CoStar (CSGP) 10-Q 2001 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

      [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.

For the quarterly period ended: June 30, 2001

OR

      [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.

For the transition period from ________ to ________

Commission file number: 0-24531

COSTAR GROUP, INC.

(Exact name of registrant as specified in its charter)

DELAWARE	52-2091509
(State or other jurisdiction of	(IRS Employer
incorporation or organization)	Identification Number)

2 BETHESDA METRO CENTER
BETHESDA, MD 20814
(301) 215-8300

(Address, including zip code, and telephone number, including area code, of
registrant’s principal executive offices)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes [ X ] – No [ ]

As of July 31, 2001, there were 15,639,229 shares outstanding of the Registrant’s Common Stock, par value $.01.

COSTAR GROUP, INC.

TABLE OF CONTENTS

PART I —FINANCIAL INFORMATION

Item 1 - Financial Statements
	Condensed Consolidated Statements of Operations	3
	Condensed Consolidated Balance Sheets	4
	Condensed Consolidated Statements of Cash Flows	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2 - Management’s Discussion and Analysis of                   Financial Condition and Results of Operations		9
Item 3 - Quantitative and Qualitative Disclosures About Market Risk		16
PART II — OTHER INFORMATION
Item 1 - Legal Proceedings		17
Item 2 - Changes in Securities		17
Item 3 - Defaults upon Senior Securities		17
Item 4 - Submission of Matters to a Vote of Security Holders		17
Item 5 - Other Information		17
Item 6 - Exhibits and Reports on Form 8-K		17
Signatures		18

2

PART 1 FINANCIAL INFORMATION

ITEM 1 FINANCIAL STATEMENTS

CoStar Group, Inc.
Condensed Consolidated Statements of Operations
(in thousands, except per share data)
(unaudited)

		For the Three Months						For the Six Months
		Ended June 30,						Ended June 30,
		2001			2000			2001			2000
Revenues		$	18,073		$	14,572		$	35,427		$	25,944
Cost of revenues			7,516			7,730			15,506			13,707
Gross margin			10,557			6,842			19,921			12,237
Operating expenses:
	Selling and marketing		5,944			11,168			12,853			19,570
	Software development		1,357			1,004			2,586			1,722
	General and administrative		7,659			6,660			15,360			12,081
	Purchase amortization		1,907			2,739			3,697			4,476
	Acquired in-process development		—			—			—			5,812
			16,867			21,571			34,496			43,661
Loss from operations			(6,310	)		(14,729	)		(14,575	)		(31,424	)
Loss on disposal of assets			—			(182	)		—			(182	)
Other income, net			374			933			949			1,959
Net loss before income taxes			(5,936	)		(13,978	)		(13,626	)		(29,647	)
Income tax benefit			41			845			82			1,410
Net loss		$	(5,895	)	$	(13,133	)	$	(13,544	)	$	(28,237	)
Basic and diluted net loss per share		$	(0.38	)	$	(0.85	)	$	(0.87	)	$	(1.91	)
Weighted average common shares			15,610			15,391			15,592			14,822

See accompanying notes.

3

CoStar Group, Inc.
Condensed Consolidated Balance Sheets
(in thousands)

		June 30,			December 31,
		2001			2000
ASSETS			(unaudited	)
Current assets:
	Cash and cash equivalents	$	42,020		$	47,101
	Accounts receivable, less allowance for doubtful accounts of $2,940 and     $2,890 as of June 30, 2001 and December 31, 2000		6,092			6,148
	Prepaid expenses and other current assets		692			862
Total current assets			48,804			54,111
Property and equipment			22,346			21,168
Accumulated depreciation			(8,971	)		(6,475	)
			13,375			14,693
Goodwill, intangible and other assets, net			69,852			76,659
Deposits			283			409
Total assets		$	132,314		$	145,872
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable and accrued expenses	$	12,667		$	13,561
	Deferred revenue		5,021			4,949
Total current liabilities			17,688			18,510
Deferred taxes			904			988
Stockholders’ equity			113,722			126,374
Total liabilities and stockholders’ equity		$	132,314		$	145,872

See accompanying notes.

4

CoStar Group, Inc.
Condensed Consolidated Statements of Cash Flows
(in thousands)
(unaudited)

		For the Six Months
		Ended June 30,
		2001			2000
Operating activities:
Net loss		$	(13,544	)	$	(28,237	)
Adjustments to reconcile net loss to net cash used in operating activities:
	Depreciation		2,496			994
	Amortization		6,938			6,835
	Acquired in-process development		—			5,812
	Loss on disposal of assets		—			182
	Provision for losses on accounts receivable		1,054			879
	Income tax benefit		(82	)		(1,410	)
	Changes in operating assets and liabilities		(1,526	)		436
Net cash used in operating activities			(4,664	)		(14,509	)
Investing activities:
Net purchases of property and equipment			(1,178	)		(8,391	)
Goodwill, intangibles and other assets			(131	)		(2,976	)
Acquisitions (net of acquired cash)			—			(2,407	)
Net cash used in investing activities			(1,309	)		(13,774	)
Financing activities:
Payment of long-term liability			—			(2,625	)
Net proceeds from exercise of stock options			892			1,092
Net cash provided by (used in) financing activities			892			(1,533	)
Net decrease in cash and cash equivalents			(5,081	)		(29,816	)
Cash and cash equivalents at beginning of period			47,101			94,074
Cash and cash equivalents at end of period		$	42,020		$	64,258

See accompanying notes.

