Cogent Communications Holdings Inc (CCOI) 2012 Q2 法說會逐字稿

Good day. Welcome to the Cogent Communications Group InCorporated second quarter 2012 earnings conference call and webcast. Today's conference is being recorded and available for replay at www.CogentCo.com. At this time, I would like to turn the conference over to your host, Chief Executive Officer, Dave Schaeffer. You may begin.

Thanks and good morning to everyone. Welcome to our second quarter 2012 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 were pleased with our results for this quarter and are optimistic about the strength of our Business and the outlook for the remainder of 2012.

During the quarter, we experienced and returned to sequential revenue growth, EBITDA margin expansion and traffic growth. Additionally, we generated $5 million of net cash flow in the quarter, a quarter which included $1.3 million being spent for the purchase of shares of our common stock and the negative impact of $1.1 million on cash flow from foreign exchange.

Our revenue growth from the first quarter was 1.2%, and grew by 3% year-over-year from the second quarter of 2012. On a constant currency basis, our revenues grew from the first quarter of 2012 by 1.7% and on a year-over-year basis grew by 5.7%. On a constant currency basis and adjusting from the impact from the loss of our largest customer, Megaupload in the first quarter in January, our revenues grew sequentially by 2.9%.

An additional third item impacted our revenue growth and it included the impact of recognizing our deferred revenue from our customers over a longer average contract period. Including this impact our revenues grew sequentially 3%. On a constant currency basis, adjusting for the loss of Megaupload and the change in customer nonrecurring install amortization, our revenues grew on a year-over-year basis 12.1% from the second quarter of 2011.

As we projected on our Q1 2012 earnings call, we would expect and did experience and extraordinary increase in our sequential EBITDA margin expansion. In this quarter, our EBITDA margin expanded by 330 basis points sequentially from the first quarter to 32.6%. During the quarter, traffic on our network grew sequentially 10% from the first quarter and slightly over 20% from the second quarter of 2011.

Since the end of the first quarter, we continued to expand our footprint by adding an additional 30 buildings, 6,200 metro fiber miles to our network and over 260 intercity fiber route miles to our network. During the quarter, our sales force productivity was 5.1 units of installed business per rep per month. This is significantly above our historical average of 4.1 units per rep per month.

Also during the quarter, we opportunistically purchased shares of our common stock in the open market under our $50 million authorized buyback program. In the second quarter, we purchased approximately 75,000 shares for $1.3 million at an average price of $16.95. As we mentioned in our press release, at our August 7 Board meeting our Board of Directors approved the payment of our first quarterly dividend for our common stock of $0.10 per share per quarter.

This dividend will be paid on September 12, 2012 to shareholders of record as of August 22, 2012. Throughout this discussion, we will highlight several operational statistics we believe demonstrate our increasing market share, expanding scale and size of our network and probably most importantly, the operating leverage of our business model. We continue to believe there's a very significant barrier for anyone to attempt to replicate the assets that we control at Cogent. We are the lowest cost, most efficient operator in the sector. We remain focussed on bringing our network to the most traffic-rich locations and selling the highest quality Internet service to our customers at the absolute lowest price.

I will review in greater detail some of the operational highlights of the quarter and our continuing operational plans. Ted will provide some additional detail on our financial performance. Following our 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. Good morning, everyone.

This second quarter 2012 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. 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.

You should also be aware that Cogent's expectations do not reflect the potential impact of mergers, acquisitions, other business combinations or financing transaction that may be completed after today. Cogent undertakes no obligation to release publicly any revision to any forward-looking statements made today or otherwise update our 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 in our website at CogentCo.com.

Now, I'd like to turn the call back over to Dave.

Thanks, Tad.

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

Our second quarter 2012 revenue was $77.8 million, an increase of 1.2% from our first quarter revenues and an increase of 3% from our Q2 2011 revenues. On a constant currency basis, our revenues increased sequentially 1.7% from the first quarter and 5.7% from the second quarter of 2011. On a constant currency basis, and adjusting for the loss of Megaupload on January 19 and the increase in our average contract length, our revenue sequentially increased 3% from the first quarter and 12.1% from the second quarter of 2011.

We evaluate our revenues based on product class, On-Net, Off-Net and Non-Core, which Tad will cover in greater detail. We also evaluate our revenues by the type of customer who purchases our services. Our customer types include two groups, NetCentric customers and Corporate customers. All Cogent customers are categorized two ways, either as Corporate or NetCentric and is either On-Net Off-Net or Non-Core. NetCentric customers buy large amounts of bandwidth from us, generally in carrier neutral data centers. Corporate customers generally buy bandwidth from us in large, multi-tenant office buildings.

Revenues from our Corporate customers grew approximately 2.5% from the first quarter. Our revenue from Megaupload was 100% On-Net, 100% NetCentric, so the loss of January of 2012 of that customer had no impact on our Corporate customer growth. Our Corporate customers represent 53% of our total number of customer connections at the end of the quarter and represent 52% of our Q2 2012 revenues. Our Corporate customer connections grew sequentially 3.3% for the quarter.

Revenue from our NetCentric customers including the impact of the loss of $900,000 of revenue from Megaupload was flat for the quarter. Adjusting for the loss of Megaupload, revenues grew from our NetCentric customers approximately 2.3%.

The impact of foreign exchange has a greater impact on our NetCentric customers. Adjusting for both the loss of Mega as well as the foreign exchange impact, our NetCentric customers grew 3.1% from the first quarter. Our On-Net customers represent 47% of our total customers connections at the end of the quarter and represent 48% of our Q2 2012 revenues. Our NetCentric customer connections grew 6% sequentially in the quarter.

Now for some trends on pricing. Our most widely sold Corporate product continues to be a 100-meg connection and our most widely sold NetCentric product continues to be a 10 Gigabit connection. We offer discounts related to our Corporate and NetCentric customers based on term of contract. We also offer volume commitment discounts to our NetCentric customers. During the quarter, over 1,300 NetCentric customers took advantage of our volume and term discounts and entered into longer term contracts with Cogent, increasing their revenue commitment to Cogent by over $11.6 million.

