Description

CCOI Long 

Overview:

CCOI is one of the largest global internet backbones in the world, carrying over 20% of internet traffic. Business targets two different customer bases

Corporate – CCOI has fiber built into 1,440 multi tenant office buildings in central business districts where they target mid size businesses - typically professional firms (financial, law, advertising, consulting)

• Core product is IP transit/connectivity with 100 mb/s of bandwidth priced at $700. This is roughly the same price the incumbent charges for a T1 – which only permits speeds up to 12 mb/s. This business segment has seen pricing declines of 4% / year – and has an average contract duration of 21 months.

• The buildings they target average 50 tenants / building. CCOI currently has about 12 of those connections today, a penetration of 24%.

• Key growth driver of this business is sales force size and productivity which have increased 30% and 25% respectively over the past year.

NetCentric – CCOI has fiber built into 660 carrier neutral data centers.

• This is a wholesale business where the company targets large content companies and other ISPs & transit providers and sells IP transit. Over the past year, a well publicized spat with Comcast and 7 other large terminating ISPs has caused the netcentric business to see slower growth than historical results.

• This business grows through internet traffic growth – forecasted to grow between 25-30% annually over the next 5 years – and new customer connections.

• While pricing has historically declined, 23.5% / year, the company has grown >10% annually by continuing to take market share as the low cost provider in the market – adding scale to its business and further reducing unit costs. On-net revenues have an incremental 100% gross margin allowing them to undercut everybody in pricing.

• One other thing to note on the netcentric business is that over 40% of this business is international – mainly Europe and is at the mercy of declining FX.

CCOI has outstanding guidance to the street that it will grow between 10-20% annually on the top line, and expand margins at least 200 bps. In 2014 – they will not hit that guidance on either the top or bottom line. While the Corporate business will grow in excess of 17% y/y in 2014he netcentric business has struggled, only growing ~7%.

• This is partly a result of the interconnection/peering dispute with the 8 ISPs mentioned above. Comcast, Verizon etc. refuse to upgrade their port connections with Cogent, and they are currently maxing out capacity. Comcast has forced Cogent’s customers, like Netflix to directly connect with the terminating ISP, and pay for this additional transit in order to have an acceptable quality of service. This has the impact of causing 4.3% of Cogent’s revenue to not grow, and in fact decline with inherent industry price declines.

• Cogent is spending $5 million this year in lobbying to the FCC that this behavior is an overreach of Comcast/VZ/T monopolistic positions in the market. The FCC has largely lumped this issue in with net-neutrality issue – which is different. However, it will likely be adjudicated by the FCC in the same proceeding – expected on February 26.

Financial Overview

Opportunity

The 5 main tenants of the CCOI thesis are:

• Free Cash Flow Ramp into 2015/6

Organic margin leverage + end of 1-time expenses

End of capex cycle

Refinancing opportunity in Februrary, 2015

• Accelerated Capital Returns from returning all free cash flow plus returns from levering up the balance sheet to 2.5x by Q4 2016 from 1.9x currently
• Removal of regulatory overhang with some form of Title II regulation for broadband providers
• Reacceleartion of top line growth through improved sales force productivity
• Potential for price decline moderation given consolidation of the industry
• Highly incentivized management team – CEO is the largest shareholder with 8% of the company – and takes $0 salary.

Free Cash Flow Ramp

• As the investment in the sales force normalizes, 1-time expenses related to lobbying the regulators, the natural margin leverage in the business will again be evident. Incremental gross margins for on-net business (75% of revs) are 95%, and 50% for off-net business.

• Capex should drop by 25% from 2014-2015 as the amount of new buildings Cogent expands its network to slows. The company is currently in less than 0.1% of all North American corporate buildings, but reaches 9% of all rentable space – highlighting the cherry picking the company has down when building out its network.

• $245 million of 8.375% senior secured notes are callable at 104% on February 15, 2015. The company will likely refinance these in the secured market between 4-5%. Their unsecured notes are trading around par at 5.6%.

Accelerated Capital Returns

• CEO is targeting to take the balance sheet from 2.5x net debt/ebitda (currently at 1.9x) by y/e 2016. They will return ALL FCF generated plus all excess cash from levering the balance sheet over that time period.

• Currently, the company has committed to a regular dividend – currently .32/shr quarterly – but this has been growing almost 100% / yr and represents a 3.7% yield.

• On top of that – they have guaranteed they will buy back AT LEAST $12 million of shares / quarter, or pay a special dividend of that amount. They have continually bought back more than the minimum (which also has been increasing). This represents another guaranteed 3.3% yield.

• To get to the targeted leverage range, the company needs to return far in excess of the 7% guaranteed. To hit the target, they need to return an aggregate 23% of their market cap in the next two years.

• Additionally, there is no real rationale for 2.5x leverage – the competitors in the market are north of 4x, and the company sees this as a first stop.

Regulatory Overhang Lifted

• The FCC has announced that they will be addressing net neutrality, and along with it interconnection at the next open FCC meeting on February 26. Chairman Wheeler has clearly taken an aggressive regulatory stance against net neutrality – and the debate now is not if, but how he will regulate broadband as a utility under Title 2 of the communications Act (rather than current regulation as an information service). This was once looked at as the extreme case.

