Cogent Communications Stock: M&A Efforts, Beneficial Expectations And Not Expensive (CCOI)

Cogent Communications Holdings, Inc. (NASDAQ:CCOI) recently delivered new information about the new assets acquired, which could, I believe, improve the valuation of the stock. Given the boost in property and equipment, we may see significant improvement in capacity and customer growth. Besides, I believe that new services appreciate optical transport and wavelength services may also bring net sales growth increases. With those reasons in mind, I believe the stock is a buy. I do see significant risks from failed M&A efforts and the total amount of debt, however I think that the company could trade a bit more expensively.

Business Model

Based in Washington, DC, Cogent Communications offers Internet access services, private networks, and data center solutions.

Its network specializes in the transmission of packet data. It primarily serves small- and medium-sized businesses, communications service providers, and other organizations with high bandwidth demands in an extensive territory in several world regions.

In my view, its commitment to quality and cost efficiency makes it an attractive option for various business connectivity needs. CCOI focuses on providing high-speed Internet access and IP connectivity services to two groups of customers: corporate clients and network-centric customers.

Customer Growth, And Links With Large Telecom Companies Could improve Future FCF Margin Growth

CCOI’s key focuses include growing the corporate customer base, offering dedicated Internet access services and private networks, expansion in the network-centric market, offering wide geographic coverage and high capacity, and the development of a global peering platform, Global Peer Connect, for traffic exchange. Given the know-how accumulated and links with large companies appreciate T-Mobile (TMUS), I believe that customer growth and geographic expansion will continue. As a result, I believe that economies of scale as well as technological innovation could bring advance FCF margin growth.

New Services Could Bring Significant Net Sales Growth

In my view, continuous improvement of sales efforts and productivity as well as the expansion of off-grid corporate Internet access through agreements with new operators could improve future FCF growth. Besides, the inclusion of optical transport and wavelength services in its offering as a result of the acquisition of Sprint Communications could also bring new net sales growth drivers. The company noted these new services in the last quarterly report.

In connection with the Company’s acquisition of Sprint Communications (as discussed below), the Company began to supply optical wavelength services and optical transport services over its fiber network. The Company is selling these wavelength services to its existing customers, customers of Sprint Communications and to new customers who necessitate dedicated optical transport connectivity without the capital and ongoing expenses associated with owning and operating network infrastructure. Additionally, the Sprint Business customers include a number of companies larger than the Company’s historical customer base. Source: 10-Q

Recent Acquisition May Bring New Capacity And The Interest Of Investors

In the last quarterly report, we could see information about the fair value of assets acquired recently. The number of assets acquired is quite significant including new property and equipment, intangible assets, and account leased assets. As a result, I believe that CCOI will procure new capacity and many more customers. The boost in total assets that will be shown in the new annual report could bring the interest of more investors. As a result, we may see increases in demand for the stock and stock price increases.

Expectations From Other Financial Analysts

I believe that financial analysts upgraded their expectations for the incoming year as a result of the recent quarterly earnings results. In the quarter ended September 30, 2023, management noted a double digit boost in service revenue, close to 83% y/y. Investors may want to have a look at the recent earnings before they see the expectations of other analysts.

Market estimates include 2025 net sales of close to $1.162 billion, 2025 EBITDA of $392 million, 2025 EBIT close to -$142 million, and 2025 free cash flow of about $130 million. Note that analysts are expecting FCF growth in 2024 and 2025. My numbers are in line with the expectations of other financial analysts.

I Do Not See A Liquidity Issue, But The Company Reports A Significant Amount Of Debt

As of September 30, 2023, cash and cash equivalents stand at close to $109 million, with restricted cash of $56 million, due from T-Mobile close to $237 million, and total current assets of about $581 million. The current ratio is larger than 1x, so I do not see a liquidity problem here.

The largest asset is represented by property and equipment, which is close to $1617 million, but the company also reports right-of-use leased assets close to $364 million and long term amounts due from T-Mobile of $284 million. Total assets are equal to $2.961 billion, and the asset/liability ratio is close to 1x.

Accounts payable stands at close to $29 million, with accrued and other current liabilities close to $120 million, due to T-Mobile of $69 million, finance lease obligations of $63 million, and total current liabilities worth $355 million. Accounts payable does not seem enough to cover the total liquidity necessary to work. As a result, management received money from debt investors.

The total amount of debt is not small. Senior secured 2026 notes stood at close to $498 million, with senior unsecured 2027 notes of $446 million, finance lease obligations of $419 million, and total liabilities close to $2.519 billion.

Cost Of Debt And Promises From Management About Lower Net Leverage

I reviewed the debt terms signed by management. Interest rates are close to 3.5% and 7%, so I assumed that a cost of capital close to 3.55% and 7.55% would not be far from reality. The following are some more details about the debt accumulated by the company.

The company had outstanding notes with an aggregate principal value of $450 million in Senior Unsecured Notes due 2027 and $500 million in Senior Secured Notes due 2026. The 2027 Notes bear interest at 7% annually, and are paid semi-annually. The 2026 Bonds have an interest rate of 3.5%, and are also paid semi-annually. In June 2022, the company issued the 2027 Notes and used part of the proceeds to redeem its 2024 Notes. The remaining proceeds are expected to be used for general corporate purposes or share repurchases.

