Comparison of Three Months Ended September 30, 2007 and Three Months Ended September 30, 2006
Revenues. Revenues grew 21.6% to $49.3 million in the third quarter of 2007, from $40.6 million in the third quarter of 2006. This increase in revenue is due to continued penetration of our subscription-based information services, the successful cross-selling into our customer base across our service platform in existing markets combined with continued high renewal rates, and additional revenues from acquired companies, including Grecam, acquired in December 2006, and Propex, acquired in February 2007. Our subscription-based information services, consisting primarily of CoStar Property Professional, CoStar Tenant, CoStar COMPS Professional, FOCUS services and Propex services currently generate approximately 95% of our total revenues.
Gross Margin. Gross margin increased to $29.8 million in the third quarter of 2007, from $26.6 million in the third quarter of 2006. The gross margin percentage decreased to 60.4% in the third quarter of 2007, from 65.5% in the third quarter of 2006. The increase in the gross margin amount resulted principally from internal revenue growth from our subscription-based information services, partially offset by an increase in cost of revenues. The decrease in gross margin percentage was principally due to an increase in the cost of revenues to $19.6 million for the third quarter of 2007, from $14.0 million for the third quarter of 2006. The increase in cost of revenues resulted from increased research department hiring, training, compensation and other operating costs, principally in connection with our retail and 81 new CBSA expansions, as well as increased cost structures associated with the acquisitions of Grecam and Propex and our international expansion.
Selling and Marketing Expenses. Selling and marketing expenses increased to $11.9 million in the third quarter of 2007, from $8.8 million in the third quarter of 2006, and increased as a percentage of revenues to 24.2% in the third quarter of 2007, from 21.8% in the third quarter of 2006. The increase in the amount of selling and marketing expenses is primarily due to increased growth in the sales force, increased marketing efforts in our 81 new CBSA markets and retail expansion, as well as increased cost structures associated with the acquisition of Propex.
Software Development Expenses. Software development expenses increased slightly to $3.0 million in the third quarter of 2007, from $2.8 million in the third quarter of 2006, and decreased as a percentage of revenues to 6.1% in the third quarter of 2007, from 7.0% in the third quarter of 2006. The increase in the amount of software development expenses was primarily due to increased costs associated with the continued development of an international platform. The decrease in the percentage was primarily due to our continued efforts to control and leverage our costs.
General and Administrative Expenses. General and administrative expenses increased to $9.7 million in the third quarter of 2007, from $8.0 million in the third quarter of 2006, and remained relatively consistent as a percentage of revenues at 19.6% in the third quarter of 2007, and 19.7% in the third quarter of 2006. The increase in the amount includes increases in personnel, equity compensation, and communications expenses as well as increased cost structures associated with the acquisition of Propex.
Purchase Amortization. Purchase amortization increased slightly to $1.3 million in the third quarter of 2007, from $1.1 million in the third quarter of 2006, and remained consistent as a percentage of revenues at 2.7% in the third quarter of 2007 and 2006. This increase in the amount was due to the acquisitions of Grecam and Propex.
Interest and Other Income, Net. Interest and other income, net increased to $2.1 million in the third quarter of 2007, from $1.9 million in the third quarter of 2006. This increase was primarily due to higher interest income as a result of higher total short-term investment balances for the third quarter of 2007 and increased interest rates for the third quarter of 2007 as compared to the third quarter of 2006.
Income Tax Expense, Net. Income tax expense, net decreased to $2.7 in the third quarter of 2007, from $3.0 million in the third quarter of 2006. This decrease was due to lower income before income taxes for the third quarter of 2007, slightly offset by a higher effective tax rate.
Business Segment Results for Three Months Ended September 30, 2007 and Three Months Ended September 30, 2006
Due to the increased size, complexity, and funding requirements associated with our international expansion in 2007, we began to manage our business geographically in two operating segments, with our primary areas of measurement and decision-making being the United States and International, which includes the U.K. and France. Management relies on an internal management reporting process that provides revenue and segment EBITDA, which is our net income before interest, income taxes, depreciation and amortization. Management believes that segment EBITDA is an appropriate measure for evaluating the operational performance of our segments. EBITDA is used by management to internally measure our operating and management performance and to evaluate the performance of our business. However, this measure should be considered in addition to, not as a substitute for or superior to, income from operations or other measures of financial performance prepared in accordance with GAAP.
