Dave Schaeffer - Founder and CEO Tad Weed - CFO.

Matthew Niknam - Deutsche Bank Scott Goldman - Jefferies Colby Synesael - Cowen & Co. Nick Del Deo - MoffettNathanson Michael Rollins - Citigroup Timothy Horan - Oppenheimer Frank Louthan - Raymond James.

Good morning, and welcome to the Cogent Communications Holdings Fourth Quarter and Full Year 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 call over to Mr.

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

Thank you and good morning everyone. Welcome to our fourth quarter 2017 earnings conference call. I’m Dave Schaeffer, Cogent’s CEO. And with me on this morning's call is Tad Weed, our Chief Financial Officer. We are pleased with our results and our outlook for 2018 and beyond.

We achieved sequential quarterly growth of 1.8% and year-over-year quarterly growth for the fourth quarter of 8.3%.

Our quarterly sales rep productivity improved again from 5.7 units installed per full time equivalent rep per month to 5.8 units per rep per month, and again that is significantly above our historical average of 5.1 units installed per full time equivalent rep per month.

Our EBITDA for the quarter increased sequentially by 7.6% and by $3 million and increased by $6.2 million and 16.6% from the fourth quarter of 2016. For the full year 2017, our EBITDA increased by 18.4 million or by 12.9% over the full year 2016.

Our EBITDA margin for the quarter increased sequentially by 180 basis points and increased by 240 basis points to 34.5% from the fourth quarter of 2016. Our gross margins for the quarter increased sequentially by 50 basis points to 51.7% and increased by 30 basis points from Q4 of 2016.

For the quarter, we achieved accelerated increases in our traffic growth. We achieved sequential traffic growth of 12%, a significant increase from the 8% sequential growth rate in the last quarter and we also achieved acceleration in our year-over-year traffic growth to 29%.

During the quarter, we returned $21.8 million to our shareholders through our regular quarterly dividend. As posted on our Web site, 50.2% of our total of $81.7 million of dividends in 2017 should be treated by shareholders as a return of capital and 49.8% should be treated as taxable dividends for U.S. federal tax purposes.

At quarter end, we had a total of $41.5 million available in our stock buyback authorization program which is expected to continue through December of 2018. We did not purchase any stock in the quarter. Our gross leverage ratio improved to 4.44 from 4.57 last quarter and our net leverage ratio declined to 2.94 this quarter from 3.00 last quarter.

We ended the quarter with $247 million of cash on our balance sheet. Of this call, 62.9 million is held at the holding company, Cogent Holdings and is unrestricted and available for dividends and/or buybacks. We continue to remain confident with the growth potential of our business and the cash generating capabilities of the business.

As a result, as indicated in our press release, we announced another $0.02 sequential increase in our regular quarterly dividend raising our quarterly dividend from $0.48 a share per quarter to $0.50 per share per quarter, representing our 22nd consecutive quarter in which we have raised our regular quarterly dividend.

[Technical Difficulty] detail some of the certain operational trends and highlights of our business [Technical Difficulty] some additional details on our financial performance. And then following our prepared remarks, we’ll open the floor for questions and answers. I'd now 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 Web site at cogentco.com. I’ll turn the call back over to Dave..

Thanks, Tad. Hopefully you’ve had a chance to review our earnings press release. Our press release includes a number of consistently reported historical quarterly metrics as well as current performance.

Now with regard to expectations and our long-term guidance going forward, our targeted long-term guidance remains for a full year constant currency growth rate of between 10% and 20%. Our long-term EBITDA as adjusted annual margin expansion targets remain approximately 200 basis points per year.

We expect those trends to continue for the next several years. Our revenue and EBITDA guidance are intended to be long-term goals and not intended to be used as specific quarterly guidance. Our EBITDA as adjusted is impacted by the amount of equipment gains and net neutrality fees as well as certain seasonality in our SG&A.

Now Tad will provide you some additional details on our year and quarter specific financial results..

Thanks, Dave, and again, good morning to everyone. I'd like to thank and congratulate the entire team at Cogent for their results and continued hard work and efforts during another very busy year and a very productive year and quarter for the company.

We analyze our revenues again based upon network type which is on-net, off-net and non-core and we also analyze our revenues based upon customer type. We classify all of our customers into two types, either net-centric customers or corporate customers.

Our net-centric customers buy large amounts of bandwidth from us and carrier neutral data centers and our corporate customers buy bandwidth from us in large multi-tenant office buildings. Revenue from our corporate customers grew sequentially by 2.9% to $78.7 million and year-over-year grew by 11.7%.

