Cogent Communications Holdings Inc (CCOI) 2010 Q2 法說會逐字稿

Good day, everyone, and welcome to the Cogent Communications Group, Inc., second quarter 2010 earnings conference call and webcast.

Today's call is being recorded. A replay will be available at www.cogentco.com.

At this time I would like to turn the conference over to Mr. Dave Schaeffer, Chief Executive Officer. Please go ahead.

Thank you very much. Thank you and good morning to everyone. Welcome to our second quarter, 2010 earnings conference call. I'm Dave Schaeffer, Cogent's Chief Executive Officer. On the call today with me is Tad Weed, our Chief Financial Officer.

We're extremely pleased with the results for the quarter despite significant foreign exchange headwinds and an improving but continuingly challenged economic environment. Our revenue grew in the first quarter sequentially by 2.6%. On a constant currency basis, however, our revenue would have grown by 4.4% sequentially. Our EBITDA margin expanded by 140 basis points from the first quarter.

Traffic growth on our network was essentially flat due to seasonal factors, but compared to second quarter 2009 was up approximately 50%. Since the end of the first quarter we significantly expanded our footprint by adding an additional 28 buildings to our network and added over 2,200 miles of intercity fiber to our network.

During the quarter, our sales rep productivity grew and increased again by 10% from the previous quarter. Our sales rep productivity increased from 3.9 units of installed business per rep per month to 4.2 units per rep per month in the second quarter.

We continue to be optimistic about our outlook for the remainder of 2010 and encouraged by the level of our backlog that we have in signed orders but not yet installed on our network. Throughout this discussion we will highlight several operational statistics we believe demonstrate our increasing market share, expanding scale and size of our network, and, most importantly, the leverage of our business model.

We have assembled a unique set of assets, infrastructure and operations which efficiently generate increasing amounts of cash while selling products that are in great demand at the lowest prices in the market. We continue to believe there are significant barriers for anyone trying to replicate the assets that we have assembled here at Cogent, and we believe we are firmly the most low-cost, most efficient operator in our sector.

I will review in greater detail certain operational highlights and our continued expansion plans. Tad will provide additional details around our financial performance, and following our prepared remarks we'll 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 second quarter 2010 earnings report and this earnings conference call discuss Cogent's business outlook and contain forward-looking statements within the meaning of Section 27A and 21E of the Securities Act. The 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.

You should also be aware that Cogent's expectations do not reflect the potential impact of mergers, acquisitions, other business combinations or financing transactions that may be completed after today. Cogent undertakes no obligation to release publicly any revision to any forward-looking statement made today or otherwise update or supplement statements made on this call.

Also during this call, if we use any non-GAAP financial measures you will find these reconciled to the GAAP measurement in our earnings release and on our website at cogentco.com.

I'll turn the call back over to Dave.

Hey, thanks, Tad.

Now for some highlights from our second quarter results. Hopefully you've had a chance to review our earnings press release. As within previous quarters, our press release includes a number of historical quarterly metrics. These metrics will be added to our website. Hopefully you find the consistent presentation of these metrics informative and helpful in understanding the financial results and the trending of our operations and our business.

Our second quarter 2010 revenue was $64.4 million, an increase of 2.6% from the first quarter of 2010. On a constant currency basis, our second quarter 2010 revenue increased by 4.4% sequentially from the first quarter of 2010.

Fluctuations in foreign exchange materially impact our revenue, particularly with our NetCentric customers. Approximately 30% of our revenues are derived from our international operations. From Q1 2010 to Q2 2010 fluctuations in foreign exchange negatively impacted our revenue by approximately $1.2 million.

We evaluate our revenue based on product class, that is, on-net, off-net, and non-core, which Tad will cover. We also evaluate our revenues by customer type, that being our two major types of customers or groups being NetCentric customers -- these are customers that typically purchase service from us in carrier-neutral data centers and whose business models are centered on the Internet -- and our corporate customers, who are located in large, multi-tenant office buildings, with whom we provide Internet connectivity to support their businesses. NetCentric customers will continue to consume more bandwidth than our corporate customers, who use the Internet to support their other businesses.

Revenues from our corporate customers grew by 6.4% in the first (sic/see press release) quarter. These corporate customers today represent 57.6% of our customer connections at the end of the quarter and represented 49.3% of our Q2 2010 revenues. Our corporate customer connections grew sequentially by 4.5%.

