spread over the subsequent 42 months. Total cash payments of $700 million with no cost of goods sold and a 100% contribution margin. In acquiring that business, we acquired 19,000 route miles of intercity fiber, an additional 1,100 miles of metropolitan fiber, and we're acquiring 1.3 million sq ft of technical space that is suitable for data center use. There's actually a total of 1.6 million sq ft being acquired, all fee simple owned. Some of the facilities are not suitable for conversion to data centers.
Within the acquisition, we actually have two very different objectives. The first objective is to jettison the unprofitable revenues, retain the large enterprise customer relationships that have been in place for nearly 30 years, and take that business from $560 million to $450 million, modernize the product suite by converting the MPLS customer base to VPLS, increasing and MPLS customer base, and probably shrink the total number of customers from 1,400 to 1,200. In doing that, we should be able to bring traffic on net. Today at this business, 93% of services are delivered using third-party networks. Only 7% is on net. Cogent, by contrast, is 75% on net, 25% off net. We believe we can convert that stable business to approximately a 20% margin business.
$450 million of revenues, $90 million of EBITDA, and about $30 million of CapEx to run it. We will probably burn a little over half of the $700 million that we're getting from T-Mobile to accomplish that restructure. If that was the only purpose, this acquisition would not make sense. The real value in what we are acquiring is the repurposing of the physical assets that were built at a capital cost of nearly $20 billion. Those assets today are basically fallow. There's 1.3 million sq ft of data center space, 160 MW of power, 37,500 racks empty. There's also a fiber network with average cross-section of about 40 fibers that is basically unused today. There's a small amount of test wavelength business and a very de minimis amount of IP services on that network.
What we will do is take one pair of fibers and migrate the Cogent IP business onto that network. To give you a sense of scale, their IP network today is transmitting approximately 10 petabytes a day. Our network is closer to 1.1 exabytes a day, or about 105 x as large as their traffic. We will then free up a pair of fibers to sell optical transport services wavelengths. This is a market that Cogent has not participated in historically. It is a $2 billion addressable market. We will have four distinct advantages in selling into that market. That $2 billion market is dominated today by Lumen and Zayo. We will have the advantage of having completely unique routes. Over 90% of the Sprint network is along right of way that no one else uses.
It was primarily along railroad right of way. We will connect that long-haul network to the existing Cogent metro footprint, and that will give us connectivity to 800 Carrier-Neutral Data Centers in North America where we can sell wavelengths. That's over twice as many as any of our competitors. We will have unique routes, we will have more ubiquity. The third advantage is our sales force. We have today a sales force of reps that focus on service providers, whether they be access networks or content generators, and that represents the majority of that wavelength market. We already have existing relationships with over three-quarters of those customers buying transit services from us, and we will be able to go after those customers aggressively. The final advantage that we'll bring is the ability to provision the services quickly.
Because of the way our network is architected, we are looking to meet the same kind of provisioning windows as we do for transit. Just to remind investors, Cogent, 17 years ago, had 0% market share in the wholesale transit market globally. Today, we're at 24%, the number two provider in the world. Because we can leverage that market position, we think we can capture a quarter of the wavelength market within seven years. Finally, because we do have a negative cost basis in the network, we're being paid to acquire it, we will price as aggressively as necessary to capture market share. When we entered the transit market, our strategy was controversial. We undercut any other provider by 50%, and it allowed us to gain market share, to grow revenues in a flat market, and expand margins.
That strategy is still continuing. We are continuing to gain share in that transit market. In the wavelength market, it's not clear to us that we'll have to be as aggressive on price. We'll compare to if necessary. The transaction is dramatically de-risked for Cogent because of the $700 million cash payment from T-Mobile.
As we think about just expanded TAM, you touched on wavelength and the $2 billion opportunity, 25% market share you're targeting. You also mentioned a lot of data center space you're getting access to. Anything in terms of, like, additional colocation revenue potential, just in terms of other maybe areas Cogent may not be as active in today that the deal may present to you?
