Cogent Communications Group (NASDAQ:CCOI)
Q3 2008 Earnings Call
November 6, 2008
David Schaeffer – Chairman, CEO
Thaddeus Weed – Chief Financial Officer
[Frank Malvin – Raymond James]
James Breen – Thomas Weisel Partners
Michael Roland – Citi Investment Research
Mike McCormick – J.P. Morgan
Jonathan Atkin – RBC Capital
[Nick Metchveloda – Barclays Capital]
Ken Lee – Jefferies
[Robert Dezago – SunTrust Robinson]
David Dixon – FBR Capital Markets
Welcome to the Cogent Communications Group third quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the call over to Mr. Dave Schaeffer, Chairman and Chief Executive Officer of Cogent Communications.
Welcome to our third quarter 2008 earnings conference call. I'm Dave Schaeffer, Cogent's Chief Executive Officer. With me on this morning's call is Thad Weed, our Chief Financial Officer.
In the third quarter we experience significant foreign exchange head winds and encountered certain non recurring events both positive and negative. Overall, we are relatively pleased with our results for the quarter and very encouraged by the growth in traffic on our network.
Our revenue and EBITDA did not meet our third quarter guidance; however, adjusting for the impact of substantial changes in foreign exchange rates, we exceeded our Q3 2008 revenue guidance. Over 30% of our business is outside of the United States.
During the quarter, traffic grew on our network by 5%. We significantly expanded our footprint as well as our sales force. We took advantage of opportunistic market condition by purchasing over $106 million of our original $200 million convertible notes for about $0.45 on the dollar. These note purchases reduced our true debt by 53%, resulting in a gain in the quarter of $9.7 million and an additional gain of $46.8 million in October. The total gain is $56.6 million.
As Thad will outline these transactions resulted in net income for the quarter and for the fiscal year and we were able to affect these transactions in a tax free manner except for AMT.
As we outlined in our last call in 2008, we expanded a pilot program and offered term discounts to all new Cogent Net-Centric customers who purchased larger volumes and to our existing Net-Centric customers who increased their total contract value with us. During the quarter, this program continued to achieve great success and our quarterly rep productivity on a contingent increase on a monthly basis from 3.4 units per rep per month in Q2 to 3.8 units per rep per month in the third quarter.
Additionally, under the program Net-Centric customers with existing contracts representing approximately $26 million in remaining contract value chose to increase their contracts by an additional $12 million in contract value, or nearly 50%. This increased the total remaining contract value from these customers to over $38 million.
Finally, our average contract length for all customers continued to expand and grew by 4% in quarter over quarter as more customers continue to extend their contracts and show greater confidence in Cogent. We ended the quarter with over 220 sales representatives. We continue to invest and improve our sales organization. As of today, we have 235 quarter bearing reps selling our services.
During the quarter, in addition to the new purchases, we also continued our stock buy back program. In the third quarter, we returned a total of $12 million to our share holders through stock purchases of approximately 1.2 million shares. As of today, we have approximately $32 million remaining under our authorized programs for stock buy backs.
Since June of 2007 under our total programs which equaled $150 million in value, we have purchased a total of 6.3 shares of our common stock for approximately $118 million. These purchases represent over 12.5% of the outstanding common shares since these programs began.
Throughout our discussions as in the past, we will continue to focus our results and impacts on our On-net business. Our On-net business represents approximately 81% of our total revenues. We will continue to highlight several operational statistics which we believe demonstrate our increase in market share, expanding sales and operating leverage of our On-net business.
I will review in greater detail certain operational highlights and our continued expansion plans. Thad will provide some additional details on our financial performance. That will also walk through some of the foreign exchange assumptions in our guidance for the fourth quarter and update our guidance for full year 2008 and provide our initial guidance for full year 2009.
Following our remarks, we will open the floor to questions and answers. Now, I'd like to as Thad to read the Safe Harbor language.
This third quarter 2008 earnings report and this earnings conference call discuss Cogent's business outlook and may contain forward-looking statements within the meaning of Section 27-A and 21-E of the Securities Act. The forward-looking statements are based upon our current intent, belief and expectations. These forward-looking statements and all other statements that may be made on this call that are not historical facts are subject to a number of risks and uncertainties and actual results may differ materially. Please refer to our SEC filings for more information on the factors that could cause actual results to differ.
You should also be aware that Cogent's expectations do not reflect the potential impact of mergers, acquisitions, other business combinations or financing transactions that may be completed after today. Cogent undertakes no obligation to release publicly any revision to any forward looking statement made today or otherwise update or supplement statements made on this call.
Also during the call if we use any non-GAAP financial measures, you will find these reconciled to the GAAP measurement in our earnings release and on our web site at cogentco.com. I'll turn the call back over to Dave.
Hopefully you've all had a chance to review our earnings press release. In previous quarters, our press release includes a number of historical metrics. These metrics will be added to our web site. Hopefully you find these metrics informative and helpful in understanding financial results and trends from our operations. As always, if you have additional suggestions or metrics you would like us to add or refine, please let us know.
Our third quarter 2008 revenue of $54.6 million was $400,000 below our guidance of $55 million. The increase in revenue represented a 1.4% increase over second quarter 2008 and a 16.2% increase over Q3 2007. The impact of foreign exchange materially impacted our revenues for the third quarter, causing a revenue reduction quarter over quarter of approximately $600,000.
As Thad will detail, a substantial revision in foreign exchange rates materially impacted our previously expected results for the fourth quarter and beyond. EBITDA as adjusted of $14.2 million was $2.3 billion below our guidance for the quarter of $16.5 million. Four factors materially contributed to this EBITDA shortfall.
During the quarter we incurred substantial write offs associated with the loss of one large customer. We were actually successful however, in picking up additional revenue as many of the customers of that customer chose to purchase from Cogent. We also incurred a substantial increase in professional fees associated with a legal dispute that has received some press attention lately.
We have accelerated the expansion into certain markets taking advantage of some beneficial pricing. We have also incurred some increased seasonal power costs. And finally, as we experienced with our international revenues, the FX impact, we noticed a reduction in our EBITDA from the translation of these foreign exchange rates.
Many of our costs reside here in the United States and our impact on EBITDA is greater than that of our impact on revenue.
