Cogent Buying Binge: Another Bubble?

Local Ethernet services provider Cogent Communications Inc. has closed its planned acquisition of bankrupt PSINet Inc. for $10 million (see Cogent Acquires PSINet). Now one huge question looms: Will it ever pay off?

Picture this: A 130-person company with roughly a half-billion dollars worth of debts and only $50 million in the bank has purchased three major companies, gone public in a reverse merger, and plans to build an Ethernet services empire. Genius or lunacy?

The PSINet deal is Cogent's third acquisition, building on the startup's strategy of picking Internet carcasses clean (see Cogent's Finances Revealed in Filing). In September 2001, six months after creating a new parent company called Cogent Communications Group Inc., Cogent bought the remaining assets of NetRail Inc., another bankrupt ISP, for roughly $11.9 million. In February 2002, it completed a reverse merger with Allied Riser Communications and went public in the process (see Cogent's Reverse Prognosis) .

The frightening part of this plan is Cogent's finances, which came to light in a recent 10-K filing with the Securities and Exchange Commission (SEC). In 2001 Cogent posted just $3.02 million in revenues and lost $91.1 million (roughly $64.78 per share). And the filing shows that interest payments alone exceeded its revenues in the last year.

Hungry for AssetsCogent officials are pressing forward nonetheless. They say the acquisition of assets is key to improving the company's financial picture.

The PSINet acquisition was first announced in February 2002 (see Cogent to Buy PSINet). Cogent got approval from the Bankruptcy Court on March 27 to go ahead with the deal, through which Cogent is taking over the majority of PSINet's U.S. assets. These include its network faclities, which Cogent says comprise three Web-hosting data centers, 13,000 miles of dark fiber, 10,000 miles of lit OC48 (2.5 Gbit/s) connectivity held under 20-year leases, and an undisclosed number of customers nationwide.

PSINet also bring Cogent so-called "settlement free peering arrangements," which will enable Cogent to switch data traffic through other carriers' networks without having to pay for it.

"There are several things that are important to us about this acquisition," says Cogent founder and CEO Dave Schaeffer. Apart from the facilities, he cites PSINet's history as the first commercial provider of Internet services, its recognizable brand name, and its supposedly large customer base (Cogent won't give numbers). These elements, he says, add up to expertise, revenues, and new customers.

Cogent acknowledges it has some work to do to get the bankrupt PSINet into shape as a working cash cow. "While eliminating some of the high costs associated with the PSINet network, combined with a reduction in staff, Cogent expects to take a business with poor operating results and turn it around," says Cogent CFO Helen Lee in a prepared statement. Company officials decline to say where cuts will be made, or how many employees will be affected.

Cogent claims the NetRail deal helped it save operating costs by, among other things, bringing new customers and peering points to Cogent. Allied Riser, in contrast, has been a mixed bag. Cogent was able to go public as a result of the merger, and Cogent's 10-K states that it benefited from the funds realized in the deal. But there is a sizeable dark side to the merger.

Riser a Downer?For one thing, Cogent acknowledges that integrating its network facilities with the in-building facilities of Allied Riser is costing big bucks. "Integrating the operations of Cogent and Allied Riser will be a costly and complex process," according to the 10-K. "We are uncertain that the integration will be completed rapidly or that it will achieve the anticipated benefits of the merger."

And there's more: Certain aspects of the merger with Allied Riser are being questioned by the SEC, although no specific reason for the inquiry has been given. Allied Riser also seems to be a lightning-rod for lawsuits, the most serious of which comes from "certain holders of Allied Riser notes," who apparently are seeking to get their money back -- now. In a series of motions, the most recent of which occurred last week, the note-holders appear to be getting aggressive.

Cogent's 10-K plainly states the risk if Cogent loses its battle with the note-holders: "[W]e could be required by the noteholders to repurchase $117.0 million in aggregate principal amount of the notes and to pay them accrued interest. We cannot assure you that we will have the ability to do this if we are required to do so." What's more, calling in the notes and interest could nudge major dominoes elsewhere in Cogent's financials by putting Cogent into violation of its debt covenants, held principally with Cisco Systems Inc. (Nasdaq: CSCO): "If we are unable to repurchase the notes and pay the accrued interest, we will be in default under the indenture and our obligations under our credit facility could become due and payable."

Debt DoubtsCogent says it's managed its money well and kept its focus. "We've used extreme discipline in deploying," Schaeffer says. "And the ability to acquire assets at a fraction of the cost gives us a huge advantage in driving down our own costs."

But the company's debt looms as the largest issue. Cogent's 10-K says the company has $564.8 million in total "contractual cash obligations," which are essentially debt obligations. Included in this figure is $181.3 million of long-term debt, $44.8 million of capital lease obligations, $160million in operating leases, and $178.7 million in unconditional purchase obligations from Cisco.

Cogent's debt load, according to SEC filings, requires a series of hefty principal payments, including $48.1 million in one year; $123.8 million in one to three years; $94.6 million in four to five years; and $298.3 million after 5 years. At present, Cogent has $50.8 million in cash and short-term investments and is still losing money. Operating cash flow for 2001 was a negative $46.8 million versus a negative $16.4 million in 2000.

Cogent's already started drawing on a $409 million credit facility for vendor financing from Cisco Systems Capital Corp., a unit of Cisco Systems. And the company has raised $177 million in private funding. But in the case of the Cisco covenants, Cogent must hold up its end of the bargain by making its debt payments and meeting a series of financial conditions related to liquidity over time. So far, it's in compliance, but the question is whether it can maintain that stance.

Schaeffer refuses to comment on the specifics of his annual report filing: "Because of our strict adherence to regulation FD [full disclosure] we do not provide interpretations of our historical results," he writes in an email to Light Reading.

In an interview earlier this week, Shaeffer conceded there are strategic challenges ahead. One, he said, is connecting end users in selected buildings quickly and economically. The other is gaining customer and investor confidence.

"The most difficult thing is to achieved credibility in a market where many providers are no longer in existence. But we know we'll be there."

— Mary Jander, Senior Editor, Light Reading
http://www.lightreading.com