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Cogent Communications Group (NASDAQ:CCOI)

Q3 2009 Earnings Call

November 9, 2009 8:30 am ET

Executives

David Schaeffer – Chairman of the Board & Chief Executive Officer

Thaddeus G. Weed – Chief Financial Officer & Treasurer

Analysts

David Dixon – FBR Capital Markets

Jonathan Schildkraut – Jefferies & Company

Michael Funk – Bank of America Merrill Lynch

Colby Synesael – Kaufman Brothers

Tim Horan – Oppenheimer

Frank Louthan – Raymond James

Jonathan Atkin – RBC Capital Markets

Michael Rollins – Citigroup Global Markets

Welcome to today’s Cogent Communications Group third quarter 2009 earnings conference call. Today’s call will be available for replay after the conclusion of the call at www.CogentCo.com. As a reminder, today’s call is being recorded. At this time I would like to turn the call over to Mr. Dave Schaeffer, Chairman and Chief Executive Officer of Cogent Communications. Please go ahead.

David Schaeffer

Welcome to our third quarter 2009 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 were pleased with our results for the quarter in an improving but challenging economic environment. During the quarter traffic on our network grew by approximately 15% sequentially quarter-over-quarter and our revenues grew at a faster rate than most of our competitors. We continued to be encouraged by the increase of traffic on our network as well as our revenue growth. We continue to be optimistic about our outlook for the remainder of 2009 and beyond.

During the quarter we again significantly expanded our footprint by adding 32 on net buildings to our network and additionally by adding over 3,000 route miles of both metro and intra-city fiber to our network. We achieved another major corporate milestone in generating a quarterly operating income for the first time in our 10 year history. As we discussed on previous earnings calls in 2008 we extended a volume and term discount program to new Cogent customers as well as to our existing NetCentric customers if they increased their total contract value with us.

During this quarter this program continued to be successful. In the quarter this program resulted in over 716 NetCentric customers representing approximately $10 million of remaining contract value increasing their remaining contract value by an additional $10 million or 100% increase. Additionally, as more customers extend their contract terms and show their confidence in Cogent, our average contract length has continued to increase this quarter on a quarter-over-quarter basis by another 2.6%.

Throughout this discussion we will highlight several operational statistics that we believe demonstrate our increasing market share, expanding scale and operating leverage of our business. I will review in greater detail the operational highlights of our continued expansion plans. Tad will provide additional details on our financial performance and then following our prepared remarks we’ll open the floor for questions and answers. Now, I’d like Tad to read our Safe Harbor language.

Thaddeus G. Weed

This third quarter 2009 earnings report and this earnings conference call discuss Cogent’s business outlook and contain forward-looking statements within the meaning of Section 27A and 21E of the Securities Act. Forward-looking statements are based on 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 under takes no obligation to release publically 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 measurements in our earnings release and on our website at www.CogentCo.com. Now, I’d like to turn the call back to Dave.

David Schaeffer

Hopefully you’ve had a chance to review our earnings press release. As with previous quarters our press release includes a number of historical metrics. These metrics will be added to our website. Hopefully you find the consistent presentation of these metrics informative and helpful in understanding the financial results and the trends of our operations.

Our third quarter 2009 revenue was $60.2 million and represented an increase of 3.9% from our second quarter 2009 revenues of $58 million. Our revenue growth rate was significant greater than the announced growth rates of most of our competitors. In fact, many of our competitors continue to see sequential declines in their revenues. We evaluate our revenue based on product class on-net, off-net and non-core which Tad will cover and we also evaluate our revenues by type of customers.

Our customer types include two major groups our NetCentric customers and our corporate customers. NetCentric customers buy large amounts of bandwidth from us and datacenters. Corporate customers buy bandwidth in large multitenant office buildings. Our corporate customers at the end of the quarter represented 58.5% of our total number of customer connections. Corporate customers represented 47.2% of our revenues in the third quarter of 2009 and revenue from our corporate customers grew at 2.2% sequentially from the second quarter of 2009 to the third quarter of 2009.

Our NetCentric customers represent 41.5% of our total customer connections at the end of the third quarter 2009. Revenue from our NetCentric customers represents 52.8% of our revenues for Q3 2009 an increase of 5.4% from the second quarter of 2009. Fluctuations in foreign currency exchange rates materially impact our NetCentric revenues. About 30% of our revenues are derived from international operations. From Q2 2009 to Q3 2009 fluctuations in foreign exchange positively impacted our revenues by $880,000. On a comparable quarter however, looking at Q3 2008 to Q3 2009 fluctuations in foreign exchange actually resulted in a reduction of revenue of approximately $930,000.

