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Cogent Communications Group, Inc. (NASDAQ:CCOI)

Q2 2008 Earnings Call

August 8, 2008 8:30 am ET

Executives

Dave Schaeffer - Chief Executive Officer

Tad Weed - Chief Financial Officer

Analysts

Jonathan Atkin – RBC Capital Markets

Frank Louthan – Raymond James

Jon Schildkraut – Jefferies

Tim Horan – Oppenheimer

David Dixon – FBR Capital Markets

James Breen – Thomas Weisel Partners

Tom Watts – Cowen and Company

Andrew Beale – Arete Research

Operator

Welcome to the Cogent Communications Group second quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the conference over to Dave Schaeffer, Chairman and Chief Executive Officer of Cogent Communications.

Dave Schaeffer

Welcome to our second quarter 2008 earnings conference call. I am Dave Schaeffer, Cogent’s Chief Executive Officer. With me on this morning’s call is Tad Weed, our Chief Financial Officer. Overall we are relatively pleased with our results for the quarter. While our revenue and EBITDA did not exceed our second quarter guidance we continue to grow our on net revenues and our EBITDA margin expanded at a record level of 270 basis points, the greatest margin expansion ever in the company’s history in a given quarter.

During the quarter we further expanded our revenue and sales productivity initiatives, reemphasized our position as an industry price leader by expanding our volume base contract discount program to our NetCentric customers. We ended the quarter with over 200 sales representatives and we have lowered our sales force turnover rate.

We are extremely pleased with the initial results of these initiatives and continue to invest in the improvements of our sales organization. During the quarter we announced an increase in our stock buy back program of an additional $50 million with a purchase authorization through the end of the year. In the second quarter we returned over $28 million to our shareholders by purchasing a total of approximately 1.8 million shares at an average price of $15.20.

As of today we have approximately $40 million remaining available under our buy back plan. Through yesterday and since June of 2007 under our total of $150 million of combined stock buy back programs we have purchased a total of 5.3 million shares of our common stock for approximately $110 million. These purchases represent over 10% of the outstanding shares in the company when these programs began.

Throughout these discussions as in the past we will continue to focus on our results and impact of on-net business which accounts for approximately 82% of our revenues. We will highlight several operational statistics that we believe demonstrate our increasing market share, expanding sale and the operating leverage of our business.

I will review with you certain operational highlights; also outline the results to date of our revenue improvement and sales productivity efforts and our continued expansion plans. Tad will provide additional details on our financial guidance. Tad will also walk through our guidance for the third quarter of 2008 as well as update and modify our guidance for full year 2008.

Following our remarks we will open up the floor for questions and answers. Now I would like to ask Tad to read our safe harbor language.

Tad Weed

This second quarter 2008 earnings report and this earnings conference call are to discuss Cogent’s business outlook can contain forward looking statements within the meaning of Section 27A and Section 21E of the Securities Act. The forward looking statements are based upon our current intent, belief and expectations. These forward looking statements and all other statements that may be made on this call that are not historical facts are subject to a number of risks and uncertainties and actual results may differ materially.

Please refer to our SEC filings for more information on the factors that could cause actual results to differ. You should also be aware that Cogent’s expectations do not reflect the potential impact of mergers, acquisitions, other business combinations or financing transactions that may be completed after today.

Cogent undertakes no obligation to release publicly any revisions to any forward looking statement made today or otherwise update our supplement statements made on this call. Also during the call, if we use any non-GAAP financial measures as defined by the SEC and Reg G, you will find these reconciled to GAAP measurements in our earnings release and on our website at CogentCo.com.

I’ll turn the call back over to Dave.

Dave Schaeffer

I’d like to give you some highlights of our second quarter results. Hopefully you’ve had a chance to review our earnings press release. As with in previous quarters our press release includes a number of historical metrics. These metrics will be added to our website. Hopefully you will find these metrics informative and help you better understand our financial results and the trends of our operations. As always, if you have any suggestions on the metrics that you’d really like to see added or refined, please let us know.

Our second quarter 2008 revenue was $53.9 million. This was 1.1% below our guidance target of $54.5 million. Revenue increase represented a 3.4% increase over revenue in the first quarter sequentially and a 19.4% increase over our revenue in the second quarter 2007. EBITDA, as adjusted, of $16.6 million was 2.4% below our guidance for the quarter of $17 million. This EBITDA increase represented a 13.5% increase in EBITDA over the first quarter 2008 and a 50% increase in EBITDA over the second quarter 2007.

Our loss per share of $0.12 was within our guidance range of $0.08 to $0.12 per share. This loss was impacted by our share repurchases throughout the quarter. Having less shares available concentrated that loss in fewer shares.

Despite a 1% decline in traffic on our network quarter over quarter since last quarter our on-net revenue in business grew by 3.3% in the first quarter and by 25.3% from Q2 2007. We believe that this revenue growth continues to be greater than the revenue growth rates of our competitors. On that revenue was approximately 82% of total service revenue for the second quarter, essentially unchanged as a percentage of revenue from the first quarter.

Approximately 85% of our new sales in the quarter were for on-net services. Our on-net customer connections in the quarter increased sequentially by 5.5%. Revenue from our off-net business also increased by 5.8% quarter over quarter and our on-core revenues declined for the same period by 9.2%. The off-net quarter to quarter revenue growth was consistent with our guidance for off-net revenue growth of over 5% and the highest off-net revenue growth rate we have experienced since the first quarter of 2005.

I’d like to take a moment and talk about pricing. Since our inception Cogent has been committed to being an industry price leader. We intend to remain committed to that policy. In the second quarter we reemphasized our price leadership position by initiating additional discounting structures that included volume based discounting as well as additional contract term discounts for customers taking multi-year contracts of greater than two years in length, in particular three year contract discounts.

In May of 2008 we completed a pilot test program where we offered volume based discounting to certain NetCentric customers. We were very encouraged by the results of that program. As a result on June 2, we expanded this program to include all new Cogent NetCentric customers and to existing NetCentric customers who increase their total contract value with us.

