Cogent Communications - Q4 2022

Transcript

Operator (participant)

Good morning, welcome to the Cogent Communications Holdings fourth quarter 2022 and full-year 2022 earnings conference call. As a reminder, this conference call is being recorded and it will be available for replay at www.cogentco.com. A transcript of this conference call will be posted on Cogent's website when it becomes available. Cogent's summary of financial and operational results attached to its press release can be downloaded from the Cogent website. I would now like to turn the call over to Mr. David Schaeffer, Chairman and Chief Executive Officer of Cogent Communications Holdings. Please go ahead, sir.

David Schaeffer (Chairman and CEO)

Thank you. Good morning, everyone. Welcome to our fourth quarter 2022 and full-year 2022 earnings conference call. I'm David Schaeffer, Cogent's CEO. With me on this morning's call is Thaddeus Weed, our Chief Financial Officer. Hopefully you've had a chance to review our earnings press release. Our press release includes a number of historical quarterly metrics. We present these in a consistent way each quarter. For a couple of comments on our results. Our revenue growth accelerated this quarter. Our corporate revenues increased by 0.3%. Our revenue for the quarter increased sequentially by 1.3% to $152 million, an increase of 3.2% year-over-year. Our revenue increased by 1.7% for full-year to $599.6 million.

On a constant currency basis, our quarterly revenue grew year-over-year by 5.5%. For full-year on a constant currency basis, our revenue growth was 3.9%. On a constant currency basis, and also adjusting for the negative impact of Universal Service Fee revenues on our revenue quarter-over-quarter or year-over-year on a quarterly basis, our revenues grew by 5.7%, and for full-year 2022 grew by 4.4%. Our corporate business continues to be influenced by real estate activity in central business districts. Key statistics that we look at are building entries as measured by security card swipes in buildings and leasing activities that year-to-date indicate that while the central business district markets have seen some improvement, this improvement continues at a slow pace and is still not at pre-pandemic levels.

We continue to remain cautious about the outlook for our corporate revenue growth given the uncertain economic environment and other challenges as a result of emerging from the pandemic. Our NetCentric business continues to benefit from accelerating continued growth in video traffic and streaming. For the quarter, our network traffic was up 11% sequentially. Traffic growth accelerated on a full-year basis to 25% year-over-year. For full-year, our network traffic growth continues to improve. On a U.S. GAAP basis, our NetCentric revenue growth grew sequentially by 2.6% and grew by 9.6% year-over-year. On a constant currency basis, our NetCentric revenue growth for the quarter increased by 15.2% from the fourth quarter of 2021, and for full-year 2022 grew by 16.7%.

Our sales force rep productivity was impacted by the rapid expansion of our sales force. Our rep productivity was 3.8 orders installed per full-time equivalent per month. We increased the number of sales reps this quarter by 26 or 5%. We ended the quarter with 548 reps and 503 full-time equivalents. This is a increase of 8.2% in full-time equivalent sales reps. For full-year 2022, we increased our sales force by a net number of 58 or 11.8%. Our average rep tenure declined due to this rapid pace of sales force expansion and did have a negative impact on full-time equivalent sales rep productivity. I'd like to take a moment and talk about our progress in closing our pending merger for the Sprint T-Mobile wireline business.

We are diligently working to close our acquisition of the Sprint wireline business with T-Mobile. We have received all material approvals from regulatory agencies globally, including in the U.S., the FCC and the California Public Utilities Commission. We anticipate this acquisition will close in the second quarter of 2023. We did incur approximately $200,000 in professional fees associated with this acquisition in the quarter, and for full-year 2022, approximately $2.2 million in fees associated with the acquisition. We anticipate the Sprint wireline revenues at year-end 2021 were $560 million. We also anticipate that the run rate at time of closing will be an annual number of approximately $450 million. We ultimately expect the number of Sprint wireline products to be reduced dramatically from approximately 30 unique products or SKUs today down to four.

We have begun to sell the Wavelengths service this quarter to our customers through a commercial resale agreement with T-Mobile. Over the next three years, we expect to continue to achieve significant cost savings through the integration of our networks. Approximately reducing the network expense of the Sprint wireline network in North America by $180 million, achieving approximately $25 million in savings in the rest of the world on the Sprint wireline network, and then finally achieving $15 million of savings for Cogent in its operation and maintenance expense for its North American network. We anticipate also additional SG&A savings and other cost and revenue synergies over the next several years. With all of the regulatory approvals now in hand, we do feel the transaction is imminent to close in the second quarter of 2023.

Now for a comment on our dividend and buyback strategy. During the quarter, we returned $44 million to our shareholders through our regular quarterly dividend. For full-year 2022, we returned $169.9 million to shareholders through our regular quarterly dividend payments. Our board of directors, which reflected on our strong cash generating capabilities, investment opportunities, and the pending merger with Sprint, decided to increase our quarterly dividend yet again by $0.01 sequentially this quarter, raising our quarterly dividend from $0.915 per share to $0.925 per share. This represents the 42nd consecutive sequential quarter of growing our regularly dividend, and the annualized growth rate in this dividend is now approximately 4.4%. Now for a couple of expectations about our long-term guidance.

