CoStar Group Inc (CSGP) 2002 Q4 法說會逐字稿

My name is Anissa and I will be your conference facilitator at this time. At this time I would like to welcome everyone to the CoStar Group fourth quarter year end 2002 earnings conference call. All lines have been placed on mute to prevent background noise.

After the speaker's remarks, there will be a question-and-answer period. If you would like to ask a question during this time, simply press star, and the number 1 on your telephone keypad. If you would like to withdraw your question, please press the pound key. Thank you. I would like to turn the call over to Mr. Mark Klionsky. Sir, you may begin your conference.

Good mornings I'm Mark Klionsky, Senior Vive President of Investor Relations, I would like to welcome you to do CoStar Groups fourth quarter, and year end 2002 conference call. Before I turn the call over to Andrew Florence, President and CEO of CoStar, and Frank Carchedi (ph) Chief Financial Officer, let me state that certain portions of this discussion include forward-looking statements which involve many risks and uncertainties that can cause actual results to differ materially from such statements.

Important factors that can cause actual results to differ materially include but are limited it to those stated in CoStar's fourth quarter press release and filing with the SEC, including form 10-Q for the quarter ended September, 30th 2002. All forward-looking statements are based on information available to CoStar on the date of this call and CoStar assumes no obligation to up update these statements. I'll turn the call over to Andrew Florence.

Thank you, Mark. Welcome to this 2002 fourth quarter and year end Conference call. For the year ended December 31, 2002, we posted pro forma net income of $1.7m or 11 cents per share. That represents an improvement of approximately $9.6m compared to pro forma net loss of $7.9m in 2001. We expect it to nearly quadruple pro forma net income to 40 cents per share in 2003.

Pro forma numbers exclude only purchase amortization and related income tax benefit. Frank Carchedi our CFO will address our fourth quarter and year-end financial in more details later in the call.

First I would like to give the number some context by focusing on the environment we're currently operating in. CoStar's reported consistent revenue growth for 18 consecutive quarters since our I IPO. In the past 8 to 10 quarters we've been selling into a depressed commercial real estate market. The net absorption(ph) of the US office space, in a key measure of the health of the commercial real estate markets has been negative for 7 consecutive quarters. In 1999, net absorption was positive, 100 million square feet.

In 2000 it was positive, 157 million square feet. U.S. net absorption of office space in 2002 was negative 61 million square feet. That is a significant drop-off in demand for office space at a time when inventories of office space are growing. Vacancy rates have climbed upward for 12 quarters. The national vacancy rate has soared 60% from it's low of 9.3% in the fourth quarter of 2000 to 14.7% today. This is putting downward pressure on rental rates. The asking rents nationally for office space average $22.60 per square foot at the end of 2002. That's 7% less than what landlords were asking at this time three years ago. [inaudible] Space rents and actual rental rates are even lower. A good example is Austin, Texas where a vacancy rate increase 163% since the start of 2000 and quoted (ph) rental rates have declined nearly 25% or about $6 a foot. A 130% rise in vacant rates in San Francisco during the period resulted in 20% or more drop in asking rental rates.

New construction starts are down dramatically and expected deliveries in 2003 will be less than half the historical average. These weak market conditions are having a negative impact on our core customer base. But our revenues continue to grow in this environment is a testament to the value, the revenue generation potential and cost savings our customers recognize in our products. One of the most interesting trends we saw in 2002 was that many of our biggest customers, the leading national and international brokerage firms were signing larger and longer term deals. Historically, the large national firms bought from us on a market by market, product by product basis.

At one point we had one customer with over 70 separate license agreements. Today that customer purchases from us on one license agreement.

In 2002, we signed multiyear national agreements with six major brokerage firms, including CB Rich Dulles (ph), Cushman and Wakefield(ph), Trammell Crow Company, the Stall back(ph) Company, Marcus and Mill chap (ph) and the most recent signing, Insignia ESG. These contracts represent an aggregate value in excess of over $21m over three years. Not coincidentally, our largest customers in the United States are the largest customers in the United Kingdom as well.