Revenues from our NetCentric customers decreased by approximately 0.9 of 1% from the first quarter due to the impact of foreign exchange. On a constant currency basis, however, revenues from our NetCentric customers increased by 2.8% sequentially from the first quarter of 2010. Our NetCentric customer connections grew in the quarter by approximately 6%. Our NetCentric customers represent 42.4% of our total connections at the end of the quarter and represent 50.7% of our Q2 2010 revenues.

Now for some trending and on our pricing. Pricing of our most widely sold corporate product is $800 per month, two-year contract for a 100-megabit connection, or $8 per megabit. We continue to offer discounts related to contract term and for volume for our NetCentric customers. We offer these volume and term discounts, and many of our customers avail themselves of these discounts. During the quarter, over 770 NetCentric customers took advantage of volume and term discounts and entered into longer contracts with Cogent. These contracts increased our average contract length again by approximately 2.8% sequentially over the first quarter.

The discounted NetCentric contracts and the impact of foreign exchange contributed to a 7.5% reduction in the average price per megabit in our installed base. The price per megabit of our installed base declined from $5.59 in the first quarter of 2010 to $5.17 in the second quarter of 2010. The price per megabit for new contracts in the first quarter was $4.02, as compared to first quarter of 2010, when it was $4.26. This resulted in a 5.7% reduction in the price per new sale in the most recent quarter.

Now to touch on ARPU, our on-net ARPU declined by 4.2% in the first quarter (sic/see press release), primarily due to the impact of foreign exchange. Our on-net ARPU was $938 in the first quarter of 2010, and that declined to $898 in the second quarter of 2010. On a constant currency basis, our ARPU for on-net services would have been $919, or a decline of only approximately 2%.

Our off-net ARPU continued to increase and actually increased by 5.8% sequentially from the first quarter due to the increased size of our connections. There is virtually no impact from foreign exchange in our off-net revenues. Our off-net ARPU increased from $1,254 in the first quarter to $1,327 in the second quarter.

Our on-net churn rate improved again in the quarter, and our off-net churn remained unchanged. As a reminder, we consistently report our churn on a gross basis. This includes moves, adds and changes. As a result, a customer who enters into a new amended contract with Cogent for either a longer term or greater volume is counted in our churn number. Our on-net churn rate improved to 2.3% in the second quarter, as compared to 2.5% in the first quarter. Our off-net churn rate remained stable at 2.7% both in the first quarter and the second quarter.

Traffic growth on our network due to seasonal factors was effectively flat on a sequential basis but up 50% year over year. Many of our existing customers under contract are just consuming less of the bandwidth that they purchase as people enjoy the outdoors in the summer season. And in these cost-conscious times, we continue to believe that, as Cogent is the low-cost provider in the market, this gives us a distinct advantage as we continue to grow revenues and network traffic because of the value proposition that we deliver to our customers.

Before Tad provides some additional details on the quarter, I'd like to address the expectations against our long-term revenue targets. As a reminder, we have previously announced that we expect to continue to grow our top-line revenue at between 10% and 20% annually. We remain comfortable with this range.

Comparing the first half of 2010 to the first half of 2009, we grew revenues by 12.5%. From Q1 to Q2 of 2010, we would have grown revenues at an annualized rate of 10.7%, inclusive of the foreign exchange impact. Getting out that foreign exchange impact and viewing our sequential growth on a quarterly basis, we would have grown first quarter to second quarter at an annualized rate of 18.9%, near the high end of our range.

Now I'd like to turn it over to Tad to go through some additional details on our results.

Thank you, Dave, and, again, good morning to everyone. I'd also like to thank and congratulate the entire Cogent team on their hard work and efforts in the results for the quarter.

I will begin with providing additional details on our revenue by product class, which is on-net and off-net.

Our on-net revenue was $50.3 million for the second quarter and increased 1.2% from the first quarter of 2010. Consistent with prior quarters, about 85% of our new sales were for on-net services.

On-net customer connections increased by 1,096 customer connections, or a 6.1% increase for the quarter. That was better than the 5.3% growth rate from the fourth quarter to the first quarter of 2010. We attribute that improvement due to an increase in sales rep productivity and also an improvement in our on-net churn rate. We ended the quarter with about 19,200 on-net customer connections on our network.

Revenue from our off-net business was $13.4 million and increased 8.6% from the first quarter of 2010. Off-net customer connections increased by 98, or 3%, for the quarter, and we ended the quarter with about 3,400 off-net customer connections on the network. We continue to increase and experience an off-net connection size due to the increase in the availability of off-net Ethernet services.

Non-core revenues were about $800,000 for the first and second quarter and are about 1% of our revenues and about 770 customer connections.

