CoStar Group Inc (CSGP) 2004 Q2 法說會逐字稿

Welcome to CoStar Group’s second-quarter earnings conference call. Today we have with us Andrew Florance, President and CEO; Frank Carchedi, Chief Financial Officer; and Mark Klionsky, Senior Vice President of Investor Relations. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer period. (OPERATOR INSTRUCTIONS). I will now turn the call over to Mr. Klionsky.

Good morning. I am Mark Klionsky, Senior Vice President of Investor Relations. I'd like to welcome you to CoStar Group's second-quarter 2004 conference call. Before I turn the call over to Andrew Florance, President and CEO of CoStar, 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 not limited to those stated in CoStar's second quarter press release and in CoStar's filings with the SEC, including its form 10-Q for the quarter ended March 31, 2004 under the heading "risk factors."

All forward-looking statements are based on information available to CoStar on the date of this call; CoStar assumes no obligation to update these statements. In addition, please visit our website at www.CoStar.com/corporate/investor for a webcast of this conference call and for the reconciliation of all non-GAAP financial measures discussed on this call to GAAP-basis results. Andy.

Thank you, Mark. Welcome to the second-quarter 2004 conference call. We are very pleased to report another quarter of strong revenue and earnings growth; our revenues for the second-quarter 2004 were 27.5 million, an increase of 4.5 percent over the first quarter of 2004, an 18.5 percent increase year-over-year. Pro forma earnings for the second-quarter increased 131 percent to 3.4 million or 18 cents per share compared to pro forma earnings of 1.4 million or 9 cents per share in the second quarter of 2003. On a GAAP-basis our performance improved from a net loss of 367,000 or negative 2 cents per share in the second quarter of 2003 to net income of 1.7 million or 9 cents per share in the second quarter of 2004.

Our pro forma numbers represent net income before purchased amortization and cost of revenues and operating expenses and the related income tax benefit. We ended the first quarter with 107.3 million in cash, cash equivalents and short-term investments for a net increase of 2.7 million over March 31, 2004. This is particularly impressive given that it was achieved as the cash acquisition of Peer Markets/Property Network and Capital Investments Equipment Photography support our aggressive current 21 market expansion.

We have no long-term debt. We continue to enjoy an outstanding financial position as we move forward in our activities to expand CoStar's market coverage and pursue the wide range of growth opportunities before us. Frank Carchedi, our Chief Financial Officer will address the second-quarter results in more detail later in the call.

First I would like to update you on some of the recent trends we are seeing in our business and report on the substantial progress we are making in our planned market expansion. We have some good news to report on market conditions in commercial real estate. Using absorption as a barometer, the office market turned in its best performance in four years in the second quarter, posting positive absorption in excess of 27 million square feet. That is 6 times greater than the 4.5 million square feet of absorption we saw in the previous quarter and was enough to push the national vacancy rate down about 3/10 to 14.4 percent for the second quarter.

It is also worth noting that the improvement was broad based. Seven markets posted at least one million square feet of positive absorption and only 3 markets were negative in the second quarter. The industrial markets were strong, as well, recording their best performance in three years. Positive absorption of almost 29 million square feet of industrial space in the second quarter of 2004 is a dramatic turnaround from negative net absorption of 14.5 million square feet in the first quarter. The vacancy rate for industrial space is now 10.6 percent, just a point or two above historical averages.

No doubt improving market conditions contributed to our strong revenue growth in the quarter. But I believe the most important single factor continues to be the overwhelming success of our Web-based CoStar Property platform. Our new technology has been in place for 18 months now and is becoming an industry utility, a must have not only for commercial brokers, but for a whole host of professionals involving commercial real estate, property owners, lenders, asset managers and institutional investors.

The satisfaction level among our existing customers has rebounded over the past year to near record highs. The renewal rate for CoStar subscription services increased 7 percentage points to approximately 92 percent in the second quarter of 2004 compared to 85 percent in the second quarter of 2003. This is a dramatic 47 percent reduction in our cancellation rate year-over-year, an accomplishment we are quite proud of. A number of factors have contributed to this major improvement in renewal rates including the strength of our new product platform, improving market conditions, deteriorating competition, greater focus on signing higher quality, core client segments, greater focus throughout the Company on customer service as our first priority, a dramatic shift in our sales culture towards account and territory management and a tremendous performance from our client services group.

