David Schaeffer - Cogent Communications Holdings, Inc. Thaddeus G. Weed - Cogent Communications Holdings, Inc..
Walter Piecyk - BTIG LLC Scott Goldman - Jefferies LLC Matthew Niknam - Deutsche Bank Securities, Inc. Colby Synesael - Cowen & Co. LLC Timothy Horan - Oppenheimer & Co., Inc. Nick Del Deo - MoffettNathanson LLC Michael J. Funk - Merrill Lynch, Pierce, Fenner & Smith, Inc. James D. Breen - William Blair & Co. LLC Michael I. Rollins - Citi Research.
Good morning, and welcome to the Cogent Communications Holdings Third Quarter 2017 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 conference over to Mr.
Dave Schaeffer, Chairman and Chief Executive Officer of Cogent Communications Holdings. Please begin..
Good morning, and thank you all for joining our call today. Welcome to our Third Quarter 2017 Earnings Conference Call. I'm Dave Schaeffer, Co-Chair and CEO, and with me on this morning's call is Tad Weed, our CFO.
We are pleased with our results for the quarter and continue to be optimistic about the underlying strength in our business and the outlook for the remainder of 2017, 2018, and beyond. We achieved sequential revenue growth on a quarterly basis of 2.7%.
Our sales rep productivity was 5.7 units installed per full-time equivalent rep per month, a productivity rate that was again significantly above our long-term historical average of 5.1 units per full-time equivalent sales rep per month.
Despite incurring $824,000.00 in net neutrality fees in the quarters, EBITDA increased by $3 million, or 8.2%, from the third quarter of 2016. Our capital expenditures decreased by 7.5% for the nine-month period ending on September 30, 2017 when compared to the comparable period in 2016.
Our capital and capital lease expenditures for 2016 nine-month period were $38 million as compared to $35.2 million for this nine-month period. For the quarter we achieved an increase in our traffic growth rates.
We achieved and accelerated a sequential quarterly traffic growth rate of 8%, a significant increase from the 3% sequential rate we reported last quarter, and also our year-over-year traffic growth improved to 27%. During the quarter, we returned $20.9 million to our shareholders through our regular dividend program.
At quarter-end, we had a total of $41.5 million available for stock buybacks under our stock buyback authorization, which continues through December of 2018. Our gross leverage ratio improved to 4.57 times EBITDA as compared to 4.26 in the previous quarter.
And our net leverage remained relatively constant and was at 3.00 times at the end of the quarter. We ended the quarter with $250,800,000 in cash on our balance sheet. Of this cash, $84.2 million is held at the holding company, and therefore, is available for dividends, other unrestricted uses, or buybacks by the companies.
We continue to remain confident about our growth potential and the cash generating capabilities of our business. As a result, as indicated in our press release, we announced yet another $0.02 per share sequential increase in our quarterly dividend, raising our regular quarterly dividend from $0.46 a share to $0.48 a share.
This represents the 21st consecutive quarter in which Cogent has been able to raise its regular quarterly dividend. Throughout this discussion we'll highlight several operational statistics, I'll review in greater detail some operational highlights, and Tad will provide additional details on our financial performance.
Following our remarks, we'll be happy to open the floor for questions and answers. Now I'd like to turn it over to 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 will turn the call back over to Dave..
Hey, thanks, Tad. Hopefully you've had a chance to review our earnings press release. Our press release includes a number of historical quarterly metrics, which are reported on a consistent basis. Now for a moment about expectations against our long-term guidance.
Our targeted guidance is for a long-term full year revenue growth on a constant currency basis of between 10% and 20%. We are slightly below that today, but have historically been within that range. Our long-term EBITDA as adjusted annual margin expansion is targeted to be approximately 200 basis points per year.
Again, this is a range in which we have traditionally performed. Our revenue and EBITDA guidance targets are intended to be long-term, and not intended to be used either for specific quarterly or even given annual guidance, but rather are designed as multi-year targets.
Our EBITDA as adjusted is impacted by the amount of our equipment gains, our expenditures on net neutrality, and seasonality effects of certain SG&A expenses. All of those factors, in fact, influenced our performance this quarter. Tad will now cover some of our additional financial results for the quarter..
net-centric customers and corporate customers. Our net-centric customers buy large (07:30) amounts of bandwidth from us and carrier neutral data centers. Our corporate customers buy bandwidth from us in large multi-tenant office buildings. Revenue from our corporate customers grew sequentially by 2.8% to $76.5 million, and year-over-year grew by 11.7%.
We have 36,883 corporate customer connections on our network at quarter-end. Revenue from our net-centric customers grew subsequently by 2.5%, and year-over-year grew by 4.3%. We had 32,534 net-centric customer connections on our network at quarter-end.
Our net-centric revenue growth experiences more volatily than our corporate revenues due to the impact of foreign exchange and certain seasonal factors. On revenue customer connections by product class, on-net revenue was $87.9 million for the quarter, which was a sequential quarterly increase of 2.7% and a year-over-year increase of 7.4%.
Our on-net customer connections increased by 3.6% sequentially and increased by 16.2% year-over-year. We ended the quarter with over 59,300 on-net customer connections on our network in our 2,472 total on-net multi-tenant office buildings and carrier neutral data center buildings.