5

COSTAR GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. ORGANIZATION

      CoStar Group, Inc. (the “Company”) has created a comprehensive, proprietary, national database of commercial real estate information for metropolitan areas throughout the United States. Based on its unique database, the Company provides information to the commercial real estate and related business community and operates within one reportable business segment. The information in the Company’s database is distributed to its clients under license agreements, which are typically one to three years in duration.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BASIS OF PRESENTATION

      The Company is a Delaware corporation and was incorporated in February 1998 to succeed its predecessors, Realty Information Group L.P. (“RIGLP”) and OLD RIG, Inc. (“RIGINC”). RIGLP was an operating entity, while RIGINC was a holding company. In connection with the Company’s initial public offering on July 1, 1998 (“the Offering”), RIGLP and RIGINC merged with the Company pursuant to the RIG Contribution Agreement dated March 5, 1998. The limited partners of RIGLP (other than RIGINC) and all of the stockholders of RIGINC received 3.03 shares of Common Stock of the Company per each limited partnership unit or share of common stock exchanged, for a total of 5,754,017 shares. As a result of the reorganization of these entities, the Company owned (directly or indirectly) all of the capital stock of RIGINC and all the equity of RIGLP.

      The merger has been accounted for as a reorganization of entities under common control similar to a pooling of interests. Following the merger, each shareholder of the Company maintained their exact same ownership of the operating entity, RIGLP, as before the merger. The transfer of assets and liabilities of RIGLP and RIGINC have been recorded at their historical carrying values. The financial statements are presented as if the Company was in existence throughout all periods presented, as one operating entity. All share amounts have been restated to reflect the conversion of partnership units to common stock of the Company. On January 1, 1999, RIGLP and RIGINC were merged into a newly formed corporation, CoStar Realty Information, Inc. (“CoStar Realty”), a wholly owned subsidiary of the Company.

      Additionally, the consolidated financial statements of the Company include the accounts of COMPS.COM, Inc. (“Comps”) acquired on February 10, 2000 and First Image Technologies, Inc. (“First Image”) acquired and merged into Comps on November 9, 2000.

INTERIM FINANCIAL STATEMENTS

      The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information. In the opinion of the Company’s management, the financial statements reflect all adjustments necessary to present fairly the results of operations for the three and six month periods ended June 30, 2001 and 2000, the Company’s financial position at June 30, 2001, and the cash flows for the six month periods ended June 30, 2001 and 2000. These adjustments are of a normal recurring nature.

      Certain notes and other information have been condensed or omitted from the interim financial statements presented in this Quarterly Report on Form 10-Q. Therefore, these financial statements should be read in conjunction with the Company’s 2000 Annual Report on Form 10-K and the Company’s June 30, 2000, September 30, 2000 and March 31, 2001 Quarterly Reports on Form 10-Q.

      The results of operations for the three and six month periods ended June 30, 2001 are not necessarily indicative of future financial results.

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CONSOLIDATION

      The consolidated financial statements include the accounts of the Company and its subsidiaries after elimination of all significant intercompany transactions.

USE OF ESTIMATES

      The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

RECLASSIFICATIONS

      Certain previously reported amounts have been reclassified to conform to the Company’s current presentation.

3. ACQUISITIONS

      On February 10, 2000, the Company acquired all of the outstanding capital stock of Comps, a San Diego based provider of commercial real estate information, for $49,015,905 in cash and 2,259,034 shares of the Company’s common stock. The acquisition has been accounted for using purchase accounting and has been valued at approximately $101,379,000 for accounting purposes. The purchase price was allocated primarily to cash, acquired technology and other intangibles, which will be amortized over a period of 2 to 10 years. In connection with the acquisition, $5,812,000 of the purchase price was allocated to purchased in-process development and expensed upon acquisition because the technological feasibility of products under development had not been established and no future alternative use existed. The acquired in-process development was analyzed through an independent third-party valuation using the expected cash flow approach.

      On November 9, 2000, CoStar completed the acquisition of First Image Technologies, Inc. The primary asset of First Image is the Metropolis software system, a single interface that combines commercial real estate data from multiple information providers into a comprehensive resource. The Company acquired all of the outstanding capital stock of First Image Technologies, Inc. for approximately $665,000 in cash and 9,424 shares of the Company’s common stock. The transaction was accounted for as a purchase and the initial consideration was valued for accounting purposes at approximately $950,000 including acquisition expenses. In addition, the acquisition agreement provides for $950,000 of additional consideration (in a combination of cash and stock) to be paid by the Company upon the achievement of certain operating goals by the sole stockholder of First Image.

      The operations of all acquired businesses were included in the Company’s statement of operations after the respective date of acquisitions. Except for the portion of the purchase price of acquisitions acquired with cash, these transactions have been excluded from the statements of cash flows.

      The Company’s unaudited pro forma condensed consolidated statements of operations for the six month periods ended June 30, 2001 and 2000, assuming the acquisition of Comps and First Image had been consummated as of January 1 of each period, is summarized as follows:

	For the Six Month Period
	Ended June 30,
	2001			2000
Revenues	$	35,427		$	27,869
Net loss	$	(13,544	)	$	(33,050	)
Basic and diluted net loss per share	$	(0.87	)	$	(2.15	)
Weighted average common shares		15,592			15,341

7

4. GOODWILL, INTANGIBLES AND OTHER ASSETS

      Goodwill, intangibles and other assets consists of the following (in thousands):

	June 30,			December 31,
	2001			2000
Capitalized product development costs	$	1,801		$	1,801
Accumulated amortization		(1,048	)		(935	)
		753			866
Building photography		4,574			4,467
Acquired database technology		17,649			17,649
Customer base		31,645			31,645
Tradename		4,198			4,198
Goodwill		37,568			37,568
Accumulated amortization		(26,535	)		(19,734	)
		69,099			75,793
Goodwill, intangible and other assets	$	69,852		$	76,659

5. NEW ACCOUNTING PRONOUNCEMENTS

      In June 2000, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities,” which amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS No. 133 was previously amended by SFAS No. 137 “Accounting for Derivative Instruments and Hedging Activities —Deferral of the Effective Date of FASB Statement 133,” which deferred the effective date of SFAS No. 133 to fiscal years beginning after June 15, 2000. The Company adopted SFAS No. 138 and SFAS No. 133 effective January 1, 2001. SFAS No. 133 and SFAS No. 138 require the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative’s change in fair value will be recognized immediately in earnings. The adoption of these new standards has not had a material effect on the Company’s financial position or results of operations.