Once we have combined with the Sprint wireline businesses, we anticipate an annual revenue growth rate of between 5% and 7%, an annual EBITDA margin expansions on the combined business of approximately 100 basis points per year. Our revenue and EBITDA guidance targets are intended to be multi-year goals and are not intended to be used as quarterly or even annual guidance. I'd like to turn the call over to Tad to read safe harbor language and provide a further review of some of our operating performance in the quarter. I will rejoin, and following these remarks, we will open the floor for questions and answers. Tad?

Thaddeus Weed (CFO)

Yes. Thank you, Dave. Good morning, everyone. This earnings conference call includes forward-looking statements. These forward-looking statements are based upon our current intent, belief, and expectations. These forward-looking statements and all other statements that may be made on this call and are not historical facts are subject to a number of risks and uncertainties. Actual results may differ materially. Please refer to our SEC filings for more information on the factors that could cause actual results to differ. Cogent undertakes no obligation to update or revise our forward-looking statements. If we use non-GAAP financial measures during this call, you will find these reconciled to the corresponding GAAP measurement in our earnings releases, which are posted on our website at cogentco.com.

Like many companies, we continue to be impacted by the COVID-19 pandemic. Our risks related to COVID-19 and other risk factors are described in more detail in our annual report on Form 10-K for 2022 that will be filed this week, the end of this week, and in our quarterly reports on Form 10-Q. On corporate NetCentric revenue and customer connections. We analyze our revenues based upon network connection type, which are on-net, off-net, and non-core. We also analyze our revenues based upon customer type. We classify all of our customers into two types: NetCentric customers and corporate customers. Our corporate customers buy bandwidth from us in large multi-tenant office buildings or in carrier-neutral data centers. These customers are typically professional services firms, financial services firms, and educational institutions located in multi-tenant office buildings or connected to our network through our carrier-neutral data center footprint.

Our NetCentric customers buy significant amounts of bandwidth from us in carrier-neutral data centers and include streaming companies and content distribution service providers, as well as access networks who serve consumer and business customers. Our corporate business represented 56.4% of our revenues this quarter, and 57.1% of our revenues for 2022. Our quarterly corporate revenue declined year-over-year by 1.2% to $85.8 million from the fourth quarter of 2021. As Dave mentioned, increased sequentially by 0.3%. For full-year 2022, our corporate revenues declined by 4.4% to $342.6 million. We had 44,844 corporate customer connections on our network at year-end.

That was a sequential decrease of 0.7% and a year-over-year decline of 1.3%. Our total revenues and our corporate revenues were negatively impacted by changes in the USF tax rates on a year-over-year basis. For the quarter, the impact of USF on our revenues was flat, but there was a negative year-over-year impact of about $300,000 from the fourth quarter of last year. For the full-year, the negative impact of USF was $3.1 million. On a constant currency basis, and if you adjust for the year-over-year decline in USF revenues, our total revenues for the full-year increased by 4.4%, substantially better than the comparable 2.4% constant currency and USF tax-adjusted revenue growth rate from 2020 to 2021.

Our NetCentric business, which represented 43.6% of our revenues this quarter, had another solid quarter and grew by 2.6% to $66.2 million sequentially and by 9.6% year-over-year. For the full-year, our NetCentric revenue grew by 11.1% to $257 million. Again, as Dave mentioned, the volatility in foreign exchange primarily impacts our NetCentric revenues. On a constant currency basis, our quarterly NetCentric revenue decreased year-over-year by 15.2% and sequentially by 2.5%. For the full-year, NetCentric on a constant currency basis grew by 16.7%. We had 51,670 NetCentric customer connections on our network at quarter-end.

That was a sequential increase of 1% and a year-over-year increase of 7%. Our on-net revenue was $114.9 million for the quarter, a sequential increase of 1.5%, and a year-over-year increase of 3.8%. Our on-net revenue increased by 2.2% for the full-year to $452.8 million. Our on-net customer connections were 82,620 at year-end. We serve these on-net customers in our 3,155 total on-net multi-tenant office and carrier-neutral data center buildings. We continue to succeed in selling larger 100 Gb connections and 400 Gb connections in selected locations, which has increased our on-net ARPU. Our off-net revenue was $36.9 million for the quarter.

That was a sequential increase of 0.7% and year-over-year of 1.6%. Our off-net revenues are impacted by incorporated the cost savings we obtain for lower local loop prices into our pricing to our customers. Our off-net customer connections were 13,531 at the end of the year. We serve these off-net customers in about 8,300 off-net buildings that are primarily in North America. The average price per Mb for our installed base declined sequentially by 2.8% to $0.26 and the year-over-year by 19.6%. However, this annual rate of decline for our installed base was better than our historical long-term average of 21.5%.

The average price per Mb for new contracts for the quarter was $0.13, sequential decline of 13.5% and year-over-year of 24%. Selling larger connections results in a change in our connection mix and has the effect of lowering our average price per Mb at a greater rate than changes in our ARPU. Regarding ARPU, our on-net ARPU for the quarter increased and our off-net ARPU continued to decline, but at a modest rate from the lower pricing again, we are obtaining for our off-net circuit vendors that we pass on to our off-net customers. Our on-net ARPU, which includes both corporate and NetCentric customers, increased sequentially by 1.3% from $458-$464.

