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 Assets Cogent 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 Doubts Cogent 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, $160 million 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
cfaller 12/4/2012 | 10:40:16 PM
re: Cogent Buying Binge: Another Bubble? Aren't these guys dead yet? I can't believe they went forward with the PSINet deal. No wonder the ARC bondholders are screaming- they know that Cogent's failure is a question of when, not if...
dc_optics 12/4/2012 | 10:40:15 PM
re: Cogent Buying Binge: Another Bubble? The fire sale should start in 6 months. Cogent is sinking and all their people are drinking the grape Kool-aid if they think they are going to make it. The only people that will make out are the CEO and CFO because they only care about themselves.
Gitreelf Olks 12/4/2012 | 10:39:44 PM
re: Cogent Buying Binge: Another Bubble? my impression of Mr. Schaeffer is that he is a shrewd business man, especially relative to some of the other start-up CEO's. I don't believe I ever spoke with him, but the decisions I heard being made were smart, real, and reasonably gritty.

That is not to say that I would buy their stock or that shrewd leadership will be enough to succeed, especially in a down economy with too many players.

But I wouldn't be too surprised.

rhynerapologist 12/4/2012 | 10:39:20 PM
re: Cogent Buying Binge: Another Bubble? He is shrewd, approaching the company like a real estate guy. He keeps buying land to offset the swamp land he bought first.
threeiron 12/4/2012 | 10:35:26 PM
re: Cogent Buying Binge: Another Bubble? I'll tell you what Cogent is doing: w/ their cash. They buy 5 black Porsche Boxters. The leading retail reps win the use of them for a quarter by signing up customers in buildings that management never intends to light up. In the intial land grab, reps were told to sign up anybody in any building, no matter how far away from fiber it was. So a building, or even a stand alone company in a little shack 150 miles away from fiber could sign an order, a rep would be paid on it, it would count towards winning the Porsche, and management would report it as a sale, therefore impressing the investors. About 95% of all Cogent current orders were taken this way. Want more? I got alot of it.
dc_optics 12/4/2012 | 10:34:04 PM
re: Cogent Buying Binge: Another Bubble? lets hear it.Give us more
Former Cogent Employee 12/4/2012 | 10:29:34 PM
re: Cogent Buying Binge: Another Bubble? I used to work for them. I sold anywhere I wanted regardless of fiber availability. I believe I sold about 30 100 mbps circuits. I think 2 are actually being billed. It's a friggin financial shell game. Stay Away!!!! After 3 years I guess they are now trying to sell into buildings where they actually have fiber availability. The kicker that a large city like a Philadelphia/Boston/Atlanta will only have about 15 buildings you can actually sell into. So let's do the math. 15 buildings X 25 cities=375 Buildings. So, you can pay off 1 billion in debt w/ 375 buildings w/ an average customer being billed $1K for a 100 mbps circuit. Get real. I'd be happy to spread more dirt...
threeiron 12/4/2012 | 10:28:40 PM
re: Cogent Buying Binge: Another Bubble? I was amazed at the way they spent their cash. The 5 Porsches, the 500 sq. ft. trade show booth w/ lasers, 3 flat screen tv's that broke every time they shipped em, and they would not ensure the flat screens, just bought new ones. The outrageous salaries for people w/ little or no experience. The fact that they would pay commissions on orders that were taken in Pennsyltucky in the middle of frickin no-where w/ no chance of fiber getting there was amazing. I knew guys that would just make up orders and be paid on em. No one would check. I know for a FACT that no one, after the mass-layoffs of Oct. 9th either sent their laptop in, or their Startac cell phone. So do the math...75 x $2,500 laptops=$187,000 and 75 x $200(cellphones) =$15,000. And the money they spent on office furniture, wholly smack!!! $800 Aeron chairs for everyone
dc_optics 12/4/2012 | 10:23:50 PM
re: Cogent Buying Binge: Another Bubble? Do tell!!!! How about pics of them running around in womens clothes.
ace2002 12/4/2012 | 10:18:35 PM
re: Cogent Buying Binge: Another Bubble? doesn't cogent have customers with higher pricing?
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