In January of this year we completed our previously announced acquisition of a London based Property Intelligence PLC, a leading provider of commercial real estate information services in the United Kingdom. Property intelligence operations principally consist of Focus information. Their robust service that provides information on buildings, available space, tenant requirements, tenants, lease deals, comparable sales, planning information and photos from across the U.K. Focus has approximately 700 customers, including the top 20 U.K. services firms. We've begun the process of melding some aspects of the CoStar and Focus operations and cross training key personnel.

CoStar transferred two staff members to London to join that office and senior managers at Focus have spent time with managers in Bethesda(ph) and participated in our sales training program. Already we've identified two solid product concepts for implementation in the U.S., based on what we have learned in the United Kingdom. Likewise in the U.K., we see opportunities to improve upon those services, the services currently offered in the U.K. and gain better cost controls by consolidating our product offerings.

Having now had several months of close interaction, I'm pleased to say that the senior management in place in the U.K. is very strong as are the financial opportunities. In fact, early exposure to the operation post acquisition reaffirms our belief that real growth opportunities exist in the U.K. The addition of this strong U.K. operation positions CoStar to deliver integrated service to our multinational customers and we believe the acquisition will lead to the expansion of the overall market for commercial real estate information services.

Our strong financial results have enabled to us make a significant investment in our core business as well. Specifically, development launch of our next generation product platform anchored by the new CoStar property. CoStar property, our flagship product drives more than $37m. of our annual revenue. It is the industries most widely used space inventory availability and analysis system used by approximately 40,000 commercial real estate professionals. This release represents our most significant platform upgrade in the past several years and positions us to maintain and grow our strong market position. We believe that this new product platform will lead a rapid and broad option of technology in a market opportunity we believe may exceed $1b. The key to realizing this potential it twofold. One, successful conversion of our existing customers and two, introduction to new customer segments.

During the product rollout this fall, thousands of customers and potential customers saw our new platform and the feedback was positive. Excitement continues to build in the marketplace as we begin converting customers from the previous desktop Internet software systems to the new platform.

In mid-December, only about 3% of our customer sites have set up accounts on the in CoStar property. Just two months later, mid- mid-February, 40% of our customers sites now have access to the new system and we have issued over 10,000 user IDs already. Usage is more than doubling by the month, and our customer service staff is working overtime to keep pace with the demand for new accounts. Our customers really seem to love this new platform for a number of reasons. The new system addresses their need for advanced productivity and greater control over the data.

Things they told us are important. Consider the enhancements only available in the new CoStar property. You have the ability to search and view property, survey results using street maps and satellite aerial imagery. We've given our customers access to high resolution satellite aerial photographs at no additional charge. You have the ability to edit the data. The ability to share reports with clients via the Internet. You have total integration with other CoStar products in one place. You have sophisticated statistical market analysis features. You have an interface that is broker friendly easy to learn and easy to navigate.

We have another major upgrade release planned for April that will add half a dozen additional features, plus enhanced statistical and analytic feature set that will provide stronger value to our customers. Originally we thought it might take as long as two years to migrate customers to the new platform. But we're seeing much more rapid adoption than we could reasonably have anticipated. Our goal now is to have the vast majority of our customers working on the new platform by October or sooner. Given the product's popularity, we believe this is achievable. At that time, we can begin to phase out the previous software platform. We've made a significant investment in developing, market marketing and training customers in the in CoStar Property platform.

Once the customer base is converted and we can turn off the old system, we believe we will see over $1m in savings annually as we can eliminate dozens of servers and Focus 100% of software development efforts on supporting one product platform. Half a million of the projected annual savings alone come from the fulfillment costs to produce and ship image CDs. In addition when our customers accept complete delivery of our services over Internet, they may be able to save millions in state and local sales taxes. At least 20 states do not currently require us to collect sales taxes if our services are delivered completely over the Internet. In some cases, these tax rates run as high as 10%. So there is a strong financial incentive for customers to take delivery solely via the Internet.

Our entire organization is extremely focused on providing customers with a seamless transition to the new web platform. We believe this new product together with our intensive commitment to customer service will contribute to continued customer loyalty and increased revenue opportunities in 2003. There are other reasons to convert. The vast majority of our brokerage firm clients only purchase data for one or two cities, but we believe that many of these customers would opt to purchase national data if the price was not cost prohibitive. We tested this concept in December with very favorable results. The technology in the new CoStar Property enables us to distribute national data much more securely and cost effectively. CoStar could see an increase in revenue through a number of scenarios.