Our off-net ARPU, which is predominantly corporate customers, declined sequentially by 0.7% from $920-$914. Our churn remained strong. Our sequential quarterly churn rates for our on-net and off-net connections were relatively stable and continue to hover around 1%. Our on-net unit churn rate was 1% for the quarter, slight improvement from 1.1% last quarter. Our off-net churn rate was 1.1% for this quarter compared to 1% last quarter. In order to reduce our customer turnover, we employ a dedicated sales group that works to retain customers who have indicated that they are considering terminating their service with us.

We may offer pricing discounts to these customers in order to induce them to reverse their termination decision, to purchase additional services from us, and/or to extend the term of their contracts with us. During the quarter, certain of our NetCentric customers took advantage of our volume and contract term discounts and entered into long-term contracts with us for over 2,150 customer connections, and that increased their revenue commitment to Cogent by over $20 million. Some comments on EBITDA and EBITDA margin. Again, we reconcile our EBITDA to our cash flow from operations in each of our quarterly earnings press releases.

Seasonal factors that typically impact our EBITDA and predominantly our SG&A expenses include the resetting of payroll taxes in the U.S. at the beginning of each year, annual cost of living or CPI increases, seasonal vacation periods, year-end bonuses paid to our employees, and the timing and level of audit and tax services, and now Sprint acquisition costs, and also annual benefit plan cost increases. We incurred $2.2 million of Sprint acquisition costs for the full-year and about $200,000 in the fourth quarter. Our EBITDA for the quarter, inclusive of the Sprint acquisition costs, decreased sequentially by $0.7 million and decreased by $0.3 million year-over-year. Our EBITDA for full-year 2022, inclusive of these costs, increased sequentially by 1.2% to $230.6 million.

Our fourth quarter and full-year 2022 EBITDA results were impacted by the increase in our sales rep headcount, increased circuit costs related to our international expansion, and a year-end $1.5 million one-time bonus that we granted to our eligible employees to help to offset the impact of inflation. Our quarterly EBITDA margin, inclusive of Sprint costs, decreased sequentially by 100 basis points to 37.6% and year-over-year by 140 basis points. For the full-year, our EBITDA margin inclusive of Sprint decreased sequentially by 10 basis points to 38.5%. Excluding Sprint acquisition costs, for the full-year, our EBITDA increased by 2.2%, and our margin decreased sequentially by 220 basis points to 37.8% for the quarter and year-over-year by 120 basis points.

For the full-year 2022, our EBITDA margin excluding Sprint increased sequentially by 20 basis points to 38.8%. Comments on foreign currency. Our revenue earned outside of the United States is reported in US dollars and was approximately 25% of our total quarterly revenues this quarter. About 16% of our revenues this quarter were based in Europe, and 9% of our revenues were related to our Canadian, Mexican, Asia Pacific, South American, and African operations. Our average EUR to USD rate so far this quarter is about $1.08, and the Canadian average rate to USD is about $0.75.

If these average rates remain for the remainder of the quarter, the first quarter of 2023, the foreign exchange estimated impact on sequential revenues would be positive by $1.4 million. Year-over-year would be negative by the same amount, $1.4 million. We believe that our revenue and customer base is not highly concentrated. Our top 25 customers represented again about 6% of our revenues this quarter. Our quarterly CapEx expenditures decreased sequentially to $19.6 million and were $79 million for the full-year. Supply chain uncertainty and purchases in anticipation of the closing of our Sprint acquisition caused us to shift our typical purchasing schedule for network equipment.

These anticipatory investments are designed to ensure that we have satisfactory inventory levels of network equipment to accommodate our growth plans, including new Wavelengths product offerings as a result of the Sprint acquisition and the interconnection of our two networks together in multiple locations to meet our customer needs. Some balance sheet comments. Our finance lease IRU obligations are for long-term dark fiber leases and typically have initial terms of 15-20 years or longer. Often include multiple renewal options after the initial term. Our longest term lease is for 44 years. Our current IRU finance lease obligations totaled $304.2 million at year-end. We have a very diverse set of IRU suppliers, and we have IRU contracts with a total of 308 different dark fiber suppliers.

At quarter end, our cash and cash equivalents and restricted cash was $275.9 million. $52.1 million of restricted cash is tied to the estimated fair value of our interest rate swap agreement. Our cash flow from operations was $36.3 million for the quarter and $173.7 million for the year. Our total gross debt at par, including IRU obligations, was $1.3 billion at year-end, and our net debt was $978.3 million. Our total gross debt to trailing last 12 months EBITDA, adjusted for Sprint costs, the ratio was 5.39 at quarter end, and our net debt was 4.2. Our consolidated leverage ratio, as calculated under our indentures, slightly different, 5.32, and our secured leverage ratio was 3.41.

