Tim Trainor - Communications Director
Andrew Florance - Founder, Chief Executive Officer and President
Brian Radecki – Chief Financial Officer
John Neff - William Blair
Jonathan Maietta - Needham & Co
Brett Huff - Stephens Incorporated
Vance Edelson - Morgan Stanley
Jim Wilson - JMP Securities
Christopher Mammone - Deutsche Bank
CoStar Group, Inc. (CSGP) Q2 2008 Earnings Call July 16, 2008 11:00 AM ET
Welcome everyone to the CoStar Group second quarter 2008 earnings conference call. (Operator Instructions) Mr. Trainor, you may begin your conference.
Good morning, everyone and welcome to CoStar Group's second quarter 2008 conference call. Before I turn the call over to our CEO, Andrew Florance, let me state 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 include, but are not limited to those stated in CoStar's second quarter 2008 press release and in CoStar's filings with the SEC, including CoStar's form 10-K for the period ended December 31, 2007 and CoStar’s form 10-Q for the quarter ended March 31, 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 of this conference call at www.costar.com/corporate/investor. Thank you again for joining us. I will now turn the call over to Andy.
Welcome everyone to CoStar Group’s second quarter 2008 conference call. I'm very pleased to report that CoStar posted another strong performance in the second quarter, one which we added a large number of new subscribing firms continued to added net new individual subscribers and continue to generate very solid earnings growth.
In May we launched our newest product offering CoStar showcase, which has surpassed even or most ambitious expectations in terms of market reception. Also during the quarter the total number of commercial property listings marketed through CoStar exceeded 1 million for the first time and continues to grow. We believe that this is by for the most property listing available through a unified database in any website in the industry and represents a monumental achievement for our company.
In addition as we announced in our release today we have made substantial progress on the comment we made to investors 12 months ago to pursue, accelerate earnings growth while in the substantial investments we made over the past years to expand our market coverage in the U.S. and the United Kingdom.
Having conclude the transition last year from a period of heavy investment in our business to one in which we generate solid earnings growth we set a goal on the second quarter of 2007 to dramatically increase our then company wide 9% EBITDA margin and achieve a 30% EBTTDA margin within the U.S. by the fourth quarter of 2008. With this quarter’s results showing a 29% U.S. EBITDA margin we have almost reached that goal. As a result we are again raising our earnings outlook to the rest of this year.
Having established a pattern of increasing profitability over the past four quarters, we intend to continue to pursue our current strategy of sequential earnings growth further strengthening the company’s financial position. Based upon our current revenue growth rate together with the demand we see for our core information products and newly launched internet marketing service CoStar showcase, we are setting a new goal for the company of doubling our EBITDA and generating 100 million in annualized EBITDA on a run rate basis by the end of 2010.
Net income for the second quarter increased 363% to $5.4 million or $0.28 per diluted share compared to $1.2 million or $0.06 per diluted share for the same period a year ago. Revenues for the second quarter 2008 were $53.5 million compared to $47.8 million to the second quarter of 2007. Core U.S. subscription revenue increased 2.9% in the first quarter to the second quarter of 2008 consistent with increases over the past several quarter. EBITDA, Earnings before Interest Tax Depreciation and Amortization to the second quarter of 2008 was $12.8 million, an increase of 204% compared to EBITDA of $4.2 million from the second quarter of 2007.
Demand for our information products remained quite strong in the second quarter. In total we added 587 net new subscribing firms in the United States, the second highest number of new subscribers the company has added in a single quarter. In addition we had approximately 785 net new paying subscribers during the quarter for a total off 91,607 authorized users. CoStar’s customer renewal rate for subscription based services remained high at approximately 90%.
By far the most significant event of the past quarter from a sales perspective was the main launch of CoStar showcase. Our innovative new marketing service that makes the listings of CoStar showcase subscribers automatically accessible to the tens of thousands of business professionals who are searching the internet for commercial real estate each day.
CoStar Showcase taps the substantial traffic on our websites and additional traffic from major search engines to provide commercial real estate professionals with an exceptional new opportunity for marketing their listings on the internet and generating more leads for their properties.
Currently, orders for this new service are approximately 4 million making it one of, if not the most successful new product launch in CoStar’s 20 year history. Since, we launched CoStar Showcase in mid May, 574 subscribing firms have had their listings exposed to internet searches from such leading companies as McDonalds, Pfizer, General Motors, Office Max, Coca Cola, Delta Air Lines and Lockheed Martin among many, many others.
I have been working closely with John Stanfill, our newly appointed Senior Vice President of sales to capitalize on a tremendous interest, commercial real estate firms and brokers show in marketing their listings on CoStar Showcase. CoStar Sales Organization has been busy setting appointments and presenting the new CoStar Showcase service to 1000s of prospects with listings across the U.S.
Our sales team has scheduled 1000s of additional CoStar Showcase presentations and follow-up meetings with prospects for the next two months. Many of our sales people are booked up well into August. We expect a large number of these prospects to become CoStar Showcase subscribers.
As an incentive, during initial launch, we have been offering limited trial periods and cancellation options to CoStar Showcase subscribers. These incentives have been extremely effective, but they do not preclude us from including these subscription orders but they do preclude us from including these subscription orders as revenue until they go firm. Therefore we have not included these Showcase contracts in our quarterly bookings number, partly because it was trial offer and the rest of our U.S. subscription contract bookings were lower in the second quarter of 2008, totaling 3.1 million down from the 3.7 million in the first quarter of 2008. However, we fully expect that number to increase as more trials convert into Showcase subscribers in the second half of the year.
Already, by the end of the July we believe we will have 1 million in recognizable annual billings from Showcase. We believe that there are two primary factors that are contributing to the search and interest we have seen for CoStar Showcase. The first is we believe CoStar Showcase provides a superior alternative to other solutions available. The second factor is the significant competitor in the space has recently passed on a series of major price hikes alienating many of its clients.
We believe in an uncertain economic environment, commercial brokers resent these unreasonable price hikes even more and so they are searching for a good alternative service that can provide them with quality leads from the Internet.