Our overall business grew by one tenth of 1% third quarter of 2008 and approximately 17.5% from third quarter 2007. The impact of foreign exchange rates reduced the growth in this revenue part of our business by approximately $500,000. Substantially all of our European and Canadian revenues are on net revenues so changes in foreign exchange rates impact our on net disproportionately compared to other portions of our revenue.
Approximately 89% of our new sales in Q3 were for our On-net services. Our On-net customer connections increased by approximately 6.4% quarter over quarter. Revenues from our Off-net businesses increased by 6.3%, Q2 2008 to Q3 2008 and our non core revenues actually increased by 14.4%.
Off-net quarter to quarter revenue growth was consistent with our guidance for Off-net revenue growth of approximately 5% and was the highest Off-net revenue growth rate we have experienced since Q1 of 2005.
Now I'd like to take a moment and talk about pricing and provisioning. Pricing for our most widely sold product remains $1,000 per month for a month to month 100 megabit connection, or $10 per megabit. We do offer discounts related to contract term as well as for larger volumes. As a reminder, our Net-Centric pricing program does not impact our corporate customer base.
Our corporate customers represent approximately 60% of our total customers and represent in Q3 46% of our revenue. This is up from 44% of revenues in Q2 2008. Our provisioning cycle guarantee remains unchanged and we guarantee our customers who purchase On-net services from us, a 17 day provisioning cycle. In the third quarter, our provisioning team again consistently outperformed our guarantee, averaging 10 business days against our 17 day guarantee.
Traffic increased on our network by 5% from Q2; reversing the decline we had seen from Q1 2008 to Q2 2008. Traffic increased from the comparable quarter in 2007 by approximately 24%.
Now I'd like to touch on our average revenue per customer. On On-net ARPU was approximately $1,210 in the second quarter, declining to $1,143 in third quarter, a decline of approximately 5.6%. The impact of foreign exchange as well as discounts associated with contract volume and contract length contributed to this decline.
Additionally, we did see an increase in our corporate customer base relative to our Net-Centric base. Our corporate customers ARPU tend to be higher. Our Off-net ARPU continue to increase as our average Off-net connection size continued to increase. Off-net ARPU increased from $940 in Q2 of 2008 to $1001 in Q3 2008, an increase of 6.5%.
Substantially all of our European and Canadians revenues are on that, so fluctuations in foreign exchange have virtually no impact on our Off-net ARPU.
Our total churn remains consistent at about 2% of revenues. On-net churn is aligned with the rates that we've experienced previously for past two years and our Off-net churn also remains consistent at about 2.5%.
Thad will now cover some additional details concerning our third quarter 2008 results. That will also provide updated guidance for fourth quarter 2008 as well as update our guidance for full year and also provide our initial guidance for full year 2009.
I'd like to thank and congratulate our team on their very hard work and their efforts this quarter. Going back to EBITDA and gross margin, as Dave mentioned, EBITDA adjusted was $14.2 million for the quarter which was a decrease of 14.6% from the $16.6 million for the second quarter. That resulted in an EBITDA margin contraction of 480 basis points or 30.8% from the second and just about 26% for the third quarter.
As Dave mentioned, during the quarter we incurred a bad debt write off of $600,000 from an unpaid accounts receivable balance associated with the loss of one of our large customers. That customer has been replaced the customers of that customer which will I'm sure we'll cover in the question and answer section.
We incurred an increase in professional fees as well associated with a publicly announced legal dispute. We also took advantage of some beneficial pricing and have accelerated our expansion into certain markets, and as we experienced with our international revenues, we also experienced an EBITDA reduction from the translation impact of foreign exchange on our international EBITDA.
Gross margin decreased by 150 basis points for the quarter. Third quarter was 55.9%, 57.4% from the second quarter. The decline is in part due to foreign exchange, the additional costs associated with our accelerated network expansion and seasonal increases in power and utilities costs.
Additionally, because most of our fixed network costs are located in the U.S., unlike the foreign exchange reduction in our comparable revenues, there's less of a corresponding translation decrease in cost of goods sold in Europe.
Our direct incremental On-net gross margins continue to be almost 100% and direct incremental On-net EBITDA margins continue to be approximately 95%. Earnings per basic and diluted common share was $0.05 positive for the quarter. The $9.7 million gain for the quarter on the buy back of convertible notes increased EPS by about $0.22 per share. If you exclude this gain, our loss per share would have been about $0.17 for the quarter.
Weighted average shares decreased by approximately $1.8 million as a result of the weighted average impact of share purchased under our stock buy back program. As Dave mentioned, we purchased an additional 1.2 million shares in the third quarter and our plan for the remainder of '08 and '09 anticipates and includes the estimated impact of additional share repurchases.
Non-tax equity based comp expense in the quarter was $4 million or $0.09 a share and that was slightly less than our guidance of about $4.5 million for the quarter. Depreciation and amortization expense was $15.5 million, again slightly less than the guidance we had which was $16 million for the quarter.
I will cover this in a little more detail on foreign exchange. About 30% of our business is outside of the U.S. 22% being in Europe and 8% related to Canada. As Dave mentioned, these unprecedented rapid changes in the Euro, Canadian dollar, to U.S. dollar conversion rates negatively impacted our comparable revenues by about $600,000.
The Euro to U.S.D. average was $1.56 in the second quarter and it dropped to $1.50 in the third quarter. As many of you know, the current Euro over U.S. dollar rate is about $1.30 and it's fluctuating wildly. Variations in foreign exchange materially impacts our U.S. GAAP revenues. For the 22% of our business in Europe, for each penny decline in the Euro to U.S. dollar, we have a negative impact of our Euro based revenues of about $100,000.
For the 8% of our business in Canada, each penny decline in the Canadian/U.S. dollar rate negatively impacts our Canadian based quarterly revenue by about $40,000.
Capital expenditures totaled $9.5 million for the quarter, up from $9 million for the second quarter. As a reminder, on a quarterly basis, we can and have historically experienced seasonal variations in our capital expenditures on construction activities and typically we experience our lowest level of CapEx in our fourth quarter.
We expect to add slightly more than the 100 buildings originally targeted for 2008. We'll have added more routes than originally planned as well. As a result, we expect our 2008 capital expenditures to be slightly over the $30 million estimate.