We had 38,006 corporate customer connections on our network at quarter-end. Quarterly revenue from our net-centric customers grew sequentially by 0.1% and year-over-year grew by 3.1%. We had 33,607 net-centric customer connections on our network at quarter-end.

Our net-centric revenue growth experiences more volatility than our corporate revenue growth due to the impact of foreign exchange and other seasonal factors. Revenue in customer connections by network type; our on-net revenue was 89.4 million for the quarter, which was a sequential quarterly increase of 1.7% and a year-over-year increase of 7%.

Our on-net revenue was 346.4 million for the year which was an increase of 7.1% over full year 2016. Our on-net customer connections increased sequentially by 3.3% and increased by 16% year-over-year.

We ended the quarter with over 61,300 on-net customer connections on our network in our 2,506 total on-net multi-tenant office buildings and carrier neutral data center buildings. Our off-net revenue was 35.7 million for the quarter which was a sequential quarterly increase of 2.3% and a year-over-year increase of 11.9%.

Our off-net revenue was 137.9 million for the year which was an increase of 12.7% over last year. Our off-net customer connections increased sequentially by 2.4% and increased by 15.8% year-over-year. [Technical Difficulty] off-net customer connections in about 6,300 off-net buildings and these buildings are primarily in North America.

Some comments on pricing. Consistent with our 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 base declined sequentially by 8.7% from last quarter to $0.99 and declined by 21.1% from the fourth quarter of last year.

The average price per megabit for our new customer contracts declined sequentially by 22.9% to $0.42 as we sold to larger customers compared to last quarter and declined by 42.1% from our new customer contracts that were sold in the fourth quarter of last year. Some comments on ARPU, which decreased sequentially.

Our on-net ARPU, which includes both corporate and net-centric customers, was $494 for the quarter which was a sequential decrease of 1.7%. Our off-net ARPU, which is comprised predominately of corporate customers, was $1,208 for the quarter which was a sequential decrease of 0.9%. Churn rates were stable during the quarter.

Our on-net churn rate was 1.1% this quarter compared to 1% last quarter and our off-net churn rate was 1.2% this quarter compared to 1.1% last quarter. Move change orders. We offer discounts related to contract term to all of our corporate and net-centric customers. 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 2,500 customer connections which increased their [Technical Difficulty] Cogent by over $22.5 million. Some further comments on EBITDA and EBITDA as adjusted.

Our EBITDA and EBITDA as adjusted are reconciled each quarter to cash flow from operations in all of our press releases. Our EBITDA as adjusted includes gains related to our equipment transactions. Our quarterly EBITDA as adjusted increased by 3 million or by 7.3% sequentially to 43.6 million and year-over-year increased by 5.8 million or 15.4%.

Our EBITDA as adjusted increased by 14.5 million or by 9.7% for the year. Our EBITDA as adjusted margin increased sequentially by 180 basis points to 34.8% and increased by 200 basis points from the fourth quarter of last year.

Our equipment gains that’s included in EBITDA as adjusted were 0.3 million for this quarter, a decline from 0.7 million from the fourth quarter of last year and 0.4 million last quarter. The gains for the year were 3.9 million this year, a reduction from 7.7 million in 2016.

Our quarterly EBITDA increased by 3 million or by 7.6% sequentially to 43.2 million and increased year-over-year by 6.2 million or 16.6%. And our EBITDA increased by 18.4 million or by 12.9% for the year.

Our quarterly EBITDA margin increased sequentially by 180 basis points to 34.5%, one of the highest rates recently and increased by 240 basis points from the fourth quarter of 2016.

We do have certain seasonal factors that typically impact our SG&A expenses and consequently that impacts our EBITDA and EBITDA as adjusted and those margins, and these include the resetting of payroll taxes in the United States 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 the timing and amount of our gains in our equipment transactions and benefit plan annual cost increases.

Some comments on earnings per share.

As with many companies, the Tax Reform Act impacted our income tax expense, so the signing of the Tax Cuts and Jobs Act which incurred in December of last year reduced the corporate tax rate from a maximum of 35% to a flat 21% rate and that resulted to an increase in our non-cash deferred income tax expense by about 11.3 million booked in the fourth quarter and also impacted full year 2017.

Under U.S. GAAP, because of the change in the income tax rate, our net deferred tax asset had to be revalued in the fourth quarter using the lower income tax rate with the gross amount remaining unchanged. The rate change impact represented about $0.25 of a loss per basic and diluted share both for the quarter and for the year.

As a result, our basic and diluted loss per share was $0.14 for the fourth quarter as compared to $0.08 in the previous quarter and $0.09 in the fourth quarter of last year. Our basic and diluted income per share was $0.13 for the full year compared to $0.33 last year.