First, we're positioned to add new brokerage firms to our roster of customers. Second as we mentioned last quarter, our new web based platform affords us much better security through the use of certificates. A technology that ties each user to a specific computer. Making it much more difficult for unlicensed users to access our services. We believe that the new product will enable us to recapture a portion of the revenue historically lost to un unauthorized users. In addition, with a desktop product we have significant costs associated with installing, training and supporting a new customer. Without those high startup costs, we believe we'll be able to more cost effectively reach smaller more price sensitive but a much broader market segment that has been historically slow to adopt our products.

Finally, the push to convert our existing customers to the new product keeps our salespeople in front of customers in a positive support role and gives account executives an opportunity to up-sell. Our experience following our recent acquisition of Real Net met in Portland bears several of these points. Following the acquisition, we turned off real net service and brought all Portland customers to the new CoStar property platform. To date we have converted 93% of Real Net contract customers to CoStar Property and Portland now has the highest usage of the product of any market in the country. Since the acquisition, we have seen a 30% increase in revenue in Portland and have signed a number of new customers, including the major brokerage firms that previously were supporting a competitive broker board system. The initial response to the new customer CoStar property release suggests that it is a compelling offering to significant number of commercial real estate firms that have yet to outsource basic data requirements.

During the launch events, prospects that have not considered outsourcing to CoStar property for sometime were asking for proposals. And a number of those firms since have signed with us. That tells us that the potential is there to sell to every major brokerage firm in the U.S. with a support from a ground swell of real estate professionals. In addition, we now have the ability to offer an easily accessible national market analysis database which we believe will open up new avenues of growth for CoStar among REITS, commercial banks and high end institutional markets. As I mentioned in April we plan to introduce some very powerful analytic features in CoStar Property that will give customers incredible perspective in analyzing their properties and portfolios.

All in all, we believe our new generation products could become the standard for commercial real estate information within the financial institution that invest in commercial real estate, just as it has become the standard within commercial real estate brokerage firms. In addition to the good news of positive customer response we are receiving from the new generation of our property product, we have some promising developments to report on our third highest revenue generating product CoStar tenant. CoStar tenant generates $15m in subscription revenues annually and is one of our fastest growing products. We have historically experienced a higher renewal rate on tenant information in this product. It is not as high as what we enjoy in property or comps products.

Vendor clients, such as moving companies use the lease expiration in our tenant product to find sales leads on companies that may be moving. Historical experience our highest cancellation rates from these customers. On the last month of their subscription to CoStar tab, these clients could query for the hundreds of lease expirations for the year to come, which is 90% of those we deliver in the coming year and terminate their contract. About a year ago, we began to work on a positive solution to this challenge. We have initiated new research methodology to generate hundreds of very high quality move leads each month that are completely different from and in addition to the lease expiration move leads we have historically generated.

With this new dimension to our product. Even if they cancel the subscription after downloading next year's lease expirations would miss out on 100 of the best move leads each and every month all year long. We have been testing this enhanced product in New York, Washington and Chicago, and have seen tenant cancellations drop 30% in the last 6 months. Over the next year we plan to expand this successful program to most of our tenant markets. To further strengthen the tenant product we have entered into a multi-year contract with Dunn and Brad Street (ph) that will allow us to double the number of tenants in our product and make it possible for our clients to request credit checks directly through CoStar tenant. While we provide our clients with detailed information on tenant specific to commercial real estate, Dunn and Brad Street provides general information on a larger universe of tenants. With this agreement we'll be able to provide our clients with the best strengths of each companies respective product in one interface all tied into the detailed commercial real estate information only we can provide.

These are just two examples of initiatives and improvements within our tenant product that we believe will drive revenue growth and higher renewal rates in 2003 and 2004. We recently held our annual sales conference in Dallas, and the primary theme of that conference was excellence in customer service. The conference focused on driving the highest possible CoStar product usage within our client base. This has been a theme we've been focusing on in our sales force throughout 2002 and it has paid off. Our subscription renewal rate in 2002 was 87% as compared to 83% in 2001. We believe that we can continue to increase renewal rates in 2003. Our newer products and our new customer relationship management software systems give us much better insight into how frequently and successfully each of our clients is or is not using our products to their fullest capabilities.