Regarding cash, debt and our balance sheet, as of September 30, our cash and cash equivalents and short term investments were $109 million. In September we purchased $20 million face value of our notes for $9.9 million in cash. After the quarter end in October, we purchased an additional $86 million in face value of our notes for $37.8 million in cash.
In the aggregate we purchased $106 million of our original $200 million face value of notes for $47.7 million in cash. That results in a gain of $56.6 million and net income for the quarter and for the year 2008.
After these transactions, we retired 53% of our true debt, which is the convertible notes and we have about $94 million of the original $200 million remaining. As a reminder, the remaining notes are not due until June 2027.
Our capital lease RU obligations totaled $103.4 million at the quarter end and about $6 million of this is a current liability, so due within a year. These lease obligations are for dark fiber, and being paid over a remaining average life of more than 10 years.
Days sales outstanding for world wide accounts receivable continue to improve and with 31 days in September 30, better than our target of 40 days and an improvement from the 32 days outstanding at the end of the second quarter and despite the one isolated incident, we are not experiencing deterioration in accounts receivable collections. And again, I need to thank our world wide billing and collections team for continuing to do a fantastic job on customer collections. Our services are a necessary utility for our customers and our customers pay their internet access and our team does a great job in following up on collections.
Operating cash flow, cash flow from operations improved significantly for the quarter by 25% and was almost $18 million compared to $14 million for the second quarter.
Regarding guidance, for the fourth quarter, updating the year and for 2009. The guidance is based upon our current end expected run rates of our business, includes the estimated impact of our share repurchase program, planned increases in our sales and marketing programs, and the estimated impact of our current and anticipated network expansion projects and current traffic trends.
Our estimates are based upon current foreign exchange rates. Any material changes in these rates will materially impact our forecast as it has materially impacted our results. Any share and note purchased will also impact our forecast. Share and note purchase primarily impact our estimates of interest income, interest expense and any gains on future note repurchases.
Also, the share repurchases impact our weighted average shares outstanding for the period and in the aggregate these transactions impact our EPS estimates.
For the fourth quarter of 2008, we expect our fourth quarter 2008 revenue to be over $55 million. We expect EBITDA as adjusted for the fourth quarter to be over $14.5 million. Our gains on the fourth quarter note purchases are expected to be about $47 million. These results combined are expected to result in a basic and fully diluted EPS per share of over $0.90. A loss per share assumes approximately $42 million weighted average shares outstanding.
Updating the guidance for fiscal 2008, total revenue for 2008 is expected to now be over $215 million. Our previous guidance was $218 million. The significant change in FX has caused over a $3 million reduction in our previous forecast.
We expect EBITDA as adjusted to now be over $60 million. Our previous guidance was over $65 million. Gains on our notes will be approximately $56.6 million. As a result, we expect net income for fiscal 2008 and expect our 2008 earnings per basic and diluted common share to be between $0.55 and $0.60. The previous estimate was a loss of between $0.50 and $0.60 per share.
Gain on the note purchases represent about $1.25 per share for fiscal 2008. Our EPS estimate assumes approximately $44 million in weighted average shares outstanding for the year.
Initial guidance for 2009, total revenues expected to be over $250 million. EBITDA as adjusted is expected to grow to between $75 million and $80 million.
As was mentioned in our press release, we have acquired an accounting change that's going to result in about $4 million of additional non-cash interest expense in 2009 and this is related to what is now our $94 million of convertible notes.
Cogent and companies with convertible notes similar to ours are required to adopt this accounting change on the first of the year 2009. The pronouncement is called APB14-1, accounting for convertible debt instruments that may be settled in cash upon conversion, and the pronouncement essentially requires that the convertible feature of our notes be separated from our notes and then separately valued.
The accounting results in an increase in the debt discount and a corresponding increase in capital. That increase in the debt discount will result in additional non-cash interest from amortizing that increase debt discount.
The accounting rules further require that the discount be amortized to the earliest put date of our notes which is June 2014, instead of the actual maturity date which is June 2027. There's no change or impact at all for cash flow.
The pronouncement also requires retroactive treatment, so Cogent and all other companies impacted by this change, either restate their 2007 and 2008 operating results for the period that the notes are outstanding.
We expect our 2009 loss per share to be between $0.15 and $0.20 per share and the impact of this accounting change, APB14-1 will contribute about $0.10 to that loss per share for 2009. Any additional note purchases will impact that estimate. Our 2009 EPS estimate assumes approximately 40 million weighted average shares outstanding.
Lastly, we expect our 2009 CapEx to be similar to the 2008 range. With that I will turn the call back over to Dave.
I'd like to take a moment and discuss sales force productivity. As many of you know, we have implemented a number of measures to improve our sales organization and we are seeing the benefits of those improvements. We began the third quarter of 2008 with 208 sales reps and ended the quarter with 223 quarter bearing sales reps.
We hired 62 reps in the quarter, the most reps we have ever hired in a single quarter in the company's history. 47 reps left the company during the quarter slightly up from the 41 reps that left the company in Q2. Our monthly sales force turn over remains approximately the same at about 7%.
We began the third quarter of 2008 with 177 full time equivalent sales reps. Those are reps that are fully ramped and ended the quarter with 194 full time equivalent sales reps. Today, we have 235 quarter bearing reps selling our services.
Productivity on a full time equivalent rep basis for the third quarter of 2008 was 3.8 unit sales per rep per month. This rate was substantially higher than the 3.4 units per rep per month that we experienced in the second quarter.
As a reminder, these rates are derived based upon customer installations, not upon contract signing, so all installations are then counted. We continue to have a discipline approach to managing our sales force and monitoring their productivity. We continue to add sales reps in 2008 and we expect to have approximately 250 quarter bearing reps by the end of the year. We also continue to enhance our sales training and sales management infrastructure.
Now with regard to our network, we added another 27 buildings to the network in the third quarter of 2008 and ended with quarter with 1,301 buildings directly attached to our network with fiber into the buildings, to the floor of each customer. For 2008, we expect now to exceed our goal which was initially 100 building and for the first nine months of 2008, we have added 84 buildings to the network. For 2009 we expect to continue this pace and add approximately 100 buildings to our network.