Let me take a moment and define that increase in total contract value. This is the number of months remaining under which a customer has an existing contract times the monthly recurring revenue that they are contractually obligated to spend. Under this program and with the assistance of our other productivity initiatives we are encouraged by the results of our June and July activities and the increase in sales force productivity.

Pricing for our most widely sold product remains at the $1,000 a month for our month to month 100 megabit products or $10 a megabit. Discounts are available related to contract term as well as volume for our NetCentric customers. Our average price per megabit of effective sold traffic remains at about $9.00 per megabit when these programs are taken into account.

The NetCentric pricing discount program did not and does not impact our corporate customers. Our corporate customers represent over 60% of our total customers and actually 44% of our revenues are today derived from our corporate customers. This is up from the 42% of our aggregate revenue that was the result of our corporate customers in the first quarter.

Our provisioning cycles remain consistent. We remain guaranteeing our customers 17 business days to provision on-net services. In the second quarter our provisioning team again delivered better results in provisioning our on-net customers at an average of 10 days.

Traffic, as I mentioned earlier traffic declined on the network by 1% for the full quarter. Traffic did increase in the months of May and April each by about 1% but then in the month of June we saw a significant decline in traffic of approximately 3%. First, we have a significant concentration in university and K-12 customers and due to the seasonality of traffic requirements, not revenue spend by those customers we saw a decline in traffic. Secondly, we saw a series of video and social networking sites who exhibited much more modest traffic growth than they previously had been exhibiting.

Now I’d like to talk about our ARPU. ARPU for our first quarter on net customers was approximately $1,239. That did decline to $1,210 in the second quarter a decline of approximately 2.3%. ARPU for our off-net customers continued to increase. Off-net ARPU increased from $890 in the first quarter of 2008 to $940 in the second quarter 2008 an increase of approximately 5.7% due primarily to off-net customers taking larger connections.

Total on-net churn remained consistent at about 2%. On-net churn is at the same rate that we have experienced for the past two years. Off-net churn also remains consistent at approximately 2.5%.

Contract terms, during the quarter we again extended our average contract length by approximately 3%. Our customers are entering into longer term contracts as they are more and more confident with Cogent’s quality and expressing their commitment to Cogent and the value that we deliver. We anticipate further increases in our average contract length due to the expansion of our term discount program.

Tad will now cover some additional details related to our second quarter results. Tad will also provide guidance for third quarter 2008 as well as update our full year guidance for 2008.

Tad Weed

I’d like to thank our team on their hard work and efforts this quarter. EBITDA and gross margin as Dave mentioned EBITDA is adjusted with $16.6 million for the quarter that was an increase of 13.5% from the $14.6 million for the first quarter. The EBITDA margin expanded by 270 basis points from 28.1% to 30.8% for the second quarter. The margin expansion was better than our guidance of 200 basis points.

Gross margin decreased by 50 basis points for the quarter. Our second quarter gross margin was 57.4% compared to 57.9% for the first quarter. The decline was in part due to our revenue mix and increased cost of goods sold related to our data centers. Our direct incremental on-net gross margin continued to be almost 100% with direct incremental on-net EBITDA margins of about 95%.

Our loss per share basic and diluted common share of $0.12 was within the range but at the high end of our range of $0.08 to $0.12 a share. On-net, our net loss and loss per share for the quarter was impacted by a combination of less cash from accelerated share repurchases and a reduction in interest rates on our invested cash and as Dave mentioned, fewer shares outstanding due to share repurchases. Each of these factors increased our loss per share by about $0.015 per share from our plan for the quarter.

Our weighted average shares decreased by about 870,000 shares as a result of shares purchased under our stock buy back program. We purchased 1.8 million shares in the second quarter for $28 million and our plan for the remainder of 2008 anticipates and includes the estimated impact of additional share repurchases.

Non-cash equity based comp expense for the quarter was $4.2 million or $0.09 a share. That amount was slightly less than our guidance of $4.5 million for the quarter. Depreciation and amortization was $15.8 million which was consistent with our guidance of $16 million. The Euro to Dollar conversion rate positively impacted our comparable quarterly revenues by about $500,000.

For the second quarter 2008 about 23% of our revenues were based in Europe and 8% of our revenues are related to our Canadian operations. These geographical percentages for our revenue mix are consistent with the percentages we have experience since the fourth quarter 2007.

CapEx totaled $9 million for the second quarter versus $9.8 million for the first quarter. On a quarterly basis we can and historically experienced seasonal variation and lumpiness in capital expenditures and construction activities. Typically we experience our lowest level of CapEx in our fourth quarter. We continue to expect our 2008 CapEx to be approximately $30 million.

At June 30, on balance sheet items, our cash and cash equivalents total $129.2 million. Capital lease IRU obligations totaled $105.4 million at June 30, and about $8 million of that is a current liability. These obligations are paid over remaining weighted average life of more than 10 years. Our day sales outstanding for worldwide accounts receivable continue to improve and was only 32 days at June 30, significantly better than our target of 40 days, an improvement from the 34 days at the end of March.

It seems that every quarter I need to mention this, but again I need to personally thank and recognize our worldwide billing and collections team for doing a great job on customer collections. Operating cash flow, cash flow from operations improved by 24% and was $14.2 million for the second quarter with $11.5 million for the first quarter.

Now I’m going to provide guidance for the third quarter 2008 and update our 2008 guidance with apparent guidance based on the current and expected run rates of our business. Our guidance also includes the estimated impact of our share repurchase program, planned increases in sales and marketing programs and the estimated impact of our current and anticipated network expansion projects and current traffic trends.

For the third quarter 2008 we expect our total revenue to be over $55 million. From the second quarter to the third quarter the components of revenue are expected to change as follows. We expect on-net revenues to increase by over 2%. We expect off-net revenues to increase by over 5% and we expect non-core revenues to continue to decline by approximately 15%.

We expect EBITDA to be over $16.5 million for the quarter. We expect non-cash equity based comp expense to be about $4.5 million. We expect depreciation and amortization to be about $16 million and we expect net interest expense to be about $2.5 million which is reflecting a lower interest rate on invested cash and the additional estimated share repurchases.

