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Cogent Communications Holdings (NASDAQ:NASDAQ:CCOI) is a mid-cap and not well known telecommunications stock that has generated strong long-term returns for shareholders while growing its dividend aggressively over that time period.
However, on a trailing twelve month basis it has generated negative returns, and the recent acquisition of T-Mobile's Wireline Business has made the shares price drop even further.
In my view, this is not all bad news, because the stock now offers almost a 7% dividend yield with a consistent growth rate (over 10 years). But before diving into charts and financial data, let me first explain the business context of CCOI.
The global Internet is a collection of separate, but interconnected networks. These networks form the primary transport for the Internet and are independently controlled by Internet Service Providers (ISPs), each with its own policies, services, topologies, and customers. What ties the ISPs together is the same Internet Protocol (IP) addressing scheme and Border Gateway Protocol (BGP) routing framework. Without diving into technicalities, these standard protocols allow all these networks to interconnect with each other directly or indirectly.
ISPs are classified into a 3-tier model that characterizes them based on the type of Internet traffic that they transport:
Cogent classifies their customers into 2 types: NetCentric (access providers and content providers whose businesses rely primarily on Internet access) and Corporate (small businesses to Fortune 100 companies).
Cogent sells connectivity to content providers and other wholesale customers, which are represented under the NetCentric business. These customers are streaming companies and content distribution service providers, as well as other service providers who connect the consumers to the internet via fixed line and mobile networks.
NetCentric business represented 42.6% of CCOI's Q2 revenues, and continued to benefit from the strong growth in streaming subscriptions and in international network traffic. Quarterly traffic from NetCentric customers increased sequentially by 3% (2.5% for the previous quarter) and year-over-year by 19%. NetCentric revenues grew by 0.3% on a (U.S. GAAP) quarterly basis and 10.2% on a yearly basis. Since ~50% of the NetCentric business is coming from outside the U.S., adjusting for foreign exchange on a constant currency basis, the revenues increased by 2.5% on a sequential basis, and by 16.2% on a yearly basis.
Corporate customers are typically professional service firms, financial service firms and educational institutions located in multi-tenant office buildings or connecting to Cogent's network through their CNDC footprint. The Corporate business has been and continues to be impacted by the effects of the COVID-19 pandemic. Indeed, while the Corporate business represented 57.4% of Cogent's Q2 revenues, it declined by 1.1% on a U.S. GAAP quarterly basis (and by an unknown amount on a yearly basis - the same holds for foreign exchange adjustments). This was mainly caused by the change in USF rates (subsidies for under-served/sparse areas) and by the decline in the number of offices due to COVID-19. In particular, adjusting for the negative USF impact, the decline in Corporate revenue for the quarter was only 0.007% sequentially. With regards to COVID-19, it is important to note that Corporate customers buy bandwidth on an unmetered basis, hence whether there are 10 employees in their office or 100, the customers pay Cogent the same amount of money. Another positive trend is that companies have defined a hybrid work schedule for their employees, which means that some corporate customers took additional ports from Cogent in a carrier-neutral data center solely for supporting their VPN connections. As stated in the Q2 2022 results call, CEO Dave Schaeffer considers this as "an additional opportunity to sell more ports to those Corporate customers, offsetting the decline in office-to-office VPNs as companies reduce the number of offices". However, while Corporate business is trending towards pre-pandemic levels, it is growing at a slower pace than expected. Cogent believes that the Corporate business is still probably several quarters away from returning to its historic sequential growth rate (of 2%, see image below).
Overall, on a U.S. GAAP basis the total revenue for Q2 2022 decreased by 0.5% on a quarterly basis, but increased by 0.4% on a yearly basis. On a constant currency basis, the quarterly revenues actually increased sequentially by 0.4%, and by 2.7% on a yearly basis. It is clear that the revenue is heavily impacted by the (negative) foreign exchange movements. If adjustments for the negative impact of USF rates are considered, the Q2 revenues would have grown by 0.6% sequentially, and 3.6% year-over-year, which is equivalent to the rate of growth in Q1 2022. Overall, the revenue keeps increasing over time at a steady pace (7.3% CAGR over 10 years).