Customers also continued to express their confidence in Cogent by entering into longer term contracts with us. Our average contract term increased by another 1% sequentially in the quarter. More than one out of every three customer contracts entered into in 2012 was either for a two or three year term.

During the second quarter, this increase in our average contract length negatively impacted our revenues by approximately $100,000. Our average price per megabit of our installed base decreased in the quarter. The average price per megabit declined from $3.81 in the first quarter of 2012 to $3.44 in the second quarter of 2012.

The price per megabit for our new customer contracts signed in the second quarter was $1.82, down from the $2.36 for new orders installed in Q1 of 2012. The decline in price per megabit for new contracts is partially attributable to certain promotional activities that we have been running in response to recent industry M&A.

Now for the average revenue per user. Our On-Net ARPU for Corporate and NetCentric customers combined declined by 2.7% sequentially from the first quarter of 2012 to the second quarter of 2012. This decline in ARPU is partially attributable to the targeted promotional activity that I mentioned earlier. Our On-Net ARPU was $731 in the first quarter and $711 in the second quarter. Our Off-Net ARPU which is predominantly Corporate customers was essentially flat in the quarter. Our Off-Net ARPU was $1,650 in Q1 of 2012 and $1,643 in the second quarter.

Before Tad provides some additional details on the quarter, I'd like to address our results against our announced revenue and EBITDA targets. As a reminder, we updated our expectations for the first and second quarters of 2012 and full year 2012 after the extraordinary event of the government shutdown of Megaupload previously, who was our largest customer at that time.

Again, we normally do not provide quarterly guidance. Rather, as in the past, we provide annual targets, related to our Q2 2012 results as opposed to the expectations on our last earnings call. Beginning in our second quarter, we experienced top line sequential revenue growth resumption. On a constant currency basis, adjusting for the loss of Mega and the adjustment for our increased contract term, our revenues increased sequentially on a quarterly basis by 3.0%.

This revenue is consistent with our long-term average quarterly growth rates. We announced the expectation of an extraordinary increase in our EBITDA margins from the first quarter of 2012 to the second quarter 2012. Our EBITDA margins increased sequentially 330 basis points. This increase was substantially greater than the long-term average sequentially improvement in our EBITDA margins of generally 40 to 50 basis points.

Additionally, we expect that our EBITDA margins on an annualized basis will resume their approximately, 200 basis point per year improvement. On a calendar year basis, we expect a reduction in our absolute capital expenditures for 2012 as compared to 2011, of approximately 10%. We expect our revenue growth for full year 2012 over full year 2011 will be below our annualized revenue growth targets of 10% to 20% due to the loss of Megaupload, as well as the negative impact of foreign exchange. We continue to anticipate full year revenue growth for 2013 over 2012 to be well within the range of 10% to 20%, and our EBITDA margin expansion for 2013 over 2012 will be at least 200 basis points.

Now, I'd like to turn things over to Tad, so he can give you some additional details on the quarter.

Thank you, Dave. Again, good morning to everyone.

I'd also like to thank and congratulate the entire Cogent team on their hard work and efforts during the quarter. I'll begin by providing additional details on our revenue by product class.

Our On-Net revenue was $57.3 million for the second quarter which was an increase of 1% from the first quarter. We continued to add On-Net customers to our network and the impact of the loss of Megaupload negatively impacted our On-Net sequential revenue results. If you exclude the impact of the loss of that customer, our On-Net revenue increase was 2.6% from the first quarter.

Similar to prior quarters, approximately 85% of our new sales for the second quarter were for our On-Net services. Our On-Net customer connections increased by 4.7% for the quarter and we ended the quarter with about 27,500 On-Net customer connections on our network in our 1,800 On-Net buildings.

Our revenue from our Off-Net business was $19.9 million for the second quarter, which was an increase of 1.9% from the first quarter as we continued to add Off-Net customers to our network. Our Off-Net customer connections increased by 3.5% for the quarter and we ended the quarter serving about 4,100 Off-Net customer connections in approximately 4,000 Off-Net buildings. Our Non-Core revenues were approximately $0.6 million for the first and second quarter and now represent less than 1% of our revenues and about 500 customer connections.

Related to churn, churn rates for both On-Net and Off-Net improved during the quarter. Our On-Net monthly gross churn rate was 2.6% for the quarter, as compared to 2.7% for the first quarter. Our gross churn rates, as a reminder, include customers who remain with us but enter into amended or so-called move, add, change Cogent contracts. If you exclude the increase in these move, add, change contracts, so net churn, our On-Net net churn rate improved to 1.2% for the quarter as compared to 1.6% for the first quarter.

Our Off-Net gross monthly churn rate was 2.3% for the second quarter, an improvement from 2.8% for the first quarter. Again, excluding the increase in move, add, change contracts, our Off-Net net churn rate also improved. The rate improved to 1.4% in the quarter as compared to 1.9% for the first quarter.

Our EBITDA margin sequentially increased, as Dave said, by 330 basis points in the second quarter, from our increase in revenue and from the expected impact of a decrease in our SG&A expenses. Our EBITDA margin was 29.3% for the first quarter and 32.6% for the second quarter. EBITDA as adjusted was $25.3 million for the quarter, which was an increase of 12.3% from the first quarter. Our gross profit margin decreased by 40 basis points in the quarter, from 55.4% to 55%. Our On-Net revenues continue to carry 100% direct incremental gross profit margin and our Off-Net revenues continue to carry a 50% incremental direct gross profit margin.

Occasional lumpiness in our EBITDA and gross margins can and does occur. If you examine our quarterly metrics for the last 29 quarters, included in each of our press releases, you will notice the lumpiness in our quarterly margin expansion. This lumpiness can occur due to seasonal and other nonrecurring factors.