These results are expected to result in a loss per share of between $0.10 and $0.15. Our loss per share assumes $44 million weighted average shares outstanding for the quarter. For the year of 2008 we’re updating the previously released estimates for the year. Total revenue for 2008 is now expected to be over $218 million, our previously released guidance is between $225 and $235 million.

We expect the following annual revenue growth rates from 2007 to 2008, on-net revenue growth of approximately 22% our previously issued guidance was an increase of approximately 30%. Off-net revenue growth of approximately 5% to 10% that’s unchanged from the previous guidance and non-core revenue declined to 35% to 40% is also unchanged.

We expect EBITDA as adjusted to be over $65 million, the previous range was $75 to $80 million. We expect net interest expense to be between $7 and $8 million from our previous estimate of $4.5 to $5.5 million, again, impacted by less cash due to share repurchases. Due to these changes we expect our 2008 loss per share to be between $0.50 and $0.60 a share. Our previous estimate was $0.20 to $0.30 a share. Loss per share estimate assumes about 45 million weighted shares outstanding. The previous estimate was 46 million weighted average shares outstanding.

Due to these revisions we no longer anticipate achieving positive net income by the fourth quarter 2008.

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

Dave Schaeffer

I’d like to take a moment and talk about sales force productivity. We began the second quarter of 2008 with 190 quota bearing sales reps and ended the quarter with 208 quota bearing sales representatives. We hired a total of 59 sales reps in the quarter, the most reps we have ever hired in a single quarter in the company’s history. Forty one sales representatives left the company during the quarter or were promoted to management positions, down from the 54 sales individuals who left the sales role in the first quarter.

This improved our monthly sales force churn number to about 6.9% per month in the second quarter. We began the second quarter of 2008 with 156 full time equivalent sales representatives and ended the quarter with 177 full time sales representatives. As of yesterday, we had 221 quota bearing sales reps selling our services. We have added additional tools and resources and continue our disciplined approach to monitoring our sales force productivity.

On a full time equivalent basis our sales force productivity per FTE was approximately 3.4, this was less than the 3.6 that we had experienced in first quarter. As a reminder these rates are customer installations and are not necessarily directly correlated to immediate sales activity because of the lag of 10 business days between sales and installations for on-net and about 30 days for off-net services.

As mentioned on the last call we have taken a number of measures and steps to improve our sales force performance and rep productivity. We expect to continue to see improvements from those initiatives. As an outlook we will continue to add sales reps in 2008. At the pace we are currently at in reps we now expect to have a total of 250 quota bearing reps by the end of the year, an increase from our previous forecast of 240 sales representatives by year end.

With regard to our footprint and our scale, we added 27 buildings in the second quarter 2008 to the network bringing our total footprint to 1,274 buildings on the network as of the end of the quarter and that is defined as fiber connectivity into the building all the way to the customer. For 2008 we expect to fulfill our goal of adding 100 buildings to our network and for the first six months of 2008 we have added 57 buildings toward that objective.

We have secured additional fiber and construction continues in expanding our network. We have added additional markets such as Tulsa, Oklahoma, Munster, Germany, Malmo, Sweden, Basel, Switzerland and Berne, Switzerland to the network. We continue to add additional markets and we continue to evaluate different routes and new extension opportunities in Europe and in North America.

The scale and size of our network continues to grow. We now have over 12,000 fiber miles of metro connectivity. We have over 32,000 inner city route miles or fiber. We are directly inner connected to approximately 2,400 networks throughout the world; approximately 330 of these networks are settlement free peers. The remaining connections are Cogent customers. We believe that our network has substantial available capacity to continue to accommodate our growth plans. We are currently and consistently utilizing approximately 21% of our network unchanged from the previous quarter.

In summary, our on-net revenue, our growth business continues to grow and is growing at a rate greater than our competition albeit slower than it has for Cogent previously. Cogent is the low cost provider and our most recent pricing changes emphasize this position in the market. We have revised our 2008 plan to reflect traffic growth rates, the stock buy back program and the expected increases in our sales force.

Our business remains completely internet based and internet focused and we believe that we are isolated from the current economic turmoil. Our business provides a necessary utility to customers. Our simple product set and limited number of SKUs allow us to continue to surpass our 17 business day provision guarantee of all on-net services.

We have a very strong balance sheet especially when compared to others in our industry. We have $67 million of true debt. During 2008 we intend to increase the lid capacity and our IP network by approximately 60% all within the 2008 fiscal year capital budget of $30 million. Under our revised 2008 guidance plan we now expect to generate approximately $0.80 a share free cash flow to the benefit of our equity holders. This is down from our previous estimate of approximately $1.00 per share of free cash flow.

Finally, we continue to be extremely encouraged by the recent results of some of our sales force productivity initiatives and our volume based pricing program. For the month of July we sold over 200 customer connections to existing NetCentric customers under this program. The total contract value to those 200 existing customers increased by greater than 100% and resulted in approximately $10 million of additional contract value for Cogent. This continues to demonstrate the wisdom of the plan that we put in place.

I’d like to now open the floor for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jonathan Atkin – RBC Capital Markets.

Jonathan Atkin – RBC Capital Markets

With regard to ARPU can you comment on the ARPU you’re seeing from customers that have taken advantage of the new pricing that you introduced on a wide scale basis in June?

Dave Schaeffer

We have actually seen an increase in ARPU from those customers taking advantage of the new volume based pricing. That ARPU increase came from both existing customers as well as new customers taking advantage of that program. However, we saw an increase in the percentage of our business that comes from corporate customers. Corporate customers increased from 42% to 44% of our total revenue. Corporate customer ARPU is substantially lower than that of our NetCentric customers and that was the primary reason for the reduction in ARPU.

Our corporate business remains extremely strong and is not impacted by the traffic trends because our average corporate customer is utilizing only approximately 8% of the bandwidth that they purchase and traditionally does not come back and buy more bandwidth at a same location but can increase their purchases from Cogent by taking additional locations.

