Cogent Communications Group Management Discusses Q2 2013 Results - Earnings Call Transcript

| About: Cogent Communications (CCOI)

Cogent Communications Group (NASDAQ:CCOI)

Q2 2013 Earnings Call

August 08, 2013 8:30 am ET


David Schaeffer - Founder, Chairman, Chief Executive Officer and President

Thaddeus G. Weed - Chief Financial Officer, Principal Accounting Officer and Treasurer


Colby Synesael - Cowen and Company, LLC, Research Division

Thomas O. Seitz - Jefferies LLC, Research Division

Barry M. Sine - Drexel Hamilton, LLC, Research Division

James D. Breen - William Blair & Company L.L.C., Research Division

Frank G. Louthan - Raymond James & Associates, Inc., Research Division

Michael Rollins - Citigroup Inc, Research Division


Good day, everyone, and welcome to the Cogent Communications Group Second Quarter 2013 Earnings Conference Call and Webcast. Today's call is being recorded. This call will be available for replay at

At this time, I'd like to turn the call over to your host, Dave Schaeffer, Chief Executive Officer.

David Schaeffer

Hey, thank you, and good morning. Welcome to our second quarter 2013 earnings conference call. I'm Dave Schaeffer, Cogent's Chief Executive Officer. With me on this morning's call is Tad Weed, our Chief Financial Officer.

We are pleased with our results for the quarter, and are optimistic about the strength of our business and the outlook for the remainder of 2013. During the quarter, we experienced sequential revenue growth, gross margin expansion, EBITDA margin expansion, network traffic growth, increased cash flow and increased sales rep productivity to the highest level in the company's history. Additionally, we returned $6.1 million to our shareholders through our regular recurring quarterly dividend of $0.13 a share, which we paid in June of 2013. We continue to remain confident about the growing cash flow generation capabilities of our business. As a result, we have -- and as indicated in our press release, we further announced an increase of 7.7% in our quarterly dividend to $0.14 per share per quarter, our fourth sequential increase in our dividend since we began paying dividends. And this will be paid on September 25, 2013, to holders of record as of September 5, 2013.

As also mentioned in our press release, our board has approved an additional regular return of capital program. This program is in addition to our regular recurring dividend payments. Beginning this quarter, in the third quarter of 2013, we intend to return an additional $10 million per quarter to our shareholders, either through a stock buyback effected in the quarter or a special dividend each quarter. For example by the end of the third quarter, if we have spent $3 million on stock buybacks, then in the fourth quarter, we would issue and pay a $7 million special dividend in addition to our recurring dividend. If we did not purchase any stock in the third quarter, the special dividend paid in the fourth quarter would be $10 million. Any special dividend will be paid on the date that our normal recurring dividend is paid as well. This return of capital program is planned to continue until our net debt to EBITDA as adjusted ratio reaches 2.5:1. Obviously, with any plan, it is subject to change if conditions change.

Our revenue growth from the first quarter of 2013 grew by 1.5% sequentially. And on a constant currency basis, our revenue growth, sequentially, was 1.8%. Our gross margins expanded by 80 basis points from the first quarter of 2013 to 56.9%. And our EBITDA margin expanded by 100 basis points from the first quarter of 2013 to 34.5%.

During the quarter, traffic grew sequentially on our network by 11% from the first quarter of 2013. And on a year-over-year basis, our traffic grew 93% from the second quarter of 2012. Our sales force productivity continued to increase. Our sales rep productivity increased over 3% from the first quarter to 6 installed units per quarter bearing rep full-time equivalent per month. This is the highest level of organic sales force productivity in the company's history, and I'm very proud of the progress the sales force is making.

Since the end of the first quarter, we continued to expand our footprint by adding another 31 buildings to our network. And for the last 12 months, we've added 122 buildings to our network. Throughout this discussion, we will highlight several operational statistics that we believe demonstrate our increasing market share, expanding scale and size and footprint of our network, and most importantly, the operating leverage of our business model. We are the lowest-cost, most efficient operator in our sector. We are focused on the most traffic-rich locations, which we bring on-net, and we sell the highest quality Internet service to our customers at the lowest price in the market.

I will review, in greater detail, some additional operational highlights and trends. Tad will provide some additional details on our financial performance. Following our remarks, we'll open the floor for questions-and-answers.

Now I'd like Tad to read the Safe Harbor language.

Thaddeus G. Weed

Thank you, Dave, and good morning, everyone. This second quarter 2013 earnings report and this earnings conference call discuss Cogent's business outlook and contain forward-looking statements within the meaning of the Section 27A and 21E of the Securities Act. These forward-looking statements are based upon our current intent, belief and expectations. These forward-looking statements and all other statements that may be made on this call that are not historical facts are subject to a number of risks and uncertainties, and actual results may differ materially.

Please refer to our SEC filings for more information on the factors that could cause actual results to differ. You should also be aware that Cogent's expectations do not reflect the potential impact of mergers, acquisitions, other business combinations or financing transactions that may be completed after today. Cogent undertakes no obligation to release or publicly -- to release publicly any revision to any forward-looking statement made today or otherwise update or supplement statements made on this call.

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

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

David Schaeffer

Okay. Thanks, Tad. Now for some highlights from the second quarter's results. Hopefully, you've had a chance to review our earnings press release. As in previous quarters, our press release has a number of historical quarterly metrics. These metrics will be added to our website. We will hope you find these consistent presentation of these metrics informative and helpful in understanding our financial results and the trends from operations. We experienced sequential revenue growth for the quarter. Our second quarter of 2013 revenue was $85.8 million, an increase of 1.5% sequentially from the first quarter of 2013 revenue, and an increase of 10.3% from the second quarter of 2012.