EBITDA margin increased by 110 basis points from Q1 2022 to 39.4% for Q2 2022, and by 70 basis points from Q2 2021 to Q2 2022. EBITDA increased by 2.3% from Q1 2022 to $58.5 million for Q2 2022 and by 2.2% from Q2 2021 to Q2 2022. As for revenue, the EBITDA keeps increasing over time at a steady pace (9.2% CAGR over 10 years).
An additional positive note on business safety is that the top 25 customers represented only less than 6% of the revenues for Q2 2022.
One point of attention is represented by the steadily increasing long-term debt. Part of the debt can be explained by the costs of raw material that increased due to higher inflation, which put even more pressure on CCOI's debt.
In June 2022, Cogent replaced some of their debt, extending the maturity date, but increasing their costs. Of course, this may look worrisome, especially considering the current rising rate environment and the increased pressure on the cash left to pay the dividend to investors.
On the other hand, CCOI went through an explosive growth and the company managed to convert the increasing debt in a profitable business, and to keep rising the dividend payments even in 2020. One slightly positive note is that the total debt increased at a lower pace than the rate on increase in EBITDA.
In the case of CCOI, earnings per share don't tell much due to depreciation and amortization charges (for the installed infrastructure) that make that metric less useful. Instead, the revenue and earnings before interest, taxes, depreciation and amortization (EBITDA) is more useful, and especially the Enterprise Value (EV) to EBITDA ratio shall be looked at.
Cogent Communications' latest twelve months EV/EBITDA is 16.8x, and it averaged 18.8x from 2017 to the end of 2021 (see below).
The current EV/EBITDA is 12.7x, which is well below the average of 18.8x of the last 5 years (~39% lower!). This makes the current shares price quite attractive, as ~39% seems like a quite big safety margin.
Given the average and current valuation, the company is a strong buy below $60 and a buy below $65. Indeed, if CCOI were to return to its average EV to EBITDA ratio, its share price would be a bit above $70, and this is without considering no growth at all, which is unlikely (see the growth section below).
Another metric that makes CCOI a very attractive buy is the current dividend yield being very close to 7%, which is ~56% higher than the average yield of 3.88% over the past 10 years.
If we were to apply the same methodology as for the EV to EBITDA ratio, the company is a strong buy below $65 and a buy below $70. If the stock were to reach its average dividend yield, its price would be $78 (again, considering no growth at all, even of the dividend which is extremely unlikely).
Moreover, the dividend increases do not seem to be stopping, continuing the impressive streak of 40 consecutive quarterly increases (and at an impressive rate).
This of course raises doubts on the dividend's safety, so let's calculate the dividend payout ratio to help with this.
As for all companies that run a capital-intensive business (think about electricity companies) the investments in infrastructure are financed on debt as they are considered to be low risk. This means that the dividend payout ratio should be calculated based on the cash flow from operations, and not based on net income or similar metrics.
Cash from operations has increased over the past 10 years, but the total dividends paid increased at a faster pace, hence the dividend payout ratio kept increasing as well (to ~88%). This may be worrisome, because if the same trend persists the dividend would become unsustainable in the upcoming few years. Nevertheless, management looks convinced that its business will recover and generate a lot more cash, especially after the recent acquisition of the T-Mobile's Wireline Business.
Moreover, the company consistently increased the dividend each quarter for the last 10 years with an impressive ~21% CAGR for that period, ~15 CAGR for the last 5 years, and ~13 CAGR for the last 3 years. While the dividend growth is admittedly slowing down, the consistent dividend increases over the last 40 months, and especially in difficult times (COVID-19), demonstrates the long-term optimism that the company has in its business. Moreover, the board acknowledged that there is substantial liquidity on the balance sheet, and substantial incremental borrowing capacity.
