Good morning, and welcome to the Cogent Communications Holdings First Quarter 2016 Earnings Conference Call. As a reminder, this conference call is being recorded, and it will be available for replay at, www.cogentco.com. I would now like to turn the call over to Mr.

Dave Schaeffer, Chairman and Chief Executive Officer of Cogent Communications Holdings. Sir, please go ahead..

Yeah, thank you, and good morning to everyone. Welcome to our first quarter 2016 earnings conference call. I'm Dave Schaeffer, Cogent's Chief Executive Officer, and with me on this morning's call is Tad Weed, our Chief Financial Officer.

We are very pleased with our results for the quarter, and are optimistic about the strength of our business and our outlook for the remainder of 2016. Our quarterly revenue growth rates and traffic growth rates accelerated both on a sequential and year-over-year basis.

For the quarter, we achieved sequential revenue growth of 3% and year-over-year revenue growth of 11.4%. On a constant currency basis, we achieved sequential quarterly revenue growth of 3% and year-over-year revenue growth of 12.2%. For the quarter, we achieved sequential traffic growth of 12% and year-over-year traffic growth of 45%.

Our EBITDA, as adjusted increased by 14.2% from the first quarter of 2015 to $35.6 million. Our sales rep productivity was again at 6.3 units per full time equivalent rep per month, a rate that's significantly above our long-term historical average of 4.9 units per FTE per month, and equals our highest rep productivity rate in our history.

Our sales rep turnover rate was substantially lower at 3.4% per month. This is significantly better than our long-term average rate of rep turnover of 6% per month. We achieved historically low bad debt, low customer churn and our days sales of accounts receivable were again improved.

During the quarter, we returned over $16.2 million to our shareholders through our regular dividend. At quarter-end, we had a total of $47.8 million available under our stock buyback program whose authorization continues through the end of 2016. We continue to remain confident about our growth potential and our cash generating capabilities.

As a result, as we indicated in our press release, we have announced yet another increase in our regular quarterly dividend from $0.36 a share to $0.37 a share quarterly. This represents our 15 consecutive increase to our regular quarterly dividend. Throughout this discussion, we'll highlight several operational statistics.

I will review in greater detail some of the operational highlights and trends in the business, and Tad will provide some additional detail on our financial performance. Following our prepared remarks, we'll open the floor for questions-and-answers. Now, I'd like Tad to read our Safe Harbor language..

Thank you, Dave, and good morning, everyone. This earnings conference call includes forward-looking statements. These forward-looking statements are based upon our current intent, belief and expectations.

These forward-looking statements and all other statements that may be made on this call that are not historical facts are subject to a number of risks and uncertainties and actual results may differ materially. Please refer to our SEC filings for more information on the factors that could cause actual results to differ.

Cogent undertakes no obligation to update or revise forward-looking statements. If we use any non-GAAP financial measures during this call, you will find these reconciled to the GAAP measurement in our earnings release which is posted on our website at, cogentco.com. I'll turn the call back over to Dave..

Hey, thanks a lot, Tad. Hopefully, you've had a chance to review our earnings press release. Our press release includes a number historical metrics. We continue to anticipate our full year revenue growth for 2016 over 2015 on a constant currency basis will be within our long-term revenue growth guidance range of 10% to 20% on a yearly basis.

On a constant currency basis, our quarterly revenues increased by 3% sequentially from the fourth quarter of 2015 and 12.2% from the first quarter of 2015. Our EBITDA, as adjusted increased by 14.2% on an absolute basis from the first quarter of 2015 to $35.6 million for the first quarter of 2016.

Our EBITDA margin as adjusted improved by 80 basis points from the first quarter of 2015 and was 32.9%. Gains on equipment transactions were $1.9 million for the first quarter in 2016 as compared to $2 million in the fourth quarter of 2015, and $1.5 million in the first quarter of 2015.

We anticipate our total equipment gains for 2016 will be similar to that of 2015 and we will return to 200 basis points year-over-year of EBITDA margin expansion as adjusted for full year 2016 over 2015. Our revenue and EBITDA guidance are intended to be long-term goals. They are not intended to be specific quarterly guides.

Our EBITDA, as adjusted was impacted by the amounts of equipment gains as well as our legal expenditures in support of net neutrality, and our litigation with one of the parties that is violating net neutrality. Tad will now cover some additional details on our results for the quarter..

NetCentric customers and Corporate customers. Our NetCentric customers buy large amounts of bandwidth from us in carrier-neutral data centers and our Corporate customers buy bandwidth with from us in large multi-tenant office buildings.

Revenue from our Corporate customers grew by 3.2% sequentially from the fourth quarter of last year to $64.6 million and grew by 17.2% from the first quarter of 2015. Revenue from our NetCentric customers increased sequentially from the fourth quarter by 2.7% to $43.7 million and increased by 3.8% from the first quarter of last year.

