Cogent Communications Holdings Inc (CCOI) 2019 Q4 法說會逐字稿

Good morning ladies and gentlemen, and welcome to the Cogent Communications Holdings Fourth Quarter and Full Year 2019 Earnings Conference Call.

(Operator Instructions)

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

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

Thank you and good morning to everyone.

Welcome to our fourth quarter 2019 and full year 2019 earnings conference call.

I am Dave Schaeffer, Cogent's CEO and with me on this morning's call is Tad Weed, our Chief Financial Officer.

We are pleased with the results for the quarter and for the year, and continue to be optimistic about the underlying strength of our business and the outlook for 2020 and beyond.

Our quarterly gross margin reached a company record of 60.3%, increasing sequentially by 40 basis points and increased by 230 basis points from the fourth quarter of last year.

Our gross margin for full year 2019 increased by 190 basis points from full year 2018 to 59.9%.

Our EBITDA margin for the quarter increased by 160 basis points from the fourth quarter of 2018 to 37.6%, and increased by 70 basis points to 36.2% for the full year 2019 versus '18.

On a constant currency basis, we achieved sequential quarterly revenue growth of 2.5% and year-over-year quarterly revenue growth of 6.8%.

Our year-over-year quarterly traffic growth was 30% and we achieved sequential traffic growth of 9%.

For full year 2019, traffic on our network grew by 35%.

During the quarter, we returned $29.8 million to our shareholders through our regular quarterly dividend.

As posted on our website, 54% of our $112.6 million total 2019 dividends should be treated as a return of capital.

And 46% should be treated as taxable dividends for U.S. tax income purposes.

We did not purchase any common stock in the quarter.

At quarter's end, we have a total of $34.9 million available in our stock buyback authorization and that authorization will continue through December 2020.

Our gross leverage ratio in the quarter decrease to 4.86% from 4.97% the previous quarter.

And our net leverage also decreased to 2.86% from 2.92%.

Cash held at Cogent Holdings at quarter end was $110,300,000.

This cash is unrestricted and available to be used for dividends, buybacks, or both.

Cash held in our operating company at quarter end was $289.1 million, giving Cogent a consolidated cash balance of $399,400,000 at year-end.

We continue to remain confident in our growth potential and cash generating capabilities of our business.

As a result, as indicated in our press release, we announced yet another $0.02 sequential increase in our regular quarterly dividend from $0.64 a share per quarter to $0.66 per share per quarter.

This represents our 30th consecutive sequential increase to our regular quarterly dividend.

Throughout today's discussion, we'll highlight several operational statistics.

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

Following our prepared remarks, we will open the floor for questions and answers.

Now, I'd like to turn it over to Tad to read our Safe Harbor language.

Thank you, Dave, and good morning to everyone.

This earnings conference call includes forward-looking statements.

These forward-looking statements are based upon our current intent, belief, and our 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 non-GAAP financial measures during this call, you will find these reconciled to the comparable GAAP measurements in our earnings release, which is posted on our website at cogentco.com.

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

Thanks, Tad.

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

Our press release includes a number of historical metrics.

Now, for some comments about our performance against expectations and targets.

Our corporate business, which represent 69% of our total revenues for the fourth quarter.

Our corporate business has been growing above our targeted guidance, long-term full year range of 10%, and in fact grew 10.1% from the fourth quarter of 2018.

Our NetCentric business, which represents 31% of our revenues, has been underperforming compared to our historical averages, and declined by 1.4% from the fourth quarter of 2018.

Our corporate business grew sequentially by 2.5% as compared to the previous quarter.

The impact of foreign exchange primarily impacts our NetCentric business.

On a constant currency basis, our NetCentric business increased, on a year-over-year basis for the fourth quarter, by 1/10 of a percent and increased by 2.6% from the third quarter of 2019.

Our quarterly cash flow as defined by EBITDA minus CapEx, minus principal payments on our capital leases.

For full year 2019, our cash flow grew by 14.1% from 2018.

Due to the excellent operating leverage of our business, we expect our cash flow to continue to grow at similar rates.

Our long-term EBITDA margin expansion targets guide to an annual improvement of approximately 200 basis points per year.

On a multiyear constant currency, long-term revenue growth target, remains approximately 10%.

Our revenue and EBITDA guidance targets are intended to be multiyear targets and are not intended to be specific quarterly guidance or even specific annual guidance.

Now, I'd like to turn it back over to Tad to give you some additional details on some of our operating results.

Thanks, Dave and again, good morning to everyone.

And I'd also like to thank and congratulate the Cogent team for their results and their continued hard work, and their efforts [to] during another very productive quarter for the company, and also a very productive year for Cogent.

Some comments on revenue by corporate and NetCentric and customer connections.

As a reminder, we analyze our revenues based upon network type, which includes on-net, off-net, and non-core.

And we also analyze our revenues based upon customer type.

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

Our NetCentric customers buy large amounts of bandwidth from us and carrier neutral datacenters.

Our corporate customers buy bandwidth from us in large multitenant office buildings, typically in North America.

Some comments on revenue and customer connections by customer type.

Revenue from our corporate customers for the quarter grew sequentially by 2.5% to 96.8 million and grew year-over-year, as Dave mentioned earlier, by 10.1%.

Revenue from our corporate customers was $373.7 million for the full year, which represented an increase of 10.6% over last year.

At the end of the year, we had 48,486 corporate customer connections on our network and that was an annual increase of 7.3% over the fourth quarter of last year.

Quarterly revenue from our NetCentric customers increased sequentially by 2.4% to 43.5 million but declined year-over-year by 1.4%.

Revenue from our NetCentric customers was $172.5 million for full year 2019, which was a decrease of 5.4% over last year.

On a constant currency basis, our quarterly revenue from our NetCentric customers increased however by 2.6% sequentially and increased year-over-year slightly by 0.1%.

We had 38,053 NetCentric customer connections on our network at quarter end, which was an increase of 9% over the fourth quarter of last year.