On a constant currency basis, our second quarter 2013 revenue increased sequentially from the first quarter by 1.8%, and increased by 10.0% from the second quarter of 2012. We evaluate all of our revenues based on product class. On-net, off-net and non-core, which Tad will cover in greater detail. We also evaluate all of our revenue by customer type. We classify our customers in 2 major categories: NetCentric customers and Corporate customers.

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

Our revenues from our Corporate customers grew 3.2% from the first quarter of 2013. These Corporate customers represent 49.1% of our total customer connections in the second quarter, and 51.7% of our Q2 2013 revenues. Our Corporate customer connections grew sequentially by 2.9%. Our revenue from our NetCentric customers was essentially flat for the quarter. Our NetCentric customers represent 50.9% of our total customer connections at the end of the quarter, and represent 48.3% of our 2013 revenues. Our NetCentric customer connections grew sequentially by 3.1%.

Now for some trends around pricing. Our most widely sold Corporate product continues to be 100-megabit per second non-oversubscribed and non-blocked dedicated Internet access connection. And our most widely sold NetCentric product continues to be a 10-gigabit port for transit services. We offer discounts related to contract term to all of our Corporate and NetCentric customers. We also offer volume commitment discounts to our NetCentric customers.

During the quarter, certain of our customers took advantage of our contract discounts for volume and term and entered into longer-term contracts with Cogent, representing over 1,950 customer connections and increasing their commitment to Cogent by over $6.3 million. Cogent -- customers continue to express their confidence in Cogent by entering into longer-term contracts with us. Our average contract term increased by yet another 0.4% in the quarter.

Our average price per megabit of our installed base for the quarter decreased, but our average price per megabit for new sales sold in the quarter actually slightly increased. The price per megabit of our installed base declined sequentially by 1.7% from $2.87 per megabit in the first quarter of 2013 to $2.82 in the second quarter of 2013, and declined by 18.2% from the $3.44 for the average price per megabit in 2012. The price per megabit for new customer contracts in the quarter was $1.72, a 1.4% increase from the $1.70 per new megabit customer contract sold in the first quarter of 2013, and a 5.6% decline from the $1.82 for our new customer contracts sold in the second quarter of 2012. The price per megabit for our new contracts and installed base is partially impacted by our continued targeted promotional programs.

Before Tad adds some additional color, I'd like to address our results and expectations for both revenue and EBITDA margin targets. Our revenue increased from the second quarter of 2012 by 10.3%; and for the first 6 months of 2013, over the comparable period in 2012, by 10.1%. These growth rates lie within our guidance range of 10% to 20%. Our EBITDA margin was 34.5% this quarter and expanded by 190 basis points from the EBITDA margin of 32.6% for the second quarter of 2012. Our EBITDA margin expanded by 100 basis points from the first quarter of 2013. Our EBITDA margin was 34% for the first 6 months of this year 2013, and this represents a 300 basis point increase from our EBITDA margin of 31% for the comparable 6-month period in 2012. We continue to anticipate our full year revenue growth of 2013 over 2012 will be in our 10% to 20% range, and our EBITDA margin expansion for 2013 over 2012 will be greater than 200 basis points.

Now I'd like Tad to cover some additional details on the quarter and the year so far.

Thaddeus G. Weed

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

And I'll begin by discussing and providing additional details related to our revenue by product class, which is on-net, off-net and non-core. Our on-net revenue was $62.7 million for the quarter, which was an increase of 1.6% from the first quarter of 2013. Similar to prior quarters, about 85% of our new sales for the quarter were for our on-net services. Our on-net customer connections increased by 3.1% for the quarter, and we ended the quarter with about 31,900 on-net customer connections on our network in our 19,021 on-net buildings.

Our revenue from our off-net business was $22.6 million for the quarter, which is a 1.3% increase from the first quarter of 2013, as we continued to add off-net customers to the network as well. Our off-net customer connections increased by 3% for the quarter, and we ended the quarter serving 4,700 off-net customer connections in about 4,000 off-net buildings. Our non-core revenues were about $0.5 million and represent less than 1% of our revenues and about 450 customer connections.

On ARPU statistics. Both our on-net and off-net ARPUs declined from the first quarter of 2013. Our on-net ARPU, which includes Corporate and NetCentric customers combined, was $676 for the first quarter, as compared to $666 for the second quarter of 2013. Our off-net ARPU, which includes predominantly Corporate customers, was $1,642 for the first quarter and declined to $1,617 for the second quarter of 2013, as off-net ARPU begins to stabilize.

On numbers regarding churn. Our net churn rates for both our on-net and off-net customers were flat during the quarter. Our on-net churn rate was 1.3% for the first and second quarter. And our off-net churn rate was 1.5% for the first and second quarter.

Regarding EBITDA and gross margin. As Dave mentioned, our EBITDA margin for the quarter increased by 190 basis points from the second quarter of 2012, and increased sequentially from the first quarter of 2013 by 100 basis points. Our EBITDA margin was 32.6% for the second quarter of 2012, 33.5% for the first quarter of 2013 and for the current quarter, was 34.5%. EBITDA as adjusted was $29.6 million for the quarter, which represented a 4.7% increase from the first quarter of 2013, and a 17% increase from the second quarter of 2012.