Our European revenue was almost entirely NetCentric revenue, and accordingly, is particularly vulnerable to the impact of variations in foreign exchange. On a constant currency basis, our NetCentric revenues grew by 5.8% from the first quarter of last year. Information on customer connections by product class.

Our on-net revenue was $78.7 million for the quarter, which was a sequential quarterly increase of 2.9% and an increase of 10.5% from last year. Our on-net customer connections increased by 3.9% sequentially, and increased by 16% from the first quarter of last year.

We ended the quarter with over 47,200 on-net customer connections on our network in our 2,271 total on-net multi-tenant office buildings and carrier-neutral data center buildings. Our off-net revenue was $29.4 million for the quarter, which was a sequential quarterly increase of 3.3% and an increase of 14.1% from the first quarter of 2015.

Our off-net customer connections increased sequentially by 5.2% and increased by 20.2% from the first quarter of last year. And we ended the quarter serving over 7,650 off-net customer connections in over 4,900 off-net buildings. These off-net buildings are primarily in North America. Some information on pricing.

Consistent with historical trends, the average price per megabit of our installed base and for our new customer contracts decreased during the quarter. The average price per megabit for our installed based declined, but at a slower rate of decline, and that decline was 3.1% from $1.52 from the fourth quarter to $1.47 for this quarter.

And the decline was 14.9% from the $1.73 we had for our installed base for the first quarter of last year.

The average price per megabit for our new customer contracts was $0.99, which is a 2.3% decrease from the $1.02 price per megabit for new customer contracts that was sold in the fourth quarter, and a 17.4% decline from the $1.20 for new customer contracts from the first quarter of last year.

These average year-over-year price changes are also impacted by changes in foreign exchange as about half of our network traffic is in Europe. Some information on ARPU, or average revenue per unit. Our on-net and off-net ARPUs decreased sequentially from the fourth quarter, but again, this was a slower rate of decline similar to the price per megabit.

Our on-net ARPU, including both Corporate and NetCentric customers was $566, which was a decrease of 1.4% from $574 from the fourth quarter. Our off-net ARPU which is comprised predominantly of Corporate customers was $1,311 for the quarter. That was a sequential decrease of 1.9%.

Our unit churn rate for on-net and off-net customers both improved during the quarter. Our on-net unit churn rate was 1% for this quarter compared to 1.1% last quarter. And our off-net churn rate was also 1% for this quarter, improvement from 1.3% last quarter. Information on gross margin and EBITDA.

Our gross profit margin was 56.5% for the quarter, which was the same rate as the fourth quarter. Excise taxes included in our cost of network operations expenses and revenues were $2 million for the quarter compared to $1.7 million last quarter.

EBITDA, as adjusted, which is reconciled to our cash flow from operations in all of our press releases in the table in the back, our EBITDA, as adjusted includes gains related to our equipment transactions. And our EBITDA, as adjusted, as Dave said, was $35.6 million for the quarter and the margin was 32.9%.

Net neutrality fees and asset-related gains do have a material impact on our EBITDA and EBITDA, as adjusted calculations, and those amounts can vary materially from quarter-to-quarter. Our legal fees associated with defending net neutrality were $0.5 million for the quarter, and our equipment gains were $1.9 million.

We do experienced some seasonality, and seasonal factors that typically impact our SG&A expenses and consequently our EBITDA, include the resetting of payroll taxes in the United States at the beginning of each year, the cost of our annual sales meeting, which is held in January of each year, cost-of-living, or CPI, increases that typically incur in January at the beginning of each year, and also an increase in the level and timing of our audit and tax services in particularly our year-end audit which is done in February and March.

These seasonal factors typically increased our SG&A expenses, similar to prior years, in the first quarter and they contributed about $1.8 million of our $2.7 million increase in SG&A expenses from the fourth quarter to our first quarter. Earnings per share.

Our basic and diluted income per share was $0.08 for the quarter, an increase from the $0.06 from the fourth quarter, and we actually had a loss of $0.04 for the first quarter of last year. Some information on FX impact. The impact of foreign currencies has reduced the proportion of our business reported in U.S.

dollars outside of the United States to about 22%. About 17% of our first quarter revenues were based in Europe, and about 5% of our first quarter revenues were related to our Canadian, Mexican and Asian operations. Continued volatility in FX rates can materially impact our quarterly revenue and financial results. The average euro to U.S.

dollar rate for the first quarter of this year was essentially the same as the rate for the fourth quarter, so there was no FX impact on our revenues from Q4 to Q1. With the average euro to USD rate for the first quarter of 2015 was $1.13, and the Canadian to USD rate was $0.81.