We have secured additional fiber and construction is underway extending our network into a number of new markets. In Europe, we are extending into Talen, Estonia, the first time we have entered the Baltic's. We are extending our network in Romania to Timorschawara, Lucerne in Switzerland.
In North America, a number of extensions as well, adding cities such as Westchester, Massachusetts, Louisville, Kentucky, Nashville, Tennessee, Colorado Springs, Colorado and Albuquerque, New Mexico. We continue to evaluate additional routes, both in Europe and North America.
Now I'd like to take a moment and comment on the size and scale of our network. We have over 12,000 miles of metro fiber. We have over 33,000 route miles of intercity fiber. We are directly interconnected today to over 2,400 networks; approximately 320 of these networks are settlement free, partners of Cogent. The remaining almost 2,100 networks are today customers of Cogent.
We believe that our network has substantial capacity available for it to continue to grow and accommodate our growth plans into the foreseeable future. Today, we are utilizing approximately 20% of the capacity of our network. This is actually slightly down from the 21% last quarter due to our expansions in our networks even though we have experienced substantial traffic increases.
Our net revenues, our business continues to grow and traffic once again is growing on our network. We believe that Cogent is the low cost and low priced provider of internet services. Our recent pricing changes have re-emphasized our position and attracted new customers with longer term contracts and increased volume commitments from new and existing customers.
We have revised our 2008 plan to represent the impact in recent currency changes that impacted our international operations. Our business remains completely focused on internet based services. We do not sell other forms of telecommunications services. We believe that these services remain isolated from the current economic turmoil's that many other businesses are facing.
Our business provides a necessary utility to our customers and the strength in our receivables and reduction in our DSO's demonstrate that our customers pay for the services that we deliver. We have strengthened our already strong balance sheet especially when compared to others in our industry. We have eliminated over $106 million of face debt of our original $200 face value of convertible notes for $0.45 on the dollar, generating over $56 million in gain and reducing our true debt by 53%.
And again, we are extremely encouraged by the sales force initiatives that we implemented earlier in the year. The 13% improvement in sales force productivity growing from 3.4 units per rep per months to 3.8 units per rep per month. We also saw continued increase in traffic in our network. For the full quarter, our traffic grew at 5%, but that's somewhat understates the acceleration in traffic growth that we are now seeing.
On a monthly basis, we grew 1% July over June, again 1% in August, August over July and over 9% in September over August, resulting in the full quarter weight of 5%. We continue to see this growth rate accelerate and in fact, from September to October we have seen traffic on our network grow on a monthly basis by another 10% where today we are carrying approximately 14 petabytes per day of information on our network.
With that, I'd like to now open the floor for questions.
(Operator Instructions) Your first question comes from [Frank Malvin – Raymond James]
[Frank Malvin – Raymond James]
Can you give us an ideal of the flow through on the FX impact down to the EBITDA line and going forward, how much do you think of the traffic growth that you've seen in the last couple of months has been due to Olympics' and election coverage and do you think that's going to subside or is that traffic related to something else? And can you give us an update on the announcement with regards to Sprint.
We have had for some time a settlement free agreement with Sprint. Sprint elected to try to charge Cogent for our internet connection which was not called for in our agreement. That matter has been in litigation in Northern Virginia and continues to be in front of the courts where we are vigorously protesting that litigation.
Last Thursday at 4:00 p.m., Sprint elected to unilaterally sever the connections between the two networks. Three days later, on Sunday at 4:00 p.m. Sprint unilaterally elected to re-establish those connections. I think that re-establishment was primarily as a result of the impact that the disconnection from Cogent caused to their customers.
We received literally hundreds of calls from Sprint wireless customers who could not reach content or customers on the Cogent network. While we remain uncertain of Sprint's intentions, we hope that they wait for the final ruling from the court and Cogent remains absolutely committed to abiding by whatever ruling the court has.
Now let me touch on traffic. Part of traffic growth is associated with seasonality, not so much to specific events such as the Olympics or the election, but rather just the return of people from vacations in the summer and because Cogent has a large concentration in the educational sector where we serve over 600 universities and the number of K through 12 systems, we tend to see a pick up in September.
So I think part of our September pick up was as a result of seasonality. I think also part of it was a result of the volume based pricing that we put in place earlier in the summer. In 2007 we actually saw a negative traffic load in August. This year we saw positive growth. So I think that shows that seasonality is only partially a result of why we grew traffic.
And I think the growth that we continue to see in October is a result of the value that we deliver to our customers. The Olympics, the election or any specific application will drive short term traffic loads, but I think the long term trend is that more and more content and more and more information that people continue to go after, they will go after on the internet as opposed to other distribution media.
So I think we continue to see long term traffic growth and hopefully the continued movement of video to the internet which will allow us to retain the long term historical trend.
Now let me touch on the FX impact on revenue and EBITDA. The FX impact in our full year guidance was about $3 million. That's on total revenue. In terms of EBITDA flow through, there is some disproportionality in that many of our costs are based here in the United States and are therefore not given the beneficial advantage of a lower FX rate, whereas revenues are disproportionately impacted.
We also have going on here with our margins, all of these other extraordinary events such as the increased litigation costs for Sprint, the disconnection and bad debt associated with our one large customer, the utility costs increases in cost of good sold and finally, we've actually seen some increased taxes from some local jurisdictions. These are not income taxes or even property taxes. But many of these jurisdictions had previously waived taxes on internet service providers and now in an environment where they're seeing a tighter budgetary environment, they are implementing or rescinding the tax holiday they had in place.
While these are not material impacts, all of these things have resulted in the change in EBITDA. It's very difficult however, because we report things on a world wide basis and many of our costs are spread throughout the world to totally isolate the FX impact on a line by line impact.
[Frank Malvin – Raymond James]
Give us your thoughts on uses of cash now going forward. You're buying debt at $0.45 on the dollar. Is that going to continue to be your focus or be more aggressive on the share buy back with the stock where it is here? Can you give us an idea of what your thoughts are going to be for that?
With regard to the debt purchases, we have not issued a tender so these have all been private transactions. We have absolutely tried to capitalize on the extreme dislocation in the credit markets and the distress that some of the bond holders were facing. We only have now $94 million of face left.