Our NetCentric revenue growth experiences significantly more volatility than our corporate revenues due to the impact of foreign exchange, larger customer sizes for the NetCentric customers, and also certain seasonal factors.

Some comments on revenue and customer connections by network type.

Our on-net revenue was $102.7 million for the quarter, which was a sequential quarterly increase of 3.3%, and a year-over-year increase of 7.7%.

Our on-net revenue was $396.8 million for the full year, which represented an increase of 5.9% over last year.

Our on-net customer connections increased by 0.9% sequentially and increased 8.4% year-over-year.

We ended the quarter with 74,554 on-net customer connections on our network and our 2,801 total on-net multitenant office and carrier neutral datacenter buildings.

Our off-net revenue was $37.5 million for the quarter.

That was a sequential quarterly increase of 0.2% and a year-over-year increase of 2.5%.

Our off-net revenue was $148.9 million for the full year and that was an increase of 2.7% over last year.

Our off-net customer connections increased sequentially by 1.4% and increased by 6.3% year-over-year.

We ended the year serving 1,660 off-net customer connections in over 6,870 office buildings and these buildings are primarily located in North America.

Some comments on pricing.

Consistent with historical trends, the average price per megabit of our installed base and our new customer contracts decreased again for the quarter.

The average price per megabit for our installed base declined sequentially by 5.1% to $0.58 and declined by 20.5% from the fourth quarter of last year.

The average price per megabit for our new customer contracts for the quarter declined sequentially by 16.2% to $0.28 and declined by 31.6% from the fourth quarter of last year.

Comments on ARPU or average revenue per unit.

Our on-net ARPU actually increased for the quarter and our off-net ARPU decreased.

Our on-net ARPU, which includes both corporate and NetCentric customers, was $461 for the quarter, which was an increase of 1.8% from $453 from last quarter.

Our off-net ARPU, which is comprised predominantly of corporate customers, was $1,079 for the quarter and that was a decrease of 1.3% from last quarter.

Some comments on our churn rates.

Our on-net churn rate increased very slightly and our off-net unit churn rate was flat for the quarter.

Our on-net unit churn rate was 1.1% for the quarter and last quarter it was -0.9%.

These are unit churn rates.

Our off-net unit churn rate was 1.1% for this quarter, which was the exact same amount as we incurred last quarter.

Some comments on move, add, and change orders.

As a reminder, we offer discounts related contract term to all our corporate and NetCentric customers.

And we also offer volume commitment discounts to our NetCentric customers.

During the quarter, certain NetCentric customers took advantage of these volume and contract term discounts, and entered into long-term contracts with Cogent for over 2,100 customer connections and that increased their revenue commitment to Cogent by almost $27 million.

Some comments about EBITDA and EBITDA as adjusted.

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

Some seasonal factors that typically impact the amount of our SG&A expenses include the resetting of payroll taxes in the United States that occurs every year at the beginning of the year.

In January, it resets.

Annual cost-of-living or CPI increases typically also incur at the beginning of the year.

Seasonal vacation periods typically occurring in the summer periods.

The timing and level of our audit and tax services, which are larger typically right now in the first quarter, as we're doing our annual audit.

And the timing, and amount, and gains on our equipment transactions.

And lastly, our annual sales meeting cost, which typically occurs in our first quarter and this year, it occurred this month in February.

And also annual benefit plan, annual cost increases similar to CPI.

So these seasonal factors typically increase our SG&A increases in our first quarter from our fourth quarter and that has happened historically for many years.

Our quarterly EBITDA increased by 4.4% sequentially to $52.7 million.

Our quarterly EBITDA increased year-over-year by $5.1 million, or by 10.8%.

Our quarterly EBITDA margin increased by 70 basis points sequentially to 37.6%, and increased year-over-year by 160 basis points.

Our full year 2019 EBITDA increased by 7.3% to almost $198 million.

Our full year 2019 EBITDA margin increased by 70 basis points to 36.2%.

Our EBITDA as adjusted, which is EBITDA but also includes gains related to our equipment transactions, which had been declining over the past few years.

But these amounts were as follows.

Our equipment gains were only $250,000 for the quarter.

They were $92,000 for the fourth quarter of last year and they were $87,000 last quarter.

Our quarterly EBITDA as adjusted increased by 2.4 million, or by 4.7% sequentially, to $53 million, and increased year-over-year by $5.3 million, or by 11.1%.

Our quarterly EBITDA as adjusted margin increased very similar to our EBITDA changes, sequentially by 80 basis points to 37.8%, and increased by 170 basis points year-over-year.

Finally, our full year 2019 EBITDA as adjusted, again, including the asset gains, increased by 7.3% to $199 million.

And our full year 2019 EBITDA as adjusted margin increased by 70 basis points to 36.4%.

Some comments on our earnings-per-share.

Our basic and diluted income per share was $0.16 for the quarter.

That was compared to $0.30 last quarter and $0.16 for the fourth quarter of last year.

Our $135 million euro notes that we issued in June of this year are reported in U.S. dollars and they need to be converted at each month end using the Euro to U.S. Dollar exchange rate.

This unrealized foreign exchange loss or gain on our notes happened to be a loss and it was $4 million this quarter and that reduced our basic and diluted income per share this quarter by $0.09 per share.

The unrealized foreign exchange gain on our euro notes was $6.1 million last quarter, the reason for the $0.30 per share that we incurred and that increased our basic and diluted income per share last quarter by $0.13 per share.

Finally, our unrealized foreign exchange gain cumulatively for the year, so since June, was actually a gain, and that was $2.3 million for the full year and that increased our basic and diluted income per share by $0.05 per share.

Some further comments on foreign exchange.

Our revenue reported in U.S. dollars and earned outside of the United States was approximately 22% of our total quarterly revenues and that percentage has been consistent over the past several years.

About 16% of our revenues this quarter were based in Europe and the remainder, or about 6% of our revenues, were related to our Canadian, Mexican, Asia-Pacific, and Latin American operations.