CoStar Showcase offers a more effective and convenient solution for those searchers and subscribers. For brokers, who already have the listings in CoStar property the process of adding their listing to CoStar Showcase is practically frictionless. For searchers the process of searching and accessing listings on CoStar Showcase is also practically frictionless. Once more this new online service leverages our existing search operations and cost structure.
All the property information is drawn from our listing data base and online image libraries, therefore requiring little additional support or investment other than software development and a pay-per-click budget. It’s a very efficient solution for our subscribers and a high margin product for us. For all these reasons, we believe CoStar Showcase as the potential to be a significant contributor to our earnings growth later in the fourth quarter next year and beyond.
Compared with our core subscription-based information sales, which tend to have a sales cycle of months, the sales cycle for CoStar Showcase appears be to a matter of weeks, and the current average Showcase contract size of $7,826 annual compares favorably with our second quarter average information contract value of $7,155 annually. We couldn’t be more pleased to offer our client as compelling and extremely effective solution from marking their listings on the internet. Going forward, I expect Showcase to be one of the primary focuses of our sales organization.
Last call, I updated you on our first and second quarter focus on strategically important, smaller sized firms that had a higher than average number of property listings. As part of this sales effort we made a concerted effort to inform these prospects of CoStar’s comparably priced, higher quality information and the fact that they maybe more affordable than they are perceived. We believe CoStar offers a compelling alternative to those firms who stand to benefit from the value of our higher quality research supported information.
In addition to expanding our customer base, sales to these smaller size firms could also lead to long-term growth opportunities given our historical proven ability to renew and up-sell firms who have become subscribers. For these and other reasons, we thought it was an opportune time to pursue this market segment even though it limited our short-term ability to grow our bookings number.
I am pleased to report our efforts in this area over the past two quarters have been a major success contributing to the record number of new subscribing firms we’ve added over the first two quarters of the year and resulting the conversions of thousands of listings to client listings, giving us higher quality data overall there by increasing our value proposition to all of our clients and prospects.
Also as I explained last call, we anticipate that the average contract value would begin to increase back towards historical levels once the sales initiative focusing on smaller sized firms wrapped up late in the second quarter and that has already began to occur. The average net contract value increased from $6,864 in the first quarter of 2008 to $7,155 in the second quarter of 2008.
Our special focus on small firms is now completed and over. At the end of the second quarter the company had 128 U.S. subscription sales field reps, eight U.S. advertising sales reps, eight in-house sales reps and 21 U.K. field sales reps for a total of 165 sales representatives. That compares with 171 on staff at the end of the first quarter of this year.
Our research department achieved a major milestone during the second quarter by adding the 1 million listing to CoStar's database. To the best of my knowledge this represents the largest aggregation of commercial property information ever assembled within a unified database anywhere in the world. This aggregation represents tremendous value for our subscribers who can now access and compare similarly researched and verified properties across markets coast-to-coast and it further strengthens CoStar’s position as a leading provider of information marketing services for the commercial real estate industry.
CoStar pioneered the concept of commercial real estate firms outsourcing their property research functions 20 years ago, fundamentally changing the way commercial real estate professionals access, use and share property information. The astounding number of listings now being accessed today across CoStar's information platform throughout the United States and United Kingdom is a clear indication of how much the industry has changed from the outmoded and inefficient exchange of incomplete paper based information to the much greater efficiency, increased productivity and cost-savings that accrued to the firms and individual brokers who use CoStar.
I have the distinct privilege of meeting the broker who recently provided the one millionth listing added to CoStar’s network. His name is Cyrus Weiss and he works for Ritchie Commercial in San Francisco. He is a World War II veteran and served in the Coast Guard. He embarked on his carrier in commercial real estate while in his early 70’s and a fine gentleman you will never meet. He is still vibrant and active in commercial real estate and also a long time CoStar subscriber and active user.
When he recently won a new listing, he contacted a member of our research team [Christian Vandeloop] who properly verified the information and added his listing. It was a three level storefront retail and office building on Lombard Street in San Francisco, the structure originally built-in 1908. With the single call to a CoStar researcher Mr. Weiss, who describes himself as the oldest broker in America added his listing for one of the oldest building in the city to what I consider to be the most advanced information system serving commercial real estate, making it almost instantly available to CoStar’s professional industry audience, as well as to a massive potential business audience searching the internet for commercial real estate each day.
The total number of listings available through our service continuous to grow. Total researched and verified commercial real estate listings in CoStar's U.S. database grew 22% year-over-year from approximately 770,000 in the second quarter of 2007 to approximately 940,000 in the second quarter of 2008. In total, between both our U.S. and International operations, the company currently has approximately 1.40 million listings in our database and the total gross building area tracked and maintained by CoStar is now approximately 60 billion square feet.
Our research team provides the core data that is the source of our value and identity as a company. They have done an outstanding job in researching all the markets we cover and they continue to demonstrate their value by aggregating more and more listings in an extremely efficient and timely manner.
While we have now completed the difficult and labor intensive phase of adding new markets to our database to complete our coverage in the U.S. and expand our coverage in the U.K, we continue to add listings at a brisk pace. We have now taken appropriate steps to stabilize our cost structure and believe the costs associated with maintaining the information is now at a relatively fixed basis.
We continue to make progress in building a strong and U.K. product offering as we had in the United States and work towards the goal of becoming the preeminent source of commercial real estate information in the United Kingdom and eventually all of Europe. Since, introducing many of the same research processes and systems we have in place in the U.S. including field research vehicles the U.K. research team has ramped up its overall productivity and is now in high gear. In fact, I believe that our Glasgow Research Center is developing into one of our best and most productive research centers globally.
The U.K. research team added more than 110 million square feet of available space during the second quarter to bring the U.K. availability database to approximately 1.1 billion square feet. The U.K. availability database is approaching the listing counts we would expect to see on a relative GDP basis.
One sure sign that we are delivering on our customer expectations is the increase in product usage we are seeing in the U.K. as clients continue to log into our system, run more quarries, produce more reports and setup more alerts. Usage of our focus products in the U.K has more than doubled year-over-year from the second quarter of 2007 to the second quarter of 2008. We firmly believe that the higher overall usage levels bode well for continued high customer renewal rates in the future.