But if you exclude the $0.25 per share income tax expense impact of this one-time $11.3 million adjustment, our basic and fully diluted income per share would have been $0.38, up from $0.33 for full year and $0.11 increase as well for the fourth quarter. Foreign currency impact; our revenue reported in U.S.

dollars and earned outside of the United States is about 23% of our worldwide revenues. About 17% of our fourth quarter revenues are based in Europe and about 6% of our revenues are 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.

Foreign exchange had no material impact on our sequentially quarterly revenues this quarter but from the fourth quarter of last year to the fourth quarter of this year, the year-over-year FX impact on our reported quarterly revenue was a positive 2.1 million and for the year it was a positive 1.9 million.

Our revenue growth on a constant currency basis therefore was 1.8% for the quarter sequentially, 6.6% over the fourth quarter of last year and 8.1% for the full year. The average euro to U.S. dollar rate so far this quarter is now a $1.22 and the average Canadian dollar exchange rate is about $0.80.

Should these rates remain at these levels for the first quarter of this year, we estimate that the foreign exchange current impact on sequentially quarterly revenues will be a positive of about 800,000 and the impact on year-over-year quarterly revenues, an approximate $3 million positive impact.

Customer concentration; we believe that our revenue in customer base is not highly concentrated and our top 25 customers represented less than 6% of our revenues for the quarter. Some comments on capital expenditures.

Our capital expenditures for the quarter were 10.6 million compared to 7.2 million for the fourth quarter of last year and 10.9 million for the previous quarter. Our capital expenditures were essentially flat for the year and were 45.8 million for this year compared to 45.2 million last year. Comments on capital leases and capital lease payments.

Our capital leases for long-term IRU obligations and typically have initial terms of 15 to 20 years or longer and include multiple renewal options after the initial term. Our long-term and short-term capital lease obligations totaled 157.5 million at year end and we have a total of 230 different dark fiber suppliers that we use.

Our capital lease principle payments are for long-term dark fiber IRU agreements and these payments were 1.8 million for the quarter and 11.2 million for the year. Capital lease principle payments, if you combine that with our CapEx, declined by 12.6% sequentially and that amount was 12.5 million this quarter compared to 14.2 million last quarter.

Capital lease payments combined with CapEx declined by 1.2% for the year and was 57 million this year compared to 57.7 million last year. At year end, our cash and cash equivalents totaled $247 million and for the quarter our cash decreased by 3.8 million as we returned 27.2 million of capital to our stakeholders.

During the quarter, we paid 21.8 million for our fourth quarter dividend and 5.3 million was spent on the semiannual interest payment on our debt. For the full year, our cash declined by 27.3 million as we paid 81.7 million in our four quarterly dividends and 30.8 million was spent on interest payments on our debt. Some comments on debt and ratios.

Our total gross debt, which includes capital leases, was 732.5 million at year end and our net debt was 48.5 million. Our total gross debt to trailing last 12 months EBITDA as adjusted ratio improved to 4.44 at year end from 5.57 last quarter, and our net debt ratio also improved to 2.94 from 3 last quarter.

Our bad debt expense was only 0.5% of our revenues from our quarter which was an improvement and was only 0.8% of our revenues for the year. Our days sales outstanding for worldwide accounts receivable was again only at 25 days at year end.

And as with every quarter, I want to again thank and recognize our worldwide billing and collections team for continuing to do a fantastic job on customer service and collections. With that, I will turn the call back over to Dave..

Thanks, Tad. I’d like to take a moment and comment on the scope and scale of our network and our network expansion. The size of our network continues to grow. We have over 893 million square feet of multi-tenant office building space connected to our network in North America.

Our network consists of 31,250 metro fiber miles and over 57,400 route miles of intercity fiber. The Cogent network is one of the most interconnected networks in the world. Today, we directly connect with over 6,150 networks, less than 30 of these networks are settlement-free peers. The remaining networks are paying Cogent transit customers.

We are currently utilizing approximately 29% of lit capacity in our network. We routinely augment capacity in segments of our network to maintain these low utilization rates. For the quarter, we achieved accelerated sequential traffic growth of 12% and an improvement in our year-over-year traffic growth to 29%.

We operate 53 Cogent-controlled data centers with a grand total of 603,000 square feet of raised floor space. We are today operating those facilities at approximately 31% utilization rate. Our sales rep turnover rate was 3.5% for the quarter significantly below our long-term average of rep turnover of 5.8%.

We ended the quarter with 455 sales reps selling our service. This is the greatest number of quarter-bearing reps in the company's history. Cogent is the low-cost provider of Internet access, transit services and VPN services, and our value proposition remains unparalleled in the industry.

