Cogent Communications Holdings Inc (CCOI) 2019 Q1 法說會逐字稿

Good morning, and welcome to the Cogent Communications Holdings First Quarter 2019 Earnings Conference Call.

As a reminder, this conference call is being recorded, and it will be available for replay at www.cogentco.com.

I would now like to turn the call over to Mr. Dave Schaeffer, Chairman and Chief Executive Officer of Cogent Communications Holdings.

Thank you and good morning, everyone.

Welcome to our first quarter 2019 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.

Now for some high-level summary of our results.

We are pleased with our results for the first quarter and continue to be optimistic about the underlying strength of our business and the outlook for the remainder of 2019 and beyond.

Our EBITDA margin for the quarter increased by 120 basis points to 35.5% from the first quarter of 2018.

Our gross margin for the quarter increased by 230 basis points from the first quarter of 2018 and by 180 basis points from the fourth quarter of 2018 to an all-time high of 59.8%.

On a constant currency basis, we achieved sequential quarterly revenue growth of 1.7% and year-over-year revenue growth of 5.8%.

Our quarterly sales rep productivity was 5.1 units installed per full-time equivalent rep per month, a productivity rate that was consistent with our long-term average of 5.1 units installed per rep per month.

On a year-over-year basis, our quarterly traffic grew by 43%.

And on a sequential basis, our traffic grew by 7% over the fourth quarter of 2018.

During the first quarter, we returned $26.6 million to our shareholders through our regular dividend.

We did not purchase any stock in the quarter.

At quarter's end, we had a total of $34.9 million available in our stock buyback program, which is authorized to continue until the end of December 2019.

Our gross leverage ratio decreased to 4.28 from 4.36, and our net leverage increase slightly to 2.92 from 2.87.

Cash held at Cogent Holdings is $106 million at the end of the quarter.

That cash is unrestricted and available to be used for either dividends or buybacks.

Our consolidated leverage ratio, however, as defined under our indenture agreements improved sequentially to 4.18 from 4.26 last quarter.

This ratio is below the incurrence test of 4.25 threshold that is included in our indenture, which now allows us access to our accumulated builder basket.

Our accumulated builder basket at the end the quarter was $88 million, which, combined with $106 million at holdings, now allows us to increase the cash at the holding company level to $194 million that will be completely unrestricted and available for either dividends or buybacks.

We expect to transfer the majority of this builder basket from our operating companies to our holding company early in the second quarter, leaving approximately $65 million of cash in the operating company.

We continue to remain confident in the growth of our business and its cash flow generating capabilities.

As a result of that, as indicated in our press release, we announced yet another $0.02 sequential increase in our regular quarterly dividend from $0.58 a share per quarter to $0.60 per quarter.

This represents the 27th consecutive sequential quarterly increase in our quarterly dividend.

Throughout this discussion, we'll highlight a number of operational statistics.

I will review in greater detail some operational trends and highlights, and Tad will provide additional details on our financial performance.

And then following our prepared remarks, we'll open the floor for questions and answers.

Now I would like Tad to read the safe harbor language.

Thank you, Dave, and good morning, everyone.

This earnings conference call includes forward-looking statements.

These forward-looking statements are based upon our current intent, belief and expectations.

These forward-looking statements and all other statements that may be made on this call that are not historical facts are subject to a number of risks and uncertainties, and actual results may differ materially.

Please refer to our SEC filings for more information on the factors that could cause actual results to differ.

Cogent undertakes no obligation to update or revise forward-looking statements.

If we use any non-GAAP financial measures during this call, you will find these reconciled to the corresponding GAAP measurement in our earnings release, which is posted on our website at cogentco.com.

I'll turn the call back over to Dave.

Hey.

Thanks, Tad.

Hopefully, you've had a chance to review our earnings press release.

Our press release includes a number of historical metrics that give investors, I think, a great deal of insight into our business.

Now for some additional clarity on our performance.

Our corporate business, which represents 67% of our total revenues, in the quarter grew year-over-year by 11.2%, which is better than the long-term growth of our entire business, which is targeted to be 10%.

However, our NetCentric business has underperformed and declined by 8% from the first quarter of 2018.

The impact of foreign currency, which primarily impacts the NetCentric business, was responsible for a significant portion of this decline.

On a constant currency basis, our NetCentric business, however, did also decline by 3% from the first quarter of 2018.

It was essentially flat sequentially.

Our long-term EBITDA annual margin expansion guidance calls for approximately 200 basis points of margin expansion.

For the first quarter of 2019, we achieved year-over-year quarterly margin expansion of 120 basis points.

Our quarterly cash flow, as defined by EBITDA minus capital expenditures minus principal payments on our capital leases, grew by 16.2% from the first quarter of 2018.

This is due to the excellent operating leverage of our business, and we expect cash flow growth to continue at similar rates.

Our revenue and EBITDA guidance targets are meant to be multiyear, not specifically quarterly or an annual guidance range for a specific short-term period.

Now I'd like to turn the call back to Tad for some additional details on the quarter.

Thanks, Dave, and again, good morning to everyone.

And I'd also like to thank and congratulate our entire Cogent team for the results this quarter, continued hard work during another very productive and busy quarter for the company.

Some comments on Corporate and NetCentric revenue.

We analyze our revenues based upon network type, which is on-net, off-net and noncore, and we also analyze our revenues based upon customer type.

And we classify all of our customers into 2 types, NetCentric customers and corporate customers.

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

Revenue from our Corporate customers for the quarter grew sequentially by 2.6% to $90.2 million and grew year-over-year, as Dave said, by 11.2%.

We had 47,257 Corporate customer connections on our network at quarter end, which was an annual increase of 20.6% over the first quarter of last year.

Quarterly revenue from our NetCentric customers declined sequentially by 0.4% to $44 million and declined year-over-year by 7.6%.