      In June 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141, “Business Combinations”, and No. 142, “Goodwill and Other Intangible Assets”, effective for fiscal years beginning after December 15, 2001. Under the new rule, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to annual impairment tests in accordance with the Standards. Other intangible assets will continue to be amortized over their useful lives. We will apply the new rules on accounting for goodwill and intangible assets deemed to have indefinite lives beginning in the first quarter of 2002. We are currently in the process of evaluating the effect of the nonamortization provisions of the Statement, which are expected to result in an increase in net income commencing in 2002. During 2002, we will perform the first of the required impairment tests of goodwill and intangible assets deemed to have indefinite lives as of January 1, 2002. We have not yet determined what the effect of these tests will be on our earnings and financial position.

8

ITEM 2 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

      The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains “forward-looking statements,” which involve many risks and uncertainties that could cause actual results to differ materially from those discussed in these statements. Factors that could cause or contribute to such differences include, but are not limited to, successful adoption of our products, competition, general economic conditions, changes or consolidations in the commercial real estate industry, managerial execution, customer retention, development of our sales force, data quality, employee retention, and the our ability to control costs. More information concerning these and other potential factors that could cause actual results to differ materially from those discussed in any forward-looking statements include, but are not limited to, those stated below under the heading “Risk Factors” and those included from time-to-time in our filings with the Securities and Exchange Commission. All forward-looking statements are based on information available to us on the date of this filing, and we assume no obligation to update such statements. The following discussion should be read in conjunction with our filings with the Securities and Exchange Commission and the unaudited condensed consolidated financial statements included herein.

Overview

      CoStar is the leading provider of information services to the U.S. commercial real estate industry. We are creating a digital marketplace where the members of the commercial real estate and related business community can continuously interact and facilitate transactions by efficiently exchanging accurate and standardized information. Our wide array of digital service offerings includes a leasing marketplace, a selling marketplace, comparable sales information, decision support, tenant information, property marketing, data hosting for clients’ Web sites, contact management, property data integration and industry news. Substantially all of our current services are digitally delivered over the Internet.

      We completed our initial public offering in July 1998 and received net proceeds of approximately $22.7 million. We primarily used those net proceeds to fund the geographic and service expansion of our business, including three strategic acquisitions, and to expand our sales and marketing organization. In May 1999, we completed a follow-on public offering and received net proceeds of approximately $97.4 million. We used a portion of those net proceeds to fund the acquisition of Comps and we expect to use the remainder of the proceeds primarily for development and distribution of new services, expansion of all existing services across our current markets, geographic expansion in the U.S. and international markets, strategic acquisitions and working capital and general corporate purposes.

      From 1994 through 2000, we expanded the geographical coverage of our existing services and developed new services. In addition to internal growth, this expansion included the acquisitions of Chicago ReSource, Inc. in Chicago in 1996 and New Market Systems, Inc. in San Francisco in 1997. In August 1998, we expanded into the Houston region through the acquisition of Houston-based real estate information provider C Data Services, Inc. In January 1999, we expanded further into the Midwest and Florida by acquiring LeaseTrend, and into Atlanta and Dallas/Fort Worth by acquiring Jamison Research, Inc. In September 1999, we acquired ARES, a Los Angeles based developer and distributor of ARES for ACT!. In February 2000, we acquired Comps. In November 2000, we acquired First Image Technologies.

      We consider regions that have had ongoing operations for at least 18 months to be established, and we currently generate positive cash flow from our operations in established regions. As of June 30, 2001, the majority of our regions throughout the United States were considered to be established. These regions provide us with substantial cash flow, which we reinvest into the business. Emerging regions are those in the process of becoming established, and require substantial investment until such time that the revenue for the region exceeds the operating costs for the region. Since our inception, the development of our business has required substantial investments for the expansion of services and the establishment of operating regions, which has resulted in substantial net losses on an overall basis.

      The incremental cost of introducing new services in an established region in the future may reduce the profitability of a region or cause it to incur losses. We expect to continue development and distribution of new services and expansion of existing services across current markets and we may expand geographically in the United States and international markets in the future. Therefore, while we expect operations in existing established regions to remain profitable and provide substantial funding, we expect our overall expansion plans to generate losses and negative cash flow from operations for at least the next six months.

9

      Although our services continue to expand, our CoStar Property, CoStar Tenant and CoStar COMPS services currently generate the largest portion of our revenue. The CoStar Property, CoStar Tenant and CoStar COMPS contracts typically range from terms of one to three years and generally renew automatically. Upon renewal, many of the contract rates increase automatically in accordance with contract provisions or as a result of renegotiations. To encourage clients to use our services regularly, we generally charge fixed amounts rather than fees based on actual system usage. We charge our clients based on the number of sites, organization size, the company’s business focus, and the number of services to which a client subscribes.