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

The foreign exchange impact on our reported quarterly sequential revenue was a negative $88,000 and the year-over-year foreign exchange impact on our reported quarterly revenues was a negative $700,000.

Our quarterly revenue growth rates now measured on a constant currency basis actually accelerated from last quarter and were 2.5% sequentially and 6.8% year over year.

Finally, for the year, the foreign-exchange impact on our reported annual revenue was material.

It was a negative $5.3 million and our annual revenue growth rate when measured on a constant currency basis was 6%.

The impact of foreign exchange primarily impacts our NetCentric revenues.

Looking forward, the average Euro to U.S. dollar rate so far has been about $1.11 and the average Canadian dollar exchange rate has been about $0.77.

Should these average rates remain at the current levels for the remainder of the first quarter here of 2020, we estimate that the FX conversion impact on our sequential quarterly revenues for our current quarter will not be material.

However, the year-over-year foreign exchange conversion impact is estimated to be approximately about $500,000 on a negative basis.

Some comments on customer concentration.

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

These numbers have been consistent over time recently.

Our top 25 customers represented less than 6% of our revenues for this quarter and also less than 6% of our revenues for the full year of 2019.

Further comments.

Capital expenditures.

Our quarterly capital expenditures decreased sequentially by almost 18% and decreased by 9.5% year-over-year.

Our capital expenditures were about $10 million this quarter.

That was compared to $10.9 million for the fourth quarter of last year and $12.1 million for the third quarter of 2019.

For our full year, our CapEx was $47 million and that was a decrease of 6% from the approximately $50 million of CapEx we incurred last year.

Some comments on our capital lease payments and our capital leases.

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 totaled 169.8 million at year end and year-end, we had IRU contracts with a total of 245 different suppliers of dark fiber.

Our quarterly capital lease principal payments under these dark fiber IRU agreements increased slightly by 1.3% sequentially but declined 3.4% year-over-year.

Our capital lease principal payments were $2.1 million for the quarter, the same amount for the fourth quarter of last year and it was $2 million for the third quarter of 2019.

For the full year, our capital lease principal payments declined by 11.6% year-over-year and were $9.1 million compared to $10.3 million last year.

When you combined our capital lease principal payments with our CapEx, combined together, the total was $12 million this quarter compared to $14.1 million last quarter and $13.1 million for the fourth quarter of last year.

Our capital lease principal payments combined with CapEx for the year in the aggregate were $56.1 million for this year compared to $60.2 million last year and that represented a reduction of approximately 7% year-over-year.

Some further comments on the balance sheet.

As Dave mentioned, our cash and cash equivalents at end of the year totaled almost $400 million.

We were at $399.4 million.

For the quarter, our cash actually increased by $3.2 million in the aggregate for the quarter.

That includes our dividend payments and all of our payment obligations.

So our cash increased net-net for the quarter by over $3 million.

We returned $38.5 million of capital to our stakeholders this quarter through our $29.8 million of our regular quarterly dividend payment, and $8.7 million that was spent on a semiannual interest payment related to our debt.

Our quarterly cash flow from operations increased by almost 38% sequentially and increased by 13.2% year-over-year.

Our cash flow from operations was $46.1 million for the quarter compared to $40.7 million for the fourth quarter of last year and $33.4 million for the third quarter of 2019.

For the full year, our cash flow from operations increased by 11.1% to almost $149 million from last year and this is due to the operating leverage of our business.

As Dave mentioned, our debt ratios, our total gross debt at par, which is at par, including our capital lease obligations, was $967.9 million at year-end and our net debt was $568.5 million.

Our total gross debt to trailing last 12 months EBITDA as adjusted ratio was 4.86 at the end of the year and our net debt ratio was 2.86.

Finally, some comments on bad debt and day sales of accounts receivable.

Our bad debt expense was about 0.8% of our revenues for the quarter , a slight increase to the 0.7% of our revenues from the third quarter of 2019, and the 0.7% of the fourth quarter from last year.

Our bad debt expense was 0.8% of our revenues for the full year and that was a slight increase from the 0.6% that we incurred last year.

Our days sales outstanding, or DSO for worldwide accounts receivable was exactly the same as last quarter and still an excellent number for us at 23 days.

And again, I would always like to thank, and recognize, and appreciate our worldwide billing and collections team members who are continuing to do a fantastic job in serving our customers, and collecting from our customers, and providing outstanding customer service.

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

A: Thanks, Tad.

Now, for a couple of comments on the scale and scope of our network.

We have over 957 million square feet of multitenant office buildings in North America directly connected to the Cogent Network.

Our network consists of over 35,520 metro fiber miles and over 57,600 intercity route miles.

The Cogent Network remains the most interconnected network in the world, with direct connectivity to 6,950 networks.

Less than 30 of these networks that connect to Cogent are settlement free peers with the remaining over 6,920 networks being paying Cogent transit customers.

We are currently utilizing approximately 29% of the lit capacity in our network.

We routinely augment this capacity, as portions of our network need those augmentations to maintain these low utilization rates.

For the quarter, we achieved sequential quarterly traffic growth of 9% and year-over-year traffic growth for the quarter of 30%.

We operate 54 Cogent Control datacenters with a total of 617,000 square feet of raised floor space, which is operating at approximately 31% capacity.

In 2019, we did add 2 additional datacenters to our footprint.

These are Cogent controlled facilities, increasing from 52 to 54 at year-end.

Our sales force turnover at 4.9% in the quarter was again better than our long-term rep turnover rate of 5.6%, but it's an area that we will continue to focus on with training and rep improvement.

Our quarterly sales rep productivity was 4.1% -- or 4.1 units per full-time equivalent rep per month, a productivity rate that's below our long-term historical average of 5.1 units per FTE per month.

Our sales rep productivity was impacted by the decline in our average rep tenure and significantly impacted by the fact that we've been selling a significantly larger number of large ports, allowing customers to aggregate traffic and not have as many lower capacity ports in a given location.

We ended the quarter with 548 sales rep cellular service, a significant increase from the 487 that we had at year-end 2018.