Seasonal factors include -- the resetting of payroll taxes, in particular in the US; our annual sales meeting costs; and costs of living or CPI increasing, which typically occur in our first quarter; timing of our audit and tax services, which are also greater in our first quarter; and then the timing and scope of our expansion activities, which does vary quarter to quarter. Additionally, in the first quarter of 2012, we experienced an increase in bad debt expense due the loss of Megaupload and the loss of the associated On-Net revenue.

Our long-term margin trend has demonstrated that our business model generates increasing EBITDA margins. As we mentioned on our first quarter earnings call, we expected that our EBITDA margin would significantly expand from the first quarter of 2012, and in fact it expanded by 330 basis points, consistent with our plans.

Interest expense, results from interest incurred on our $175 million of senior notes that we issued in January 2011 and our $92 million of 1% convertible senior notes and also interest in our capital lease obligations. Our interest expense was $9 million for both the first and second quarters of 2012. Our basic and diluted loss per share was a loss of $0.04 for the second quarter as compared to a loss of $0.05 per share for the first quarter.

Reducing our loss per share in the first quarter was a tax benefit of about $0.7 million, which is about $0.01 per share for the first quarter. So, if you exclude that tax benefit, the loss per share was 6% -- $0.06, rather, for the first quarter, as compared to the $0.04 we incurred for the second quarter.

Foreign currency -- approximately 27% of our business is located outside of the United States and about 20% of our revenues are based in Europe with the remaining 7% of our revenues related to our Canadian and Mexican operations. Continued volatility in foreign exchange rates can materially impact our comparable quarterly and annual revenues and financial results. The foreign exchange impact on our revenues from the first quarter to second quarter was a decrease of approximately $0.4 million.

Our revenue increased from the first quarter by 1.2%, but on a constant currency basis that was 1.7%. The foreign exchange impact on our revenues from the second quarter of 2011 to the second quarter of 2012 was a significant decrease of approximately $2.1 million. Our revenue increased from the second quarter of 2011 to the second quarter of 2012 by 3% but on a constant currency basis was approximately twice that rate at 5.7%.

The average Euro to US dollar rate thus far in the third quarter of 2012 is approximately $1.23. That's a relatively significant decline from the average rate of the Euro to US dollar exchange rate for the second quarter of 2012, which was $1.28. Should the average exchange rates for Q3 remain at current levels, we estimate that the foreign exchange conversion impact on sequential quarterly revenues from the second quarter of 2012 to the third quarter of 2012 will be a reduction in sequential quarterly revenues of approximately $0.8 million.

Our revenue and customer base of approximately 32,000 customer connections is not highly concentrated. For the second quarter of 2012, no customer represented more than 1% of our revenues and our top 25 customers represent approximately 6% of our revenues.

On a quarterly basis, we can and have historically experienced seasonal variations in our CapEx, prepaid capital lease payments and construction activities. Our quarterly CapEx and prepaid capital lease payments 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. Our capital expenditures totaled $10.6 million for the second quarter, versus $12.3 million that we incurred in the first quarter of 2012.

We added another 30 buildings to our network in the second quarter and we've added 130 buildings to our network over the last 12 months. Our capital lease payments, including prepaid capital leases, were $1.7 million for the second quarter, compared to $7.1 million from the first quarter of 2012. We continue to expect to expand our network in 2012 but at a slightly more moderate pace than we experienced in 2010 and 2011.

On some balance sheet items. At the end of the quarter, our cash and cash equivalents totaled $237.2 million, and as Dave said, for the quarter our cash increased by $5 million as our $19.5 million of operating cash flow that includes our $0.5 million semiannual interest payment on our convertible debt was only partly offset by $10.6 million of CapEx, $1.7 million of IRU capital lease payments and $1.3 million spent on stock purchases.

Our operating cash flow increased to $19.5 million from the second quarter, from $12.7 million for the first quarter. Our operating cash flow for the first quarter included a semiannual interest payment of $7.3 million on our senior notes and the impact from the loss of Megaupload. Our operating cash flow continued to be impacted by our $7.3 million semiannual interest payments on our senior notes. These interest payments occur in February and August and will be made through 2018.

We have about $92 million of our original $200 million in face value of our convertible notes outstanding. These notes carry an interest rate of 1% and mature in June 2027 and may be redeemed by us or put by the holders beginning in June of 2014. The notes are reported on our balance sheet at $79.5 million, which is net of their unamortized discount.

Our capital lease IRU obligations are for long-term fiber leases and typically have initial terms of 15 to 20 years or longer, and include multiple renewal options after their initial term. These capital lease IRU fiber lease payments or obligations totaled $131.6 million at the end of the quarter.

As Dave mentioned, our average contract term continued to increase and increased by another 1% for the quarter. Increases in our average contract term impacts our revenue recognized under US GAAP, an increase in our average contract term and the estimated customer life results in a longer period over which to recognize or amortize our nonrecurring installation revenues. Therefore, that reduces the amount of revenue that's recognized under US GAAP during the period. This increase negatively impacted our revenue in the second quarter by about $100,000.

Our bad debt expense improved to 1.1% of our revenues for the second quarter. Our bad debt expense included the impact of Megaupload in the first quarter was 2.8%. Lastly, our Days Sales Outstanding or DSO for worldwide accounts receivable was 27 days at the end of the quarter, which was an improvement from the 28 days outstanding at the end of the first quarter.

I've said this many times, but I want to personally again thank or recognize in worldwide, billing and collections team members for continuing to just do a great job on customer collections and credit monitoring.

I'm going to turn the call back over to Dave.

Thanks, Tad.

We're going to take a moment and chat a little about sales force activity and productivity. We began the second quarter of 2012 with 273 reps and ended the quarter with 269 reps selling our services. We hired 51 sales reps in the quarter and 55 sales reps left the Company during the quarter. Our monthly sales rep turnover was 7% for the quarter. This was the same rate as we experienced in the first quarter and is consistent with our long-term historical trends. We began the second quarter of 2012 with 269 full-time equivalent reps. We ended the quarter with 256 full-time equivalent sales reps.