Our off-net revenue was $34.9 million for the quarter, which was a sequential quarterly increase of 2.6% and a year-over-year increase of 12.6%. Our off-net customer connections increased sequentially by 4.2% and by 17.7% year-over-year.
We ended the quarter serving over 9,700 off-net customer connections and over 6,100 off-net buildings, and these off-net buildings are primarily in North America. Some comments on pricing. Consistent with historical trends, the average price per megabit of our installed base and for our new customer contracts decreased for the quarter.
The average price per megabit for our installed price declined sequentially by 7.4% from the second quarter to $1.08, and declined from 15.7% from the third quarter of last year.
The average price per megabit for our new customer contracts, actually, was flat at $0.54, which was the same price as the second quarter, and year-over-year was a 47.7% decline. Some comments on ARPU. Our ARPU has decreased sequentially but at a lower rate of decline from the decline that we experienced last quarter.
Our on-net ARPU, which includes both corporate and net-centric customers, was $502 for the quarter which was a decrease of 1.3% sequentially. Our off-net ARPU, which is comprised predominately of corporate customers, was $1,220 for the quarter which was a 1% decrease from the second quarter for 2017.
Churn rates, our on-net turn rate improved sequentially and our off-net churn rate was stable during the quarter. Our on-net churn rate improved to 1% for the quarter, which was an improvement from the 1.2% we experienced last quarter. And our off-net churn rate was the same this quarter as last quarter, and was 1.1%.
We offer discounts related to contract term to all of our corporate and net-centric customers, and we also offer volume commitment discounts to our net-centric customers.
During the quarter, certain net-centric customers took advantage of our volume and contract term discounts and entered into long-term contracts for over 2,400 customer connections, which increased their revenue commitment to Cogent by over $23.2 million. Some comments on EBITDA and EBITDA as adjusted.
Our EBITDA and EBITDA as adjusted are reconciled to cash flow from operations in all of our press releases. Our EBITDA as adjusted includes gains related to our equipment transactions. And our EBITDA as adjusted decreased by $0.5 million, or 1.3% sequentially, to $40.6 million, and increased year-over-year by $2.7 million, or 7.2%.
Our EBITDA as adjusted margin decreased sequentially by 130 basis points to 33%, and decreased by 50 basis points from the third quarter of last year. Our equipment gains, which again are included in EBITDA as adjusted, declined sequentially and also declined year-over-year.
Our equipment gains were $400,000 for the quarter compared to $700,000 for the third quarter of last year, and $1 million last quarter.
The $600,000 sequential decline in equipment gains and the $600,000 increase in net neutrality fees combined, resulted in a $1.2-million negative impact on our EBITDA as adjusted this quarter, and contributed 100 basis points to the 130 basis points sequential decline in our EBITDA as adjusted margin.
Our EBITDA, which does not include asset gains, increased by $100,000, or 0.3% sequentially to $40.2 million, increased year-over-year by $3 million, or 8.2%. Our EBITDA margin decreased sequentially by 80 basis points to 32.7% and decreased by 20 basis points from the third quarter of last year.
The sequential increase in net neutrality fees of $600,000 contributed over 50 basis points to the sequential decline in the EBITDA margin. Seasonal factors that typically impact our SG&A expenses and consequently our EBITDA and EBITDA as adjusted include the resetting of payroll taxes in the U.S.
at the beginning of each year, annual cost of living or CPI increases, the timing and level of our audit and tax services and net neutrality fees, and also the timing and amount of gains on our equipment transactions, and lastly benefit plan annual cost increases.
EPS, our basic and diluted income per share was $0.08 for the quarter compared to $0.10 last quarter, and $0.08 for the third quarter of last year. Some comments on foreign exchange. The impact of foreign currencies has reduced the proportion of our business reported in U.S. dollars outside of the U.S. to about 23%.
About 17% of our third quarter revenues were based in Europe and the remaining 6% of our international revenues were related to our Canadian, Mexican and Asian operations. Continued volatility in foreign exchange rates can materially impact our quarterly revenue results and our financial results.
The foreign exchange impact on our sequential revenue resulted in a $1.7-million increase to our reported revenue. From the third quarter of last year to this quarter, the year-over-year foreign exchange impact on our reported quarterly revenue was a positive $1.3 million. Changes in foreign exchange rates primarily impact our net-centric business.
The average euro to U.S. dollar rate so far this quarter, so the fourth quarter, is approximately $1.18, and the average Canadian dollar exchange rate is $0.80.
Should these rates remain at the current average levels this quarter, we estimate that the foreign exchange conversion impact on our sequentially quarterly revenues will not be material, and the foreign exchange impact on a year-over-year basis will be an approximate $2.1 million positive. Customer concentration.
We believe that our revenue in customer base is not highly concentrated. Our top 25 customers represented less than 6% of our revenues this quarter. Some comments on CapEx. Our CapEx for the quarter was $10.9 million, compared to $8.7 million in the third quarter of last year, and $12 million last quarter.
And as Dave mentioned, our capital expenditures decreased by 7.5% from the nine months ended September 30 last year to the nine months ended September 30 this year, from $38 million to $35.2 million. Cash and operating cash flow. At quarter-end, our cash and cash equivalents totaled $250.8 million.