So from the first quarter of 2015 to the first quarter of this year, we had a negative FX impact of close to $1 million. It was $900,000. The average euro to U.S. dollar rate so far this quarter, this is the average, is about $1.12 and the average Canadian dollar is about $0.77.

If those averages continue at those current levels for the current quarter, so the second quarter of 2016, we estimate that the FX conversion impact on sequential revenues will be a positive impact of about $0.5 million, and the FX impact from Q2 last year to the second quarter of this year would not be material. Customer concentration.

We believe that our revenue and customer base is not highly concentrated. For the first quarter of this year, no customer represented more than 2.2% of our revenues, and our top 25 customers represented less than 8.1% of revenues for this quarter. CapEx for the quarter was $15 million, as compared to $12.9 million for the first quarter of last year.

We typically have an increase in CapEx in our first quarter. Capital leases. Our capital lease principal payments are for long-term dark fiber IRU agreements. These payments were $3.4 million for the quarter, which was a decline from the $3.7 million from the first quarter of last year. Some balance sheet information.

At quarter end, our cash and cash equivalents totaled $196.1 million. For the quarter, our cash decreased by $7.5 million as we returned $22.9 million of capital to our stakeholders through our dividend and debt interest payments.

During the quarter, we paid $16.2 million for our first quarter dividend, and $6.7 million was spent on interest payments on our debt obligations. Our cash flow from operations materially increased this quarter, and was $27.6 million compared to $22 million last quarter, and $18.4 million for the first quarter of last year.

Capital leases and debt information. Our capital lease IRU obligations are for long-term dark fiber leases, and typically have initial terms of 15 years to 20 years or longer, and often include multiple renewal options after that initial term. Our long-term and short-term capital lease obligations totaled $137 million at quarter end.

Our total debt which include capital lease obligations was $606 million at the end of the quarter, and net debt was $409.9 million. Our total gross debt to trailing last 12 months EBITDA as adjusted ratio was 4.39 at quarter end, and our net debt ratio was 2.97.

Lastly, as Dave mentioned, we have fantastic bad debt results for the quarter, and our bad debt for the quarter was significantly improved and was only 0.2% of our revenues.

And our days sales outstanding for worldwide accounts receivable was at its lowest level historically and only 22 days at quarter end with just tremendous cash collections from customers. And again, I want to thank and recognize our worldwide billing and collection team members who are doing another fantastic job for the company.

And with that, I will turn the call back over to Dave..

Hey, thanks a lot, Tad. Now, for a couple of comments on our network, scale and scope. The size of our network continues to grow. We have over 834 million square feet of multi-tenant office space in North America directly connected to our network on-net. Our network consists of over 28,300 metro fiber miles, and over 56,100 intercity route miles.

Our network remains one of the most interconnected networks in the world where we are directly connected to over 5,615 networks, of which approximately 30 of these network are settlement-free peers, and the remaining 5,585 networks are paying Cogent customers. We're currently utilizing approximately 28% of the lit capacity in our network.

We routinely augment capacity on parts of our network to maintain these low utilization rates. We operate 51 Cogent data centers with approximately 565,000 square feet of raised floor space. In summary, we believe that Cogent is a low cost provider of Internet access, transit services, and our value proposition remains unparalleled in the industry.

Our business remains completely focused on the Internet and IP connectivity and datacenter collocation, and these services provide a necessary utility to our customers.

We expect our annualized constant currency long-term growth rates to remain in the 10% to 20% rate, and our long-term EBITDA margin, as adjusted, to expand at approximately 200 basis points year-over-year for multiple years. We have incurred material, real and economic analyses fees related to net neutrality.

These were about $0.5 million in the first quarter of 2016. And for full year 2015 we spent $3.7 million. We continue to incur additional fees in 2016, but we expect these fees to continue to decline and be less than full year 2015. Our board of directors approved yet another increase in our regular quarterly dividend to $0.37 a share.

Our dividend increase demonstrates our continued optimism regarding the cash flow capabilities of our business. We are opportunistic about the timing of purchase of our common stock.

At quarter end, we have $47.8 million remaining under our current authorization for buybacks which runs through December of 2016, but is currently limited due to certain of our debt covenants. We are committed to returning an increasing amount of capital to our shareholders on a regular basis. With that, I'd like to open the floor for questions..

And our first question comes from the line of Colby Synesael with Cowen and Company. Your line is now open..

Great. Two questions, if I may. First off, on the builder basket and how that ties back into the desire, or ability to give capital back to investors? A few quarters ago, you suspended your quarterly – I think it was $12 million at the time minimum distribution, and I think it was tied to this.

When would you anticipate reinstating some form of additional capital distribution in addition to the dividend increase we've been seeing now for those, I think you said 15 quarters? And what's the likelihood on that, that you would actually put in place a minimum, like the $12 million that you had previously, or doing it in some other form? And then my other question is on your notes payable.

