Shares of Cogent Communications Holdings, Inc. (NASDAQ:NASDAQ: CCOI) has followed the same downward trajectory as the tech-heavy ETF Invesco QQQ Trust (QQQ) since mid-November 2021, once it became clear that the Fed have to raise interest rates. Thereafter, unlike QQQ which rebounded around 15% from its mid-March lows, the difficulties continued for this communication game, whose shares are now available for around $65.
Its shares are now more aligned with the small-cap-focused iShares Russell 2000 (IWM) ETF. With expectations of increased financial stress for small, highly indebted tech companies due to the Federal Reserve rate hike, it’s time to assess Cogent’s outlook in this new market environment, as well as any possible impact. on turnover after the company stopped providing Internet services to its Russian partners. clients.
I start with the financial results.
Cogent is a Tier 1 service provider, which means its network can directly reach anywhere on the global Internet, including customers in Russia, without having to pay fees to other carriers. This contrasts with Tier 2 providers whose DIA (Direct Internet Access) customers must deal with other providers, which incurs delays and additional costs. These are referred to as “net-centric” customers consisting of telecommunications operators as well as online content providers located in geographic areas ranging from North America, South America, Europe, from Asia, Australia and Africa. The company also serves “businesses” that range from small to large multinationals.
Approximately 60.8% of fiscal 2021 sales were from the United States and Canada, where, due to work-from-home mandates implemented during the pandemic and subsequently during the Omicron scare, employees did not visit the offices where Cogent makes money by renting internet fiber to their employers.
As a result, service revenue from enterprise customers decreased by 6.5% to $358.4 million in 2021. However, sales from net-centric customers actually increased by 25.3% to $358.4 million in 2021. $231.4 million over the same period. As a result, the service’s overall revenue increased to $589.8 million, as shown in the excerpt below.
As for operating profit, it was helped by a gain on lease termination of $7.4 million following a legal settlement with a former fiber optic supplier in Spain. As part of the settlement, Cogent will have to pay $0.7 million in Q1-2022.
Looking ahead, executives see the strength of net-centric business driven by streaming service providers aggressively targeting overseas markets. In terms of market positioning and ability to sustain growth, the company established connections to 1,413 data centers, including 54 of its own last year. This coverage expansion strategy aims both to improve the quality of service and to grow at a faster rate than other operators.
In view of the competition, by geography, Cogent compete with several other Internet Service Providers (“ISPs”) as well as with large communications providers like Lumen Technologies (LUMN), formerly known as CenturyLink. There is also the giant Verizon (VZ), which offers a global MPLS solution of a large private network carrying Internet traffic.
Despite its much smaller size, Cogent is growing its global Internet footprint at a very rapid rate. According to its CEO, Dave Schaeffer, his company is connecting to data centers faster than others in the enterprise. So, by the end of last year, the company had established connectivity to 7,560 networks, an increase of 3.1% over 2020, with plans to add around 100 points of presence (POPs) in neutral data centers per year to expand its network over the next few years.
As a result, Cogent should maintain its superior growth compared to Lumen. As for Verizon, which operates under the telecommunications services industry, it also relies on its mobile cellular network to generate sales.
Thinking strategically, Cogent’s accelerated web weaving process aligns with the strong demand for wider and faster connectivity from service providers whose customers are now consuming more video traffic on their smartphones. This in the context of mobile network operators upgrading their cellular networks to 5G. By tapping into the mobile data traffic market, which is expected to grow at a CAGR of 28% from 2020 to 2026, Cogent wants to make sure to monetize its infrastructure.
In terms of profitability, Cogent’s gross margins – which are already the highest (table above) – should benefit from the dynamics of the content provider and the access network. Here, the more a network expands its geographical reach, the more it attracts content distributors like Netflix (NFLX) who essentially serve access network providers like local ISPs and who in turn serve subscribers like you and me. Now, by serving these two groups, most traffic begins and ends on Cogent’s network itself instead of going through other routes. This allows the ISP to control traffic at a lower cost, ultimately generating more profit.
The risk/reward ratio
However, to be realistic, in addition to the extent of service availability, competition is based on other factors, such as product pricing, customer support, and brand recognition. In this case, to be more recognized in a world where larger peers have been around longer and are better known, the company must spend on sales as part of operational expenses. This is evidenced by Cogent’s relatively lower EBIT margins (table above). Interestingly, sales and marketing together accounted for 63% of the company’s total workforce in 2021.
Additionally, it suffered from the “big quit” problem, which prevented many employees from returning to the office after working remotely during the Covid period. As a result, there was a 7% monthly churn in the sales/marketing organization. Staff have since been recruited, but with strong salary inflation, operating expenses are expected to remain high in the first half of 2022.
Additionally, with the nature of jobs becoming hybrid with employees working both from home and in the office post-pandemic, there may be less demand for Cogent’s internet routers and upgrade jobs than before. So, with the reopening, its enterprise business should see some growth, but that’s not expected to match pre-pandemic levels, at least in the first half of this year. In addition, there are expected to be pricing pressures from low-end vendors of legacy protocols such as circuit-switched voice, ATM, and frame relay. Eventually, this competition should gradually fade with the evolution of technology.
It is because of this uncertainty factor that the corporate segment is shaded yellow in the risk-reward matrix below, while the EBIT margins I discussed earlier are shaded red.
As for the risks of Russia invading Ukraine, as the company does business with Russian carriers, these represent “a very small portion of Cogent’s total traffic and net-centric revenue.” The company has no commercial activity in the two countries.
On the other hand, Cogent’s strategy of differentiating its offering through lower prices and lower long-term volume commitments, as well as prioritizing the most profitable net-centric services, which accounted for 75% of total services revenue in 2021, should generate better margins. This is a positive point and is shown in green above.
Evaluations and key points
Another bright spot is management’s target to double the annual revenue growth rate, as shown in green above. Achieving this goal will depend on the timely delivery of network equipment and dark fiber circuits. With hiring, network expansion and high inventory, this ambitious growth trajectory is entirely achievable barring a prolonged supply chain downturn (shown in red in the risk-reward matrix).
The company also expects to increase its free cash flow and increase EBITDA margin by 2% on an annual basis from 2022. This would be more than twice the growth of 0.9% seen from 2020 to 2021. This is also feasible, because compared to incumbents, Cogent, which started operating in 1999, has newer fiber optic infrastructure, which explains its much lower capital expenditure as shown the table below. This, combined with the ability to generate high-margin sales, should lead to a decline in the ratio of long-term debt to total capital, which is rather high. In fact, there was some progress on the gross leverage ratio at the end of the year.
Thus, Cogent is a buy, but, with an EV/EBITDA multiple of 19x, the company is highly valued and its share price performance will now depend on momentum factors such as revenue and earnings, as well as its ability to continue to pay dividends. . To that end, the company had total cash of $328.6 million as of December 2021, of which $147.4 million was immediately available to pay dividends or effect share buybacks. Continuing further, $39.6 million was returned to shareholders in the fourth quarter, with quarterly dividends and distributions rising from $0.83 per share to $0.855 per share. This is the 38th consecutive increase in quarterly dividends.
Finally, I’m also bullish because the risk-reward matrix has more green areas than red ones. The stock may rally to the $75-80 level as it offers higher and lower results. However, be aware that in a rising rate environment, volatility will be the new normal. That said, Russia’s exit should have negligible impact.