Our business remains completely focused on Internet IP connectivity and data center colocation services. What we are providing is a utility to our customers and they recognize the value that we deliver.

We expect our annualized constant currency long-term revenue growth rates to be within our historical norms of 10% to 20% top line and we expect our long-term EBITDA as adjusted margins on an annual basis to increase by approximately 200 basis points.

Our Board of Directors approved yet another increase to our regular quarterly dividend increasing the dividend by $0.02 per quarter per share to $0.50 per share per quarter. Our dividend increases recognize the continued optimism we have in the cash flow generating capabilities of our business.

Increasing the dividend and continued delevering is a sign of the strength in our business. We are optimistic about utilizing our buyback authorization and will try to take advantage of opportunistic situations to deploy the 41.5 million remaining under our current buyback authorization, which continues through December of this year.

We are committed to returning an ever increasing amount of capital to shareholders on a regular basis. With that, I’d like to open the floor for questions..

[Operator Instructions]. Our first question comes from Matthew Niknam with Deutsche Bank. Your line is now open..

Hi, guys. Thank you for taking the question. Just two if I could. One, Dave, on revenue growth, so constant currency growth this quarter was about 6.6%. It’s the lowest we’ve seen in some time.

Just wondering, is this a little bit more of a newer reality at least in the interim? And then more specifically what are the kind of catalysts do you expect that help net-centric growth reaccelerate, because I think that’s been the one piece of the business that revenue growth has been somewhat lagging? And then secondly, just in terms of tax reform, wondering how that changes the company’s outlook as it relates to both investments and CapEx as well as capital allocation and shareholder returns? Thank you..

Thanks for the questions, Matt. So while our year-over-year quarterly constant currency growth rate was low, our constant currency sequential growth rate in the fourth quarter was the best of the year at 1.8%.

We also do anticipate on a constant currency basis our growth rate to continue to improve both on a sequential basis and on a year-over-year basis. I think the year-over-year fourth quarter was specifically distorted by some strong growth in the fourth quarter last year that we didn’t have from several very large customers.

We do expect our net-centric growth to improve from the 3.1% year-over-year growth rate that we delivered this year which is substantially below our long-term average of 10% net-centric growth rate.

We are continuing to see an improvement in our traffic growth rates, so our sequential growth rate improved on a quarterly basis from 8% the previous quarter to 12%. Even accounting for seasonality, our year-over-year growth rate continued to improve and improved throughout the year and ended up at 29%.

That is still below our long-term average but we are seeing consistent improvement as the negative impacts of violations of net neutrality continue to fade, we see new customer business models, we see existing customers taking more traffic and we do feel that our net-centric business will continue to improve albeit at a slow pace but consistently improve while our corporate business continues to perform along historical trends and quite honestly quite consistent and quite well.

The growth of 2.9% sequentially in that business and 11.7% year-over-year demonstrates the durability and consistently in that business. Now with regard to tax reform, clearly it had an impact on our reported EPS due to the reversal of the tax reserve that we had taken adjustment for.

Secondly, the Tax Act does I think institutionalize for four years bonus depreciation through 2022. That will most likely push out when Cogent will be a tax cash payer by about three years. We were initially anticipating having to make structural changes to avoid cash taxes by mid-'19. Now I think that’s more like mid-2022.

We are still considering corporate structures and other changes to our tax policies to further minimize long-term taxes. Now with regard to capital expenditures, Cogent expends capital based on the expected rate of return. We have excess capital on our balance sheet and yet we continue to moderate our capital spending.

Our CapEx as measured by CapEx and principle payments on capital leases declined albeit modestly from $57.7 million to $57 million on a year-over-year basis. We expect those declines in absolute terms to continue going forward. Clearly, as a percentage of revenue, the declines are more pronounced as we continue to grow top line.

We do not see bonus depreciation or any other changes in tax policy having us accelerate our capital spending because we don’t think there are building opportunities to connect to that would generate sufficient returns and we remain disciplined about our footprint to expansion..

Got it. Thank you very much..

Thanks, Matt..

Our next question comes from Scott Goldman with Jefferies. Your line is now open..

Thanks. Good morning, everybody. Dave, maybe you could just talk a little bit about the sales force expansion plans for 2018? I think you’ve been growing the sales force probably high-single digits to almost double digits at various times.

Wondering how much of your growth outlook is dependent upon further sales force expansions along the lines of what we’ve seen? And then secondly, Dave, you just mentioned sort of the tax reform not impacting the capital spending side but maybe you can just help us understand what the opportunity is in terms of adding buildings onto your network? It feels as though over time you’ve sort of downplayed the multi-tenant office building opportunity that we continue to see that being almost an equal driver to data centers in terms of adding buildings onto the network? Thanks..