A client uses our product heavily as much more likely to renew their subscription, buy additional products, recommend our products to other potential customers and purchase our products should they switch jobs to another employer. Each of our clients is assigned to a sales account manager and under our 2003 commission plan, the commission rate each sales person earns is variable based upon how frequently that sales person's existing customers are using and relying on our systems systems. This new commission plan rewards our sales professionals with higher commissions for higher usage rates and hence, incent advises sales professionals to provide proactive customer service to their clients. Our ultimate goal is to increase customer loyalty by providing the highest possible level of customer service.

In the area of software development, we have set very aggressive goals for 2003 and 2004 to streamline the number of software systems we maintain and support to collect and distribute information to our clients. In 2002, we successfully consolidated 7 discreet and disparity client management software systems into one streamline and easier to maintain vastly powerful relationship management systems. Looking forward in the most aggressive scenario, we would like to consolidate the remaining 25 or more discrete systems we've utilized today down to 5 or 6 systems. We believe achieving this goal would dramatically reduce the cost of maintaining our software systems. Increase our systems security and reliability increase our system capabilities, decrease our development cycle time, improve our data quality, and reduce both our internal and external training costs. We may potentially achieve indirect but substantial research cost reductions from the success of streamlining of our software systems. Currently, because of our history of acquisitions and because of software and training costs are our research organizational structure is very product oriented.

One researcher may research the tenants in a given building, another may research the sale of that same building and another may research the availabilities in that building. Each of those researchers report up through several layers of their respective product and geography oriented management connecting ultimately with our CEO, Larry Dressel.

This fragmentation leads to inefficiencies. While we have excellent data quality, we believe we can have higher data quality. We believe streamlining our research software systems will dramatically lower the cross-training barriers we face today and would potentially allow us to unify the majority of research we do on a given building to the responsibility of one researcher. The results could include much greater researcher job satisfaction.

Much higher data quality, and significant cost reductions in our single greatest expense, research. In summary, although the commercial real estate market remains weak, conditions appear to be stabilizing and we could begin to see signs of recovery in 2004. We've demonstrated our ability to generate solid revenue growth despite severe market conditions, and our earnings have improved dramatically as we have grown revenues over a relatively fixed cost structure. We believe revenue growth will accelerate as our customers businesses improve and we believe we can still achieve further cost savings to the software and structural initiatives I have described. I look forward to updating you on our progress throughout 2003. At this point, I'm going to turn the call over to our Chief Financial Officer Frank Carchedi.

Thank you Andrew, as reported yesterday, revenues for year-end December 31, 2002 were $79.4m, a 9.4% increase over the prior year. Pro forma net income for 2002 improved to $1.7m or 11 cents per share, versus a pro forma net loss of $7.9m or 51 cents per share in 2001. The company's 2002 GAAP basis net loss was $4.8m or 30 cents per share compared to GAAP basis net loss of $20.2m or $1.29 per share for 2001. Revenues in the fourth quarter increased 11% from $18.6m in 2001 to $20.7m in the fourth quarter of 2002. Gross margin has improved from $11.4m in the fourth quarter of 2001 to $13.7m in the fourth quarter of 2002. And margin percentages have improved from 61% to 66.2%. Selling and marketing increased as planned from $5.4m in the fourth quarter of 2001 to $6.1m in the fourth quarter of 2002, due principally to growth in sales force headcount.

In addition, software development increased slightly as the company continues to focus on product enhancements and internal systems while general and administrative expenses remain flat. Pro forma net income improved significantly from $222,000 or 1 cent per share in the fourth quarter of 2001, to $783,000 for positive 5 cents per share in the fourth quarter of 2002. Meanwhile, our GAAP basis results have improved. A loss of $2.6m or 17 cents per share in the fourth quarter of 2001, to a loss of $770,000 or 5 cents per share in the fourth quarter of 2002.

Year over year progress we have made is substantial, but I'm going to focus on a discussion of the fourth quarter 2002 results as they come compare to the third quarter of 2002. The sequential results of Q3 and Q4 are important in understanding current trends and why we believe we are positioned for continued revenue and earnings growth. Total revenue grew sequentially by 3.1% over all from Q3 to Q4. Increasing from $20.1m to $20.7m.