On a constant currency basis, our quarterly revenue from our NetCentric customers was flat sequentially and declined year-over-year, again, as Dave said, by 3%.

We had 35,265 NetCentric customer connections on our network at quarter end, which was an increase of 1.5% over the first quarter of 2018.

Our NetCentric revenue growth experienced significantly more volatility than our Corporate revenues due to the impact of foreign exchange, also due to customer size and certain seasonal factors.

Revenue and customer connections by network type.

Our on-net revenue was $97.2 million for the quarter, which was a sequential quarterly increase of 1.9% and a year-over-year increase of 5.2%.

Our on-net customer connections growth accelerated this quarter and increased by 3.3% sequentially and 12.2% year-over-year.

We ended the quarter with 71,066 on-net customer connections on our network in our 2,706 total on-net multi-tenant office buildings and carrier-neutral data center buildings.

Our off-net revenue was $36.8 million for the quarter, which was a sequential quarterly increase of 0.8% and a year-over-year increase of 1.9%.

Our off-net customer connections increased sequentially by 1.5% and 8.8% year-over-year, and we ended the quarter serving 11,138 off-net customer connections and over 6,640 off-net buildings, and these off-net buildings are primarily in North America.

Some comments on pricing.

Consistent with historical trends, the average price per megabit of our installed base decreased for the quarter.

However, the average price per megabit for our new customer contracts was relatively stable.

The average price per megabit of our installed base declined sequentially by 6.9% to $0.68 and declined by 24.4% from the first quarter of last year.

The average price per megabit for our new customer contracts for the quarter was relatively flat sequentially and relatively flat year-over-year and declined by 3% from both periods to $0.39.

Some comments on ARPU.

Our on-net ARPU and our off-net ARPU both decreased sequentially for the quarter.

Our on-net ARPU, which includes both Corporate and NetCentric customers, was $463 for the quarter, which was a decrease of 0.8%.

Our off-net ARPU, which is comprised predominantly of Corporate customers, was $1,111 for the quarter, which was a sequential decrease of 1.2%.

Some comments on churn.

Our on-net churn rate improved during the quarter and our off-net generate increased slightly.

Our on-net unit churn rate was less than 1% at 0.9% for the quarter, which was an improvement from 1% last quarter, and our off-net churn rate was 1.1% this quarter, a slight increase from 1% last quarter.

We offer discounts related to contract term to all of our Corporate and NetCentric customers.

We also offer volume commitment discounts to our NetCentric customers.

During the quarter, certain NetCentric customers took advantage of our volume contract term discounts and entered into long-term contracts for over 2,300 customer connections, which increased their revenue commitment to Cogent by over $19.7 million.

Some more detail on EBITDA and EBITDA as adjusted.

Our EBITDA and our EBITDA as adjusted are both reconciled to our cash flow from operations and all of our quarterly earnings press releases.

Seasonal factors that typically impact our SG&A expenses and consequently our EBITDA and EBITDA as adjusted include the resetting of payroll taxes in the United States at the beginning of each year, annual cost of living or CPI increases related to salaries, the timing and level of our audit and tax services, which are higher in the first quarter, the timing and amount of gains in our equipment transactions and our annual sales meeting costs and benefit plan cost increases.

These seasonal factors typically increase our SG&A expenses in our first quarter from our fourth quarter.

Our quarterly EBITDA was flat sequentially at $47.6 million, really excellent results given our seasonal increases in SG&A that we experienced in the quarter.

And our EBITDA increased year-over-year by $3.5 million or 7.9%.

Our quarterly EBITDA margin decreased by 50 basis points sequentially to 35.5% but increased year-over-year by 120 basis points.

Our EBITDA as adjusted, which includes gains in our equipment transactions.

Our equipment gains were $536,000 for the quarter, which was an increase from $117,000 for the first quarter of last year and $92,000 last quarter.

Our quarterly EBITDA as adjusted increased by $426,000 or by 0.9% sequentially to $48.1 million and increased year-over-year by $3.9 million or by 8.8%.

Our quarterly EBITDA as adjusted margin decreased sequentially by 20 basis points to 35.9% but increased 160 basis points year-over-year.

Some comments on earnings per share.

Our basic and diluted income per share was $0.20 for the quarter, which was a 25% increase from $0.16 last quarter and a 33% increase from the first quarter of 2018, which was $0.15.

Some further details on foreign currency.

Our revenue reported in U.S. dollars and earned outside of the United States was about 22% of our total revenues, consistent with prior quarters.

About 17% of our revenues this quarter were based in Europe, and the remaining 5% of our international revenues were related to our Canadian, Mexican, Asia Pacific and Latin American operations.

Continued volatility in foreign exchange rates can materially impact our quarterly revenue results and our overall financial results.

The foreign exchange impact on our reported quarterly sequential revenue was a negative $135,000, and the year-over-year foreign exchange impact on our reported quarterly revenue was much more material and was $2.1 million.

Our quarterly revenue growth rates on a constant currency basis were 1.7% sequentially and 5.8% year-over-year, and the impact of foreign exchange primarily impacts our NetCentric revenues.

The average euro to U.S. dollar rate so far this quarter is $1.13, and the average Canadian dollar exchange rate is $0.75.

Should these average foreign exchange rates remain at these levels for the remainder of our second quarter, we estimate that the FX impact on our sequentially quarterly revenues for the second quarter will be a negative, about $200,000, and the year-over-year foreign exchange impact will be a negative $1.5 million.

We believe that our revenue of new customer base is not highly concentrated.

Our top 25 customers represented less than 6 point -- 6% of our revenues this quarter.

On CapEx, our CapEx was $13.3 million this quarter compared to $14.9 million for the first quarter of last year and $10.9 million for the fourth quarter of last year.

Capital leases and capital lease payments.

Our capital lease IRU obligations are for long-term dark fiber leases and typically have initial terms of 15 to 20 years or longer and often include multiple renewal options after the initial term.