Now for some overall highlights and trends, pricing and provisioning in our networks. Pricing for our most widely sold corporate product remains at $900 per month for a 100 megabyte connection or $9 per megabyte. We continue to offer discounts related to term contracts for all of our corporate and NetCentric customers. We also offer volume commitment discounts for our NetCentric customers. As I mentioned earlier, over the quarter 760 existing NetCentric customers took advantage of these volume and term discounts as well as many new customers.

These discounts for NetCentric customers contributed to a 7.3% reduction in our average price per megabyte of our installed base. In Q2 2009 that number was $6.82, in the third quarter of 2009 that number was $6.33. The average price for a new megabyte of sold services in the third quarter of 2009 was $4.82. One of our competitive advantages is our ability to rapidly install our on-net orders. We guarantee the installation of any on-net services in 17 days or less. In the third quarter our provisioning team consistently outperformed our guarantee and averaged slightly less than 10 days to install new services.

On-net ARPU declined however, at a much lower rate than we have experienced in previous quarters. On-net ARPU declined 2.8% from the second quarter of 2009 to the third quarter of 2009 due to increased contract NetCentric volume discounts and partially offset by the foreign exchange impact. Our on-net ARPU was approximately $1,010 in the second quarter of 2009 and $982 for the third quarter of 2009.

Our off-net ARPU continued to increase and increased by approximately 8/10ths of 1% as the size of our average off-net customer connection continues to increase. Off-net ARPU increased from $1,118 in the second quarter of 2009 to $1,127 in the third quarter of 2009. Substantially all of our international revenues are on-net so no variations in foreign exchange impacted our off-net ARPU.

Now, to discuss churn; our on-net churn rate actually improved to 2.9% for the third quarter as compared to 3.1% in the second quarter of 2009. As a reminder, we consistently report our churn numbers on a gross basis. As a result, as a customer remains with us but amends their Cogent contract, they are counted in our churn and are included in this churn rate. Moves, adds and changes are included. Our off-net churn rate also improved to 3% for the third quarter 2009 as compared to 3.2% in the previous quarter. Our churn rates have been impacted by our continued stringent monitoring of our customers collections and credit quality.

Traffic on our network continued to increase and increased by approximately 15% quarter-over-quarter. The increase in traffic was substantially greater than the 10% increase that we experienced Q1 ’09 to Q2 ’09 and much better than the comparable period last year when in fact our traffic grew Q2 2008 to Q3 2008 by 5%.

In these cost conscious times, we believe that as a low cost provider Cogent has a distinct advantage. We continue to anticipate growth in network traffic as more and more of our customers take advantage of our value proposition. Before Tad provides some additional details on the quarter, I’d like to address our results against our long term revenue targets and expectations.

As a reminder, we have previously announced we expect top line revenue growth of between 10% and 20% annually. For the third quarter, our revenues grew at 3.9% quarter-over-quarter or approximately a 17% annualized growth rate. This is well within the range we have forecasted. Now, I’d like to turn it over to Tad to provide some additional details on the third quarter 2009.

Thaddeus G. Weed

I’d also like to thank and congratulate our entire team on their hard work and efforts during the third quarter. I’ll begin with providing additional details on our revenue by product class which is on-net, off-net and non-core. With respect to on-net revenue, our on-net revenue was $48.1 million for the quarter and increased 3.4% from the second quarter. About 75% of our new sales in the third quarter were for our on-net services. Our on-net customer connections increased by 645 customer connections or by 4% from the previous quarter and we ended the quarter with about 16,600 on-net customer connections on our network.

Our revenues from our off-net business were $11.1 million for the third quarter and increased 5.3%. Off-net customer connections were flat at about 3,300 customer connections. Our non-core revenues were about $1.1 million and represent less than 2% of our revenues. EBITDA and gross margins; the operating leverage of our business continued to result in healthy growth in EBITDA margins. Our gross profit margin however declined by 150 basis points from the quarter from 57.7% from the second quarter to 56.2% for the third quarter. The decline was primarily due to an increase in investment in our expansion activities including an increase in seasonal power cost.

EBITDA as adjusted was $17 million for the quarter and increased 2% from $16.7 million for the second quarter. Our EBITDA margin declined by 50 basis points. The EBITDA margin was 28.2% for the third quarter and 28.7% for the second quarter. Quarterly lumpiness in the expansion of our gross margin and EBITDA margin can and does occur. If you examine our 18 quarters of quarterly metrics you will notice occasionally lumpiness in our quarterly gross margin and EBITDA margin expansion.

This lumpiness can occur due to seasonal factors such as the timing of the performance of certain professional services including audit and tax services and more importantly to the timing of our expansion activities. However, our long term trend is for increasing gross margin and EBITDA margin expansion and we expect that long term trend to continue.