• The market largely expects that the commission will either apply Title 2 to all of the broadband infrastructure including interconnection – and forbear certain provisions around pricing OR do some hybrid approach which for Cogent’s sake will also regulate interconnection as a utility.

• While this will not bring immediate changes to the current growth issues Cogent is having in the net neutrality business, it will bring a path forward to new rules and oversight, and begin to lift what has been a year-long regulatory overhang.

Reacceleration of the top line

• After growing the sale-force 30%, and improving sales force productivity by 25% in the past 18 months, 2014 has shown a re-acclereation of the corporate on-net business as a result. The off-net business is beginning to accelerate, and because install timing trails that of the on-net business, there is a lag between on-net and off-net acceleration.

• The company anticipates that growth on/off net corporate should further accelerate through Q4 and into 2015. The street is not modeling much in the way of growth acceleration.

Price Decline Moderation

• While I have not baked this into any forecast, there are some industry consultants and some evidence that price/bit declines are moderating – largely due to the consolidation over the past few years by long haul providers such as Level 3/Global Crossing. This would be pure upside and flow through.

Incentivized Management Team

• As mentioned, the CEO Dave Schaeffer owns over 8% of the company, and has declined to take a salary. This company is the most frugal company I have ever seen – CEO has no secretary. CEO actually owns the building – and is paid under market rents by Cogent.

Catalysts/Timing

• The FCC meeting agenda will be released 1 week before the Feb 26 meeting – on Feb 19  we should get more clarity here, and then during the meeting on what the Commissioner is proposing for net neutrality. I would expect stock to react positively to anything referencing Title II. Unless the FCC completely ignores interconnection, any relief is better than the status quo where over 4% of revenues are declining – and there is no relief mechanism in place.

• Q4 should see a further acceleration in the growth rate of the enterprise business. The net centric business should remain choppy, and will get hurt from $1-$1.5 mm in FX headwinds. Margin leverage should be more apparent in Q4, but more importantly in Q1 2015. I expect the company was very active in its buybacks – as it has been buying aggressively around the $34 level – where the stock largely resided during Q4.

• Returns of capital through 2015 have to continue to accelerate to get anywhere close to leverage target. This will include large increases in the quarterly dividend, and buybacks at an accelerating rate. If the stock were to run, the company would likely return a portion of the capital as a special dividend.

Consensus view?

• The street largely does not understand the interconnection issue, which is mired in technical jargon, and there are no public contracts that investors can analyze.

• Street models do not incorporate an acceleration in the pace of buybacks to reach the targeted level

• Despite spending over $5 million in non-recurring expenses to fight net neutrality, the street has based expense projections for 2015 on a higher than usual expense base. I am projecting EBITDA that is 2% and 5% higher than consensus for 2015 and 2016 on similar revenue estimates. I, nor the street has modeled what the CEO is talking about – brining the top line growth rate to the midpoint of the 10-20% range. Estimates (as well as mine) show a slight acceleration to 11%.

• The outlook for capex declines, while voiced at public presentations remains elevated in sell side models. Also – there is no benefit given to the Feb refinancing – or the share reduction from buybacks (which are effectively guaranteed).

Upside/Downside Price Targets

Key Risks to Reaching PT

• Net Centric revenues could remain weak with FX headwinds, and continued issues around interconnection. While regulatory relief will help sentiment – it will not bring immediate changes to the financials.

• FCC has been unpredictable – while I expect something that will be better than the status quo for CCOI, given Wheeler’s track record anyting is possible.

• Unintended consequences from FCC regulation artificially reduces internet traffic growth, and network investment

• If the CEO does not get what he wants from the FCC, he could continue to spend on lobbying in 2015 which would be taken negatively by the street.

• Any change in Capex guidance relative to what has been discussed at recent conferences.

• There are $5-6 million of non-recurring 'equipment revenues' in 2014, which will bleed partly into 2015 and have helped EBITDA in 2014, but will be a comparable tail wind in 2015. The fall off in non recurring expenses from net neutrality, and sales force incremental expense slowing should reduce the drag from this.

• Continued FX headwinds from the Euro are a reality – and will likely continue.

Revenue Breakdown of Regulatory Overhang

Comparables

Catalyst

·         The FCC meeting agenda will be released 1 week before the Feb 26 meeting – on Feb 19 à we should get more clarity here, and then during the meeting on what the Commissioner is proposing for net neutrality.  I would expect stock to react positively to anything referencing Title II.   Unless the FCC completely ignores interconnection, any relief is better than the status quo where over 4% of revenues are declining – and there is no relief mechanism in place.

·         Q4 should see a further acceleration in the growth rate of the enterprise business.  The net centric business should remain choppy, and will get hurt from $1-$1.5 mm in FX headwinds.  Margin leverage should be more apparent in Q4, but more importantly in Q1 2015.  I expect the company was very active in its buybacks – as it has been buying aggressively around the $34 level – where the stock largely resided during Q4.

·         Returns of capital through 2015 have to continue to accelerate to get anywhere close to leverage target.  This will include large increases in the quarterly dividend, and buybacks at an accelerating rate.  If the stock were to run, the company would likely return a portion of the capital as a special dividend.