For the quarter, our cash decreased by $5.7 million as we returned $31 million of capital to our stakeholders. During the quarter, we paid $20.9 million for our third quarter dividend payment, and we paid $10.1 million on a semi-annual interest payment on our debt. Capital lease and capital lease payments.
Our capital lease IRU obligations are for long-term dark fiber leases, and typically have an initial term of 15 to 20 years and even longer, and often include multiple renewal options after the initial term.
Our long-term and short-term capital lease IRU fiber lease obligations were $154.3 million at the end of the quarter, and we have a total of 127 different dark fiber suppliers that we use. Our capital lease principle payments are for long-term dark fiber IRU agreements.
These payments were $3.3 million in this quarter, and if you combine capital lease principle payments with CapEx, that total was $14.2 million in this quarter, compared to $11.1 million in the third quarter of last year, and $14.2 million the second quarter of 2017. Comments on debt ratios.
Our total gross debt, which includes capital leases, was $728.5 million at quarter-end, and our net debt was $477.7 million. Our total gross debt to trailing last 12 months EBITDA as adjusted ratio was 4.57 at quarter-end, and our net debt ratio was 3. Comments on bad debt and days sales outstanding.
Our bad debt expense for this quarter was again less than 1% of our revenues, and was only 0.9% of our revenues for the quarter. And our days sales outstanding for worldwide accounts receivable was 25 days at quarter-end.
And finally, as always, I want to again thank and recognize our worldwide billing and collections team members for continuing to do a fantastic job on collections and customer service. I will now turn the call back over to Dave..
Internet, IP connectivity, and VPN services, complemented by our colocation services. We expect our annualized constant currency growth rates to be consistent with our long-term averages, and be within that 10% to 20% range.
As I mentioned earlier, we were below that this quarter, but we will consistently be able to achieve that over a long period and as our net-centric business continues to improve. Our EBITDA targets have our adjusted annual EBITDA margin rates expanding at approximately 200 basis points per year.
Again, this is consistent with long-term historical trends, and there can be significant fluctuations in the short-term but we continue to trend positively. We did incur extra fees related to our litigation with Deutsche Telekom in defending net neutrality. Those fees materially increased in the quarter to $824,000.
We do not expect significant fees in the fourth quarter. Our board of directors has approved yet another increase in our regular dividend of $0.02 per share, bringing our quarterly dividend to $0.48 share, or on an annualized basis, $1.92 a share.
Our dividend increases demonstrate our continued optimism in our business, as well as the fundamental cash flow generation capabilities of our business. Even though we have been growing our dividend, we've been able to maintain our net leverage targets, pretty much at the midpoint of our guidance range.
We will remain opportunistic in the purchase of our – and time of purchase of our common stock in the open market. At the end of the quarter, we had $41.5 million remaining under our current buyback program, which will continue through the end of 2018.
And maybe most importantly for shareholders, we remain committed to increasing the amount of capital that we return to our shareholders on a regular and methodical basis, each and every quarter. With that, I'd like to open the floor for questions..
Thank you. . First question is from Walter Piecyk of BTIG. Your line is open..
Thanks. Couple of questions. I'll try to limit them, I guess, to two. The sales turnover being lower, Dave, can you give us a little bit more color on why that's the case? I think you said 4% versus 6%.
And why are people staying longer?.
Yeah. We have done a great deal in terms of improving our sales force training. As a result of that, we have seen a general increase in the productivity of the sales force. Most of our sales force turnover is involuntary, meaning we're asking the reps to leave because they do not achieve their quota targets.
The fact that we have been able to reduce that turnover rate from 5.1% of the sales force per month down to 4.4% is a direct result of just better training and a higher percentage of our reps being able to achieve quota objectives.
And we've done this while we've concurrently increased the size of the sales force, both in terms of total number of reps at 444, the highest in the company's history, and also on a full-time equivalent basis, that is reps that have ramped. And just the past quarter, we increased about 2.5% going from 410 full-time equivalent reps to 420.
Our average sales force tenure has declined slightly as we've grown the sales force, but we've been able to marry that with better training and therefore, better productivity on average. Yes, our productivity dipped from a record last quarter, but it is still substantially above our long-term trend lines..
So what was that peak churn from a couple of years ago, before – I think I remember two or three years ago you had kind of restructured sales a bit..
Yeah. We actually peaked at over 8%....
Wow..
...of the sales force terminating every month, and we've been able to cut that, roughly, in half..
Amazing. Okay. So my other question is just a quick one is – on net neutrality, you've talked a bit in the past about the fact that, look, if net – is – under the current administration it becomes – if the Republicans change it and that you had these contracts in place with the ISPs Verizon, whoever, Comcast, but it didn't really matter as much.
So why are you spending any money on net neutrality legal expenses if these contracts are already in place?.
Yes. 100% of our expenditures on net neutrality this quarter were related to the litigation that we have in Germany... (27:46).
...so we do have a contract with Deutsche Telekom as we have with all of the other major providers. Every other provider, who had been throttling ports, is now behaving, increasing capacity on a regular basis, and there is no congestion between our network and any of those networks.