So back in the second half of 2015, we started to see a form of notes payable grow, I think something to the tune of maybe $19 million now as at the first quarter.

Can you give us a little bit more color on what that is? What's the interest rate that you're paying on that? And then perhaps how you expect to pay that down? It looks like there's now a new line item tied to debt payment of around $2 million, which I'm guessing is tied to that. Just a little bit of color on all those things would be helpful.

Thanks..

Yeah. Sure, Colby. Thanks for the questions.

First of all, with regard to our access to capital that is sitting at our operating company level, we have approximately $135 million at the operating company level that has been accrued in a builder basket, but cannot be dividended between the operating company and the holding company until our gross leverage falls below 4.25-to-1.

We're today at about 4.39-to-1. We do expect in 2016 for that gross leverage ratio to fall below the 4.25-to-1, and therefore be able to move capital from the operating company to the holding company. It's at the holding company level that we then make distributions to shareholders in the form of both buybacks and dividends.

Cogent has returned approximately $400 million to-date to equity holders through a combination of buybacks and dividends. That return of capital has been basically equally split with about half of the capital being returned through dividends, about half of it being returned through buybacks.

We think that's probably a reasonable balance to continue going forward. We are committed to our regular dividend, and we also believe that the growth in our business will allow us to continue on the pace of growing that dividend.

With regard to a specific commitment, whether it's $12 million a quarter, or some different number, I think the board will address that as soon as the builder basket becomes available at the holding company level, and we can begin to return more than just our regular dividend to our equity holders..

So at least at this point then, Dave, I mean, with all those parameters, I guess the takeaway would be that you will get below that leverage threshold on the growth side this year. That will enable you to start allocating more capital back to investors, which you intend to do. But the form and size has yet to be determined by the board.

But we should expect some form of additional capital redistribution to shareholders later this year at some point?.

I think that's a fair summary. That is correct Colby..

Okay..

And then for your second question with regard to the note payable to our vendor Cisco, that note actually bears no interest, it's i.e., a zero interest note. That note was related to certain equipment and software that we needed to make upgrades to our network.

We are in the process of repaying that note, and it will be repaid over the next several years..

Okay. Great. Thank you..

And our next question comes from the line of Eric Pan with JPMorgan. Your line is now open..

Good morning, guys. Thanks for taking the question. Seen nice growth on the NetCentric side this quarter.

Can you give us an update on where you are in terms of the port upgrade, and are you seeing any congestion? And then where are you in terms of the negotiation with Orange and Telefónica and litigation with Deutsche Telekom?.

Hey. Great, Eric. Thanks for the question. First of all, our NetCentric revenue growth grew 2.7% sequentially, and on a constant currency basis grew 5.8% year-over-year, which is an acceleration, but is still below our historical trend line at least on a year-over-year basis. So we do anticipate continued room for improvement.

In terms of that revenue growth occurring, we obviously need to see continued acceleration in traffic growth. We saw our year-over-year traffic growth grow to 44%. We saw our sequential traffic growth grow to 12%. Those are both improvements over the previous quarter.

We also continue to see moderation in the rate of price decline on our price per megabit, which also helps our revenue growth in that business.

Now, in terms of specific port congestion, with the five major North American ISPs that were refusing to upgrade, four of the five providers today have adequate connectivity to Cogent, and there is no congestion. Only CenturyLink remains congested.

We have an agreement in place, and both parties have been actively installing additional port capacity, but it is an ongoing process. It may take another quarter or so to be fully completed. With regard to the three European providers, the story is different in each case.

In the case of Telefónica, we actually publicly announced yesterday a new bilateral peering agreement. That agreement matches the terms that we've gotten here in the U.S.

It's a long-term agreement and it calls for substantial port upgrades in Europe and in North America to support our connectivity to some of Telefónica's Latin American assets as well as their European assets. With regard to Orange, we have had continued slow, but some upgrades to ports and the parties are still negotiating a final agreement.

And then finally, with regard to Deutsche Telekom, there is a settlement for a peering agreement in place between the parties. Deutsche Telekom has breached that agreement, and we have sued them in Eastern District of Virginia Federal Court to try to enforce that contract.

And that litigation is underway, so I probably can't comment much beyond the fact that the litigation is occurring..

Great. And then maybe on the higher CapEx in the quarter.

Can you give us some color on what that was spent on? Just by adding fewer on-net buildings this quarter?.

Yes. So, if we look at our CapEx, it typically spikes up in the first quarter. First quarter from fourth quarter is always traditionally the lowest.

Also, we're doing construction work and incurring costs for some buildings that are not necessarily added in the quarter and it's effectively construction-in-progress that will show up in subsequent quarters. And you need to look at the CapEx number in conjunction with capital leases.

