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CoStar Group, Inc. (NASDAQ:CSGP)

Q1 2009 Earnings Call

April 23, 2009 11:00 am ET

Executives

Timothy J. Trainor – Communications Director

Andrew C. Florance – Founder, President and Chief Executive Officer

Brian J. Radecki – Chief Financial Officer

Analysts

John Neff – William Blair

Jonathan Maietta – Needham & Company

Brett Huff – Stephens Incorporated

Jim Wilson – JMP Securities

Vance Edelson – Morgan Stanley

Operator

Ladies and gentlemen, thank you for standing by and welcome to the CoStar Group’s First Quarter 2009 Conference Call. Today we have CoStar Group’s Chief Executive Officer, Andrew Florance; Chief Financial Officer, Brian Radecki; and Communications Director, Tim Trainor.

At this time all lines have been placed in to a listen-only mode. Later we will conduct a question-and-answer. (Operator Instructions) As a reminder, this conference is being recorded.

I would now like to turn the conference over to Mr. Trainor. Please go ahead.

Timothy J. Trainor

Thank you, operator and good morning everyone. Welcome to CoStar Group’s first quarter 2009 conference call. Before I turn the call over to CoStar’s Chief Executive, Andrew Florance, let me state for the record that certain portions of this discussion contain forward-looking statements, which involve many risks and uncertainties that can cause actual results to differ materially from such statements.

Important factors that can cause actual results to differ included, but are not limited to those stated in CoStar’s first quarter 2009 press release, which we issued yesterday and in CoStar’s filings with the SEC, including CoStar’s Form 10-K for the period ended December 31, 2008 and CoStar’s Form 10-Q for the quarter ended September 30, 2008 under the heading Risk Factors.

All forward-looking statements are based on information available to CoStar on the date of this call and CoStar assumes no obligation to update these statements. You can find a webcast on our website at www.costar.com/investors. Thank you for joining us.

I will now turn the call over to Andy.

Andrew C. Florance

Thank you Mr. Trainor and welcome everyone to CoStar Group’s first quarter 2009 conference call. I’m very pleased to once again report that CoStar Group completed another profitable quarter earning $6.1 million in the first three months of 2009. This represents a 21% increase from $5 million in net income in the first quarter of 2008.

First quarter 2009 EBITDA also increased year-over-year to $14.4 million a 25% increase compared to EBITDA of $11.5 million in the first quarter of 2008. Being able to report year-over-year growth in quarterly net income in the middle of a very challenging economy is a testament to the strength of our business model and certainly something that all of us here at CoStar Group are proud of.

I’m pleased to report the company continues to enjoy a very strong financial position. CoStar Group completed the first quarter with no debt and very large cash reserves. Because we identified deteriorating market conditions more than two years ago, we have focused on growing earnings, expanding our EBITDA margin, and significantly strengthening our balance sheet, which remains one of the company’s greatest assets. We increased our cash balance by $8.9 million in the first quarter of 2009 for a total of 20, $233.5 million in cash, cash equivalents and investments on hand.

The majority of these assets are in cash or invested in U.S. Treasury or other U.S. government money market funds, putting CoStar in a very secure and strong financial position. Commercial real estate market conditions have continued to weaken in the face of unprecedented job cuts and deteriorating credit markets. As a result many of our customers have experienced severely declining revenues and slowed their purchasing activity.

Many commercial real estate companies and related companies have failed. Despite the current environment renewal rates for CoStar Group’s services remain relatively high within our core cut client based. Demand for our services is strong and we believe not nearly a cyclical or volatile as real estate markets are overall. In fact search activity in both our subscription based information products and in our lead generation marketing products has been climbing steadily reaching an all time high of activity in March. We believe CoStar is still an essential part of the commercial real estate business providing indispensable research verified information that is integral to our customers’ leasing asset valuation, marketing and sales processes.

Furthermore, we believe we are still in the early phases of penetrating the full potential for commercial real estate information and marketing services in the United States, United Kingdom. Last year for example approximately 56% of our gross sales were derived from new customers. As economic conditions improve we believe we will see a return to higher sequential quarterly revenue growth, given our leading market position, the highly advantaged infrastructure we have in place, and the vast potential market we see for our services we believe we can continue to achieve significant earning goals we have set for the company as we have consistently done over the years.

While this past quarter has been slow for the industry it’s been busy and productive for CoStar’s research operations. In that prior 12-month period CoStar research interviewed 275,000 different industry players. In doing so we conducted more than 2 million telephone interviews in order to verify and collect information. We processed more than 3 million incoming electronic submissions with information coming from brokers, owners and the like, we reviewed nearly a 100,000 SEC filings, CMBS filings, generally over the course of 24 hours after they’re filed.

Our Research Analysts added more than 425 million square feet of new space availability during the first quarter of this year. Together with the more than 500 billion in for sale inventory that was listed in our database this comprehensive aggregation is available for-lease and for-sale listings, represents a unique competitive advantage for our subscribers.

As I stated last call, the last thing I believe we should do in this current situation is to potentially harm our business by reducing the quality or scope of our research. Certainly keeping an eye on cost and minimizing spending are the watchwords of any recession. But even more important I believe is keeping the focus on our customers and ensuring that CoStar continues to provide the quality of information they expect and require in their line of work.

We’ve begun the process announced last call to grow our research operations slightly this year in order to continue to meet customer expectations. We are committed to protecting what we view as our unique competitive advantage by ensuring that our information and marketing services remain an indispensable solution for our customers. It appears that commercial real estate asset market has followed the residential real estate into an asset bubble condition and the bubble is well into the process of bursting. The CMBS and debt markets remain frozen creating something of a liquidity nightmare, spreads on existing CMBS debts have skyrocketed.

The commercial real estates are in disarray and in fact Dr. Larry Summers one of President Obama’s top economic advisers said on ‘meet the press’ this weekend that commercial real estate markets are falling apart. Outside of the credit problem the most serious issue is soaring job losses. We have lost 5.2 million U.S. jobs in the past 18 months and it’s quite possible that we’ll lose a total of 8.6 million before the economy recovers.