In fact, Deutsche Telekom began to increase capacity and then stopped, forcing us to go to court to enforce the contract that was in place. So we're not suing on a regulatory issue, but rather a contract issue. The case was initially filed in the U.S., Deutsche Telekom argued for change of venue to Europe, that was granted.
The court is in bond of reviewing this. It has gone to the second level of court appeal. The German system is a little different than ours, and it's not a jury trial but rather a three-judge tribunal. And we continue down that process. We did have some substantial filings that were due the past quarter, and that was for the uptick in the phase.
We do not anticipate any material fees in the fourth quarter..
Got it. Thank you, Dave..
Thanks, Walt..
Our next question is from Scott Goldman of Jefferies. Your line is open..
Hey. Good morning, guys. I guess two questions as well. Dave, if you look at your net-centric growth, it looks like it's been pretty consistent for the better part of the last year and change probably a little bit below where it was maybe a few years ago before some of the port congestions.
So just wondering if you could walk us through, what does it take to get this net-centric growth to accelerate a little bit from here to help you get back into that range? Is that sales force productivity? Is it really predominantly a function of traffic growth, which looks like it's been relatively stable? And then just secondly on the margin side, it looks like network operation expense ticked up a little bit, and maybe that pressured the margins on a year-over-year basis this quarter.
Anything we should be looking at in that line item that may have pressured it this quarter? Thanks..
Yeah, sure. Let me try to take all of those. So our net-centric growth has been performing at a subpar level since 2012. So for five years, our net-centric growth has underperformed the previous 10-year trend line. And we go back and look at the reasons, some are extremely easy to identify. We lost Megaupload in 2012. Very clear.
Largest traffic producer in the world at the time and solely honed to Cogent. We also had experienced significant headwinds in that business due to foreign exchange, with 52% of our net-centric business outside of the U.S.
Quite honestly in the last quarter and over the last year, that became a little bit of a tailwind, but over the past five years, that's been a headwind. The third thing is that for a period of about two years, a group of eight ISPs were refusing to increase their customers' connectivity to the Internet. And that behavior dampened the whole market.
So our historical rate of traffic growth has been around 50% year-over-year, about double the market. That's Cogent's historical average as we gain market share. In the past year, we only grew 27%. Now that was an improvement from the 26% the quarter before and an improvement from the quarter before that.
So we are seeing some rebound, but it's not as rapid as we would like. Net-centric revenues do carry higher contribution margins because they are a greater percentage of revenue that is on-net versus off-net.
So in our corporate business it's roughly 60% on-net and 40% off-net; in the net-centric business it's roughly 95%, 5%, with about 95% of net-centric revenues being on-net revenues. In order to accelerate net-centric revenue growth we need three things to happen. One, we need to continue to improve our sales force efficacy and we're doing that.
The question Walt asked about turnover, about productivity, those things are happening and they impact both the corporate and net-centric side of the business. Two, we need prices to decline at a stable rate. In fact, we are doing better than our long-term average over the last year or so in rate of price decline on the net-centric market.
Maybe that's a shift in the competitive dynamic. We commit to being the lowest cost provider and undercutting our competitors by 50%. We have not seen as fierce of competition and therefore our rate of price decline at 15.7% is actually below the 21.9% long-term rate of price decline that we've experienced.
But it's the other side of the equation that has had our net-centric revenue growth below trend line. So if we look at the long-term average of over the past 15 years, for Cogent, since we've been a public company, we've achieved 2.2% sequential growth and just under 10% on a year-over-year basis.
In this most recent quarter, our net-centric business only grew 4.3% year-over-year. So we're under performing and that's because traffic growth at 27% is still below the long-term average of 49%.
So for the 38% of our revenues that come from net-centric to materially improve, get back to or even above trend line, we will need to see a continuation and hopefully even an acceleration in the improvement of traffic growth. And I think we're seeing signs of it. Our sequential growth went from 3% last quarter to 8% this quarter.
I think early indications are it'll be better even next quarter. And then in terms of margin, your second question, I've touched on it.
But the other component that does negatively impact margin and hurt cost of goods sold is the sale of our corporate off-net products, and we are selling a lot of VPN services, and those products do carry almost universally some off-net component to them. And that has raised the cost of network services that grows cost of goods sold line.
But we still feel comfortable that with our aggregate growth rate, we should be able to achieve both the 10% to 20% top line and about 200 basis points a year of margin expansion..
Great. Thank you, David..
Hey, thanks..
Our next question is from Matthew Niknam of Deutsche Bank. Your line is open..
Hey, thanks. Just a follow-up, two if I could. One more of a follow-up to Scott's question. But on net-centric, we've heard a lot about over the top video really taking off intra-quarter.
I'm wondering if you can attribute any of the pickup in traffic to this ramp in OTT, and maybe if you can allude to what you saw over the last three months, over the course of the quarter in terms of traffic ramp overall for the net-centric business, just talking about exit rates into this quarter.
And then secondly, on cash taxes, maybe if you can give us an update on your expectations for how we should think about cash tax payments in 2018 and 2019 as you whittle down remaining NOLs. Thanks..
Sure. So two very different questions. Let me start with the traffic growth acceleration question. Even though the growth has not been as rapid as we'd like it to be accelerating, it is accelerating, and it is driven heavily by our OTT segment.