Our fixed coverage ratio, as calculated under the indentures, was 3.49. We are party to an interest rate swap agreement that modifies our fixed interest rate obligation with our $500 million 2026 notes to a variable interest rate obligation based on the Secured Overnight Financing Rate for the remaining term of these notes. We record the estimated fair value of the swap agreement at the end of each reporting period, and we incur corresponding non-cash gains or losses due to changes in market interest rates. At quarter end, the fair value of the swap agreement decreased from last quarter by $2.6 million to $52.1 million. We are required to maintain a restricted cash balance with the counterparty equal to the liability. The settlement payments under the swap agreement are made each November and May.

Under our initial payment made in November 2021, we achieved a net cash savings, interest savings of $0.6 million. For the next payment for the period of August 2021 to October 2021. The next payment, I'm sorry, under the payment that we made in May 2022, was an additional savings of $1.2 million for the period for November 2021 to April 30, 2022. Under the previous settlement payment that we made in November 2022, we had a net cash cost of $3.4 million for the period from May to October 2022. Finally, some comments on bad debt and day sales, which were excellent for the year and for the quarter. Our bad debt expense was only 0.5% of our revenues for the quarter and 0.4% of our revenues for the year.

That was an improvement of 0.6% of our revenues from last year. Our day sales outstanding is very consistent and excellent at 22 days at year end. We want to thank and recognize, as always, our worldwide billing and collections team members for continuing to do just a fantastic job in serving our customers and collecting from these customers. With that, I will turn the call back over to Dave.

David Schaeffer (Chairman and CEO)

Hey, thanks, Tad. I'd like to highlight a couple of strengths of our network, our customer base, and our sales force. We've achieved excellent revenue growth in our NetCentric business. We're a direct beneficiary of increased over-the-top video and streaming services, particularly in international markets. At quarter's end, we are on net in 1,458 carrier neutral data centers. We also have 54 Cogent owned data centers, bringing our total on net data center footprint to 1,512 data centers. More than any other carrier globally is measured by independent third-party research. The breadth of this coverage enables our NetCentric customers to better optimize their networks and reduce latency. We expect to continue to widen this lead over the market as we project to connect an additional 100 carrier neutral data centers per year to our network over the next several years.

We will be also adding approximately 45 Sprint data centers to our network footprint. At quarter end, we directly connect to 7,792 unique networks. The collection of ISPs, telephone companies, cable systems, mobile operators, and other carriers give us direct access to the vast majority of the world's broadband subscribers and mobile phone users. At quarter end, we had a sales force of 216 professionals who focus solely on this NetCentric market. We believe this group of professionals is the largest and most sophisticated sales team focused on this market segment. This sales force will also primarily be responsible for the sale of our Wavelengths products as we close the Sprint transaction. For a couple of comments on the corporate market segment.

We are seeing positive trends in our corporate business as work from home environment becomes established as part of the way in which people work in an office. We believe our corporate customers will continue to look to upgrade their internet access infrastructure to larger capacity connections and more diverse connections. Our corporate customers are aggressively integrating some of the new applications that became part of the work from home environment, such as video conferencing. This usage will require high bandwidth connections both inside and outside of the premise. Our aggressive push to lower bandwidth costs and provide greater coverage has begun to boost corporate demand for our robust bi-directional symmetric 1 gig and 10 Gb ports. Corporate customers are increasingly buying connections in carrier neutral data centers for redundancy and to support the ad hoc VPNs that their hybrid workforce requires.

We remain focused on our sales force productivity and sales worth growth, and continue to improve our sales training programs and manage out underperforming sales reps. On a sequential basis, our total sales rep headcount increased by a net of 26 or 5% sequentially, and by 11.8% year-over-year to 548 quota bearing reps. Our number of full-time equivalent reps, those reps that have been in seat for more than three months, increased from 500-503 from 465. Our sales force turnover rate improved again to 4.7% per month from last quarter, when that number was 5.5% per month.

This is down substantially from a peak during the pandemic of 8.7% turnover per month, and that was in fact the worst sales force turnover rate in our corporate history. We are now operating below historic averages, with sales force turnover rate averages over the past 17 years averaging 5.7%. In summary, we remain optimistic about our unique position in serving small and medium sized businesses located in the central business districts of major North American cities. We have 1,837 large multi-tenant office buildings on net, representing over 1 billion sq ft of rentable space, an average building size of approximately 550,000 sq ft.

We are excited about adding large enterprise customers to our customer base through the Sprint acquisition and are most excited about our ability to sell Wavelengths or Optical Transport Network services, a new product to Cogent that we are adding to our portfolio and expanding into all of our U.S. data center footprint. Currently, key indicators of office activity, including workplace reentry and leasing activities, are improving but do remain below pre-pandemic levels. We are encouraged that many tenants have indicated that they are returning to office, they are leasing new space, and they are now settling on what their new network architectures will look like. As certain corporations elect to downsize their office space requirements in multi-tenant office buildings, this increases the opportunity for new tenants to move into those buildings and allows us to increase our total addressable market in on net corporate buildings.

Under our indenture agreements, including the $250 million general restricted payments basket carve-out, we have a cumulative amount available for dividends and stock buybacks that actually exceeds the $275 million of cash that we have on hand. We are diligently working to close the Sprint wireline transaction. We are excited and very optimistic about the cash flow generating capabilities of the combined company with our expanded product set and footprint. We expect the transaction to close in the second quarter of 2023. With that, I'd like to now open the floor for questions.