      Our contract renewal rate generally exceeds 90% on an annual basis. However, recently many telecommunications companies (which represented approximately 6% of our revenues at their peak) have discontinued or curtailed their operations. This has resulted in an increased number of cancellations of our services by these telecommunications companies. These cancellations, together with other factors, including an overall slowing of economic growth, could result in a lower annual renewal rate for our services during 2001.

      Our clients pay contract fees on an annual, quarterly, or monthly basis. We recognize this revenue over the life of the contract on a straight-line basis beginning with the installation or renewal date. Annual and quarterly advance payments result in deferred revenue, substantially reducing the working capital requirements generated by the growth in our accounts receivable.

Three Months Ended June 30, 2000 Compared To
Three Months Ended June 30, 2001

      Revenues. Revenues grew 24% from $14.6 million in the second quarter of 2000 to $18.1 million in the second quarter of 2001. The growth was principally the result of further penetration of our products in our potential customer base across our national platform, as well as the successful cross selling of our products into our existing customer base.

      Gross Margin. Gross margin increased from $6.8 million in the second quarter of 2000 to $10.6 million in second quarter of 2001. Gross margin as a percentage of revenues also increased from 47% to 58%. The increase in gross margin amounts resulted principally from significant revenue growth. Gross margin percentages have increased as a result of the relatively fixed cost structure required to operate within the scope of our current business. Our cost of revenues for the three months ended June 30, 2001 includes purchase price amortization from the LeaseTrend, Jamison, ARES, Comps and First Image acquisitions amounting to $1.3 million compared to $1.2 million for the same period in 2000.

      Selling and Marketing Expenses. Selling and marketing expenses decreased 47% from $11.2 million in the second quarter of 2000 to $5.9 million in the second quarter of 2001 and decreased as a percentage of revenues from 77% to 33%. Selling and marketing expenses decreased principally as a result of a reduction in required marketing activities after the successful completion of the rollout of our CoStar Exchange product, which was launched at the end of the second quarter in 2000 and required significant non-recurring marketing costs through the fourth quarter of 2000.

      Software Development Expenses. Software development expenses increased from $1.0 million in the second quarter of 2000 to $1.4 million in the second quarter of 2001 and increased as a percentage of revenues from 6.9% to 7.5%. The increase in expenses reflects development costs for the increased number of products we now offer including CoStar COMPS, CoStar Exchange and CoStar Connect, as well as our emphasis on the enhancement of our products and internal systems.

      General and Administrative Expenses. General and administrative expenses increased from $6.7 million in the second quarter of 2000 to $7.7 million in the second quarter of 2001 but decreased as a percentage of revenues from 46% to 42%. General and administrative expenses increased due to the hiring of new employees, including senior executives, to support our expanded operations and client base.

      Purchase Amortization. Purchase amortization decreased from $2.7 million to $1.9 million. Purchase amortization decreased primarily due to adjustments of the purchase accounting for the acquisition of Comps.

      Other Income, Net. Interest and other income decreased from $933,000 in the second quarter of 2000 to $374,000 in the second quarter of 2001. This decrease was primarily a result of lower average cash balances from one period to another, and a decline in market interest rates for invested cash and cash equivalents.

      Income Tax Benefit. Income tax benefit decreased from $845,000 to $41,000 as a result of the previous recognition of net operating losses arising from recent acquisitions.

10

Six Months Ended June 30, 2000 Compared To
Six Months Ended June 30, 2001

      Revenues. Revenues grew 37% from $25.9 million for the six months ended June 30, 2000 to $35.4 million for the six months ended June 30, 2001. The growth was principally the result of further penetration of our products to our potential customer base across our national platform, the successful cross selling of products into our existing customer base and the acquisition of Comps in February 2000. Our Comps division contributed $9.7 million to revenues for the six months ended June 30, 2001, compared to $7.8 million for the same period of 2000.

      Gross Margin. Gross margin increased from $12.2 million for the six months ended June 30, 2000 to $19.9 million for the six months ended June 30, 2001. Gross margin as a percentage of revenues also increased from 47% to 56%. The increase in gross margin amounts resulted principally from significant revenue growth and the acquisition of Comps. Gross margin percentages have increased as a result of the relatively fixed cost structure required to operate within the scope of our current business. Our cost of revenues for the six months ended June 30, 2001 includes purchase price amortization from the LeaseTrend, Jamison, ARES, Comps and First Image acquisitions amounting to $2.7 million compared to $2.1 million for the same period in 2000.

      Selling and Marketing Expenses. Selling and marketing expenses decreased 34% from $19.6 million for the six months ended June 30, 2000 to $12.9 million for the six months ended June 30, 2001 and decreased as a percentage of revenues from 75% to 36%. Selling and marketing expenses decreased as a result of a reduction in required marketing activities after the successful completion of the rollout of our CoStar Exchange product, which was launched at the end of the second quarter in 2000 and required significant non-recurring marketing costs through the fourth quarter of 2000.

      Software Development Expenses. Software development expenses increased from $1.7 million for the six months ended June 30, 2000 to $2.6 million for the six months ended June 30, 2001 and increased as a percentage of revenues from 6.6% to 7.3%. The increase in expenses reflects development costs for the increased number of products we now offer including CoStar COMPS, CoStar Exchange and CoStar Connect, as well as our emphasis on the enhancement of our products and internal systems.

      General and Administrative Expenses. General and administrative expenses increased from $12.1 million for the six months ended June 30, 2000 to $15.4 million for the six months ended June 30, 2001 but decreased as a percentage of revenues from 47% to 43%. General and administrative expenses increased due to the hiring of new employees, including senior executives, to support our expanded operations and client base.