So if we looked at first quarter last year, we spent $12.9 million in CapEx, $3.7 million in capital leases. This year in the first quarter, we spent approximately $15 million in capital and $3.4 million in capital lease payments, principal payments. So the net delta was about $1.6 million, or about an 8% increase over last year.

Quite honestly, it's just a bit lumpy and there's going to be that type of volatility on projects. So as we look at what we spent the capital on, we've continued to make substantial upgrades in our network in terms of capacity. Our utilization fell from 30% to 28%, even though our traffic grew 44%.

We had some remedial work at some of our data centers that we did some air conditioning and power work. There was no one item that stood out particularly, but rather a fair number of small items.

And then finally on capital, we expect that total capital number, which is principal payments of capital leases and CapEx, to continue to decline on a year-over-year basis, but there will be some quarterly volatility..

Got it. Thank you for taking the questions..

Hey, thanks, Eric..

And our next question comes from the line of Nick Del Deo with MoffettNathanson. Your line is now open..

Hi, thanks for taking my question. Following up on Eric's question, you didn't add many MTOBs this quarter, but you're suggesting there will be more buildings coming online in the future.

Can you update us on where you stand with respect to the number of MTOBs that you think you can profitably add to the network?.

Yeah. Sure, Nick. As we've commented multiple times to investors, we remain very, very disciplined about where we deploy capital in buildings. There's probably another 50 or so MTOBs, or multi-tenant office buildings that we will add to our network that are currently constructed.

Also, in addition to that, every year there's both a few new large buildings being constructed, I know there's a couple in New York, a couple in Chicago that are going to be coming online over the next few months.

And then finally, the sales force occasionally will identify a few additional opportunities, but I do think you should expect to see the number of multi-tenant office buildings added continue to decline and asymptotically approach something close to zero over the next couple of years.

With regard to adding data centers, we continue to see robust capital inflows into the data center space, and a number of new data centers coming on market. So, I actually think we'll see a slight acceleration in 2016 over 2015 in the number of data centers that we will connect to our network.

These are not Cogent data centers, but rather third-party carrier-neutral facilities..

Okay. Great. And then over the last year, year and a half, obviously you added a bunch of Cogent owned data centers to the network.

Can you talk a bit about how those have been performing, and the degree to which they're contributing to your performance?.

Sure. So, data center space and power represents about 3.2% of our revenues. We're running at about 29% occupancy in our 565,000 square feet of raised floor space across those facilities. Prior to that surge in data center expansion in 2014, we have seen our utilization climb to over 37%.

So we're about eight percentage points below where we historically have been, and accomplished our goals to get to as close to 100% as is practical. We continue to sell those services.

They do continue to be an amenity to help us expand our bandwidth sales, but we should return to a much more modest rate of data centers added to our network – Cogent-owned data centers, of two data centers to three data centers a year which has been our historical run-rate prior to 2014..

Okay. Perfect. Thanks..

Hey, thanks, Nick..

And our next question comes from the line of Walter Piecyk with BTIG. Your line is now open..

Hey, Dave. How are you doing? Can you scale the amount of the CapEx decline, I think you have in response to a question or two ago, I forget who had asked it. You were saying it was going to come down, last year it was down, I think like 25%, 30%.

So can you give us a sense of what it'll be down for the year?.

It will definitely be down for the full year but probably not as large of a step-down in 2016 versus 2015 as it was in 2015 over 2014. And the reason for that more rapid rate of decline was the fact that we weren't adding as many data centers which did require some capital to refurbish those centers and bring them up to code.

Even though they were built out, we were not building them from scratch. When we took over these vacant facilities, we oftentimes had to do augmentations to the fire and power systems to bring them up to current code requirements. The fact that we added many less facilities in 2015 than 2014, that was the main reason for the pronounced step-down.

Gradually, over the next few years we expect our capital each year sequentially to come down, but as I said, it'll probably be less than 25% reduction this year..

Well, that's a pretty big gap between zero and 25%, so can you give us some sense of how much it would come down?.

I think 10% is a more reasonable percentage to think about..

Got it. And then my quarterly question, I think this is on Netflix. Is it still growing above your overall NetCentric rate? And then kind of a twist on that is there's been some additional commentary of other content distributors that are kind of morphing into that model.

So, I'm just curious, can you give us any color on whether you're seeing any of that new traffic, new customers, or maybe existing customers starting to ramp up the amount of traffic they're about to deliver?.

Sure. So, Netflix continues to be a significant customer of Cogent. Their percentage of our revenue stay effectively constant at 2.2% sequentially. Reminding people on the call, the more people buy, the lower their price per megabit gets, and that's true of all of our customers.