I would also like to briefly update you on the status of one of the law suites that we currently have pending against LoopNet. In November 2007, LoopNet filed a complient over CoStar’s use of listings forwarded to CoStar by broker’s whishing to market their listings on CoStar. Essentially, LoopNet claims when a commercial real estate broker uploads their own listing to LoopNet service that listing becomes a “LoopNet listing” and then LoopNet has the right to restrict how that broker can further market, distribute or use his/her listing information.
LoopNet’s complaint appears to allege that a broker who authors and types the listing into LoopNet may not use the e-mail to a friend function available LoopNet to send that listing to CoStar for inclusion in the CoStar database. Not only do we think that LoopNet’s legal arguments are wrong, but we also thing that the LoopNet customers will be dismayed to discover that LoopNet’s claiming controls and may restrict the marketing and distribution of listings where the brokers themselves have one photographed, uploaded, written and typed.
CoStar filed defenses to LoopNet’s suit and filed a cross complaint alleging among other things that LoopNet had violated and breach the terms of a selling agreement entered into by the parties in September 2005 that clearly provides that CoStar may obtain and use listings from the public portion of LoopNet’s website. LoopNet then filed a motion under California law asking the court to strike CoStar’s cross compliant on the grounds that lacked merit.
On Friday June 6, CoStar won the motion and the court denied LoopNet’s motion to strike CoStar’s counter claims. Concluding that CoStar had shown a reasonable probability of succeeding on the merits of its claims that LoopNet violated the settlement agreement. LoopNet has now appealed the California judge’s decision.
Not withstanding our expectation that CoStar will prevail in the merits of this case, as far as the discovery process we have gone to the hundreds and hundreds of CoStar researchers and asked them to identify for us any listings they have entered, that have been copied from the public portion of LoopNet’s website. Today we have heard back from virtually all the researchers and out of the 1 million plus active listings currently in our database, they have identified one listing that was obtained from the public portion of LoopNet’s website in the absence of a direct request from a broker to have the listing added to the CoStar database; that’s right, one. We have confirmed that the broker currently responsible for that one listing wanted it on CoStar’s website. Again our investigation today shows that CoStar has not added listing from the public portion of LoopNet’s website unless directed to do so by the broker that created the listing.
Ultimately, we believe that because LoopNet has been losing thousands of subscribers over the last few quarters and it appears unable to stop the client exodus, they have out of desperation resorted to suing CoStar in a misguided attempt to salvage their clients enlisting. We are very confident that LoopNet’s lawsuit is completely frivolous and that the exorbitant amount of legal fees being spent by both parties in the courts has been and will continue be a colossal waste of time and money.
Unfortunately, CoStar has being engaged in litigation on and off of LoopNet for nearly a decade and at this space we continue to be for the foreseeable future. Our related legal fees are trade as an ongoing regular expanse item and so are reflected in our financials and unlike LoopNet are reflected in our EBITDA and our guidance. We are pleased with the courts recent favorable ruling and we are seeking to recoup our legal fees in our countersuit. We remain confident that LoopNet’s law suite will not impact our ability to show consistent sequential quarterly earnings growth.
To read some of the recent pronouncements made in the media on the conditions in commercial real estate markets one might think we are in the midst of the worst downturn in the past 25 to 50 years, but based on our analysis the facts and statistics simply do not support the view that the commercial real estate market is falling into a severe downturn.
Our latest analysis based upon the performance of a core set of major U.S. markets found that the conditions for the office, retail and investor, real estate sectors during the second quarter remained mixed, but many of the most important metrics are well within range of conditions considered healthy by most interpretations.
Clearly, it appears that the transaction activity has slowed especially on the sales side. However, many key industry indicators continue to reflect unprecedented strength. Rents are generally at multiyear highs. Construction activity is robust. Vacancy rates have risen, but are generally moderate across the majority of markets and well within the ranges considered healthy.
Overall, office absorption remained positive in the second quarter with a total of 7 million square feet net absorption reflecting relatively strong demand. 27 of the core office markets we analyzed, experienced positive absorption this past quarter, while 16 saw a negative absorption, but interestingly reflecting the mixed state of market conditions at midyear, 15 of the core office markets we analyzed saw vacancy decrease over the past year, while office vacancy increased in 26 of the markets.
Eight office markets have vacancy rates below 10%. The office market with the lowest office vacancy rate in the country is also the largest, New York City at 5.6%. A 5.6% vacancy rate is an indication of an extremely tight and strong commercial real estate market.
Another clear indication of market strength can be found in office rental rates, which continued to go up in the second quarter, the 10 consecutive quarterly increase in average office rents. I can tell you first hand, that office rents are more than holding their own. I just received several lease proposals in our sales office in Boston and from what I say at least Boston rents are as healthy as I’ve ever seen them.
We are seeing a slowdown in commercial real estate sales activity but we believe that CoStar has modest exposure to a slowdown in that section. The situation is much the same across industrial and retail property sectors. The fact is commercial real estate marketing conditions have remained fairly resilient. We certainly have not witnessed the Hallmarks of a true commercial real estate downturn characterized by consecutive quarters of clearly raising vacancy rates, falling rents, asset base, negative absorption, CoStar construction activity; rather it appears capital for commercial real estate, both equity and debt remains reasonably available under the terms in 2008, especially compared with the true downturns we had in our early 90’s.
Obviously, market conditions are weaker than they were two years ago and could weaken further. More likely, individual markets will strengthen and weaken at different paces, reflecting the underlying strengths of the local economies and their positions in the real estate supply cycle. I believe this only underscores, the way of having access to comprehensive research verified property information that CoStar can provide.
Before turning the call over to Brian Radecki, our Chief Financial Officer for a more in-depth discussion of our financial performances and outlook let me reiterate that the company is very focused on adding and retaining subscribers across the U.S and U.K. controlling our costs and enhancing the high-quality of research we conduct. We expect to continue to generate consistent earnings growth as we move into 2008 and into 2009 and beyond. We are very focused on our goal of doubling our EBITDA to achieve 100 million in annualized EBITDA run rate for the company by the end of 2010.