      Purchase Amortization. Purchase amortization decreased from $4.5 million to $3.7 million. Purchase amortization decreased primarily due to adjustments of the purchase accounting for the acquisition of Comps.

      Acquired In-Process Development. Acquired in-process development costs of $5.8 million for the six months ended June 30, 2000 consisted of in-process development costs that were written off in connection with the Comps acquisition.

      Other Income, Net. Interest and other income decreased from $2.0 million for the six months ended June 30, 2000 to $949,000 for the six months ended June 30, 2001. This decrease was primarily a result of lower average cash balances from one period to another, and a decline in market interest rates for invested cash and cash equivalents.

      Income Tax Benefit. Income tax benefit decreased from $1.4 million to $82,000 as a result of the previous recognition of net operating losses arising from recent acquisitions.

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Liquidity and Capital Resources

      Our cash and cash equivalents balance was $42.0 million at June 30, 2001, a decrease of $5.1 million from $47.1 million at December 31, 2000. This decrease was due principally to the cash used in operating activities and $1.2 million in purchases of property and equipment. During the six month period ended June 30, 2001, we financed our operations and growth principally through cash flow from our profitable regions and proceeds from the follow-on offering. Net cash used in operating activities for the six month period ended June 30, 2001 was $4.7 million compared to net cash used in operating activities of $14.5 million for the six month period ended June 30, 2000. This $9.8 million decrease in cash used in operating activities was a direct result of increased revenue growth and a reduction in expenditures required for expansion, both of which contributed to a reduction of our net loss for the first six months of 2001 compared to the first six months of 2000.

      Net cash used in investing activities amounted to $1.3 million for the six months ended June 30, 2001 as compared to net cash used in investing activities of $13.8 million for the six months ended June 30, 2000. Net cash used in investing activities decreased by $12.5 million during the first six months of 2001 compared to the first six months of 2000 due to a decline in required purchases of property, equipment and building photography. Additionally, the acquisition of Comps occurred during the first quarter of 2000 and required $2.4 million of investment.

      We have entered into numerous operating leases for office space throughout the country, including our headquarters, and have commitments for rent payments ranging from $450,000 to $3,989,000 annually over the next ten years. We currently have no material commitments for capital expenditures.

      To date, we have grown in part by acquiring other companies, and we may continue to make acquisitions. Our acquisitions may vary in size and could be material to our current operations. We expect to use cash, stock, or other means of funding to make these acquisitions.

      During the first six months of 2001, we experienced losses and negative operating cash flow as a result of the recent expansion in emerging regions, expansion of services within the majority of regions and costs for the introduction of new products. Some of these costs are non-recurring, and the remainder are generally fixed operating costs, which are not expected to increase at the same rate as revenue growth. As we emerge from a period of rapid product and geographical expansion, for the remainder of 2001 we expect continued sequential quarterly growth in revenue and a fixed or declining overall operating cost structure. As a result, we expect reductions in the level of operating losses and negative operating cash flow during the remainder of 2001.

      Based on current plans, we believe that our available cash combined with positive cash flow from our established regions should be sufficient to fund our operations for the foreseeable future.

      Through June 30, 1998, we operated as either a Subchapter S corporation or a limited partnership, and we were not subject to corporate income taxes. After June 30, 1998, we became a taxable entity. Although we have experienced losses to date, future profits, to the extent not offset by the benefits of loss carryforwards, would result in income tax liabilities. In addition, we have recorded a valuation allowance for the portion of the deferred tax assets related to tax loss carryforwards. We do not expect to benefit substantially from tax loss carryforwards generated prior to July 1998.

      We do not believe the impact of inflation has significantly affected our operations.

Recent Accounting Pronouncements

      In June 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141, “Business Combination”, and No. 142, “Goodwill and Other Intangible Assets”, effective for fiscal years beginning after December 15, 2001. Under the new rule, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to annual impairment tests in accordance with the Standards. Other intangible assets will continue to be amortized over their useful lives. We will apply the new rules on accounting for goodwill and intangible assets deemed to have indefinite lives beginning in the first quarter of 2002. We are currently in the process of evaluating the effect of the nonamortization provisions of the Statement, which are expected to result in an increase in net income commencing in 2002. During 2002, we will perform the first of the required impairment tests of goodwill and intangible assets deemed to have indefinite lives as of January 1, 2002. We have not yet determined what the effect of these tests will be on our earnings and financial position.

Risk Factors

      Investing in our common stock involves a high degree of risk. You should consider the following risk factors, as well as the risk factors contained in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2001 and other SEC filings, before deciding to purchase any shares of our common stock. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations. If any of the following risks actually occur, our business, financial condition, operating results and stock price could be materially adversely affected.

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      Our future profitability is uncertain due to our continuing operating losses. We have never recorded an overall operating profit because the investment required for geographic expansion and new services has exceeded the profits generated in our established markets. We intend to continue investing in the expansion of our operations and new services and therefore expect to sustain losses for at least the next six months. Our ability to earn a profit will largely depend on our ability to manage our growth, and to generate profits that exceed our investment in geographic expansion and new services. In addition, our ability to earn a profit, to increase revenues, or to control costs could be affected by the factors set forth below. We may not be able to generate revenues or control expenses sufficient to earn a profit, to maintain profits on a quarterly or annual basis, or to sustain or increase our future revenue growth.