This is the most sales reps we have ever had selling our service.

We ended the quarter with 502 full-time equivalent sales reps, a significant increase from the 436 full-time equivalent sales reps we had at year-end 2018.

So in summary, Cogent is a low-cost provider of internet access transit services.

Our value proposition remains unmatched in the industry.

Our business remains completely focused on the Internet, IP connectivity, and datacenter collocation services, all of which are necessary utilities to our customers.

Our multi-year, constant currency, long-term growth target rate of 10%, and our long-term expectation of EBITDA margin expansions of approximately 200 basis points are a demonstration of the strength of our business model.

Our Board, convinced of this strength, approved the 30th consecutive increase in our regular quarterly dividend, increasing the dividend quarterly by $0.02 a share to $0.66 per share.

Our consistent dividend increase demonstrates this confidence in the growth of our business and its cash flow generating capabilities.

We will remain opportunistic about the repurchase of common stock.

At quarter's end, we had $34.9 million remaining in our current buyback authorization through year-end 2020.

We are committed to returning increasing amounts of cash to our shareholders on a regular basis.

With that, I'd like to now turn the floor over to questions.

(Operator Instructions) Your first questions comes from Sami Badri from Credit Suisse.

Dave, maybe could you just -- well, perhaps maybe taking a step back at a high level question as you've always referred to the big or the next big app that could really come onto your network.

And I think we've been hearing about a couple of new apps that have been coming into the broader global network.

Would you say that next big app that could take Cogent to the next level is here and beginning its commencement through your network?

Or would you say that there's still something else that could come through that is much bigger?

So I think the internet, while approximately 30 years old and has grown at a compounded rate of 25%, has been able to avoid the law of large numbers and slow down due to new applications.

Over the past year, we've seen a proliferation of over-the-top, direct-to-consumer products that is dramatically increasing viewership on the internet.

We think over the next several years, the majority of minutes of video will be consumed via streaming services.

The streaming services are also becoming higher resolution.

So we feel very comfortable that this single application will continue to drive compounded growth for the internet.

And therefore, Cogent, as the low-cost provider, will disproportionately capture that growth and grow even faster.

And in fact, our growth rate, year-over-year, at about 35% indicates that.

Finally, I think there are many new applications that are being developed, different forms of video, more interactive video, video that will have augmented or virtual reality embedded in it.

And it is these higher resolutions that I think will provide yet another next leg in internet traffic growth.

So we remain extremely positive on the long-term prognosis for accelerating traffic growth.

And as we've seen competition deemphasize transit as a product, we are increasingly gaining market share.

And I think all of this is now reflected in the fact that, on a sequential basis, our NetCentric revenues improved materially, almost to our long-term growth targets.

And then on a constant currency year-over-year basis, we returned to positive growth after a period of negative growth.

So we feel very confident that these trends will continue over the next several years.

Got it.

Thank you for that color.

And then my next question has to do with sales force productivity.

And maybe I was hoping you could expand on some of the comments you just made regarding the dynamics there were there.

It's just that this sales force productivity number that you just reported was probably one of the lowest in the company's history.

And at the same time, your revenue growth rate year-on-year actually accelerated.

And I know you mentioned a couple of factors, but can you just kind of expand on what's going on here?

Just because I believe this is a new dynamic that's being introduced into the model and that dynamics that we may not necessarily be very well-versed into.

Fair, Sami.

So there are 2 different things going on.

The first is across the entire sales force where we accelerated hiring and therefore, the average tenure of a rep declined.

And we think we will revert back to kind of a normal rate of hiring in 2020.

Our goal is to hire between 7% and 10%.

Last year was a 13% increase, which was outsized, and therefore tenure came down.

But the more significant factor in driving the divergence between unit productivity and revenue growth has actually been the sale of larger ports.

The reason we give the metric of unit productivity is it's the only common measure across the 3 different groups within our sales force, that being our NetCentric reps, our corporate reps that sell to larger, multisite customers and our reps that sell to smaller, single site customers.

So we try to come up with some kind of uniform metric, but what has happened, and for the second quarter in a row, the majority, more than 50% of our corporate sales have been GigE interfaces.

And that is why our corporate ARPUs actually increase sequentially in the quarter.

Secondly, on the NetCentric side, we are seeing a rapid adoption of 100-gig interfaces.

This is actually the third time in Cogent's history that we've seen grooming going on with NetCentric customers.

So 15 years ago, most NetCentric customers took gig interfaces.

There was a migration in the kind of 2006 through 2008 period to 10-gig interfaces where customers consolidated multiple 1-gig interfaces into fewer 10-gig interfaces.

Over the past year, as the equipment vendors have brought down the port prices on 100-gig interfaces, we are seeing most NetCentric customers choose to use 100-gig interfaces.

So on a unit basis, they may be selling fewer connections but are in fact able to generate more revenue with higher committed bandwidth rate and higher usage base bandwidth.

So one 100-gig connection may be replacing 4, 5, or 6 10-gig connections.

This is accelerated by the fact that most carrier neutral datacenters charge a recurring fee for cross-connects and customers are constantly looking to reduce their cost basis in delivering services.

And if they can groom cross-connects, they can in fact lower their effective cost per-megabit.

So I think we've still got a ways to go in this trend.

I know equipment vendors are, today, testing 400-gig interfaces.

I think we are probably still several years away from that being commercially available on a cost effective basis.

But I do think for the next several quarters, we'll continue to see a proliferation of 100-gig interfaces with NetCentric customers and 1-gig interfaces with our corporate customers.

Got it.

Thank you for that clarification.

And then my last question has to do with the fact that your adjusted EBITDA margins are clearly delivering expansions.

Your cash flow is clearly growing.

And then the one thing is that your dividend growth rate isn't necessarily growing.

It's actually decelerating now.

Is there scope at some point for you to consider increasing the step-ups in the quarterly dividend from $0.02 to something higher.

Can you just give us maybe an idea on how you're thinking about capital allocation from there?