Regarding EBITDA and gross margin, the operating leverage of our business continued to result in healthy gross and EBITDA margins. We experienced significant EBITDA margin expansion of 140 basis points in the second quarter due to our revenue increase and our quarterly reduction in SG&A expenses. As we mentioned in our first quarter call, we do incur certain seasonal SG&A costs which total about $1 million in our first quarter that we do not incur in the second quarter. In particular, our first quarter we experience material increases in audit fees, the costs of our annual sales meeting and also an increase in payroll taxes from the resetting of payroll taxes in the United States.

Our EBITDA margin was 29.3% for the second quarter, expanding from the 27.9% in the first quarter and expanding from the 28.7% in the second quarter of 2009. EBITDA as adjusted was $18.9 million. That increased 7.8% from the $17.5 million for the first quarter and was up 13.3% from the $16.7 million for the second quarter of 2009.

Gross profit margin declined by 50 basis points for the quarter, from 55.3% to 54.8%. This is primarily due to a continued increase in investment in our expansion activities and also an increase in our off-net revenues.

Quarterly lumpiness in our gross margin and EBITDA margins can and does occur. If you examine our 21 quarters of quarterly metrics that we've included in each one of our press releases, you will notice that lumpiness in quarterly gross margin and EBITDA margins, although they have expanded over time. And that lumpiness can occur due to some of the seasonal factors I mentioned above and also the timing of our expansion activities. However, our long-term trend has demonstrated increasing gross margins and EBITDA margins, and we expect that long-term trend to continue.

On earnings per share, our basic and diluted loss per share was $0.02 for the second quarter, compared to $0.01 loss per share for the first quarter of 2010, and for the second quarter of 2009 a loss per share of $0.10. There were, however, some nonrecurring items in particular in the first quarter of 2010 which reduced that loss per share, so excluding those items the loss per share for the first quarter of 2010 would have been about $0.05. As a result, our recurring loss per share declined by $0.03, or improved by $0.03, from the first quarter of 2010 to the second quarter of 2010.

Dave mentioned foreign currency. About 30% of our business is located outside of the United States, and for the second quarter 22% of our revenues were in Europe and about 7% of our revenues were related to Canada. These relationships are consistent with prior quarters. We have just begun to recognize revenue related to our Mexican operations, which are minimal at this point.

Continued volatility in the euro and Canadian dollar to US dollar conversion rates materially impact our comparable quarterly revenues and financial results. At our first quarter earnings call we estimated the negative foreign exchange conversion impact on sequential quarterly revenues would be a decrease of about $800,000. The impact, actual impact, on our sequential quarterly revenues, was a decrease of $1.2 million, as after the call the dollar further strengthened against the euro.

The euro to US dollar average was $1.38 for the first quarter of 2010, and that decreased by $0.11, or 8%, to $1.27 for the second quarter. The rate for the second quarter of 2009 was $1.36. At current rates the euro to US dollar exchange rate is about $1.30, which is an increase of the average $1.27 for the second quarter. Should the average exchange rate for Q3 remain at $1.30, the foreign exchange impact on sequential quarterly revenues we anticipate would be an increase of about $200,000.

Capital expenditures -- our capital expenditures totaled $13.2 million for the second quarter, versus $11.3 million for the first quarter and $13.4 million for the second quarter of 2009. On a quarterly basis, we do have and historically have experienced seasonal variations in capital expenditures related to our construction activities. Quarterly capital expenditures are, in part, dependent upon the number of buildings we connect to our network each quarter and the timing and scope of our network expansion activities. Typically we experience our lowest level of CapEx in our fourth quarter.

We added another 28 buildings to our network in the quarter, which was four more buildings than we added in the first quarter. We continue to expect to expand our network in 2010 and continue to expect to add about another 120 buildings to our network for the year. In the first half of 2010 we added 52 buildings to our network.

Regarding balance sheet items, as of June 30, 2010, at quarter end, our cash and cash equivalents totaled $52.4 million. For the quarter, cash declined by $2.6 million as we continued to invest our operating cash flow in our network and geographic expansion, and also the decline in the euro impacted our cash balance. The impact of foreign exchange rates on cash was $1.1 million, or 40% of the $2.6 million reduction in cash for the quarter.

We still have about $92 million of our original $200 million at face value of our convertible notes remaining. Those notes mature in June 2027 and may be redeemed by us or put by the holders beginning in June 2014. The notes are reported on our balance sheet at $68.7 million, which is net of their unamortized discount.