Cogent today, prior to the acquisition, has 54 data centers, approximately 8,000 racks, 69 megawatts of power, and that business generates roughly $20 million a year for Cogent. We will end up taking that rack count to over 45,000. We will almost quadruple the amount of power that we have, and these facilities that we're acquiring are actually owned, so there's no rental payments associated with them. We think we can add pretty quickly about $30 million of run rate in the colocation product. The only direct cost there is the incremental power, which is typically billed directly to the customer. This will be additive to the Wavelength opportunity.
What's the latest on deal close timing?
You know, we were initially expecting the deal not to close till the latter half of the year. About 10 days ago, we received our final regulatory approval from the California Public Utilities Commission. We've received regulatory approval in 23 international markets, all 50 states, and the FCC. The two items that are left for the deal to close are the completion of the carve-out audit by T-Mobile. They are busily working on that, and I know Peter's gonna be here tomorrow and you can ask him, but we anticipate that being done over the next month. The second thing will be the completion of the transition services agreement. While we negotiated an initial framework along with the transaction negotiations, we really didn't fill in the details. We're now beginning that process.
There's over 220 different areas that need to be covered. They're not all just for Cogent's benefit. Many of them actually benefit T-Mobile long term. There's gonna be wireless equipment that are located in buildings that we're acquiring. There's gonna be certain network assets that are shared, network control systems that have to be shared. From our side, we'll need access to some of their centralized data center and processing capability because those applications were moved off of standalone Sprint into a combined T-Mobile environment. It is our expectation that it'll take another 6-8 weeks to fully negotiate that transition services agreement. Coupled with the, you know, completion of the audit, we're anticipating closing some time in the second quarter.
Okay. If we tie this all together, you've obviously in the past provided sort of a multi-year growth to profitability sort of algorithm for classic Cogent. If we think about the pro forma company, what does annual sort of target growth, margin expansion, leverage look like for the pro forma entity?
Let me start with what Cogent has actually done. Since going public with Deutsche Bank's help, we have been able to generate 10% organic top line growth, 200 basis points a year of margin expansion, to the point where we're about $600 million in revenue and just under 40% EBITDA margins. We're acquiring a business that will shrink to $450 million. Much of that shrinkage is occurring right now while T-Mobile still owns the asset because those unprofitable products have been end of lifed by T-Mobile. If we had closed in the fall, they would've been further along in their retirement. We'll probably end up with a little more than the $450 million that we anticipated and probably a little worse margin profile just 'cause we're earlier in the process.
That revenue will burn off. Those revenues and products will burn off. The $450 million large enterprise business that is comprised of selling VPN services and DIA will be flat to 2% growth, call it a 1% growing business with probably a 20% EBITDA margin. You've got $600 million of Cogent with a 40% margin. You got $450 of T-Mobile with a roughly 20% margin. You have the Wavelength business on top of that. The Wavelength business is very embryonic. It's really just a test bed at this point with about an $8 million run rate.
It was severely constricted by the fact that T-Mobile did not have a sales force to sell it, and it only terminated in 24 Carrier-Neutral Data Centers as opposed to the 800 that we're bringing online. That business will grow very rapidly for a few years. I think once we kind of reach maturity in that business, it should grow at about 5%-7%. When you blend these three different components of growth together, the total Cogent business within five years should be about a $1.5 billion business. It should have roughly low 30s EBITDA margins, with margins expanding about 100 basis points a year and combined revenue growth, including the low growth enterprise business of between 5% and 7%. In looking at the blended business, the investor can think about top line of 5% to 7% growth.
Understood. Is there a sort of? I'm gonna hit on leverage a little bit later in the discussion. Maybe just as we're sort of talking about the deal itself, where would your leverage. I think you've been a little bit maybe north of four of last quarter. I'm just wondering where you sort of envision the pro forma business being.