Productivity on an FTE basis for the first quarter was substantially lower than the 5.1 units that we were able to deliver in the second quarter. As a reminder, our sales force productivity rates are based not upon contract signing, but are based upon actual installations of customers onto our network and the beginning of the recognition of revenue from those customers.

Now to the scale and scope of our network. The size and scope of our network continues to grow. We added 30 buildings to the network in the second quarter and now we have over 1,800 buildings directly connected to our network. Our network consists of over 26,100 metro fiber miles and over 56,500 intercity route miles of fiber.

The Cogent network is the most interconnected network in the world. Today, we connect to over 4,050 other networks. Approximately 40 of these networks are settlement free peers. The remaining networks connected to Cogent are paying customers. We continually monitor the utilization on our network and we upgrade sections of the network as needed.

In the most recent quarter, we were utilizing approximately 16% of our lit capacity. We have a well-diversified customer base with relatively low customer revenue concentration with no customer representing more than 1% of our revenues. Our top 25 customers represent only 6% of our revenues. We believe our network has substantial capacity in order to allow us to continue to grow our revenues.

We continue to evaluate additional fiber routes and have taken advantage opportunistically of the volatility in European markets which has presented us additional opportunities. In summary, we believe that Cogent is the low cost provider of Internet access and transit services and our value proposition to our customers is unparalleled in the industry. Our pricing strategy has continued to attract many new customers, has resulted in longer customer contracts and increased volume and revenue commitments from our existing customers. Our business remains completely and entirely focused on the Internet and the Internet increasingly has become a necessary utility for our customers. We expect our annualized revenue growth and EBITDA margins to return to their historical rates.

We are opportunistic about the purchases of our common stock. At the end of the second quarter of 2012, we had purchased 307,000 shares of stock back for approximately $4.2 million at an average price of $13.79 under our most recent buyback program. During the second quarter, we purchased 75,000 shares for $1.3 million, at an average price of $16.95. We have $45.8 million remaining under this authorized program for the purchase of shares through February of 2013.

We continue to be very encouraged by the growth in traffic as a result of our sales initiatives. Our sales force productivity improvements and the targeted promotional programs that we are running has resulted in an increase in our order backlog. We are committed to providing annualized top line growth targets of 10% to 20% and expanding our EBITDA margins by approximately 200 basis points per year and generating increasing free cash flow for our shareholders.

We like and are confident that our network reach, our product set, allows us to go after the most lucrative business. Our addressable market is appropriate. Our operating leverage is great. In short, we continue to like our business.

On August 7, our Board of Directors approved the quarterly dividend that we had mentioned in our last call of $0.10 per share. This dividend payment will be made to shareholders on September 12, 2012, demonstrating our commitment to a regular return of capital to our shareholders. We remain optimistic about the growth in free cash flow at our business and our ability to continue to return capital to shareholders both through buybacks and through our dividend program.

Now, I'd like to open the floor for questions.

(Operator Instructions)

Colby Synesael, Cowen and Company.

I have two questions or two lines of questions. The first one has to do with the Off-Net revenue. I think you had mentioned in the past that you'd been seeing some installation delays, particularly at Verizon and the Off-Net was a little bit later than we were expecting this quarter. I was wondering if you could give us an update on that delay. The other part of that question is, you actually added 138 Off-Net customers, which is actually a very large number for you guys. Just curious what's driving that, if there's any concern that with such a big backlog now and potentially no change in the installation delays at Verizon, is that going to potentially lead to some issues down the road. Then I have one other question after that.

Sure. Let's take the Off-Net installation delays. We have seen those delays grow to over 105 days. They've shrunk back to about 94 days. That's still about three or four days above the long-term historical average, but we have seen an improvement from what we saw in the first quarter. Many of these installs came later in the quarter, so therefore that was the reason why we did not recognize revenue for the entire quarter for many of those installs. Our sales force productivity was extremely high. We continue to sell a large amount of Off-Net as well as On-Net. As Tad mentioned, 85% of our sales are On-Net but 15% consistently have been in our Off-Net product. The final point that probably has impacted the growth rate in our Off-Net revenues is that we had and still have a base of TDM customers. Increasingly, almost all of our Off-Net sales are Ethernet. We appear to be through the rotation of our existing customers migrating from TDM to Ethernet, those that want to. Almost all of the new sales are Ethernet and for that reason you saw a plateauing in our average revenue per user in those Off-Net circuits. So we do expect to see continued improvement in unit growth in the Off-Net business in Q3 and forward, particularly as these installation windows have normalized and we also expect to see revenue growth. We may not, however, see continued increase in average revenue per user in the Off-Net business.

Okay. Then my other question, just in terms of the dividend, I was wondering if you could just talk about what the correlation going forward is going to be between free cash flow growth and potential dividend growth? Maybe add into that conversation or explanation what the Company's view is on the amount of cash that you actually want to hold in the balance sheet -- or on the balance sheet, because I think you're actually at a much higher number than you stated that you need and how that could potentially impact the dividend going forward as well.

Yes. Sure, Colby. So we are committed to a regular return of capital. In that return of capital we have two tools in our toolbox. One being the dividend program, the second being the buyback and the buyback allows us to opportunistically take advantage of market volatility. The $1.3 million that we spent in the second quarter allowed us to buy back stock at I think either at or near the lowest prices in the quarter on days of extreme volatility. We are committed to continuing to use buybacks to supplement the dividend program. As Tad mentioned, we had $237 million or slightly over $237 million of cash on our balance sheet, which is far in excess of what we need to run the business. We are growing our sales force, our footprint and we have continued to look at M&A opportunities but not seen anything that represented value that would be accretive to our equity.