Our gross profit margin significantly increased for the quarter by 80 basis points from 56.1% for the first quarter to 56.9% for the second quarter of 2013. Our on-net revenues continue to carry a nearly 100% incremental direct gross profit margin, and our off-net revenues continue to carry an approximate 50% incremental direct gross profit margin.

Occasional lumpiness in our EBITDA and gross margins can and does occur. And if you examined our quarterly metrics for the last 33 quarters, included in each of our press releases since we became a public company in 2005, you'll notice lumpiness in our quarterly margin expansion. And this can occur due to seasonal and other nonrecurring factors, including the timing and scope of our expansion activities, which can vary from quarter-to-quarter and seasonal factors, which includes SG&A expense increases, such as the resetting of, and increase in, payroll taxes in the U.S., cost of our annual sales meeting, annual cost of living increases and the timing of our audit and tax services. Severance costs and an increase in bad debt expense added to our SG&A expense in the second quarter of 2013. Despite quarter-to-quarter variations, our long-term margin trend has demonstrated that our business model generates increasing EBITDA margins.

Interest expense. Interest expense results from interest incurred on our $175 million of senior notes that we issued in January 2011. Our $92 million face of convertible notes and interest on our capital lease obligations. Our interest expense was $9.9 million for the first quarter and $10.2 million for the second quarter. The components of our $10.2 million of interest expense for the second quarter of 2013 were as follows: $3.8 million was related to our senior notes; $1.8 million was related to our convertible notes, and of that $1.8 million, $1.6 million is noncash amortization of the note discount, with the remaining $0.2 million was paid in cash; and $4.6 million of our interest expense was related to our capital lease obligations.

Earnings per share. Our basic and diluted income per share was $0.03 for the quarter as compared to $0.01 for the first quarter of 2013.

On foreign currency impact of our business. About 27% of our business is located outside the United States, and as in previous quarters, about 20% of our revenues are based in Europe and about 7% of the revenues are related to our Canadian, Mexican and Japanese operations. Continued volatility in foreign exchange rates can materially impact our comparable quarterly and annual revenue and financial results. The foreign exchange impact on our revenue from the first quarter to second quarter was a decrease to revenue of approximately $0.3 million.

Our revenue increased from the first quarter by 1.5%, and on a constant currency basis, the increase was 1.8%. The foreign exchange impact on our revenue from the second quarter of 2012 to the second quarter of 2013 was an increase to our revenue of about $0.2 million. Our revenue increased from the second quarter of 2012 to the second quarter of 2013 by 10.3%, and adjusted for currency, it was 10%.

The average euro to U.S. dollar rate, thus far, for the third quarter of 2013 is about $1.31, although currently trading at $1.33. And $1.31 was the same as the average rate for the second quarter of 2013. If the average exchange rates at current levels remain, there would be no material impact on sequential revenues from Q2 2013 to Q3 2013.

The average euro to U.S. dollar rate for the third quarter of 2012, however, was $1.25. So should the average rates for the current quarter remain at current levels, the foreign exchange conversion impact, on a year-over-year quarterly revenue basis, would be an increase of about $0.5 million.

Customer concentration. Our revenue and customer base of about 37,000 customer connections is not highly concentrated for the second quarter of 2013. No customer represented more than 1.5% of our revenues, and our top 25 customers represented less than 7% of our revenues.

CapEx. On a quarterly basis, we can and have historically experienced seasonal variations in our CapEx, prepaid capital lease payments and construction activities. Our quarterly CapEx and prepaid capital lease payments are primarily dependent upon the number of buildings we connect to our network during the quarter, and the timing and scope of our network expansion activities. CapEx decreased for the quarter by 23.7% to $12.5 million versus $16.3 million for the first quarter of 2013.

As Dave said, we added another 31 buildings to our network in the quarter, and we've added 122 on-net buildings to our network over the past year. Our capital lease principal payments for long-term dark fiber IRU agreements were $2.1 million for the quarter as compared to $5 million for the first quarter of 2013. We expect to continue our network expansion in 2013, but a slightly more moderate pace than we experienced in 2011 and 2012, with continued moderation in 2014.

On some balance sheet statistics. At the end of the quarter, our cash and cash equivalents totaled $237.4 million. And for the quarter, our cash increased by $2.4 million after and including our dividend and all interest payments. Cash flow from operations was $22.7 million for the quarter as compared to $15 million for the first quarter of 2013, and $19.5 million for the second quarter of 2012. Our $22.7 million of operating cash flow this quarter was partly offset by $12.5 million of CapEx, $2.1 million of IRU capital lease payments and $6.1 million for our second quarter 2013 dividend payment.

Our operating cash flow for the second quarter included our $0.5 million semiannual interest payment on our convertible notes, and that was paid in June. Excluding our cash returns to our stakeholders through dividend and interest payments, we were cash flow positive by $9 million for the second quarter of 2013.

Our operating cash flow will continue to be impacted by our $7.3 million semiannual interest payments on our senior notes, and those interest payments occur in February and August through the maturity date in 2018. Our operating cash flow was also impacted by our $0.5 million semiannual interest payments on our convertible notes, and those payments occur in June and December. We have about $92 million of our original $200 million of face value of our convertible notes remaining. The notes mature in June 2027, and may be redeemed by us or put by the holders beginning in June of next year. The notes are reported on our balance sheet as $85.6 million, which is net of the unamortized discount. Since the convertible notes may be put by the holders beginning in June of 2014, which is within a year from the balance sheet date, they are now classified as a current liability on the June 30, 2013 balance sheet.

Our capital lease IRU obligations are for long-term dark fiber leases and typically have an -- initial terms of 15 to 20 years or longer, and often include multiple renewal options after that. Capital lease IRU obligations were $151.9 million at June 30, 2013.