And I think some of the hesitation that occurred with the headline news that net neutrality was going to go away has now given into complacency, as most of the OTT content providers figure that the market will demand some form of net neutrality, even if Title II protection goes away.
With that, we saw accelerating traffic growth throughout the quarter. Some of that is seasonal, but also when we measure it on a weekly or even daily basis year-over-year, we were seeing an improvement in the rate of growth.
And anecdotally, in talking to some of our larger OTG customers, we are hearing them get more and more comfortable that while D.C. will probably come up with some new regulations, net neutrality in some form is here to stay. And I think they are also comfortable that the contracts that we have for interconnection are durable.
Because if the counterparties believed that the net neutrality rules would be repealed, they would be dragging their feet and congesting ports, and they are not. So I think we are seeing the early signs of a reacceleration in global Internet traffic. And Cogent, as historically, will participate more than other carriers.
I think finally on that, we're continuing to see a transition in the net-centric competitive dynamic, where some of the companies that had previously focused on this market segment are now defocusing it. I think most recently the closure of the Level 3-CenturyLink merger provides yet an additional opportunity in this segment for us.
With Level 3 being the largest player in the market and CenturyLink previously being a major player and having withdrawn from that market, it's likely that the combined company will be less aggressive and therefore helping the competitive dynamic. On the tax side, I'll let Tad take it. We do have some NOLs left and we do have some strategy.
I'll let Tad tell you kind of where we're at..
Sure. So we continue to update our tax forecast each quarter. I'll start I guess, internationally, there's no expectation of material income taxes due to the existence of net operating losses for the foreseeable future, I'll put it that way. With regards to the United States, we do have some minimum taxes we need to pay at the state level.
Some state taxes are based upon gross margin and there are other net operating loss limitations. That's not expected to be material, but to increase on a quarterly basis as we go forward here. With respect to U.S. Federal income taxes and talking about the current law as it stands today, not expected to be paying material U.S.
Federal income taxes through the beginning of 2019..
And moving into 2019, we are exploring alternate structures that would be more tax efficient than our current structure. We have made no decisions on that, but we have been working with third party advisors to help us, and we both have a large amount of NOLs outside of the U.S., which don't have the same limitations that some of our U.S. NOLs have.
As well as the precedent for reconversion or even MLPs in similar businesses. So, we're exploring both of those avenues vigorously. And as we come to a strategy and our board approves it, we'll keep investors apprised of that. But we're highly mindful of minimizing our cash tax payments as long as we could do so within the confines of the law..
Got it. Thank you, Dave and Tad..
Our next question is from Colby Synesael of Cowen & Co. Your line is open..
Great. A few questions, if I may.
Specific to the dividend, this time last year when you increased it from $0.01 increments to $0.02 increments, any color on whether or not the board would consider raising it further, and if so, when that might potentially be looked at? Secondly, can you give us a sense how much you have left in terms of equipment gains or gains from asset sales? That number, as you mentioned, was down this quarter.
Where should we expect that to go, whether it's next quarter, as we go into 2018? And then just lastly on the REIT component that you just brought up, I mean, I could see potentially how the net-centric portion of your business does (42:59) maybe qualify for something like that, but I'm a little, I guess, skeptical about the corporate side of the business.
What's your just, well, impression of your business relative to someone like a Crown Castle's fiber business as it stands today? Thanks..
Yeah. Let me take all of those, Colby. So first of all with regard to the dividend, we actually had a board meeting yesterday. As we do at every board meeting, we look at the dividend and the pacing of the growth of the dividend. We feel comfortable with the $0.02 raise that we currently have.
We will continue to examine that on a regular basis, but I don't want to lead investors to believe there's some kind of imminent changing of the pacing. What we are committed to is utilizing leverage effectively. We are at the midpoint of our guidance range today at 3 times net leverage. We are naturally de-levering.
We are committed to not hoarding cash, and in fact we are committed to further discouragement of the excess cash on our balance sheet. And that will be through either buybacks or dividends. If we are not doing buybacks, by default it will have to be dividends.
But we are not in a position today to kind of tell someone there's going to be a permanent change in the growth rate of the dividend at least this quarter. And it'll be revisited every quarter and it'll be weighed against the metrics that I've just described.
Switching to your second question of equipment gains, we literally have huge stockpiles of equipment. But the challenge for Cogent is finding a way to dispose of that equipment, finding a willing party to take that equipment and pay us what we're looking for. That is a lumpy process.
We have said that equipment gains have been, a fact, at Cogent now for four or five years and will continue. In 2016, they were almost double the historical rate at nearly $8 million as opposed to about $4 million a year.
I think kind of that $4 million run rate on an annual basis is probably the right way to think about it for 2017, 2018, and probably even 2019. So we do anticipate these sales continuing, but they can't be lumpy depending on the counterparties in a given quarter.
And then finally to your readability question, it is a very valid one and it is one that quite honestly we're not 100% comfortable with, if we were, we probably would have been further along in this process. We understand that portions of our revenue do not fit as neatly into a REIT structure as others.
That is part of the reason why one of the strategies we're looking at is a more benign test of an MLP. That has positive and negative consequences associated with it. It provides flexibility, which is positive, but it does burden shareholders with a nix for reporting requirement and a K-1. And we're reluctant to do that unless it's a last resort.