Office sector job losses alone could claim as high as 2.8 million, assuming the average office worker consumes 250 square feet of space this number of job loses implies a potential for 700 million square feet of negative absorption. While there has been increase of hundreds of millions of square feet of available space being marketed for future availability we have actually seen just 20 million square feet of negative absorption in the office sector as of the end of the first quarter of 2009.

The vacancy rates, the negative absorption, that’s the sort of stuff that a REIT or a CMBS would report in their public filings. What’s not being reported is that 680 million square feet of negative absorption lies ahead potentially. Leasing activity is down by approximately 30% and office vacancy has claimed from the recent low of 11% to a current rate of 12.4% which is really not that bad a vacancy rate, it is pretty, it’s decent.

The space availability rate however, which is the leading indicator for future vacancy has climbed from 14% in the first quarter of 2006 to 24% today. This is a level we have not seen since the late 1980s and is an extremely high level. The spread between vacancy and availability rates historically is approximately 200 basis points and it’s now around 1100 basis points. Also the average number of days that a block of space remains on the market before being leased has climbed from 166 days, the strongest point in this market, to over 474 days today.

The U.S. office vacancy rates could climb to over 18% before it peaks which is expected to occur in early 2010 and that would be ranging from 14% Los Angeles to more than 27% in Detroit. Inflation adjusted rents have fallen from an average of $29.88 per square foot in 2001 to $24.69 per square foot today. With climbing vacancy rates rents will likely continue to fall and income per square foot will also decline. Cap rates in the office sector have increased from 5% in the second quarter of 2008 to 7.6% currently, a 268 basis point increase in unprecedented rate and speed of deterioration.

However, Cap rates have historically averaged 8.5% in the office sector so they could erode further to revert to the mean. All this is cumulative and unprecedented drop in prices per square foot for Class A office space. Inflation adjusted prices for Class A office peaked at $400 per square foot in the second quarter of 2008 and has fallen more than 50% to $185 per square foot currently.

Inflation adjusted prices for Class A office space have reverted to their 20-year mean within two quick quarters. At the same time sales volumes have fallen off the cliff to as low as $1 billion per quarter. While many feel that because this drop in average sales prices is associated with small volume of building sales, is not really reflective of true asset values. Others believe that the low volumes reflect the slow acceptance among sellers for either structural or psychological reasons the new reality of lower price levels.

Nonetheless, the change in volumes, liquidity and sales prices create the risk for significant debt defaults ahead. So, in point of fact we feel that the company’s 2.8 sequential decline in revenues quarter-over-quarter given the extremely negative market conditions demonstrate the strength of our business model rather than any weakness.

In addition, CoStar historically begins to see improvements in market performance a quarter or so before vacancy levels peak, which we believe should occur within 3 to 4 quarters from now. On more positive news, CoStar won two prestigious awards during the first quarter of 2009, we became the first commercial real estate related company to win Energy Star Award of excellence for promotion from the U.S. Environmental Protection Agency. The EPA selected CoStar for this award in recognition of our role in databasing green buildings and the information available to the commercial real estate industry.

In addition we are recognized for producing the groundbreaking study we published on the income premium associated with green buildings specifically those that have earned the EPA’s Energy Star Label. The American real estate society awarded CoStar’s study a prestigious academic real estate award. We did co-author that study with Dr. Norm Miller from the University of San Diego.

ARES whose members include leading global academic and professional researchers annually recognizes papers that explore the critical issues of applied real estate decision-making. CoStar has been and continues to be an active supporter of academic research involving energy efficiency issues in the built environment. We’ve partnered with ARES to sponsor the journal of sustainable real estate a new real estate academic series with the goal of publishing a collection of research papers addressing sustainable real estate issues.

In addition to actively sponsoring academic research CoStar has a long-standing program that provides qualified university professors and their students with full access to our comprehensive online information services for use in their research and in the classroom. More than 1100 professors and graduate students in more than 100 universities are currently enrolled in the CoStar University Program. These institutions include Harvard University, MIT and the Wharton School of Business. We are very happy to be playing an active role in providing market data and research tools for these future industry leaders.

By introducing our services to new entrants in the industry as they first start their careers we believe we could gain life long customers. I think you would agree that calling the current commercial real estate conditions challenging is certainly an understatement. The widely publicized problems in the economy and particularly their impact on the commercial real estate industry continue to have an adverse effect on sales and revenue as has the devaluation of the relative value of the pound to the dollar.

Our revenues declined 2.8 sequentially quarter-over-quarter from $52.9 million to $51.4 million. At the end of the first quarter 2009 the company had 154 sales representatives on staff consisting of 114 U.S. subscription sales reps, eight U.S. advertising sales reps, 11 in-house sales reps, and 21 very good UK skilled sales reps, they had a great month last month.

This is a slight increase over the prior quarter, we currently have a strong class of sales reps in training and we’ve been fortunate to attract several top candidates for the exceptional sales in commercial real estate experienced. With a weaker market we are now focusing on hiring only experienced sales reps with commercial real estate experience. I expect our overall sales force to grow moderately in the second and third quarters. The average new contract value for the first quarter was down at $4,964.

We signed a total of 613 new subscribing firms during the first quarter of 2009, a 19% increase over the fourth quarter of 2008. And although these new firms tend initially to buy at a lower price point, once they become clients and learn more about our product offerings they tend to buy additional information and marketing services from us. Last year just under half of our gross sales were from existing clients. So, we are very happy to see this continued success in attracting new subscribers.

The impact from adverse market conditions was also apparent in our net subscriber account, which dropped during the quarter to approximately 84,000 subscribers. The UK saw a disproportionate share of this decline in subscriber account due to product consolidation, weak market conditions and customer list scrubbing. The overall number of subscriber sites dropped only slightly during the quarter from 15,920 at year-end to 2008 to, I am sorry from 15,920 at year-end 2008 to 15,500 subscriber sites at the end of quarter for 2009. So you have about 420-subscriber site drop q-over-q.