This represents an upturn in sequential quarterly growth from the 2.7% growth we experienced in Q3. Growth of the quarter was principally the result of further penetration of the potential customer base across our national platform, as well as the successful cross-selling of products to our existing customer base. Renewal rates continue to generally trend to higher levels and subscription based information products including CoStar property tenants, comps, exchange and connect continue to account for over 90% of revenues. Gross margin increase from $13.1m in Q3 to $13.7m in Q4 as margin percentages grew from 65.2% to 66.2%. Cost of sales remained constant at $7m in Q3 to Q4. With regard to operating expenses, overall operating expenses excluding purchase amortization increased as expected by approximately 1.5% from Q3 to Q4. A more detailed level, [inaudible] marketing expenses increased slightly from $5.9m in the third quarter of 2002, to $6.1m in the fourth quarter of 2002.

This was primarily due to increased marketing expenditures in the fourth quarter, related to a launch of web property. Software development remained constant at $1.4m for the third and fourth quarters of 2002. The company continues its focus on product enhancement and development as well as enhancement of internal information systems. General and administrative expenses remain constant at approximately $6.3m for the third and fourth quarters of 2002. The company continues to control its overhead costs as our business grows. I'll summarize these results by discussing our pro forma earnings for the fourth quarter. Pro forma results exclude purchase amortization and the related tax benefit. Pro forma net income per share was 5 cents for the quarter, an increase of 2 cents from the third quarter of 2002.

This represents the fifth consecutive quarter of pro forma earnings for the company. The recent improvement of pro forma earnings results from sequential revenue growth, growth in margin percentages, and relatively stable operating expenses. Our EBITDA improved from $1.6m in Q3 to $2m in Q4. Reconciliation of EBITDA as well as pro forma net income to GAAP results are shown in detail in our press release. We close the quarter with approximately $43.5m in cash and short-term investments, making us cash flow positive for the fourth quarter and for 2002. In December 31, 2002 as shown on our balance sheet, $16.4m was year marked for the Property Intelligence PLC acquisition which closed in early January.

We continue to believe we have adequate resources to operate under our current business plan, and that we are in a strong financial position as we move forward in 2003. Now I'll discuss the outlook for the first quarter in 2003. For the first quarter, as we indicated in our press release, we expect quarterly sequential revenue growth and approximately 9%, including the acquired Property Intelligence revenue stream. We expect pro forma earnings for the first quarter of 5 cents per share. Our goal for 2003 continues to be reaching $95m in revenue, 20% overall growth rate from 2002 and 40 cents of pro forma earnings per share, which would be a significant increase from last year's 11 cents of pro forma earnings per share. We continue to believe that in a longer term, higher revenue growth rates are possible. We saw sequential quarterly growth rates of 7% or more during the fourth quarter in several of our markets, while operating in adverse economic conditions.

Some of those market performances include Pittsburgh, which grew 11% and Houston, which grew 8%. Gross margin percentage is expected to remain stable in Q1, compared to Q4 of 2002 due to an increase in purchase amortization from the Property Intelligence acquisition. Margin percentages are then expected to continue to trend upward by approximately one half to one percent quarterly, moving forward through 2003 based on revenue growth and relatively fixed cost structure. Operating expenses including selling and marketing software development and GNA are expected to increase by approximately 2% over all in Q1, compared to Q4 of 2002. In addition to the step up for the acquired cost structure of Property Intelligence. Thereafter we expect a 1% overall per quarter increase in 2003.

The increases in our cost structure are expected to be primarily due to salary and benefit cost escalations although the Q1 increase is slightly higher due to internal sales training costs that occurred in the first quarter. Purchase amortization is expected to increase by $350,000 to $400,000 per quarter during 2003 as a result of the Property Intelligence acquisition and will be allocated between cost of revenues and operating expenses. We're within reach of GAAP basis earnings and continue to make progress toward it. With the fourth quarter of 2002 GAAP loss coming down to $770,000, we expect to report GAAP earnings for 2003. In conclusion, we believe we have and will continue to demonstrate the strength of our business model and our ability to execute our plan. We believe we're well positioned to continue to achieve revenue and earnings growth for 2003 as we have in a difficult business environment throughout the past two years.

