Cogent Communications has two business segments, corporate and netcentric. On the corporate side, Cogent installs fiber in multi-tenant office buildings and sells bandwidth to the tenants. Cogent's primary competitors in the corporate space are AT&T and Verizon which typically offer T1 lines. Cogent offers those customers a 100 Mbit/s fiber connection carrying 65 times the bandwidth for the same price as that T1 line. This has been a stable and slowly growing business for Cogent and accounts for about half of Cogent's revenues.
On the netcentric side accounting for the other half of revenues, Cogent sells to customers whose primary concern is bandwidth for the price. In this space, prices have been consistently dropping throughout the industry. In this business, Cogent has had a robust growth in traffic over the past several years, a very good growth in customer connections over the same time and a slow, but steady growth in revenues—revenue growth which has been even slower over the past year or so.
First let's take a look through history—Cogent was formed by buying and rolling up the distressed fiber assets of thirteen companies through the bankruptcy courts about a decade ago, including those assets of PSINet, a major ISP in the 90's. These companies had raised a combined $14 billion in investment. With these assets purchased for pennies on the dollar, Cogent started offering bandwidth pricing at $10/Mbit (E.g. $10 per month for per 1 Mbit/sec of bandwidth) a decade ago when the rest of the industry was charging $300/Mbit. As such, Cogent didn't see much pricing pressure for years and in 2007 Cogent's stock enjoyed an upward trajectory to the mid $30's. That changed at some point and in mid 2008 Cogent announced that they were slashing prices and would go as low as $4/Mbit for high-volume customers under longer contract lengths. Cogent had grown to delivering around 17% of the world's traffic largely because Cogent was offering bandwidth at price points far below the industry average but now industry pricing had dropped to meet Cogent's pricing. To keep this growth, Cogent dropped their prices to continue to deeply undercut competitors, a practice often ill-advised by business schools.
It didn't take long for Cogent's bandwidth prices of their installed base to start dropping in earnest. In the fourth quarter of 2008 conference call, Cogent announced that their average price per Mbit was $8. Five quarters later in 1Q2010 that average price was $5.59/Mbit and new business was being sold at an average price of $4.26/Mb. Total netcentric revenue still increased over those five quarters but only by a modest 12% as the 30% decrease in average netcentric price per Mb offset most of the gains in volume. The price drops have some of Cogent's competitors saying that current prices are not sustainable.
In the recent conference calls given by CEO Dave Schaeffer over the past few months, Mr. Schaeffer said that pricing pressure had moderated for Cogent over the past two quarters and they currently have their lowest standard pricing still set at $4/Mbit. The drop in the average price per Mb over the past two quarters was largely a result of the sharp decline in the euro as Cogent derives about 30% of its revenues from Europe. While Mr. Schaeffer also says that pricing will drop perpetually in the industry, it seems there may be a reprieve at least for a short while where Cogent can grow revenues at a faster rate until bit volumes start increasing and prices start dropping again. There might be an indication that prices at Cogent were dropped more than needed and may allow revenues to grow with the higher growth rate of traffic for a while.
Cogent is also in a temporary accelerated expansion mode as cost-effective opportunities for purchasing assets have presented themselves over the past year or so. The network has expanded by nearly 50% over the past one and a half years due to these purchases. This could also have been seen on the changes to the network map on Cogent's website, Cogentco.com. Over the past two years, Cogent has added fiber in the U.S., down into Mexico, through Spain, from the U.K. to France and Netherlands, and in Eastern Europe.
Mr. Shaeffer expects this expansion to continue for the next twelve to twenty-four months but indicated that Cogent's expansion to reach it's optimal target market was nearly done. There are currently about 1,050 multi-tenant office buildings wired by Cogent and Mr. Shaeffer expects this to grow only to 1,250 to 1,300 buildings. Cogent's target universe also includes 55,000 to 57,000 intercity route miles, up from the current 50,000 route miles. Once complete, Mr. Shaeffer says Cogent will be focused on generating cash.
Mr. Schaeffer expects that EBITDA margins will expand by 100 basis points for the rest of 2010 over 2009, a lower rate due to the increased cost of expanding the network and the resulting increased fixed costs incurred before those new assets start generating revenue. He says there will be a re-acceleration in the growth of EBITDA margins closer to 300 basis point starting next year as expansion slows. This EBITDA growth projection may have tempered market expectations somewhat as Mr. Shaeffer's projected 10% to 20% annual growth rate in revenues with a weighted 80% incremental margin contribution based on the last four quarter's growth in on-net and off-net revenues seems to imply EBITDA margin expansion of between 400 and 700 basis points per year, at least initially. There's no way to tell if those somewhat tempered expectations resulted in the share price drop from around $11 a few months ago to around $7 on Friday but the projected 300 basis point annual EBITDA growth certainly seems on the low side of what many may have been expecting.
Based on Cogent's low prices and significant assets, there don't appear to be too many competitive threats lurking out there for Cogent, at least in the near future. As has been the case for a long time, in addition to Cogent's pricing which is at half the industry average, Cogent also has very significant assets including 50,000 miles of intercity fiber, almost 14,000 miles of metro fiber and thirty-six data centers. The network extends through 27 countries in North America and Europe. Carrying 17% of the world's traffic, Cogent certainly provides significant value. All that for an enterprise value of under $400 million.
As strictly a back of the envelope comparision and a glance into some fiber being built, Spread Networks is building an 825 mile low-latency network between New York and Chicago concurrent with a debt offering of $75 million. In addition, Allied Fiber is also embarking on an ambitious project of laying 11,500 miles of fiber between five cities in the U.S.. The price tag for that project is expected to be $670 million just for the fiber not counting lighting that fiber. Cogent's enterprise value of under $400 million with 64,000 miles of fiber across twenty-seven countries seems extremely cheap by comparison.
For now margin and revenue growth may be slower than many shareholders would like but Cogent is still generating significant cash from operations and still growing revenue and market share. That is more than most of Cogent's competitors can say. Hopefully a much clearer growth picture will emerge when Cogent completes its targeted expansion in the not-too-distant future and returns to a focus on growing cash flows.
Disclosure: The author holds a long-term position in Cogent Communications.