Earnings per share; our basic and diluted loss per share for the quarter was $0.07. This was a significant improvement from the loss of $0.10 per share for the second quarter. Dave touched on foreign exchange, some additional details, approximately 30% of our business is outside of the US. For the third quarter of 2009 about 22% of our revenues were based in Europe and about 7% of our revenues were related to our Canadian operations. These percentages are similar to the percentages for the first and second quarter of this year.

Continued volatility in the Euro and Canadian Dollar to the US Dollar conversion rate impact our comparable quarterly revenues and financial results. The impact on our revenues was an increase of about $880,000 from the second to third quarter of ’09. However, if you look at the comparable quarters for 2008 it was actually a decrease of revenues of $930,000. The Euro to US Dollar rates were for the second quarter $1.36 and an increase to $1.43 for the third quarter. If you look back to the third quarter of ’08, the rate was higher at $1.50. The Canadian Dollar rate was $0.86 for the second quarter and increased to $0.91 for the third quarter but again, if you look back to the third quarter of 2008 it was $0.96.

Capital expenditures; our capital expenditures were $16.7 million from the third quarter, an increase from the $13.4 million for the second quarter. On a quarterly basis we can and have historically experienced seasonal variations in our cap ex and our construction activities. Our quarterly cap ex is in part dependent upon the number of buildings we connect to our network each quarter and to the timing and scope of our expansion activities including adding route miles to the network.

Typically we experience our lowest level of cap ex in our fourth quarter and we expect that to continue. We added another 32 buildings to the network in the quarter which was similar to the 34 buildings we added in Q2. However, we also added over 3,000 metro and intra-city fiber miles to our network during the quarter which is a material increase. We now expect to add the previous addition was about 100 buildings to the network and that has increased to about 120 buildings to our network and further increase our fiber miles for the remainder of 2009. As a result, our 2009 cap ex will be greater than our 2008 cap ex. The increase is due to acceleration of our expansion plan and expansion opportunities including the impact of adding more buildings to the network.

Cash, debt and the balance sheet; as of September 30 at quarter end our cash and cash equivalents were $51.1 million. We have about $92 million of the original $200 million of face value of our convertible notes remaining and those notes mature in June of 2027. The notes are reported net of their discount on our balance sheet at $65.1 million.

Capital lease obligations were $110 million at September 30 and about $10.8 million of that is a current liability. As a reminder, these obligations are entirely for long term dark fiber leases and are being paid over a remaining average period of more than 10 years. In October we entered in to a $20 million revolving credit facility that may be used for general corporate purposes, acquisitions and/or share or note purchases. We have not borrowed under this facility. We have $30.1 million of authorized purchases remaining under our existing stock purchase program and we did not purchase any shares during the quarter.

Days sales outstanding for our accounts receivables was 33 days at September 30, 2009 which was significantly better than our targeted rate of 40 days however, it did increase from our Q2 DSO of 27. I want to personally again thank and recognize our worldwide billing and collection team for continuing to do a fantastic job on customer collections and credit monitoring. In this economic environment we will continue to closely monitor our credit standards and our accounts receivable. While the DSO did increase, bad debt expense declined as a percentage of revenues. Bad debt expense was less than 2% of our revenues for the quarter, an improvement from the 2.4% of revenues from the second quarter.

Decreases in our average contract term which Dave mentioned increased about 2.5% from the second quarter and our credit monitoring activities have an impact on our future revenue performance under US GAAP. For example, an increase in our average contract term and estimated customer life results in a longer period over which to recognize non-recurring installation revenues. An increase in the amortization period results in a reduction in the recognition of revenues under US GAAP. Additionally, closer credit monitoring activities can result in the rejection of certain orders for determination of an account.

Operating cash flow; cash flow from operations was $14.8 million for the third quarter, an increase of 13% from the $13 million for the second quarter of ’09. Operating income, finally as Dave mentioned for the first time in our 10 year corporate history, we achieved positive operating income of $458,000 for the third quarter. One of our next corporate financial milestones will be achieving net income and positive EPS.

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

David Schaeffer

Let me take a moment and talk a little bit about sales force activity and productivity. We began the third quarter of 2009 with 230 quota bearing reps and ended the quarter with 250 quota bearing sales reps, an increase of 20 in the quarter. We hired 76 reps in the quarter which is the most we have ever hired in a single quarter. 56 reps left the company during the quarter. This number was similar to the 57 reps that had left the company in the second quarter of 2009. Our rep churn rate for the quarter improved slightly to 7.8% from the 8% in the previous quarter.

We began the third quarter with 214 full-time equivalent sales reps. Those reps that have ramped to productivity and ended the quarter with 215 full-time equivalent sales reps. Productivity on a FTE] basis for the third quarter was 3.8 per FTE] per month. The performance was relatively in line with our organic productivity rate. As a reminder, our sales rep productivity rates are not based upon contract signing but rather are based on delivered and installed services.