Operator (participant)

Thank you. At this time, I would like to remind everyone, in order to ask a question, press star then the number one on your telephone keypad. We'll take our first question from Frank Louthan at Raymond James.

Frank Louthan (Managing Director and Senior Equity Research Analyst)

Great. Thank you. Just to be clear, do you think this is going to close more towards the beginning of the quarter or towards the end? Can you give any updates on how the revenue and the EBITDA are going to be able to recognize that from any updates from the accountants? Thanks.

David Schaeffer (Chairman and CEO)

Yeah, thanks for both questions, Frank. While we have all regulatory approvals in hand, and we have been working diligently with over 30 working groups on the integration, the longest lead item remaining is the successful completion of our transition services agreement. While we have the framework of that agreement, and we've identified all of the requisite items to be included, the negotiation of that is continuing. I would say probably mid-quarter is the most likely closing date, but we feel highly confident it will close during the quarter. It is probably unlikely that we will close at the very beginning of the quarter, just based on the fact we only have five weeks to complete that transition service negotiation, and there are over 200 discrete items that have to be addressed and agreed to by both parties.

While we characterize the negotiations as very constructive and both parties are determined to get this done, there is just a lot of detail, work that needs to occur. Now to the question about the transit services agreement that we entered into with T-Mobile as part of this transaction. In consultation with Ernst & Young, our auditors, we feel comfortable that we will be able to recognize the vast majority of that $700 million stream of revenue as revenue for Cogent, and therefore, will be included in our reporting and in our financials.

Frank Louthan (Managing Director and Senior Equity Research Analyst)

Okay, great. Thank you very much.

Operator (participant)

We'll go next to James Breen at William Blair.

James Breen (Senior Equity Research Analyst)

Thanks for taking the question. Just a follow-up on that. You talked about sort of the run rate of revenue, at close, I think you said around $450. Any sort of thoughts on, you know, is that sort of the bottom there and you've taken it down to the bare minimum, and it grows from there, or do you think you'll see more revenue attrition once the deal closes? Thanks.

David Schaeffer (Chairman and CEO)

Thanks for your question, Jim. Two points. We do project the stable revenue run rate of the acquired enterprise customer base to be approximately $450 million. Because the transaction is probably going to close sooner than we had initially anticipated, it is our expectation that at closing in the second quarter, the annualized run rate will actually be above $450 million. There was a requirement in most of the acquired customers' contracts to give them adequate notice about the end-of-life product sets. We will probably see some of those end-of-life products at closing being acquired, and then over the next several months, we'll probably get down to that $450 million run rate.

We've also identified a team of individuals, primarily Sprint sales professionals, but also some Cogent sales professionals will be focused on that customer base of about 1,200 large enterprises with the goal of improving the quality of their service, modernizing their networks, and preserving that revenue initially. The ultimate expectation is that we will be able to grow the enterprise revenue base at about 1%-2% per year. We think we're probably a year or two away from that, but we do expect to plateau at about $450 million of large enterprise revenue.

James Breen (Senior Equity Research Analyst)

Great. Thanks. Just on the cash flow side around the transaction, the first payment that you get from T-Mobile, would that come right as the deal closes, or is there a lag period between when the deal closes and when you receive that payment?

David Schaeffer (Chairman and CEO)

It comes at the end of the month, first month after closing, and that payment is slightly over $29 million a month for the first 12 months, and then reduces down to approximately $9 million per month for the next 42 months. Because this is going to be able to be treated as recognized revenue, we will probably end up having to straight line that contract value. We will have some initial deferred revenue that will then burn off over the life of the lease.

James Breen (Senior Equity Research Analyst)

Great. Thanks.

Operator (participant)

We'll move next to Brandon Nispel at KeyBanc Capital Markets.

Evan Young (Equity Research Analyst)

Hi, thanks. It's Evan Young on for Brandon. Could you talk about your SG&A expenses for the quarter, and your sales rep hiring going forward? Do you think that that's going to continue impacting expenses?

David Schaeffer (Chairman and CEO)

For the quarter, Evan, we first of all elected to do a $1.5 million bonus to our global workforce as in lieu of a larger CPI increase. We felt that much of the impact of inflation was a one-time shock. While there is a continuing component, we did not wanna be locked into that continuing higher expense. That was an extraordinary expense in the quarter and, you know, was roughly 100 basis points of margin hit through that bonus. Second of all, to address the headcount number. We were very clear that pre-pandemic, we had about 600 total reps, about 550 quota-bearing FTEs. The pandemic was particularly hard on our headcount. We actually experienced headcount decline of approximately 18%.

As we have emerged from the pandemic, we have accelerated our hiring to the fastest pace in the company's history in order to regain that lost ground. We anticipate getting back to that pre-pandemic level of about 600 quota-bearing reps, about 550 full-time equivalent quota-bearing reps. These numbers are not inclusive of the roughly 60 quota-bearing individuals that will come from the Sprint transaction, so they are additive. Off of that base, of about 660 total reps, and with the Sprint team, almost the entire team is an FTE since our average tenure is quite long. We expect to grow the sales force headcount on a going forward basis at a much more normalized rate of about 7% per year.