With regard to other video distribution businesses, we're seeing some significant upticks from a couple of other very large household names, and we're also seeing a lot of startups, as well as some direct content libraries that are being made available by the content owners.

So I think we're still at the very early stages of over-the-top acceleration, and we expect continued improvement and the fact that we remain the lowest cost solution, as well as the fact that we have adequate connectivity to these terminating networks are all positives for that business.

It's very hard to take those long-term trends though and project specific quarterly results.

For example, and I'm not trying to be pessimistic here, but typically, in the summer months people watch less video, both linear and over-the-top than they do during colder months, and that tends to impact the rate of sequential traffic where it's not necessarily year-over-year, but sequential.

I think Netflix is no different than any of the other video providers, and they probably see minutes of usage go down slightly in the summer months..

Is there any chance you could benefit from any type of Olympic traffic? And is Hulu a customer?.

So, in terms of Olympic traffic, the answer is, probably yes, although obviously these Olympics haven't occurred yet, we did benefit both with the last winter Olympics, and the previous summer games. I would expect that will happen again this year, and in fact some those providers have in fact ramped up port capacity to us in advance of that.

With regard to your specific question of Hulu, I have to be a little careful based on NDAs, but we provide capacity, which I am allowed to speak about to many of Hulu's content owners, and I'll just leave it at that..

Okay. Great. Thank you, Dave..

Hey, thanks, Walt..

And our next question comes from the line of Louie DiPalma with William Blair. Your line is now open..

Good morning, Dave and Tad. This is Louie DiPalma on behalf of Jim Breen.

As a follow-up to the builder basket question, does your board meet on a quarterly basis such that if your gross leverage falls below 4.25 for the second quarter, it would be possible for you to announce a new capital return program in August on your next earnings call?.

So the board does meet at minimum four times a year in advance of each of our earnings calls. And also, it meets on a more ad hoc basis intra-quarter, if necessary. And the board does review our leverage, our return of capital program at every board meeting. That is a key topic that's discussed.

It would be presumptuous of me to kind of lead you to the conclusion of where the board's going to be when it's presented the results of Q2. But I can assure you they will review it..

Okay. And as a follow-up to Walt's question, streaming video is obviously a major driver of Internet traffic and it's big for your NetCentric business.

Can you discuss the impact on Cogent's business of the recent trend of cellular carriers and content providers compressing streaming video resolution over cellular endpoints, and zero-rating data traffic in general?.

Sure. So anything that promotes the migration of traffic from linear sources to over-the-top, and increases the number of minutes of consumption, is a net positive for Cogent. We're in the business of selling bits, and we'll sell to either side.

So if one side elects not to charge its customers and if that increases unit demand, that's a net positive for us. In terms of compression, there has been a historic trend of improvement in linear compression for the past dozen years averaging about 7% per year.

Those compression algorithms are more effective in small screen applications than large, just because the imperfections of the compressed data are less visible. So I don't think you need the same pixel count on a 4-inch screen that you need on a 70-inch screen to have a positive user experience.

So net-net, I think it's a positive that people are watching more video mobilely. Also, I want to caution investors, mobile still represents a very small percentage of global internet traffic..

Great. Thanks, Dave..

Hey thanks, Louie..

And our next question comes from the line of James Moorman with D.A. Davidson. Your line is now open..

Thanks for taking the question. Just in continuation of what you were – on the over-the-top comment.

So in terms of, as we go forward it sounds like we're just in the beginning – early stages of this and now that you're kind of free or largely free of congestion will there – do you think with the contracts in place that you'll be able to keep timely capacity of the peering ports up-to-speed as that traffic grows? And then second question, just kind of update on the sales force.

It looks like things have really taken hold.

Could you just differentiate between, NetCentric was a little bit behind Corporate, just kind of where we are with NetCentric kind of improving on the sales force side?.

Yeah sure, Jim. So first of all, with regard to interconnection capacity, remember, about 62% or 63% of our interconnection occurs with our customers. And it's our sales force's job to constantly go to those customers, show them that their ports are congested and they need to buy more capacity, and oftentimes that results in a lower price per megabit.

So that's all very positive and there's never really been an issue on the paying customer side. On the peer side, because there is no money is changing hands in these agreements, we put forward a projection, the other side puts forward a projection, and quite honestly, Cogent grows about twice as fast as the Internet has grown.

And often times there's debate on whose projection is correct. We both go through a process of upgrading. Once those upgrades are in place, if there's more that needs to be done, there's a second, a third and often a fourth round. So I think this is a little bit like a hamster on a treadmill, and that we're constantly running.

But we've got agreements in place, we're keeping them with penalties and with a commitment to continue to upgrade. So I feel pretty comfortable that we're going to continue to see no issues with ports as they've been upgraded. Now, with regard to the sales force, our sales force is largest it's ever been.