We will continue opportunistically to talk to those bond holders. We are not initiating a tender. We do have some authorization from the Board on continued debt buy back and believe we could go back to the Board for even greater authorization, but it has to be on an opportunistic basis.
With regard to the share buy back, we do have $32 million left in the buy back program and we fully intend to deplete that program over time. Clearly with the stock at this level, we absolutely want to be opportunistic and aggressive.
I would just add at the end of the quarter we had $109 million in cash. As we mentioned in October, we spent $38 million on the subsequent note re-purchase, so call it $79 after that point. And we are generating our own cash. We've also included assumptions on the remaining share purchases program within the plan for the remainder of the 2008 and also into 2009.
Your next question comes from James Breen – Thomas Weisel Partners.
James Breen – Thomas Weisel Partners
It looks as if sales force turn came up a little bit in the quarter. Can you talk about what's happening there? With the ARPU you touched on it a little bit, it looks like ARPU were down 7% range sequentially on your On-net business. Can you talk about a currency environment where if currency stays constant quarter to quarter, what would that number look like? With respect to guidance for '09, what kind of assumptions are you making with currency either improving or deteriorating further for next year to get to where your current numbers are?
With sales force turn, it was actually down slightly on a percentage basis quarter over quarter. While the absolute number of sales people that we turned over was slightly higher at 47% as opposed to 41%, it was because it was off of a larger base. We continue to see sales force turn over being flat for the two middle quarters, tends to be very low in the fourth quarter as we generally try not to turn over people in the fourth quarter of the year, then it picks up a little bit in the first quarter.
I do think that some of the training and management initiatives we've put in place have improved things. We've actually seen the percentage of the sales force achieving quota continuing to rise. It went up from the mid 50's to today being 64% of the sales force is at quota, so that all bodes well and there has been no real increase in sales force turn over.
With regard to ARPU you've really got three things going on simultaneously. First and absolutely the most significant is FX. For our On-net revenues virtually all of the revenues in Europe are On-net because ARPU is just simply the number of customer connections divided into total revenue, because that revenue goes down because of FX, ARPU go down.
Secondly, the percentage of customers that are corporate actually increased from 44% to 46% of revenues. For our corporate On-net customers, they tend to take smaller connections than our Net-Centric customers, so as we see an increase in the percentage of our On-net customer base that is corporate, that will pull down ARPU. That has not changed the effect of price per megabyte sold. That number remains about constant at a little over $9.00. I think our average price is about $9.30 right now.
And then finally, you've got an increased discount associated with contract lengthening as we mentioned early. Contracts have lengthened an average by about 4% in the quarter, now getting up to just under 12 months. That has a positive impact in more revenue, but it does slightly degrade ARPU. On a going forward basis, if there were no FX changes, we would expect ARPU to be effectively constant. But I think at this point those other two impacts are fairly minimal.
As we have done in the past, essentially taking the current rates in using the forecast, and we'll use the same amounts in the forecast for the quarter and obviously the year '08 and in '09. So I've not assumed further deterioration or increase depending upon which side of the pond you're on.
Specifically, we've used the rates as they are today, so as a reminder, Europe is about 22% of our business and it's about $1.30 so that's what we have in our assumption with no change in that rate going forward. To the extent it changes, it's going to impact those estimates.
Canada is about $0.90 on the dollar and that's about 8% of our business. So we're using the current rates with no forecasted change up or down in the currency rate for the remainder of this year and next year.
Your next question comes from Michael Roland – Citi Investment Research.
Michael Roland – Citi Investment Research
As you look at what's going on in the competitive environment, where do you see in terms of pricing on a 12 or 24 month view of how tough it could get, or do you think we're near a bottom of where pricing is? Could you talk a little bit more about the assumptions underlying on On-net and Off-net in the '09 guidance?
With regard to pricing, we have two very different customers' bases and addressable markets and we're seeing different dynamics in each of those two markets. For the 46% of our revenues that are derived from corporate customers, we have seen a stable pricing environment, and I think that environment based on everything that we can see will remain stable for the next 12 to 24 months.
Remember, our corporate buy not on a per megabyte basis, but rather on a per connection basis. What Cogent is offering is a completely alternative connection at a price that is equivalent to what will be provided either by the Ileck or a competitive carrier using Ileck facilities that is much less capacity and generally less robust.
Because of some of the regulatory changes and the lack of competitive overbills on true facilities based networks, we've seen that pricing environment be stable and I would expect with the increased costs of capital, you will continue to see few overbills to compete on a facilities basis and that environment will be stable.
I think the second part of our business which is a larger portion of our business; it is 54% of our revenue today, which is our Net-Centric, our service provider business. That is where we sell in a carrier neutral data center. That business has experienced substantial price reductions on average over the years and it's generally where investors focus when they talk about price per megabyte.
What we are selling is a functionable commodity at the same location as typically a handful of other competitors. In that environment, we have seen the competitive landscape change quite a bit. We've seen a lot of the Legacy carriers elect not to compete for new business and just totally withdraw from the market.
We do see typically a couple of active competitors in that environment who have lowered their prices to get closer to Cogent but we remain absolutely committed to being the price leader.
In that market, we offer both volume discounts and term discounts that have taken our $10 price down to as low as $4.00 per megabyte. In that environment, we're probably today selling at an average of about $6.50 a megabyte based on contract value and term. We will continue to be the price leader.
I think we have not seen our competitors able or willing to get down to our price points. We remain committed to beating their price points and I think based on the reported financial performance of a couple of companies we actively compete with, I think their ability to compete is greatly restricted.
We think we're going to see probably less competition going forward as people focus on other parts of their business that are much higher margins.
With respect to how we build our revenue forecast, we start with a trailing six month average, and often we include since we're October is behind us, we have that data. We incorporate that data into that, so often it's trailing six months including October in most cases.
We take our historical mix. We take our historical pricing. We take our historical turn rate and then we take our assumptions on web turn and hires. For example our disclosed increase was to get to 250 reps by the end of '08.
Using those six months averages and not blindly using them, we look for any out wires, you will get certain events that create an out wire in any one month, we'll discard that. And that's what we use to build our plan going forward. It's based upon the past.