Yes, sure, Scott. So let me take each of those questions in order. We intend to grow our sales force between 7% and 10% for the year. We have a significant addressable market opportunity and not enough sales people to cover that opportunity both on-net and off-net. Our sales force is roughly 72% corporate, about 28% net-centric.

We intend to grow both portions of the sales force to attack each of those markets. We think that the VPN migration away from MPLS to either VPLS or SD-WAN provides our corporate reps with added addressable market opportunity.

So as we think about growing our business, we look at plenty of targets for us to sell to, a very predictable rate of price decline in the marketplace both corporate and net-centric after a number of years and an ability to continue to elevate our sales productivity and the fact that we were able to go from 5.7 units installed to 5.8 and yet we had the most number of reps in the company’s history, 455, the most number of full-time equivalent reps, these are fully ramped reps of 429, our rep tenure continues to grow.

So we will continue to invest in sales as the primary way to continue to accelerate revenue growth. Now with regard to footprint expansion, we remain extremely disciplined about the type of buildings that we go into.

Now we go into data centers as new data centers are being constructed and there continues to be a significant amount of capital going into the data center market that has had us continue to add to that footprint at a rate of about 65 to 70 facilities per year. We are 800 data center buildings with about 960 discrete data centers served.

On the MTOB or corporate multi-tenant office space, we continue to add about 60 a year that has slightly decelerated as we’ve seen the economy improve, there has been some new construction of large buildings. Our average building size remains consistent at about 550,000 square feet per building.

In fact, if you do the arithmetic on the last quarter, the average building that we added in the fourth quarter, MTOB, multi-tenant office building was actually larger than the average. But we do have a very defined list of which buildings meet our criteria and we continue to go after those buildings, but we are not changing our criteria.

We do not think the Tax Act has any impact on that decision because it’s driven entirely by return on capital. And then with regard to the Tax Act and our ability to return capital to shareholders, dividends remained at the same tax rate. Corporate rate is lower but that has been not an important factor for Cogent.

And we will continue to try to be thoughtful about returning capital as opposed to issuing taxable dividends and using buybacks when appropriate. So I think while the Tax Act is clearly a positive for business, it is not going to change the way we approach the market either to our customers or to our shareholders..

Great. One quick follow up on the Tax Act.

Are you seeing – understood in terms of what the impact is for you guys, are you seeing any impact in terms of the demand equation from your customers? Does it change – help drive traffic acceleration now that maybe they’re keeping a little bit more in the coffers?.

I don’t think so, Scott. The drivers for Internet traffic growth and corporate customers needing the Internet are much more profound and substantive and intact. The Internet is a necessary utility to all of our customers and what is driving their need for more bandwidth and more connectivity are their business applications, not their tax decisions.

On the corporate side, we are seeing an accelerated pace of MPLS, VPN replacement with various over-the-top strategies that I think will provide significant tailwind to the corporate business.

On the net-centric side, as the new ways of net neutrality dies down and all of the last [indiscernible] networks that had previously decided to block traffic are now freely upgrading their ports, we continue to see our net-centric customers rollout new businesses, new applications.

And the Internet traffic growth is beginning to rebound for the whole industry and clearly for Cogent it’s rebounded. So while we grew 29% year-over-year, the industry is only growing at about 20%. So we’re not at that 27%, 28% industry growth rate yet and we’re not at the high 40s average Cogent growth rate..

Okay. Thanks a lot, Dave..

Thanks..

Our next question comes from Colby Synesael with Cowen & Co. Your line is now open..

Great. Two questions, if I may. First off on CapEx, I’ve had the opportunity to cover Cogent for quite some time now and I think if I go back a few years, at this point we’re expecting CapEx to be and that includes capital leases to be in the low to mid-40s with a target of actually I think getting into the high 30s at some point yet.

We’re still at around that 57 million number that you referenced earlier. What’s changed versus maybe expectations a few years ago and do you think that those lower numbers are still realistic? And then secondly on growth, specifically within the net-centric business and the 6.6 that was mentioned this quarter.

You keep on mentioning net neutrality as one of the issues that is hindering growth, but I have another thought that I wanted to suggest or get out there and see what you think. We’ve seen the hyperscale companies shifting a lot of their traffic needs out to an on-net, so buy more dark fiber, buy more wavelengths.

And it seems like that’s coming at the expense of IP trend that’s somewhat similar to have at one point, they used to be big purchases of CDN services and they brought that in-house.