We have a net leverage target of between 2.5x and 3.5 x EBITDA. We have been above that for two reasons. Part of it is spending associated with the integration of the networks that actually began in advance of the regulatory approvals through a series of arm's length commercial agreements. The second was our continuance of growing the dividend at our historical rate. We have 42 sequential consecutive quarters of growing our dividend. Prior to the pandemic, EBITDA was growing at mid-teens, so 15%, 16%, and we were growing our dividend at about 13% or 14%, two and a half cents per share sequentially. We continued that during the first part of the pandemic for 2.5 years, believing that our corporate business would recover more quickly.
Our NetCentric business, which is 44% of revenues, actually accelerated and continues to grow about 60% faster than its historical average. 9% historical average growth, about 16% today on a constant currency basis. The 56% of our revenues that come from corporate users that had traditionally grown at 11% are now growing at about 2%. They had actually faltered in -9% during the pandemic. As a result, our leverage ticked up. Because we are going to be able to count the vast majority of the T-Mobile payments as revenue, we are making available to them transit ports. Whether they use them or not is still to be determined. We can recognize that as revenue. The payments are asymmetrically front-end loaded. The revenue will have to be recognized ratably over the 54-month contract.
In the first year, we'll be getting $29 million a month for a year. That payment steps down to $9 million a month for the next 42 months. From a income statement perspective, we will recognize approximately $13 million of revenue per month. That, because it has a 100% margin contribution, will rapidly de-leverage us.
I'm going to pause if anybody has any questions in the audience. Okay, let's talk about the core classic business. You hit on corporate, maybe it's a good place to start. Obviously, as you noted, we've seen revenue, I think, from the start of the pandemic, I think we declined for about eight straight quarters, but now we've actually gotten back to a little bit of improvement the last two quarters. Can you help us just think about the puts and takes here, the outlook for 2023, and maybe we can weave in some of the commentary around vacancy trends in some of your central business districts?
Our corporate business is focused on 1 billion sq ft of large multi-tenant office buildings in the central business districts of major cities. That's the exact footprint that was hurt the most by the pandemic. The vacancy rates in the buildings we serve went from 6% to 18%. They've retreated somewhat. They are at about 17.5%, but still far above historical averages. If you look at employee entry into those buildings, as measured by security badge swipes, we went from 100% pre-pandemic down to literally 0 at the worst of the pandemic, and the climb back has been slow. We're at about 55% today. The corporate recovery has been slower and more gradual than we had originally anticipated. The other compounding factor has been the fact that many businesses don't know what the future is gonna look like.
They went from a world where they designed their networks around 97% of work days in the office, 3% remote, to then 100% remote, no work days. The standard has been kind of solidifying around 60% in office, 40% hybrid. There's a lot of companies who are ready to move on. They need to modernize their networks. They're making decisions. In fact, our corporate growth rate has turned positive for the last couple of quarters. It's back up to a couple percent annual growth rate. Again, this is against an enterprise market measured by all the other providers that are shrinking at about 8% to 10% a year. We'll continue to grow at an accelerated rate. I do think it's gonna be at least a year before we're back to that historic 10%+ corporate growth.
I think for companies, many of them are still grooming secondary locations. Some of them just don't know what the future is, so they're a bit paralyzed. For other companies, they're now ready to move on. They've been living with antiquated technologies like MPLS through the pandemic that they wanted to jettison before the pandemic started, and they've just kind of been procrastinating. You know, it's not uniform. What we are seeing is a number of good leading indicators. Number of proposals being issued are up. Time from proposal to contract signing has shortened. We're seeing vacancy rates decline, albeit slowly, and we're seeing office occupancy rates as measured by employee entrances go up. There are a number of leading indicators that we're tracking that says corporate growth should continue to improve, albeit at a gradual pace.