Our first goal in the short-term, intermediate term and long-term earnings growth is our long-term earnings growth. I believe this quarter’s results have clearly delivered this goal and we remain confident in our ability to continue to deliver earnings growth throughout the rest of the year and the following and the following.
I want to thank all of the staff in CoStar Group for turning in a tremendous quarter and at this point, I want to turn the call over to Brain Radecki, to go into more detail on the quarter’s numbers.
CoStar posted another strong quarter of earnings growth at the mid-year point. As Andy, mentioned earlier and as we stated in yesterday’s press release net income increased 263% in the second quarter of 2008 to $5.4 million or $0.28 per diluted share, compared to $1.2 million or $0.06 per diluted share in the second quarter of 2007.
EBITDA, which is Earnings before Interest Taxes, Depreciation and Amortization for the second quarter of 2008, was $12.8 million, an increase 204% compared to EBITDA of $4.2 million for the second quarter of 2007.
Today I am going to principally focus on the sequential results for the second quarter of 2008, compared to the first quarter and in our outlook for the third quarter and full year of 2008. Total revenue grew sequentially from $52.3 million in Q1 of 2008 to $53.5 million in Q2 of 2008.
Core U.S. subscription revenue increased by 2.9% from Q1 to Q2, which is consistent with the past several quarters. It was slightly offset by lower non-subscription or ad hoc revenue during the quarter. Subscription revenues continue to account for approximately 95.3% from our total revenue during the quarter.
Our 12 month trailing customer renewal rate remained strong at 90.9%. The subscription revenues accounting for approximately 95% of our total revenue and the majority of our subscribers on annual agreements, we consider our 12 month trailing customer renewal rate to be a good indicator. Also for the second quarter our customer renewal rate for subscription based services remains solid at 89.7% or as we stated in the press release approximately 90%. All-in-all these are very healthy numbers based on where we are today in the economy.
International revenues increased 3% from Q1 to $6 million in Q2 of 2008. International operations contributed approximately 11% of total revenues in the quarter and international subscription revenues account for approximately 90% of this revenue. Year-over-year international revenues modestly increased by approximately 2%, due to the discontinuation of acquired product offerings that were duplicative, some of the client and certain consulting revenues and an unfavorable impact on exchange rate changes. However, our year-over-year international subscription revenues increased at approximately 10%.
Again let me remind everybody, the company has reported sequential revenue increases in every quarter since its IPO in 1998 and through several commercial real estate cycles since Andy founded the business over 20 years ago. We continue to expect that we’ll add new subscribers, renew current subscribers and grow our revenue and earnings through the current economic and real estate cycles.
Speaking of the IPO, that reminds me July 1 marked CoStar Group’s 10-year anniversary of our IPO in becoming a publicly traded company on NASDAQ. A decade ago, I remember thinking of the daunting task ahead of us expanding by market-by-market across the U.S.
During that period of intense investment we produced a consistent pattern of revenue and earnings growth market-by-market all across the U.S. Now a decade later, after completing the major investments required to research both the U.S. and U.K. commercial real estate asset classes, we have leveraged our subscription based business model over relatively fixed cost structure to establish a pattern of increasing profitability, but now on a country level in the U.S. quarter after quarter after quarter.
As Andy stated earlier, after announcing a year ago in Q2 of 2007, our goal of achieving a 30% EBITDA margin in the U.S. by the end of this year, we have nearly reached that goal after four quarters. Now, we have set a new goal of working towards doubling our EBITDA company-wide to 100 million run rate by the end of 2010. We believe this goal is achievable based on our strong subscription based business models and based on the current revenue growth rates in the current economic and commercial real estate environments.
Gross margin increased by $2.6 million from $32.5 million in Q1 of 2008, to $35.1 million in Q2 of 2008 on a $1.2 million increase in revenues and a $1.4 million decrease in cost of revenues. Approximately half the decreased in cost of revenues, was directly related to permanent operational and efficiency gains, i.e. the elimination of excess leases across the company, elimination of redundant data cost from recent acquisitions etc, etc. The remainder of the decrease relates to variable finding differences with new hires, headcount and other related costs.
Overall, gross margin percentage expanded to $65.7 million in Q2 of 2008 from $62.3 million Q1 of 2008. This increase in both gross margin dollars and percentage demonstrates the strength of our business model. Now, that we have completed the previous step-ups in cost structure, as I’ve stated several times, we expect the majority of revenue added during the quarter to drop directly to the gross margin line as we’ve seen for the past several quarters.
Overall, operating expenses increased $1.3 million during quarter from $25.3 million in Q1 to $26.6 million in Q2 as expected. This increase was principally in selling and marketing with the seasonally high expenses from CoStar’s participation in the ICSC trade show in May, along with the cost associated with a successful launch of CoStar Showcase.
In more detail, G&A also saw a slight up-tick this quarter due to the termination of a lease and write-off of certain lease-hold improvements that is now saving the company over $1.1 million over the remaining two year term of the lease, as we consolidated excess office space in Maryland, which we discussed last quarter.
In addition, legal expenses included in G&A also remained high in Q2 at approximately $900,000. As always we follow GAAP basis accounting and report all of our legal expenses in our income statement, EBITDA number and on our earnings outlook for the year, unlike other companies I am aware of. Throughout the reminder of 2008, we expect the company’s overall operating expenses to remain stable and relatively fixed.
Our revenue growth of $1.2 million coupled with overall expenses, cost of sales plus operating expenses were consistent from Q1 to Q2, resulting in EBITDA for the second quarter of $12.8 million, an increase of $1.3 million compared to EBITDA $11.5 million in the first quarter of 2008. Reconciliation of EBITDA to all non-GAAP financial measures discussed on this call, to GAAP basis results are shown in detail on our press release issued yesterday. The press release is available on our website at www.costar.com.
Capital expenditures for Q2 of 2008 were approximately $1.2 million. We ended the second quarter of 2008 with approximately $198.3 million in cash, cash equivalents short-term and long-term investments. Also, we have no long-term debt.