Once we get to that roughly 660 headcount, we expect our hiring pace to decelerate. We hope that our turnover rate will continue to be below historic averages. We think the training programs that we've put in place have helped quite a bit. With that, the total sales force should grow at about 7% per year or about 45 net reps. A lower pace than we're growing today.

Evan Young (Equity Research Analyst)

Great. Thanks, Dave.

David Schaeffer (Chairman and CEO)

Okay, thanks, Evan.

Operator (participant)

We'll move next to Nick Del Deo at SVB MoffettNathanson.

Michael Srour (Equity Research Associate)

Hey, thanks for taking my questions. This is Michael Srour on for Nick. On your last earnings call, you shared how you had received expressions of interest for Wavelengths and dark fiber from customers you spoke with at NANOG shortly after the deal was announced, and that was obviously very encouraging. Now you've mentioned that you began to sell Wavelengths through a commercial resale agreement with T-Mobile. I was wondering if you can give us an update on the degree to which that's continued, and what it might mean for the speed with which you might start recognizing Wavelengths and dark fiber revenue after closing.

David Schaeffer (Chairman and CEO)

Yeah, sure, Michael. Thanks for the questions. We needed to negotiate that commercial agreement, that we could, allow us to sell Wavelengths pre-closing. That agreement was put in place last month. Actually, in February, we began training our sales engineers and training staff at the beginning of the month to sell Wavelengths. Actually just last week, formally launched the product to the sales team through a series of teach-ins around the world. In the initial period, the process is actually more complicated than it would be after the deal closes in the next couple of months. It does require us to enter into arm's length agreements to then resell. We also have a much smaller number of locations that we can sell in today than what we ultimately anticipate.

Just to refresh your memory, Sprint had trialed this product and was only able to sell it in about 25 locations. By integrating the networks, we have added an additional 50 locations immediately. Today, Wavelengths are available at Cogent, or Sprint can resell our metro footprint in about 80 locations. Over the next 60 days, we expect that number to go from 80 to approximately 200. It probably will take another year before the Wavelengths product is standard across our 800 locations. You know, we have already booked initial orders. We do have a great deal of interest. I would say the initial order count at this point from the Cogent side is probably about 12 Wavelengths. I think that's pretty good for less than a week of selling.

You know, I think the Sprint side, using our metro network, since they could formally do that also beginning last week, is also in that same kind of roughly 10 or so. These are pretty encouraging discussions. In terms of dark fiber sales, we have a memorandum of understanding with one counterparty on one route. We have been cautious in trying to sell dark fiber in advance of the transaction closing for three reasons. One, it's not a product that Sprint has ever sold. Two, there's not a lot of precedent for arm's length pricing. If we were reselling it, we would need to demonstrate arm's length prior to deal closing, and we didn't want to take any regulatory risk.

Finally, we wanted to make sure that the value of monies received from a sale would accrue to Cogent and not T-Mobile, we would not want a dark fiber sale to be completed until after the transaction is closed. I think, you know, realistically, we're gonna focus on Wavelengths first, dark fiber second, I think by the time we report, third quarter, we should be in a position to give much more color on the dark fiber market opportunity.

Michael Srour (Equity Research Associate)

Got it. Thanks. One more, if I can. Can you talk about the cadence of corporate sales activity from Q3 into Q4, and how it's trended into the first quarter and the overall state of the funnel?

David Schaeffer (Chairman and CEO)

I would say that it has continued to improve. In fact, the sequential 0.3% growth is much better than what we had been experiencing during the pandemic. I also wanna temper that by saying we're far from the pre-pandemic kind of 2% sequential growth rate, so we have averaged. When we look at all of the leading indicators, whether it be proposals, orders, ARPU, all of those are giving us encouraging, you know, indications that there'll be continued sequential corporate improvement. As I've tried to counsel on the last couple of earnings calls, you know, we anticipated a more rapid return to our normalized corporate growth rate, and now we're really taking a wait and see.

We're encouraged, but I think it's gonna still be, you know, more than a year before we're back to that kind of 2% sequential corporate growth rate.

Michael Srour (Equity Research Associate)

Got it. That makes sense. Thanks, Dave.

David Schaeffer (Chairman and CEO)

Thanks, Michael.

Operator (participant)

As a reminder, if you would like to ask a question, please press star one. We'll go next to David Barden at BofA Securities.

John Crawford (Equity Research Analyst)

Hey, you got, John Crawford on for Dave. Just curious about leverage. It's continued to grow over the past few quarters above that two and a half to three and a half range. Wondering what direction you're expecting that to head in 2023, and if your mindset about disgorging excess cash has changed since last you spoke on it.

David Schaeffer (Chairman and CEO)

Thanks for the question, and a correction on Dave's name, it's David Barden. I think we've had a consistent policy of utilizing our balance sheet and slowly disgorging cash through a systematic increase in the dividend. I think we are going to remain committed to that strategy. It is true that our leverage did increase in the quarter, primarily due to our elevated capital lease principal payments and our increase in CapEx. Much of this is a effort to tie the networks together. As I indicated earlier, we've got an additional 50 data centers connected to the Sprint network. Each of those had a capital expenditure associated with that. We have another 150 in process where we have also already spent that capital.