Our total debt, including capital lease obligations, was $412.5 million at the end of the quarter, and our net debt was $175.1 million. Our total debt to trailing last 12 months EBITDA as adjusted ratio was 3.7 at June 30, and our net debt to trailing last 12 months EBITDA as adjusted ratio was 1.6.

Our bad debt expense increased for the quarter and was 1.1% of our revenues for the quarter as compared to 0.6% for the first quarter, and 1.1% of our revenues for Q2 2012. The first quarter of 2013 included some debt recoveries, which lowered the bad debt expense to a rate, kind of, below our historical average.

Our days sales outstanding, or DSO, for worldwide accounts receivable was at a very low level at only 25 days at the end of the quarter compared to 26 days at the end of the first quarter. And as with previous quarters, I want to personally thank, again, and recognize our worldwide billing and collections team members for just continuing to do a fantastic job on customer collections, customer service and credit monitoring.

Now I'll turn the call back over to Dave.

David Schaeffer

Hey, thanks, Tad. Now for a few words about our sales rep activity and productivity. We began the second quarter of 2013 with 262 sales reps, ended the quarter with 269 sales reps. We hired 56 sales reps in the quarter, and 49 sales reps left the company during the quarter. Our monthly sales force turnover rate was 6% for the second quarter, slightly better than our long-term average of 7%. We began the second quarter of 2013 with 248 full-time equivalent sales reps and ended at 249 full-time equivalent sales reps. Productivity on an FTA, or full-time equivalent basis, for the quarter was 6.0 reps or units per rep per month. This rate of organic productivity is significantly better than our long-term historical sales force productivity average of 4.4 units per rep per month, and a 3% improvement from the 5.8 units per rep, again, ahead of the industry or our long-term trends that we experienced in the first quarter of 2013. As a reminder, our sales rep productivity rates are not based on contract signings, but rather are derived from completed, installed customer orders. We are very pleased to announce that last week, Ernie Ortega joined Cogent as our Chief Revenue Officer. We are looking for Ernie to help us accelerate the expansion of our sales team and to accelerate the rate of our revenue growth.

Now for a few words about our network expansion. The size and scale of our network continues to grow. We added 31 buildings in the second quarter of 2013, and now have over 1,920 buildings directly connected to our network. Our network now consists of over 27,000 miles of metro fiber and over 57,000 miles of intercity fiber. The Cogent network is one of the most interconnected networks in the world. Today, we connect to over 4,660 networks. Approximately 40 of these networks are settlement-free peers, and the remaining 4,620 networks are paying Cogent customers. We are currently utilizing approximately 20% of our width capacity. We routinely augment capacity in sections of our network to maintain these low utilization rates.

We currently serve only 12% of the NetCentric customers in our footprint, and 21% of our Corporate customers that are available for service in our on-net footprint. We have a well-diversified revenue base with low customer concentration. No customer represents more than 1.5% of our revenues, and our top 25 customers represent less than 7% of our revenues. We continue to believe that our network has substantial capacity to accommodate our future growth.

In summary, we believe that Cogent -- that we are the low-cost provider of Internet access and transit service, and our value position to our customers is unmatched in the industry. Our pricing strategy is continuing to attract many new customers, resulting in increased sales force productivity, average contract lengths continuing to increase, customer volume and revenue commitments to Cogent continuing to increase.

Our business remains completely focused on the Internet. And the Internet is increasingly becoming an absolute necessity for our customers. We expect to continue to see our annualized revenue growth and EBITDA margin expansion rates to be consistent with our historical rates of 10% to 20% revenue growth, and greater than 200 basis points of EBITDA margin expansion on a year-over-year basis.

For 32 out of 33 quarters as a public company, we have produced organic sequential revenue growth, and continued to be encouraged by the cash flow generation derived from this growth. We continue to be encouraged also by the growth in traffic on our network and our network connectivity. As a result of our sales initiatives and targeted promotional programs, our sales force productivity and order backlog continue to be at record levels.

We are confident in our network range, our product set, our addressable market and the operating leverage that we demonstrate. In short, we are pleased with our business. We continue to feel that we have an underserved ample addressable market in our on-net footprint, enabling us to grow our revenues at our historical growth rates. We are committed to providing top line revenue growth of 10% to 20%, and continue to see expanding margins, as well as increased cash flow being returned to our equity holders. We are very opportunistic about the timing of purchase of our common stock. At the end of Q2 2013, we have purchased 307,000 shares of our common stock for $4.2 million under our current buyback program. We have $45.8 million remaining under this program and the board has extended this program through February 2014. Our Board of Directors approved an additional increase in our quarterly dividend of 7.7%, raising our quarterly dividend to $0.14 per share, which will be paid on September 25, 2013. And we have formalized the return of capital program, assuring investors that we will return $10 million per quarter above our recurring dividend, demonstrating the optimism we have around the growth and growth in cash flow in our business, as well as our ability to return that capital to shareholders.

With that, that concludes our prepared remarks, and I'd like to now open the floor for questions.

Question-and-Answer Session


[Operator Instructions] And we'll take our first question from Colby Synesael with Cowen and Company.