We do incorporate percentage changes, so if our rep productivity has been trending down, we will use that and incorporate that in the forecast going forward. If ARPU has been trending down, that will be incorporated in the forecast going forward. If mix has slightly changed in terms of new sales, that will be incorporated going forward. And the turn rate.
It's kind of built as a revenue roll forward with your starting run rate, your forecasted ads by product type, and your forecasted cancellations by product type, getting you to the end, revenue for the following month and that's where we start from.
We have as we mentioned, used in the past and have used in our current plan, the current foreign exchange rate. Frankly, that has had the most material impact on what we forecasted for this quarter versus what we experienced.
Your next question comes from Mike McCormick – J.P. Morgan.
Mike McCormick – J.P. Morgan
On the economy, anything on the corporate customer side as far as either pulling back on the scale or scope or cancelling products all together? Looking into the fourth quarter guidance, it sounds like you're saying pricing is pretty stable at least on the corporate side. Traffic seems to be improving pretty nicely but we're looking for margin compression versus prior guidance, I'm assuming that's FX but if you could clarify, that would be great.
First of all, it is absolutely clear that there is a lot economic turmoil and the country is in a serious recession if not something approaching a depression. While there may have been some ambiguity around that a quarter ago, I think the events of the past two months have absolutely convinced everyone that we're headed into a dramatically slowing environment.
We however, have been somewhat immune from that. The service we sell is a utility, meaning I think virtually everyone who buys our product needs it to run their business whether they be a corporate customer or a Net-Centric provider. We are the lowest cost provider and I think customers are more value conscious. So if they are looking for internet connectivity they will generally buy the best value and therefore switch to Cogent.
I think we're also seeing an acceleration in the long term trend of shifting traffic away from other higher cost types of networks to the internet where you're getting product displacement so things are moving away from TDM frame related ATM and private land networks all to the internet. All these things are contributing to a healthy traffic growth and a healthy demand environment.
If you look at our corporate foot print, you can go to our website and see the buildings going in. They can see rates have not really kicked up in those buildings. Maybe rents are not rising as quickly, but because we focus on class A skyscrapers, we tend to have a little bit more isolation and we haven't seen a huge uptick in space in those buildings which would make our selling more difficult to the corporate customers. In fact, our corporate productivity is as good as ever.
On the Net-Centric side, if unemployment goes up, people have more time on their hands; probably spend more time on the internet, using the internet more to find a job or download entertainment, looking for lower cost ways to get content and information. All of these things bode well for traffic.
Anecdotally in meetings with our sales organization, we had a meeting about four weeks ago where we brought all of our directors together from around the world, and as we brought those people together, there were directors who were meeting goals, some exceeding it, some weren't meeting their goals.
So I started quizzing people, starting with the people who were doing the worst, saying, 'Have you seen a lengthening of sales cycle or is the reason why you're not hitting your target the economy?" Not a single one of the directors said that they were seeing the economy as a problem. There may be other issues but the economy is not a problem.
Let me switch now to the FX and our guidance. Clearly the top line reduction is entirely attributable to FX. For the EBITDA and margin compression, FX is part of the story but we also have seen this increased litigation cost which we have to be conscious of and budget for. We have some seasonal audit type things that are factored into the budget.
Overall, you should continue to see going into 2009 a resumption of the margin expansion that we've demonstrated. If you took the past year for example, we've dialed it to about 100 basis points quarter over quarter both gross margin and EBITDA margin expansion. That's in fact exactly what we did.
There's going to some quarters that will go up 200% and another quarter it may go down a little bit, but if you look over a long term, we are able to demonstrate that type of operating leverage in business, and we expect that to continue going forward.
Your next question comes from Jonathan Atkin – RBC Capital.
Jonathan Atkin – RBC Capital
I wonder if you could clarify the situation about the large customer that you mentioned that left. The accelerated entry into the markets and the associated OpEx burn, I assume that also is one factor behind the compressed EBITDA margins. Is that basically a long haul route construction or is that accelerated pace of On-net buildings. On the traffic growth trends that you referenced and taking a step back, how sensitive are your revenues compared to prior quarters. It strikes me that in the wake of the re-pricing particularly the volume based discounts that customers are taking advantage of, maybe your business is less user expensive than it used to be.
The customer that we lost was a company called Alpha Red. They are a large hosting operator based in Texas. They ran into some financial difficulty. We had kept that customer on a fairly short lease although it can never be short enough and we did end up taking a charge for the bad debt that we had to write off from that customer. That did impact our margin in third quarter.
We had a little bit of a ramp up as we then basically focused the sales force on going to their customer base. We were actually very fortunate and we were able to sign up most of their very large customers and get actually more of a percentage of their business than we previously had. The net recurring revenue that we booked out of the customer base that was aggregated through that company actually went up.
So I think that's good. Customer concentration actually continues to decline. If you look at our top customers, our top five customers today are about 8.5% of revenues. If you look at our top 25 customers, they're about 15% of revenues. We have a great deal of customer diversity and particularly as a percentage of our business is more corporate, we see even a greater amount of diversity.
With regard to new markets, the costs that we bear in those markets, building costs are pretty much equivalent everywhere. We have added a few more markets than we originally planned at the beginning of the year. That's part of the reason why we're going to add more buildings than we initially planned, and a few more routes. That all affects capital. Those are really operating costs.
What we really pick up in operating costs are two things. One, the field tax and field support people necessary to support those remote markets, whereas if we add additional buildings in existing markets, we don't need to add more field people because they're within driving distance. But as we extend into places like Kiev or Bucharest it just becomes too logistically challenging for a guy to support those out of Germany or Austria so you just need to have more field people.
We now service customers in a total of 23 countries. Each of these countries has their own legal requirements in terms of the entities and minimum presences. There's just some kind of base pace number that we have to spend in each country and we've probably added more countries than we originally planned. I think that had a little bit of an impact.
I would expect to see those start up costs going down next year. That's part of the reason why I think we'll see some improvement in margin.
Finally, let me touch on your usage sensitivity question. Historically, most of our customers buy fixed commits. In fact all of our corporate customers buy fixed commits. Our Net-Centric customers however, typically will have a fixed-commit and then will use more than that fixed commit, paying a slight penalty.