Now, to our network scale; we added 32 buildings to the network and have 1,421 buildings directly connected to our network at the end of the third quarter of 2009. In 2009 we now expect to increase our target for number of buildings to add to 120 for the year, approximately 20% more than we had originally projected. We now have over 12,900 miles of metro fiber and over 40,000 route miles of intra-city fiber on our network, an increase of over 3,000 miles from the second quarter of 2009.

We continue to evaluate additional dark fiber acquisitions for our ability to expand our network both in Europe and North America. Cogent remains one of the most interconnected networks in the world. This is critical because we sell Internet connectivity and that service is dependent on our connections to other networks. Today we are directly connected to over 2,840 other networks. We believe that our network has substantial available capacity to accommodate additional growth. We are currently utilizing approximately 19% of our lit capacity in our network.

In summary, traffic continues to grow on our network and revenues grow as well. In fact, we are growing both traffic and revenue faster than the market and our competitors demonstrating our increase in market share. We believe that Cogent is the lowest cost provider and it is our value proposition that is unmatched in the industry. Our pricing program has attracted many new customers, existing customers have increased their average volumes and contracts with us and our ability to grow revenues continues.

Our business remains completely focused on the Internet and therefore provides a necessary utility to our customers as the Internet becomes more critical to our customers’ businesses and their lives. We have a strong balance sheet compared to others within in our industry. We are putting some of our cash flow to work to expand our footprint and expand the number of markets we serve as well as expand our sales force.

We continue to be encouraged by the results of our sales initiatives and our ability to attract high quality sales representatives. We are committed to providing top line revenue growth of between 10% and 20% annually and to expand our both gross and EBITDA margins. With that, I’d like to open the floor to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from David Dixon – FBR Capital Markets.

David Dixon – FBR Capital Markets

Just a question on the pricing environment, if you could give us a sense of how we’re positioned today in the NetCentric base specifically? Some of the [inaudible] some more aggressive pricing there as well as some updates this quarter in terms of benefits that we’re seeing from some of the content players in the market. The secondly, if you could just delve in to the lowest price guarantee a little bit more for us? I wanted to understand the mechanics of this and in particularly trying to get a sense of the extent to which you have some flexibility there to reject some of these lower prices on the basis of non-comparable networks and how that’s determined? That would be very helpful. Thanks so much.

David Schaeffer

The NetCentric market is one in which we and other providers are selling a commodity based service. We offer the greatest amount of connectivity and capacity operating on a network on a non-oversubscribed and non-blocked basis. We have a standard pricing policy that prices services anywhere from $4 to $10 per megabyte depending on contract term and length. Occasionally we do offer special promotional programs either on a given period of time or in a given geographic region.

We remain the lowest cost provider. We believe that our price at $6.33 for our install base is at about 50% of where the market is. In addition to that, our average new sale in the quarter at $4.82 we believe is less than 50% of the average price in the market. We have seen situations a couple of times in this most recent quarter where we have offered lower prices in response to discounts from others. We have a policy where if a customer shows us an invoice from another tier-1 network operator, some other network operator that is offering global connectivity, we will beat that price and we did that a couple of times in the quarter.

We’ve actually seen a decline in the rate in which we’ve had to offer those very aggressive prices. If in fact, a customer provides us a price and it is not documented we will push back on them and request that they provide us documentation under a non-disclosure agreement because we have no intention of being in the business of negotiating against ourselves. Then finally, we are looking for networks that can provide the service so it really comes down to the locations in which the service is requested and the scope of the network. But, we remain the lowest cost provider and in fact, we have seen less competition as we’ve seen the number of companies that we actively compete with continue to decline.

David Dixon – FBR Capital Markets

Just to clarify then, that is where they would have to share an invoice from a tier-1 global provider?

David Schaeffer

That is correct.

Operator

Your next question comes from Jonathan Schildkraut – Jefferies & Company.

Jonathan Schildkraut – Jefferies & Company

A couple of things here Dave, first this was a pretty nice uptick in sequential traffic growth and I was wondering if there were certain things that drove the traffic to expand at the rate that it did whether it was seasonal, whether we were seeing some secular changes, uptick of online video or whether this was just kind of a continued market share shift? Beyond that if you can also kind of talk about the acceleration in the number of buildings that you’re adding to the network? I’m trying to get a sense of whether that’s being driven by opportunity that you see out in the market or whether you feel like you need to accelerate new business locations in order to maintain your growth rate?

David Schaeffer

First of all in regards to our rate of traffic growth, I think seasonally we do see acceleration in the fall and winter months for this. I stated last year that acceleration resulted only in a 5% sequential growth. Now, off a much larger base we grew at 15%. I think this is a result of some of the take-or-pay contracts that we had put in place earlier in the year. It also is a result of some business models getting real traction and therefore customers requiring a lot more bandwidth. We are continuing to see a proliferation and acceleration in the growth of various video business models.