We look forward to reporting our progress to you. With that, I will open the call for questions and answers.

Thank you. Once again, I would like to remind everyone, in order to ask a question, please press star and then the number 1 on your telephone keypad. We'll pause for just a moment to compile the Q & A roster.

Your first question will come from Dalton Chandler from Needham & Company.

Congratulations on another nice quarter.

Thank you Dalton, got your name right.

This time. On your guidance for 20% top line growth this year, can you break that out between what you expect from the existing domestic business versus acquisitions and talk about what you expect the growth rate for the European operations to be going forward?

Dalton, I think the 20% breaks down to approximately 8% from the acquisition, including their 12% organic growth in the core business. I think that -- I mean, I fully expect that the London operation will grow organically at a pace, you know that, keeps up with the overall organization or even slightly faster.

Okay. And you -- I guess you had already hit your target for the number of salespeople for the year by the end of the third quarter, but can you talk about what you expect this year in terms of growth domestically and in Europe, do you need to make any changes or additions there?

Yeah, Andy might speak toward London because he just spent a significant amount of time there this month. Domestically, we did hit our target for salespeople and we're not anticipating significant growth in headcount there for 2003. We are, rather, focused on the productivity of the people that we have and enhancing their ability to generate new revenue and provide better customer service.

The London operation is currently, I think is a ratio of the U.S. operation adequately staffed on sales professionals. Where we might see some growth in outer quarters or in 2004 if there is significant revenue growth potential in the outer markets. U.K. operation where we currently provide a product where but we don't have salespeople actually in those markets. So, for instance, Manchester, Birmingham and market like that, we don't have a -- an actual sales presence in those markets. There is a fair amount of revenue potential there. So that's where we see growth but not immediately.

How many salespeople do you have there now?

There are approximately 8 to 10 salespeople, a little more of a hybrid customer sales model.

Okay. And the new sales commission structure that you talked about that's based on customer usage, when did you put that in place and what kind of reaction has the sales force had to that?

We put that in place last month, and I'd say that the re reaction has been overall very positive. The program is really going to to -- the people are going to be negatively impacting the people who have both low sales production and bad customer usage. They -- and in those cases, you know, that's not really our primary focus.

Among the people who are producers, the reaction is very positive, and it's pretty easy to achieve the higher commission rates by basically making sure that customers are utilizing the full benefit of our products.

So are you anticipating a pickup in turnover as a result of this?

We're in a very good place right now where as Frank said, we're not trying to grow the sales force dramatically this year, we're trying to refine the sales force and make sure that we have the best team. It's unlikely that top producers are going to be turning over in reaction to this commission plan plan, because they actually can make a it better than the program. The turnover if any would occur at the lower ranks where we like to see the turnover.

Okay. Well, congratulations again.

Thank you, Dalton.

Your next question comes from Michael Grossman with Essex Investment Management.

Hi, guys. I have two questions for you. First, what is the magnitude of the opportunity in converting unlicensed users to licensed users and the second question is what percent of your sales currently are coming from cross-sales into the existing customer base and how much more of an opportunity is there? Thanks.

It's obviously difficult to quantify a pirate user base because of the very nature of it. I imagine that that could be, you know, if I were to take a swag, I would think it is somewhere in the $3m-$10m range annually, so I think we could recapture several million annually on reducing piracy.

In terms of our current cross-selling, we are seeing typically a little over 50% of each month's sales are into our existing customer base, or cross-selling efforts. In December, with the national data sales that hit an all-time high, it was somewhere around 60% to 65% cross-selling revenue, which is why customer service is so important to us, because we've got so much revenue growth from our existing customer base. I believe that we can maintain numbers of 50% to 60% revenue growth from cross-selling existing customers for quite sometime. I wouldn't expect nor want it to go a lot higher than that. I'd like to see -- there is an awful lot of new customer opportunity out there that we want to keep focusing on. I hope that answers your question, Michael.

Thank you.

We've reached the end of the allotted time for questions and answers. Do you have any closing remarks?

We would like to thank you for joining us for the 2002year end and fourth quarter 2002 earnings call. We look forward to speaking with you again at the first quarter 2003 conference call. Thank you very much for joining us.

Thank you ladies and gentlemen. For your participation. This does conclude the conference. You may now disconnect.