Our number of full time equivalents are the most we've ever had. And our productivity is the highest it's ever been. Those are all great things. On the NetCentric side, we have seen our revenue growth accelerate both sequentially and year-over-year.

That will continue, and we are continuing to add people to our NetCentric sales team, but we do have more adds that need to occur..

Great. Thanks, Dave..

Hey, thanks, Jim..

And our next question comes from the line of Frank Louthan with Raymond James. Your line is now open..

Great. Thank you. Looking at your long-term guidance on the margin expansion. It looks like you've seen the gross margins flatten out a little bit. It seems like it's kind of being negatively increased by the off-net sales.

Can you talk about why your long-term guidance is still appropriate given sort of the trend we see in the margins, and when do we expect to see some of that margin leverage over the next year or two years? Thanks..

Yeah. Sure, Frank. So a couple points. First of all, we did demonstrate 80 basis points year-over-year of margin expansion. Secondly, on a year-over-year basis, we actually have about 90 basis points of drag from the flow-through of USF. Remember, we're collecting USF and that hits our cost of goods sold this year.

It did not last year as our VPN service customers were not subject to USF prior to mid-June of last year. So that's had a bit of a drag on the rate of margin expansion. That's just a straight pass-through. Our contribution margins are in the high 40%s today; they'll actually continue to improve.

You are correct that our off-net business does carry a lower contribution margin than our on-net business, but our off-net growth has actually been fairly similar to our entire business growth. So if we look to sequentially growing 3.2% off-net versus 3% for the whole business, it's roughly equivalent.

And if we actually looked on a year-over-year basis, since our off-net business is almost entirely in our Corporate customer segment, our total year-over-year Corporate revenue growth, and this does include USF pass-through was 17.2%. Off-net was actually only 14.2%. So therefore, the on-net portion actually corporately grew closer to 19%.

So net, net we feel that our on-net business, which is 73% of revenues will continue to be the key driver and that carries much higher contribution margins. So again, we feel comfortable with the 200 basis points year-over-year for the next several years.

And while there could be some lumpiness in the quarter, and particularly, some of the abnormal expenses that Tad's talked about in Q1 you'll see, I think even better for flow-through in Q2..

Okay. Great. Thank you..

And our next question comes from the line of Michael Rollins with Citi. Your line is now open..

Hi, Dave. Thanks for taking the question. Just a follow-up on the margins point and some of the questions on the expenses.

Can you talk about where you see the mature size of your sales force? And to get from here to there, how much more investment may be needed, and maybe you can give a sense of the timeframe over which you'd like to achieve that? Thanks..

Yeah. Sure, Mike. So we had under-invested in our sales force in the 2009 through 2013 timeframe. We had under-invested in training, under-invested in hiring, and as a result, our growth rate decelerated and our sales force size stagnated at about 250 reps.

We then in 2014 went through a very rapid period of growing the sales force almost 40% in six quarters. We're now returning to a more moderate rate of sales force expansion, and we expect that to be in the order of 8% to 10% year-over-year.

So meaning, the roughly 400 people or 398 people that we had at the end of first quarter of this year, will be about 435 people to 445 people by first quarter of next year. We expect that to continue for the next couple of years.

We will then have I think reached a bit of a plateau as our on-net Corporate addressable market, which is really about three quarters of the sales force, will have been pretty well-saturated, and then I would actually expect the sales force to actually start to decline. But I think that's several years out.

And on the NetCentric opportunity, as I mentioned earlier, we're continuing to invest, hire and train those reps. So we expect kind of that 8% to 10% growth for the next few years, and then a couple years of plateau, and then maybe a slight rate of decline in sales force size..

Thanks very much..

And our next question comes from the line Michael Bowen with Pacific Crest. Your line is now open..

Thanks, Dave. Thanks for taking the question.

Following up on that, with regard to the adds in the sales force, I'm sorry if I missed it, but could you give a split between how many you added in NetCentric versus Corporate? And then secondly, with sales rep productivity, we can do the math obviously, but can you kind of give us some thoughts as far as revenue productivity, not only in the quarter, but where you might see that going over the course of 2016? Thanks..

Yeah. Hey, sure, Michael. So as we've said earlier, we are going to continue to grow our Corporate sales force, but we need to grow our NetCentric sales force at an even more rapid rate. Today, we're roughly three quarters Corporate and about a quarter NetCentric.

We need to change those ratios slightly and get back to our historical long-term average of roughly two-thirds Corporate and one-third NetCentric. So, as we think about that next – 40 or so reps over the next 12 months, more will be NetCentric than Corporate.