In this sort of new normal where maybe, you know, vacancy rates may never go back to 6%. Maybe I'm wrong. We'll see how it plays out. You're still confident in sort of the 10% plus growth, admittedly on a year plus.
I actually think a few things are gonna happen. Average office floor plates have shrunk about 20% from pre-pandemic levels. If a company typically took 11,000 feet, now it's taking 9,000 feet. The good news for Cogent is, because we sell one connection per location to a business, we actually have a bigger TAM if the building returns to its historical 94% occupancy rate. The second thing that's happened is a significant amount of office inventory has come out of the market being converted to residential use. That trend is continuing. It typically is not in the buildings that we're in, but it is mopping up the excess supply at the lower end of the market in the B or C building.
We feel pretty comfortable that in our footprint, while the equity ownership of those buildings may change, they are still gonna be occupied and will return to historical average occupancy rates, which were about 94%. As a result, we'll actually have a bigger number of customers we can sell to and actually a larger opportunity than we had pre-pandemic.
Let's maybe pivot to the NetCentric business. That's actually seen some pretty outsized revenue growth. I think you were in the mid-teens in terms of growth last year on a constant currency basis, despite some tougher comps. If we can maybe talk about what's driving the strength and then what's the outlook for that business for 2023?
I have to admit, while I was too optimistic on the rebound in the corporate business, I was too pessimistic of the outlook for the NetCentric business. I thought that there was a significant pull forward of the migration from linear to streaming, and it was a one-time event. In fact, what we're seeing is that trend continuing through multiple streaming providers and, more importantly, the globalization of streaming as a phenomena, moving away from being just a developed world product and now really being widely accepted in the less developed world. We saw our NetCentric business go from 3% growth going into the pandemic, actually below long-term average growth of 9%. These are revenue numbers. It shot all the way up to over 25%, 25.5% at peak, and today it's about 16%.
It is coming down, but it's coming down very slowly. What is driving that are four factors. One, the globalization. More of the growth is coming from less developed markets where pricing is better. Second, the market is more fragmented. We charge more for smaller customers than we do for our largest customers. You know, Telkom Kenya pays more than Google per megabit for their service. Third, we have been able to get a higher percentage of our business where we get two-sided payment, meaning the traffic is going from one Cogent paying customer to another, from an access network to a content network or a content player to an access network. Finally, on the content side, the market has also become more fragmented. It was dominated by one single player a couple of years ago.
While that player remains significant and is a Cogent customer, there are many other alternate streaming services. It's not really our place to opine on winners and losers, but rather just to supply the bandwidth to facilitate all of their business models, whether they be ad-based or subscription-based, whether they be English language or some other language.
This is primarily, it sounds like video or are there other maybe use cases that are generating this rampant traffic?
Video is by far and away the dominant use case today. You know, we provide majority of the bandwidth for TikTok, for example. Is that traditional video? Not exactly. It's probably more like the way YouTube was when YouTube first got started, and YouTube morphed more into a Netflix type model. You know, we support all of those models. We also have seen gaming be a significant driver of bandwidth in certain windows. It's not as consistent as video. Finally, I think there will be a leg of growth that comes from virtual and augmented reality. I think that's more hype than, you know, kind of a real traffic generator today. I think there's a lot of work being done by a number of our customers on various products that will meaningfully move the needle over the next few years.
Virtual reality is just a different form of video, but it's still one that kind of drives off of the same type of user experience.
As we think about sort of the multi-year, you've been maybe punching above your weight and growing a little bit faster, but is 9% still sort of a reasonable assumption to think about for NetCentric on a multi-year?
I think that's right. I think we can grow over the next couple of decades at about the rate we've grown over the past couple of decades in NetCentric. You know, our competition has shrunk. It has become defocused, and those that are left have a significant number of other challenges. It's important to remember that the transit market, while critical to the global economy, is only a $1.5 billion TAM. For almost any vertically integrated telco, it's not big enough to solve the problems that their balance sheets are facing. Logically, they focus on other areas in their business. That's given us the opportunity to grow and continue to capture market share.