I think we will see our leverage on a net basis, maybe go up a little from here, but not much, and then start to come down. Remember, the recognition of the $700 million in cash payments from T-Mobile as revenue flows directly through to EBITDA because our transit product is a 100% gross margin product. The locations that we have reserved port capacity for T-Mobile to utilize that service, if they choose to, would have no incremental OpEx cost for Cogent. With that additional revenue stream and margin, we will rapidly delever.

John Crawford (Equity Research Analyst)

Got it. Thanks. Another, if I can. I know you mentioned that the NetCentric team would be working on Wavelengths sales. I was wondering if your philosophy on headcount rationalization from that transaction has changed since you announced it, like the number of people you're hoping to bring over.

David Schaeffer (Chairman and CEO)

It really has not. Remember, the Sprint organization at the day we signed the deal had 1,320 employees, and only 60 of those were in sales. All of those salespeople remain. There have been a number of voluntary reductions in force that have occurred under T-Mobile stewardship. T-Mobile has been very generous in the severance packages that they have offered employees. That headcount today is slightly below 1,100 employees. We expect that number to continue to decline through the use of these severance packages. All of the employees are expected to become Cogent employees. We have realigned our organizational structure with both senior Sprint people in management roles as well as Cogent, but following the Cogent organizational structure. My guess is there will be some additional fallout post-closing as some individuals choose not to take those new assignments.

We negotiated an additional $25 million pool of capital above and beyond the $700 million with T-Mobile so we can mirror their severance program post-closing. I would say that we anticipate at closing to be somewhere around 1,000 employees additional to the about 1,075 that Cogent has. Just over 2,000. We would expect some additional operational attrition post-closing, offset in part by our growth in the sales force. We anticipate the combined company's headcount to be between 2,000 and 2,100.

John Crawford (Equity Research Analyst)

Great. Thanks.

Operator (participant)

We'll go next to Bora Lee at RBC Capital Markets.

Bora Lee (VP of Equity Research)

Hi, Dave. Thanks for taking the questions. Can you remind us where you're expanding internationally and how you're thinking about those efforts and CapEx while integrating the Sprint wireline assets?

David Schaeffer (Chairman and CEO)

Yeah. Thanks for the question, Bora Lee. You know, Cogent today operates in 51 countries around the world. Our most recent expansion was Peru, we are constructing through IRU acquisition, multiple rings in Lima as our initial market. When we go into an international market, we typically buy dark fiber intercity also dark fiber intracity look to connect to all significant data centers in those markets. We are in the process of several other countries that Cogent is organically adding. In addition to that, we will be acquiring three new markets where Cogent had intended to go has had significant regulatory lags. That being India, Thailand, Malaysia. Sprint already has the requisite licenses in each of those markets, they will come on net quickly.

I would suspect in 2023, we will add those three markets and probably about another five or six additional countries that Cogent organically is working on. That is factored into our expectation of adding approximately 100 carrier neutral data centers a year. Just to remind investors, the Sprint network outside of the U.S., inclusive of Canada and Mexico, was entirely based on lit rented capacity. The Cogent network is entirely based on owned dark fiber. We are in the process of converting over those Sprint intercity networks and data center connectivity onto the Cogent owned network. About 15 of those international data centers have already been brought on net. We have about another 30 in process. We'll continue that effort until we have completely eliminated the leased Sprint international network.

That is anticipated to result in about a $25 million a year annual savings rate.

Bora Lee (VP of Equity Research)

Thanks for that. One more, if I could.

David Schaeffer (Chairman and CEO)

Sure.

Bora Lee (VP of Equity Research)

You somewhat alluded to this in your answer to my question, but in terms of the long-term guidance of 5%-7% revenue growth, and more specifically, 100 basis point margin expansion per year, how are you thinking of the sources of that margin expansion between COGS and SG&A? Thank you.

David Schaeffer (Chairman and CEO)

You know, historically, Cogent has gotten its 200 basis points of margin expansion almost equally from COGS efficiency and SG&A efficiency, roughly a 50/50 split, if you go back and look at the past 17 years of public, you know, filings. I think going forward, we would expect about the same. You know, when we looked at our EBITDA performance, we actually had the very best gross margin quarter, I think, in the company's history. It's 62.5% in the fourth quarter, continued improvement. You know, the smaller rate of EBITDA margin expansion year-over-year was really impacted by SG&A, and it was really this rapid rehiring of our sales force post-pandemic.

I think we'll be through that by mid-year this year. We should get back to kind of a cadence of about half of our EBITDA margin improvement coming from gross margin pickup and about half of it coming from SG&A efficiency.

Bora Lee (VP of Equity Research)

Great. Thanks, Steve.

David Schaeffer (Chairman and CEO)

Okay, thanks.

Operator (participant)

We'll take our next question from Michael Rollins at Citi.

Michael Rollins (Managing Director)

Hi, good morning. I'm curious, as you think about the process of taking share in each the corporate and the NetCentric segments, how does the practice of taking share generally compare with your expectations of that pace, you know, when you create the multi-year, you know, business plan and update that every so often? What are the factors that you find cause the variance, whether it's a positive variance or negative variance, and is there something to learn from that as we try to consider the opportunities to take share from these products that you're gonna expand with this upcoming acquisition? Thanks.