SegmentRevenues. U.S. revenues increased to $43.5 million from $37.3 million for the three months ended September 30, 2007 and 2006, respectively. This increase in U.S. revenue is due to further penetration of our U.S. subscription-based information services and the successful cross-selling into our customer base across our service platform in existing markets, combined with continued high renewal rates. International revenues increased to $5.8 million from $3.3 million for the three months ended September 30, 2007 and 2006, respectively. This increase in international revenue is principally a result of a combination of a further penetration of our subscription-based information services and the acquisitions of Grecam and Propex.
Segment EBITDA. U.S. EBITDA increased to $9.4 million from $8.9 million for the three months ended September 30, 2007 and 2006, respectively. The increase in U.S. EBITDA was due to increased revenues, partially offset by increased research costs and growth in the sales force as a result of our expansion. International EBITDA increased to a loss of $1.5 million from a loss of $124,000 for the three months ended September 30, 2007 and 2006, respectively. This loss is due to our increased investment in international expansion. International EBITDA also includes a corporate allocation of approximately $450,000 and $252,000 for the three months ended September 30, 2007 and 2006, respectively. The corporate allocation represents costs incurred for United States employees involved in international management and expansion activities.
Comparison of Nine Months Ended September 30, 2007 and Nine Months Ended September 30, 2006
Revenues. Revenues grew 21.6% to $142.0 million for the nine months ended September 30, 2007, from $116.8 million for the nine months ended September 30, 2006. This increase in revenue is due to further penetration of our subscription-based information services, as well as the successful cross selling into our customer base across our service platform in existing markets combined with continued high renewal rates and additional revenues from acquired companies, including Grecam acquired in December 2006 and Propex acquired in February 2007.
Gross Margin. Gross margin increased to $85.3 million for the nine months ended September 30, 2007, from $77.3 million for the nine months ended September 30, 2006. Gross margin percentage decreased to 60.1% for the nine months ended September 30, 2007, from 66.1% for the nine months ended September 30, 2006. The increase in the gross margin amount resulted principally from internal revenue growth from our subscription-based information services, and additional revenues from acquired companies, including Grecam acquired in December 2006 and Propex acquired in February 2007, partially offset by an increase in cost of revenues. The decrease in gross margin percentage was principally due to an increase in cost of revenues to $56.7 million for the nine months ended September 30, 2007, from $39.5 million for the nine months ended September 30, 2006, which principally resulted from increased research department hiring, training, compensation and other operating costs, principally in connection with our retail and 81 new CBSA expansions, as well as increased cost structures associated with the acquisitions of Grecam and Propex, and international expansion.
Selling and Marketing Expenses. Selling and marketing expenses increased to $39.8 million for the nine months ended September 30, 2007, from $31.9 million for the nine months ended September 30, 2006, and increased as a percentage of revenues to 28.0% for the nine months ended September 30, 2007, from 27.3% for the nine months ended September 30, 2006. The increase in the amount of selling and marketing expenses is primarily due to increased growth in the sales force, as well as increased cost structures associated with the acquisition of Propex, and international expansion.
Software Development Expenses. Software development expenses increased to $9.4 million for the nine months ended September 30, 2007, from $8.8 million for the nine months ended September 30, 2006, and decreased as a percentage of revenues to 6.6% for the nine months ended September 30, 2007, from 7.5% for the nine months ended September 30, 2006. The increase in the amount of software development expenses was primarily due to increased cost structures associated with the acquisition of Propex. The decrease in the percentage of revenues was due to our continued efforts to control and leverage our costs.
General and Administrative Expenses. General and administrative expenses increased to $26.8 million for the nine months ended September 30, 2007, from $23.2 million for the nine months ended September 30, 2006, and decreased as a percentage of revenues to 18.9% for the nine months ended September 30, 2007, from 19.9% for the nine months ended September 30, 2006. The increase in general and administrative expenses was principally a result of increased cost structures associated with the acquisition of Propex and international expansion, an increase in equity compensation, communications and depreciation. The decrease in the percentage of revenues was primarily due to our continued efforts to control and leverage our overhead costs.
Purchase Amortization. Purchase amortization increased to $3.8 million for the nine months ended September 30, 2007, from $3.3 million for the nine months ended September 30, 2006, and remained relatively consistent as a percentage of revenues at 2.7% for the nine months ended September 30, 2007, and 2.8% for the nine months ended September 30, 2006. This increase in the amount was due to the acquisitions of Grecam and Propex.
Interest and Other Income, Net. Interest and other income, net increased to $5.8 million for the nine months ended September 30, 2007, from $4.9 million for the nine months ended September 30, 2006. This increase was primarily due to higher interest income as a result of higher total cash, cash equivalents and short-term investment balances and higher interest rates for the nine months ended September 30, 2007, as compared to the nine months ended September 30, 2006.