Our capital lease IRU fiber lease obligations were $164.8 million at quarter end.

And at quarter end, we had IRU contracts with a total of 240 different dark fiber suppliers.

Our capital lease principal payments under these IRUs were $3 million for the quarter.

And if you combine capital lease payments with our capital expenditures, that total was $16.3 million this quarter compared to $13.1 million in the fourth quarter and $17.2 million for the first quarter of last year.

At the end of the quarter, our cash and cash equivalents totaled $259.1 million.

And for the quarter, our cash decreased by $17 million as a result of returning $38.5 million of capital to our stakeholders.

During the quarter, we paid $26.6 million for our regular quarterly dividend payment and $12 million was spent on a semi-annual interest payment on our debt obligation.

Our quarterly operating cash flow this quarter was $28.6 million.

Some comments on ratios and bad debt.

Our total gross debt at par, which includes capital leases, was $811.3 million at quarter end and our net debt was $552.2 million.

Our total gross debt to trailing last 12 months EBITDA as adjusted ratio was 4.28 at quarter end and our net debt ratio was 2.92.

Our bad debt expense improved this quarter and was only 0.5% of our revenues for the quarter, and our day sales also improved and was only 23 days at quarter end.

And again, I want to thank and recognize our worldwide billing and collection team members for continuing to do a fantastic job in serving and collecting from all of our customers.

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

Hey.

Thanks, Tad.

A few comments on the scope and scale of our network.

At the end of the quarter, we had over 949 million square feet of multi-tenant office space connected directly to our network in North America.

Our network consists of over 33,600 metro fiber miles and 57,400 intercity route miles of fiber.

The Cogent network remains the most interconnected network in the world, and we connect directly to over 6,660 networks.

Less than 30 of these are settlement-free peers.

And the remaining 6,630 networks are Cogent customers purchasing transit services from us.

We are currently utilizing approximately 28% of the linked capacity in our network.

We routinely augment capacity as portions of our network reach higher utilization rates to maintain these aggregate low utilization rates.

For the quarter, we achieved sequential traffic growth of 7% over the fourth quarter of 2018 and 43% over the full year period from 2018.

We operate 52 Cogent data centers with 587,000 square feet of raised floor space, and we're today utilizing approximately 32% of that data center capacity.

Our rep turnover rate was 5.1% in the quarter, which is better than our long-term average rep turnover rate of 5.7%.

Our quarterly sales rep productivity was 5.1% (sic) [5.1] per full-time equivalent rep per month.

The productivity rate that is consistent with our long-term average of 5.1 installed orders per full-time equivalent rep per month.

We ended the quarter with over 500 reps selling our service, 501, a significant increase from the 487 reps that we had at the end of 2018.

And this is the largest our sales force has been in our history.

Cogent remains the low-cost provider of Internet transit services, and our value proposition remains unmatched in the industry.

Our business remains completely focused on the Internet, IP connectivity and data center colocation services, which all are necessary utilities for of our customers.

Our multi-year constant currency long-term growth target of 10% and our long-term EBITDA margin expansion of approximately 200 basis points should be met over the next several years.

Our Board of Directors has approved yet another increase on our regular quarterly dividend of $0.02 a share increasing our quarterly dividend to $0.60.

Our dividend increase continues to demonstrate the optimism we have in the strength of our business, the underlying growth and the improving cash flow capabilities in a sector that continues to see most of our competitors experiencing declining revenues and declining margins.

We will be opportunistic about the use of our balance sheet.

We'll be opportunistic about the timing and purchase of common stock.

At quarter's end, we still had $34.9 million remaining under our current buyback authorization, which continues to year-end.

We remain committed to returning increasing amounts of capital to our shareholders on a regular basis.

With that, I'd like to open it up for questions.

(Operator Instructions) And our first question comes from Philip Cusick with JPMorgan.

So Dave, 2 if I can.

First, can you expand on what sounds like pressure on the NetCentric side?

And then second, full-time and total reps are running at new highs and up a lot and productivity continues lower.

I recognize there's a relationship here.

But is there an intention to trend lower productivity per rep that we should be thinking about?

Sure.

Thanks, Phil, for the questions.

So first of all, on NetCentric, our business has experienced a slowdown in traffic several years ago due to violations of net neutrality.

And now traffic has rebounded to close to historical growth rates.

However, the majority of that incremental traffic, that 43% year-over-year growth has come from our largest customers, which get the lowest pricing.

So while the average price per megabit continues to decline at rates consistent with our long-term averages of about 23%, it was 24.4% this quarter, the volume-weighted decline has been greater, resulting in flat sequential revenues on a constant currency basis and a 3% year-over-year decline in light of traffic growth.

We expect to see a more normalized pattern of traffic growth from a broader base of customers.

And with that, we believe that our NetCentric revenue growth will return to its historical averages, which are about 9.5% year-over-year as opposed to the 3% decline that we had this quarter.

Obviously, the Corporate business continues to perform strongly and has really been unimpacted by these trends.

Now to the full-time equivalent rep and total rep size and productivity question, 2 points.

First of all, we are committed to increasing the size of our sales force at between 7% and 10% per year.

We achieved that last year.

We expect to achieve that this year.

In the quarter, we increased the number of total reps by 14, but actually, our full-time equivalent reps went up by 28, therefore, meaning a lot of reps that were hired towards the end of last year reached their third month and are now counted as full-time equivalents.

As we have commented on in the past, rep productivity actually consistently increases from month 1 to about month 30 when it plateaus.

So the decline in rep productivity was really as a result of the average tenure of the reps coming down due to the fact that we have 28 reps that are in their fourth or fifth month, not fully productive yet but still counted in the base.

We achieved aggregate productivity in line with our long-term average.

It is correct that it's declined from the last several quarters, but it's because of the step function increase in the number of FTEs in the quarter.

We expect that to normalize over the course of the year.