Capital lease IRU fiber lease obligations were $109.4 million at the end of the quarter, and about $9.5 million of that is a current liability. Capital lease obligations at the end of Q1 were $107.1 million. As a reminder, these obligations are for long-term dark fiber leases, and typically they have initial terms of 15 to 20 years or longer, often with multiple renewal rights.

In October 2009 we entered into a $20 million revolving credit facility that we may use for corporate -- general corporate purposes, acquisition, share or note purchases. We have not borrowed under this facility since its inception.

Days sales outstanding on accounts receivable was 29 days at the end of the quarter, and that metric continues to be better than our targeted rate of approximately 40 days, and also it was an improvement from the 30 days that was outstanding at the end of the first quarter.

Now, I've said this for many quarters, but I personally want to thank and recognize our worldwide billing and collections team for doing just a fantastic job on customer collections and credit monitoring. In this economic environment, we will continue to closely monitor our credit standards and our accounts receivable. Further demonstrating our excellent customer collections performance, our bad debt expense was only 1.9% for the quarter, of revenue.

As Dave mentioned, our average contract term continued to increase and increased by another 2.8% for the quarter, as more and more customers enter into longer term contracts with Cogent. When we have an increase in our average contract term and also due to our credit monitoring activities this can and has impacted our revenue performance under US GAAP. As an example, when we increase our average contract term and the estimated customer life results in a longer period, that lot longer period is used to amortize our installation revenues. We have experienced an increase in this amortization period used to recognize our installation revenues, and that has reduced our revenues reported under US GAAP. Additionally, as we closely monitor credit and our accounts receivable, this can result in the rejection of certain orders or the termination of an account.

Cash flow from operations was consistent with the first quarter and second quarter at about $15 million and was $13 million for the second quarter of 2009.

Finally, on operating income, we continue our progress towards achieving net income and positive earnings per share by increasing our operating income by another 10%, from $2.7 million for the first quarter to $3 million for the second quarter.

I would now like to turn the call back over to Dave.

Hey, thanks, Tad.

I want to take a moment and chat a little about sales force productivity. We began the quarter with 262 quota-bearing sales reps, and we ended the quarter with 248 quota-bearing sales reps. We hired 30 reps during the quarter, and 44 reps left the company during the second quarter of 2010. Our monthly rep churn rate did increase slightly, to 5.8%, as compared to 4.5% in the first quarter of 2010. This rep turnover, however, is still substantially below our historical rates of approximately 8% of our sales force per month. We continue to invest in training, but we also manage out those reps that are not well suited for selling Cogent's services.

We began the second quarter with 250 full-time equivalent sales reps -- these are reps that have ramped to full productivity -- and ended the quarter with 236 full-time equivalent sales reps. Productivity on these full-time equivalent-basis reps for the second quarter was 4.2 units, or customer connections, installed per rep per month during the quarter. This performance was a 10% improvement from the 3.9 units per FTE rep experienced in the first quarter and better than our long-term historical average of 4 units per rep per month over the past four years. As a reminder, our rep productivity numbers are not based on contract signings but are derived and based on actual installed customer connections.

Now to the scale of our network, we added 28 buildings to our network in 2010 second quarter and have reached a significant milestone in having over 1,500 buildings directly connected to our network, actually 1,503 at the end of the quarter. We continue to expand our metro footprint and have 14,200 miles of metro fiber and over 50,600 miles of intercity fiber. Cogent's network is one of the most interconnected networks in the world, where today we are directly connected to 3,250 networks. Approximately 110 of these networks are settlement-free peers. The remaining 3,140 networks are in fact customers of Cogent.

Our network has substantial available capacity to accommodate additional growth. At the end of the quarter we were utilizing about 18% of the width capacity in our network. We continue to evaluate additional fiber routes, both in North America and in Europe. We do try to take advantage of the opportunities presented to us due to the volatility in the market, and we continue to be opportunistic in taking advantage of these opportunities to accelerate our expansion plans.

So, in summary, traffic on our network continues to grow. Revenues are growing faster than virtually everyone in our sector. We are selling our services at the most competitive prices. We believe that Cogent's strategy as a low-cost provider and our value proposition to our customers is truly unmatched. Our pricing strategy has attracted many new customers, improved rep productivity, increased our average contract length, lowered our churn rate, increased our volume and revenue commitments from existing customers. Our business remains entirely focused on the fastest growing segment of the telecommunications industry -- that is, the Internet. And we provide a service that is a necessary utility to our customers.