Now, I will discuss the outlook for the third quarter of 2008. As indicated in our press release, we expect a sequential quarterly increase in revenue from the second to the third quarter of 2008 from approximately 2% to 4%, with fully diluted net income per share of $0.28 to $0.30 in the third quarter of 2008.
We also expect to grow earnings from U.S. operations through 2008 and to 2009 and beyond as a result for the consistent core revenue growth coupled with our relatively fixed cost base. Based on the current visibility and operation of our business we are again raising the outlook for net income for the full year of 2008. The company now expects a $1.10 to $1.15 per diluted share for the full year of 2008.
We continue to believe there is upside revenue growth potential later in 2008. Revenue growth continues to be largely depended on the successful management and productivity of the sales force particularly in the unit of revenue opportunities resulting from momentum in established markets, new markets and the new Showcase offering.
Now, if our sequential quarterly revenue growth rate does not accelerate as we expect, we continue to expect to meet our updated earnings outlook while possibly coming in at the bottom of our year-over-year annual revenue growth range which we set for this year. For the full year of 2008, we expect approximately $5 million to $6 million in pre-tax non-cash equity compensation charges relating to investing of restricted stock options.
Gross margin percentage is expected to improve slightly from Q2 to Q3 as we continue to leverage our stable U.S. cost structure and identify operational efficiencies. Operating expenses are expected to be relatively fixed or decreased slightly from Q3 to Q2.
As we continue to invest internationally the mechanics of our effective tax rate calculation continue to be effected by the amount of income or loss in the U.K. where we do not get an equivalent tax expense plus benefit to offset the U.S. corporate tax. This results in an overall blended effective rate that may increase or decrease over the current rate. We currently continue to expect our overall effective rate to be in the range of 43% to 45% for 2008.
In conclusion we continue to expect earnings growth in our core U.S. business operations to be the story for the reminder of 2008. Our Q2 results demonstrate that we are delivering on these expectations. We also expect our international operations to continue to move towards break-even by the end of 2008, while we develop the next generation of international software, which we expect will position us for the long-term growth opportunities in the U.K. and Europe later in 2009 and beyond.
As Andy, stated earlier the entire CoStar management team remains fully committed to achieving the 30% EBITDA margin in the U.S. and break-even in our international operations by the end of 2008 and now working towards our new goal of 100 million in annualized EBITDA for the entire company by the end of 2010. We look forward to reporting that progress to you and with that I will open up the call for any questions.
(Operator Instructions) Your first question comes from John Neff with William Blair.
John Neff - William Blair
You mentioned with the Showcase product, you mentioned a fair number of retailers that sounded like they were trying the product. Was that retailer trying it directly or through the brokers? Any sort of -- can you give us maybe an update on sort of the retailer appetite for the product and what you think it could mean as far as penetrating that market? And then, can you give us an updated view on how you’re thinking about capping the listings inventory available on Showcase?
I think the product retailers who have access to inventory that are trying to dispose, they would be interested in the product because it would typically while those dispositions are going to be picked up by smaller mom and pops or at retailers and Showcases a great venue to reach a general business audience on the Internet. Also, retail in general, when you get outside the retailers, we’re seeing about a third of the activity on the Showcases coming from retail real estate and that’s a very fragmented part the commercial real estate market often under-served by the brokerage community.
So, a lot of the business community at the smaller end of retailers spending for themselves and CoStar Showcase is an ideal way for them to try to find opportunities. So, we do think that a big part of the growth story in retail and then in Showcase will be around that whole retail segment. I’m surprise to see that the retail segment for us in Showcase is larger, the second element in the office segment’s larger than the industrial segment.
What we intent to do, in your second part of your question, I’m capping how much we’re putting in there, we intent to initially cap at about half of listings in any given metropolitan market can go into Showcase and because of the really great response we’ve received for the product, there are some markets in which I believe we are approaching 30%, of the listings being Showcased. So in those markets I anticipate we will bump up against the 50% cap, but generally across the United States we would be in the -- I would not see us hitting the cap in the substantial number of markets for another year or two and by then we would have an awful lot of revenue from the product. Does that answer your question?
John Neff - William Blair
Yes, yes that’s great and just one more Showcase question. The 587 new subscribing firms you added during the quarter, does that include Showcase or is that for traditional kind of products?
John Neff - William Blair
With the international revenue growth, can you just remind us of the businesses that were business lines or products that were discontinued and also Brian remind us of why the sharp drop -- in looking at the EBITDA for international, why the sharp drop in corporate expense allocation from a year ago 285,000 from 975?
Sure. As we talked about and I think if you went back to last year you will see when we acquire the Propex acquisition in the second quarter of last year, they had a couple of product lines that were duplicative with product lines that we had. One in specific of which I know we’ve mentioned on prior calls was Screen Data.
So, we essentially closed down that screen data and some other smaller product lines last year because they are duplicative with what we had. So, when you look at the kind of the quarter-over-quarter results they are growing, approximately where we are on the U.S. platform. It’s when you look at the year-over-year results you’re not really comparing apple-to-oranges because you had those numbers in the first half of last year which are no longer there this year and as far as the corporative allocation goes, sorry but Andy’s sitting right here, but Andy spent the entire summer over there last year. So, he is no longer there anymore, he is shaking his head, but I got to tell it the way it is, so we are not spending as much over there, so they’re not getting as big as an allocation.
John Neff - William Blair
Okay and some of the other Propex kinds of products, like the deal introduction platform and the auction platform, are those part of subscription revenue or are those part of non?
Those are part of subscription revenue.
Brian J. Radecki
Yes, there is some marketing components of the Propex. There are some marketing components and if you look at, I mentioned it this time in the call; I’m not sure if I’ve mentioned it before, but the international side I mean it’s not much but they are only at about 90% subscription revenues, so they do have a little bit more variability. So, the Propex component has namely a subscription fees, but there is a small non-subscription fees that goes along with it, so. I think because the U.K. numbers are a little smaller than the U.S. and the fact that they are slightly less, subscription based, it’s still 90% which is high, but a little bit more subject to, variability on the non-subscription or ad hoc type areas.