We believe the training programs, market segmentation and management initiatives that we put in place will allow our rep productivity over time to continue to trend up.

We also in the quarter lost some additional time.

We had our annual sales meeting.

Normally, that meeting is 3 days in length.

This year, it was actually expanded to 8 days to give us greater ability to train reps.

And for our Corporate reps, that is highly impactful because their call volume and just number of days in the office is directly proportional to their selling.

So we effectively lost an additional half a week of selling in the quarter, which also had a drag on rep productivity because it's only based on installed orders.

I think you'll see a rebound in the next quarter.

Can I expand that a little bit?

The growth in reps, is that mostly Corporate or is the NetCentric rep growth pretty strong as well?

So there is growth in both segments, but we're roughly 74.5% of Corporate and about 25.5% NetCentric.

So the aggregate number of reps that increased are far more Corporate than NetCentric, and that ratio has been relatively consistent.

And is your -- your assumption of NetCentric sort of broadening of traffic growth, is that reliant on the expansion of reps there?

Or is there something else going on that your other customers will start ramping up?

It's not really dependent on number of customers.

It's really dependent on change in traffic patterns.

So what we saw is some of our largest customers, as their direct connect agreements that they were forced to sign under the net neutrality violations have begun to lapse, they have shifted more of that traffic back to transit and much of that has come to Cogent.

Also, we have seen a trend in the past few years where 10-or-so large content companies are growing much faster than the average base of content companies.

We think those trends are somewhat transitory.

Our NetCentric sales force is about 130-or-so reps spread out around the world and the fact that we sell to 6,630 access network shows you how broad their reach is.

And we sold to over 4,200 content companies.

So I don't think it's necessarily a result of needing more reps.

It's really that those smaller customers just need to achieve the same kinds of traffic growth rates as the largest customers are doing.

And our next question comes from Walter Piecyk with BTIG.

Dave, you just mentioned that your FTEs, full-time employees, increased by 28 reps as the explanation for that drop in productivity.

In Q1 of 2017, they rose by 32.

And in Q1 of 2016, they rose by 22.

And in those quarters, your productivity remained flat at 6.1% versus 6.1% in the prior quarter and at 6.3% versus 6.3% in the prior quarter.

So what was -- how does that play a role in this quarter as opposed to not playing a role with similar circumstances in those 2 years?

So it is just an arithmetic fact that whenever you hire new reps, those reps increase in productivity for a much longer period than when we count them as full-time equivalents.

And the reason for the full-time equivalency cutoff is that is the period of time in which Cogent is paying a guaranteed commission on the variable portion of the rep's compensation.

At the end of that period, that bridge or that guaranteed variable goes away and the rep is just left with their base salary and then the variable component is totally driven by their performance, and we do see that performance increasing.

In terms...

But that has not been a factor in the past 3 years.

No.

I heard you on the -- in the past periods, maybe some of the training programs that we have rolled out had a bigger impact.

There's also just some lumpiness in sales.

We did lose an additional 4 days of selling time this quarter, which does impact the Corporate reps.

It doesn't really impact the NetCentric reps very much.

But that did have an impact as well and some of it's just the lumpiness.

I can't account for the difference in the past years.

What I can tell you is that the long-term trend line in our rep productivity has continued to improve.

It is not a perfect straight line, and the step-back that we had this quarter was really just to the long-term average.

And as I stated earlier, I fully expect that rep productivity to rebound and continue at above historical rates.

Got it.

So let's approach this from a different angle then.

If you look at the sequential growth in your Corporate business, we go back to the improvements that were made in the sales force back in 2014.

I mean, it wasn't down dramatically this quarter.

But this is the lowest sequential growth you put up in Corporate since 2013.

So is your expectation that now you have these 28 new full-time employees that's going to ramp, but you can get your sequentials back to 2.7% or at least sustained at a 2.7%, 2.8% range going forward?

So the answer is, yes, we should continue to see Corporate growth be particularly strong.

And to your point of the historical inflection in Corporate growth, much of that came from the introduction of our VPLS product, which we've spoken about on a number of occasions, and the fact that roughly 25% of our Corporate sales are for VPN services, either VPLS or SD-WAN and that will continue.

We feel very comfortable that we should be able to achieve consistent Corporate growth in that 11%, 12%, 13% range.

And as I stated, we did lose an additional 4 days of selling time in the quarter, which is not insignificant in a highly transaction-driven model, where a number of outbound calls is directly correlated to sales and installs in that quarter.

Got it.

And then just one last one on NetCentric.

Again, you mentioned this 9% target.

I mean, you haven't topped 9% in NetCentric since 2013.

So when you define this as a long-term growth rate, I mean which years are you talking about?

And when -- what type of time line can we expect to it to ever get back to that type of growth rate because it just -- I mean is it like 5 years now?

And that's a fair point.

I commented on it extensively on the last call, and it was part of the reason why we took the aggregate target down for our long-term growth rate.

When we look at NetCentric, there are really 2 drivers.

The first driver is traffic growth.

And again, our long-term traffic growth is approximately 50%.

It had decelerated to the low 20s.

It's back at 43%.

That's an important prerequisite to be able to get our NetCentric revenue growth to accelerate.

The second thing is the average price per megabit.

And while the average price per connection sold is very similar, what we have seen though is most of the growth coming from our largest customers.

Therefore, the effective price per megabit has declined much more rapidly over the past 12 to 18 months as those direct connections shift back to using transit as a preferred way to connect to the Internet.

We think that is a transitory phenomena.

Those contracts were between 3 and 5 years in term.

They are lapsing at this point.

All of our counterparty peers are honoring net neutrality rules with the exception of Deutsche Telekom, which we've commented on historically.

And we do expect...

Have you given up the fight there because you didn't book any net neutrality fees this quarter?

Well, we didn't have to spend anything.

It doesn't mean we gave up.

But we have a pending case still in front of the German appeals court.