We have a very strong balance sheet when compared to others in our sector and have been able to grow our business out of internally generated funds. We are putting our operational cash flow to work by continuing to expand our domestic and international footprint. We are encouraged by our sales initiatives, the size of our sales backlog, and we are committed to providing top-line revenue growth of between 10% and 20% and continuing to expand our EBITDA margins and, most importantly, generating meaningful free cash flow for our shareholders.

With that, I'd like to now open it up for questions from the floor.

Thank you.

(Operator instructions.)

And we'll go first to Frank Louthan, with Raymond James.

Good morning. This is [Mike Ciaccia] for Frank. Thanks for taking the questions. First, on the price per Mb for the new contracts, do you think that you're going to have to drive that down more this year to stay ahead of competition, and can you give us a sense on where you think that's going over the next 12 months? And then, on the data center business, can you give us an idea on what demand like is there, and are you seeing any pricing pressure? Thanks.

Okay, great. Thanks for the question. In terms of price per megabit, this is really a relevant metric for our NetCentric customers. Our corporate customers, while they purchase on a per megabit basis, actually think about their purchase on connections, as they're only utilizing about 9% of their capacity purchase. For our NetCentric customers they do buy per megabit. We expect prices to fall perpetually. However, we are encouraged by the deceleration in the rate of price decline. And you saw that in the fact that our installed base declined sequentially at 7.5% quarterly, yet the price of new sales in the quarter declined by only 5.7% sequentially.

We do think that prices will continue to fall, led by Cogent, not driven by competition, but rather driven by our desire to help grow the market and capture additional market share. And the fact that we can become more efficient due to our scale is demonstrated by the fact that even in an environment of declining prices we're seeing margin expansion and free cash flow expansion. We expect that number to continue to decline going forward and expect rates of decline similar to what we saw in this most current quarter.

Now, to address the data center question, we operate 40 data centers and about 350,000 square feet of raised floor space. It is a relatively small part of Cogent's business in that we have approximately 4.6% of our revenues derived from rack and power. We do operate our data centers primarily to help us sell bandwidth, which is our primary business. We continue to see robust demand both for bandwidth and data center space. Our data centers are spread out in approximately 33 markets, and it really is a question of which markets. In some markets we see extremely tight demand and our data centers are near or at capacity. In other markets we have substantial capacity available. We remain substantially underutilized in our data center footprint and have sold only about 35% of our available data center space.

Our centers are technically carrier neutral, but it is often difficult for other carriers to justify construction into a Cogent-owned facility knowing they're going to have to compete with Cogent and really only can possibly get a backup position due to their higher pricing structure. So, practically our centers are de facto single-provider centers, even though we allow other carriers into the facilities. This does not fit the requirements of all customers. We continue to see strong demand in the carrier-neutral facilities, where people can readily get backup providers to us, as well as a number of customers prefer our centers because of our lower price, generally, for rack and power than the carrier neutrals.

Great. Thanks.

Hey, thanks a lot.

We'll go next to David Dixon, with FBR Capital Markets.

Thanks, Dave, and good morning.

Hey, Dave.

I wanted to ask you a question on your NetCentric pricing strategy, to extend on the last question there. You mentioned you are still a low-cost provider here, and you're offering volume and term discounts, and our checks that we've been doing are highlighting that you've got some promotional pricing out there in the market at around $1 per Mb that continued through the quarter. And I wondered if you could talk about what was driving that initiative specifically, whether that was perhaps a reaction to specific competitive pricing activity or a desire, as you mentioned, to get out in front on price again.

And, secondly, we're seeing Hurricane Electric get out there at $1.00 per Mb, but that's for IPv6. Is that a market share grab, in your view, or, if that is the case, how important do you think IPv6 is to your business going forward?

Okay. Let me start with promotional pricing. We consistently have promotions at all times, both for our corporate and NetCentric customers. These promotions sometimes include waiving install, sometimes a reduction in price in exchange for longer term. In the case of our $1 offer, it was actually driven by technology. We had a large inventory of ports. These are on 10Gb interfaces that have a constriction based on the chip set on those cards. They can only support 5 Gb of traffic on a 10Gb interface. Anything greater than that would cause oversubscription and a degradation in throughput.

Because we had such a large inventory of these ports and a large inventory of full-line-rate 10Gb ports, as well, what we decided to do was offer a special offer in the quarter where you could get 5 Gb on a 10Gb port. It would only be for that very specific interface and commitment at $1.00 a Mb to try to sell out of those cards that could not be upgraded due to the ACYC limitation. So it was driven not by competitive pressures but rather by some technology limitations in some older interface cards in our network that are a minority of the 10Gb interfaces in our network.