Our client services group headed by 15-year veteran Susan Jeffers has really responded to the challenge of creating a world-class customer service hotline. This year they have extended their hours, added Saturday hours and adopted a culture of solution providing as opposed to call answering. They have supercharged their performance such that they are responding to client customer calls faster than the average 911 Center. Many of the worst weather inclement days, threat of hurricane days you'll see their group working despite the fact that the rest of the staff is headed home.

Last quarter Susan's group took more than 24,000 customer support calls. The average caller is connected to a live voice in 9 seconds and 98 percent of callers reach a live voice in less than 30 seconds. Our sales force in the course of two years has gone from spending less than 25 percent of their time with existing customers to spending approximately 50 percent of their time with existing customers. The sales force has been reorganized into territories in order to give them greater knowledge of their specific client base, increase their efficiency in conducting face-to-face meetings with clients and prospects and to give them a much greater sense and reality of ownership with their client base. All the hard work they have put into these efforts is paying off in much higher client satisfaction as evidenced by these higher renewal rates.

At the same time we continue to reach new customers with our services. We signed over 280 new customers in our existing markets in the second quarter of 2004. About half of our new monthly revenue came from signing new customers and half from selling additional services to existing customers. We began offering subscriptions to Property Express in March and now have about 75 client firms subscribing to this like version of our CoStar Property Professional system. This new product is proving to be very effective introducing the smaller, more price sensitive customers to CoStar's services.

I would also like to talk briefly about a very favorable trend we see developing on the competitive front. In a span of about ten short days in June, CoStar signed license agreements with four of the leading brokerage firms in San Diego with terms of up to five years. San Diego and Atlanta have been two of our most competitive markets, and the San Diego firms, very reputable high-end firms, Colliers, Lean Associates, Voigt Commercial, Inland Pacific have been customers of our competitor, Xceligent. San Diego was the primary market this competitor pointed to as a demonstration of its success and some of these firms have been active references for Xceligent.

With these signings 18 of the top 20 brokerage firms in San Diego have now chosen to use CoStar information services, and we are hopeful we can sign the two firms needed to complete the top 20. CoStar now has over 270 client firms in San Diego. We believe that it is irrefutable that CoStar is the clear first choice in information services in San Diego. Right before the July Fourth holiday we learned that the Atlanta Board had canceled its contract with Xceligent effective at the end of July. We believe this will eliminate Xceligent as an effective competitor in Atlanta.

The contract Xceligent had with the Atlanta Board will be assumed at the end of this month by another Atlanta competitor. Nonetheless, we think that the Xceligent loss of approximately 100 clients in Atlanta should open up additional opportunities for us. In talking to brokers in these markets, listening to them in focus groups and reading their comments in the press, it is clear to us that brokerage firms consider a number of factors in choosing who will provide their essential market information. We believe these new signs prove the quality of information, the usability and the reliability of the software and the effectiveness of customer service are much more important than association endorsement or price alone. We believe their products are a vital utility to our clients and the products so leverage our clients’ businesses that the price is not the first factor they consider in evaluating these various services.

As we discussed during last quarter's conference call we plan to expand CoStar services into 21 new geographic markets in the U.S. in 2004 and 2005. That expansion effort is now very much underway. Year to-date, we've invested approximately 3.6 million in capital expenditures to purchase equipment and technologies for our data collection (technical difficulty) these new markets. We have purchased and deployed a new fleet of 32 field research vehicles.

In May CoStar deployed 25 of these field research vehicles and 42 newly trained staffers in 20 expansion cities. Since May our field teams have photographed and gathered over 27,000 new properties totaling half a billion square feet of commercial space. This represents approximately 20 percent of the total number of properties we estimate are in these expansion markets. After this earnings call I am headed to Nashville where an additional 7 trucks and 20 field researchers began intensive training and data collection exercises this week. These teams are scheduled to be deployed on August second into their assigned markets. This will bring our total to 32 trucks and 62 field researchers canvassing the U.S. expansion cities on top of the 40 some teams researching our existing U.S. markets.

Of all the field research teams trained and deployed, CoStar expects to begin delivering databases in expansion markets in November, 2004 with the majority of the new cities delivering approximately in the middle of 2005. If you happen to be in one of our expansion cities and come across one of our distinctive technology packed trucks, feel free to come by and say hello. Our field researchers would be happy to show you what they do and the technology they use to do it with.