Colby Synesael - Cowen and Company, LLC, Research Division

The first line of questioning, I just want to talk about your return of capital. You've previously talked about how, as you move towards 2014, you would align the dividend with free cash flow, something, let's just make it up, something around 75% of free cash flow being returned or higher, I think you said, back in the form of a dividend. Does what you announce today replace that or is that still the expectation and therefore, what was announced today it's going to be on top of that? Just a little bit of color. And then, also maybe some color on how you're going to go about deciding whether you should be using that for the buyback or for the dividend? And then, just my second line of questioning, you talked about record rep productivity, but you're at the lower end of your targeted revenue growth of 10% to 20%. Just trying to understand why that is and what we could expect going forward?

David Schaeffer

Yes, hey, sure, Colby, it's Dave. First of all, we are absolutely committed to growing our recurring regular dividend and continue to use that dividend to return the majority of our cash flow that we generate from operations to shareholders. In addition to that, we realized that we have an underutilized asset in our balance sheet, and the board has committed to take advantage of the current interest rate environment and allow us to return the excess capital we have on the balance sheet until we reach a prudent leverage ratio of 2.5:1, and do that in a measured manner. So we intend to return $10 million per quarter, every quarter above our recurring dividend. Now we've retained the flexibility to be able to buy our stock back if the market's correct and we have the opportunity to buy a large amount of stock back at what is a market discount due to market dislocation, not due to Cogent. And we also have the ability, under our buyback program, to buy more than $10 million in a quarter. But we are guaranteeing to do that. If we do not spend the $10 million on a buyback, we are committed to proving to shareholders that we are serious about returning the capital and therefore, we'll return whatever portion of the $10 million is not spent in a quarter in the form of an additional dividend above our recurring dividend to help make sure that they know we're serious about that return of capital.

And we think the 2.5:1 net leverage that we've outlined allows us to maintain adequate, if even not excessive, liquidity on our balance sheet and still have a prudent amount of leverage relative to others in our space. With regard to additional increases and a recurring dividend, both next quarter and then in 2014, we'll evaluate that each quarter with the board and adjust that dividend appropriately. Now in terms of rep productivity and revenue growth, our Corporate growth was actually quite strong in the quarter at 3.2%, sequentially. And virtually no FX impact in that. Our NetCentric growth was a bit weaker, coming in basically flat, making our constant currency sequential growth rate 1.8%, and our year-over-year growth rate of 10.3%. We need to get better on that. What is happening is we are seeing many of our NetCentric customers become more efficient in utilizing the bandwidth that they purchase. A slightly greater percentage of our NetCentric revenue is coming from burst traffic, meaning, people are paying by the megabit, not a fixed commit. So we actually saw our burst revenue, for the first time in the company's history, exceed 5% of our aggregate revenue. And we also saw our average NetCentric customer utilization rate during the quarter actually exceed 100%, meaning, that if we added up all of our NetCentric customers, they were using more than they had committed to. That increased efficiency has been what has, probably, slowed down our rate of NetCentric growth. We do feel pretty comfortable that it should begin to accelerate and that the relative mix in our business of 50-50 Corporate and NetCentric, will continue. And we do believe we will be able to achieve the long-term average growth rates going forward that we have historically. And if you look over the -- since the company has gone public, over an 8-year period, that growth rate -- that 8-year or 33-quarter average now is about 12.9% right in our range.

Colby Synesael - Cowen and Company, LLC, Research Division

Okay. So I mean, I apologize for taking so much time, but it does sound like you're not committing to the -- tying the dividend to free cash flow like you were before, is that accurate?

David Schaeffer

Well, we said we would evaluate it and announce a program. If you look historically, we are actually returning about close to 100% of our free cash flow. And with this added program, we'll actually be most likely returning more than 100% of our free cash flow for a period of time as we take our net leverage up from 1.6 to 2.5.


And we'll take our next question from Barry McCarver with Stephens Inc.

Unknown Analyst

This is Brad Henry in for Barry. A couple of questions. I just wondered if you could talk a little bit about your peering relationships and how those stand today? And then, also, if you could provide a little additional color on the sales team ramp, if you have a specific number in mind or if that ramp will have a meaningful effect on costs going forward?

David Schaeffer

Yes, sure, Brad. Thanks a lot. First of all, with regard to your peering question, Cogent today is interconnected to 4,660 networks, actually making us the most interconnected network in the world. 4,620 of them are paying customers, roughly 60% of the exiting traffic from our network goes to those paying customers, about 40% of our exiting traffic goes to those 40 peers. Globally, we interconnect to other Tier 1 backbones and very large, supra-regional backbones. Many of those peers have been somewhat resentful of the type of customers that Cogent has attracted, particularly some of the over-the-top video operators. And as a result, they have been slower than they historically have been in increasing capacity. Today, we have no peer, which we have de-peered or have -- they have de-peered us and we have not had a significant de-peering since 2008. Because we carry nearly 20% of the world's traffic, I think it makes that option almost inconceivable for any major network. We have, in Europe, had discussions with regulators and it's public knowledge that the European Commission has started a formal investigation and raided the offices of 3 major European operators. We've had similar discussions with U.S. regulators and they are evaluating the procrastination that some of the access networks those peers have had to upgrading capacity because of over-the-top video. We remain committed to carrying all types of traffic. Our network traffic, in aggregate, is relatively balanced in and out across our network. But some of our peers have slowed down the rate of which they're willing to upgrade those connections because of the nature of some of our customer's business models, and we think that is wrong. In fact, we've had 1 particular peer call us up and say, "Please have your customer send our customers less traffic." And our response was, "Well, we can't do that. The only traffic that is exiting our network is -- to your network is traffic that was specifically requested by your customer base." So in general, I feel pretty good about where we are at on peering. We have more interconnection capacity than any other network in the world, and we're in a good, competitive position to see these connections continue to increase. Now switching over to your sales force question, we are accelerating the ramp in our sales force. As I mentioned on the call, we ended the quarter at 269 reps. Actually, since the end of the quarter, we've had significant hiring and are at an all-time high. Today, we have 304 reps hired, and expect that number to continue to grow. We do, however, expect our cost of revenue acquisition to remain extremely low and we do not anticipate any material increase in our sales cost. And therefore, our SG&A, in total, should remain flat on a going forward basis, allowing us to deliver that greater than 200 basis point quarter-over-quarter EBITDA margin expansion.