The 2026 Notes were issued in May 2021, are due on May 1, 2026 and bear interest at a rate of 3.50% per year. Interest on the 2026 Notes is paid semi-annually on May 1 and November 1 of each year. In June 2022, the Company redeemed and extinguished its €350.0 million aggregate principal amount of Senior Unsecured Euro Notes due 2024 (the “2024 Notes”). The 2024 Notes were due on June 30, 2024 and bore interest at a rate of 4.375% per year. Interest on the 2024 Notes was paid semi-annually on June 30 and December 30 of each year. Source: 10-Q

With regards to the total amount of debt, I believe that it is worth noting that Cogent promised to lower its net leverage ratio to close to 3x EBITDA. In my view, lower leverage would most likely push the EV/FCF up, which could bring higher stock price valuation.

Income Statement Expectations

Given previous expectations given in 2023, I believe that we have sufficient information to design a realistic income statement model. CCOI expects to deliver net sales growth of about 5%-7% and aggregate net sales of $1.5 billion by 2028. I did use these estimates in my DCF model.

My expectations include a median net sales growth close to 7%, with 2032 service revenue of $2.083 billion and 2028 revenue close to $1.5 billion. I believe that my numbers are conservative.

My income statement includes 2032 service revenue of $2.083 billion, with expenses from network operations of $775 million, selling, general, and administrative expenses close to $543.55 million, and depreciation and amortization of about $342.55 million. 2032 total operating expenses would be close to $1661.55 million.

Now, without gains on equipment transactions or gains or losses on lease terminations, 2032 operating income would be close to $422 million, with 2032 interest expense of -$249 million. Note that I did not include 2032 foreign exchange gain on notes, losses on debt extinguishment and redemption, or interest income. Finally, 2032 net income would be close to $84.55 million.

My Cash Flow Expectations Based On Previous Assumptions And Previous Cash Flow Statements

My cash flow expectations include 2032 net income of $84 million, depreciation and amortization of about $204 million, and 2032 equity-based compensation expenses of $28 million. Besides, with gains on equipment transactions and others of -$1 million and deferred income taxes close to $18 million, I also included changes in accounts receivable of $4 million.

Also, assuming prepaid expenses and other current assets close to -$1 million and change in accounts payable, accrued liabilities, and other long-term liabilities of -$18 million, 2032 net cash provided by operating activities would be close to $304 million, and with purchases of property and equipment of -$32 million, 2032 FCF would be about $272 million.

Valuation Model

Given previous trading multiples close to 36x and 38x, I assumed exit multiples close to 35.55x and 38.55x, which I believe are conservative. We are talking about a large company with previous consistent FCF margins, which may explain these trading multiples.

Also, with a WACC close to 3.55% and 7.55%, the implied valuation including cash in hand would range between $4.9055 and $7.8 billion. The median valuation obtained would be close to $5.5 billion and $6.5 billion.

If we also divide by the share count, the implied equity valuation would be between $105 and $168.5 per share. The median price forecast would not be far from $135 per share. Finally, the median IRR would not be far from 10%.

Risks

The company faces several risks. Rising inflation may put pressure on the costs of electricity and other services, which could impact profitability, especially if they cannot be fully passed on to customers.

Additionally, I believe that failed M&A could also bring significant damage. As a result, the company may have to deliver impairment of intangibles, lower net sales guidance, and lower FCF expectations. In the worst case scenario, in my view, we could see lower stock valuation.

I also saw risks due to agreements with TMUSA. I am not in a position to comprehend whether the prices at which these services will be provided are fair. I believe that certain investors out there may see conflicts of interest.

In addition, on the Closing Date, the Buyer and TMUSA entered into a commercial agreement for colocation and connectivity services, pursuant to which the Company will supply such services to TMUSA for a per service monthly fee plus certain third-party costs incurred in providing the services. Source: 10-Q

Besides, the company is vulnerable to acts of terrorism due to the concentration of customers in cities prone to attacks. Destruction or significant damage to key facilities could disrupt network traffic, damage reputation, and guide to loss of customers, negatively affecting business and operating results.

Competitors

In my opinion, the company faces fierce competition in the communications services market. Competitors include traditional telephone and cable companies as well as established network operators with financial resources, sales capabilities, and strong customer bases. It also faces competition from new market entrants. Although the company has a state-of-the-art fiber optic network, its lack of ownership of the majority of fiber infrastructure presents a challenge as it relies on long-term leasing agreements with suppliers. Competition is based on factors such as price, speed, reliability, and customer service. Competitive pressure on pricing comes from slower, cheaper services offered by traditional ISPs, which are upgrading their technology to match the company’s quality and speed.

My Opinion

The net sales growth expectations delivered for 2028, the recent information about new assets acquired, and market expectations could improve the stock valuation. In my view, new services appreciate optical transport and wavelength services may also boost net sales growth. Those are great reasons to buy the stock. Yes, there are risks from inflation, intense competition in the communications services market, and debt levels. Besides, the recent acquisition could stumble, bringing lower FCF growth than expected. With all that being said, the stock could soon trade a bit more expensively.