Discrepancy between the very small drop in subscriber sites and a larger drop in individual subscribers is predominately attributable to pervasive head count reductions among our clients. Our 12 months trailing customer renewal rate for CoStar’s subscription based services dropped slightly to 87%. And renewal rates with customers who have subscribed to CoStar for more than five years remained over 90% which we believe is very encouraging given that many of these firms are seeing significant declines in their revenue.

In order to maximize our renewal rate we actively track all of our cancellations and attempt to accurately determine their root cause. Our sales quality assurance team makes every attempt to debrief any lost customer, review the customer history, speak with the CoStar account rep that was on the account and ultimately determine the true cause of the cancellation, by doing this and making this invest, we hope to learn what actions we can take to reduce any cancellations.

For the first three months of 2009 we can tell you that 56% of the cancellations are attributable to economic conditions, 7% are due to a customer leaving commercial real estate. 13% are due to bankruptcy, 1% we shutoff because they were sharing passwords or stealing services, 3% canceled because of concerns about our data quality, 1% canceled to use a competing service, 5% canceled because they just didn’t find enough use for our service, 3% cited their inability to afford or justify the price.

And 10% we attribute to our poor customer service or account executive performance. We can further concentrate the cancelation’s causes to 76% due to economic conditions, 13% are CoStar’s fault, 9% because the product is not the right fit, 1% is due to theft and 1% is due to competitive loss. If you factor in those cases where customers reduced the number of seats of service to reduce their contract spend well more than 80% of our current cancellations are possibly attributable to economic conditions.

As I previously indicated we have put into effect several policies to address this issue of higher cancellation rates especially among our newest clients who traditionally take up several years to fully integrate our products into their business operation. Under our current 2009 commission plan CoStar sales executives are paid only for new subscribers who actively use our services in any given month during their first year of service.

As a result the usage rate among new customers has soared to 70%, at this point the usage associated with our newest customers is on par with that of our established customers. With the 2009 sales incentive plan there is much greater focus in making sure that all of our subscribing potential users are in fact using and gaining value from our products. During the course of the first quarter 2009 nearly 5000 individual subscribers who are not recently or had never used our products began using them.

CoStar signed a number of major clients to renewal agreements during the quarter. In addition to the multi-million dollar enterprise wide agreement with Cushman & Wakefield we announced this February we’ve renewed agreements with Wells Fargo the financial services giant that recently acquired Wachovia and that has Eastdil Secured a large a leading investment sales broker as a subsidiary.

We’ve renewed Simon Property Group the largest U.S. shopping-mall owner and UGL Equis’ a leading tenant rep firm with 27 offices throughout the United States. In addition we renewed Deloitte the auditing, financial advisory, risk management, and tax services firms.

CoStar Group welcomes the opportunity to continue serving these clients for years to come. Since launching last May CoStar Showcase has proven to be an extremely viable tool for helping commercial real estate brokers maintain or expand their floor leads from prospective tenants and buyers at a time when traditional lead channels are drying up.

Total search volume on Showcase again increased during the quarter from $2.9 million searches on Showcase in the fourth quarter 2008, to $3.3 million in the first quarter of 2009 and property views increased as well during the same period to more than $96 million. We now have more than 1,500 subscribing entities representing approximately 4,000 brokers with listings.

As a result we’re now generating more than $3.3 million annualized revenue from Showcase. We believe we can show strong growth in the product throughout the year, we also believe that the product is now probable and that incremental sales are at an extremely high margin. As a standard practice CoStar offers our information services under company wide subscriptions and that is how we initially marketed Showcase.

However we believe Showcase holds wide appeal for individual brokers who may want to take advantage of the service, but whose company is not prepared to subscribe. For this reason we’ve recently made the decision to begin offering individual Showcase subscriptions, in addition to the company wide subscription option we have offered since launch.

Primarily competitors to Showcase offer individual subscriptions so we believe this move now puts Showcase on an equal footing with those services in terms of contract structure. To further enhance the appeal of Showcase we are making the these individual subscriptions available at a low flat monthly rate of 4,995 no matter how many listing the client listings, the client chooses to advertise. That’s basically an ‘all you can eat’ buffet; the service can be ordered directly from our website using a credit card and is available on a month-to-month basis with no long-term agreement required.

We believe this pricing model of one low price and unlimited listings will compete very favorably with the primarily competitor in this space, which bases its fees on the number of listings advertised and has aggressively raised its prices off late particularly of those people who have a large number of listings. We believe an individual with one to three listings will save $240 a year if they use Showcase rather than the primary competitor in this space. Individual or a broker with four listings will save $720 a year using our service rather than the competitor service and a broker with 15 listings will save $2,340 a year or 79% by using Showcase rather than the competing service.

One low very simple price no matter how many listings the broker has. We also are convinced that Showcase is a superior service that the value proportion is even more compelling spending dramatically less and get a much better service, it’s like asking would you rather spend $4 a gallon for regular unleaded or save 79% and pay $0.84 per gallon per premium unleaded. All Showcase subscribers will continue to benefit from the features that we believe have really helped distinguish Showcase from competitors in this space including CoStar’s ongoing significant investment in paid search marketing efforts on behalf of our clients to capture more traffic from major search engines such as Google and Yahoo and MSN.

The strong appeal for searches to take advantage of the continuously updated listing information available on Showcase through CoStar’s extensive research operations, and the fact that Showcase does not require searchers to register before they can see all details on a Showcase listing.

Before turning the call over to Mr. Radecki for more in depth discussion of our quarterly financial performance and outlook let me reiterate that we remain very focused on managing our business efficiently, minimizing spending and preserving value to continue operating profitably in this difficult economic environment.

There is no question that the rest of 2009 will be challenging and of course we will continue to monitor our position very carefully and respond accordingly. We believe that the fact that we continue to generate strong earnings during what certainly appears to be the worst recession in two generations reflects the strong fundamentals of our business. I’m confident that we will continue delivering long-term value to our customers and shareholders as well as opportunity to our employees and additional growth opportunities for CoStar Group. Brian?