We'll take our next question from Tom Seitz with Jefferies.

Thomas O. Seitz - Jefferies LLC, Research Division

Two, if I could. Dave, I know you've been disappointed in the Corporate sales effort and you've changed leadership. But is there any possibility at all that the market for just raw bandwidth that you sell had just reached a point where the majority of the remaining tenants in any particular building want some level of managed services, and as a consequence, revenue growth is going to be -- is going to remain at this lower-level going forward just depending on the trajectory of the NetCentric business? I guess, do you need another hook, like a unified communications platform, potentially? And then, the second question is, customer concentration is increasing just a bit. Can we assume that that's Netflix?

David Schaeffer

Okay. So let me take the first one first. So the penetration in our Corporate buildings continues to increase, as well as the number of buildings. In the quarter, we saw our customer connections per building grow from 10.5 to 10.9 per building. Our Corporate revenue growth, sequentially, was 3.2%. So while it's still a little below where it's been over an 8-year period, it did pretty well and accounted for the majority of our growth. We do believe we can do better on that. That's, in fact, why I asked Jeff to lead the company a period of time ago and we conducted an extensive search. And that's a big part of Ernie's mandate as he comes on to help us grow the sales force and accelerate that rate of Corporate growth. We believe there is ample addressable market in our Corporate buildings for us to continue to grow our penetration per building. In existing buildings, we tend to add about 1.8 customers per building per year. We expect that rate to continue. Now we, ourselves, do not sell a unified communications product or a managed product, but we support hundreds of different providers of those unified services on top of our network. I think the trend for customers is almost the exact opposite of what you've outlined, Tom, which is, I think the customers like to be able to buy the bandwidth from 1 provider and then, either deploy their own applications or hire a specialist in the applications that they are working to provide. So we see great opportunity on the Corporate side, both to continue at a moderate pace to add buildings, and that is going to slow, and then, continue to see good increases in penetration in the building. On the NetCentric side of the business, it's clearly traffic growth and price declines that drive our revenue growth. We have seen continued improvement from our customers in terms of their utilization of the bandwidth that they purchased. I think we're near the end of that, so we expect to see that NetCentric part contributing as well to our top line growth, getting us, hopefully, to the midpoint of the guidance that we laid out. We feel pretty good about that. Now to the customer concentration topic. We generally don't name specific customers, but it is fair to state that our largest single customer is probably the largest provider of over-the-top video. We are their primary bandwidth provider and expect to continue to grow traffic with that customer, but also with a broad set of customers. We have over 37,000 customer connections. We have nearly 18,000 NetCentric customers, and we expect to continue to have a very diversified customer base. And in fact, if you looked at our top 5 customers, it's pretty evenly split between over-the-top content and large access networks who are downloading that content, most of that content being over-the-top video. So on the unit volume side, we expect over-the-top to be the primary driver of unit volume growth for the foreseeable future, and we expect both regional access networks to deploy -- rely on us for their upstream, as well as the publishers of that content to continue to drive our revenue growth. But I don't expect to see any material increase in revenue concentration.


We'll take our next question from Barry Sine with Drexel Hamilton.

Barry M. Sine - Drexel Hamilton, LLC, Research Division

A question on your CapEx strategy and what you're doing terms of your building expansion. I know you've said that you're looking to moderate that a little bit. Where are you going in terms of the new buildings that you're connecting, and then, how can we think about that? If I look at the ratio of revenue you're getting from on-net versus off-net, it's been relatively constant. Do you see an opportunity to put more traffic on-net and in so doing, increase margins?

David Schaeffer

Sure. Thanks for the questions, Barry. So first of all, the 122 buildings that we added to our network over the past 12 months, it was about equally divided between Corporate buildings in North America and data centers globally. We expect to continue to add about 60 data centers a year to our footprint, both in North America and internationally, primarily in Europe because that seems to be about the rate at which those new facilities are being commissioned and brought online. We need to be in that footprint in order to be available to serve our NetCentric addressable market. On the Corporate side of our business, we are very selective about the buildings we go into. We would look at the size, we would look at the proximity to fiber, we would look at the diversity of the customer base or potential customer base in a building as we make that investment decision. Today, we have about 1,333 multi-tenant office buildings connected to our network. Those buildings average about 550,000 feet with 51 potential customers. As I mentioned earlier, we have 10.9 in those buildings. We do expect to add additional Corporate buildings, but there's a very limited universe of buildings that meet our criteria that are not yet connected to Cogent. So for that reason, we expect that 60 or so a year on the Corporate side to continue to taper off and eventually go to 0 over the next several years. In our off-net business, we serve 4,700 customer connections in about 4,000 buildings or about 1.17 connections per building as opposed to the 10.9. It is not cost-effective for us to deploy capital and connect those smaller buildings with fewer potential customers that are farther from fiber. We instead have chosen to use that capital to return capital to shareholders. Going forward, you should expect to see our total capital expenditures moderate, as we've outlined in the past and it has, they have done for the past 4 years. And then, secondly, our mix of on-net and off-net to remain relatively constant.