Now, to the IPv6 question, we offer IPv6 and IPv4 to our customers. IPv6 remains a very limited product segment. To put it in perspective, today the IPv4 routing table contains approximately 285,000 entries. The IPv6 table has about 3,100 entries, so it's about 1% of the size. If you actually measure IPv6 traffic by flows, it is even less than 1%, as most devices are today not IPv6 capable. We do think that as IP space exhaustion hits other service providers there will be a push towards IPv6. We, however, sit on probably the third or fourth largest pool of IPv4 space in the world and have adequate space for all of our customers.

So we expect to continue to see IPv4 dominate traffic on the public Internet, but there will be an increasing market for IPv6, and, again, we offer 6 and 4 at the exact same price. There is no premium. And, in fact, what we allow customers to do on a single port is offer both IPv6 and IPv4 everywhere, as opposed to some providers who only offer it in very limited locations.

That's very helpful, Dave. And you mentioned, just as a follow-up, you mentioned that traffic growth was flat this quarter. It was up 10% sequentially in second quarter '09. We seem to be seeing an acceleration in the convergence between CDN and IP Transit services. We're seeing companies, for example, Disney, buying IP Transit and seeking CDN to close to zero incremental cost layered on top of that. And your competitors appear to be folding CDN into their IP Transit services to a varied extent. I'm wondering to what extent that could drive a market share shift away from Cogent going forward.

I believe we are probably the largest provider of Transit to the CDN industry. We have hundreds of CDNs as customers today. And, remember, a CDN still consumes Transit. It may reduce the milage that the bit travels, but it still needs Transit to get to its end user customers. And in most CDNs they actually consume more Transit than they sell in the fact that they do not have 100% of their content cached at all locations. So we actually are a direct beneficiary of any CDN growth.

We grew traffic 50% year over year. I believe that is faster than the general Internet is growing. That is faster than the CDN industry. And, in fact, we have been growing our revenue substantially faster than the couple of publically traded CDNs, as those companies have really morphed quite a bit and have become more software-as-a-service and selling more analytical tools and deemphasizing their distributed hosting product, which is really what a CDN is. So we don't see CDNs at all as competitors, but rather we see them as a robust customer segment.

Okay. Thanks very much, Dave, and best of luck for the second half.

Hey, thanks a lot, Dave.

Thank you. We'll go next to Colby Synesael, with Cowen & Company.

Great, thanks for taking the questions.

Hey, Colby.

I wanted to talk about your cap structure, both as it includes your cash position as well as your debt, and what you think is the optimal balance of the two for a company like Cogent. And, on the same topic, can you remind us what you think the total amount of on-net buildings makes sense for someone like Cogent? If I recall correctly, I think it's a limited amount of buildings that makes sense for you, and as a result of that maybe in 2012 or, excuse me, 2011 we should start to see on-net building net adds come down, and that would obviously have a positive impact on reducing CapEx. So just trying to get a better understanding of the optimal cap structure and what you could potentially be doing with some of this excess cash in the future.

Sure, Colby. So, our primary focus on capital is first of all having enough capital to run the business, and that includes the ability to invest in the business and also the ability to have enough liquidity that we are not constrained in the short term. We feel that our current cash balance of a little over $50 million is probably a little beyond what we need as that cash cushion, but we're also in some fairly uncertain times.

So, in the past we have taken cash from operations and used it to buy back stock. We've bought back our debt when it was appropriately priced. And we have also decided to accelerate our footprint expansion, and that footprint expansion has primarily been in route miles, where our long-haul network in the past five years has gone from 24,000 to almost 51,000 miles, our metro network has gone from 8,900 to about 14,200. So we continue to invest by expanding the footprint.

In terms of leverage on the balance sheet, we look at many of our competitors who are more heavily levered than us. We could, in fact, put additional leverage on and return that cash to shareholders, although because of the volatility in the capital markets we have maybe erred on the side of being a little bit more conservative and decided to keep Cogent underlevered relative to our competitors. We are committed to generating free cash and returning that to shareholders. As a reminder, over the past two and a half years we reduced our share count by over 15%, and we have also purchased in over half, or about 55%, of our outstanding convertible debt.

