How's Shutdown Impacts Cogent Communications

Jan.25.12 | About: Cogent Communications (CCOI)

By now most people have heard of the FBI's shutdown of, a file-sharing site which was also often used by users to upload and download pirated content. As Megaupload used Cogent Communications (NASDAQ:CCOI) as a bandwidth provider and additionally rented Cogent's servers based in the U.S., the FBI had grounds for shutting down Megaupload, and late last week, with warrants in hand, raided Cogent's facilities to retrieve data about Megaupload.

With Megaupload taken down, internet traffic worldwide dropped by a whopping 4%, as bandwidth-intensive video from Megaupload ceased to exist. As a large customer, Cogent received about $1 million a month from Megaupload for providing the bandwidth for Megaupload. Prior to this, 16% (about one-sixth) of the world's internet traffic went across Cogent Communication's network. Now it will probably be closer to 12%. Last Friday, Cogent's stock dropped $3.51 on the news to close at $15.30.

The indictment shows that Megaupload paid Cogent about $13 million in 2010, which is about 4.9% of Cogent's 2010 revenues. As Cogent's 2010 10K says, no single customer counted for more than 4.9% of revenues, but it's clear that Megaupload was that biggest customer in terms of revenues in 2010. With Megaupload's payments being roughly constant at $1 million per month, and that being about 4% of Cogent's revenues of $77 million in the last reported quarter, it's likely Megaupload still accounted for 4% to 5% of Cogent's 2011 revenues before they were shut down. That's a large hit for a company with operating leverage as high as Cogent's--roughly $3 million per quarter less in future revenues will find its way to Cogent, resulting in a substantial reduction in Cogent's net income.

Determining the impact to Cogent is relatively straightforward--quantify the net present value of the likely lost revenue stream and that's how much Cogent's value as a company should be reduced, just like any other investment, project or cash flow stream is valued. The net present value is how much the loss of future cash flows from Megaupload would have been worth today, keeping in mind that future cash inflows are discounted by an appropriate annual rate.

We do have some information which allows a rough guess. In previous conference calls, Cogent's CEO, Dave Schaeffer, said that the average customer stays with Cogent for 42 months. On average, that would mean that any current customer will stay with Cogent for roughly 21 months into the future. My guess is that since Megaupload appeared to be very profitable, they would have stayed significantly longer than average, but that was information neither I nor the market would have known, so roughly two years seems appropriate.

For an annual discount rate to use in the net present value calculation, it doesn't matter too much, since we're only calculating two years out, but it's worth coming up with an estimate anyway. For the calculation using the capital asset pricing model, I'm going to throw out Yahoo!'s estimated beta for Cogent of 0.87 because, although the stock has been more stable over the past year, it may be that Cogent's anticipated stock buyback of up to $175 million is keeping the price more in line. I'm going to estimate a much more volatile beta of 2.0 if Cogent had no debt. That gives about 13% for a cost of equity; 13% is probably a good guess of a discount rate to use to account for the risk in the revenue stream from Megaupload.

Based on the above, the loss to Cogent of two years of Megaupload's revenues at $13 million per year and an annual discount rate of 13% would be about $23 million, with the brunt of the loss being taken by the common shares, or about $0.50 per share. That means holding everything else constant and in an efficient market, the news of the loss of Megaupload's business should result in Cogent's stock price being reduced by somewhere around $0.50. The financial hit isn't nearly as bad as the traffic hit of the nearly 50 petabytes per day of data which Cogent delivered, now reduced by around one-fourth.

That said, there may be concern that a domino effect may occur as a result of the FBI's shutdown of Megaupload, either by additional FBI raids, by bandwidth customers with pirated content moving to service providers located outside the U.S. to lessen the chance of being shut down by the U.S. Department of Justice or by other shifts in traffic. We'll have to wait to see what plays out and what impact that may have. No shift resulting from the FBI's shutdown of Megaupload would likely be positive for Cogent's revenues, though it would be hard to visualize that any additional resulting fallout could be worse than Megaupload's shutdown, which immediately took 4% of the world's internet's traffic with it.

Although there may be other repercussions of the Megaupload shutdown, my own guess is that the 20% drop in Cogent's stock last Friday was not directly related to that event. Cogent has historically been a volatile stock and recently hit a new 52-week high. It's not surprising to me that the news of the loss of a large customer would have catalyzed some volatility in the stock price.

Disclosure: I am long (CCOI).