We'll take our next question from James Breen with William Blair.

James D. Breen - William Blair & Company L.L.C., Research Division

Dave, just in terms of the numbers, when I was looking at the on-net revenue per connection and off-net revenue per connection, it seemed like on-net revenue on a sequential basis decelerated downward a little bit. And additionally, off-net had gone down probably more than it has in a number of quarters on a year-over-year basis. Can you just talk about the pricing in the off-net side? Obviously, you had good margins, so are you seeing both the costs, as well as revenue per unit coming down there? And that's what's allowing you to price at a lower point?

David Schaeffer

Yes, sure. So let me take the on-net side first. On-net ARPU did decline from $676 to $666, about a 1.7% sequential decline. And pretty much in line with the rate of decline that we've been experiencing. Actually, our Corporate ARPU increased slightly and what has happened is, we're getting a continued amount of smaller NetCentric connections pulling down that ARPU. And all of those numbers are derivable from the numbers that we give out publicly. On the off-net side, we actually were able to go in and negotiate a significant reduction in our 2 major off-net providers, circuit cost to us for Ethernet services as we are either their largest or one of their largest purchasers of Ethernet services in North America. And part of that is reflected in our reduction in cost of goods sold and therefore, our margin expansion. And some of that is reflected in our ability to sell the off-net Ethernet services at a lower price. Just to remind the attendees on the call, the goal here is for us, in any off-net product, to effectively double our cost of the underlying circuit, achieving a 50% gross margin in that product. And because we're paying less for the off-net circuit, we're able to pass some of those savings on to our customers and still see the margin expansion. We hope, over time, that the major off-net providers will continue to reduce their prices to us, allowing us to serve even a larger footprint. Because we are going to remain very disciplined about where we deploy capital as a company, bringing on-net only the very best buildings. But I wouldn't draw anything into it in terms of margins, hurting our margins. The lower prices, actually, are helping our margins.

Thaddeus G. Weed

Yes. And the off-net ARPU, if you look back -- let's say, we go back to the first quarter of 2010, back that far, it was about $1,250. And we saw that ARPU increasing through the third quarter of 2012, fourth quarter of 2012, and the mix of customers in there were key ones being replaced by Ethernet circuits. It's essentially, the base has kind of stabilized and it's primarily Ethernet circuits at this time so that's why we're seeing the off-net ARPU really stabilize, although we did have a 1.5% decline from the first quarter of 2013.


[Operator Instructions] And we'll take our next question from Frank Louthan with Raymond James.

Frank G. Louthan - Raymond James & Associates, Inc., Research Division

Can you comment a little bit on the Internet traffic trends, growing about 11% sequentially, that's down from maybe 18 in the first quarter and in the 20s in the fourth quarter. Any concerns in Internet traffic growth and your ability to -- do you continue to see the top line kind of hit your targets? And then, can you give us a little more color on the new head of Sales and any changes that he might be making to the overall sales quotas or approach to the business that will be different than in years past, and when we might start to see positive impacts from that change?

David Schaeffer

Yes, hey, Frank. Thanks. So first of all, we typically see, in the summer months, a deceleration in the rate of traffic growth. In fact, we have seen Q1 to Q2 actually be negative some quarters. So 11% is not a problem. Typically, Q2 to Q3 also tends to be a weaker quarter and we tend to see the stronger quarters in the cooler months. 93% year-over-year growth is actually the best year-over-year number that we've delivered since 2006. Now with that growth in traffic, so I'm not at all worried about growth in traffic. As I said, our customers did become more efficient in utilizing the bandwidth that they purchase, and our revenue growth was not as great as I would have liked it to be. Remember, traffic growth only impacts our NetCentric revenues, as our average Corporate customer buys a fixed connection and uses only about 12% of the connection that they utilize. So the 3.2% sequential growth that we delivered on the Corporate side really wasn't impacted at all by traffic growth. And quite honestly, the 93% year-over-year growth, which is the best we've had in 7 years, didn't really help us as much as I'd like it to on the NetCentric side. But I do think, going forward, we are going to see some pickup as those customers have reached kind of the technical limit of how efficient they can run their purchases to us. Now with regard to Ernie, we went through an extensive search. We were a bit frustrated that our sales force growth was not, in terms of headcount, was not growing as fast as we'd like. We saw some decent growth in the quarter going from 262 to 267. Ernie, just joined us at the first of this month. We are already up to 304 quota-bearing reps. So real good progress there. Ernie comes to us with a very extensive 20-plus year track record in the industry. And actually, had only worked at 2 companies over that entire period, roughly about a 10- or 11-year career in a number of senior positions at MCI. And then for the last, I guess, 10 years or 11 years of his career, has been in a number of positions at XO and actually led XO's sales force. Now that was a much larger sales force, selling a very different set of products, much more voice-focused. And I think he's bringing a lot of discipline in terms of managing a bigger and more geographically diverse sales force, and I think we'll benefit from. We've already implemented some changes in our training programs. From his short tenure here, we are reviewing all of our quota and hiring and management programs. And to be fair to Ernie, he's only been on the job about 10 days, so -- not even 10 days, so we got to give him a little more time to get his feet wet. But we fully expect to see both acceleration in the number of people, as well as acceleration in the productivity per individual. And we're doing that off of a record high in terms of productivity. So we feel pretty good about the changes he's bringing in. My guess is, you'll see the impact of that over the next several quarters.