So we have not pursued any M&A. With that, we continue to build cash, as demonstrated, we generated even with the buyback an extra $5 million this most recent quarter and we expect that trend to continue going forward. What that means is, we either need to be buying more stock back or increase the dividend. We think that we need generally about six weeks of revenue as a liquidity cushion to adequately run the Company. That would be a number much lower than where we are today, probably in the $40 million, $50 million range would be plenty of liquidity. We are committed to returning that capital, so I think the Board will evaluate the volatility in stock and the ability to use the remaining buyback and if we're unable to use that more aggressively, probably continue to see us increase the dividend as a way of returning the cash that we're generating from operations as well as feeding in to the cash balance on the balance sheet.

James Breen, William Blair.

Just a couple questions. One, with respect to the margins, can you just go through again -- there were a lot of puts and takes relative to the sequential growth in EBITDA margins. Can you talk about -- obviously you saw a big jump this quarter. Do you expect those to come down. Or are you just saying that you expect them to stay flattish with current levels through the rest of the year. That's the first question. Thanks.

Okay. On margin, this quarter was heavily impacted by the fact that in the previous quarter we had the bad debt expense associated with the loss of Megaupload. Our margins globally are fairly consistent, so there has not been any real distortion in our margins due to FX. Our SG&A is pretty much at a good run rate now. As Tad mentioned, we have these very high operating leverage as we add incremental revenues, 100% gross roughly $0.95 incremental EBITDA on On-Net and about $0.45 of incremental EBITDA in that Off-Net business. We do expect that our margins will continue to grow next quarter at about 50 basis points. I said earlier, we view the expansion from full year 2012 to full year 2013, 200 basis points is an absolute floor. We actually think we can do a little better than that. In terms of puts and takes, probably the greatest volatility is usually in the first quarter where we have these extraordinary expenses. Other than that, things are actually pretty consistent in terms of margin expansion.

Jennifer Fritzsche, Wells Fargo Securities.

Just a question on new customer adds. With the Level 3/Global Crossing transition, has there been -- or integration, has there been any opportunity to pick off new customers and if you can offer some color there. Also, Netflix seems to be a new customer for you and I was wondering if you could offer any further color there as well.

Yes, sure. First of all, in terms of customer additions, as you can see from our numbers the net number of new customer connections increased by only about 800 in the first quarter over the fourth quarter of last year and this year or in the second quarter over the first quarter was up almost 1,400. So a material acceleration in the number of new customers that we have connected. Many of those customers came as a result of these promotions. As I had mentioned previously, we had targeted about 1,500 customers that bought from other leading companies that were going through merger and acquisition with some extremely aggressive pricing. That pricing is $0.75 a megabit. That pulled down our average new sale price in the quarter from $2.36 to $1.82. That did result in slightly lower ARPUs but lower prices per meg. Now, the installed base did not fall as rapidly. It only fell from $3.81 to $3.44 in the quarter. We have had success, meaning we have connected about half of those targeted customers. That means there's still half to get.

Most of those customers have not yet experienced any network disruption as a result of those networks trying to be integrated. Also it's important to note that many of those customers gave us only a very small portion of their business in the form of a limited number of ports. Some of them were under what we call try and buy programs, where we actually give some free connectivity for a limited period of time, 30 to 60 days, to give customers the ability to test our network and get very comfortable with the quality that we deliver. That I think has helped us increase the number of customers and obviously showed up in our traffic growth, which sequentially was 10%. If you go back and look historically, Q1 to Q2, because of our heavy concentration of university customers, tends to be a flat quarter for traffic growth. So we had a significant uptick in the rate of growth as a result of these promotional programs. Some of them did not necessarily result in revenue immediately, but will result in revenue going forward as those customers move from those free trials into the paying customers under the promotions that we had laid out.

To the second part of your question, we generally don't comment on specific customers. I think to the best of my knowledge, I don't think Cogent's ever issued a press release on a specific customer win and with regard to Netflix we issued no press release. I believe some analysts did discover in channel checks that Netflix has made a significant commitment to Cogent and we view them as a potentially very large customer. We continue to see video being the key driver and they are one of the leading providers of video over the Internet. They have a large number of connections. They are migrating from an outsource CDN model to an in-source model in which we will be providing them bandwidth, both under a committed contract as well as there's some ramp up agreements in place. We did not recognize any material revenue from Netflix in the second quarter. We will be seeing some more material revenue from them as they continue to ramp out their CDN deployment and that should be hitting us in the third quarter and beyond.

Tom Seitz, Jefferies.

I guess it's a follow-up on what you just discussed. No secret, you're always cutting -- shaving price, but given what you're doing with the Level 3 and Global promotion and securing contracts like the expansion of the Netflix business, are we in another period like a few years ago when you started the bigger term discounts? It's going to take a couple quarters for volumes to catch up. As a consequence, on a constant currency basis, revenue growth is likely to be at the lower end of the 10% to 20% guidance range for a couple quarters and then in six months or so we'll see revenue acceleration again? Or was coming in at the lower end of your guidance range or your typical sequential quarterly growth strictly a function of customers coming in late in the quarter and these promotions that you were just referencing and we'll see a pickup in third quarter?

Sure, Tom. So first of all, adjusting for foreign exchange, our NetCentric revenues grew 3.1% in the quarter as opposed to being flat. So the vast majority of our FX hits the NetCentric business. Two, we did install a large number of orders later in the quarter, which will have some impact. Again, we don't give specific quarterly guidance. There can always be some volatility. Each of these customers has their own business model and many of them have commitments to other providers that need to unwind as they get comfortable in the savings that Cogent offers its customers. I don't necessarily think that there's going to be a material acceleration in the third quarter from the second quarter, particularly as Tad outlined the fact that we've got -- based on where we're at now, $800,000 of FX headwind that we know about going into the quarter.