Brian J. Radecki

Thank you, Andy. I think we just set a record, we did. It was 35 minutes. So, I think in ten years of doing earnings call that was 31 since 31 minutes and Andy’s shortest script, he cut it back from a 100 pages down to 50. It’s good, thanks Andy.

Andrew C. Florance

You’re welcome Brian.

Brian J. Radecki

As mentioned, as Andy mentioned we are continuing to manage the business well in this very difficult economic environment. Despite U.S. GDP falling over 6% in the fourth quarter of 2008 and the national unemployment rate raising 8.5% in March, CoStar achieved another strong quarter of earnings and cash generation in the first quarter of 2009. Our net income for the first quarter of 2009 increased 21.1% a $6.1 million or $0.31 per diluted share from five million or $0.26 per diluted share in the first quarter of 2008.

EBITDA which is our earnings before interest, taxes, depreciation, and amortization for the first quarter of 2009 was $14.4 million an increase of 25.2% compared to EBITDA of $11.5 million for the first quarter of 2008. Reconciliation of EBITDA and all non-GAAP financial measures discussed on this call to GAAP basis results shown in detail on our press release issued yesterday is available on our website at www.costar.com.

Revenues in the first quarter of 2009 decreased approximately 900,000 compared to the first quarter of 2008. These revenues included unfavorable impact of foreign exchange rate fluctuations of approximately $1.6 million on our international revenue.

On a functional currency basis U.S. revenue in the first quarter of 2009 totaled $47.1 million, which is a 1.6% increase compared to $46.4 million in the first quarter of 2008. International revenue totaled £2.9 million in the first quarter of 2009 compared to £3 million pounds in the fourth quarter of 2008. International operations contributed approximately 8.2% of total revenues in the first quarter and international subscription revenues account for approximately 88.8% of the international revenues in the first quarter of 2009.

In Q1 of 2009 non-subscription based revenues, which is ad hoc revenue that is mostly related to services to facilitate the buying and selling of commercial buildings continued to be extremely weak. We do not expect that type of non-subscription based revenue to improve for several quarters given the current market condition. But as most of you probably know this type of non-subscription based revenue accounts for less than 5% of CoStar’s total revenues.

CoStar’s subscription revenues actually accounted for 95.9% of our total revenues in the first quarter of 2009. Turning to our renewal rate, which is a measure of renewing subscribing revenue, our 12-month trailing renewal rate remained strong at 87.3%. We consider the 12-month trailing renewal rate to be a good indicator of the strength of our business model as subscription revenues account for most of our total revenue and the majority of our subscribers are on annual or longer-term agreements.

As we have publicly stated for more than a year now we do expect our 12-months trailing renewal rate to continue to decline at low to mid 80s for the calendar year in this current economic cycle. Our EBITDA margin for our U.S. operations was $30.9 million in the first quarter 2009, which is a testament to the earnings power of our business model in even the most challenging environments.

Our overall consolidated EBITDA margin for Q1 of 2009 was 28.1 compared to 22% in Q1 of 2008. We remained focused on our 2009 plan and outlook and working towards our goal that we set out in Q2 of 2008 of $100 million in annualized EBITDA run rate. We fully expect to return to more normalized revenue growth rates we have enjoyed in the past decade and expanding margins once we see positive GDP growth and encouraging employment figures.

For now we continue to expect to add new subscribers, renew current subscribers and to generate strong earnings and cash flow through the challenging environment. I would like to remind everybody that when we return to revenue growth the majority of our incremental revenue drops from the top line to the bottom line, which provide us the strong earnings and cash flow generation.

Moving to gross margin on a quarter-over-quarter basis, gross margin decreased by approximately 700,000 from $35.2 million in Q4 of 2008 to $34.5 million in Q1 of 2009. Gross margin percentage improved to 67.1% in Q1 of 2009 from 66.5% in Q4 of 2008.

Turning to expenses for the quarter, overall expenses were at $23.7 million in Q1 an increase of $1.3 million from $22.4 million in Q4 of 2008. This increase resulted principally from increased sales and marketing expenses, as well as a slight increase in bad debt as expected. Legal expenses for the first quarter was approximately $1.1 million, an increase 300,000 from Q4 2008.

We consider these legal costs like most other public companies, to be normal reoccurring costs and we anticipate these will continue for the foreseeable future. As you are aware we are currently involved in several lawsuits, and could be involved in others aimed at protecting our intellectual property rights. As always we follow U.S. GAAP based accounting to report all our legal expenses, in our income statement, EBITDA and in our earnings outlook for the year.

With respect to the balance sheet we ended the first quarter 2009 with approximately $233.5 million in cash, cash equivalents and investments an increase of $8.9 million since December 2008 and we have no long-term debt.

Now I will conclude my remarks with our outlook for the second quarter and the full year 2009 in detail. As is typical our guidance takes into account recent growth rate in our results, which maybe impacted by uncertainties surrounding foreign exchange rate fluctuations as well as changes in the global economy. We have attempted to reflect global weakness in the economy in our guidance to recognize we had a period of significant flux and the economic environment is still an uncharted territory.

However, we remain confident in our earnings guidance, as we believe one of the key strengths of our subscription based business model with a relatively fixed cost structure is it provides good earnings visibility even in a difficult environment. Unlike many other public companies out there, who have decided not to give annual guidance, we continue to provide this visibility and we include our legal expenses.

As stated in our press release, we expect for the second quarter of 2009 revenue in the range of $49.5 million to $51 million and for the full year we continue to expect approximately a $198 million to $203 million in revenues. Given the unprecedented current economic conditions our actual second quarter results and full year 2009 results could differ slightly from our guidance.

In more detail, let me talk about the rest of the P&L. We expect cost of revenues, which is approximately $16.9 million in Q1 to rise slightly throughout the year due to the variable timing differences of new hires and research and other research related costs. As we explained last quarter we expect to continue to hire and staff our research group to provide the highest quality information to meet the needs of our clients in this difficult environment.

Moving down to P&L we expect seasonally higher, selling and marketing expenses of approximately $1 million primarily associated with the ICSC Trade Show and the marketing of Showcase.