So we are continuing to talk to advisors. We also look at the magnitude of our international NOLs. We're also trying to make sure that if we utilize those more effectively we're not going to trip ourselves up if there's a change in U.S. tax law.
So again, we've been treading slowly and we're not in a position today to tell you that there's a specific strategy we're using. What we are in a position to tell shareholders is that we're going to do what we can and be as aggressive as we possibly can within the confines of the tax code..
Okay. And just one quick one. The 15% reduction in pricing on a per megabit basis, it's the second quarter in a row now below the typical average around 20%, 25%.
Do you think that that's kind of a permanent thing now? Because obviously if you're not seeing as much traffic growth as you were before, you could obviously make up for it if the pricing is not going to go down to the same level. Thanks..
Yeah, and it's actually been more than a couple of quarters. It's actually been the last year or two, the rate of price decline has moderated some. I think it is continuing to moderate. We are still getting the benefits of lower cost of production through improvements in technology and lower prices for replacement gear that we're deploying.
So on a per bit-mile production cost, our costs continue to fall. But we've been able to not have to pass all of that onto our customers in part because of this maybe more orderly competitive marketplace.
I'm not ready to declare a stable marketplace, but it does appear that over the past year or two we have seen a moderation in the rate of price decline on the net-centric side..
Okay. Thanks..
Thanks..
Our next question is from Timothy Horan of Oppenheimer. Your line is open..
Thanks, guys. I guess just two part questions. Dave, on the REIT front, I'm kind of assuming Light Tower and (49:06) goes to the process should be a pretty good indication of kind of what's going on.
Are there other things you can do with your contracts or your business model on the corporate side to make it more readable or other things you're kind of looking at? Because, I mean, it seems like the IRS has never turned down a REIT application to date and there are things that I think you can kind of do and it seems to be logical.
And then secondly, let me just talk about the on-net traffic volumes. There's some concern out there that just a lot more traffic volumes are going internal to the kind of top six hyperscale Internet companies, just maybe what your thoughts are there. And just your confidence level on kind of when the volume growth might pick back up. Thanks..
Yeah, sure. So on the readability, I think the IRS is in a little bit of a state of paralysis right now around issuing private ruling letters. And I think we would need that to make our board comfortable in moving towards a REIT structure. We're also not convinced that that is the optimal structure. We are exploring it.
And you are correct, Tim, that there's no glory in being first and letting a couple of other companies maybe establish some benchmarks could be to our advantage. And then finally, while maybe I'm not as optimistic as some on changes in tax law or a complete sweeping re-write of the tax code, I think there will be some changes.
And I think it would be to our benefit to wait and see what those changes are. Finally, we do have this added lever of a big amount, as Tad referenced, of non-U.S. NOLs without the same types of restrictions that our U.S. ones have. So we're exploring all of those angles and again, I'm just not in a position to tell people. We have a strategy.
It's not a certainty that we will be able to avoid double-taxation, but I think it's highly likely based on all of the options we have in front of us, we'll be able to come up with one that works.
And then finally, we have also been shareholder-friendly in that the majority, if not all, of our dividends have been able to be treated as return of capital, making it extremely tax-efficient, deferring gains for the recipient by reducing their bases that they had purchased stock in Cogent.
So we are going to look at the world both at a corporate level and a recipient level to make sure that we're optimizing our return of capital.
One of the interesting things is that by migrating to either a REIT or MLP, we may not be forced to do an E&P-type problem because of our negative book basis, which I think gives us some advantages over some of the other companies that you may have mentioned.
And then with regard to traffic growth, we provide service to all of the major content providers globally. They are predominately U.S. companies. All of those companies have some level of direct connect agreements that they were pressured into. Many of those agreements have mandatory terms and have term remaining on them.
We understand that that does siphon some of the growth off, but virtually every one of these companies has been growing with Cogent faster than the Internet.
And it's part of the reason why our price per megabit of new sales in the quarter on a year-over-year basis was actually down so much because a large number of the sales were coming from some of these hyperscale customers. But we feel transit will continue to gain share because it's cheaper, it's easier to use, and it is more flexible.
And even though there is concentration both on the content and on the access side of the Internet, it is still on both sides a very balkanized world, and transit is the glue that holds that together, and I think all of our customers recognize that..
That's great color. Thanks a lot..
Our next question is from Nick Del Deo of MoffettNathanson. Your line is open..
Hey. Thanks for taking the question. I want to go back to the margin issue. If I look at your margins today compared to 2013, so after Megaupload. And I guess for off-net being a bigger share of the revenue mix, gains on equipment, legal costs, and USF, to get to more of an apples-to-apples comparison.
As best as I can tell, they're roughly flat over that timeframe despite the business being substantially larger than it was back then.
So given that, as we look over the next several years, how do we get comfortable with the idea that margins will expand meaningfully from here?.
You actually left out a very meaningful component of increasing cost in that time period. We increased our data center footprint from about 200,000 square feet to about 600,000 square feet, and picked up all of those operating costs.
And as we commented on, that diversification into data centers beginning in 2013 was defensive, it was a long-term bet, and that has had a somewhat depressing cost or impact on our margins as we picked up that cost. If you took that additional incremental cost out, I think you would see a much better gross margin story.