We also have a two-minute video clip on our website that shows our field research teams at work in Richmond. You can access it at wwwCostar.com by clicking the truck logo on the left-hand side of our homepage. We recently began conducting presales activities in Richmond, Virginia, which we expect will be our first completely new market delivered this year. The reception we are getting is very encouraging. Real estate firms in these cities view the addition of their market to the CoStar network as an economic catalyst that will make their local opportunities more visible to all the very important national and international lenders and investors and will help them bring more value to the relationships with their clients as they grow outside of their market.

Last week we signed a multiyear license agreement with Thalheimer (ph) a member of the Cushman & Wakefield alliance, and the largest brokerage firm in Richmond. And yesterday we signed the Grubb & Ellis and Harrison Bates, the market's second-largest brokerage firm and a major fixture in Richmond since 1910. I have known of these firms’ outstanding reputations for years and their help and support in establishing our service in Richmond will be invaluable. We are honored to have these two firms as partners in our efforts in opening the Richmond market. We have contracts out to a number of the market’s other leading players and we hope to have more good news to report in the next few weeks.

We began introducing our services to Richmond market leaders in May and received a very favorable response. I recently returned to Richmond to revisit with these market leaders and brought with me photographs of more than 3,000 buildings we had added to our database in the several months doing research in Richmond, talking about almost a foot thick stack of photographs. When these firms saw concrete evidence of the speed, commitment and effectiveness with which we are working on our expansion markets they began signing contracts for November service delivery.

While we will not realize the revenue from these customers until our delivery of service in these markets, we believe we can open some of the new markets with enough monthly revenue from presales to cover the monthly baseline operating costs of those markets. We are off to a fast start in Nashville and Memphis, two additional expansion cities through our acquisition in May of PeerMark, the leading provider of commercial real estate information services in Nashville and Memphis. We have already completed integration and conversion of the PeerMark database and our field research photographers have added over 2700 high-quality building photos in the last ten weeks alone. We plan to release CoStar Property in Memphis later this month and have signed approximately half of the customers in that market to new CoStar license agreements. We plan to officially release CoStar Property Nashville around Labor Day.

By that time we believe our field researchers will have photographed and collected data on approximately 6500 buildings. This impressive effort will more than triple the size of the database we acquired from PeerMark. In addition our Nashville service with monthly confirmation of listing information significantly upgrades PeerMark’s historical quarterly updating. Our competitors in Nashville have done some significant negative (indiscernible) against CoStar for more than a year prior to our arrival; we are confident with our overwhelming advantage of software, advantage in depth and quality of data and our commitment to customer service, our products will speak for themselves after we deliver them.

Another business area that appears to be very promising is online advertising. Last fall I told you that we believed there was an opportunity with a modest investment in product development staff to increase the revenue we generate from advertising within our subscription services. We believe that broad adoption of our web-based platform together with high levels of space availability of most property markets would greatly enhance our opportunities in this area. In September 2003, Jim Black, founder of the Black's Guide print office directories joined us to lead our efforts in this area.

In March we released a new search based advertising model similar to the advertising model in a Google or in Overture, which enables property owners to put their building in front of brokers who are searching for that type of space. I am very encouraged with the results we've seen so far, though still very early. The volume of advertising contracts through the first six months of 2004 have surpassed the volume of advertising contracts booked in all of 2003. We believe we have the right product, the right market conditions, and are headed in the right direction. Over time, I believe we may be able to grow this business into a multi-million dollar revenue stream.

We now have 18 months under our belt in the United Kingdom and are making solid progress there on several fronts. When we acquired FOCUS, they had revenues of approximately 4 million pounds for 2002. Today, their annualized revenue run rate is approximately 5 million pounds. We believe that our UK operations have significant potential for revenue growth. Effective actions of our management team headed by Jonathan Bray have taken -- the actions they have taken have positioned us for a potential stage of significant revenue growth. FOCUS has historically been extremely strong in its core market of greater London where we consistently capture approximately 88 percent of available properties. In 2004, we've been concentrating on strengthening FOCUS' data quality and coverage in other major UK markets, specifically greater Manchester from Liverpool on through Leeds. We're doing this through the type of intensive field research we routinely successfully perform in the United States, engaging up to 15 contract photographers in Manchester and 3 staff field researchers in London. We've added more than 17,000 high-resolution images this year and thousands of new listings to the FOCUS database.