Software development should remain fairly consistent quarter-over-quarter and flat for 2009. G&A is expected to increase by approximately $1 million in the second quarter due to the increased legal cost. And we expect approximately 700,000 in purchase amortization in Q2 of 2009 and approximately $3.5 million for the full year 2009.

We continue to expect the interest rate or interest income to be approximately 0.5% in 2009. The majority of our approximately $233 million in cash, cash equivalents and investments currently in cash and assets in U.S. treasuries or other Government money market funds.

Overall our effective tax rate we expect to be approximately 45% for 2009. In terms of earnings, we expect second quarter 2009 fully diluted net income per share of approximately $0.22 to $0.25. We continue to expect fully diluted net income of approximately 1 to $1.05 per share for the full year 2009, which includes approximately $6 million in pre-tax, non-cash equity compensation charges related to restricted stock and options.

Capital expenditures for the first quarter 2009 was approximately $1 million, and we continue to expect capital expenditures in 2009 of approximately $4 million to $7 million, which include investments in the facilities to upgrade several field sales office hubs, network equipment and workstations to upgrade and support the ongoing operations.

We continue to look for areas of cost savings and may consolidate or move office space in 2009 to save money and/or upgrade the space which should create lease operating gains or losses for the company which is similar to what we did in Q4, 2007 and Q2 of 2008. Just like in prior years we would expect this will create substantial long-term savings for the company.

In conclusion, the entire CoStar management team remains focused and fully committed to achieving our outlook for 2009. We expect to manage the business through this current environment and capitalize on our stable subscription based business model to position us for long-term growth opportunities and working towards our long-term goal of $100 million in annualized EBITDA run rate.

Economic conditions could worsen, but we believe we are prepared to weather this economic cycle. We believe our services our core to our clients’ ability to deliver on their business and that the market need for our service remains resilient.

Our business model remains strong and the fact that we have a 95% subscription based business with high renewal rates, a unique proprietary database with a market-leading position, strong balance sheet, no debt and high cash flow.

We believe these challenging times will continue to create opportunities for us as a market leader. We continue to believe there is significant opportunity for high margin revenue growth following the investments we have made, in the addition of new services like CoStar Showcase.

No company is recession proof, but as I said many times CoStar is not immune to the challenges in these economies, but without a doubt we are clear about our priorities and confident in our plans. We continue to look forward to reporting that progress to you and with that I open up the call for any questions

Question-and-Answer Session

Operator

All right thank you. (Operator Instructions). And our first question comes from John Neff from William Blair. Please go ahead.

John Neff – William Blair & Company

Hi guys.

Andrew C. Florance

Good morning Mr. Neff.

Brian J. Radecki

Hi John.

John Neff – William Blair & Company

A few questions for you and then I can get back in queue for some others. But the, last quarter the guidance range was $201 million to $207 million now 198 to 203, is that all due to foreign exchange and what does it assume exchange rates continue as of when, the end of the quarter or where they stand today?

Brian J. Radecki

John, I didn’t change those. As I reiterated it and what I did was consolidated it. When we came up with and provided our initial calendar year 2009 revenue guidance in February, we assumed that the U.S. dollar would strengthen versus the pound over the course of 2009 because that was the trend for the prior six months and there was no sign of it stopping. We’re really not trying to forecast exchange rates, really just kind of reiterating the same thing and I consolidated them to make it simpler for people because I think there is some confusion around that.

John Neff – William Blair & Company

Okay. So, it’s purely a reflection of the UK correction of the business.

Brian J. Radecki

Correct.

John Neff – William Blair & Company

Okay. So, it’s really just due to FX?

Andrew C. Florance

Correct and we confused you in order to avoid confusion.

John Neff – William Blair & Company

What were the net annualized subscription bookings in the quarter?

Andrew C. Florance

Do you have the number?

Brian J. Radecki

John, I mean they are obviously negative because revenue growth is negative. So, we haven’t really talked about that, the last few quarters we’ve been focusing on more some of the operating metrics.

John Neff – William Blair & Company

Okay. And then you mentioned bad debt expense, DSO’s are creeping up a little bit, but what’s going on with bad debt expenses, has that been keeping pace and where does that stand at the end of the quarter?

Brian J. Radecki

Yeah it’s up slightly over the fourth quarter, it’s right about where we thought it would be, we kind of assumed we’d have $0.5 million or a million more in bad debt this year and right now it’s right around where we thought it would be so. Hasn’t really gotten significantly worse but obviously in this environment you’ve got companies that are struggling and some of them that are just going out of business.

John Neff – William Blair & Company

Okay, and then the quick question on the Showcase then I can get back in queue? The new individualized contract pricing, 49.95 a month, roughly 600 a year. How does that compare to the average enterprise annual subscription price?

Brian J. Radecki

If you take the average enterprise agreement it would be, it would be just slightly less than that, so you’d have some enterprise agreements that would be slightly more and some will be slightly less. But on average the new individuals slightly below that enterprise agreement level. You get more benefits if you are in enterprise, so for instance you get the company website and you don’t get that if you are an individual subscriber, you get, your listings on Showcase and you get a broker page, but if you are a firm subscribing, you get a firm website, broker pages for all your brokers plus all your firm listings on the site. So, they’re not entirely similar, there’s slightly, there is little more benefit especially associated with the enterprise agreement.

John Neff – William Blair & Company

These enterprise agreement, is it $900 on average or is it.

Brian J. Radecki

I only have the numbers for it, what above stand to on a per person basis and it’s just slightly more than the individual cost and that reflects the benefit of the firm website and the fact that firm has a tougher time, managing, collecting, and posting all their listings up, then does a individual broker. So, I think there’s not a lot of competition between the two.

John Neff – William Blair & Company

Okay.

Brian J. Radecki

There’s some but not a lot.

John Neff – William Blair & Company

Great, thank you.

Brian J. Radecki

Welcome.

Operator

Thank you. And our next question comes from Jon Maietta from Needham and Company. Please go ahead.

Jonathan Maietta – Needham & Company

Thanks very much.

Brian J. Radecki

Hi Jon.

Jonathan Maietta – Needham & Company

Hi Andy, hi Brian.