The Internet is morphing from a symmetrical communications network to one that is delivering video competing with broadcast and cable networks for the distribution of that video content. We are seeing significant pickup from a number of customers that have various video business models and we are still at the early stages of that growth. I think the fact that our traffic grew at 15% and we actually saw an acceleration in the rate of growth in our NetCentric revenues as well shows that we are able to grow our revenues even in an environment where there is volume based pricing pressure.

We will continue I think to see further acceleration in traffic growth in the fourth quarter much as we did last year in the fourth quarter as well as that tends to be seasonally probably one of our strongest quarters historically. Now, to the building growth, we have chosen opportunistically to take advantage of the dislocations in the market both from suppliers of dark fiber as well as from construction companies that help us connect our network to the end buildings.

We chose to plow back in some of our additional cash flow to accelerate the growth in both of those areas. We added over 3,000 route miles to our network, that’s about a roughly 6% expansion in the network just in one quarter. We have been able to take advantage of the distress of other companies in the past by buying the whole companies. Our strategy has changed somewhat and now we are trying to just buy dark fiber as opposed to buying the whole company and then use our equipment to light that fiber. That’s in fact what we did in the quarter.

That did result in an increase in our rate of capital spending but we think this is transitory. Also, with regard to adding additional buildings, we have been very clear about the criteria that our buildings have. They either have to be large carrier neutral datacenters where we believe there is a sufficient addressable market or they are multitenant office buildings. To refresh the groups’ memory, the average building on our network is approximately 580,000 square feet, about 41 stories in height and approximately 51 tenants.

Today we have just under 590,000,000 square feet on-net that represents a corporate footprint of about 1/10th of 1% of the buildings in North America but in excess of 8% of all rentable office space in North America. We expect to continue this accelerated pace of building connections probably for the remainder of this year. As Tad said our capital spending will go down as we spent much of that capital and are finishing up the final connections. Then, we should expect to see that continued accelerated rate at least in the first half of next year.

Until we see a general improvement in the employment picture, we intend to take advantage of better pricing to accelerate our footprint expansion. To your growth question John, we will be able to continue our growth out of our existing footprint as in 2009 and each of our previous years over 90% of our growth in that given year comes from the preexisting footprint, that is the footprint that existed on the Cogent network at the beginning of the year. We expect that same trend in 2010 as most of our 2010 growth will come from our existing footprint and we are really looking to expand our addressable market with these route expansions as well as building expansions.

Jonathan Schildkraut – Jefferies & Company

Are you open to talk about who you picked up some of these dark fibers from?

David Schaeffer

We prefer not to disclose those. Today we have over 135 different suppliers of both metro and long haul fiber. Some of them are well known companies, some are companies we compete with, sometimes it’s a cable operator or a local utility as well as international governmental backed entities but I wouldn’t feel comfortable in exposing any specific names.

Operator

Your next question comes from Michael Funk – Bank of America Merrill Lynch.

Michael Funk – Bank of America Merrill Lynch

Two quick questions, for the on-net corporate revenue growth it appears there was a deceleration sequentially on that line. I don’t know if you could call out or highlight the impact of some of the term and the volume discount had on that if there was any? You mentioned some accounting impacts earlier. Then second, just on the share repurchase, clearly you’re choosing to invest your cash back in to the network over the next six months or so, as we think about the share repurchases given the accelerated or greater network purchases relative to the previous expectations?

David Schaeffer

A couple of points, first of all you are correct, our corporate on-net revenue growth did decelerate. We have seen a lengthening of the sales cycles. For the quarter, our corporate growth in aggregate was 2.2%. As Tad mentioned, we do account for the installation over a longer and longer period however, we did not see any material impact from that longer period of accounting. I mean, it was minor at best.

Our off-net corporate business continues to grow well as our average connection size increases. On the corporate on-net we have seen very little volume increases from corporate customers as the average corporate customer is using only about 10% of the capacity they purchased. So, the only decrease in ARPU from those customers is as a result of longer term contracts and as we said the contract lengths extended about 2.9% quarter-over-quarter and are slightly longer than one year now.

Now, with regard to the share repurchase, we do have approximately $30 million still remaining under our program. We do have additional availability with the line of credit that we have if we so chose to use that to purchase either debt or stock back but we believe in these turbulent economic times with unemployment over 10% that it is prudent for us to redeploy capital in accelerating the expansion of our network in to as large an addressable market as makes sense but also remain disciplined about where we will connect the network only going after the highest traffic locations.