John Neff - William Blair
And then Andy I was looking for maybe an update on the sales force, if you could update us on the average tenure experience of the sales force, had some time to absorb some of the new folks, your view on sort of headcount growth going forward and then maybe an update on turnover?
I don’t have hard numbers right here on average sales tenure or turnover. What I can tell you anecdotally having just spent the five weeks with about 18 sales people on training per week, advance training or ongoing training of the showcase product in the last five weeks, I would say that we’re seeing, I’m beginning to see a clear maturation in the sales force that’s actually fairly unusual to have a new salesperson come into one of these training classes, so I would think that our average tenure has probably gone up by eight months or so over the last year and which is a very good thing.
I would say that our turnover is down, this year over last year and while we are down a little bit quarter-over-quarter in the headcount in sales, I would anticipate that number would fluctuate up and down a little bit and be fairly stable and what we’re focusing on is doing exacting what we’re doing which is continuing to put more training into the existing players that are there, bring that tenure up and build their experience level. So, I’m a pretty comfortable with where that group is and what they’re achieving at this point.
Your next question comes from Jon Maietta with Needham and Company.
Jonathan Maietta - Needham & Co.
First question I had was for you Brian with regard to cash flow, that kind of that bogey of $100 million revenue EBITDA run rate for year-end 2010; it implies some healthy cash flow growth. How shall we think about approximately for cash flow growth? Is that EBITDA growth kind of the best proxy, as you think about it?
I think the EBITDA growth is the best proxy and I think if you just took modest revenue growth figures which we’ve been seeing here in the past few quarters and you look at the fact that a high percentage of those revenues dollars are dropping to the bottom line, so you’ll be looking at 70%, 80% are dropping at the bottom line, you can fairly easily calculate on a pretty high-level, getting to the $100 million annual EBITDA before the end of 2010 and that’s how we look at it internally, so that’s how I would expect a lot of investors to be looking at that. It’s also, I hate to say it, but you can pull up our proxy, it’s our bonus too, so that’s what the company is focused on.
Jonathan Maietta - Needham & Co.
Yes, and that really is the base case scenario because I mean you are basically saying, as the market faces today excellent progress in macro growths and things like that…
I mean I think we’re looking at where we are today? What's happening today? And, we feel obviously a very good about it. We’ve raised guidance twice this year. Our business model is healthier than anything else I’ve seen. I mean it seems like every time I’ve pick up the paper we are bombarded with negative news, other companies reducing guidance, loosing customers, going out of business and trying to raise more capital and to be honest with you I mean our business is just performing exceptional and it’s healthy as it’s ever been. So, we’re very pleased.
Jonathan Maietta - Needham & Co
And then Brian I may have missed it; did you disclose what the cash flow from operations number was for the quarter. I got cutbacks, but not…
I don’t think I talked about it. It was about $8 million.
Jonathan Maietta - Needham & Co
Okay, got it. Then on the -- the other thing I think I missed, you talked about kind of a sequential increase in revenue in Q3 and Q4, but could you reaffirm kind of that 14% to 16% number for the full year?
I didn’t reaffirm it. I think what we talked -- what I said was that I think we’re in the 2% to 4% range and that’s where we have been in the last couple of quarters. So, I think we’re kind of still in that 2 % to 4% range, until we see us come out of that. I mean I think obviously the economy and those types of things are going to be a factor in there, but I think that’s a good range that we’re going to be into for quite some time.
Jonathan Maietta - Needham & Co
And then Andy with regard to John coming onboard and running the sales force, is it pretty much the same game plan in terms of running the ball and you plan any chance of sales force compensation or anything like that?
I don’t foresee at this any material change in sales force compensation other than the typical period incentives and special initiatives but I think it’s more of a switching of leadership and leadership style rather than a issue of big restructuring.
Your next question comes from Brett Huff with Stephens Incorporated
Brett Huff - Stephens Incorporated
I have two questions; one, last call you talked about kind of step up retention efforts and obviously I think that worked pretty well with keeping retention flat at 90%, can you just talk a little bit more about that and also the dynamics of how the sort of marginal smaller commercial brokers health is because I think that’s part of that dynamic.
As we came into the first and second quarter we had implemented some changes to the sales forces compensation plan at the end of ’07 and very beginning of ’08, but we felt it began to take effect as the year went on where we were putting more emphasis on them proactively driving usage up across their book of business and they’ve been doing that and I think that by-and-large the vast majority of folks in the sales force are in good in contact with their clients and that’s keeping the retention at a good level. I can tell you that I discussed the fact that the -- looking at the statistics for what the statistics say in commercial real estate you did not see evidence of any sort of disaster anywhere, the possible exception being slowdown in investment sales, financing on larger projects, but when you’re listening to large numbers of sales calls and sort of the atmosphere out there, you do have extreme anxiety and just pick up a newspaper and reader and the small brokerage firms can read those newspapers too and they are anxious about the outlook, so you got people who are more likely to cancel as a precautionary measure to control their expenses in the event of a downturn and so its making a slightly more challenging environment and in particular it’s at the low end; its still, 1%, 2%, 3% shops who are perhaps taking down their shingle and going back into a larger shop or going into insurance sales or something. So we are holding a reasonably solid retention rate given the psychology of the market right now and interestingly our gross sales number, our ability to sell product is still pretty strong.
Brett Huff - Stephens Incorporated
Okay thanks and then just one other sort of color on the reversal of the average sales price or I forget what you guys call the metric, but the change from 6,800 to 7,100 platform. When you look forward what are the major drivers of that continuing to go up over the second half and sort of into ’09?
Well that special incentive program ended mid-May and so that’s going to -- with the elimination of special focus on small firm asking to bring the average number back up and then we are enjoying a period here where we’re signing up some larger dollar Showcase deals which is driving it up as well and then the sales force is becoming more mature which would also drive it up and you could have some smaller Showcase accounts where sales people are going into their existing customers and who don’t have a lot of listing, but good customers and selling them Showcase, which could be a $100 a month sale so as an individual addendum to a contract it’s a small number, but the overall account value will be continuing to grow. So, I would expect the average number to be moving up in the third and fourth quarter inline with what we thought in the first quarter.