I want to talk a little bit about the sales force. I know you've been pretty active rehiring in terms of quarter over year and growth, trying to get back to where you were pre-pandemic. That's maybe driven a little bit of a decline near term in terms of productivity per sales rep, just in terms of the headcount actually growing. Where are you now in terms of hiring? How does the sales force evolve pro forma for the Sprint GMG deal?
I'll start with the Sprint GMG transaction. There are 60 salespeople. They are completely relationship-driven. They do not go out and look for new customers. In fact, they don't even have a commission plan. They're paid on salary. That's not what I think of as a sales force. Pre-pandemic, Cogent had approximately 600 salespeople. We actually continued to hire through the pandemic at record rates, but because we sent our sales force home and they were working remotely, the turnover rate spiked. We have an outbound telesales model. Over 90% of our sales occur either through email or through the phone, never actually physically meeting the customer. Only 1% of our sales come through third parties like VARs and channel.
Our turnover rate went from an average of 5.7% of the sales force a month, spiked at 8.7% during the pandemic. We saw our total sales force decline from 600 to 480. We have rebuilt that sales force by continuing to hire, but more importantly, by reducing the turnover rate down to 4.7%. We got our employees back in the office. We intensified our training efforts, lowered that turnover rate. Maybe someone in the audience is thinking, "Well, that's still an awful number. You're still turning over 75% of your sales force a year." Well, if anyone's ever actually cold called telemarketed and lasted a year, they're a very unusual person. It is a very, very challenging job. You know, I wish all of my salespeople succeeded.
They all come to Cogent with the best intentions. We do the best we can in training them, but there are a few that can actually do that day in and day out. We last quarter on a year-over-year basis, grew the sales force 11.8%. As a result, our average sales force tenure in the past year declined from 34 months down to 29 months. That resulted in lower productivity numbers. We anticipate another quarter or so of outpaced hiring. We want to get back to that 600 number that we were at pre-pandemic. At that point, we want to revert to a more normalized rate of sales force growth of about 7% a year. Down from 12 back to 7. That should allow productivity to increase. We will layer on the 60 acquired sales professionals from Sprint.
They will be given a quota plan. They will be expected to help grow revenue as well as maintain the relationships they have. Hopefully, they'll all do a good job at that, and then we'll just grow off of that base. I think investors should expect for 2024 and 2025, more like a 7% growth rate in sales force, and therefore a reversion in productivity back to the roughly 5.2 orders, which has been our historic average per rep per month.
Got it. Got it. We tie this all together in the time we have left. 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 12 months?
Yeah. We get lumped with other enterprise telecom companies, and that's an awful neighborhood to be in because the Internet is deflating the industry and cannibalizing legacy products. We buck that trend because we focus very efficiently on the fastest-growing but also most commoditized part of the market. I think in the core Cogent business, our product differentiation is still misunderstood by investors. Our ability to grow top line when everyone else is shrinking, expand margins. On the Sprint acquisition, I think investors scratch their heads and say, "This is a 40-year-old network, you know, how can it be worth anything?" Sometimes it's better to be lucky than smart. The original fiber that was deployed actually turns out to be better for coherent transmission than the fibers that were deployed in the late 1990s and early 2000s.
It's a long, unique right of way. It was buried in armored cable. The downside is it's very hard to pull additional fiber. With the advances in optronics, you don't need that. I think the other part of the Cogent story that's maybe not fully appreciated is our ability to repurpose those assets. It's not like we've never done this before. You know, Cogent started out in 1999 to build a network organically. When the dot-com meltdown occurred, we did 13 acquisitions and built Cogent out of those repurposed assets. We waited for 16 years till the next opportunity came along, and I think investors will be rewarded because of our patience.
It's a great place to end it. Dave, thank you again.
Matt, thank you for hosting me, and thanks, everyone.