Now, with regard to on-net buildings, there are two types of on-net buildings we connect to the network. Data centers, we have about 450 of those today, and we have a virtually ubiquitous footprint throughout Europe and North America. That business, however, is reactive. As new data centers get built, we connect to them. One of the major carrier-neutral operators earlier this week announced a new facility in northern Virginia. We will connect to that facility. We continue to see facilities either that were mothballed coming back on line or brand new facilities being built, and we expect that number to grow. And, to be quite honest, I can't give you a firm prediction on what that number is ultimately going to plateau at, but we expect it to grow.

On the multi-tenant office building side, we actually do expect to see a finite market. The finite -- the number of buildings greater than 500,000 feet in North America -- that's US and Canada, which is where our multi-tenant office building portfolio is -- is about 1,800. Some of those buildings are far from fiber. Some are single tenanted. Today we have about 1,050 of those buildings with an average square footage of about 580,000 square feet and about 9.2 customers per building. We look for buildings that have about 50 opportunities, on average. We think that number will increase from the roughly 1,050 to somewhere between 1,250 and 1,300 and we will have kind of reached all of our targeted markets.

We actually expect to see a deceleration in capital spending, not because of a reduction in the rate of building additions, at least for the next couple of years, but rather a reduction in the rate of new routes being added to the network. That 24,000 to 50,600 miles has been pretty rapid and really has accelerated in the past year or year and a half. We expect to see that rate of new route expansion start to decelerate, not because there's not enough opportunities. It's just there's not enough markets that make economic sense for us to expand to.

We've been pretty clear with investors what our targets are and which markets are probably not good targets for Cogent either due to lack of demand, regulatory environment or extremely high cost to serve. So you should see the rate of route mile expansion slow first, then the rate of building expansion follow after that. Both of those will contribute to a reduction in capital spending, coupled with the increase in EBITDA [shall] see accelerating free cash flow in the out years.

And, Dave, if I could just slip in one real quick one, it sounded like you added 2,200 route miles during the quarter. In the past, when you've gone and lit that fiber, because you are buying dark fiber, when you light that fiber there is a cost we've seen reflected on the income statement. Should we expect that in the third quarter, and could that have a near-term negative impact on margin?

Well, you actually saw it in the second quarter in that our gross margin declined by about 50 basis points, as Tad commented on. We quickly start to get density on those routes with new customers and absorb those costs. While we may expect a slight impact in gross margin in the upcoming quarters, we think it will be minimal and not very impactful and should not really impact EBITDA margins in third and fourth quarter.

Great, thank you.

Thank you. We'll go next to James Breen, with William Blair.

Thanks. I just had a question about the margins. I understood what Tad was saying about some of the costs coming out in the second quarter, but, nonetheless, margins look like they have been increasing on a year-over-year basis. Can you just talk about sort of the levels you're seeing going forward from an SG&A perspective and from a margin perspective, and is this just due to a growing business? Thanks.

Yes, good morning. This is Tad. There's really a couple of impacts if you look at the sequential margin change, which we mentioned was a 50-basis-point decline. There's really two major components of that. We have the cost associated with expanding. We mentioned the fiber, which carries a maintenance cost associated with that being the major component of that. And then we also have -- we had a substantial increase in off-net revenues quarter over quarter, and there's about a 50% margin on that off-net business, so you have the associated cost of the circuit that's carried with that. So the margin on that business, call it 50%, while the direct gross margin on on-net is, frankly, about 100%, because there's no direct cost of goods sales associated with that. So it's really attributed to both expansion and mix.

And in terms of the SG&A part, Jim, it is a question of scale. The sales force is becoming more efficient. We're defraying the G&A portion of the SG&A over a larger revenue base. So we anticipate continued margin expansion at the historical rates that we have demonstrated, and we expect that going forward.

Great, thanks.

(Operator instructions.)

We'll go next to Michael Funk, with Bank of American Merrill Lynch.

Great. Thank you for taking the questions. I just have two quick ones. First, on the economy, it looks like your on-net disconnects have been trending down pretty reliably over the last year or so from their peak. I'm hoping to get some insight into what you're seeing here for the remainder of the year. Second, coupling that with the increase in backlog or contract signings that you've seen certainly implied projected acceleration in top-line growth ex-currency for the remainder of 2010 into 2011. And then, finally, just digging a bit more into the CapEx question, more granularity on spending for building connections, data center connections, and then just maintenance, I think it would help us in our modeling going forward.

Yes, sure, Michael. Thank you for the question. Let me try to take a couple of them here. On the economy, listen, 2009 was a really tough year, and we grew at about 9.2%, and when you factor in currency it was about 11 -- or excuse me, 9.4%, and with currency it was about 11.2% on a constant currency basis. So even in a tough economy it shows Cogent can grow because of the value we deliver.

