Countering Falling Prices with StrategyStreet

by Donald Potter

Cogent Communications sells inexpensive, all purpose, digital connections to the business community. Today it carries 17% of all internet traffic. This is comparable to companies like AT&T, Verizon and Level Three Communications. Its revenue this year is on pace to grow by 19%. That all sounds good until you realize that the company expects to lose $25 million this year on the $220 million in revenue it expects. What is the problem?

Cogent is a low-end competitor. We have studied several hundred of these competitors and we characterize Cogent as a Predator Competitor. A Predator Competitor offers a product with functions equivalent to those of the industry’s leaders, whom we call Standard Leaders, but at a lower price. They can do this because they can achieve a distinctive cost-advantage over the Standard Leaders. The company sells what it calls a “dumb pipe.” Its pipe works as well as anyone else’s pipe, but the company has a less well-known brand name and presence in the market. It is a little harder for a buyer to buy from it. Its cost advantage comes from its ability to assemble its network by obtaining the networks of other failing competitors at very low prices. And, of course, the company depends on low pricing in order to gain its market share.

Cogent got into the business in 2001, when the going cost for high capacity data transmission was $300 per megabit per second. Cogent’s initial price was $10. Today, the market price to move a megabit per second is about $20. Cogent charges a lot less. It advertises itself as the “home of the $4 megabit”. The company is certainly cheap. It offers discounts of 50 to 98% off the price of data transport services that the better known companies offer.

The company doesn’t make money because its price discounts are too great. Our research suggests that Cogent could offer discounts beginning at 25%, and ending well before 50%, and still enjoy high rates of growth. These lower discounts would yield better profitability. That is, until the industry Standard Leaders respond and reduce the price gap they have with Cogent. As we have seen in other markets, the Standard Leaders are very reluctant to reduce prices, even to stop a low-end competitor like Cogent.

So Cogent could take some pressure off itself by reducing its cost of discount to something like an average of 33%, rather than the 80% discount they seem to be offering. Cogent is almost certainly going to have to raise its average pricing because it will have difficulty financing growth in its capital intensive business. It does have $30 million of free cash flow today, but its market cap is only $400 million. This supports an asset base with a replacement cost in excess of $2 billion. Not good enough for the next round of growth.