In the greater Manchester area, we believe FOCUS is on pace to exceed its target of 15,000 new high-resolution photographs by the end of 2004. By meeting with clients and photographers in the Manchester, Leeds, Liverpool region last week reinforced my optimism that this region with approximately the same population of Chicago has significant revenue potential for us. The lesser (ph) of this fact is that year-to-date we have doubled the number of clients we have in Manchester. We expect this enhanced market coverage will give us a major competitive in Manchester where we compete with EGI. The FOCUS system is designed to provide a broker with comprehensive information about a particular property. Type in an address and you will get back all the information about that subject property.

While we have not converted our UK clients and databases into our powerful U.S. software systems, we have been given the software code behind some of our more popular product features to our UK software developers. They have successfully implemented some of these new features into the FOCUS software products. The new FOCUS service combines the standard input screens and popular map based searching, map display, results ordering and high-resolution photography display and printing software that we use in the U.S. We believe this product clearly demonstrates CoStar's ability to leverage its market knowledge and software development expertise in ways that may result in increased revenues for our FOCUS services. Every broker that we have spoken to who has seen this new service has been impressed. It tells the UK market has been waiting for a service like this to help them more effectively search for available space.

We believe the value provided to our national clients in the UK and our international clients here also will be enhanced by our acquisition through FOCUS of Scottish Property Network. SPN, Scottish Property Network, is the leading provider of subscription based, space availability and done deals data in Scotland. Based just outside of Glasgow, SPN was a joint venture between the University of Paisley and Scottish Enterprise. Scottish Enterprise is Scotland's main economic development agency.

The business has 14 employees and is close to breakeven on approximately 700,000 in annual revenues. Approximately 65 percent of SPN's revenue comes from the public sector. We believe SPN's legacy of concentrating effort in this sector means that their penetrations of private sector in Scotland is low, leaving the potential for significant revenue growth opportunities. At the same time public sector subscriptions represent less than 5 percent of FOCUS' revenue. By better understanding the needs of the public sector in Scotland, our FOCUS team believes they will be better positioned to exploit the considerable revenue growth opportunities in England, as well.

Scotland has a population of approximately 5 million people, representing about 9 percent of the total UK population. Unusually over 72 percent of the total population and two-thirds of the total GDP of Scotland are concentrated in a tight central belt that extends between Glasgow and Edinburgh. This means that the two largest CVDs in Scotland are close together and therefore data should be relatively easy and cost-effective to collect. Based upon population this unified market area is approximately the size of Boston or Dallas.

I met with a number of staff clients and prospects in Glasgow and Edinburgh last week; one of my missions was to get a feeling for how they would receive the CoStar style product offering over the current product offering they now have as an option. The response was clear and I believe decisively positive.

Our strategy in the UK is the same as our strategy in the U.S. We believe there is a local market for information and national market for information. When a bank in the UK needs to understand a property in London, Manchester or Glasgow we want to be the universal source of quality, national information for all of the UK.

One final note before I turn the call over to Frank, on July 1, CoStar was added to the NASDAQ financial 100 index, an index of the 100 largest domestic and international financial companies listed on the NASDAQ stock market based upon market cap. We are honored to receive such a prominent recognition on our financial achievement.

At this point I will turn the call over to Frank Carchedi, CoStar's Chief Financial Officer.

Thank you, Andy. As reported in our press release yesterday and as Andy indicated, year-over-year financial progress we have made is substantial. I'm going to move directly to a discussion of the second-quarter results as they compare to the first quarter of 2004. Sequential results of Q2 and Q1 of 2004 are important in understanding the Company's progress, why we believe we will be able to continue to balance our investment in 21 planned new markets with continued revenue and earnings growth during 2004.

Total revenues grew sequentially by 4.5 percent overall from Q1 to Q2, increasing from 26.3 million to 27.5 million. Growth for the second quarter was principally a result of further penetration and successful cross selling of products, combined with a renewal rate of approximately 92 percent for the quarter. Organic growth was approximately 4.1 percent,the remainder of our growth or about $90,000 resulting from the acquisitions of PeerMark and SPN during the quarter.

Subscription revenues for the Company continued to account for approximately 94 percent of revenues during Q2. Our UK operations contributed approximately 8 percent of the revenue in Q2 as expected. Gross margin increased from 18.3 million in Q1 to 18.6 million in Q2. I would like to point out that the increasing cost of revenues from Q1 to Q2 of approximately $900,000, of that about 700,000 related to the expansion into new markets. These are principally the costs of initially staffing the field research efforts in new markets, as well as substantial travel and training costs. Most of these initial types of costs cannot be capitalized to photo libraries or initial databases, therefore going directly against operations.