Brett Huff - Stephens Incorporated
Okay, and then last question Brian, can you just repeat the -- or maybe Andy you said this; the number that you’re going to recognize in revenue from Showcase instead of a $1 million was that for 3Q or 2Q, I just missed that statistic.
That is the number that by the end of July it appears that we will have achieved in annualized recognizable run rate of $1 million so over the next 12 months what we do in July will be one -- we’re able to call, recognize what revenue in July, where the trails expired, the contracts firm, the one year to two year contracts, so at that point we have a high confidence on a $1 million of revenue. The number, there is not a lot of trails expiring in August and then there is a large number of trails expiring in September and October, a lot of revenue going firm in September and October.
And Brett what that is, is it’s not going to -- $1 million drops in from those contracts. I mean what that is that those cancellation provisions passed that the client decided that they’re getting a lot of value from their new service, so that number will then come in over two or three months or something like that. So, it’s not like it’s all going to drop into one month and so there will be a kind of a ramp up as those come, but obviously the more-and-more we pass those cancellation provisions and clients continue to go firm obviously you start to build no that and I think that’s where you could see some upside, late in the year as you build on that numbers.
Brett Huff - Stephens Incorporated
And is that ratably -- is $1 million ratably ratable over a year or is it coming in differently than that?
No, it’s the same as the subscription-based service, so once they go firm depending on the month it is they come in, the monthly subscription-based subscriber, I think that’s why it’s important that you pass those trail periods obviously and then once you do it, it becomes just like any other subscription-based service that we sell and we will include those numbers in our total, you would say 95.3 of the subscription-based services will be included in that number, once they pass that trial period.
Your next question comes from Vance Edelson with Morgan Stanley.
Vance Edelson – Morgan Stanley
First, I’m just trying to get a feel for how the selling and marketing expense trends from here. I may have missed it, but I didn’t hear too much on that specific portion of OpEx. There was a little step-up in the second quarter. Is that sort of a onetime bounce-back following the first quarter’s low end marketing or is that increased more and more permanent would you say going forward?
As I put in my script Vance there was kind of a one-time Q2 high about $700,000, $750,000 for ICSC. Otherwise I think it will be relatively stable now. So, you could see a decrease a little bit because that’s only a one-time thing during the second quarter that doesn’t happens in the rest of the year, but that would be somewhat offset on a pay-per-click budget and some other marketing efforts surrounding the new Showcase offering. So you could see a slight decline, but I wouldn’t count dollar-for-dollar that coming off of there, but otherwise besides ICSC I think you had a pretty nice level that you’re going to be at for while.
And you’ll see that ICSC bounce again in second quarter of ‘09.
Correct. Every second quarter you’ll see a very similar number for ICSC between $700,000 and $800,000.
Vance Edelson – Morgan Stanley
Okay, that’s helpful and I just want to dig a little bit more on the reduction and the net new subscribers which was I think a little bit more than 2000 in last quarter than the 785 level this quarter and since the retention rate was generally flattish I guess that indicates a drop in gross new subs as well. Can you comment on kind of what drove that decline? Is that mainly just broader market conditions would you say?
No, it’s actually -- I would actually focus on the fact that the number of firms coming on, the net firms coming on is actually fairly stagnant about the same number, which is a second highest we’ve seen ever. So, the number of net new firms come out, a second highest ever. I think what happened as much as anything as in the United Kingdom would be integration of our shop property product into our general information product. Our retail product was integrated to our general product as well as we were cleaning up with the acquisition of these 12, 13 different companies being blended together in the United Kingdom, we are getting a lot of consolidation going on. So, you got the screen data office information products being superseded by the focus office information product, the shop property information product being encompassed into the focus information product. So a lot of that’s going on in the U.K. that dropped those counts and then the other thing that’s going on which is sort of somewhere between the subscription revenue product and the one off revenue product, but we’re counting it in our authorized user account. The market for lower cost for sale information, our CLMS product, that market is weak. People who are traditionally paying us $29 a month, it’s our lowest cost product of all. People are paying us $29 a month for information only on fore sale properties, particularly like in the California and Florida, those folks are going away. So, if you have exposure to low end fore sale players, that’s weak. Now the good news is those folks -- where there’s those folks falling off, they are probably in eight of our average authorized user value. So, I think the number was weak but its elements of it in the United Kingdom were purely mechanical and then if you had to choose some reduction area it would be CLMS because of the low value. That’s CLMS to be under the same kind of pressure until Fannie Mae and Freddie Mac stock comes back up to what it was last year.
And just you know I mean that the CLMS is barely over a $1 million in total revenue and it’s not subscription based, it’s pretty ad hoc, so I think we have very, very little exposure in that area, as a company.
Vance Edelson – Morgan Stanley
Okay that’s helpful, and just a final follow up on the sales force question earlier with a total number of sales reps down just a bit. Could you provide a little more color on the decline there? Is that entirely voluntary departures or are you doing any kind of trimming of the lower performers for example?
The company will always look at trimming folks who -- which is just not a good fit for them, that will happen. So that’s probably the normal process that goes on and then I think we’ve got -- part of it is we are proactively trimming people that perhaps would be more successful somewhere else. The third is probably people that understand that’s on the rise and that there is probably people who are voluntarily choose to pursue other options and typically those folks go into brokerage working for our customers. So, I’ll say that for the voluntary left, they’re all probably CoStar users now.
Yes and if you look at that number it’s still fairly consistent, it only dropped by a few bodies and then we didn’t want to have a bunch of new training class while we are brining in a hundred and some people for advanced training in July.
Your next question comes from Jim Wilson with JMP Securities.
Jim Wilson - JMP Securities
Two questions; so the first was as you’re finding new customers and signing people up on Showcase, have you any success or what would be your strategy or the opportunity trying to kind of cross sell them, other CoStar products and do see levels of interests a little early in those kind of discussion?