Traffic can be a bit volatile. There's generally more traffic growth in the fall and winter months than in the summer months. But as you saw in this quarter, our promotional activities are working. I feel very comfortable with our long-term guidance with the ability of NetCentric and Corporate revenues to each grow long-term in that 3% to 4% sequential range which gets us right at the midpoint of our long-term guidance which is what we've historically done. I can't really comment exactly on next quarter or the quarter after, other than -- the trends are encouraging. Probably the one thing we know about today that's discouraging is the FX impact and the rate at which video migrates to the Internet does have some impact in our NetCentric business, actually, two ways. One, we directly benefit from the companies that are publishing the content like the Netflix. But remember, we have over 75 PTTs around the world. Virtually every major cable operator in the Western world and hundreds of CLACs as access networks that draw down content. So we actually benefit two ways from this migration. One from the publishers, like Netflix, but also from the networks that are drawing that traffic who need to buy upstream connectivity. I'm just -- I'm not a good enough forecaster to tell you whether or not the next hot show is going to drive a lot of traffic next quarter, but I feel very comfortable in our long-term growth trajectory for the NetCentric business.

Yes. I don't think there's any question that given the customer growth, the revenue growth is going to be there. I guess I'm just looking for a little help so that you're not a victim of expectations and whether or not this promotional activity could result in you guys being at the lower end of the historical growth rate for a quarter or two before this influx of customers results in revenue reacceleration.

It could, Tom, but in the past when we've ran different types of targeted promotions, some quarters you're absolutely right. We saw a quarter or two lag. Other quarters it hit us immediately. We're going to be as aggressive as possible. The best help we can get is for those companies that merge to try to achieve synergies and combine their networks, because when that network combination occurs, that's when customers are going to feel the pain. It's important to remember that Level 3 and Global Crossing today still run two completely separate networks with completely separate autonomous systems and they're not even interconnected today. So there's a lot of upside here. I just can't tell you that -- I just can't forecast that it's going to be a little slower this quarter or next. I just don't have that kind of visibility beyond the FX that I talked about.

No, I understood. Thanks so much for the color.

Alex [Sklar], Raymond James.

Can you give us an idea what the year-over-year and sequential traffic growth was excluding the impact of Mega and then I guess a little bit more color on the sales rep productivity this quarter. What do you think ultimately is driving the increase. Do you think it's a result of less new reps coming on in the quarter or is it just the success from the promotional pricing? Then any comments if it's tracking at a similar level so far in third quarter. Thank you.

Yes, sure. So our historical growth rate for the past couple of years, year-over-year, had been around 44%, 45%. Now, that included Mega that was growing at about the same pace as the remainder of our customer base. This quarter was obviously on a year-over-year basis heavily impacted by the loss of that customer. Probably if you removed Mega from both numbers, we actually saw an acceleration in our year-over-year traffic growth, in part due to this promotional activity and picking up these other accounts, probably in the 55% range. If you want to look on a quarter-over-quarter basis, we were up 10% but the first quarter had 19 days of Mega traffic included in that. If we took that out, we were probably up closer to 18% or 19%.

The traffic measurement that we use is very straightforward. We literally measure every port on our network, every five seconds. We take the number of petabytes, meaning actual traffic transferred, not the speed or the throughput, but the actual bits transferred, in and out, over the course of the entire quarter and we report that number. So it is an absolute objective number measuring every single port. Let me switch to the second question, which is rep productivity. We still have a goal of growing the sales force. We're actively recruiting. We're actively hiring people. Our rep turnover has been pretty consistent. I do think the promotions that we are running contribute to our unit productivity.

At 5.1, that is substantially above the 4.1 that we have averaged historically over the past 7.5 years as a public Company. We are continuing to see improvement. It is not as a result of having less reps. In fact, we still have huge amounts of our addressable market that are not yet being adequately penetrated by our sales organization. So we still desperately need more reps. In terms of the third quarter, we are encouraged by what we are seeing in the quarter so far, in terms of rep productivity and it should be above our long-term average.

Michael Funk, Bank of America Merrill Lynch.

I guess first (inaudible) of your view on the opportunity for acquiring assets in the current market, obviously valuations have been bid up. Just wondering what you're seeing out there today. Then maybe just a little more color than you've provided in the past about your view on use of capital. I know you provided some comments in the call about the share repurchase and obviously the dividend. But maybe just some thoughts on whether it was better to be a buyer or a seller in the current environment, given those valuations that I mentioned.

Yes, sure. So Cogent had been an extremely active acquirer in the 2001-2005 time frame. We have not participated in any material way in M&A since then. We have added a few data centers to our footprint. We have opportunistically bought more dark fiber. We have a very simple filter that we use in looking at acquisitions and it's a two-prong approach. The first approach is by acquiring the whole company, are we acquiring assets that we need to run our business, less expensively through the acquisition than we would through either building out those assets ourselves or just buying the assets and not the whole company? We have never been a significant builder of network and have no intentions to do that, other than connecting buildings to our network.

Then in terms of acquiring whole companies, it's been far more prudent for us in the past seven years to just acquire the assets. The second filter that we apply is, if we buy the ongoing business, is it -- whether we pay cash or issue stock, accretive on a free cash flow per share basis? That's a very objective measure. We have not been able to find any businesses that trade in our sector -- that trade at a lower free cash flow multiple than our business based on looking at the growth in our free cash flow. So we will continue to look at opportunities, but I will assure shareholders that I take the job of capital allocation seriously. Tad does. The entire Board does. We think about it. In terms of the second way to approach that question, should we be a seller? I tell shareholders all the time the Company's for sale every day. It's bought and sold in the public markets and the markets determine our price.

Ultimately, the value, though, of this business is its future stream of free cash flow and of what the appropriate discount rate you apply to that is. It's somewhat subjective. If someone paid a premium, we would always listen. But at the end of the day, we are very comfortable in where we sit in the ecosystem, in the value chain, in the competitive landscape and intend to execute our business on a standalone basis. In terms of use of capital, I couldn't be any clearer. We have too much capital on the balance sheet. We are committed to returning it regularly in a dividend. We will evaluate how we need to grow that dividend to get that cash back. But buybacks are tax efficient. They compound. They allow us an additional degree of freedom where we could be opportunistic. You saw us in the last quarter take advantage of that. I think the Board, at least today, wants to preserve both tools as ways to return capital.