So that capital allocation discussion is probably the most important discussion at each of our quarterly board meetings.

We had a meeting yesterday where that was a major topic of discussion.

Just arithmetically, as the base gets larger and the unit size of the increase is $0.02, to refresh people's memory, at one point, we were increasing at $0.01 a share and then we increased the rate -- have increased to $0.02 a share.

That will arithmetically decelerate.

It is something the Board is very cognizant of.

They took absolute note of the fact that our gross leverage and net leverage ratios declined in the quarter and are below the midpoint of our net leverage target.

So it is something that is under active consideration.

But I think for this quarter, the Board felt staying the course due to a lot of the macro uncertainty made the most sense.

Your next question comes from Philip Cusick from JPMorgan.

Thinking about NetCentric again, it seems like this is stabilizing at least.

Have we may be bottomed on the impact of customer concentration?

I think so, Phil, because we're seeing a number of new OTT players compete for consumers' eyeball time and therefore, the base is starting to broaden.

I'm not trying to imply that any one service provider is necessarily suffering, but I think the growth of the market is now being spread out among a half a dozen different players as opposed to 1 or 2 major players.

And that means there's less monopsony power on the part of that customer.

And therefore, we see the effective rate of decline on a volume weighted basis moderating, even though the nominal rate is continuing to decline pretty much in line with historical averages.

We are seeing a lot of growth at a faster rate than the average from some of these new entrants.

Do you think that on a sequential basis, currency adjusted, this could continue to grow in the next 12 months?

It appears to be the case.

To remind investors, this is a usage based business.

Even our customers don't have exact visibility into how many minutes a day each of their end users is going to be spending.

But when we look at our NetCentric sales funnels, the roughly 180 NetCentric reps.

They appear to drive port sales that will ensure a growth in revenue.

We see on a customer by customer basis, very encouraging signs of traffic growth.

But again, we can't predict the consumer reaction to different products or series that are outlined by the various different providers.

We think they'll all be successful.

There's been some providers, household names, that have had more a linear model that now are going direct-to-consumer and have had just tremendous uptake.

And we think that's going to continue.

So long answer to your question, we think we're going to see sequential improvement but it is just not something that's totally in our control.

And then following up again on the reps, given the growth in that sales force, should we expect as large or maybe even larger sequential pressure on margins in the first quarter?

So you will expect EBITDA margin pressure in the first-quarter due to increased SG&A on a seasonal basis, but not on a year-over-year basis when looking at the quarter.

Gross margins will continue to improve at kind of the similar pacing we've had.

SG&A expenses tick up in the first quarter for the reasons that Tad enumerated.

We spent about $1.2 million on our sales kickoff meeting.

That may sound like a small number but to a company like Cogent that's a meaningful extraordinary expense.

The bulk of our audit expense falls in this quarter and we have the reset on social benefits and our payroll resets, employee-employer taxes.

All of those have a bit of a drag on margin.

So you should expect a step down in EBITDA margins Q4 to Q1 as we have every year.

But when compared Q1 of '20 versus Q1 of '19, we'll be doing better.

But no bigger than typical seasonal step down?

That is correct, Phil.

Your next question comes from Colby Synesael from Cowen.

First off on the dividend, you have a longer-term goal for revenue of plus 10%, EBITDA margin of plus 200 basis points.

Curious if it makes sense to have a longer-term dividend objective or goal, maybe plus 10% as an example.

And has you or the board considered that?

Second, did I hear correctly perhaps in response to Sami's question that you anticipate traffic growth being above the 30% we just saw here in the fourth quarter when we look back on 2020?

And then I guess driven by the OTT guys.

And then the last question tied to that.

Can you remind us how the contract structure works for these OTT deals that you're assigning?

Are these month-to-month?

Are these year-to-year?

Should we be thinking that there could be, maybe a year from now, some significant step-down?

Just trying to get a sense how to think about the pricing negotiations.

Thanks for all the questions.

Let me start with the return of capital question and the dividend question.

We are very cognizant of our leverage.

We realize that our underlevered balance sheet is an asset that we need to put to work for our equity holders.

And we're constantly evaluating the debt markets, which would give us additional flexibility in accelerating return of capital.

Secondly, as we have publicly commented in the past, we are somewhat agnostic to dividend versus buyback as a mechanism of return, looking at the relative efficiency at a given point in time.

We fully acknowledge that without adjusting either the rate of buybacks or the rate of increase in the dividend, we will fall below our leverage targets and not be returning the optimal amount of capital.

I think to kind of target a specific rate of growth and dividend is probably not optimal.

I think we want to maintain the flexibility of using both tools in our toolbox.

But as I said in the response to Sami's question, there is a vigorous debate at the board level.

And that will continue and be the primary focus of the board for each and every of our board meetings.

And we acknowledge that we will either have to step up the pace of buybacks or step up the pace of dividend growth, or arithmetically we will fall below our targets.

Again, these are good problems to have compared to many companies that we're often compared with.

Now, with regard to traffic growth, we believe that there is a long-term secular trend of OTT that is accelerating.

Cogent has relationships with almost, well, every major OTT provider and the vast majority of access networks globally that are the recipients of this over-the-top traffic.

We expect that to continue due to our ubiquitous footprint in 45 countries and over 1,200 carrier neutral datacenters.

We also think that our pricing allows us to capture a disproportionate share of the market.

With that said, we're coming off of a larger base that continues to grow.

We think that we will achieve better than 30% traffic growth.

We can definitely understand what the port capacity installed is, but the usage is highly dependent on how successful these various launches are.

There's been a couple of high profile Cogent customers that have had very successful launches over the past few months and we think that's going to continue.

And we also think the market is going to broaden and the trends we see in the U.S. then circulate around the world.

But it's almost impossible for us to tell you whether any particular OTT product is going to be successful.

All we can say is we'll get the majority of that traffic growth.

Finally to the contract terms.

Those terms have 3 components.

Typically, a duration.

Most common is actually a 3-year contract.