Income Tax Expense, Net. Income tax expense, net decreased to $5.1 million for the nine months ended September 30, 2007, from $6.1 million for the nine months ended September 30, 2006. The decrease in income tax expense is a result of decreased income before income taxes, slightly offset by a higher effective tax rate.
Business Segment Results for Nine Months Ended September 30, 2007 and Nine Months Ended September 30, 2006
Segment Revenues. U.S. revenues increased to $125.6 million from $107.6 million for the nine months ended September 30, 2007 and 2006, respectively. This increase in U.S. revenue is due to further penetration of our U.S. subscription-based information services and the successful cross-selling into our customer base across our service platform in existing markets, combined with continued high renewal rates. International revenues increased to $16.4
million from $9.2 million for the nine months ended September 30, 2007 and 2006, respectively. This increase in international revenue is principally a result of a combination of further penetration of our subscription-based information services and the acquisitions of Grecam and Propex.
Segment EBITDA. U.S. EBITDA increased to $21.0 million from $18.7 million for the nine months ended September 30, 2007 and 2006, respectively. The increase in U.S. EBITDA was due to increased revenue, partially offset by increased research costs and growth in the sales force as a result of our expansion. International EBITDA decreased to a loss of $3.8 million from income of $39,000 for the nine months ended September 30, 2007 and 2006, respectively. This loss is due to our increased investment in international expansion. International EBITDA also includes a corporate allocation of approximately $2.2 million and $756,000 for the nine months ended September 30, 2007 and 2006, respectively. The corporate allocation represents costs incurred for United States employees involved in international management and expansion activities.
Recent Acquisitions
Grecam. S.A.S On December 21, 2006, CoStar Limited, a wholly owned subsidiary of CoStar, acquired Grecam S.A.S. (“Grecam”), a provider of commercial property information and market-level surveys, studies and consulting services located in Paris, France. CoStar Limited acquired all of the outstanding capital stock of Grecam for approximately $2.0 million in cash.
Propex. On February 16, 2007, CoStar Limited acquired Property Investment Exchange Limited (“Propex”), a provider of web-based commercial property information and operator of an electronic platform that facilitates the exchange of investment property in the U.K. Propex’s suite of electronic platforms and listing websites give users access to the U.K. commercial property investment and leasing markets. CoStar Limited acquired all outstanding capital stock of Propex for approximately $22.0 million, consisting of cash, deferred consideration of $2.9 million, and 21,526 shares of CoStar common stock.
Accounting Treatment. These acquisitions were accounted for using purchase accounting. The purchase accounting for the Grecam and Propex acquisitions is preliminary until the valuation of the intangibles is finalized. The purchase price for each acquisition was primarily allocated to acquired database technology, customer base, trade names, and goodwill. The acquired database technology is being amortized on a straight-line basis over four years. The acquired customer base for the acquisitions, which consists of one distinct intangible asset for each acquisition and is composed of acquired customer contracts and the related customer relationships, is being amortized on a 125% declining balance method over ten years. The Grecam and Propex acquired trade names are being amortized on a straight-line basis over three years. Goodwill is not amortized, but is subject to annual impairment tests. The results of operations of Grecam and Propex have been consolidated with those of the Company since the respective dates of the acquisitions and are not considered material to the consolidated financial statements of the Company. Accordingly, pro forma financial information has not been presented for either acquisition.
Liquidity and Capital Resources
Our principal sources of liquidity are cash, cash equivalents and short-term investments. Total cash, cash equivalents and short-term investments increased to $164.2 million at September 30, 2007, from $158.1 million at December 31, 2006. The increase in cash, cash equivalents and short-term investments during the nine months ended September 30, 2007 is due to our cash flow from operations and proceeds from exercises of stock options, offset by the purchase of Propex, net of cash acquired for approximately $16.7 million and capital expenditures.
Net cash provided by operating activities for the nine months ended September 30, 2007 was $28.0 million compared to $24.4 million for the nine months ended September 30, 2006. This $3.6 million increase in net cash provided by operating activities was principally due to increased earnings before non-cash charges for depreciation, amortization, stock-based compensation, and provision for losses on accounts receivable, slightly offset by changes in working capital.
Net cash used in investing activities was $26.1 million for the nine months ended September 30, 2007, compared to net cash used in investing activities of $24.8 million for the nine months ended September 30, 2006. This $1.3
million increase in net cash used in investing activities was due to the acquisition of Propex for approximately $16.7 million, net of acquired cash, partially offset by increased net sales of short-term investments and decreased purchases of property and equipment.