Michael Bowen, Pacific Crest.

A couple things. I'm sorry if I missed this, but you mentioned in the past that Corporate pricing has been very solid. Can you tell us what you're seeing now? Then secondly, on the EBITDA improvement that you're looking for, I think you said over 200 basis points 2013 over 2012. Can you give us a little idea on how much of that do you think might be coming from the cost side versus the pricing and revenue side? Thanks.

Sure, Michael. I'm going to take the first part and Tad will take the EBITDA piece of it. On the Corporate pricing, let me break that into two pieces. Roughly 60% of our Corporate business, just Corporate, is On-Net, 40% is Off-Net. For our Corporate On-Net product, a 100-megabit symmetric, non over-subscribed Internet access service for $700 a month has been our price for the past dozen years and we have not modified that at all. Now we do potentially run promotions that could impact it. Buy a two year contract and get the three year pricing or buy 12 months, get the 13 month free. Part of sales is always having some excitement and call to action. But there's been no significant degradation in the competitive landscape or the pricing dynamic.

We expect that our Corporate On-Net pricing still represents the most compelling value, whether compared to cable, to telephone, or CLAC offerings and we hear consistently from customers when we do surveys that price is almost too good to be true. So on the Corporate On-Net, no change whatsoever and we see a very stable environment. Off-Net, we also see stable environment. As I commented earlier, the ARPU at $1,643 is plateauing as we've migrated to Ethernet, but we see a very stable environment there. I think increasingly, customers realize that T1s or TDM based services are no longer reliable or large enough for most Corporate users and wherever possible, they're trying to migrate to an Ethernet based product. Tad will take your margin questions.

Dave, real quick, before Tad gets to that, on the promotions. Promotions tend to have almost a negative connotation across the communications sector. Have you looked at historically when you run the promotions, is there any way to look at kind of like a payback or percentage benefit on those promotions? Is that a good way to look at it?

Yes. We actually do look at it that way. So we say, if we give up something, either waive an install or we give away a free month or we give a longer term discount for a shorter term contract. Those are the most common flavors of these Corporate promotions. How many incremental orders would we get? What is the margin of those orders? What is the payback? We generally see paybacks very quickly, generally, three to six months when we run those promotions. But what you've got to be careful of is that you don't want promotions to become the new standard price. You still need to create in the customer's mind some variability in the offering, some excitement and some call to action. So we constantly probe the market.

One of the interesting promotions that we ran, actually some of it was run last quarter, was if a customer showed us an invoice from a pre-existing provider, we would actually agree to buy them out of their contract, meaning we would give them free service on Cogent for the remainder of their contract. So they would only pay one bill, as long as you signed a multi-year contract with us. What that did is, one, it spurred activity, but two -- the second thing it did that was very interesting is gave us on the Corporate side a much more granular and precise view of the competitive landscape. We get that all the time on the NetCentric side. But on the Corporate side, it really opened our eyes to just how much better Cogent's value prop is than virtually anyone else in the market. Let me let Tad take that EBITDA question.

Sure. On our plan, if we look at full year 2013 over 2012, again, we are very comfortable with the revenue guidance of 10% to 20% and we're very comfortable with the EBITDA expansion of at least 200 basis points. So that's from a high level view. Granular on that, really don't expect any material changes in trends on the revenue front and this forecast, our updated forecast includes the most current rates of foreign exchange that are included within that. If you look at our cost side, really the variability that we have in the cost side is when we add each Off-Net connection, about 50% of the revenue increase adds to cost of the tail circuit. We do have some costs associated with expansion related to maintenance on the fiber routes and lease costs for facilities that are added. Expect that pace to be slightly lower than it has been historically. As we mentioned, CapEx, we expect to be about 10% less, though the rate of expansion in terms of those costs would be similar.

Then lastly, we have a CPI on many of our contracts and those tend to roll over on the first of the year. That's the cost of goods sold line. If you look at the SG&A component of our costs, besides the seasonality that we went over in the call in the first quarter, on an annual basis the changes we see are about -- historically, about 1% of our revenues wind up as bad debt expense, so 99% of the amounts we bill are paid in cash and the remainder we need to write off as uncollectible. Then the increase in our sales force is baked into that, as we expect the sales force to continue to grow and then you do have a CPI again on SG&A expenses. So that's -- if you look at our run rate and if you're modeling and how we look at changes in costs, both COGS and SG&A when we're forecasting forward.

Donna Jaegers, DA Davidson.

It's Nick, here for Donna. Just a quick question on your comments about taking advantage of volatility in Europe. Can you give -- provide a little bit more color on that on what opportunities are you talking about and are you looking to increase your exposure in Europe, then? Thanks.

Yes. Sure, Nick. Our ability to take advantage of volatility in Europe hits us two ways. First of all, it's purely to allow us to purchase fiber assets to serve additional European markets. We by far and away today already operate the densest Pan-European network. If you go look at our map against any of the other global network operators, we have far more POPs in more locations, in more cities, in Europe. We operate in, I think, 25 of the 27 EU countries and three or four non-EU countries in Europe. Our ability to take advantage of the volatility is two-fold. One, as the dollar gets stronger relative to the Euro, things just get cheaper in dollars. So that's a good thing for us as a US-based Company. Then secondly, some of the owners of fiber who may have been more reluctant to sell in better times become more interested in cash.