      Our operating results may fluctuate significantly. Our operating results, revenues, and expenses may fluctuate with general economic conditions and also for many other reasons, such as: successful adoption of the Company’s products; competition; loss of clients or revenues; changes or consolidation in the real estate industry; the development of our sales force; managerial execution; cancellations or non-renewals of our products; data quality; employee retention; our investments in geographic expansion; the timing of new service introductions and enhancements; the timing of investing the net proceeds from our offerings; acquisitions of other companies or assets; sales, brand enhancement and marketing promotional activities; client training and support activities; changes in client budgets; our ability to control expenses; or our investments in other corporate resources.

      We may not be able to attract and retain clients. Our success and revenues depend on attracting and retaining subscribers to our services. The CoStar Property, CoStar Tenant and CoStar COMPS subscription contracts, which generate the largest portion of our revenue, generally range from terms of one to three years. Our clients may decide not to renew or to cancel their agreements as a result of several factors, including: a decision that they have no need for our products; a decision to use alternative products; pricing and budgetary constraints; consolidation in the real estate industry; data quality; technical problems; or economic or competitive pressures. If clients decide not to renew or cancel their agreements, then our revenues will be adversely affected.

      Our operating costs may be higher than we expect. Many of our expenses, particularly personnel costs and occupancy costs, are relatively fixed. Therefore, we may be unable to adjust spending quickly enough to offset any unexpected revenue shortfall. Additionally, we may experience higher than expected operating costs, including increased personnel costs, selling and marketing costs, occupancy costs, communications costs, travel costs, software development costs, outside services costs, and other costs. If operating costs exceed our expectations or cannot be adjusted accordingly, our business, results of operations and financial condition will be adversely affected.

      Competition could render our services uncompetitive. The market for information systems and services in general is highly competitive and rapidly changing. The barriers to entry for Web-based services and businesses are low, making it possible for the number of competitors to proliferate rapidly. Many of our existing competitors, or a number of potential new competitors, may have longer operating histories in the Internet market, greater name recognition, larger customer bases, lower prices, easier access to data, greater user traffic and greater financial, technical and marketing resources than we have. Our competitors may be able to undertake more extensive marketing campaigns, adopt more aggressive pricing policies, make more attractive offers to potential employees, subscribers, distribution partners and content providers and may be able to respond more quickly to new or emerging technologies and changes in Internet user requirements. Increased competition could result in lower revenues and higher expenses, which would reduce our profitability.

      If our data is not accurate, comprehensive or reliable, our business could be harmed. Our success depends on our clients’ confidence in the comprehensiveness, accuracy, and reliability of the data we provide. The task of establishing and maintaining accurate and reliable data is challenging. If our data is not current, accurate, comprehensive or reliable, we could experience reduced demand for our services or legal claims by our customers, which could result in lower revenues and higher expenses.

      If we are unable to hire, retain and continue to develop our sales force, it could have a material adverse effect on our business. In order to support revenue growth, we need to continue to develop, train and retain our sales force. Our ability to build and develop a strong sales force involves a number of risks, including: our ability to integrate and motivate sales personnel; our ability to effectively train our sales force; the ability of our sales force to sell an increased number of products; the length of time it takes new sales personnel to become productive; the competition we face from other companies in hiring and retaining sales personnel; and our ability to manage a multi-location sales organization. If we are unable to hire, develop or retain the members of our sales force, or if our sales force is unproductive, it could have a material adverse effect on our revenues and expenses.

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      Cyclical downturns and consolidation in the commercial real estate industry could have an adverse effect on our business. Our business may be affected by conditions in the commercial real estate industry, including conditions affecting businesses that supply or invest in that industry. A decrease in the level of commercial real estate activities could adversely affect demand for our services. The traditional economic downturns in the commercial real estate industry could also harm our business. These changes could increase cancellation rates, which could have a material adverse impact on our operating results. Also, companies in this industry are consolidating, often in order to reduce expenses. Consolidation could reduce the number of our existing clients, reduce the size of our target market and increase our clients’ bargaining power. Any of these factors could adversely affect our business.

      General economic conditions could have an adverse effect on our business. Our business and the commercial real estate industry are particularly affected by negative trends in the general economy. The success of our business depends on a number of factors relating to general global, national, regional and local economic conditions, including inflation, interest rates, perceived and actual economic conditions, taxation policies, availability of credit, employment levels, and wage and salary levels. A negative trend in any of these general economic conditions could adversely affect our business. For example, a recent downturn in telecom related businesses has forced many of our telecom company clients to discontinue or curtail their operations, which has resulted in an increased number of cancellations of our services. If other clients choose to cancel our services as a result of economic conditions, our financial position could be adversely affected.

      We may not be able to successfully introduce new products. Our future business and financial success will depend on our ability to continue to introduce new products into the marketplace. Developing new products imposes heavy burdens on our systems development department, product managers, management and researchers. In addition, successfully launching and selling a new product, such as CoStar Connect or CoStar Exchange, puts pressure on our sales and marketing resources. If we are unable to develop new products, then our customers may choose a competitive service over ours and our business may be adversely affected. In addition, if we incur significant costs in developing new products, or are not successful in marketing and selling these new products, it could have a material adverse effect on our results of operations.

      We may not be able to adapt to the rapid technological changes to the Internet and Internet products.To be successful, we must adapt to the rapid technological changes to the Internet and Internet products by continually enhancing our products and services, and introducing and integrating new services and products to capitalize on the technological advances in the Internet. This process is costly and we cannot assure you that we will be able to successfully integrate our services and products with the Internet’s technological advances. The collection, storage, management and dissemination of commercial real estate information from a centralized database on the Internet were developed recently and continue to evolve. Our market is characterized by rapidly changing technologies, evolving industry standards; increasingly sophisticated customer needs and frequent new product introductions. These factors are exacerbated by the rapid technological change experienced in the computer and software industries. Our business increasingly depends on our ability to anticipate and adapt to all of these changes, as well as our customers’ ability to adapt to the use of our existing and future services and products on the Internet. We could incur substantial costs if we need to modify our services or infrastructure in order to adapt to these changes, and our customers’ failure to accept these changes could have a material adverse effect on our revenues. If we incurred significant costs without adequate results or we are unable to adapt to rapid technological changes, it could have a material adverse effect on our business.