It's a 3-judge tribunal and it is a very lengthy process.

If you think the wheels of justice turn slow in the U.S., they turn slower in the EU.

So this is going to be a protractive fight.

And listen, we're not happy that we're doing it on their turf, but that's where...

I mean Dave, I just think investors will be more interested in knowing when it's not going to -- or when it's going to stop declining as opposed to talking about getting to a 9% number that you haven't hit in 5 years?

Well, then let me couch it a different way.

The rate of decline improved.

It became less negative this quarter than it was the previous quarter.

So there is an inflection, the second derivative is positive and things are improving.

But I do believe they will improve through getting to flat and actually get to a point of positive revenue growth.

And our next question comes from Matthew Niknam with Deutsche Bank.

Just 2 if I could.

One on gross margin, so pretty big improvement year-on-year.

Can you talk about what drove this and the sequential decline in network operation expense this quarter?

Just wondering if this is sort of recurring or if there any onetimers in the quarter.

And then secondly, on shareholder returns, you talked about having access to the builder basket with leverage below -- the gross leverage below the 4.25%.

Is that sort of a precursor?

Or should we expect an uptick in terms of the rate of dividend growth or total shareholder returns as a result?

Yes.

So first of all, 2 very good questions.

Thanks, Matt.

In terms of gross margin, we have had consistent long-term improvement.

Over the past couple of years, it's averaged about 100 basis points a year.

It was steeper this year.

I think that is in part because of the operating leverage in our business and the fact that roughly 3/4 of all sales are on-net which carry a 100% gross margin, contribution.

In terms of the sequential improvement, we do have certain maintenance fees that are paid, some quarterly, some semi-annual and some annually.

We did have an annual fee that hit last quarter, so that was part of the sequential, but that also hit the year before as well.

In general, investors should expect for the next several years on average about a 100 basis points a year of gross margin improvement due to the operating leverage of the business.

With regard to shareholder returns, we are absolutely committed to using our balance sheet effectively.

We have reduced our leverage below the indenture test to be able to move all of the available builder basket, $88 million, to the holding company, which we'll do, bringing cash then at the holding company to $194 million.

And we have under our indentures probably about another $150 million of borrowing capacity at the operating company level and no restriction on borrowing at the holding company level.

We will explore the debt market and possibly put additional debt on at the operating company level based on current market conditions seeming to be fairly favorable.

We don't have an exact timing for that, but it is something that we are going to explore.

And then with regard to now returning that $194 million to shareholders, we are very committed to growing our dividend, 27 consecutive quarters of sequential growth I think proved that.

The fact that our dividend grew at nearly 16% year-over-year and we interjected opportunistically buybacks.

I think if we see a period of market volatility, you'll see us re-enter the market and use our buybacks.

If we are in a prolonged period of no market volatility, I think the Board will consider using that excess cash in bigger dividends.

But I don't think that decision has been yet made and we're going to be patient in our long-term return.

But I think what investors should expect is we will continue to increase the amount of cash we return to them.

And we've been prudent about not over-levering, we've been measured in the pacing of that return, and I think you should expect that going forward.

And if I could just follow up real quick.

On the maintenance fee that you talked about that was present in 4Q, was seemingly not present in 1Q.

Can you quantify that amount if it's meaningful?

It was not insignificant.

That particular contract is covered by an NDA.

But it was meaningful enough that it showed up in the numbers.

I'll just leave it at that.

And our next question comes from Tim Horan with Oppenheimer.

[Sorry to comment on NetCentric here], but you sound very confident on growth kind of coming back.

And your peers -- or the industry is talking about better volume growth they're seeing, like, this year or this quarter.

The cable industry's a lot more over-the-top video kind of occurring.

But it sounds like you think you were going to get -- or you're starting to see growth coming from other locations.

But can you just give us a little bit of color on maybe the timing when you might see a little bit more diversification on the traffic growth?

Or maybe a lot of it just coming even from the largest companies?

And related to that, how much can these large NetCentric customers save by using you for transit instead of going direct connect to the carriers, roughly?

Yes.

So 2 very different questions.

First of all, clearly, the aggregate growth in traffic, not only that we are seeing, but the rest of the industry is seeing, is a leading indicator to an improvement in the NetCentric market.

And we have historically grown at about double the market rate and that's what we're doing today.

And I think it's a clear indication we are gaining market share.

I do think there is a broadening of applications that are very bandwidth-intensive and some of these are earlier stage, some of them being more augmented reality, gaming-type applications that will diversify growth away from some of the biggest names in video distribution.

But they remain strong as well and we expect growth to come from both segments.

We also benefit from the fact that we have 6,630 access networks buying from us.

So they're kind of the counterparty to that traffic growth, meaning their customers are pulling down more content.

We don't pick winners and losers.

We sell to everyone.

We have a very transparent pricing model in terms of discounts to competitors and volume and term discounts.

We think this simplicity has helped us win our customers' confidence and shows that we continue to gain market share.

So for all of those reasons, I feel pretty confident that we are going to see a broadening of base.

And what I don't have perfect visibility to is how much direct connect still exists and how much can be converted back.

Now to the question of savings.

We have had some customers who have built their own networks for their own proprietary needs, usually, to link their own data centers and transfer information between those centers.

We've also had customers who have previously built networks and abandoned those networks using transit as a lower cost, more flexible technology.

I actually met with a very large content-producing company that had built out a global network and pointed out to them that if they had just used Cogent with our volume discounting, they can literally be saving hundreds of millions of dollars in capital expenditures per year by just using the efficiency of our network.

Now they may have other requirements that I'm not seeing, but just on their network, there would be massive savings.

Some of these companies view it as strategic, and that's their decision.

And as long as their models remain profitable enough to allow them to be not efficient in the purchase of bandwidth, so be it.

But we are convinced that for every NetCentric customer, we provide the very best cost alternative and the scale and cost structure of our network is far better than trying to build it yourself.