Jonathan Atkin – RBC Capital Markets

Can you also give us a refresh on the mix of new revenue coming from existing customers versus new logos? In the revised guidance what are your assumptions on that mix going forward? A question about the expansion that’s been ongoing and continues, particularly the new long haul route of the lateral. Are the revenues that you’re seeing along the new route meeting your expectations? Is the revenue growth there disproportionately higher or low, did it take a while to ramp up the revenues along those new routes.

Dave Schaeffer

Two very different questions. In terms of existing customers taking additional business with Cogent, on the corporate side that rate of mix has not materially changed, with approximately 30% of incremental revenues in a given month coming from an existing customer and approximately 70% coming from a new customer.

For our NetCentric business, however the cost of the slow down in traffic the percentage of business that we are getting from existing customers has declined to only about 15% of incremental business with about 85% of business coming from brand new businesses that do business with Cogent. I think this is a result of those companies taking less bandwidth because they’re underlying businesses are not growing at as fast of a pace.

Shifting gears and looking at the route expansion strategy. Cogent has always been focused on the largest and most desirable pockets of traffic that are economically served. We go through a detailed analysis as we evaluate new route opportunities. We look for existing customers who will purchase more in those markets as well as customers who have expressed interest in Cogent services but have not been able to connect to us because of a lack of inner connect facilities to get to a Cogent point of presence.

We also evaluate whether or not the fiber that would be let is in our inventory which does exist in some cases or needs to be purchased and then finally we evaluate the addition of the new market in enhancing the quality of service to the entire base by increasing Cogent’s level of inner connectivity. As I mentioned Cogent’s network inner connectivity increased by about 5% in the most recent quarter going from approximately 2,300 networks globally to 2,400 and those have an impact on the entire organization and all of our customers.

All of those factors weigh into our evaluation of new markets. We expect this to continue but at a slower pace than it has been in the past. We also do expect to continue to add buildings at a comparable pace at least for the next several years.

To your question of revenue production on these new routes, many of the routes are very new. That revenue production is lumpy. Some of the routes have brought revenue on faster than we have anticipated, others have been slower. Some of the more Eastern European countries tend to have a little bit more regulatory burden in terms of dealing with customers and being able to get those customers to quickly move to Cogent.

In some cases customers sign orders but we have not been able to provision them as quickly because they need certain types of regulatory approvals to connect to us. All of these factors have created a situation where some markets have developed new revenue slower than we’d like, others may be a little bit faster but on balance we think our strategy has been correct and will remain effectively consistent.

Operator

Your next question comes from Frank Louthan – Raymond James.

Frank Louthan – Raymond James

Looking at your business, obviously you’re growing your percentage of corporate customers, does that also imply that’s where you’re seeing some mix shift that’s putting pressure on margins as those corporate customers are more and more off-net. Can you give us an idea of how quickly the traffic has been falling off and remind us what the traffic growth was in Q1 and Q4. When did you start to see this traffic fall off and what’s been the experience with some of your larger embedded customers so far this quarter, has that continued to get worse or is that stabilizing, what are the thoughts there?

Dave Schaeffer

Two very different questions. In terms of margin pressure we delivered the largest sequential EBITDA margin expansion quarter over quarter in the company’s history. It is unrealistic to expect 270 basis points of EBITDA margin expansion quarter over quarter. We have told investors to think of Cogent as delivering about 100 basis points quarter over quarter, we did about 500 basis points for the past four quarters and we will expect to continue to do that going forward.

On the next quarter we have guided to lower margin expansion rates simply because we had such great performance in the most recent quarter and quite honestly not sure it can continue as well as we have some seasonally expected costs particularly on the cost of goods sold line where our data centers are now all being built at summer power rates which on a per megawatt basis for the locations in which we directly buy the power as opposed to a third party are seasonally impacted and generally charge a higher rate.

Corporate customers do generally generate less margin because we have the cost of the local loop. Our corporate business that is off-net has increased which has also dampened the rate of margin expansion. Our corporate on-net business has identical margin characteristics to that of our NetCentric business which is a 100% incremental gross margin and 95% incremental EBITDA margins. We expect those types of margin expansions to continue going forward as we add additional customers.

Let me shift gears and focus on the traffic question for you. In terms of traffic, one we saw in both April and May sequential traffic growths of 1%, which is far below our historical growth rate. Cogent’s compounded traffic growth rate for the past five years is about 120% even counting in this most recent down turn in traffic rate. Clearly 1% monthly sequential is far below the rate we have seen historically.

Secondly, we have in the past seen a slow down in the rate of traffic growth in the summer and in fact last year saw one month, the month of August where we had negative traffic growth. This year, that negative traffic growth came in the month of June where we saw that traffic growth go down 3% month over month resulting in the full quarter being down 1% which is the first time in our history we have seen traffic growth be negative for a full quarter.

Our revenue growth is partially impacted by that but it is still possible to grow revenues substantially faster than traffic. You saw that with the mix shift to a greater number of corporate customers which are not particularly traffic sensitive and the fact that we grew revenues in the quarter 3.4% in aggregate even though we experienced this traffic growth it does mean the sales force has to work harder there’s not that natural up lift from those existing NetCentric customers.

If we look at our trends over the past year or 18 months we began to see a deceleration in the rate of traffic growth really at the very beginning of the year when we built our full year guidance and issued it in November we were basing it on run rate data that was compiled in October and September of 2007. A big part of our modification and reduction in our full year guidance is a result of the observations that we have made in the market of the actual traffic trends that we are seeing.

While many of our competitors comment on traffic anecdotally I think a number of them have demonstrated and some of them forthright and others maybe not quite so forthright in acknowledging this slow down in traffic growth and it is supported by unique impression views on the internet over the past year. The internet will continue to grow but it is in a period of transition.

Tad Weed

Your specific question on the last quarter to quarter growth to previous quarter that was 6.4%.

Frank Louthan – Raymond James

What’s in the experience in July as this traffic continued to worsen and can you give us some color on that?

Dave Schaeffer

In July traffic actually increased 1%. That’s clearly better than the June performance of a negative 3% that is not however robust growth and we do believe that part of the reason why it didn’t continue to decline was in fact volume based pricing initiatives that we put in place. Normally we would see traffic continue to deteriorate over the summer and in fact that we saw a 1% sequential growth rate was encouraging and we think in looking at the specific customer data that a large portion of that growth came from customers who didn’t take advantage of the volume based pricing program.