David Schaeffer (Chairman and CEO)

Yeah, sure, Mike. Thanks for the question. I think going forward, there'll actually be a third category, which is large enterprise, which really is a very different customer base than our traditional corporate customer, which tends to be a smaller medium-size business. You know, I think when we look at the corporate segment, our gain in market share is as a result of more footprint and better penetration in that footprint. I think the variance came as a direct result of the pandemic, the increase in vacancy rate in that footprint, and the, I think, paralysis of decision-making by the remaining tenants with the uncertainty around their office configurations. As we are emerging from that and companies are kind of settling on a work plan, whether it be a hybrid or entirely in the office, we're seeing an improvement.

Because there is still elevated vacancy and those work plan implementations are not universally adopted yet, I think we've seen a slower than expected rebound in the corporate business. It is rebounding. It is clearly much better than it was during the pandemic. It is not back to kind of the pre-pandemic consistency that we had, and I think we're trying to be realistic about that. We look at all of the leading indicators as well as actual performance and then modify our plan. That's why earlier in the call I said we're probably at least a year away from that 2% sequential growth just based on the data we have. Moving over to the NetCentric business, there we look at, you know, actual traffic patterns on a daily basis.

We look at the need of our customers to have multiple connections to reduce latency in their applications. We look at aggregate traffic growth. There we were probably too conservative in our modeling around the NetCentric business. I think we're very accurate in a rate of price decline, and I think that will continue, and we've been very consistent in that messaging. In terms of the rate of traffic growth and the gain in market share, we were probably too conservative. You know, we continue to grow our NetCentric business on a year-over-year basis, constant currency, at about 60% faster than our long-term average. We expect that outpaced growth to continue for longer than we expected, but we also think that it will at some point begin to moderate.

The final piece, which we have less empirical data on other than, you know, the diligence materials we've reviewed inside of Sprint, is that large enterprise customer base. The fact that they've been with Sprint for 30 years is extremely encouraging. They've been through multiple technology refresh cycles, and we can improve margins and quality by bringing those services on net. We think that we're being pretty conservative in our belief that we will see, you know, the $560 million run rate decline to $450. It'll plateau for a year or two, and then only grow at a modest 1%-2%. That's kind of the thinking that goes into each of those assumptions. They are literally revisited every quarter.

You know, we adjust our projections to the board each and every quarter based on real-world inputs in each of these categories.

Michael Rollins (Managing Director)

That's helpful. Thanks.

David Schaeffer (Chairman and CEO)

Thanks, Mike.

Operator (participant)

Next, we'll go to Walter Piecyk at LightShed.

Joe Galone (Senior Director and TMT Analyst)

Hi, David. This is, this is Joe on for Walter. Apologies if I missed this earlier, but I guess capital intensity remains elevated. Is there a way to think about kind of what's maintenance versus growth and what's kind of baked in from an acquisition standpoint going forward? 'Cause this year, I guess at least in Q4, there was the large capital lease principal repayment

David Schaeffer (Chairman and CEO)

Yep. We have been very clear about, you know, the three categories. You know, the first being the maintenance number for Cogent as kind of its organic business. That number needs to be about $35 million a year, and we anticipate that number continuing. What we would be spending above and beyond that would be expansion. We have added about 120 buildings at an average cost of about $125,000 a building or about $15 million in building connectivity. We also add additional metro fiber, either in new markets that we expand into or densifying markets that we are in. Above and beyond that, we have said that we will spend $50 million one time for the integration of the Sprint and Cogent networks.

Some, actually a significant part of that capital lease was to get the fiber to begin to integrate those networks. The Sprint locations were oftentimes not in central business districts and needed to be connected in, we've spent a significant portion. There is still some more to spend on that one-time integration expense. The third bucket of capital intensity, which will be higher for the combined company, is that the Sprint business that we're acquiring, inclusive of the capital needed to support the Wavelengths product, is about $30 million a year. The way to think about the business once this one-time integration effort is complete is 35 for the Cogent business, 30 for Sprint, $65 million of recurring CapEx, and then whatever footprint expansion we're going to do.

That's probably right now running in the neighborhood of about $30 million-$35 million. About $15 million of that is buildings. As we said, we'll be adding about 100 carrier neutrals, and then the necessary either inner city or metro fiber in these new markets.

Joe Galone (Senior Director and TMT Analyst)

Okay, great. Thank you.

David Schaeffer (Chairman and CEO)

Thanks. I'm glad you gave Walt the day off.

Operator (participant)

That does conclude our question and answer session. I would like to turn the conference back over to David Schaeffer for any closing remarks.

David Schaeffer (Chairman and CEO)

I'd like to thank everyone. Hopefully, we've been complete in answering all of the investors' questions. Most importantly, we look forward to closing the Sprint transaction quickly, making sure that we have a fully negotiated transition services agreement that protects both parties. We feel quite confident that will happen in the second quarter. Take care, everyone, and we'll talk soon. Bye-bye.

Operator (participant)

This concludes today's conference call. Again, thank you for your participation. You may now disconnect.