And then just a follow-up on pricing.

Your new sales price now has been kind of flat for a year or a little bit longer, basically.

Should that indicate better revenue growth going forward?

Because your discount on the average price to the new sales price is kind of relatively low at this point.

I do think that is one of the leading indicators that are helping us get comfortable with the idea that NetCentric revenue growth will resume.

And any idea why the new sales price has been relatively flat here?

And is that kind of remaining the case, do you think, for the next couple of quarters?

Well, I think it's that precursor of broadening the base.

So again, the big guys have already bought.

They're filling up the pipes that they have, and we are going out and seeding a next generation of business models that are buying lots of small ports.

And what has always been a key to our NetCentric growth is when one or more of those newer businesses become the next dominant traffic generator.

And our next question comes from Nick Del Deo with MoffettNathanson.

Off-net growth has decelerated pretty materially over the last several quarters.

To what degree is that tied to lower prices from your off-net vendors versus the rate of VPN sales versus other factors?

Nick, I would say it's 2 things.

One, average contract length continuing to increase both for on-net and off-net.

But for off-net, it's much more a result of lower loop prices.

So we today, from 90 different vendors, have fiber off-net availability in 1,030,000 buildings.

That is a big footprint.

And in most of those cases, we're actually saying 2 alternatives, usually, an incumbent and some competitive carrier.

And in many cases, that's the cable provider as they've aggressively overbuilt in large part to facilitate 5G and small cell deployment.

So with that fiber plant, so whether it's AT&T with Project VIP; or Verizon with its new 5G overbuild, not FIOS, but their own fiber buildout; and then whether it's Spectrum or Comcast, we've seen very aggressive fiber building, which has driven down our price for loops.

Our off-net business is a derivative of our on-net Corporate business.

It all starts with an on-net corporate sale.

And then if the customer needs us in multiple locations either for VPN or Internet access or both, then we get the very best loop price that we can.

And we've seen those loop prices falling fairly precipitously and we're passing a lot of that savings on to our customers.

Actually, the loop prices are falling faster than our ARPU is falling in large part because a lot of our customers are under long-term contracts and won't be able to avail themselves of those lower prices till their initial term expires.

Got it.

And then turning to SD-WAN, recognizing that it's still early days for product.

Can you talk about the traction you're getting with customers?

Anything you've learned about the sales process or sticking points?

Yes.

So I think 3 points.

First of all, I would acknowledge SD-WAN sales for us and for other vendors have probably been slower than we would have initially expected.

Two, I think SD-WAN has paralyzed the MPLS market and has really created a customer dynamic where no customer will expand or modify their MPLS network.

So I think it's the third point, which is most of our SD-WAN discussions have actually resulted in incremental VPLS sales for Cogent.

And that is because when you outline the pluses and minuses of each of the technologies, the VPLS solution is more mature.

It more closely fits the customer requirement.

So we repeatedly have discussions with customers who want to move off of MPLS to an SD-WAN product.

We outline our SD-WAN offering, we compare it to competitors and we compare it to our VPLS, and increasingly, what we have seen is the customers continuing to choose the VPLS product.

Even though they came in asking for SD-WAN, they walked out the door with VPLS.

And our next question comes from Colby Synesael with Cowen and Company.

I guess 2 questions.

One, just sticking on off-net.

Historically, going back many years ago, that was thought to be a T1-oriented business where you'd effectively purchase T1s from the Verizons and AT&Ts of this world and sell them to your customers.

And I know that over the last few years that the conversation has shifted a bit more to fiber-oriented solutions.

But I'm curious, how much of off-net revenue -- Corporate off-net revenue at this point is coming from T1s?

And how much of that slowdown in growth that we've seen the last several quarters might actually be a function of churn, and more specifically, T1 churn?

And then secondly, equipment gains, again, something we've talked about for many years now.

I think there was a time where we thought that was going to slow, and now we've seen it kind of come back and it ebbs and flows each quarter.

Where are your expectations for equipment sales in 2019?

And what is the updated view on how that looks over the next few years?

Sure.

Let me take the T1.

That was a super easy question.

We have 0 T1s and have had 0 T1s, T3s or any TDM-based off-net product for 3 years.

100% of our off-net sales are fiber-based, no coax, no fixed wireless, no ADSL, only fiber and only Ethernet.

So it means that Cogent can serve 55% of the business locations in North America, 10% on-net for our footprint, 45% from the 90 different vendors that we can buy from.

And it also means 45% of locations are no-bid for Cogent.

So we have no churn coming from TDM or T1 services and have not for our 3.5 years since we've been able to phase all those out.

We have seen significant price declines, however, on those Ethernet-based fiber-delivered services and the competitive tension is what's driving down cost.

We also had previously been willing to sell lower speeds than 100 megs, and now virtually all of our off-net sales are 100 meg or greater via fiber.

We still have some limited 50 meg services, but increasingly, we're trying to steer our customers to 100 meg off-net as a minimum product.

And then to the equipment sale question, Colby, we have significant inventory of gear that we constantly rotate in out of our network that is not efficient and has been replaced by newer technology.

However, there's not always buyers available for it.

It's not our primary business.

We don't recognize those sales and revenue.

But because there is usually no basis in that equipment, those gains have to be reflected in our reporting of cash flow and EBITDA, but not in revenue.

I would suspect equipment sales for this year will be similar to last year.

I think the uptick that we experienced this quarter was a bit of a off -- a one-off in that we were able to sell some gear that we just found a customer for.

But it's not something that we can predict with any kind of certainty.

And our next question comes from Michael Rollins with Citi.

Dave, I was wondering if you could unpack a bit the unit volume you had and the revenue by the different products that you're selling, between your bandwidth and some of the additional products, like the VPN, the data center.

And then as you move forward, how are you thinking about product mix and your interest to add additional products to the menu?

Sure.

So I'll start with the second question first, which is one that new hires always ask, when are we going to sell something new?