Frank Louthan – Raymond James

Can you give us an idea of a range we should think about with what margin pressure you get in the summer months from the peak power rates is there any rule of thumb or how much your power rates have been going up and how we should be thinking about that from a modeling perspective.

Tad Weed

On a quarter to quarter basis it’s in the neighborhood of $250,000 if you look at the aggregate quarter over quarter change. When we build our forecast what we have done historically and continue to do is look at the trailing six month averages not blindly take that figure but also incorporate the trend and then use that rate going forward. We’ve incorporated that increase into the anticipated rate for the second half of the year.

Dave Schaeffer

We basically took the $250,000 per quarter hit to our gross margin and an increase in cost of goods sold due to the increased power costs.

Frank Louthan – Raymond James

Last question, on the corporate side with the economy are you seeing customers taking harder to sell because they’re laying people off so they don’t need as much incremental bandwidth or are they pushing the sales, is the sales cycle lengthening at all any changes in that direction and so far have you progressed as far as bad debt in this quarter?

Dave Schaeffer

It would be very easy to use the economy as a shield to explain the slower traffic growth and we do not see that, that is just not our experience. In talking to our sales force and measuring opportunities within our sales funnel and the amount of time that they spend in the funnel to move to closure the actual sales cycle time has not expanded, if anything the cost of our value position in the market we may actually be benefiting from a tough economic environment as customers look to get more value.

The internet is a utility and very few businesses today can function without internet connectivity on the corporate side. On the NetCentric side people buy bandwidth because they need it. They incorporate that bandwidth into the final good or service they sell or they distribute it to their end users in smaller increments. They are more likely to buy from Cogent than less likely if their margins are compressed.

I know some of our cable customers have actually commented publicly that their upstream costs have fallen and that was in part due to the fact that they have shifted traffic to Cogent. I’m going to let Tad talk about the bad debt and collections experience.

Tad Weed

If you look back through the first quarter 2006 through the end of the most current quarter bad debt expense as a percentage of revenues ranged anywhere from 0.05% was the low in the first quarter 2007 to 2.3% in the third quarter 2006. While those numbers are not large in terms of the percentage of revenue it’s a decent range. We are very pleased with the performance in the current quarter where bad debt was 1.3% of revenues.

Frank Louthan – Raymond James

Do you think that’s going to increase going through the rest of the year?

Tad Weed

As I said, we take the last six month average and anticipate that trend remaining constant. I’ve not incorporated a reduction nor an increase in bad debt expense.

Operator

Your next question comes from Jon Schildkraut – Jefferies.

Jon Schildkraut – Jefferies

I’d like to go through a couple of things, in the past you’ve talked about sales force productivity numbers in terms of net and gross revenue dollars. When we visited with you in June you pointed to about $400,000 of net sales productivity in the prior quarter per month in that you had given us some numbers around your launch of the new price card, at least a test period, that net sales force productivity had gone up to about $750,000.

I’d like to get a sense to where the net and gross sales force productivity numbers are coming out of the quarter as we look into your guidance for next quarter you’re implying about $150,000 per month of net sales force productivity.

Dave Schaeffer

You are correct, we saw and we’re very encouraged by the initial test results and saw a tremendous level of take away from those NetCentric reps that were given the test products. That did result in an increase in the number of sales. Remember for revenue there is a bit of a lag between those sales and our ability to recognize that revenue. As we said we see very little impact in the second quarter.

On the counter, negative side, what we have seen is this drag from a lack of traffic growth from existing customers. We factored that into our guidance and that’s why we came up with the lower sequential revenue growth in the guidance simply because we’ve experienced a reduction in the rate of traffic growth from customers, actually went negative. We also gained some customers so you could obviously see that if total traffic was negative 1% in the quarter some customers were negative even more than that considering we added customers that didn’t exist in the quarter and we ended up with more customers.

We also derived a portion of our revenues from customers who exceed their commitments and that rate of burse penalty actually declined by about 25% and we factored in that decline into our analysis. Clearly if traffic accelerates or even if the 1% trend that we saw in the month of July is not impacted in August and September good, we’ll be great and do better than what we said.

To Tad’s point around guidance we wanted to be very conservative and take the most recent data we had and project it going forward.

Jon Schildkraut – Jefferies

No specific numbers around gross and net sales force productivity?

Dave Schaeffer

Yes, I reaffirmed the analysis that you said of net and the churn rate remained the same so obviously the gross number has come down and part of the reason for that is there is a negative gross number that comes from the reduction in that penalty revenue.

Jon Schildkraut – Jefferies

As we look into the back half of the year EBITDA guidance I know that Tad mentioned some incremental costs due to power but still it looks like the operating leverage implied from an incremental EBITDA margin perspective had significantly less in the back half of the year than the front half of the year. Beyond power are there other things that we should be thinking about? There was a fairly substantial reduction in SG&A in the quarter perhaps that will scale up again as you add more headcount.

Tad Weed

If you look at the quarter to quarter trend as anticipated we did experience a reduction in SG&A this quarter compared to the first quarter and the planned increases that will occur from Q2 to Q3 primarily include two things. One, the increase in headcount from the expansion of the sales force, secondly we frankly have lumpiness in terms of the timing of the professional services that are required to run a public company specifically audit work and stocks related work which is more in the third quarter than the second quarter where a bulk of that is performed.

All that timing is scheduled out based upon our experience what the contractual amounts are and how we expect those services to perform. That is the two major components for the change Q2 to Q3 in SG&A.

Dave Schaeffer

I’d like to follow up on margin. If you think about it we have a fixed cost business and because the growth rate of our off-net business has slowed that does impact incremental margins and the fact that our off-net revenue growth has actually accelerated which is less margin favorable I think that needs to be calculated in as well.

Jon Schildkraut – Jefferies

Final question, a bit of a housekeeping item. Can we actually get one more significant digit on the percent of revenue that comes from your corporate customers please?

