CoStar Group: A Cheaper Zillow?

Summary

• Zillow is basically a household name; CoStar Group is not.
• While they do not compete directly, they do operate in very similar niches.
• The short case relies on new market entrants disrupting the business. That hasn't happened, and some competitors have relied on copying CoStar data to compete.
• CoStar is expensive, but with 40%+ incremental EBITDA margins and double-digit revenue growth, earnings will grow quickly.

Zillow (Z) has had a meteoric rise this year, but lesser-known CoStar Group (NASDAQ:CSGP) has had an even better start to 2017. Both companies are similarly sized, but Zillow remains the more known name, both among retail investors and on the street. While these two do not compete directly, they do operate in complementary spaces: Zillow dominates the residential real estate space, while CoStar Group leads the commercial real estate industry. While rumors have swirled that Zillow would enter the commercial space for years, it seems hesitant to do so. Both companies are similar-sized, and Zillow seems content to continue to grow in the much larger residential real estate market. This leaves CoStar free to continue its stranglehold in the much more fragmented commercial space. Does CoStar have a further runway of opportunity?

Business Overview

CoStar provides industry professionals and consumers of commercial real estate and apartments with data to smooth the transaction process between buyers and sellers. Data is delivered via an integrated suite of online service offerings, providing data like space available for lease, comparable sales information, tenant data, internet marketing services, analytics, while also offering online marketplaces for real estate listings and rentals. CoStar has five brands under its umbrella: CoStar, LoopNet, Apartments.com, BizBuySell, and LandsofAmerica. A large chunk of revenue is subscription-based, with data services provided primarily through the CoStar flagship brand.

Like in residential, the commercial real estate has a number of parties involved in the process – brokers, property owners/managers, bankers, appraisers – all of which require standardized data and analysis in order to perform their job well. CoStar simply does it better than peers. The short case on CoStar relies heavily on intrusion by competitors, as well as the position that CoStar gets its information in an inefficient manner (manual research versus data scraping). Competition comes from VTS, Hightower, and CompStak, and there has been some pressure, particularly within information services which is seeing negative growth. While this trend is continued to persist through 2017, the integration in the back half of this year, as well as an expansion of cross-selling efforts between LoopNet (commercial real estate listing service) and CoStar (data on nation-wide listings) could drive a bit of incremental growth back into information services.

Outside of data, there are no signs of a letup in growth. In the first quarter of 2017, CoStar suite saw 13% growth, bolstered by 22% y/y growth in multi-family revenue. The company had its highest quarterly sales bookings ever, up 18% despite pressure from information services. The sales team has grown 40%, so CoStar has more reach than it ever had in the past. Beyond CoStar, Apartments.com saw 22% growth in unique visitors, now up to 23M/month. Expanding on strength there, in February the company launched Apartamentos.com, a Spanish language version of Apartments.com that is being promoted on Telemundo and Univision, as well as local ad spots in top Hispanic markets. Within two months, the site has over 1M visits, which is a solid value add given there are tens of millions of Hispanics who rent in the United States, or 20% of the overall rental market. Building off ancillary market opportunities like this one, CoStar recently announced the acquisition of LandWatch, an online leader in marketing rural properties and land like timberland, farms, and ranches. This builds off of CoStar’s ownership of LandsofAmerica.com and LandandFarm.com, which gives the company exposure to a multi-trillion dollar real estate asset class here in the United States. Management believes this is a huge area with lots of potential, and CoStar is far and away the leader now in terms of revenue, leads, and search engine optimization (“SEO”) footprint.

Framing 2017 Guidance, Valuation

After the LandWatch acquisition, as well as some solid performance, CoStar raised its revenue guidance to $950M at the mid-point, up $113M from prior year levels. This implies a growth rate of 13.5%, which is a decrease from the five-year compound annual growth rate of 24%, as well as last year’s growth of nearly 18%. Still, this is a healthy rate of growth, particularly given the underlying margins within the consolidated business. Gross margin has expanded 1300bps from fiscal 2012 to 2016, which has led to incremental EBITDA margin expansion as well: 22.3% in 2014 to guidance of 28.5% in 2017. Note this is different than CoStar’s adjusted EBITDA number, which excludes stock-based compensation (I generally include its impact as it’s a real and recurring expense).

CoStar had a net cash position of $275M at the end of Q1 2017, and net interest expense is basically non-existent (<$10M annually). This gives it a substantial amount of firepower to continue to pick up smaller market entrants with compelling technology, all while building its portfolio of brands. This has been working well for the company thus far, with online marketplaces (Apartments.com, ApartmentFinder.com, BizBuySell, etc.) growing from 31% of revenue in 2014 to 42% in 2016.

CoStar isn’t cheap. Based on 2017 guidance, the company trades at more than 30x EBITDA. While that seems expensive, CoStar hasn’t traded this cheaply at any point in the past five years except for a short period before the start of 2017 (marked the bottom of the 35% rally CoStar has seen this year). Why so expensive? It's really a story of incremental margins, as well as overall balance sheet health. Management has pinned incremental EBITDA margin in the 40% range (i.e., each new dollar of revenue generates $0.40 of EBITDA due to leverage off the fixed cost base), with the potential for more as certain costs related to facility expansion in Richmond, Virginia wind down, as well as slowing litigation costs.

Roughly $15M of expenses – not excluded from EBITDA guidance – relates to litigation with Xceligent. According to CoStar Group, Xceligent, now owned by the Daily Mail, told employees to create thousands of CoStar accounts to access data, rotating IP addresses and using proxy services to try to disguise the activity. The goal was to strip information for free and resell it as a supposed competing service. To put the level into context, CoStar found more than 10,000 instances of its copyrighted photos and data on the Xceligent website, and believes its pages have been accessed more than 1.7 million times by Xceligent. If you read CoStar’s public release on the case, it’s actually quite interesting to see the level of effort Xceligent went through to access information from its competitor. I think this statement sums it up quite well:

Xceligent’s suggestion that the lawsuit impedes brokers from marketing their listings with CoStar competitors is a smokescreen. The mountain of evidence from the Philippines shows that Xceligent “researchers,” directed by management, systematically copy CoStar content from CoStar’s website and subscription database, and use elaborate schemes to cover their theft. This is not about broker uploads or broker sites – this is deliberate and unlawful freeriding on a competitor.

Without these costs, EBITDA would be 5.6% higher next year, putting overall EBITDA growth above 20%. At these growth levels, it won’t take long for CoStar to grow into its valuation. 15-25x EBITDA multiples are not unusual in the SaaS/advertising space, particularly given the low capital expenditures needed to maintain these businesses, as well as general balance sheet health. Zillow makes for an excellent comp, and CoStar actually trades cheaper based on 2017 expectations (Zillow trades at 38x fiscal 2017 EBITDA), as well as having a more proven history of operating profitability and better tailwinds heading into 2018. With the roll-off of litigation and some lighter litigation expense next year, I would not be surprised to see $335M in EBITDA in fiscal 2018, which would put the valuation at the high end of that range. Like usual, you have to pay for quality, particularly in entrenched SaaS companies with fragmented competition, and I think the long case is actually a solid one here compared to alternatives.

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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.