      Unsatisfactory Internet performance, interruption or failure could have an adverse effect on our business.Our business increasingly depends upon the satisfactory performance, reliability and availability of our Web site, the Internet and the World Wide Web. Problems with our Web site, the Internet or the Web may impede the development of our business for a number of reasons. As the number of Internet users or their use of Internet resources continues to grow, and as companies deliver increasingly larger amounts of data over the Internet, the Internet’s infrastructure must also grow. Growth in Internet usage that is not matched by comparable growth of the infrastructure supporting the Internet could result in slower response time, cause outright failure of the Internet, or otherwise adversely affect usage. In addition, if we experience technical problems in distributing our products over the Web, including interruption or failure of services provided by our local exchange carriers or Internet service providers, we could experience reduced demand for our products.

      Temporary or permanent outages of our computers, software or telecommunications equipment could have an adverse effect on our business. Our operations depend on our ability to protect our database, computers and software, telecommunications equipment and facilities against damage from potential dangers such as fire, power loss, security breaches, and telecommunications failures. Any temporary or permanent loss of one or more of these systems or facilities from an accident, equipment malfunction or some other cause could harm our business. If we experience a failure that results in our not being able to deliver our products to clients, or to update our products, we could experience reduced demand for our products.

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      We may be subject to legal liability for displaying or distributing information. Because the content in our database is distributed to others, we may be subject to claims for defamation, negligence or copyright or trademark infringement or claims based on other theories. These types of claims have been brought, sometimes successfully, against Internet services in the past. We could also be subject to claims based upon the content that is accessible from our Web site through links to other Web sites or information on our Web site supplied by third parties. Even if these claims do not result in liability to us, we could incur significant costs in investigating and defending against any claims. Our potential liability for information distributed by us to others could require us to implement measures to reduce our exposure to liability, which may require the expenditure of substantial resources and limit the attractiveness of our service to users.

      We may be unable to enforce or defend our ownership and use of intellectual property. The success of our business depends in large part on the intellectual property involved in our methodologies, database and software. We rely on a combination of trade secret, patent, copyright and other laws, nondisclosure and noncompetition provisions, license agreements and other contractual provisions and technical measures to protect our intellectual property rights. However, current law may not provide for adequate protection of databases and the actual data. In addition, legal standards relating to the validity, enforceability and scope of protection of proprietary rights in Internet-related businesses are uncertain and evolving, and we cannot assure you of the future viability or value of any of our proprietary rights. Our business could be significantly harmed if we do not succeed in protecting our content and our other intellectual property. The same would be true if a court should find that our services infringe other persons’ intellectual property rights. Any intellectual property lawsuits in which we are involved, either as a plaintiff or as a defendant, could cost us a significant amount of time and money. In addition, if any intellectual property claims are adversely determined, this could result in a material adverse result on our financial position.

      Litigation in which we become involved may adversely affect our business. Currently and from time to time, we are involved in litigation incidental to the conduct of our business. We cannot assure you that we will have insurance to cover our pending claims or our future claims. Any lawsuits in which we are involved could cost us a significant amount of time and money. If any pending claims or future claims are adversely determined, they could have a material adverse effect on our financial position or results of operations.

      Our business depends on retaining and attracting highly capable management and operating personnel. Our success depends in large part on our ability to retain and attract management and operating personnel, including our President and Chief Executive Officer, Andrew Florance, our officers, and other key employees. Our business requires highly skilled technical, sales, management, Web-development, marketing and research personnel, who are in high demand and are often subject to competing offers. To retain and attract key personnel, we use various measures, including employment agreements, a stock option plan, and incentive bonuses for key executive officers. These measures may not be enough to retain and attract the personnel we need or to offset the impact on our business of the loss of the services of Mr. Florance or other key officers or employees.

      Problems with our software could impair the use of our services. The software underlying our services is complex and may contain undetected errors. We have previously discovered errors in our proprietary software. Despite testing, we cannot be certain that errors will not be found in current versions, new versions or enhancements of that software. Any errors could result in adverse publicity, impaired use of our services, loss of revenues, cost increases and legal claims by customers. All these factors could seriously damage our business, operating results and financial condition.

      We may not be able to manage successfully our geographic expansion. Our future business and financial success will depend on our ability to manage our geographic expansion. Our efforts to manage expanded growth must occur while information technology is rapidly changing. These efforts impose additional burdens on our research, systems development, sales, and general managerial resources. If we were not able to manage our expanded growth successfully, it would have a material adverse effect on our profitability.

      If we are unable to provide our clients with training and technical support, our business could be harmed. Since many of our clients are not sophisticated computer users, it is important that they find our products easy to use. To meet these needs, we provide client training and have developed a client support network that seeks to respond to client inquiries as soon as possible. If we do not maintain adequate training and support levels, we could experience reduced demand for our services.