And the answer to that is probably not.

I think our key success, and I think it's even more accentuated today vis-a-vis our competitors than it ever has been is the simplicity of our product portfolio.

And we expect that to continue.

So there's really 3 product categories: some form of Internet access, which is about 81%, 82% of revenues; some flavor of VPN, which is either SD-WAN or VPLS, which in total revenues is generally about 17% of revenues; and then finally, our colocation space and power, which is traditionally a couple of percent of revenues.

Now to the bandwidth products, for Corporate customers, the flagship or the standard product has been and continues to be a 100 meg connection.

Although we are increasingly selling either fractional gigs or full-gig interfaces in corporate buildings as most corporate customers in their land refresh cycle are able to now accept a full gig handoff.

Ironically, we deliver to the customer a fiber gig interface, but we rate-limit it down and convert it to copper because that's what the customer could take in the handoff.

I do think over the next several years, the gigabit product for Corporate customers will become the de facto standard.

I do think eventually it'll be priced at identical prices to the Fast E product.

It's not there today, we do charge a premium for it.

But I think as it becomes the standard, it will become our product at the same price points.

And ironically, it will actually improve our cost of delivery because we don't have to buy that piece of equipment, it's about $300, that we place in the customer's suite to convert it from fiber to copper.

We can do a direct fiber handoff and it eliminates one point of failure as well.

And it will also help us lower our installation cost for customers because traditionally we charge the customer for that piece of customer prem equipment.

And just following up on the Corporate point.

In the past, you talked about the low utilization of bits by the Corporate customers on that 100 meg connection.

Can you help us visualize where the growth of that corporate traffic is going and what you're seeing trend line-wise?

Sure.

Actually, this last quarter, our average Corporate growth or traffic utilization at peak was about 14.7% of those connections.

And part of the reason it's drifted down a little bit is because some customers are taking gigabit connections even though they don't need them.

And I think where that traffic is going is really 2 primary drivers.

As businesses move computing off-site into a remote location or cloud that is requiring more bandwidth and a greater percentage utilization of the port.

The second is as businesses migrate software away from licensed premise-based software to SaaS, that also requires more bandwidth.

But remember, most business users are only in their offices 40, 50 hours a week.

So while I'm giving you the peak number.

If you look at corporate utilization on an average basis, it's a fraction of 1% on a 24/7 basis, which is an extremely different use pattern than a NetCentric customer that tends to utilize its ports at 70% or 80%, but 24/7.

And our next question comes from Mike McCormack with Guggenheim Partners.

I guess just one thing on the margin side.

If you could just talk about the puts and takes that you mentioned for Q1.

Obviously, there's some seasonality there.

Maybe the magnitude as you step into 2Q, or the step down in cost, if you can sort of try to frame that.

And then secondly, I know Dave, you mentioned cable with respect to the sort of enabling 5G and access cost coming down.

What about cable as far as a threat on the corporate customer side for you guys?

Are you seeing anything sort of looming on that front?

Yes.

Sure, Mike.

Two different questions.

So first of all on the margin side, we in this quarter experienced a couple of extra -- Q1, experienced a couple of significant extra SG&A costs.

The first is our sales meeting.

This year, it was longer and actually ran over $1 million, which is not insignificant at a company of Cogent's scale.

We also have the payroll reset and health care generally goes up as well as COLA increases pass through in the first quarter.

Our SG&A as a percentage of revenue went from about 22% to about 24% of revenue sequentially.

You should expect it to drift down over the course of the year.

In terms of gross margin, just the 3/4 of all sales that are on-net, that will continue to drive improved gross margin and that's how we get to the roughly 200 basis points a year, roughly half of it coming from gross margin uplift, half of it coming from SG&A.

Now to your cable competition question.

In off-net locations, cable competition is very real.

However, we don't go out to sell in that location.

The only time we go to that location is when we have a customer that has an on-net location with us.

We don't see cable having the on-net footprint in multi-tenant skyscrapers or the scale that we're in, in central business districts.

They haven't prewired the buildings, they haven't built out a full distribution system, making installation lengthy and also expensive.

Also for multi-site customers, cable footprints can be somewhat limited.

And our footprint, being global, just gives us some real advantages.

And our next question comes from Michael Funk with Bank of America.

Quickly, just back to the NetCentric growth.

I appreciate your optimism on turning the revenue growth trend.

I heard your comments about thinking that maybe some of the traffic losers might actually pick up some traffic growth and the help you could be getting there.

Really, it relates to the return of capital though.

Given that, I guess, continued return of capital seems to be predicated on turning the NetCentric revenue growth higher, right, given the high-margin aspect of that business, I'm just wondering, to what degree return of capital in the future is predicated on getting back to that 10%-plus growth.

And how much you and the Board consider maybe a suboptimal outcome when thinking about returning capital.

Not wanting to be in the box of hitting up against leverage targets, given that you're already paying out more than 100% of your free cash flow with the dividend.

And certainly, your valuation at this point is probably solving, I guess, for the dividend yield.

And some of the examples we've seen in the RLEC space, where similarly, management teams are optimistic about turning the top line, it just didn't happen and ended up in a box where the payout became unsustainable.

So I guess the question is, do you even open to consideration that revenue may not get back to where you want it to be?

And does that inform your decision about incremental returns of capital or keeping that cash in the balance sheet?

Sure.

A very good question, Mike.

So a couple of points.

First of all, we have grown our dividend throughout the period in which NetCentric has underperformed.

To Walt's point, it's been 5 years since NetCentric has performed well.

And during that 5-year period, we have 20 consecutive increases to our dividend.

Second, we are very different than an RLEC.

We do not have an aggregate business that's in decline.

Our top line growth continues strong.

Our addressable markets have plenty of additional opportunity available to us and we continue to gain market share in those markets.

The products we sell are in demand.

It is not like residential landline services that are being eliminated and substituted away with broadband or with a mobile connection.