The second is a fixed commitment, meaning there are a certain number of ports and then a base commitment on those ports.

And then finally, a usage component that is typically charged at a premium to the fixed commitment.

What commonly happens is customers in turn, come back to Cogent, increase their commit, increase their number of ports, and reduce the price per megabit.

In fact, that was the 2100 connections that Tad referred to earlier and the increased commitment to Cogent of $26 million of total contract revenue.

That is almost exclusively NetCentric and that will happen on a routine basis.

We do not anticipate any extraordinary repricings.

There are none schedule.

There are contracts that have built-in price reductions based on volume, but none of those we think will be material enough to impact on aggregate revenue results.

Your next question comes from Walter Piecyk from LightShed.

Want to talk about NetCentric.

I think on our maps, it looks like this is the first time you've returned to annual growth for, like, 9 quarters.

Does that sound right, year-over-year growth?

Yes, that is correct.

And then if you look back, like, I don't know, whatever, X number of years, however long our model goes back, there seems to be an ebb and flow on the sequentials.

The sequentials are obviously a little bit more interesting to us.

So I'm just curious if you can give us a little bit more sense of what drove -- I think you had like 2.5% sequential NetCentric this quarter was - whether it's geographic color or type of customer color, anything.

And then also as part of those comments, kind of wrap in thoughts on sustainability.

And again, we had, what, 4 or 5 quarters of negative sequentials.

But again, if you look back over 6 or 7 years, you're up a couple of quarters, you're down a couple of quarters.

Just thought process around what drove this one and what you're thinking going forward.

So I think the key driver on NetCentric remains OTT video.

There were a couple of very high profile launches in the past 6 months that have driven material acceleration in revenues for NetCentric.

And we win 2 ways.

We win by carrying traffic for those OTT players, but we also win because of the 6,920 access networks around the world whose customers download more content from those players.

So I think the broadening of the universe of OTT players has done 2 things.

It's accelerated OTT in general and it's allowed us to not be as dependent on a few names and therefore at the very lowest price point.

We've seen multiple instances in the past where customers hit an inflection point in their business.

We benefit for several quarters and their rate of growth starts to mature.

So the NetCentric revenues, which are highly usage dependent are very hard to predict over the short-term.

Over the long-term, the cycles that you refer to are actually pretty easy to predict.

And I think it's important for investors to step back and look at the bigger trends.

Also on the corporate side, which tends to be this very granular business of small connections, there we see a much more linear progression of growth.

Corporate is obviously very predictable.

But on this one, I guess you could argue that we're at an inflection point.

Cord cutters are kind of -- this is the point, right.

So is it possible that you can just sustain sequential growth in NetCentric going forward?

Or do you think we're still going to have some of these kind of 3 quarters off, 3 quarters on type of situation?

It is really too hard to predict, Walt.

I think we -- after you pointed out, have had 9 poor quarters and now a positive quarter, I think we're in for a period of better performance.

Will it be permanent?

We just don't have visibility into that.

What we can be very confident of is that if the market grows, we will grow faster than the market.

We will capture a disproportionate share and that disproportionate growth comes from the fact that we price at a lower price point.

One last question, Dave.

People are looking for shelter on the sell-off based on coronavirus.

Have you seen any increased usage in areas that have been affected in terms of traffic?

Is this something that could stimulate traffic if people are not going outside and using the internet more in any of these given markets?

Any learnings there in the past couple of weeks?

So obviously, logic says that if people are staying home, they're looking for things to do and OTT video is a low-cost and virtually unlimited way to fill up that time.

Obviously, China has been the hardest it.

We are the main provider to the 3 major state-sanctioned networks in China.

But they, the Chinese Government, kind of throttles what goes in and out of the country.

So it has been a little hard for us to determine actually how much of the growth in traffic from those 3 providers is directly related to coronavirus.

I do think as the fear of contagion spreads, we will see some traffic benefit from that.

Dave, you haven't seen anything in Spain, as another example, in the past couple of days?

We've seen a slight pickup in traffic over the past weekend, but again, I've seen pickups in the past and I'm going to take 3 days and attribute it to a single cause.

I just don't have enough predictive data.

The next question comes from Frank Louthan from Raymond James.

Got one strategic question and then more of a practical one.

On the strategic side, from the peak, the NetCentric business is down about 40% as a now percentage of your revenue from where it used to be.

And kind of given that pretty consistent trend and then how well you've done on the corporate side, should you adjust your strategy to become much more of a corporate focused business going forward to drive growth and just let the NetCentric kind of do what it's going to do, with sell provisioning and other things impacting you.

How do you think about that from a strategic standpoint.

And then secondly, I apologize if this was addressed in the remarks but the asset sales ticked up a bit.

Are we back to dusting off some of the equipment from the supply room and selling it?

And how should we think about that as how it's contributing to revenue and cash flow for the remainder of 2020?

Okay.

So 2 very different questions.

Let's start with corporate versus NetCentric.

There is kind of natural skewing.

In other words, we go where the demand is.

And corporate demand is driven heavily by the adoption of cloud, SaaS, and other OTT applications, the biggest being SD-WAN and VPNs.

We are growing both parts of our sales organization.

NetCentric has always ebbed and flowed as part of our business.

We remain committed to that market and continue to focus sales resources.

In fact, as it was pointed out earlier, it is growing on a sequential basis and more importantly, we are gaining market share.

Both customers create a network effect for Cogent where our corporate customers benefit from the number of NetCentric customers and NetCentric from corporate.

More of the growth in our headcount has been on the corporate side because there's quite honestly just more addressable market and more marketing for us to do.

The NetCentric market is one where Cogent is fairly well known.

We are the second largest provider in the world and virtually all prospects know of us.

Now, oftentimes, they still need sales support to help them do more with us.

We think both of these businesses can be meaningful contributors to free cash flow going forward.

Our process always begins with an outbound telesales effort for both corporate and NetCentric.

This is not a self-provisioned product.

So I don't see that materially impacting our growth in either business.

Finally, to your question of asset sales, I'll let Tad touch on that.