Historically about 2% of our revenues came from those first fees. We saw that drop last quarter to 1.5% and it's dropped even further. Part of the volume based pricing initiative has actually incented people to take greater commitments. So while it's good for aggregate revenue, the amount of burst or overage revenue has substantially decreased where today it's probably less than 1% of revenues, and we expect that trend to continue. By incenting people to take these fixed commitments, I think we've isolated ourselves from short term traffic fluctuations.
Your next question comes from [Nick Metchveloda – Barclays Capital]
[Nick Metchveloda – Barclays Capital]
I wanted to get some more detail on 2009 expansion plans, where you're thinking of going, U.S. versus abroad.
As we look at our foot print, Cogent is becoming very ubiquitous both in Europe and in North America. I would say most of the cities that we are adding are secondary cities. Come of those are fill ins along existing routes. Some are on new routes. I think there are some additional routes in North America where we own fiber that we have not let, that we will be adding in some smaller markets.
We also will be adding in Europe primarily not so much smaller markets in our existing foot print but probably a few countries. There's still a few markets that we don't have, probably the ubiquity that we'd like and there are one or two markets where we don't have the redundancy that we would like to add, primarily in Eastern Europe. We will probably close some range.
Our European expansion will be almost entirely Net-Centric, connecting to data centers. We have today a total of two corporate buildings in Europe. We are considering adding some additional corporate buildings in London in the Canary Wharf area to try to test that market. But that's a limited market for us.
In North America, we are pretty ubiquitously penetrated in the corporate buildings. We have added some smaller markets like Des Moines, Minneapolis, Omaha, and we are continuing to add corporate buildings in those markets. For example in Minneapolis today we have half a dozen buildings on net and there's probably 20 targeted buildings. So we will substantially increase the building foot print in a place like Minneapolis.
In North America finally, we are reactive to the growth plans of the data center operators. A number of data center operators, Equinox switching data, digital Royalty Trust, Dupont, Fabros have all announced a number of expansion plans and we typically want to serve 100% of their foot print. So if they expand, we'll expand.
Your next question comes from Ken Lee – Jefferies.
Ken Lee – Jefferies
I wanted to get your thoughts on debt repurchase versus share repurchase. It seems that your convert is 1% convert. Why the repurchase now versus buying back more shares.
You are correct, it's close to free money, and we're very fortunate to be able to time the markets and acquire that capital at a very low cost. That instrument however, is potable in about 5.5 years, so we do think about that. We think about the yield. Just on the debt portion, while the convert is very far out of the money, we hope that within that 5.5 year period that it's not always the case, although it's not really the equity component of the convert that's driving our decision.
It's really the ability to buy at a very good yield to worse which is approximately 20% at the prices that we've been buying. The convert is opportunistic. We are not generally tendering for it. We are being contacted by convert holders who have their own liquidity situations and we base those purchase decisions on a case by case basis opportunistically to create value and strength in the balance sheet.
Basically for each dollar we spend, we create about $1.20 of that enterprise value in purchasing the converts, so that is very accreted and as Thad pointed out, we are generating free cash in addition to having excess liquidity on our balance sheet. While it's free money, the opportunity cost for that capital is high if we can put it to work.
If we think about the share repurchase program, we view that as a measured program that is designed to return value to shareholders. We've been consistent. We've bought back over 12.5% of the company in the past 18 months. We absolutely plan to be consistent and have a measured pace to continue to do buy back.
We'd like to be buying at today's prices as opposed to where we've bought in the past, but the purpose of the buy back program is to return value to shareholders in an orderly way. We will consistently buy back stock. We will opportunistically buy back the debt. There's more of an opportunity right now in stock than in the debt simply because there's not that much debt left out there.
Your next question comes from [Robert Dezago – SunTrust Robinson]
[Robert Dezago – SunTrust Robinson]
You spoke of the increase in the contract value of the customers that were taking advantage of the price point. Can you talk about the change you're seeing in the monthly spend of these customers versus the actual contract value?
In the vast majority of cases we've seen the monthly spend go up. There have been some instances where the customer has elected to increase contract value solely by extending term. However, there is no commission paid in that situation. So the way in which our commission structure is based, is a rep who would be processing that is only paid on the increase and monthly recurring revenue from an existing customer, and obviously the entire revenue from a brand new customer.
For our sales force, on average, 50% of their compensation is fixed or the base 50% is variable. So they have a strong incentive to get a greater amount of recurring revenue on a monthly basis from the customer. So the vast majority has resulted in a lengthening of the contract. It's gone up on average about 4% as well as an increase in monthly spending.
But there have been a limited number of cases where the spend has stayed constant, or even in a few cases has gone down. That was impactful in ARPU and is reflected in the number. We also see that the majority of existing customers taking advantage of this program have decided, and most of the people taking advantage of the term and volume discounts now are brand new customers not existing customers as was the case when we initially rolled the program out in June.
[Robert Dezago – SunTrust Robinson]
So the existing customers are not calling in looking for this new thing, it's mostly new customers?
[Robert Dezago – SunTrust Robinson]
You had previously indicated that the expected corporate revenue will continue to decline as a percentage of revenue longer term but the last few quarters you've seen a change in that as it's risen. Can you let us know what your expectations are as far as revenue growth or percentage of revenue for your '08 and '09 guidance for corporate revenue?
Long term, we believe that our two addressable markets will determine the split in revenue. Our Net-Centric addressable market is larger than our corporate market simply because of the discipline we apply to the types of buildings that we will go after. What we have seen however, is a slow down in the rate of traffic growth on the internet.
To counter that and to accelerate our gain in market share, which I think you've seen in the numbers we've demonstrated, particularly in the September and October monthly sequential traffic growths, were absolutely countering those trends.
In an environment where the internet is not growing as rapidly, we would see corporate pick up as a percentage. Long term, I think Net-Centric will still increase as a percentage from the 54% it's at today to probably 65% of our revenues. Whether that occurs in '09 or not, is unclear.
In the short term, it's basically a result of existing customers not growing as fast, putting the price volume breaks in place and gaining share. And if we look at penetration, on the corporate side we have today about 7.5 customers up from about 7.2 per building. So it continues to increase. But that's often a market of about 51 customers per building so we have a long way to go on the corporate side.