Frank G. Louthan - Raymond James & Associates, Inc., Research Division

Okay, great. Just to follow up, with the high productivity per rep, it's definitely a positive. Is there any sign there that maybe you need to change the quota as things shifted or should we expect that productivity to grow? Or are we going to kind of -- you maybe have to make some changes, so just don't want to see an abrupt change in that, it was really more a function of a quota target change than, necessarily, a bad sign in the business. So how should we think about rep productivity that we'll see in the coming quarters?

David Schaeffer

Yes, nothing would make me happier than to pay every Cogent sales rep more because they are more productive. So the more they sell, the more we want them to make. And I think that's a good thing. I do think we are still the lowest cost of revenue acquisition in the industry. And we are continuing to focus on that cost of revenue acquisition, in large part, by making the individuals more productive that are here, as well as getting more individuals in seats. I do think there may be some quota adjustments. I think probably, the one thing that Ernie has identified quickly is we may need to do some work on the new hires and try to maybe give them either a longer ramp or a little more relief to get them more seasoned. We had been on a 3-month ramp and that may need to extend a little bit. And we also have a program that's been in place for some time, and I think we're going to continue, which says that every rep who achieves quota every 6 months that they're able to do that, gets an increase in their base salary. And that's helped us with retention in the most productive reps. So I think there's a number of tweaks that we're going to make to the sales model. But I do not anticipate any material increase in costs and I expect a gradual continued improvement in productivity.


And we'll take our next question from Michael Rollins with Citi.

Michael Rollins - Citigroup Inc, Research Division

A couple of things. First, I was wondering if we can get an update on the possible backlog of business you have to customers who are on promotion that might eventually come off and release some additional ARPU or some additional revenue into the business. Can that be a catalyst for the back half of the year, and is there a way for you to size that? And then, secondly, just taking a step back. Have you recently explored the idea of adding additional products to the portfolio beyond what you have today, trying to leverage all the customer relationships? I know in the past, when you've looked at this, you've stuck primarily to your core strategy. But any new thoughts on that subject would be great.

David Schaeffer

Hey, sure. Thanks for the questions, Mike. Let me start with the backlog. So we actually have the largest backlog of orders signed but not installed. Again, in the company history, by unit, it's nearly 2,000 on-net and just slightly over 1,000 off-net orders that are in the provisioning queue to be installed. So these are orders that will turn into revenue once they are activated. Secondly, on the promotions, I'm going to break it down to Corporate and NetCentric. So we are not running any, and have not run any, real aggressive Corporate promotions, probably, for the past 4 or 5 months. But we did have a promotion that allowed customers to have us effectively replace their existing provider and not double pay. So we were buying out contracts by providing free service for a period of time and then, that service would go to our standard rate once their current contract expired. And we are seeing some benefit from that program in the second quarter. And you'll see probably more benefit from that in the third quarter, and I think that was partially attributable -- one of the reasons that attributed to our 3.2% sequential Corporate revenue growth. And I think we do have a pretty good backlog of those buyout orders that are rolling off on the Corporate side. On the NetCentric side, we continue to run promotions but they are not general in nature but rather, targeted at specific carriers and specific customers. We picked up roughly 120 additional ASs [ph] connected to us this quarter versus last quarter, going from 4,540 to 4,660, almost 4,670 this quarter. So I think we're getting some good traction in getting our foot in the door with more accounts. Secondly, many of these customers have initially come in with no commitment to us and are now moving to committed products because they are sold at a lower price. So I do feel optimistic that on the NetCentric side, we should start to see some re-acceleration in revenue growth. But if I look of the quarter, quite honestly, the NetCentric side was the more disappointing side this quarter, even though I think the productivity improvements can be the greatest on the Corporate side. On the NetCentric side, we had good unit volume growth but not the revenue growth that I would have hoped for. But in general, I think we will see some re-acceleration. Now to the product side, that really impacts the Corporate business, not the NetCentric side because our Corporate customers use our bandwidth to run their voice applications, their video conferencing, their disaster recovery and their VPN services, whereas, our NetCentric customers are just buying bulk bandwidth to connect to the public Internet, either as an access network or as a content publisher. So on the NetCentric side, not a lot of product augmentation even possible to think about. On the Corporate side, we remain committed to being the most efficient bandwidth provider, and have no interest in providing additional services i.e., higher level applications. But as I had mentioned earlier, we intend to do that with hundreds of various partners or providers who provide the application on top of our network. The one significant product augmentation that I think will materially impact our Corporate customers is, we have always been willing to run tunnels for our customers for an additional $50 per month per connection on our network. Historically, those tunnels had been to build point-to-point VPNs, and the technology we used did not scale well for point-to-multipoint. Recently, there have been some significant router advances that have allowed us to deploy both new hardware and software at the edge of the network that are going to allow us to very aggressively roll out multipoint networks or fully meshed networks on a global scale. And we do think this is a service that our Corporate customers want. And it is a bandwidth service, so it will help us sell more connections and it will help us also generate those additional $50 a month per connection management fees. So it's not what I would consider a change in strategy of selling the application layer, but rather, just an extension of our bandwidth business and listening to our customers. We do have customers who want this multi-site functionality that, historically, we've provided with a bunch of point-to-point connections that had to be managed independently. Now with this ability to build a meshed solution, it kind of minimizes the amount of management the customer has, and we do think that's a significant augmentation to our product portfolio.


And there are no further questions at this time.

David Schaeffer

Well, again, I want to thank, everyone. We did pretty good on time. And again, hopefully, everybody is supportive, and we look forward to talking next quarter. Take care. Thanks.


This concludes today's presentation. We thank you all for your participation.

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