Do you think that that’s a trend that you’re seeing impact your business and traffic growth and could that also be part of the reason for why the traffic has slowed? Thank you..

Yes, sure, Colby. Let me take both questions. First of all on the CapEx question, our long-term CapEx guidance is that as methodologically our capital lease and CapEx number will approach about 35 million. Clearly 57 million is above that and the rate of decline has been slower.

Now what has probably been a bit surprising over the past few years has been two things.

One, the amount of data center footprint that Cogent has added to its footprint, Cogent-owned data centers; and then secondly, the accelerated rate at which new third party carrier neutral data centers are being built as measured by either square footage or megawatts of power. And because of that we are extending our network more aggressively.

We have also extended our network to some new markets that were not initially contemplated, some of the Asian markets such as Singapore, Tokyo and Hong Kong.

We do continue to evaluate other areas of the world and possibly could grow to those areas, but we do expect our absolute CapEx that has CapEx and principle payments on capital leases to continue to decline, albeit at a slower rate of decline than we’d expect it. Now to the net-centric growth rates.

First of all, it is absolutely true that larger hyperscale companies and Cogent serves virtually every one of them have their own proprietary data center footprint and they have built networks to connect those data centers to one another and to connect those networks to major exchange points.

However, those companies continue to use transit services to connect to the Internet. They have a discrete waterfall that they look to migrate traffic off of their networks. First and foremost, they seek settlement-free peering agreements.

If anyone will give them free connectivity, they will take it and clearly that’s a competitive offer that Cogent cannot or does not want to compete with. Secondly, they will use paid direct connections.

Those connections are typically more expensive than the market price for transit and they will only use those if they are forced to under contract or if they feel that the underlying interconnections are at risk from their transit providers. Those fears are going away.

And then finally, transit which is the easiest use and most ubiquitous service with the lowest cost point continues to be used by all of the hyperscale players. In fact, we saw our traffic growth accelerate on a year-over-year and sequential basis. If your thesis was correct, we would not see that.

Now there is traffic that previously existed on the Internet that no longer exists on the Internet through direct connections. We’ve seen, for example, some of the over-the-top video providers take their traffic and no longer are treated as Internet traffic but rather as a channel on a linear closed table system.

That traffic disappeared from the Internet. It is no longer over-the-top traffic and it is now being delivered on a closed network. That trend will probably continue for some of the largest providers but the aggregate amount of Internet traffic continues to grow and actually is now growing at an accelerating rate.

And for that reason we feel optimistic that our net-centric business is going to continue to improve albeit at a slower pace that we would have hoped..

Great. Thank you..

Our next question comes from Nick Del Deo with MoffettNathanson. Your line is now open..

Good morning. Thanks for taking my questions. First the capital structure one. So, Dave, you’ve always described taking on debt as I think you used the term renting cheap capital rather than a more permanent decision.

Rates remain pretty low by historical standards but what would we have to see for your calculus regarding the appropriate capital structure for the business start to change?.

Yes, fair enough. And I do view debt as temporary not permanent capital, equity as permanent capital.

And at Cogent, we have the luxury of building our business without debt and then taking on debt to accelerate returns of capital to our stakeholders and quite honestly suffered some negative carry by carrying excess cash on our balance sheet, such as the $247 million that we currently have.

Our debt is fixed term debt with the maturities in '21 and '22. Our debt also is trading above par, so therefore the market is still pricing our debt below our coupon for that debt. Interest rates have risen. We are probably in a short-term period of increased rates.

Maybe this is my personal opinion but I believe that the rate increases will be more benign than people think and maybe more short lived. The underlying growth rates are still somewhat muted for the economy and interest rates around the world remain extremely low.

For all those reasons, we will keep the debt structure that we currently have in place through those maturities. We may opportunistically look at extending maturities and/or increasing debt if it was cost effective. Today, it is probably not. And we maintain the flexibility to actually payoff our debt if rates do materially increase.

And you can see that with the substantial improvement in both our gross leverage and net leverage numbers. Our gross leverage improved sequentially from 4.57 to 4.44. That’s a fairly material improvement in a given quarter.

Our net debt improved from 3.00 to 2.94 again sequentially, again a pretty significant improvement in a single quarter and we expect those trends to continue for the next several quarters even with our increased dividend commitment..

All right, that’s helpful. And then maybe one the cost side. You run a pretty lean operation.

Are there any cost savings opportunities out there like real estate rationalization or consolidating cross connects or automation that you might be able to take advantage of going forward or that have been helping results as of late?.