All of this is occurring as expected in advance of product release and there are no current revenues associated with these costs. Initial ramp up of operating costs resulted in an expected short-term decrease in margin percentages from Q1 to Q2, 69.8 percent to 67.8 percent, although margin percentages at this level remain higher than at this time last year. Without the charges for expansion markets, margins in the core business would be over 70 percent, and some individual markets continue to experience gross margins in excess of 80 percent.

With regard to operating expenses, overall operating expenses excluding purchase amortization increased only slightly from 16 million in Q1 to 16.2 million in Q2. These costs on the whole were lower than expected, as we continue to control and leverage our overhead, even with the market expansion. On a more detailed level, selling and marketing expenses decreased 7.2 million in the first quarter of 2004, 6.9 million in the second quarter of 2000 (ph) (technical difficulty). This decrease resulted principally from the annual sale of training costs that occurred in Q1 did not reoccur in Q2. Software development increased slightly from 1.9 million in the first quarter of 2004 to 2.2 million in the second quarter of 2004, principally from a slight expansion in the development group.

General and administrative expenses increased slightly from 6.8 million in the first quarter of 2004 to 7 million in the second quarter due to higher professional fees during Q2. Income tax expense of 56,000 relating to state taxes and federal alternative minimum taxes (technical difficulty) in Q2. Income tax benefit of 130,000 resulted from the deferred income taxes we recorded related to the Property Intelligence acquisition. This benefit will continue to be recorded in this amount each quarter, corresponding to non-tax deductible amortization of purchased intangibles. This benefit is excluded from the calculation of pro forma earnings.

Pro forma earnings per share, which is our net income before purchase amortization and the related income tax benefit was 18 cents for the second quarter, an increase of 1 cent per share from the first quarter in 2004. The Company has continued to experience growth in current earnings, while also investing in future growth. Our earnings before interest, taxes, depreciation and amortization grew from 4.5 million in Q1 to 4.6 million in Q2 of 2004.

Our GAAP-basis net income improved from 1.5 million or 8 cents per share in Q1, 1.7 million or 9 cents per share in Q2 of 2000 (technical difficulty). Reconciliation to GAAP-basis results of all non-GAAP financial measures discussed on this call including EBITDA and pro forma earnings is shown in detail on our press release issued yesterday which is available on our website.

Capital expenditures for Q2 of 2004 were approximately 4.1 million as planned, principally related to our planned 21 market expansion. A majority of this cost went to purchase trucks and equipment for field research, totaling approximately 3.1 million and the remaining to support our normal existing platform. We closed the quarter with approximately 107.3 million in cash, cash equivalents and short-term investments, an increase of 2.7 million over the first quarter of 2004. Our strong cash production from EBITDA, cash collections and working capital provided more than enough cash through significant capital expenditures and two acquisitions. We then additionally grew cash overall through 2.4 million of proceeds from stock option exercises for approximately 107,000 shares of common stock during the (ph)(technical difficulty).

Now I will discuss the outlook for the third quarter and 2004. We have discussed for the last couple of quarters and as Andy has just described during the second quarter we began the field research phase of our planned 21 market expansion. We generally had not experienced this type of expansion over the last few years but as in past expansion plans we expect our cost structure to continue to escalate in advance of revenue in these markets, invest in future revenue growth opportunities in 2005 and beyond.

This is consistent with our plan to balance earnings growth (technical difficulty) an expansion of the business platform, focus on long-term opportunities. As we indicated in our press release, we expect quarterly sequential organic revenue growth of approximately 4 percent for the third quarter. Also, we expect pro forma earnings of approximately 20 cents per share for the third quarter to be up 2 cents from the second quarter. We now expect approximately 75 to 77 cents of diluted pro forma earnings per share for the year, which is up from our original expectations.

In addition, we expect diluted GAAP-basis net income of approximately 11 cents per share for the third quarter. We now expect approximately 39 to 41 cents diluted GAAP-basis net income per share for the year.

Gross margin is expected to increase by 1 percent or more from Q2 of 2004 to Q3 of 2004 based on our assumed Q3 revenue growth and existing markets outpacing expected additional research operations’ expense levels in new markets during Q3. We expect operating expenses including selling and marketing, software development and G&A expenses to increase by approximately 3 to 4 percent overall in Q3 of 2004. We expect to move more directly into the selling and marketing phase of planned new market expansion. We believe these expected increases include escalation in the underlying cost structure, the existing core business of approximately 1 percent due to normal salary and cost escalations.