Dave Schaeffer

I don’t have that on my sheet Tad. It was just rounded to 44%. He wants to get it right. I have to admit I don’t have the numbers to that level of detail.

Tad Weed

Bear with me; I have it, 44.0%

Operator

Your next question comes from Tim Horan – Oppenheimer.

Tim Horan – Oppenheimer

Some of the sources I use to measure internet traffic growth show that we haven’t really seen a slow down. Some of these sources they measure out at the edge of the network where I think it’s a little bit easier to measure. Can you give us your thoughts on why you think the volumes have been lower. Does that have to do with exchanging traffic with data centers more, more CDN traffic just curious on some of your thoughts?

Level three would argue they’ve seen traffic go from IT back to private lines in some form or other forms of traffic which is directly opposite from what we saw the last tech day. I’m curious on your thoughts.

Dave Schaeffer

Let me try to take those in reverse order. I think traffic will go to the technology and platform that delivers it at the lowest cost per bit mile provided the quality is equal and that bit mile includes the router or switching as well as the transport. With internet transit prices where they are today there is generally about an order of magnitude lower cost to deliver traffic over a transit pipe than either a private IP network, a wavelength network based on the utilization or an ATM network.

Unless customers are going to pick the more expensive not the less expensive alternative I don’t believe there is substitution of IP transit by those other products. I think the trend is exactly the opposite. IP transit as you pointed out for the past decade and will continue to become the dominate way in which connectivity occurs and traffic passes.

Now to your point of CDN’s, some CDN’s have experienced deceleration in their rate of traffic growth as well. Others have maybe been less transparent about that. CDN’s are really hosting companies that still need to purchase transit from someone to connect. You need to get to the machine and then you need to get from the machine to other networks and customers.

The average bit travels about 2,700 miles across the internet and is distributed to literally thousands of locations. Few if any CDN’s have all of their content available at all of those locations. CDN’s typically charge a premium per megabit mile for their services they may be able to extract that premium because they’re adding additional services but if anything I think transit again double counts, because it counts the CDN business as well and second of all it continues to be lower cost mechanism and capture more market share.

The final point was could cross connects within a data center somehow cannibalize the transit market. In fact, cross connects within the data center is critical to the transit market. It’s critical for two reasons, 96% of our traffic comes from NetCentric customers. Those customers buy cross connect and about 350 data centers to connect to Cogent or some other network. The cross connect exists in the data center so the customer can get to a network operator.

Secondly, cross connects in the data center are critical because of peering or inter connection agreements. We are inter connected as we said with over 2,400 networks around the world. I think we are the most inter connected network when you look at size, connection, number of locations and number of networks connected. That is very important; however it’s interesting to note that the top 16 networks that connect to Cogent actually exchange about 60% of the traffic with us. That means 40% is exchanged with all of those other networks.

Smaller networks may elect to exchange traffic among one another but major networks generally look for someone to pick up the load and carry that bit their fair share. Someone’s got to carry bit 2,700 miles the content and the networks do not all coexist in the same location. Either you buy wave lengths and connect which is more expensive per bit mile when you look at the utilization rates and the current pricing or you buy transit that’s why I think transit continues.

Traffic slow down is a different issue. Traffic slow down is driven by business models. We’ve seen a proliferation of broadband connectivity where we now have almost 80% broadband penetration in the Western world. Line rates on those mass mile connections have increased to close to 5 megabits of download speed which is sufficient for most applications particularly video.

You’re not going to get an uplift from more broadband penetration or greater download speed. What you need are more applications that consumers want to use more and more. You have to look at the size of the install base. At 70 megabytes a day that base is very large. Many applications that people point to could migrate to the internet or increase and not materially move the needle because the base is large.

There are applications that will drive growth and we’ve been pretty clear that this is really video we see that with a number of customers and we see that trend continuing but we have not seen the massive migration of video consumption over the internet. Today video is consumed about 4.5 minutes a day on the internet that’s peer data research and television, which is traditionally delivered by a broadcast satellite, cable or DVD, is consumed 4.5 hours a day.

Until those trends, there’s some shifting in that relative mix we will see slower growth and if not software as a service or email or even voice migration that will materially drive growth. The internet is not going to decelerate, it’s not going to go away but it is going to be a bit lumpy in the way in which it reaccelerates.

Tim Horan – Oppenheimer

Have you assumed any decline in revenues in the NetCentric side in your guidance going forward? If you not see much in the way of revenue growth on the margin through pricing that’s coming down because of the turn in volume contracts, what’s embedded in that going forward?

Dave Schaeffer

As Tad said, we took all of the pricing trends that we implemented; we looked at the customers that took contracts with us. When we saw those customers increase their contract value we also looked at how much of that came from more spend per customer and how much of it came from contract lengthening. For those 200 customers that we talked about in July sales that increased total contract value by $10 million we saw their average contract length lengthen to about 17.9 months. Our install base is about 11.8 months so we did see some contract lengthening but we did not see a reduction in their monthly spend.

I also commented on our price per megabit sold which actually had come down slightly from the previously quarter from about $9.20 to $9.00 so we are seeing some reduction in the price per megabit as a result of the value base pricing and the term base discount but the average monthly spend is actually going up. The only reason ARPU declined by the 2% was because the mix of corporate customers as a percentage on net customers increased.

Tim Horan – Oppenheimer

Can you give us those numbers again, what was the corporate customers a year ago and maybe last quarter and now and what do you expect going forward?

Tad Weed

It was exactly 44% for the quarter and historically if you go to the Q2 2007 it was 43.5% of revenue. Then it trended down then it has trended back up.

Tim Horan – Oppenheimer

If your volumes are growing it seems like it’s hard to grow the NetCentric revenue base overall so it would seem like your corporate NetCentric revenue has to expand perhaps buying that revenue growth is that what you’re expecting going forward and are you shifting yourself towards that?

Dave Schaeffer

The mix of sales people has been pretty consistent at roughly two thirds of the sales force has been focused on corporate customers and one third NetCentric we expect that to continue. I do disagree with your assertion that without volume growth we cannot grow the NetCentric business because we have the ability to capture a significant amount of market share so we can grow either by existing customers taking more bandwidth clearly that’s easier or we can grow by winning customers away from other providers which we are doing.