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      Our increasing use of the Internet and the World Wide Web exposes us to regulatory and other uncertainties.Most of our clients currently receive their CoStar data via the Internet. This exposes us to various uncertainties arising from the future course of development of the Internet and the World Wide Web. Governments in the United States and abroad might adopt laws or regulations applicable to Internet commerce that could harm our business by, for example, regulating our transmissions over the Internet or exposing our business to new taxes in various jurisdictions. User concerns about the privacy and security of Internet-distributed communications might impede the growth of our business. We may need to expend substantial resources to protect against security breaches on our Web site or in our Internet communications.

      We face risks associated with legislation in the real estate industry. Real estate is a regulated industry in the United States. These laws and related regulations, and any newly adopted regulations, may limit or restrict our activities or could require us to expend significant resources to comply. As the real estate industry evolves in the Internet environment, legislators, regulators and industry participants may advocate additional legislative or regulatory initiatives. Should existing laws or regulations be amended or new laws or regulations be adopted, we may need to comply with additional legal requirements and incur resulting costs, or we may be precluded from certain activities. In addition, if we are found to be in violation of these regulations, we may incur penalties and legal costs or we may be precluded from certain activities.

      Our business depends on our management team’s ability to execute our business plan.In 2000, we added several key officers to our management team. Our business depends on the ability of our assembled management team to successfully execute our business plan. The inability of our management team to successfully execute our business plan could have an adverse effect on our operations.

      If we do not generate sufficient cash flows from operations, we may need additional capital. To date, we have financed our operations through cash from profitable operations in our established markets, the sale of our stock and borrowing money. If we do not generate enough cash from operations to finance our business in the future, we will need to raise additional funds through public or private financing. Selling additional equity securities could dilute the equity interests of our stockholders. If we borrow money, we will have to pay interest and agree to restrictions that may limit our operating flexibility. We may not be able to obtain funds needed to finance our operations at all or may be able to obtain funds only on unattractive terms. If we require additional funds and are not able to obtain such funds, it would have a material adverse effect on our operations.

      International expansion may result in new business risks. If we expand internationally, this expansion could subject us to new business risks, including: adapting to the differing business practices and laws in foreign commercial real estate markets; difficulties in managing foreign operations; limited protection for intellectual property rights in some countries; difficulty in collecting accounts receivable and longer collection periods; costs of enforcing contractual obligations; impact of recessions in economies outside the United States; currency exchange rate fluctuations; and potentially adverse tax consequences.

      Market volatility may have an adverse effect on our stock price. The trading price of our common stock has fluctuated widely in the past, and we expect that it will continue to fluctuate in the future. The price could fluctuate widely based on numerous factors, including: quarter-to-quarter variations in our operating results; changes in analysts’ estimates of our earnings; announcements by us or our competitors of technological innovations or new services; general conditions in the commercial real estate industry; developments or disputes concerning copyrights or proprietary rights; regulatory developments; and economic or other factors. In addition, in recent years, the stock market in general, and the shares of Internet-related and other technology companies in particular, have experienced extreme price fluctuations. This volatility has had a substantial effect on the market prices of securities issued by many companies for reasons unrelated to the operating performance of the specific companies.

      Stock ownership by executive officers and directors provides substantial influence over matters requiring a vote of stockholders. Our executive officers and directors, and entities affiliated with them, beneficially own a sufficient number of shares of our outstanding common stock to exercise substantial influence over the election of directors and other matters requiring a vote of stockholders. This concentrated ownership might delay or prevent a change in control and may impede or prevent transactions in which stockholders might otherwise receive a premium for their shares.

ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

      We do not have significant exposure to market risks associated with the changes in interest rates related to its cash equivalent securities held as of June 30, 2001.

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PART II.       OTHER INFORMATION

ITEM 1             LEGAL PROCEEDINGS

      Currently and from time to time, we are involved in litigation incidental to the conduct of our business. We are not a party to any lawsuit or proceeding that, in the opinion of our management, is likely to have a material adverse effect on our financial position or results of operations.

ITEM 2             CHANGES IN SECURITIES

      None

ITEM 3             DEFAULTS UPON SENIOR SECURITIES

      None

ITEM 4             SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

      The Annual Meeting of our stockholders was held on June 19, 2001. The following people were elected to our Board of Directors for a one-year term: Michael Klein, Andrew Florance, David Bonderman, Warren Haber, Josiah Low III, and John Simon. The vote was as follows:

Name	Votes For	Votes Withheld
Michael Klein	13,616,940	318,404
Andrew Florance	13,013,991	921,353
David Bonderman	11,989,615	1,945,729
Warren Haber	13,655,140	280,204
Josiah Low III	13,655,140	280,204
John Simon	13,655,140	280,204

      The appointment of Ernst & Young, LLP as our independent public accountants for the fiscal year ending December 31, 2001 was approved upon the following vote: For 13,861,477 shares; against, 70,607 shares; and abstain 3,260 shares.

      The amendment to our 1998 Stock Incentive Plan, as amended, was approved upon the following vote: For, 12,666,344 shares; against, 1,253,875 shares; and abstain, 15,125 shares.

ITEM 5             OTHER INFORMATION

      None

ITEM 6             EXHIBITS AND REPORTS ON FORM 8-K

EXHIBIT NUMBER:  EXHIBIT DESCRIPTION:

10.1	CoStar Group, Inc. 1998 Stock Incentive Plan, as amended.
10.2	Separation Agreement for John Place

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	COSTAR GROUP, INC.
Date: August 13, 2001	By: /s/ Frank A. Carchedi
	Frank A. Carchedi Chief Financial Officer (Principal Financial and Accounting Officer and Duly Authorized Officer)

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INDEX TO EXHIBITS

Exhibit No.	Description
10.1	CoStar Group, Inc. 1998 Stock Incentive Plan, as amended.
10.2	Separation Agreement for John Place