I would expect for the short term to see us plow most of that capital back in to either the network or the sales force. As we sit down with the board each quarter we outline the uses of our free cash and the highest and best use continues to be to grow the sales force. After that we then look to divert cash in to the growth of the network and then only after we are comfortable that we have optimized those two growths do we look for a mechanism to return cash to shareholders. But, we are committed to not sitting on a large pile of cash but rather be efficient in either deploying it towards growth or to return it to shareholders as we’ve demonstrated in the past.

Michael Funk – Bank of America Merrill Lynch

One quick follow up if I could please, so the off-net corporate growth that was mainly due to existing customers adding more satellite offices or was that due to some of the newer on-net corporate customers coming on board with more off-net offices?

David Schaeffer

It was actually our number of connections was virtually flat so while we churned some customers, the customers that replaced them tended to buy larger connections and we also tended to see some existing off-net customers increase their connection size. What we are seeing in our off-net business is a significant acceleration of Ethernet off-net services. So previously our off-net products were TDM based either T1s or T3s and for some customers they would take multiple T1s as a bonded product.

As the local network operators increased the availability of point-to-point Ethernet services we then can purchase either 10 meg or 100 meg off-net loops, connect them in to our network and cost effectively offer IP transit over those circuits. The reason for the growth in that off-net revenue was the number of connections remained the same but the ARPU went up and the ARPU went up because the average connection size is getting larger. That’s both a combination of the natural evolution of some smaller customers churning and larger customers replacing them as well as some existing customers upgrading to larger connections.

Operator

Your next question comes from Colby Synesael – Kaufman Brothers.

Colby Synesael – Kaufman Brothers

Regarding the fiber purchases I think you mentioned 3,000 route miles purchased, considering that your network is mostly in the form of cap leases and dark fiber IRUs, is part of those purchases because you think that you may be losing other routes in the near future because of your contracts might be expiring so this is kind of to back fill that before that happens or is this truly just for route expansion? Then, I have another question after that.

David Schaeffer

Our average remaining IRU life is in excess of 20 years and virtually all of our IRU agreements, as I mentioned those agreements are with over 135 different suppliers, the fast majority of those agreements have extension rights in them. Most of those extensions actually come at no charge and give us the ability to exit if we so chose because of increases in operation and maintenance expenses. We do not anticipate any loss of fiber in the near term or even over the next 10 years from any of our existing IRUs.

What we are looking at is the ability to add new routes either for new markets to be served or to add additional redundancy to the network. Our network is built as a series of rings but as our traffic volume increases, it does make sense to potentially bifurcate these rings. Two great examples of that are here in North America where we have taken our western ring and cut it in half creating a west-west ring and kind of a Midwest ring. We’ve done the same thing in the east where we’ve bifurcated our eastern ring in to two rings. We’ve done similar things in Europe and in those bifurcations we also ended up picking up new markets as well.

Thaddeus G. Weed

To add Colby just one follow up there, the only route that has been cancelled if you will was back in Q1 of ’08 we had a route on one IRU agreement that was the only impairment that we’ve had on an [inaudible] in our corporate history. So, to answer your question the new routes are all expansion and we haven’t had any cancellation of routes really since that period.

Colby Synesael – Kaufman Brothers

My other question is you mentioned in your comments, I know this is a big part of just the Cogent strategy that you’re 50% below the market both for the install base as well as for new sale. Can you just explain to us or at least remind us what the benefit of being so far below the market is? In other words, if you were just 25% below the market, what is the concern that if that was what your strategy was – I guess what I’m getting at is can you remind us again why you’re so far below the market and what the advantage is and is there concern that these customers would no longer look at your services as valuable if you were to be just a little bit below the market?

David Schaeffer

In our pricing strategy we compete with other Internet service providers but there’s also a more global question which is the Internet’s competition with other forms of telecommunications and that is broadly defined to also include things such as DVD distribution via the mail. I think it is critical that Internet transit prices continue to fall in order to accelerate the adoption of these new business models and increase traffic growth on the Internet in its entirety.

In addition to that, it is I think a key part of Cogent’s strategy to continue to accelerate its gain in market share and you see that in either the amount of lit capacity we have, the number of routes that we’re carrying, the number of networks that we’re interconnected to and there is a natural advantage of continuing to gain scale over our competitors helping us further get down the price curve. So, I think the pricing model that we’ve adopted and continue to support helps us lower our cost of revenue acquisition and accelerate our gain in market share.

What we have seen is a pattern where a number of companies we compete with chose not to compete with Cogent not because they can’t compete but because they have other streams of revenue they are looking to invest their capital in to and kind of move up the value chain. It’s a constant refrain of service providers that they believe they want to move up the value stack. We at Cogent are very comfortable where we’re at, at the bottom of that value chain and we’ve demonstrated our ability to operate profitably, expand our margins and generate free cash in that portion of the kind of value gradation.

I think our pricing strategy continues to be one that helps us gain market share and lower our cost of revenue acquisitions. We think kind of the differentials we maintain are appropriate for those two goals.