Part of the structure behind our volume base pricing model is to accomplish both of those goals. I think we are seeing that and as I said we would have expected a bigger traffic decline in July than June and in fact because of the K-12 exposure and in fact we saw traffic increase in the month and it’s hard to read into this a lot of data from monthly trends but there are clearly a number of new business models many of them Cogent customers who are exploring different ways of bringing video to the internet professional video and some of them are more successful than others.

Directly answering your question we can grow our NetCentric revenue even in a moderate or slow traffic environment for NetCentric aggregate growth.

Operator

Your next question comes from David Dixon – FBR Capital Markets.

David Dixon – FBR Capital Markets

Could you comment on the magnitude of the increase that we’ve seen from new business from NetCentric customers in the third course of relative to the 15% that you mentioned in the second quarter? Looking at the outlook for costs I know that the average price in the base is $9.00 per meg currently I imagine that’s the second quarter point of reference. What’s your expectation for that as we look out over the next 12 months?

Dave Schaeffer

I’ll take the pricing one first, I would expect that number to go down. It has consistently gone down. That will be as a result of average contract lengthening as we said the average contract in the quarter lengthened by about 3% that’s pretty consistent with the rate of lengthening and not nearly as extensive as we saw in the middle of last year.

Secondly, we would expect to see customers taking more and more of the volume base discounts on the NetCentric side which would get them lower prices. However, that will probably increase the amount of non-used bandwidth that they purchase so the effective price per megabit, i.e. not the price sold but the price used may in fact go up based on that it’s somewhat irrelevant to Cogent all that matters to us is getting more revenue with the relatively low utilization rate in the network.

With regard to incremental sales for the month of July to NetCentric customers existing customers and new business I would say it’s equivalent to what we saw in the most recent quarter at the roughly 85%/15% split however it can be a little lumpy within a month and I’m not willing to say that one months makes the quarter.

David Dixon – FBR Capital Markets

I’m trying to reconcile, some larger customers that we’ve been speaking to that indicate that the price per megabit is in the $4.00 range now and I’m trying to back into the outlook for the base going forward. I was trying to get a point estimate perhaps, I appreciate your point about used versus non-used but where would you see it a point estimate in 12 months.

Dave Schaeffer

First of all you’re absolutely correct, our largest customers are at $4.00 a meg and even some of our customers that are not our largest customers can be at that level because to get that price point a customer would enter into a three year contract and they would take a full 10 gig port whether they used it or not. Clearly they would expect to have a high degree of utilization whether or not that actually came to fruition could change.

If I looked out over the next year I would say that the rate of decline over the previous 12 months which obviously did not have the volume based pricing in it was probably from about $9.60 to $9.00 based almost exclusively on the term discounts not on the volume. I would expect that rate to actually accelerate and probably be greater however there is a counter balancing force which is the continued focus on smaller NetCentric customers that does have the tendency of pulling ARPU down.

That will mitigate the rate of decline. I hate to predict an exact number and be held to it because I’ll be honest I’m happy with the revenue I’m not as concerned about the number but I would suspect the average number probably will be in the $8.15 to $8.20 range a year from now. That’s just a guess.

David Dixon – FBR Capital Markets

I wondered if you could give us a sense of where you see the pricing for waves currently versus IP transit, I thought that was very interesting commentary about IP transit and potentially at these levels we could obviously start to see a shift away from appealing back to IP transit which obviously could be a benefit.

Dave Schaeffer

We have some major cable company customers, for example who previously had a wave length base network and elected to shift back to transit because they would save all the cost when they figured their utilization rates, the cost of polarcating and purchasing routers, maintaining them and then maintaining peering connections and buying transit for those carriers that would not peer with them.

As I said there is a world of haves and have nots. I think wave length pricing falls because of the technology changes, however, that competitive universe has changed quite a bit and there are many less players in the wave length space. There are also many less customers as well because the majority of the wave length market was sold to companies who tried to build IP networks on top of wave length.

When the price per megabit was much higher you could afford to buy routers, buy wave lengths and use them relatively inefficiently and run an IP network and make money. What we are seeing is a continued reduction in the number of global backbone and particularly most of that reduction has come from those companies that buy wave length.

I was talking to an EVP at a competitor who runs the sales organization and we were just chatting and anecdotally we both concurred that the entire market globally for wave length customers, this being corporate as well as service providers is probably no more than 300 to 400 organizations. Clearly, internet access in transit is a much bigger addressable market.

Operator

Your next question comes from James Breen – Thomas Weisel Partners.

James Breen – Thomas Weisel Partners

I was wondering if you could comment on a competitive environment and as you’re going through the process either bidding for new business or with existing customers you’re seeing the gap closing between you and the next highest competitor from a pricing perspective. How willing are the guys that previously had been pricing at a premium to come down to your price points?

Dave Schaeffer

Prices do continue to fall and the gap has closed. Remember when Cogent started selling we had a 30 to one advantage today we probably have a 2.5 to one advantage so that’s a much smaller gap. With that said, there are a whole lot less competitors so we see a lot less bid activity on large opportunities with generally only two or three other bidders, generally two other bidders and ourselves in most opportunities.

Sometimes there are second tier players in there as well. I would say those other carriers have gotten more aggressive yet they have not matched Cogent’s price point, they have not even matched twice our price point. I can’t really comment on why that is but I do know that they are lowering their rate faster than the 30% that they have indicated but still not fast enough to get down to even 2x our price point.

We anticipate pricing falling and that is built into our model and today’s point when you got me out on a limb that $8.00 number assumes all of these trends.

Operator

Your next question comes from Tom Watts – Cowen and Company.

Tom Watts – Cowen and Company

I know in your revenue guidance there are a number of different factors and it sounds like you assume the same traffic flow you saw this quarter continuing. If there were further traffic slowing would that lead to revenue reductions lower than your guidance?