Net cash provided by financing activities was $2.9 million for the nine months ended September 30, 2007, compared to $5.0 million for the nine months ended September 30, 2006. This $2.1 million decrease in net cash provided by financing activities was the result of a decrease in proceeds from exercises of stock options in the nine months ended September 30, 2007 compared to the nine months ended September 30, 2006.
During the nine months ended September 30, 2007, we incurred capital expenditures of approximately $8.4 million. Additionally, we expect to incur approximately $2.0 to $4.0 million of capital expenditures in the fourth quarter of 2007, and continue to expect to incur approximately $12.0 million of capital expenditures for the year ended December 31, 2007.
On March 9, 2007, we entered into an operating lease agreement, pursuant to which we agreed to lease approximately 32,341 square feet of office space located in White Marsh, Maryland. The lease has an initial term of 60 months and an average base rent of $24.95 per rentable square foot per year.
On September 14, 2007, FOCUS Information Limited, a wholly owned U.K. subsidiary of CoStar, entered into an agreement with Trafigura Limited to assign to Trafigura our leasehold interest in the office space located in London. If the lease assignment is completed on or before February 29, 2008, Trafigura will pay FOCUS £4.0 million, exclusive of VAT; if the assignment is completed between March 1, 2008 and March 31, 2008, Trafigura will pay FOCUS £3.5 million, exclusive of VAT; and, if the assignment is completed between April 1, 2008 and June 24, 2008, Trafigura will pay FOCUS £3.0 million, exclusive of VAT. FOCUS anticipates it will incur expenses associated with the assignment and resulting relocation of office space in London of approximately £300,000 to £500,000. Upon completion, CoStar expects to record the amount paid by Trafigura to FOCUS, net of expenses, in connection with the assignment of the lease as “Gain from lease assignment, net” on its Consolidated Statement of Operations.
In 2007, we expect the majority of our taxable income to be absorbed by our net operating loss carry-forwards. As a result, we expect our cash payments for taxes to be limited primarily to payments of federal alternative minimum taxes and state income taxes in certain states. The assignment of the London lease will impact the effective rate in the period it is completed.
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, debt or other means of funding to make these acquisitions.
Based on current plans, we believe that our available cash combined with positive cash flow provided by operating activities should be sufficient to fund our operations for at least the next 12 months.
Recent Accounting Pronouncements
In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”), which became effective for our company as of January 1, 2007. FIN 48 addresses the determination of how tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under FIN 48, we must recognize the tax benefit from an uncertain tax position only if it is more-likely-than-not that the tax position will be sustained upon examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate resolution. Our reassessment of our tax positions in accordance with FIN 48 did not have a material impact on our results of operations and financial condition.
In September 2006, FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value in accordance with GAAP, and expands disclosures about
fair value measurements. SFAS 157 does not require any new fair value measurements under GAAP and is effective for fiscal years beginning after November 15, 2007. The effects of adoption will be determined by the types of instruments carried at fair value in our financial statements at the time of adoption as well as the method utilized to determine their fair values prior to adoption. Based on our current use of fair value measurements, SFAS 157 is not expected to have a material effect on our results of operations or financial position.
In February 2007, the FASB issued SFAS No. 159, “Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115” (“SFAS 159”), which permits entities to choose to measure many financial instruments and certain other items at fair value. We have assessed the provisions of SFAS 159 and it is not expected to have a material effect on our results of operations or financial position.
Cautionary Statement Concerning Forward-Looking Statements
We have made forward-looking statements in this Report and make forward-looking statements in our press releases and conference calls that are subject to risks and uncertainties. Forward-looking statements include information that is not purely historic fact and include, without limitation, statements concerning our financial outlook for 2007 and beyond, our possible or assumed future results of operations generally, and other statements and information regarding assumptions about our revenues, EBITDA, fully diluted net income, taxable income, cash flow from operating activities, available cash, operating costs, amortization expense, intangible asset recovery, net income per share, diluted net income per share, weighted-average outstanding shares, capital and other expenditures, effective tax rate, equity compensation charges, future taxable income, purchase amortization, financing plans, geographic expansion, capital structure, contractual obligations, legal proceedings and claims, our database, database growth, services and facilities, employee relations, future economic performance, management’s plans, goals and objectives for future operations and growth and markets for our stock. The sections of this Report, which contain forward-looking statements, include the Financial Statements and Related Notes, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, “Quantitative and Qualitative Disclosures About Market Risk”, “Legal Proceedings” and “Risk Factors”.