Operator

Your next question comes from Tim Horan – Oppenheimer.

Tim Horan – Oppenheimer

Just out of curiosity how much do you pay for an Ethernet 10 meg connection versus T1?

David Schaeffer

Typically demanding on loop laying, a dry T1 and we are not a [inaudible] so we buy either under tariff or under negotiated contract. I would say the average T1 cost for us is in the neighborhood of about $150. That does not have the IP layer on top of it, that is just the raw point-to-point T1. Again, there’s a great deal of variance depending on loop laying. For the Ethernet services, the 10 meg Ethernet services can range anywhere from about $500 to about $1,500 and for 100 meg, which I know you didn’t ask but becomes fairly common, we see pricing of anywhere from about $800 up to about $2,500. All of those variances are dependent upon service territory and loop laying.

Tim Horan – Oppenheimer

Do you see customers putting more voice over IP over top of the Ethernet or other applications like existing private lines? Where are we in that process do you think?

David Schaeffer

I think there’s a long term structural change going on in the industry that all other technologies, whether they be frame relay, x25 or dedicated WAN services are migrating to IP and are generally put over a converged facility so voice continues to migrate to our network as packets running where the customer or a third party is running the VOIP service. Teleconferencing is another application for our corporate customers, disaster recovery and then obviously for our NetCentric customers it’s really their business models whether it be a social networking site, a gaming site, a video distribution site, all of those applications are only enabled by the public Internet which is IP.

So, I think over time Ethernet will become the dominate wide area interface just like it is already the dominate local area interface. IP becomes the common transport mechanism and I think the growth in traffic is coming both from new applications that previously didn’t exist as well as existing applications moving to our network. Today people consumer about 1/60th of their video over the Internet. The other 59/60ths are consumed via some other distribution mechanism. I think over the next few years it will be that increase in video consumption, so that’s not a new application but it’s rather the Internet, Ethernet and IP displacing other usually QUAM based delivery mechanisms as the primary way of delivering that content.

Tim Horan – Oppenheimer

On the pricing front, I was a little confused at what you were going at with your ARPU. Were you saying ARPU trends have improved substantially? It seemed they worsened a little versus second quarter. I know they’re a lot better versus third quarter of last year and I guess more importantly maybe roughly what do you think ARPU on-net is going to be going forward. Related to that, sorry for the long question, but the $4.82 on new sales pricing how has that been trending which I guess is kind of all tied in.

David Schaeffer

There’s really two different questions to focus on, the first question is the price per megabyte which is very relevant for understanding our ability to grow our NetCentric revenues and to remind you those revenues grew sequentially actually at an accelerated pace in this quarter of 5.4% quarter-over-quarter. That new price in the third quarter of $4.82 compares to a new sale in the second quarter of $5.05 so that is coming down but coming down at a slower pace than it previously has come down.

The install base is conversion to that lower price coming from $6.82 per meg in the second quarter to $6.33 in this quarter but that was more than offset by the volume increases resulting in that increase in NetCentric revenue. ARPU for on-net services combines corporate as well as NetCentric, it looks at the contract length, the volume and type of connection and is impacted by fx. It did decline by about 2.8% in the quarter.

I would expect that as NetCentric has increased as a percentage of revenues we should see that start to moderate and even head up. So, the average connection size gets bigger and the ARPU goes up. We actually have seen that happen in the off-net business about six quarters ago, about a year and a half ago. We had seen previously sequential revenue ARPU decline in that business but then we started to see it go up. The reason it went up was the average connection got bigger. We should start to see that as well on the on-net business.

Tim Horan – Oppenheimer

You think we can see that in the fourth quarter or is that more a 2010?

David Schaeffer

You know it’s really difficult for me to predict accurately. I feel more comfortable with a 2010 estimate than a fourth quarter estimate.

Operator

Your next question comes from Frank Louthan – Raymond James.

Frank Louthan – Raymond James

A couple of questions, just to clarify on the 3,000 route miles that you added, are those actually lit now? When you say you’ve added them, you bought dark fiber and you’ve actually lit them? Then, how many additional buildings do those 3,000 miles give you an opportunity to add to? Then the last thing is, can you give us an idea on verticals where you’re getting some traction or seeing any changes and what the top three customer verticals are that you’re selling to currently?

David Schaeffer

First of all, all 3,000 route miles are lit at this point in time and it’s actually in excess of 3,000. That is in fact part of the reason why the utilization rate in our network decline from 20% to 19% so while traffic grew our utilization rate actually declined because we were able to light these additional miles and it is a combination of both metro and long haul. Our network today serves approximately 1,420 buildings. It literally passes within 1,000 feet hundreds of thousands of buildings but many of those buildings do not meet our stringent criteria in terms of prospectively building in to them.