So I think the Board has taken a very measured approach.

We've had calls from investors to increase the pacing at which we are increasing our dividend.

In fact, our cash flow grew year-over-year 16.2% and our dividend only grew 15.8%.

So we acknowledge that we are using the balance sheet efficiently, but we remain far less levered than any other company in our sector and with our top line growth, even with underperformance in the NetCentric business.

So I think the rate of dividend growth that we have now should continue and is not predicated on a belief that we have a rapid turn in NetCentric revenue.

If we see that NetCentric revenue starting to inflect faster, and again, as I answered earlier, the rate of decline has slowed.

It is not yet positive, but it is improving.

As it improves, that gives us further ability to increase the pacing of our revenue growth and therefore the pacing of our growth in dividend.

But I think we have demonstrated in a tough pricing environment, a tough macro environment for our sector, our ability to consistently grow aggregate revenues and expand cash flow.

Our cash flow is growing at like 20% per year roughly over the past several years.

And with that, having dividend growth the way we have delivered is in no way putting our balance sheet at risk or putting investors in any area where they would have to assume that they would be susceptible to dividend elimination.

Listen, if you've got negative top line growth, you can't cost-cut your way to a fix.

You have to eventually cut your dividend and that may not be enough to save the business.

We don't have that problem.

What you're focused on is the incremental benefit from 1/3 of our business growing at a faster rate.

But the underlying strength of our cash flow growth is unmuted.

Can you give me very -- just the time today Dave, maybe one more if I could.

You mentioned that the data center is 30% occupied.

I get that maybe that it's strategic for a portion of the business, but seemingly maybe underutilized assets there.

Very strong valuations we're seeing in data center sales recently, cap rates anywhere from 4% to 8% in the sales.

Have you considered giving any kind of thought to monetizing that asset, maybe to strengthen the balance sheet even more?

We have looked at that, Mike, but 2 things.

First of all, they're completely integrated to the Cogent network.

Meaning we typically have sales offices there, we have our hubs colocated.

So they serve multiple functions.

Could they be segregated?

Sure, but it would take some work.

And the second, you actually just criticized me for trading at too high of a multiple, and the reality is our multiple is comparable to many of the data centers.

But actually on a cash flow and growth as adjusted cash flow multiple, we trade at a significant discount to the data centers.

And our next question comes from Brett Feldman.

As you were noting before, your outlook for improved NetCentric growth is based not just on an improvement in the rate of growth of traffic as new applications come to the Internet, but that is a broader base.

And so maybe for context, the improvement in traffic growth you have seen recently, it seems like that's been predominantly driven by video.

But if it's more nuanced, that context would be helpful.

And then second, what are some of these new uses that you think are going to drive faster growth in data traffic?

And what gives you confidence that the sources of those are going to be different than the tech heavyweights that I suspect are behind the growth you've seen recently?

Sure.

Thanks, Brett, for the questions.

So first of all, the Internet remains a very dynamic ecosystem.

And every time there's a belief that all the things that people are going to use are out there, someone comes up with a new model.

And we have traditionally been the service provider of choice for startups and smaller companies that experiment.

Secondly, today and probably for the foreseeable future, most growth is going to continue to come from linear video substitution moving to over-the-top.

That will continue to drive growth and that business has been dominated by a handful of companies and I think that's probably going to continue.

There may be some broadening of that base.

We're seeing, for example, Disney launch its own product, we're seeing new models like [Quivid] come out.

There is an attempt to have a broader set of consumer choices and packages, and I think that will be helpful.

But I think when we think about new business models, it will be things that are probably more interactive, meaning suited only to the Internet.

While massive online multiplayer gaming remains a significant subset of the market, it is still not yet completely mainstream.

Also, virtual reality and augmented reality products are I think in their infancy.

And if I was smart enough to pick which business would be the winner, I wouldn't be on this call, I'd be investing in that company and sitting on a beach somewhere.

But what I do know is consumers are fickle, the battle is for eyeball time and there will be new products coming out that are more immersive than those that we have today, more flexible.

And yes, we will someday reach saturation of Internet traffic growth, but I think we have a long way to go.

And it's not clear to Cogent that those large FAANG-type names are the only innovators on the Internet.

Now they may buy up those innovators, but right now, there's a broad base of new models being tried out.

And our next question comes from Brandon Nispel, KeyBanc Capital Markets.

Okay.

Great, real quick.

Just want to touch on the maintenance fee again.

Can you maybe remind us when it hit last year so we can sort of rightsize our model from a sequential impact to gross margins?

And then maybe for Tad, was there any impact on the lease accounting standard to the income statement?

Or was it just a balance sheet presentation change?

Sure.

On the new lease accounting standard that we had to adopt this quarter and record that January 1, we did not retroactively adjust our financials, and there is no income statement impact at all.

The accounting for lease expense is identical this quarter as it has been historically.

It's purely a balance sheet transaction.

And the total aggregate present value of the leases that we had to record, which were largely related to our facilities, was $97 million but it's purely a balance sheet transaction.

And then Brandon, in terms of the maintenance fee, while I didn't disclosed the exact amount, it is material.

We do have these quarterly, semi-annual and annual ones and there are a very few monthly ones.

And it was just material enough that it did impact the sequential.

But I think kind of on a recurring model basis, you should expect some additional maintenance fees in the fourth quarter of this year.

But in aggregate, we expect it to lever about 100 basis points of gross margin expansion per year for the next several years.

Okay, thank you.

And with that, this concludes our Q&A session for today.

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

Well, I'll keep it short because we did have a lot of excellent questions.

I want to thank everyone for taking the time and I look forward to fielding any individual questions and seeing folks out at conferences over the next few weeks.

Take care, everyone.

Thanks.

Ladies and gentlemen, thank you for your participation in today's conference.

This concludes the program.

You may now disconnect.

Everyone, have a great day.