Quoting the CEO Dave Schaeffer again from Q2 2022 results call: "The pace of that [dividend] growth may vary. It is not today".
Analysts project that Cogent will grow its revenue at a 6.3% annualized rate and that the dividend will grow at a 9.6% annualized rate. Admittedly, the dividend growth is lower than the last 3Y and 5Y CAGR, but it is still a very considerable rate, especially considering the current high yield.
As mentioned during the Q2 2022 results call, the CEO is also "encouraged by the fact that [the company's] sales force productivity numbers increased to 4.9 installed orders per full-time equivalent rep per month, up from 4.7 last quarter. This is actually the best sales force productivity since the fourth quarter of 2018".
In terms of pure share price appreciation, while in Q2 2022 Cogent didn't purchase back any shares, the company has a total of $30.4 million available for buybacks, which the Board has authorized to continue through year-end. However, buying back $30 million worth of shares would result in a negligible price appreciation of ~0.10%.
Considering the historically low EV to EBITDA ratio (39% below average), the forecasted growth (6%), and the upcoming dividend increases (between 2% and 3% per quarter), using a very simplistic Dividend Discount Model results in a reasonable target price of above $80 In 12 months. This makes CCOI a strong buy in the range of $60-65, and a buy below $72, with a total upside of ~50% in less than a year based on a purchase price of $55.
As briefly mentioned at the beginning, ISPs with similar volume of traffic might peer with each other, allowing free traffic passes between them. As Tier-2 (and Tier-3) ISPs develop, they may increase peering with same-tier ISPs, reducing the needs of (i.e., bypassing) Tier-1 ISPs, thus reducing their costs. However, while peering is growing, Tier-1 ISPs are still needed for intercontinental or long-distance data traffic. Moreover, the businesses that would benefit from peering are limited, as some companies are either too small or not willing to share their (valuable) data.
As long as data volumes keep growing steadily (thanks to IoT, increasing access to internet, etc.), the Tier-1 intercontinental network alone could be enough to generate revenues at current levels. However, similar to the risk stated above, peering might be the only way to manage the expected massive growth in data.
As with all acquisitions, there are doubts about the recent CCOI's claim that they will be able to convert the T-Mobile Wireline Business into a profitable one. On the other hand, Cogent acquired T-Mobile's business for a symbolic $1, hence they did not issue any new debt to finance the acquisition. Actually, T-Mobile will pay Cogent $700 million for leasing back the services that have been just sold. Of course, the downside for CCOI is in terms of full operating responsibility of the wireline business, and its short-term impact on the EBITDA of the company.
An additional risk is represented by foreign exchange movements, as the total revenue may be (and has been) impacted by this, and especially by the significant strengthening of the U.S. dollar against the Euro. Indeed, the company expects the negative impact of foreign exchange on next quarter revenues to be even more significant.
With regards to the declining Corporate business, this is mainly due to the impact of COVID-19 which reduced the amount of corporate offices. However, this loss could be offset by the opportunity of selling more ports to support the increasing demand of VPN connections.
And a last risk but not the least, the dividend payout ratio is steadily increasing, which together with the growing debt, makes future dividend increases at risk.
CCOI is exposed to quite some risks, and the future looks uncertain. However, the board looks capable of managing the risks, and appears convinced about its ability to keep growing the business and dividend payments.
Due to the aforementioned risks and the recent economic context, the company is currently priced at historically low valuations. There is not only a potential upside of almost 50% in less than 12 months, but also a very high dividend of almost 7%, which keeps increasing each quarter. Altogether it is impossible to look away because the current share price looks extremely compelling, but risky.
Indeed, I would consider buying below $65, but I would be careful about any higher price due to the underlying risks. It is worth repeating that this suggestion is mainly for speculative investors who are capable of managing a "high risk, high reward" type of investment.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in CCOI over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.