Andrew C. Florance

Hi Jon.

Jonathan Maietta – Needham & Company

Andy the first question I had was it, I don’t think you talked about the analytics offering at all this quarter, could you just maybe talk about those processes of refreshing that offering?

Andrew C. Florance

Sure. That remains a significant focus for us and we are toning down our discussion of it so that when we release those products there will be something of a surprise in nature and depth and scope to our competitors. So, we are, our development teams are working on that and we’re continuing to grow our capabilities there. We think it’s a $50 million to $100 million potential revenue add over 5 years plus but we are discussing, we are not discussing the details about it as much now.

Jonathan Maietta – Needham & Company

Got it fair enough, okay. And Andy just a point of clarification, you had mentioned I think that you would either you, CoStar or the markets will typically see a rebound couple of quarters ahead of the vacancy rates peaking, was that correct or?

Andrew C. Florance

Yes we, I mean really have a sample set of two cycles, but there appears to be a pretty strong correlation where our market performance tends to pickup about a quarter or so before vacancy rates shift directions or hit their peak. So, I mean that’s generally because people can sort of tell right before the vacancy rates hit the peak that the markets are turning and vacancy rates are pretty much the driver of the income and the rental rates and the values outside of capital market costs.

Jonathan Maietta – Needham & Company

Got it okay. And then Brian as you think about kind of revenue linearity over the course of this year just given the nature of the subscription model does it become tough to go sequentially negative three quarters in a row, four quarter in a row, barring, you know, a dozen larger customers falling out in one quarter.

Brian J. Radecki

Yeah I mean barring anything major, which still happens at some of the large financial service firms I mean, I think we, we are anticipating the renewal rate to decline a little bit, I think you are going to see the second quarter is going look a lot like the first quarter. And I do think as you get into the third and fourth quarter because of the subscription based model, I do think it is get harder, but I definitely think that the second quarter is going to look a lot like which is what we have expected for a long time now the first quarter.

Andrew C. Florance

And you have sort of hit a plateauing here so you know sort of a decline in the rate of decline.

Jonathan Maietta – Needham & Company

Yeah, and then just a couple more quick ones. The million dollars in incremental legal expense that was probably on the press release was that is that incremental to the guidance that was provided on the last quarterly call or was that already taken through the earnings guidance?

Andrew C. Florance

I’m going to read my prepared statement from my legal council here and I anticipated this question so I had him giving it to me right before the call started. During Q2 we have increased discovery related legal cost depositions, document productions et cetera connected with our lawsuits against LoopNet in the Europe and California. We also have a trial scheduled in June on one of our anti-piracy cases. For Q3 we anticipate while our preliminary injunction hearings in July on our California case against LoopNet and continuing discovery costs on our New York litigation against LoopNet. But I think this is, and again we have to see how these things pan out so that was my prepared statement. I think that it remains to be seen. I think what’s happen is some of the costs maybe accelerated, they’re coming sooner so of course you have to wait and kind of see how those things pan out. So, it’s definitely it’s an increase in Q2 which is, which is I didn’t originally anticipate, but I think it’s baked into the kind of that dollar to dollar five range that I had already given for the year, so I’m not really coming off of that.

Jonathan Maietta – Needham & Company

Got it, okay. And then just the last one from me. I was wondering if in addition to the renewal rate that you guys published do you also track kind of dollar renewal rates. So, if you had X amount of dollars coming up for renewal this quarter what percentage of those actually renewed?

Brian J. Radecki

Well the renewal rate is based on dollars not, you know, sites or paying subscribers. It’s based on the dollars renewing that’s essentially what it is, obviously if you actually looked at, if you look at those three metrics the sites only decreased slightly the revenue decreased slightly 2.8% but the paying subscribers dropped a lot more. So, it’s only dollars renewing it, it wouldn’t be fair to say if we lost a client that was paying us $10 million a year that, we only lost one client, a small percentage of our clients. So and then, but the two by chance tend to be fairly similar.

Jonathan Maietta – Needham & Company

Correct

Brian J. Radecki

The sites and dollars, the sites and dollars will track much closer than the paying subscriber number.

Jonathan Maietta – Needham & Company

Okay got it. Okay thanks very much.

Andrew C. Florance

Yeah, you are welcome.

Brian J. Radecki

Thanks John.

Operator

Thank you. And our next question comes from Brett Huff, Stephens Incorporated. Please go ahead.

Brett Huff – Stephens Inc.

Good morning Brian, and good morning Andy.

Andrew C. Florance

Good morning Brett.

Brian J. Radecki

Hi Brett.

Brett Huff – Stephens Inc.

Question on just Andy may be you could give us some color on how the conversations are going just from a value proposition point of view both when you all are pitching new business, and or when you are pitching cross sales just so that I get a better sense of what are the things people are focused on and what seems to be working?

Andrew C. Florance

Well, it’s, a lot of the same value proposition is that it has always been, it is cost reduction. So I think the bigger firms are more focused on the fact that our products cut their costs in total and provide a high quality service for their folks at the mid size and smaller firms it’s revenue generation that they are focused on as much as anything. So being able to produce a more powerful, more professional presentation and generate leads off the Internet is working and the appraisal side of the world, they’re actually likely to see a little bit of an up tick in appraisal volume and in fact the cancellation rates there are haven’t even come off of historical highs, their cancellation rates are very, very low right now. And those folks it’s just critical them in terms of productivity. It allows them to do appraisals much more cost effectively so they really need it to make their margin goals. And a big overriding challenge is the fact that some of these firms it’s not unusual that these firms are seeing their revenues down in excess of 40% right now. So that’s the challenge we’re getting through.

Brett Huff – Stephens Inc.

Okay. And when you, can you give us more of a sense of cross sale, you’ve never given us really data on sort of what the cross sale numbers where in terms of numbers of firms that you’ve cross sold additional products into and/or sort of the average dollar amount? Could you give us any even qualitative sense of that, is it more or less or steady versus couple quarters ago or can you give us any color on that?