So I think the answer is yes to all of the above. I appreciate the compliment that we run a lean operation. We try to be cost effective. You saw a material improvement on a sequential and year-over-year basis whether it’s gross margin and in our SG&A efficiency resulting in our operating leverage.

Some comes from revenue growth, some comes from continued real estate and other operational cost savings. We constantly evaluate our facilities, figure out if we can lower their costs. On cross connect, we’ve continued to migrate away from 10 Gig cross connects for customers or peers that have a large amount of traffic to 100 Gig.

That grooming process is a significant savings. And then in terms of automation, our primary business is delivering Internet not developing new IS systems. However, we do have internal process improvement teams, we do consistently do more with less.

And if you look at our headcount increases, almost all of our headcount, over 90% of the increase in employment at Cogent over the past year came in the sales organization with less than 10% of our aggregate increase in headcount coming in operations.

That is indicating that while our revenues grew at 8.6% and our traffic grew at 29%, the people that are actually producing the big miles are becoming increasingly efficient and we expect those trends to continue or possibly even accelerate..

All right, that’s great. Thanks, Dave..

Thanks, Nick..

Our next question comes from Michael Rollins with Citi Investment. Your line is now open..

Hi. Thanks for taking the question. Dave, you talked about the opportunity for net-centric to improve going forward.

Is there a risk though that it could decline or have subpar performance if certain things don’t go your way in terms of customer acquisition or just the expectations that you have for traffic growth in the category?.

Yes, sure, Mike. Thanks for the question. So clearly we need to be paranoid in any business that has risk and we cannot be complacent about our improvement in performance or even on our current performance. We have 15 years of experience. We have relationships with over 6,120 transit purchasing networks that is more than anyone else in the world.

We monitor our customers’ traffic literally on a daily basis and see changes in their traffic patterns both in terms of volume and destination or source depending on whether it’s an access network or a content producing customer. And we are encouraged by the continued albeit slower improvement in aggregate Internet traffic growth and our growth.

We do not generate the demand for Internet traffic. That is our end users doing that. The death of the Internet has been predicted many times. Colby alluded to it with hyperscale carriers building their own networks. I’ve heard cross connects are going to be put us out of business. CDNs are going to put us out of business.

Extended peering exchangers are going to replace transit. Transit continues to dominate the market because it is the easiest use, most ubiquitous and most importantly lowest cost way for where anyone who has a large amount of content or needs to access a large amount of content to get that content moved. Those trends are going to continue.

Our net-centric business and the growth in that business is dependent on three very simple principals.

One, is the market going to continue to grow? Two, is Cogent going to be able to continue to win new customers? And if you look at just the number of ASs connected and the progression in that path, it’s been pretty consistent and improving and we continue to do that.

And then third, will we get a larger share of the wallet from those customers? And you actually saw some indication of that even this quarter. Now it’s a negative indicator in the sense that our rate of sequential new sale decline was greater than it had normally been, being that large customers were buying more of their traffic than small customers.

There’s a lot of dynamism in the net-centric market but we continue to grow and we capture market share. And I feel very comfortable that we’re going to see continued improvement.

And again, the 3.1% year-over-year growth is low by our historic standards but is still better than the 0% growth or even negative growth that we’re experiencing at the height of port congestion and you see the results of that in the operating leverage of the entire business and the increase in our on-net business..

Thanks very much..

Thanks, Mike..

Our next question comes from Tim Horan with Oppenheimer. Your line is now open..

Thanks a lot. Dave, just a couple of clarifications. If you continue on these trends, it looks like you’re going to head down to below 2.5x debt to EBITDA next year.

Is that what you’re kind of saying that you’re okay to let that happen or do you want to kind of maintain the debt to EBITDA more in the 3x range with stock buybacks? And then I have a follow up? Thanks..

Yes, sure, Tim. So we have a scalded range that we will maintain between 2.5x and 3.5x on a net basis. We’re actually below the midpoint and trending down. We will maintain that range and if we breach it on the low end, we would most likely either increase the pacing of our dividend increases or be more aggressive about buybacks. That’s a hypothetical.

We’re not there today but we are committed to this leverage range. Now to the question Nick asked, if interest rates materially spike, we may reevaluate that. But we’re not talking about 100 or even 200-basis point increase. Anything within that range our thinking would stay consistent.

And we are delevering at a fairly significant rate and we are growing our dividend. These are good problems to have..

No, I get it. But is your [indiscernible] to let things go down to 2.5x or would you rather kind of stay around 3, or just kind of see how the market kind of plays out? And then related to that, your effective interest rate is 6.7. It seems like it’s really high versus the fundamentals. Your peers are below 5%.

Does it feel like there’s things you could do to get that down also?.