Dave Schaeffer

We built some margin in this is not a precise science. As I said with a greater percentage of our business coming from corporate where there is no correlation between traffic we’ve seen the ability of the business model to basically immunize itself from a slowing traffic environment and that’s why in fact with negative 1% traffic growth revenues grew 3.4%.

On our projections we have assumed a pretty pessimistic view; we took July’s tight numbers and projected them out. Remember we don’t have any long term history of negative traffic growth. We did factor the negative number from June in as well. I think we could sustain a 5% or 10% reduction in traffic quarterly and meet our numbers that we have outlined.

If internet traffic fell by 50% we’d be back having a different conversation but we have no empirical evidence that that is happening and in fact the 1% growth that we saw in July while not great is clearly better than the negative 3% that we saw in June.

Tom Watts – Cowen and Company

You talked about some of the factors that are going to pressure EBITDA margins in the second half. You said that you wanted to even those are not greater you wanted to take offsetting factors to reduce costs. Are there areas other than sales where you could have additional cost reductions?

Dave Schaeffer

We do have a fixed cost business. There is little variability other than our off-net business and in our off-net business we do have 50% gross margins. That is still added to cash flow and maybe diluted to incremental margins but it’s still in aggregate a good business. The only variable cost in Cogent’s business beyond those customers is the cost of sales which is relatively small.

I look at our business and don’t believe we have a cost issue. I think it’s really can we continue to grow the top line and can we even accelerate that rate of top line growth.

Tad Weed

Just to reemphasize it really is a fixed cost business with the exception of the variability with the hiring rate. We talked about the range of bad debt expense although the performance is good you can be from a 0.5% to more than 1.5% and then the lumpiness in terms of the timing of the service and professional fees.

When I look at what we had in the plans for the second quarter versus what was actually achieved was a combination of costs of goods sold and SG&A combined it was a 1% difference and that’s very small on about $36 million of aggregate costs. Fortunately for us I think within a very small range it’s easy to forecast what we expect. Unfortunately to your direct question on offsetting factors there’s not a great deal of offsetting factors. I think it’s relatively fixed base with the increases that we talked about.

We didn’t mention the timing of expansion of routes as soon as you accept a fiber route you’ll have the maintenance charges incurred with that albeit those numbers are not very significant to the second half of the year. That would offset to the extent that that timing is delayed or that would accelerate to the extent that timing is accelerated.

Tom Watts – Cowen and Company

Particularly with the off-net business and the potential for growth there are there any trends that you’re seeing in sales circuit pricing, is there any upward pressure on that, is there any potential to get more leverage on that to make your off-net more competitive?

Dave Schaeffer

We buy generally at tera, we do shop, and we buy from over 150 different teal circuit vendors where there is facilities based competition. For the most part there isn’t a lot of competition. I would say teal circuit pricing is basically flat which gives us a stable price point. Our ability to roll our costs would require us to take on some additional regulatory burden and also make additional volume commitments.

We are uncomfortable with either of those strategies and are content with the 50% gross margin in the off-net business and are happy to grow with that. I just think the mechanisms to improve that margin are not worth the risk.

Operator

Your next question comes from Andrew Beale – Arete Research.

Andrew Beale – Arete Research

In terms of the NetCentric volume trends that you gave us from April through July are you sure that those are the end user experiences of volume trends or do you think there’s a market share overlay that we should be thinking of on top of those.

Dave Schaeffer

There is also a market share overlay but because we are the lowest priced provider and because maybe the economy is a little more difficult than it was in the past I think we’re probably getting a bigger share. We also have anecdotal evidence from customers that we are getting a bigger share of their business and finally with the volume based initiatives that we put in place the only adopters of those initiatives were existing customers who were shifting us to even more share because they couldn’t generate more traffic in that short period of time.

Almost all of that increased volume that they gave us came through shifting. I do think it is buffeted somewhat and I think the end user experiences actually probably a little more extreme.

Andrew Beale – Arete Research

In terms of your volume pricing can you give us an idea of the drag on that revenue that that caused you in Q2 and what the effect will be in the full quarter in Q3 perhaps you want to tell us on the gross on that basis after the volume improvements that you anticipate.

Dave Schaeffer

It had no impact on our results in Q2 simply because there was virtually none of the orders installed and when we looked at the orders installed to date we actually see no negative impact in our guidance for Q3 simply because of the contract value requirement for existing customers taking more bandwidth so there is little or no exposure to getting less monthly revenue from an existing customer we have not data that says that’s in fact what’s happening.

Most of the customers, our largest customers are taking advantage of this have done so by increasing their monthly spend with Cogent. With regard to winning new business in the market it’s really hard for me to tell whether or not its business but the volume base placing was responsible for us winning or we would have won it without it. We have factored no drag in our guidance.

Andrew Beale – Arete Research

Essentially it gives you less elasticity to whatever the volume trend is through the year through the summer quarter is that right?

Dave Schaeffer

That’s correct.

Andrew Beale – Arete Research

Moving to the sales force, how have you refocused them on corporate and particularly selling off-net corporate is there something that you’ve done differently in terms of the incentive that you offered them?

Dave Schaeffer

It’s actually the exact opposite of what you would expect which is we have dis-incented them from selling off-net because they only get paid on the gross margin which does not include the local route it means they only get paid on the port that they sell. We had not done that until March so what you saw was business that was sold in part of the first quarter fully take effect for the full second quarter but we also continue to see a significant set of new bookings of off-net services and particularly those with higher roof capacity and therefore ARPU for us.

In fact, the sales force is dis-incented to sell off-net yet we continue to see that as a growth business. It is a huge addressable market and it’s a market in which traffic volumes play little or no role.

Andrew Beale – Arete Research

Is it fair to say the sales force is just a big opportunity even if they get paid less dollars per dollars monthly revenue?

Dave Schaeffer

That’s correct, although the majority of our sales as Tad said continues to be or on-net product with about 85% of sales being on-net.

Operator

We have no further questions.

Dave Schaeffer

I thank everyone. I know it was a long call but a lot of good topics covered and we look forward to continuing to deliver good results and chat with you next quarter.

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Source: Cogent Communications Group, Inc. Q2 2008 Earnings Call Transcript
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