Andrew C. Florance

I could say that because our Showcase and a larger volume of smaller sort of smaller contracts, the cross selling activity is slightly lower because the other side picked up. So we’re at probably 45% of the sales of each month, little more than 45% of sales each month is cross selling products. I don’t have hard data on the number of firms or any given time period. I think it’s remained fairly constant. It’s basically half of what the new sales activity is and I would imagine that it is probably similar in terms of number of contracts. There’s a lot of new markets to add on, they add on additional services, be it Showcase, be it COMPS or Tenant, and then there is a lot of new user growth. So right now there is a lot of musical chairs going on in the industry and you might have a firm failing and then other small firms in the market picking up. The brokers who are at that firm and they will add a license here or there and we couldn’t consider that cross selling. So there are already clients, they pickup a broker here from sales firm and they add two seats and begin paying us incrementally more for those additional seats.

Brian J . Radecki

And Bred I think, when I look back at that I would say historically over the past decade it’s always been around 50%. So as Andy said I think it may be it’s down to 45%. I think that’s because we’re getting a lot of these newer Showcase type people and which I think we talked about a couple of quarters ago that was what we anticipated to happen. But it’s typically around that that 50% plus or minus 5% and it is exactly what Andy said it’s people adding new geography, either new products and services, upgrading the suite. I think we have a very successful track record for decade and a half, two decades of getting people in kind of on a basic service and after they see the value on that, up selling them and it’s something we’ve done for decades and I would anticipate a lot of these sales that we have today will do the same thing over the next decade.

Brett Huff – Stephens Inc.

Okay, and then one last question again sort of bigger picture, in the, I don’t know how you want to talk about them, but in the secondary and tertiary markets that are relatively newer to your geography spread. I remember looking at your slide there is that pyramid of early adopters, middle and then late. Can you give us color on how that’s going has the economy made that harder? Have you found that the characteristic of those markets are making it easier or harder to penetrate right now and/or how many markets you feel like you are being very successful in or you can give us a sense of that?

Andrew C. Florance

I think it’s safe to say and I think different markets during different phases and cycles and it’s no different than the larger market. So, you know like a Boston would have been extremely successful for us right off of the bat, whereas Philadelphia was a slow bloomer, but is a now extremely successful market. So it may have Philadelphia probably took us couple extra years to get going but is now extremely successful. The same thing is true with these 200 new markets. Some have come on really quickly like Richmond, Virginia and then others are much slower and it could be something like Grand Rapids where the economy there is just not very robust and there is not lot of demand for anything there. So, I would say that the majority of the markets are current, of the small tertiary markets are in the top of the pyramid still, they are in the early stages. And a smaller percentage, maybe 20% are moving into the mid part of the pyramid. We know that traditional moving into owners and smaller brokerage firm space. But we have a strategy that we hope to deploy within the next quarter or so for these smaller markets that we think will accelerate the growth in the smaller markets that we’re really quite excited about and think it will be, I think it’s a very strong strategy that we’re not going to talk about.

Brett Huff – Stephens Inc.

Okay, and I do have one last question. I guess do you have any color on specifically that, I think it’s round numbers 20% that are of customers that are owners, bank lenders, banks, REITs, stuff like that any change in how that’s looking I assume it’s not getting better, I know it’s getting worse but...

Andrew C. Florance

Yeah, when you go through a list of who some of your bigger cancellations are they, they are the names, there is some bigger owners or banks or lenders or commercial real estate investment banks. So, but big picture that looking at where the reversals come from the brokerage reversals are slightly less than they, than they are as a percentage of our revenue and the owners and mortgage folks and institutional investors are slightly higher than they represent as a percentage of our customer base. And then I think retailers are slightly higher than they represent part of our customer base. And then appraisers and governments remain very low at the cancellation level.

Brett Huff – Stephens Inc.

Okay, thank you.

Operator

Thank you. And our next question comes from Jim Wilson of JMP Securities. Please go ahead.

James Wilson – JMP Securities

Thanks. Good morning guys.

Andrew C. Florance

Hey Jim.

Brian J. Radecki

Hi Jim.

James Wilson – JMP Securities

Let’s see, I wonder I guess just to continue one little further part of the new customer question. I’m guessing it’s too early but are you seeing any interest or sales to real estate private equity opportunity funds or anything starting to crop up that you might see as the vulture share eventually attack in the commercial real estate shift of assets?

Andrew C. Florance

Well, I mean, you’re right to pick up on the fact that some people are who are fresh capital are going to begin acquire assets now moving forward are probably going to end up making a real killing over the next decade a la Sam Zel then look at what he did in the past cycle. So, I think we are beginning to see some of that, but we’re probably, they’re forming right now. We are hearing a lot about it now and some of them are basically people who are traditional commercial side investors who are just found themselves distressed. The vulture funds to raise capital but you’re beginning to see and you saw the Vornado equity offering with a label of distressed opportunity funds kind of thing. So, it’s beginning to pickup and I think and we’ve been waiting for that and I think that’s probably something we’re going to see this quarter, next quarter. One interesting little segment we’re seeing some revenue come from is engineers, who are looking to go into buildings and certify them as energy star. We had a great sales month in London last month on the basis of these engineers looking to go in there and get ready to capture some of these conversions to more energy efficient buildings and in the U.S. I think it will even bigger market with all the stimulus dollars going into retrofitting buildings, someone’s got to do that and CoStar has the all the information as to which ones are green, which ones are not and who is who. So I think that will also drive some unusual revenue.

James Wilson – JMP Securities

Okay, and then I guess my second question, that’s great, on kind of your overview and five year outlook on the analytic side. I was wondering since as part of your guidance at the beginning of the year to be adding research staff sort of how, how that’s progressing, are you in quarters away ahead of a 12-month curve or how should we kind of think about that?

Andrew C. Florance

Yeah I think I mean we have actually just begun I mean, it seems like we had talked to you guys yesterday but that process just kind has begun at the end of the first quarter so I think we are up. I don’t have the exact numbers with me but 10 or so researchers I think we plan them being up 50 or 60 this year. So I think we’re starting that process and it will probably be fairly gradual throughout the year, so that’s just kind of beginning now.