Our forward-looking statements are also identified by words such as “believes,” “expects,” “thinks,” “anticipates,” “intends,” “estimates” or similar expressions. You should understand that these forward-looking statements are estimates reflecting our judgment, beliefs and expectations, not guarantees of future performance. They are subject to a number of assumptions, risks and uncertainties that could cause actual results to differ materially from those expressed or implied in the forward-looking statements. The following important factors, in addition to those discussed or referred to under the heading “Risk Factors” in Item 1A. of Part II of this Report, and other unforeseen events or circumstances, could affect our future results and could cause those results or other outcomes to differ materially from those expressed or implied in our forward-looking statements: general economic conditions; our ability to continue to grow revenue and to capture potential revenue from prospective customers; our ability to further penetrate the potential customer base across our platform and successfully cross-sell services; customer retention; competition; our ability to integrate our U.S. and international product offerings; our ability to introduce a uniform international platform; our ability to continue to expand successfully; our ability to identify and integrate acquisitions; our ability to efficiently consolidate U.K. research operations and combine U.K. sales operations; our ability to effectively penetrate the market for retail real estate information and gain acceptance in that market; our ability to control, stabilize and leverage costs; development and productivity of our sales force; employee retention; litigation; changes in accounting policies or practices; changes or consolidations within the commercial real estate industry; release of new and upgraded services by us or our competitors; data quality; technical problems with our services; managerial execution; changes in relationships with real estate brokers and other strategic partners; our ability to obtain consent to assignment of our London lease in a timely manner; foreign currency fluctuations; legal and regulatory issues; changes in accounting policies or practices; whether we continue to use stock-based compensation; and successful adoption of and training on our services.
Accordingly, you should not place undue reliance on forward-looking statements, which speak only as of, and are based on information available to us on the date of this Report. All subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this section. We do not undertake any obligation to update any such
statements or release publicly any revisions to these forward-looking statements to reflect events or circumstances after the date of this Report or to reflect the occurrence of unanticipated events.
We provide information services to the commercial real estate and related business community in the U.S., U.K., and France. Our functional currency for our operations in the U.K. and France is the local currency. As such, fluctuations in the British Pound or Euro may have an impact on our business, results of operations and financial condition. We currently do not use financial instruments to hedge our exposure to exchange rate fluctuations with respect to our foreign subsidiaries. We may seek to enter hedging transactions in the future to reduce our exposure to exchange rate fluctuations, but we may be unable to enter into hedging transactions successfully, on acceptable terms or at all. As of September 30, 2007, accumulated other comprehensive income included a gain from foreign currency translation adjustments of approximately $6.8 million.
We do not have material exposure to market risks associated with changes in interest rates related to cash equivalent securities held as of September 30, 2007.
We have a substantial amount of intangible assets. Although, as of September 30, 2007, we believe our intangible assets will be recoverable, changes in the economy, the business in which we operate and our own relative performance could change the assumptions used to evaluate intangible asset recoverability. In the event that we determine that an asset has been impaired, we would recognize an impairment charge for the excess amount by which the carrying amount of the impaired asset exceeds the fair value of the asset. We continue to monitor these assumptions and their effect on the estimated recoverability of our intangible assets.
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Security and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As of September 30, 2007, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective and were operating at the reasonable assurance level.
There have been no changes in our internal control over financial reporting during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II ¾ OTHER INFORMATION
On May 8, 2007, we filed a lawsuit in the United States District Court for the District of Maryland against Centers & Malls LLC and two individuals. CoStar's complaint alleged that these defendants unlawfully obtained part of CoStar's proprietary and copyrighted database and subsequently sold this stolen data for profit. Shortly after filing suit, CoStar obtained a Temporary Restraining Order barring Centers & Malls LLC from selling, utilizing, or distributing its products that were pirated from CoStar's database. On July 2, 2007, Centers & Malls filed an appeal
of the grant of the Temporary Restraining Order with the United States Court of Appeals for the Fourth Circuit, and on August 13, 2007, the Company filed a motion to dismiss Centers & Malls’ appeal and the Fourth Circuit’s ruling on that motion is currently pending. CoStar seeks equitable and monetary relief, including but not limited to a permanent injunction barring defendants from unlawful use of CoStar products, disgorgement to CoStar of ill-gotten gains, CoStar's attorneys' fees, and statutory damages.
In addition, from time to time, we are involved in other 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.
In addition to the other information set forth in this Report, you should carefully consider the factors discussed in Part I, Item 1A. “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2006, which could materially affect our business, financial condition or future results. The risks described in our Annual Report on Form 10-K are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or results of operations.