If we get a customer request for a building that doesn’t meet our requirement we will build in if the customer either guarantees sufficient recurring revenue or gives us a large non-recurring fee that would cover our cost of construction. That rarely happens because our sales force is really only focused on the lit buildings that we’ve prospectively built in to. So, while we connect to 1,400 pass hundreds of thousands I would expect there will only be a few hundred more buildings either datacenters or corporate that we will proactively connect to.

Now, with respect to verticals I’m going to answer that question both on the corporate and NetCentric side. On the corporate side, our verticals continue to be number one law firms, number two financial services companies and number three, general consulting. Those tend to be the most common types of business that locate in our addressable market. Remember, we tend to focus on the largest and usually the most expensive real estate in a given market. These have been our biggest verticals and will continue to be that.

On the NetCentric side, our business is actually divided almost equally between access network operators, so today we have literally dozens, multiple dozens of international phone companies that are our customers, we have hundreds of competitive carriers, we’ve got hundreds if not thousands of regional ISPs and cable companies as customers and over half of the universities and colleges in North America coupled with a large number of K through 12 systems. The access network operators account for about half of our NetCentric revenue.

The other half comes from a variety of content businesses and there it’s hard to pick any one business model. Some are social networking, some are purely video distribution models, some are major well known existing video producers, others are brand new video producers. It’s hard to pick a specific vertical inside the content other than video being the most common theme.

Operator

Your next question comes from Jonathan Atkin – RBC Capital Markets.

Jonathan Atkin – RBC Capital Markets

I wondered if you could talk a little bit about the seasonality that you saw during the quarter as well as any common [inaudible] in October on the traffic trends and sales force productivity as well as the sales reps that you hired, the 20 net new was that mostly on the corporate side or mostly on NetCentric?

David Schaeffer

I’ll let Tad take some of the seasonality on the cost side, I’ll take the rep and traffic question.

Thaddeus G. Weed

From the cost side I would say if you look at the two lines that are EBTIDA impacting so cost of goods sold and SG&A, on the cost of goods sold side a little seasonality with the exception of power costs, the remainder increase is associated with our expansion activities. If you look at the SG&A line, the seasonality impact there would be an increase in professional fees associated with audit and tax activities which are increased in the third quarter from the second quarter and the second quarter is also up from the first quarter. Absent that, not a great deal of seasonal impact on the cost components of EBITDA.

David Schaeffer

On the demand side and revenue side, the corporate business remains relatively steady on a year round basis. The NetCentric business is susceptible to increases in traffic and as we’ve stated in the past the Internet is primarily a northern hemisphere phenomena and much of that traffic growth occurs in colder months. We believe that you will continue to see an acceleration in traffic growth even though the base is getting larger.

While we do not disclose specific monthly trends, I will say that October has trended actually better than what we saw on average in the third quarter much as last year we saw a continued acceleration in the fourth quarter and first quarter in our rate of traffic growth and we should expect to see that even though the base is getting larger.

To the rep question, roughly two thirds of our reps are corporate, about one-third of our reps are NetCentric. The hiring that we did in the quarter mirrors that ratio as we have kind of a fixed regime of openings on a global basis. We’re looking to hire specific reps for specific offices and that roughly two thirds one third ratio will be maintained on a going forward basis.

Operator

Your final question comes from Michael Rollins – Citigroup Global Markets.

Michael Rollins – Citigroup Global Markets

I was just wondering if you can give a little bit of an update on I think there were take-or-pay contracts you described a couple of quarters ago in terms of you were looking to get some benefit in the ramp of revenue in the back half of the year?

David Schaeffer

We absolutely saw the benefit of that and that was in fact part of the reason for the traffic growth and the 5.4% sequential revenue growth in our NetCentric business. Those take-or-pay contracts did not really impact our corporate customers and will not on a going forward basis. This was not a new program instituted this year but rather part of Cogent’s normal business activity. We continue to sign those contracts in both the second and third quarter, we continue to see the benefit of those contracts that were signed either at the end of last year or the beginning of this year and we expect to be able to comfortably meet the top line revenue guidance that we’ve had in part because of these take-or-pay contracts. But, we often forward price customers who are testing new business models and give them the greater volume discounted price in order to help stimulate their business in exchange for a commitment from them to take additional bandwidth for a greater period of time. That trend remains intact.

Operator

We have no further questions at this time. I’d like to turn the call back over to our presenters for any additional or closing remarks.

David Schaeffer

Thank you all very much for taking time out on a Monday to join us. Hopefully you’re as pleased with our results as we are and we expect to continue to see both growth in traffic and revenue along the same lines as we’ve delivered this quarter. Thank you all very much.

Operator

That does conclude today’s call. Thank you for your participation.

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Source: Cogent Communications Group Q3 2009 Earnings Call Transcript
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