On the Net-Centric side we're at about 15 customers per data center out of a possible market of about 200. So again, long term we have a great addressable market that's unserved on the Net-Centric side of the business. Short term, because of the slower growth environment, we may see corporate pick up for the next quarter or two, but I think long term, Net-Centric will dominate.
In our guidance, I don't think there's a whole lot of variance baked into our guidance.
We actually don't build it by corporate versus Net-Centric. It kind of happens by a function of what's happened in the past and kind of baked into the mix that we focus on in On-net and Off-net as opposed to corporate versus Net-Centric.
And the impact of pricing differences between them would be dealt with by including the historical trends on ARPU changes. That's kind of how we look at it even though we do evaluate results based upon mix of corporate and Net-Centric in terms of forecasts and future revenue. We do it by product class on that.
[Robert Dezago – SunTrust Robinson]
You talked about the number of building you were going to do for '08. Can you talk about the number of buildings you're expecting to add in 2009?
At least 100. It may be slightly better than that.
[Robert Dezago – SunTrust Robinson]
Do you give a total traffic count on your network for the quarter?
We did. As of today, we're carrying about 14 petabytes a day. Traffic for the quarter increased from the previous quarter by 5%.
Your next question comes from David Dixon – FBR Capital Markets.
David Dixon – FBR Capital Markets
Looking at the customer turning down in the quarter, wanted to just make sure I'm interpreting the recurring revenue correctly. You mentioned previously that you had kept this company on a tight leash reflecting some credit concerns. Should I be interpreting that $600,000 impact as a weekly revenue commit and therefore calculating that at around $2.5 million per quarter? Just confirming that you've received a recurring revenue lift off that space and whether that occurred in the same facility? That business as I understand was split evenly between yourselves and level 3. Could you talk a little bit about how you were able to achieve a greater mix of that customer business within a very challenging transition period?
With regard to the customer, that particular customer had been a customer of Cogent for about four years and had grown rapidly with us. They had experienced consistent payment issues and initially while I call other customers on a monthly payment plan, and as they fell behind we realized that to keep them on a short leash we wanted to put them on a weekly payment plan.
That does not mean however that their balance was zero. They were carrying a balance forward so the $600,000 that we lost represented several weeks, almost a month of their revenue that was not their weekly run rate. I wish we were that good at collecting and people were basically current by the week. So while they had a weekly payment plan to Cogent, that revenue was multiple weeks, close to a month's worth of recurring revenue even though they had to make weekly payments to make it.
With regard to picking up business, the business that we picked up was both in the two facilities in Texas that that operator controlled as well as a third facility in Texas where they were subleasing space. So the traffic that we ended up winning from their customers was in all three of their locations as well as those customers chose to diversity adding additional capacity with Cogent both in Europe, on the East Coast and the West Coast. So the traffic wins that we got from those customer bases are now spread over half a dozen locations as opposed to being concentrated in three.
As a percentage of the dollar spend by those customers, because of the volume based pricing structure that we have in place, they were highly incented to give us a greater percentage of their business. So while I won't say that we have 100% in every one of those customer's cases, I think we have a much greater percentage than we had previously with the one customer.
While we did lose this customer, we had to write off their outstanding balance, and we were able to replace the revenue actually with greater revenue in the long term, and improved concentration replacing one customer on a payment plan with a series of customers who actually paid in advance.
There's a ramp up for the month of October in replacing that revenue as those connections were installed. As we're geared today, the run rate is actually higher, but for the month of October cumulative revenue because of the install is actually less.
That was baked into our guidance, that ramp for those series of customers.
David Dixon – FBR Capital Markets
On the $600,000 being a monthly revenue amount, is that equivalent to the amount of traffic we would have had previously as a base reference point?
First of all, it was slightly less than a month so it's slightly more than that in terms of traffic and they had multiple ports so they were not necessarily getting the $4.00 price point. In other words, they spread their traffic over a larger number of ports. To get that price point you have to have a full 10 gig port and concentrate your traffic on those ports.
David Dixon – FBR Capital Markets
So despite the reduction there we've actually seen a 10% increase in October which would have incorporated the effect of the turn down of that customer.
Not only the turn down but also the ramp. If that particular customer that was distressed went away and all of their customers instantaneously turn back up at the exact same moment, the weight of traffic growth in October would have actually been greater than the 10% we reported.
David Dixon – FBR Capital Markets
Any sense of a continued cost estimate to Sprint with this dispute that's underway, how we should be thinking about that going forward whether you're accounting for any contingency there. Or could you give us some assistance with what we could see potentially if you did see an adverse outcome there from the courts?
We are not accruing although we have listed in our disputes the Sprint litigation, the actual principal amount. We have no contract with them that calls for us to pay monies so we find it very difficult that they can present us a bill since there's no contract for services with a dollar amount associated with it. So I don't know under what theory they are litigating.
That is separate and somewhat distinct from the inner connection litigation which is basically a series of requirements that we met that they are alleging that we did not meet. We have reserved money for and have budgeted monies for the legal expense associated with that litigation and that's in the order of several hundred thousand dollars a quarter. Obviously with any kind of litigation we always hope it settles prior to being fully adjudicated.
The only think that we think we're going to be spending unfortunately, is money with lawyers and it is unlikely that we will be able to recover those legal expenses.
David Dixon – FBR Capital Markets
It does seem a little odd that related to what had been occurring over a year ago for the claims to be made now, it seems given the amount of time has elapsed to what was the trial period that they referred to.
We fully paid for the trial period. There's no dispute about the payments that were made during the trial. The dispute is for the period after. But you are correct that it is a bit unusual for someone to wait that long before raising the issue which I think also focuses on the weakness of their case.
This concludes our question and answer session. I would like to turn the conference back over to Mr. Dave Schaeffer for any additional or closing remarks.
Thank you everyone for listening. I know these calls sometimes go a long time but we do try to be complete in answering questions.
I'd just like to take this opportunity to thank the entire Cogent team. This is a difficult economic environment. I think the team has performed exemplarily. We're doing a very good job. Our business continues to grow. We are focused on the right markets, the right customers and most importantly the right products at the right price point. I think you'll see continued strong performance from the entire Cogent team, so I'd like to thank the roughly 500 members of that team that are responsible for us being able to deliver these results to you.
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