James Wilson – JMP Securities

Okay. All right, great. Thanks.

Andrew C. Florance

Thank you Jim.

Operator

Thank you, and our next question comes from Vance Edelson of Morgan Stanley. Please go ahead sir.

Vance Edelson – Morgan Stanley

Hi, and thanks a lot. First just following up on a recent question could you provide a little more color on the pricing environment? It sounds like at least for Showcase competitors are charging more, which is good news for you. Elsewhere what are you hearing from customers in terms of their ability and their willingness to pay given the macro environment? So in other words regardless of the value proposition to their own business, how is the pricing environment for your services?

Andrew C. Florance

I think that on the Showcase front we’re a new entrant there and we have the advantage of having a major piece of our cost base is covered through our other profitable product areas so this is sort of a product for us which has incremental margin, we think we’re cost advantaged here so we can take a significant share and generate good earnings out but with a more competitive price points. It’s more a competitive positioning issue for us. Most of the folks, can afford to pay aren’t really on lead generation in a down market they are willing to pay for it. You’ve got a clear segment of the market which is probably, 40% of the folks out there right now who are down to only essential expenses or have moved below essential expenses, and for those folks it is just tough to sell them anything or renew them on anything and then you’ve got another segment of the market, as Jim Wilson points out folks who are beginning to come in as vulture investors who have are very flush, hedge funds or very flush to come into this space. Pricing is not an issue with those folks and then another thing that when the, silver lining in a negative cycle is many, many, many of these larger firms get really serious about cleaning out overlapping expenses and they rely more and more on CoStar group in a down cycle like this and they are very, they want to get a fair price but they are looking to save five, ten times as much out of their internal operations by going to a CoStar group. So they are less price sensitive and ultimately we come out of the cycle with a stronger relationship with those bigger firms.

Vance Edelson – Morgan Stanley

Okay.

Andrew C. Florance

Hope that helps.

Vance Edelson – Morgan Stanley

Yes, that answers it thanks. And then I may have missed it but what are you thinking in terms of uses of cash considering the healthy cash balance? Could you just give us an update on your thinking there?

Andrew C. Florance

We are, continuing to evaluate at every Board meeting the options there for buyback, dividend and the like. Obviously in this very unusual environment we like to have a window to when the vacancy rates stabilize that’s usually our strong point, we like to be, have a clear vision of that position of strength as we make such decisions. And there is a fairly robust set of opportunities out there for acquisitions that become more reasonable as the market moves on. So we think there are some interesting things out there that could be uses of cash that would be accretive to the company and strategically valuable.

Vance Edelson – Morgan Stanley

Okay, that’s great. Thanks a lot.

Andrew C. Florance

Thank you.

Operator

Thank you and our next question comes from John Neff, William Blair. Please go ahead.

John Neff – William Blair & Company

Hey, guys thanks for the follow-up. Brian I just want to make sure I understood the timing. You talked about the $100 million annualized EBITDA as being a long-term target. I wanted to see if that was in anyway anchored to the previous not expectation but exiting 4Q ‘10 in terms timeframe, in determining the timeframe?

Brian J. Radecki

Yeah, I think we are still focused on it. I mean that is the long-term goal and I think Andy and I stated last quarter I think as we, as things clarify at the end of this year and early next year if conditions improve, that could still be doable. So I think obviously it’s fairly long-term it’s out there, it’s a couple of years away and we’ll just see how it goes each quarter.

John Neff – William Blair & Company

Okay and then you mentioned Andy good color on the sort of the reasons or rationale for cancellations. I think you said 3% of the cancels fell into sort of a data quality issue...

Andrew C. Florance

Yes.

John Neff – William Blair & Company

And I was just wondering if you could give us a little bit more color on what were the concerns that were voiced about data quality and how seriously you take those?

Andrew C. Florance

Well, obviously you’d like the number to be zero, but the, what we attempt to do as a business is obviously impossible to do perfectly in tracking the large to manageable moving marketplace in a pretty wild, wild west environment. So as things go 3% cancellation for data is very low, we are not entirely happy with it and it would be it would be something that we, we are increasing the size of the research staff to continually improve the quality of the data right now. We think that as we come through the year and get that research staff the number of people managing portfolios up by 50 plus people, we can probably pull that cancellation first from 3% per data down to 1.5% per data. You will never get it to zero because there will be somebody who has purchased the product for some sort of function that requires perfect, perfect data and maybe data we don’t collect or maybe they are trying to get, they are trying to sell elevator maintenance and they need to know precisely the number of elevators in every property and the speed or something we just don’t have that data. So it could be a market where they are, perhaps the researcher causing it or it could be something where the expectation for what we could provide was simply not realistic. But big picture it’s that, pretty good number. I’d say that in our operating history there have been probably two different periods where the number was probably dramatically higher than that and so we probably had a period or two where we were in the 10%, 12% so 3% is pretty good.

Brian J. Radecki

Hey John let me just add a few things to that, 3% is actually a very, very low in this type of environment when you track discreet data as we do that, that’s moving as fast as it is, but I would just like to make sure to reiterate we’ve got almost 900 researchers, we are looking at adding 50, 60, 70 this year to improve the data quality even more. What we add this year will be more than more researchers than anybody else out there, just what we add this year forget the 900 we already have. So I think it’s always comparable to what’s the next closest person out there, I think it’s not even close, our data quality is heads and tails so much higher than anything else out there. And that’s why you see the DB agreement, you see the Cushman & Wakefield agreement I mean it just, it speaks for itself.

John Neff – William Blair & Company

Great. Thank you very much.

Brian J. Radecki

Great thanks guys.

Andrew C. Florance

So with that we are at an hour and almost 15 minutes we are going to wind up our first quarter call. Thank you all very much for joining us, and look forward to updating you on our progress and performance at the next quarterly earnings conference call.

Operator

Thank you, and ladies and gentlemen that does conclude our conference for today. Thank you for your participation and for using AT&T Executive Teleconference Service. You may now disconnect.

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Source: CoStar Group, Inc. Q1 2009 Earnings Call Transcript

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