So if we look back -- I'm looking back through the first quarter of 2018, but we have not had an asset sale amount more than $500,000.

So the amounts really have been de minimis really since the beginning of 2018.

The largest amount in that one quarter was $500,000 in the first quarter of 2019.

So they have not been material as of late but it could change in the future.

But currently, they've really not been material.

It's really dependent on the market's need for the commitment that we view as obsolete to Cogent.

We have huge inventories of equipment and sometimes there's buyers, sometimes there's not.

And finally, that revenue or that cash that we received is not booked as revenue because it is not Cogent's core business.

We report service revenue but the gain is reflected in EBITDA and it is cash, but we don't actually book that as revenue.

Your next question comes from Nick Del Deo at MoffettNathanson.

I'll just ask one given the time.

If I look at your total network operations expense ex-USS, it was down a little over a percent full year 2019 versus full year 2018 just by the expansion in your network.

And I'm talking dollars not percent of revenue.

How much of that decline was a function of FX?

What are the other drivers we should be aware of and what should we expect going forward for that line item?

So roughly 25% to 30% of the network resides out of the U.S. And therefore, FX would impact that third of the expense to the extent that the dollar has strengthened.

Therefore, on a reported basis would be a lower expense.

The second big network expense area is actually the cost of off-net circuits.

And we have been able to negotiate with all of the major loop providers in North America substantial discounts in large part because of the aggressive competition between telco and cable for providing wholesale, point-to-point services for buildings that we have not brought on net.

So we have about 1.6 million buildings in North America.

We have 90 different vendors but the reality is 5 are material and we've seen an average decline in the price per loop for a comparable loop of about 8%.

So a big part of why the ARPU decline on off-net has occurred is because those loop prices have come down and we're roughly at a 50% margin in that service.

Now, that's partially offset by the same trend that we're seeing in on-net corporate, which is a move towards larger connections.

So for a long time, we were supporting sub-100 meg, Ethernet-based, off-net services.

Today, we will only do those on a special assemblage.

Most of our sales are still 100-meg but we expect the trend like we're seeing in on-net to bleed over to off-net.

And eventually, gigs will become more standard.

Finally, we've seen a number of new subsea cables be constructed and those cables put pressure on that market.

And we concluded long ago that renting versus owning there made more sense.

In fact, Cogent did own some cables earlier in its history through various acquisitions that we abandoned, and today remain an effective leaser of capacity.

Your next question comes from James Breen from William Blair.

Thanks for taking the question.

Can you just talk about the impact you're seeing in the SD-WAN market and the VPN market.

I know you guys have moved into a little bit more and how that sort of is progressing going forward.

So just to remind investors, roughly 25% of our corporate ports sold are for VPN purposes.

About 75% of corporate ports are for dedicated internet access.

We see a large number of MPLS customers begin the sales conversation around SD-WAN.

Most SD-WAN sales have actually turned into VPLS sales.

We have and continue to sell SD-WAN.

It becomes a critical part of the sales discussion.

But when customers understand the limitations of the current state of customer premise equipment, they typically choose to go for VPLS to get higher throughput rates.

Now, we are seeing improvements in equipment.

I think the reality of that CPE equipment will catch up to the hype over the next year or 2 and we'll see a broader deployment of true SD-WAN.

But I think the key takeaway is customers are increasingly fed up with MPLS and are willing to switch and will switch to either product.

Today, most of it is VPLS and we think that the MPLS market in aggregate has already declined about 20% from its peak.

Your next question comes from Michael Rollins from Citi.

Just 2 follow-ups if I could.

The first is just in terms of the USF changes that have helped a little bit on the revenue line.

Is there an expectation that those rates could actually decrease in the future?

Is that something that we should just be keeping in mind as the government is always rebalancing those rated periodically?

And then secondly, just in terms of some of the pricing metrics that you disclosed.

On the average price per new contract going to $0.28 a meg, how does that impact the flow of revenues as we look out over the next 12 to 18 months?

I'm going to let Tad take the USF and I'll take the pricing question.

I guess similar to foreign exchange, the rate of USF, the tax rate is entirely outside of our control and it is directed each quarter by the government.

Recently, it has increased.

However, it is going to decrease and it is scheduled to decrease in the first quarter.

So it's kind of out of our control.

Recently, for example, for the fourth quarter, it was about $4 million.

It was about $4 million, about the same amount for the third quarter.

It was about $3.5 million for the second quarter because the rate had increased.

But the rate that has been scheduled to decrease for the first quarter of 2020.

It's established by the government and it's literally outside of our control.

And maybe just a little background on how that works.

So our VPN services are subject to USF.

The government sets a target amount of money it wants to distribute through Cat 2, or Big Tap, or [E-Rate programs, and then reverse engineers the applicable base of services to target how much they want to raise and then projects a new rate.

That is adjusted quarterly.

We pass that through on a gross basis.

It actually negatively impacts margin but it does obviously help revenue because revenues were reported inclusive of that USF.

I would suspect as the government really tries to accelerate broadband deployment in rural areas, in aggregate, this rate is probably going to go up over time as the base is shrinking and the amount of money needed is going up.

But on a quarterly basis, it's really impossible for us to predict.

Now, to the flow through of discounting.

Customers consistently look to optimize their spend.

This is really a NetCentric phenomena.

As I mentioned earlier, the typical customer signs a 3-year contract.

But because of outsized growth in their business during that term, they'll come back and renegotiate.

And when they do, it's usually for a larger commitment.

It's at a later point in time and it will re-extend the contract for another longer period since they're partially into their period.

This phenomena has been very consistent for the past 10 years or more.

We've reported that number consistently and it hasn't materially changed.

So I think the decline in the rate of new sales this quarter is pretty much in line with historical trends.

The installed base actually declined a little less rapidly than historic average.

The new sales declined a little faster.

But if I point you back to 2 or 3 quarters ago, those 2 parameters were almost completely inverted new sales were declining less rapidly and the base was declining more rapidly.