So two beautiful [ph] questions. Our goal is to kind of hover around the middle of the range to be honest. That doesn’t mean we would tolerate being below that. Buybacks are something to use opportunistically and the increase in volatility may give us some opportunity. But markets are still at all-time highs.

With regard to our interest rates, remember part of our interest rate is driven by our capital lease imputed interest which we have no control over. That is really the capital lease issuers’ decision and based on the marketplace when we took on that debt through the capital leases.

With regard to the – I recall more discretionary debt, our two high yield instruments. The coupons are 5 and three-eighths and 5 and three-eighths [ph], both are trading above par and I think the current mark-to-market on those is about 4.2 for the secured debt and about 4.5 for the unsecured debt.

And with the underlying increase in the 10-year, I think we’re doing pretty well. I don’t think there’s a lot of opportunity for us to refinance that to a lower rate and there is a make hole [ph] associated with it..

The blended rate on capital lease is about 10.5%, so that’s obviously part of the interest expense and that has to do – several of those were entered into many years ago when rates were much higher and those rates do not change when you enter into the lease agreement, you continue to use that rate throughout the term..

Got it.

And then just lastly, Dave, on the corporate side on the connections, can you talk about maybe the percentage of the base that is more kind of virtual private line versus kind of incremental new sales? You might not give the exact number but just qualitatively are you seeing a lot more higher percentage of kind of virtual private line versus the base sales?.

Yes, so we are absolutely seeing an acceleration in VPLS business, our VPN business. Today, it’s about 25% of the corporate base, about 17% of total revenues. We have not yet productized and rollout an SD-WAN product. We have fully tested those products in our labs and expect to roll out a SD-WAN product in the next couple of quarters.

We think that will further accelerate the VPN part of our corporate business because now customers will have two choices of technology as opposed to just the VPLS choice that we offer today..

Thank you..

Our next question comes from Frank Louthan with Raymond James. Your line is now open..

Great. Thank you. I wanted to talk about some of the sales force mix and when do you think you can get a higher mix of the net-centric sales people kind of go for a while to try to see how that’s there? And then on the data center utilization, fairly low relative to some of the public guys.

What do you think you could do to maybe get some better utilization of those data centers or is that calculated sort of excluding some of the space that you use for yourself, or how should we think about that? Thanks..

Okay. So the calculation is what is net rentable. It does not include Cogent utilization within the centers for our equipment. Two, we did see a slight uptick from 30% to 31% sequentially in the quarter in terms of utilization and we did not add any new data center footprint.

We also have about 18 months ago implemented a data center certification program for our sales force. If a rep goes through that additional training and passes it, they actually get some additional compensation on data center sales which has helped us sell additional RAC and power in our footprint.

Our data centers are relatively low powered density, so it is probably not totally fair for us to compare them to some of the other operators. We have about 70 megawatts across our footprint or about 125 watts per square foot as opposed to most public operators at about 250 watts per square foot.

So there are some structural differences but there aren’t many customers, mostly corporate who our data center is a very good footprint and [indiscernible] and we expect to see that continue to grow. It represents about 2.9% of revenues and 4.9% of our actual connections are RAC and power in our data centers.

Now with the regard to the net-centric sales force, we are continuing to grow that force and we do anticipate that over 2018 the growth rate of net-centric sales people will be greater than that of corporate.

Both sales organizations will grow but there will be probably a greater emphasis on net-centric as we’re seeing the underlying demand in that segment continue to improve..

And just a follow up on the data center. So I appreciate the lower power density.

If maybe asked a different way, what would utilization look like if you looked at it on say what percentage of your 70 megawatts that you have sold? Would that be a higher percentage to I would assume higher power density gears taking less floor space but using substantially more power? So how would the metric stack up onto that sort of scenario?.

It would actually be the same and the reason is we measure based on the restriction of the data center. So some data centers limiting factor is power, some are cooling and some are square footage. So when we put the theoretical number out there, it’s actually built off of the most constricted variable on each of the 53 centers.

So there’s no one answer to that. But I do think that we could sell across the footprint 3x as much data center space and therefore revenue as we’re currently getting..

Okay, great. Thank you..

Thanks, Frank..

At this time, I’m showing no further questions. I’d like to turn the call back over to Dave for closing remarks..

I’d like to thank everyone for joining us on today’s call. We are encouraged about the growth in our business and most importantly the operating leverage that we continue to demonstrate. The 12.9% year-over-year growth in EBITDA I think is a strong indication of how our business is performing.

And in particular, all of that growth is organic which leaves us I think in the best position in our sector. So again, I want to thank everyone for joining us and I look forward to seeing you all soon. Take care. Bye-bye..

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