Probably the most extreme example of that we witnessed was our entry into Greece probably about a year ago. There were no other global network operators that had a dark fiber network in Greece. It was all owned by Greek National companies. We were able to go into Greece and establish the first facilities-based network in Greece that is not run by a Greek National or a company controlled by a Greek National company. So it's that ability to take advantage of volatility. On the customer side, we're trying to sell all customers. You can argue that as people become more concerned about their economic viability, they may be more interested in buying from Cogent just because we're a lower cost solution. So I think as many of our customers are experiencing pressures in the their business, they're more open to buying from Cogent. I think that's part of the reason why we've been gaining market share. Remember, our European business is almost exclusively NetCentric. We virtually don't have a Corporate European footprint.

Dave, just a quick follow-up on that last point. Obviously, there's some very meaningful ties between some of the wireless companies and the PTTs. Is there desperation for profitability? Are you seeing any better success in prying away and becoming second source for some of those wireless carriers?

Yes, we have a number of wireless carriers in Europe where we are the upstream provider. In some cases, we're the second provider. In some case, we're the third. A couple of the incumbent operators try to operate something that resembles a global network. I would argue none of them really have a true global footprint. DT, FT, Telefonica, so it's a little difficult sometimes to be the primary to those companies, but we do sell to some of the subsidiaries in a secondary position. But for the non-affiliated wireless carriers, we actually do very well in that market segment.

Michael Rollins, Citi.

Two questions. First question is, did you mention the capital lease inception for the quarter, if we could just get that number. Then secondly, just to follow up on some of the promotions, Dave, is there a way to think about what the promotional discounts, the free service promotions, et cetera, what that total amount represented in the second quarter in dollars or as a percent of revenue? Maybe comparing that to some past quarters to try to understand the built up potential to get more revenue out of the customers that you've already signed up and added to the network. Thanks.

I'm going to let Tad take the capital lease question first.

Sure. Good morning. For the six months, we added net present value of new capital leases of $5.7 million. For the quarter, that number was $3.4 million.

Then our capital lease payment in the quarter, actual cash out the door was $1.7 million.

Principal payment was $1.7 million; that's correct.

Yes. In the quarter. To the promotional activity, I do think it was probably more aggressive than our historical run rate. To put a dollar value on that is actually difficult because in many cases, particularly on the NetCentric side, we give customers one or two ports, 10-gig ports, at no charge for a period of 30 to 60 days to test us. Those customers have almost unanimously entered into some contract with us, but in many cases they're under pre-existing obligations to their incumbent provider and have far more than 20-gigs of traffic that they could send us and therefore pay us for and the transition from the test to the initial revenue to a stable state of revenue may take 6, 9 or even as much as 12 months for us to fully recognize.

I think just as a back of the envelope way to look at it, you can see the extreme increase in the number of customer ports installed versus the more moderate or normal rate of revenue growth and those are pretty good indicators. So as I said earlier, we went from adding 800 net ports to 1,400 net new customer connections in the quarter, but our revenue growth sequentially, subject to the adjustments that I mentioned, was 3%. So it was an abnormal quarter in ports, a normal quarter in terms of revenue growth. So I think there's definitely some catch-up that will happen. It's just that I don't want to put a number out there because some of it's dependent on the contracts that customers have.

Dave, one just other follow-up. How are you assessing the risk today versus maybe when you've addressed this question in the past -- the risk that at some point the volume growth doesn't offset the price declines within the NetCentric segment. Do you feel any differently about that risk or managing that total revenue growth than you have in periods past and what would contribute to that answer? Thanks.

Sure, Mike. As I've stated numerous times to investors, the total addressable market in dollar terms in the NetCentric universe has been flat at about $1.5 billion now for about a dozen years. We have not seen any significant degradation in that market. Clearly, as the dollar has strengthened a little and some of that market is denominated in other currencies, in nominal terms it may have shrunk a little but the market in local currencies for Internet transit globally is flat. We expect that to continue. I am very conscious of not being at the forefront of driving down prices and destroying that addressable market. But I'm balancing that and our pricing decisions against the 84% of our lit capacity that is being unsold every day at the high incremental margins associated with that it.

We continue to be the most aggressive provider in the market. Some independent third parties -- I know TeleGeography just did a study and it said that the rate of Internet transit pricing declines had accelerated and it actually noted that it was as a result of some targeted promotional activity. We have always been at the forefront of leading that pricing reduction, prices won't go down forever. But at the end of the day, the number that we're solving for is maximum revenue for Cogent and we're getting growth when others are not by capturing market share in a flat market. We have not necessarily seen a need to shrink the market, ie, drive down prices even faster to increase our revenue even faster. We haven't seen any correlation there. We think that our discount structure is sufficient that when we survey existing customers, we find that price is not a major issue.

When we go and try to talk to people who don't buy from Cogent it's almost never that we think Cogent's too high. There's usually some perception issue that we need to overcome and that's the reason for these promotional programs that we talked about. I think that's a better tool for us to continue to gain share. So I feel very comfortable that our NetCentric revenues over the next five, six, seven years, for Cogent will grow very similarly to the rate of growth that they've experienced in the past seven years we've been public, right at the midpoint of our range. If you look historically, our revenues have been relatively equally split between Corporate and NetCentric. That hasn't changed at all. We think that will continue going forward and we feel very comfortable that we're not reducing our revenue opportunity. But we're also not necessarily destroying the market. We're trying to take a balanced approach here. But quite honestly, I don't care about my competitors. I care about Cogent's shareholders.

Barry McCarver, Stephens.

This is actually Mac Tatman in for Barry. I just had a quick housekeeping question that I think I missed earlier. What was the bad debt expense as a percent of revenue in the quarter?

Sure. Let me give you the precise number here. Just bear with me one second. We did have unusual bad debt expense in the first quarter related to Megaupload. It was 1.1% for Q2 2012.

Okay. Great.

As I said before, our consistent -- relatively consistent with our historical average, absent the Megaupload impact.

There are no further questions at this time.

We thank everyone and appreciate your interest in Cogent and we'll talk on the next quarter. Take care. Thanks.

That concludes today's conference. We thank you for your participation.