In terms of revenue productivity, we actually divide the sales force into four groups, senior and junior Corporate reps, senior and junior NetCentric reps. And the best revenue productivity and the lowest cost of revenue acquisition actually comes from the most senior reps in each of the two categories.

But, you know, we continue to see an improvement overall in unit productivity and an improvement in revenue productivity as well, and that's why our growth rate is really accelerating. I don't know if I could be that much more specific, but we continue to see more reps and more productivity..

So this quarter did you add more on the NetCentric side out of the 20 incremental?.

No. In absolute numbers, we added more Corporate than NetCentric. But we, as a percentage added more NetCentric..

Okay.

And where do you expect in the marketplace to be able to pick up, and maybe you can't be that specific, but what's going to be the draw to get some of these NetCentric, these and the folks over to Cogent?.

Well, that's actually pretty simple. Most of the people who come NetCentric had sold against us at another provider and are typically unhappy about losing to us, so they prefer to come to Cogent where they can get a higher close rate, a higher probability of success just because of our lower pricing.

So it's really our other NetCentric competitors, whether it be an NTT or a Telia, Level 3 or some of the smaller resellers, we're bringing reps over from those players as well as from the legacy providers to continue to de-emphasize transit sales..

Okay. Thanks. Just make sure you don't put junior on the business cards. Thanks, Dave..

Hey, Michael..

And our next question comes from the line of Jonathan Atkin with RBC Capital. Your line is now open..

Yes. I was interested in whether the mix of data center revenues or off-net revenues going forward and any reason to expect that that might change relative to the current composition? And then with respect to sales and any initiatives in the indirect channel, I know you've dabbled in that a little bit, but any kind of update there? Thanks..

Yeah. Sure, Jonathan. I'll take them in reverse order. First of all, indirect continues to improve for us. We've actually expanded our indirect channel team. It today accounts for about 5% of new sales in the last quarter. That's up from 2% historically, and we are continuing to see good improvement there, and we continue to invest in it.

So it remains at 5% much lower than any of our peers that we're comped to as a percentage of sales. Now, with regard to product mix, let's start with data centers. Clearly, with our vacancy rate higher, our occupancy rate lower at 29%, we need to accelerate that.

We've actually implemented a certification program for our reps to get certified in being more competent in selling data center space, and they actually once receiving that certification get some additional quota relief on data center sales. So I think that's a positive to help accelerate that.

I don't ever think it becomes a material part of our business, but it probably gets closer to 4% than 3% it is today. With regard to off-net, most of our off-net sales are driven by on-net relationships. Oftentimes, driven by the requirements of VPLS services, i.e., private networks or VPNs.

And as I said, our off-net business is entirely Corporate and it grew slightly less rapidly than the total Corporate business. On a year-over-year basis, it actually grew slightly faster in the quarter.

I would expect it actually this quarter to maybe grow a little slower just simply because of the challenges that Verizon has in provisioning off-net services due to their strike. But kind of over time, I think the on-net Corporate and off-net Corporate should grow at about the same rate..

Great. Thank you..

Hey, thanks, Jonathan..

And we have a follow-up question from the line of Colby Synesael with Cowen and Company. Your line is now open..

Yeah. Hi, I just had a modeling question. With USF becoming a bigger portion now of revenues, I just wanted to confirm a few things. One is, that's just being reported in on-net Corporate, I believe, just want to confirm that.

And second, how would you suggest that we model that? Is that based on a percentage then of revenue and we should try and think of that as a percentage of on-net Corporate, or should we keep the $2 million flat on a go-forward basis? Just any color you can we provide just as we start to perhaps more explicitly think about that..

I'm going to give that one to Tad since he's the USF expert at Cogent..

Yeah. That's fine, yes. USF is actually allocated between on-net and off-net, so it's included in both, and they're primarily Corporate customers. It's about the same mix as the overall revenue, so call it about 80/20 which is about our new sales mix between on-net and off-net.

The percentage that's applied to the Layer 2 revenues depending upon on the rate established each quarter, it's about 17% of revenue this quarter, I think it might be 17.9%. So that's a quarterly rate that's established by USAC. But it's that percentage of our Layer 2 revenue..

So is there a simpler way for us that don't have that explicit of detailed numbers to think about that in terms of how to model that or (01:00:43)?.

A couple of million a quarter is probably the best way....

Yeah, it was about $2 million this quarter. You could kind of assume it will grow consistent with our overall growth rate..

Okay. Great. Thank you..

And I am showing no further questions at this time. I would now like to turn the call back over to Dave Schaeffer with any closing remarks..

I'd just like to thank the entire Cogent team for a great effort, our sales organization, and thank everyone for taking time to listen, and we'll be chatting soon. Take care. Bye-bye..

Ladies and gentlemen, thank you for your participation in today's conference. This concludes today's program. You may now disconnect. Everyone have a great day..