In terms of the SG&A side, we did concurrently with that ramp up our sales force. We have grown the sales force faster in the period from 2013 through 2017 than we did the previous five years. We are reaping some of the benefits and lower turnover and higher productivity.
But I think both on the SG&A efficiency as well as the cost of good efficiency side, we have room to deliver the margins. Our contribution margins, even with those impacts, have averaged around 43% during that period.
That's not great, that's not Cogent's potential, but that was when we were doing these expansion phases, both in the sales organization and the data center footprint. With both of those behind us or slowing down, I think you'll see an improvement in our contribution margin which will result in delivering that 200 basis points..
All right. And then as we think about traffic growth, obviously video is the big traffic driver for net-centric today.
Are you seeing any emerging or up-and-coming product categories or video product niches that you think might be nice tailwinds over the next several years? Or is it too early to call anything like that out?.
Yeah. I mean we have some of the large gaming customers, whether it's EA or Sony or Microsoft, and I think as they move to a more virtual reality gaming format, we think that will be a material driver. And I also believe on the emerging side, the sharp division between interactive video, i.e., gaming and more single-stream video.
I don't want to use the word linear because it's not truly – it's linear for each user, but it's not linear across multiple users concurrently. But I think you'll end up seeing video that is more multidimensional, meaning it will be tailored more to the specific user.
So the content will be something in between a game and video as we know it today, where the outcomes may be different for different viewers. And we have a few smaller customers that are experimenting with those types of business models.
That's all I would say in the kind of science project stage, but should end up being another leg up in overall traffic growth..
Okay. Thanks for that, Dave..
Thanks, Nick..
Our next question is from Michael Funk of Bank of America. Your line is open..
Hi. Good morning, Dave. A couple of quick questions here. I'm trying to square the board continuing to raise the dividend, clearly a gesture of confidence, I guess, in your ability to return to that longer term target of 10% to 20% top line growth.
With some of the recent trends we've seen for the last eight quarters you've fallen below that longer term target, so I guess first question, from where does the board get the confidence or you get the confidence to return to that target? And what's the tolerance to maintain that dividend increase if you fall below the longer term target?.
Sure. So, I'm actually going to try to take those in reverse order because I think that makes the most sense. We have been below our guidance range for a couple – more or less for the past couple of years yet we've been growing the dividend and we've been doing that and not growing our net leverage.
So since we have excess cash on the balance sheet, our commitment is to return it to shareholders. We have been able to do that both through periodic buy backs but more recently it's been dominated by growth in the dividend, and yet our leverage has not increased.
So even if we are below our guidance range, which I do not believe we will be, we will have the ability to consistently raise the dividend for the foreseeable future. And that's not just a few quarters, that's multiple quarters, probably multiple years out based on even sub-historical performance in the business.
Now with your first question, which is our ability to return to our historical growth rates of about 12%, which is within our range. We need both parts of our business performing there. Our corporate business is performing there. It has become a bigger part of Cogent and it's in fact roughly 62% of revenues.
That business has some real natural tailwinds, whether it be Saas, cloud computing or VPN services, all helping drive our growth. Those are all very positive trends for Cogent's corporate business.
And actually in talking to investors and even bearish sell-side analysts, I think there's almost no concern about our corporate business, unless someone has something that I haven't really heard. I think all of the angst is on the net-centric side, and that business has underperformed. 4.3% year-over-year growth is not 10%.
It's less than half of what your trend line is. And we've spent a fair amount of time talking about all those reasons. And with reduced competition, with increased comfort around a set of regulations that are going to protect the Internet, whether it be some new regulation or just the honoring of existing contracts.
And then finally, the acceleration in applications and demand. I mean the beauty of the Internet is no one picks winners and losers, the market does. And the barrier to entry to new business models is very, very low.
I was talking to someone who had worked at a video search business recently, and it was an interesting business model, but what he was explaining to me was just the sheer magnitude of their infrastructure build, meaning their bandwidth and compute bill is growing almost exponentially.
And what they are struggling with is how do they come up with enough advertising revenue to monetize it. But that's an example of an application that will far outpace the growth that we've seen of the Internet, that 20%, 25%.
And as we migrate into a more dynamic world with more video and more things such as what I talked about with Nick, augmented reality, virtually reality, embedded content. I think we'll see this acceleration in growth..
And one quick follow-up, Dave, I guess related to your comments about traffic. You commented earlier that a number of the big content providers have these direct connect agreements. I guess first get your thoughts on winning some of that business back, why you believe that you can.
And then second, is slower growth at Cogent in traffic also a factor, where a function of some of the content origination moving away from your network? Meaning, we've seen rapid growth in data centers the last few years. And has some of that growth moved away from your network, perhaps requiring more CapEx in that part..
So two very different questions. The direct connect question is extremely simple to answer. This is a commodity; it comes down to one thing, price. And if the quality is the same, which it will be if there's adequate interconnection, and our price is lower, we will win the business.
The only reason we would not win it is if there's some artificial constraint such as there was when companies were blocking ports. Now companies can be tied up under contracts and have take-or-pay obligations that have to run out. They have given up on the idea of having those contracts negated by the FCC.