There's just some oscillation based on when customers renegotiate these contracts.

And much like you give for FX commentary about the expectation sequentially or year-over-year in the coming quarter, is there some help in terms of the amount of change that USF factor would impact revenue in the calendar first quarter?

Well, first of all, we only have visibility after USAC, the FCC's contractor, establishes a new rate, which changes every quarter.

So an annual projection would be meaningless on our part.

And I think the materiality of this, just from where we sit to this quarter, is not meaningful.

I mean it will be down a little bit but it's not a material number.

Just as a reminder again, it's a U.S.-based tax, only U.S.-based, and it's only based upon part of our services that it's applicable to.

You might be talking about a couple hundred thousand dollars maybe.

I mean it's just not a meaningful number.

What the FCC is going to do with their USF rate, it's just -- I guess I wasn't surprised when it increased but I was frankly surprised when it recently decreased.

So it's--

Not meaningful.

Your next question comes from Tim Horan with Oppenheimer.

So Dave, you were adding a ton of sales people obviously and I'm assuming you think you can gain a lot more market share in both your market segments.

Can you just talk about maybe where you think you are with market share on both sides and what's that kind of trending at?

And I guess specifically on the NetCentric side, it seems like the CDNs grew a lot faster in this quarter than you did.

Do you think they're hurting you at all in terms of your growth or market share there in delivering traffic?

Or just how you think about it?

Thanks.

So we're adding sales people to both corporate and NetCentric.

I would say that the rate of increase is slightly greater on the corporate side than NetCentric.

So on the corporate side, we start with the buildings we're in and the number of connections, and number of unique customers we've sold per building.

And we've sold 23 connections per building to about 15.5 customers per building.

So out of 51 potential customers, we're roughly 30% penetrated.

We are adding new buildings.

In the off-net corporate market, we have less than 2% market share.

But we also know that without an on-net relationship, the cost of sales are prohibitively high.

So we have no real desire to go after just off-net only corporate customers.

And increasingly, as the remaining customers in our footprint who have not bought from us, deploy new technologies like cloud and SaaS, they become ripe to switch to Cogent.

And that's why our rate of penetration per building continues to improve almost linearly, even over buildings that have been on net for more than 10 years.

So we feel that we have a long runway to grow.

On the NetCentric side, our market share can be measured 3 ways.

We have roughly 27.1 connections per datacenter.

Secondly, we have about 22% of the bits generated we have about 13.5% of the dollars spent on transit services.

We are gaining share under all 3 of those metrics, selling more customers per datacenter, getting a bigger share of traffic, and most importantly, a bigger share of revenue.

To your point about CDNs, every major CDN is a Cogent customer.

We sell bandwidth either directly to consumers who build around CDNs or to third party CDNs that then incorporate our bandwidth into the service they are selling.

So CDNs are not competitors but rather a portion of our ecosystem and a customer base for Cogent.

Buildings over 10 years, can you maybe give some color on the penetration here, where we can kind of get to.

And do you think the CDNs didn't grow fast enough this quarter?

It seems like they were -- talking to the 3 or 4 that we know, it seems like they did grow a bit faster and clearly, revenues accelerated a bit more for them.

Yes, and I think some of that acceleration in Cogent's revenue growth came from those same CDNs.

Some of it came directly from end user customers and CDNs incorporate space, power, processing, storage, and bandwidth as a bundled product.

We think we will continue to win a disproportionate share of revenue from them.

In terms of penetration, we think on the NetCentric side that we can eventually get to about a third of the market, particularly as a number of other historical players continue to deemphasize transit due to the rate of price decline and the commoditization.

And I think as Cogent has proven, over 15 years as a public company, 2 things.

One, the death of the Internet has been greatly exaggerated and it is not going away.

And then secondly, even in a world where prices

Decline 23% per annum compounded, we have demonstrated our ability to continue to grow our revenues.

And most importantly, and grow our cash flow against that.

So we feel very comfortable that we're committed to the transit market and our penetration is only going to increase.

Your next question comes from Bora Lee from RBC.

So following up on your comment about more benefit as a percent of corporate sales being gig interfaces, what's the mix of new sales versus swapping out of lower bandwidth existing connections?

And then secondly, can you give a sense of the pricing differential between gig ports and the most commonly taken lower bandwidth corporate connections?

So first of all, a majority of those sales are brand new ports and as the customer equipment is capable of taking gig connections, many of them are willing and want to do that.

We do have some swap outs.

I would say that it's less than 10% of incremental sales in the quarter were upgrades of existing corporate customers, migrating from a fast-E connection to a GigE connection.

Today, we sell that GigE interface at about a 20% premium to a fast-E interface.

We think that differential will eventually disappear.

And at some point in the future, when CPE of customers becomes ubiquitously able to take Gig interfaces, we think's Cogent standard product will become the Gig product.

Today, not all customers can accept that.

So rather than seeing ARPU decline on the corporate side, we'll just see the connection size increase.

In fact, our average corporate utilization of a connection has fallen from about 18% to 12% in large part because of this proliferation of GigE interfaces.

And then the final point, which is kind of unique one to Cogent.

It's actually cheaper for us to sell a Gig than it is an FE.

And the reason is we do not need to put a media converter in the customer's suite to step down the fiber connection to a copper connection.

So all of our connections are delivered to the customer suite via fiber.

But if the customer is still running a 100-meg connection, we have to step that connection down from a gig to 100 megs and convert it from optical to copper.

That's about a $300 piece of CPE that's typically charged in our customer install NRC.

And if the customer takes a gig, that $300 cost to Cogent disappears.

So it's kind of a weird fact pattern that we want to actually sell more for the same price point.

There are no further questions at this time.

Well, I would like to thank everyone for their attention and support.

We're very pleased with our results.

I look forward to seeing a number of investors at upcoming conferences.

Take care and talk soon.

Thanks.

Bye-bye.

Ladies and gentlemen, this concludes today's conference.

Thank you for your participation and have a wonderful day.

You may now disconnect.