You're absolutely right that the economy probably is at least stabilizing and not in free fall, I'm not going to say it's robust, and we should expect to see continued acceleration in our growth. Witness what we did in this most recent quarter. The 2.6% sequential growth, while strong, was really dramatically understated because of the volatility in foreign exchange, and we expect -- the contract volumes that we've been signing, unit contract volumes are at unprecedented levels. We continue to see record number of unit sales even with a few less full-time equivalents. So that is all going to result in accelerating revenue growth.

We clearly have no control over the currency fluctuations, and we try to be smart about it, but, as Tad said, we even lost $1 million, or $1.1 million, just because we had money parked in Europe and it became less valuable. So we're obviously not currency traders. We're providers of Internet service. I'm going to let Tad touch on the churn question a little bit, and they maybe I'll come back and bifurcate the capital question.

Yes, I mean, we're pleased with the improvement in churn rate, and a couple of the amounts as a reminder, so on-net churn was 2.3% for the quarter, it was 2.5% for the first quarter of 2010. And if you go back to the second quarter of 2009 it was 3.1%. So it has trended down, or it has improved. And I think a major contributing factor to that is, frankly, the increase in contract terms. So we're signing up more customers to longer term contracts. I think we're being -- I know we're being more stringent on what customers we accept on the front end, and that's -- you can see that in our day sales of accounts receivable approving. So I think we've got a more sticky group of customers that's lowering our churn rate, and they're signing up for longer terms, which is resulting in these improved rates.

On the off-net side it's been very similar. Historically we have had some acquired customers in that base. That is really probably 18 months, two years behind us. But we're seeing a similar result in that business, as well, similar declines in the churn rate. And those rates were -- it was flat Q1 to Q2, 2.7%, but if you go back to the second quarter of 2009 it was 3.2%. So you're seeing a similar improvement -- longer term contracts, better mix of customers and more stringent monitoring of the base.

And higher ARPUs due to the fact that these customers are typically, when able, trying to migrate to Ethernet services, which has always been our core competency.

Now, to the CapEx number, our capital spending is broken into three major subcategories -- new buildings being added to the network, and following on to Colby's question, at least for the next couple of years we expect that to be relatively constant, and that's about a $15 million expenditure. We also spend capital on new routes, and that capital spending occurs actually three ways. It occurs in entering new capital leases that are prepaid. That actually doesn't show up directly in CapEx but capital lease balances, many of which are prepaid. Sometimes we take title to the fiber, in which case it directly hits capital. And then there is the actual cost of hiring contractors or capitalizing labor to install the equipment that we have.

All of that results in elevated levels of capital, which you saw in 2009 and we've guided to in 2010, and, as you saw, our capital spending levels for Q1 and Q2 were virtually identical for the two years. We do expect to see that expansion capital start to come down as, again, we slow down the rate at which we're adding new routes to the network.

And then, finally, there's a maintenance CapEx number. This is what we have to spend to keep the current network running. That number right now is between $13 million and $15 million on an annual basis. We expect that number to actually creep up over time as equipment gets older. And, following on to Dave Dixon's question, there are certain technologies that are not cost effectively upgraded. Witness the fact we had some cards that had this line rate limitation on them. Now, fortunately, it was a small subset of our total inventory of total 10Gb ports, and we had a way of generating the maximum amount of revenue on them with the promotion that we ran. But we expect over time to see that maintenance number creep up, but our total capital spending should decline from what you saw in 2009 and 2010.

And one quick follow-up, if I could, last quarter you guided to a 100-basis-point year-over-year increase in the EBITDA margin. Maybe I missed it, but could you comment on that previous guidance?

Yes, we still think that's about correct based on the rate at which we are adding network elements or -- either buildings or long-haul routes. We think that once our rate of expansion slows, that a 100-basis-point rate of margin expansion will actually reaccelerate to look more like the 300-basis-point annual rate we were experiencing in '06, 05', 07.

Great. Thank you very much.

Okay. Thanks, Michael.

And we have no further questions at this time.

I would like to turn the call back to Mr. Dave Schaeffer for closing remarks.

Well, we thank you all very much for helping us. I want to congratulate the entire Cogent team, particularly the sales organization, on a tremendous effort and great results for the quarter. Thank you all for taking the time, and we look forward to chatting with you in another quarter. Take care. Bye-bye.

Thank you. That does conclude today's conference. We thank you for your participation.