So part of this is just a question of waiting and allowing this to run its course. But we do feel comfortable that we will see traffic growth or transit continue to grow. To your second point, which is data centers. Data centers are integral to this ecosystem, and are the place where traffic is originated.
There is a explosion of data centers, both commercially third-party-funded as well as the hyperscale facilities that are being built by corporates for their own integrated purposes. All of that means more content is available in more locations.
But we actually have consistently tracked for 17 years the average packet travel distance on the Internet, and it actually has not materially changed more than about 10% up or down any one year. So even though these data centers are being built, we're in over 970 data centers around the world.
My guess is we'll be in 70 or 80 more next year as they are built. So I don't see data centers as a threat; I see them as an additional place where we can sell services..
Great. Thank you for the time, Dave..
Our next question is from James Breen of William Blair. Your line is open..
Thanks for taking the question. Yes.
As we look at the margins year-over-year, even when adjusting for the legal expense and the equipment sales that were down, is there a tie-in between – I think you mentioned on the call there are around 2,600 customers where you renegotiated contracts and termed those contracts out, I'm assuming, at a lower unit price.
Can you talk about the impact that has in the business as that happens over time? Obviously it secures a longer-term revenue stream, but is it likely to be at a lower margin? Thanks..
Well, it absolutely impacts aggregate revenues. It does not impact margins, as 95% of net-centric revenues and those statistics only apply to net-centric customers, are on-net. And because it's on-net, it carries 100% gross margin contribution, about $0.95 of EBITDA.
So even though it will be a lower absolute number, it will not negatively impact margins. Really the impact in margins has come from two things. One, those data center footprint expansions that we talked about, and that's over a several-year period and most of that is behind us at this point if not all of it.
And then secondly, this continued increase in VPN services which are corporate services that do have a relatively significant off-net component, which has a direct cost to goods sold and a lower contribution margin. That's a real structural change.
It's a bigger market opportunity, but it's also one that structurally will carry lower contribution margins, but the take away of having both transit and VPN services to sell the customer means that we should still be able to achieve contribution margins north of 60%, up from the mid 40s today..
Great, and then just one follow-up. I think Tad said that the top 25 customers are less than 6% of revenue. How has that trended over the last couple of years and obviously diversified as a customer base, wondering where some of that traffic is going. Thanks..
Yeah, I mean, we have had a couple of our large customers be sensitive to us mentioning their names. So we lump them together. We continue to work diligently on diversifying. As I said, all of the major household names are customers, but we also have a lot of aggregators that fit into that top category on the content side.
And then on the access side, we sell to the largest access networks in the world, whether it be China Mobile or Reliance Jio or China Telecom.
Maybe our access guys are a little less sensitive to us mentioning their names or maybe I'll get a nasty call after today about that, but we have a great deal of diversity, but we have nearly 6,000 access networks as customers..
And how has that customer concentration changed in the last year if it's 6% now for the top 25?.
It's relatively constant..
It is reduced. For example, if you go back – I have the report in me for the third quarter of last year, it was a little bit over 7%..
Yes, it's gone from 7% to 6%. I mean, it's a minor diversification, but we've been pretty diverse for a long time. We learned our lesson from Megaupload..
Great. Thanks..
Our next question is from Michael Rollins of Citi Investment Research. Your line is open..
Hi. Thanks for taking the question. I was wondering if you could talk a bit about the VPNs and how it's impacting volume as well as the opportunities to go after your customers and revenue? Thanks..
Sure. So while VPNs represent approximately 17% of aggregate revenues and 26% of corporate revenues. It is almost exclusively a corporate product, and our VPNs account for less than 2% of the bit traffic on our network. So on a per-bit basis, it is an expensive service relative to Internet.
But it is much cheaper for the customer than their alternatives, which have traditionally been MPLS based services. That large MPLS market is being disrupted. And there are customers who are taking different paths. Some customers are going straight to internet and just encrypting behind their firewall. We benefit from that.
We have customers who are deploying virtual private line services, which we deliver.
They deliver a full line rate and are priced at parity to our internet services, and that's the VPN revenue that we report as a separate line item, because we have no visibility to a customer taking an Internet port and using it for a VPN if they're doing it themselves. And then third, we're starting to see a SD-WAN solution.
But those SD-WAN solutions are still not quite ready for primetime in two respects. One, they don't have complete standards uniformity yet. That's coming and the vendors are working diligently at it. The second is the overhead in running those is still relatively significant. We are testing multiple vendors and multiple products in our labs.
Over the last couple of months we've seen material improvements from various vendors, not just one, on SD-WAN performance. And for very low speed customers, those in the 10 meg to 20 meg range, the SD-WAN products that are available today work fine.
For those customers that may have a higher demand and bit load, the products aren't quite there yet, but probably over the next year will be. And I firmly believe that 90% of the current MPLS market is going to migrate to one of those strategies.
For Cogent, this is great news, because we have no MPLS revenue to lose and only incremental business to win..
Thanks very much..
Thank you. There are no further questions at this time. I'll turn the conference over to Mr. Schaeffer for any closing remarks..
Well thank you all very much. We managed to keep our prepared remarks to less than normal, but we had better questions than normal, so we did run a little longer. But I want to thank everyone and we'll talk soon. Take care. Bye-bye..
Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Have a wonderful day..