Earnings Primer for Cogent Communications

Hello all. Rob has given me the opportunity to write the Cogent primer! Cogent Communications (CCOI) reports earnings before the bell on Thursday. As readers of this blog and the IV board may know, as the market melted down I took positions in CCOI, TWTC, and Q, along with my core position in LVLT. As a consequence I have done a fair amount of research on Cogent and thought it might be interesting for me to put up some info that I have found compelling in supporting my long position. So, just to be official: DISCLOSURE – Long CCOI.

Ok, with that out of the way, let’s talk turkey.

On the Q2 conference call CCOI was forced to cut guidance across the board. The consequence of that cut, along with the market meltdown has taken the stock from $11.22 to $4.54 as of close yesterday; a drop of gulp…60%. Furthermore, the ev/ebitdas multiple has contracted from around 9 to about 4 during that same period. Suffice to say, it’s been a long ride down.

So what should we expect on the Q3 call tomorrow? Well first off, here’s a base model showing Q1/Q2 results and my projected Q3 numbers.

			Est
	q1	q2	q3
on-net	42811	44215	45109
off-net	7994	8459	8884
non-core	1305	1185	1009
total rev	52110	53859	55001
Cogs	21958	22952	23641
gross profit	30152	30907	31361
sga	15550	14448	14860
ebitdas	14602	16459	16500
one-time gain	16	126	0
adj. ebitdas	14618	16585	16500
interest	671	1986	2500
working cap	2439	250	211
cash flow operating	11492	14223	13789
Capex	9778	9029	7193
FCF	1714	5194	6596
repay cap lease	-6396	-3638	-7000
mature short term invest	0	650	0
disposition	22	44	0
stock option	53	47	0
exchange rate	245	100	0
adj. FCF	-4362	2397	-404
stock buy	-18054	-27994	-11984
debt buy	0	0	-9900
change in cash	-22416	-25597	-22288
begin cash	177021	154605	129008
end cash	154605	129008	106720

Below are some thoughts on what I think might impact the numbers:

1. Slower growth on on-net traffic. The company reported, for the first time in its history, that Internet traffic had actually decreased in Q2. This was quite a shock as traffic had been growing 100%+ compounded year over year since the company went public. Consequently, I went looking for data-points to make sure that this wouldn’t happen again in Q3. What I found was that in the transcripts of the Q2 call, as well as during a Q&A session during an investor conference with Kaufman Brothers on Sept 4^th the CEO made comments that traffic had actually grown 1% for July and August and said that because a large part of their on-net base was educational they expected traffic to pickup as kids went back to school. Consequently, I believe that the risk of on-net traffic falling, and as a consequence on-net revenues falling, as overdone and believe we should see about 2-3% growth for the quarter.
2. Accelerating growth in off-net traffic. The company has forecasted around 5% growth in off-net traffic vs. approx. 2% in on-net for the Q. This rate is higher than in the past which leads me to wonder if they are being too aggressive. What I found was the following: 2/3^rd of the sales force, which has nearly doubled over the last year or so, focuses on corporate customers who almost all need off-net service. Further, a vast majority of these corporate customers/targets are serviced by ILEC’s whose predominate service offering is T1’s, which are orders of magnitude more expensive than the Ethernet based services of CCOI. Also, the addressable market is huge so there is quite a bit to shoot at. AND, of course CCOI is the low cost provider by a margin of around 2.5 – 1 which should play well in the current environment. When I add all this up I have a feeling of comfort that they will meet their projection.
3. Hedging, or lack thereof. CCOI doesn’t hedge and since they get around 30% of their revenues from Europe and Canada I wonder how bad they will be hurt by currency devaluation. I pointed this out to Rob, who made the off-hand comment that perhaps, due to their large recent investments in Eastern Europe, they actually might have higher COSTS than REVENUES which would mean the impact would be muted. Now there is simply not enough data to support this thought, so I suspect that we will see some sort of “currency adjustment” which could mean that their revenues fall short of their project but the impact on ebitdas is not drastic as their costs also come down in a big way. Keep in mind that a lot of the loss in the Euro actually happened in October so perhaps the impact on Q2 won’t be that big.
4. Capital Leases and “Unconditional Lease Obligations.” One of the largest expenses below the ebitdas line is for capital leases. I spent a fair amount of time trying to forecast this number as the company gives almost no clarity on this line item. What I found was the following: on page 33 of the 10k the company says that they expect 15.651M of Cap Lease Obligations in 2008. If you look at the 2Q cash flow statement you see that they have already taken 10.034M of that expense; so they I believe that have approx. 5.617M to go. But it doesn’t end there. On page 62 of the 10k they also point out that they have a minimum payment of approx. 8.4M in “unconditional lease obligations” which I take to mean in addition to the 15.651M in capital lease obligations; or said another way, I believe that they may have up to 15.651 + 8.4 or 24.051M for all of 2008. Since they have already paid 10.034 I believe they have approx. 14M to go or 7M per quarter. Rob and I spoke on this item and we are unsure if the 8.4 is already baked into the 15.651M or somewhere else that we cannot separate out, I don’t believe so, so I add them, but I might be too conservative on this point. It’s just not clear
5. Stock Buy Backs are coming……..whether you read the above and got a sense of comfort or not, what you absolutely should expect is that regardless of how well the company does it will be buying A LOT OF STOCK in the near term. Based on the latest 8k, they have $32.1M of cash available to buy stock by year end. The last slug of stock (1.232M shares) was purchased for an average of 9.72 per share, with the stock trading at half that number you can expect the number of shares to be purchased to increase dramatically. The company has said that they will not buy back stock until Q3 numbers are made public, so tomorrow would be the first day that they can get back into the market. So what sort of impact should we expect? Well, there are around 600k shares traded daily, however, over the last few weeks that number has been cut in half. So we are seeing around 300k share per day, with most lots going off in 00’s share blocks. In fact, you see most activity in the last 5 minutes of trading, where I believe you see traders who have been accumulating shares all day make 25k or 50k share trades as that’s the only time there is sufficient volume to clear their positions. By my count CCOI can step in and buy around 7M shares which would take all the volume for around 23 days! What this tells me is that when you have NO volume and you have a HUGE buyer we will see price spikes. I would add that we’re talking about a reduction of more than 15% of their shares outstanding. That’s big.

I’m looking forward to the numbers and if you have a counter point of view feel free to share it. I’m not saying that CCOI is a company that will last the next 50 years, but certainly in the short-term I think the selling is WAY overdone and I think that regardless of whether the market is willing to increase their multiple, CCOI has the cash to make it happen regardless. I’m prepared for a much higher stock price in the very near future.

thejuice.

PS: Following the initial drafting of this primer the following data came to light that I wanted to make sure we included. On the Q2 con call the CEO said, ” during the quarter, we announced an increase in our stock Buyback Program of an additional $50M, with a purchase authorization through the end of the year” which I take to mean 2008. however, if you look at the 10k for the most recent quarter, on pg 10 they say, “in June 2008, the company’s board of directors approved an additional $50.0M of purchases of the Company’s common stock under the buyback program to occur prior to December 31, 2009.

So there’s a conflict.  On the call they say the end of 2008 and in the filing they say end of 2009.  So i don’t’ know what the right answer is.  I just called IR and expect someone to call me back with the answer and will update shortly.

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