Jim, I’m waiting with bated breath for exactly that. So, initially a lot of our primary focus is going into our best existing customer base and selling them Showcase as an add-on to the existing contract and that is the complicated reasons that would be to them, potential cost savings to buy Showcase. Secondarily, we’re going into the 10,000 best potential new prospects for who don’t currently buy anything from CoStar Group and we’re going in using a marketing hook, a lead generation hook in the form of CoStar Showcase and our hope would be that maybe they initially weren’t thinking about information product, but once we got in them and began to develop the client relationship with them on the Showcase side, they find value in it, we get our reps could establish a relationship with them and we could begin a cross sell, up-sell process using the marketing as the entry point, instead of the traditional attack using the information. I’ll tell you right now, in an environment where people are a little more anxious, it’s absolutely serendipity that we have the ability to switch from saying, we can help you with information products that enable you to efficiently handle high volumes of transactions, we can switch our pitch and our sales force too, we can keep your lead flow coming in the door using Showcase to capture, the tens to thousands of business searching for commercial on the web, so we’re shifting to a revenue increased story off of an efficiency streamline story and it’s great from that perspective and they’re receptive.
Jim Wilson - JMP Securities
Okay. Good. And then my other question is, had the total growth, revenue growth hit a quarter, how much came from existing customers adding new markets and products and how much came from, new customers?
I think it’s probably very similar to what we’ve seen in the past, although I think Andy and I probably would expect that number to start coming more towards from our current clients kind of skewing our historical average of little bit, which as always said has been about 50/50, because of showcase, because as Andy said we are targeting our best clients first. So I think as you move towards the back half of the year, that number might move a little bit more towards current clients, but I think in this quarter it was probably about the same we have seen for past decade.
So I would anticipate that over the next two quarters, that would probably be our -- the highest the ratio ever goes skewing towards revenue growth from existing customers.
Jim Wilson – JMP Securities
Okay good and part of that is going to be I guess maybe your existing customer base or probably the bigger and stronger players in those markets and probably obviously therefore financing better shape and it’s easier for them to spend money than the small guys who aren’t doing so well.
That’s certainly true. You look at the -- we are fortunate that our core customer base is at the upper end of the pyramid and they are benefiting to some degree from the leading out that’s going on where a lot of the smaller entrepreneurial folks have started up in the last year or two are losing their nerve. CB Richard Ellis or a Jones Lang Lasalle, premier brand, when the transaction volume goes down 25% those premier brands can go coach business from the marginal players and keep their shares stable and as we are seeing so that the easiest ones are sell to right now.
Your next question comes from Chris Mammone with Deutsche Bank
Christopher Mammone - Deutsche Bank
Just a back to the quarter revenue growth; I know your currently at the lower end of the range announced. I guess could you expand on maybe what factors maybe beyond on showcase could help you, maybe get back to the higher end of that range in the back half of the year.
Well, I would say that, yes so we are at basically the middle of the range and the guidance and similar to what we had last time and I would say that anyway look at it, showcase appears to dramatically exceed our expectations and that would move us up to the upper end of the range if it continues to do that the way looks like it’s doing, if that goes, else you are looking at your more traditional business, but it is where it is. I think right now we have I would say the highest number of pending demonstration, sales meetings we’ve ever had as a company and I would not be surprised if -- I think we’ve got something like two thousand sales presentations schedule for July and begin of August which is by far the largest number we’ve ever had and that’s showcase.
Christopher Mammone - Deutsche Bank
Okay. I guess there’s a follow up; its been several months now I think since you got rolled out the 80 additional markets in the U.S. that gave you ubiquitous coverage basically in the U.S., have you sold all those additional markets into your national accounts yet or there are still some of your best and brightest clients that haven’t taken it on. I guess how is that going?
Well, Chris, we actually fell like here one of our major national customers -- we basically just flow that data through to you the day that we brought online. So if you were already an institutional customer that subscribed to the first 80 markets, since we added the additional 80 markets they just showed up. So its more of the same way for that national customer. Every single day even in our oldest shows like Washington DC, we’re discovering new, more and more building, so we probably add a couple 100 buildings a month that we discovered in Washington every single month and those buildings just flow into the information system for all the clients in Washington automatically and we don’t charge for them. The same thing is true as we add Reno in Nevada into the network for the institutional national customers, it just grows in. Now, some customers were they don’t subscribe for the whole country, for example that would be CB Richard Ellis's and that mega deal we did with them ,the $100 million plus deal, that would be specifically were they want to step up and get all those markets in one step. They’re our biggest customers and they are now onboard with us 80 markets and I know that our major accounts team is moving through. There are other customers and one of the other top two players out there, one of the semi-peers to CB actually express interest in doing a similar kind of deal what CB did, so we are sort of moving through it, but it’s probably relatively early stage on that.
Our final question comes from Michael Grossman with MFS Investment.
Michael Grossman - MFS Investment
Just looking at your balance sheet with 200 million in cash and generating kind of $50 million to $60 million a year in free cash flow and it doesn’t sound like giving your 2010 EBITDA target, you know that your going to be making any kind of major investment in the interim period, what do you plan to do with the excess cash here, it’s kind of bring the whole I guess at a pretty low interest rate right now on the returns?
Right. The interest rate certainly it’s not existing out there right now and in real terms it is negative. So the -- obviously the -- it is exactly the kind of problem a CEO likes to wrestle with which is too much cash and we are at each quarter, every board meeting we are looking at the options, alternative share buyback dividends and the like in the boards considering them. In the uncertain environment I think the board expressed a view that they wanted move slower rather than quicker and in making a decision of what to do there and we also cannot rollout the potential acquisitions where a CoStar Group quite the operations of another company and create or make significant cost cuts and come up with some very accretive acquisitions and those acquisitions could potentially both domestically and internationally run anywhere from $50 million to well in excess of $100 million. So we like to have the strong balance sheet to continue keep those options opened.
Thank you. I want to thank everyone for joining us on this second quarter 2008 conference call and again I want to thank to staff for turning out an outstanding performance in the second quarter and giving us a really good quarter. Thank you.
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