We expect purchase amortization in the third and fourth quarter to continue at approximately 1.7 million. We also expect to incur tax expense of approximately 55,000 in Q3. As mentioned earlier, we also expect to have an income tax benefit of approximately 130,000 in Q3 relating to deferred income taxes from the Property Intelligence acquisition.

Finally, we expect capital expenditures in Q3 of 2004. We continue to include investments in assets required to support our planned market expansion, including additional field research vehicle equipment, substantial building photography, communications equipment, initial databases and measuring, photographic and computer equipment all totaling approximately 1 to 1.5 million for the quarter. In addition, we expect approximately 500,000 to a million of capital expenditures in Q3 of 2004 to support existing operations consistent with the past several years.

In conclusion we believe we have and will continue to demonstrate the strength of our business model and our ability to execute our plan. As we have in the past we believe that during 2004 we will continue to grow earnings and revenue while balancing our investment into new markets to prepare for expected future growth during 2005. We look forward to reporting our progress to you. With that I will open the call for questions and answers.

(OPERATOR INSTRUCTIONS). Brandt Sakakeeny, Deutsche Bank.

Question for Frank and Andy. Can you just give us an update on the search for your head of sales and how that's proceeding and when you think you might have someone named?

The search is proceeding well. We've retained a search firm in that that we've identified several dozen candidates. Actually just after this earnings call we have a meeting with them to whittle it down to a field of about 12 candidates for further interviewing and proceeding along. We were actually very encouraged by the speed and the response we got to the job opening, and it's proceeding well.

Okay, great. Frank, just a question on the presale accounting. Is that just booked as a deferred revenue until the point at which you can start to recognize revenue?

No, the presale accounting in the markets does not relate to that deferred revenue account. The deferred revenue account is where we collect money in advance for ongoing customers. (technical difficulty). And the presale accounts are held on file, basically, and have no impact on the books until the market is released at which time we start providing service to the client and billing the client.

Oh, I see. So the presale you are actually not invoicing the clients?

No, we are not; and the deferred revenue you see on the balance sheet does not relate to contract bookings or anything like that. It relates to the customers who choose to pay their contracts in advance of the monthly payment schedule.

Actually I was referring to, I think the wording in the press release that talked to how some of your presale activity could help fund the investment activity into some of these new markets.

What we're talking about is the fact that we can presell markets -- we may potentially be able to presell markets up to an ongoing monthly revenue level that is high enough that upon market opening that market would open at breakeven or even profitable.

Oh, I got it, okay.

And that's what Andy was mentioning, and that would obviously be a huge win both from a market opening standpoint and a financial standpoint. If a market is open at breakeven or positive margin, then we've essentially eliminated all further investment in that market, and we are really getting a higher return at that point.

Okay, perfect. And final question on, I think if I remember right you have been fairly active on the back office database integration side. How is that progressing, and do you expect to perhaps see some benefits from that beginning early part of next year?

It's progressing extremely well. It is a complex and significant project. We've been doing actually a week or so ago spent two-day retreat reviewing where we were with the screens, and we have put a real emphasis on FOCUS on trying to maximize what the software is doing for the researchers. And as you know, with 600 people in research anything we can do to get a 5, 10, 20 percent efficiency gain in their workflow is going to have a big impact on our bottom line.

The new interfaces the researchers use are very graphical, things like being able to drag a tenant out of the graphical representation of one building and drop it into a graphical representation of another building takes hundreds of keystrokes and makes it one or two mouse clicks. Things like almost predictive dialing where I'm looking at an inbox of tasks I have to do, I can just click on the task comes dialing the phone without me picking up the receiver or anything.

We are putting a lot of effort into usability of this system, readability of the system, and we are going to -- I think we will deliver the system the new backend system for research in the November timeframe, and I think it will be very well received by our research department, and I think it will have a benefit for data quality and for productivity. It is going well, a lot of work, but on target and doing quite well.

Congratulations on a good quarter.

Dalton Chandler, Needham & Co.

I was wondering if you could comment on pricing trends in your renewals and also the number of seats in renewals if that's going up or down or what's going on with that.

On the number of seats you've got two different factors going on there. There's no question that over the last several years in commercial real estate in some of these firms the number of brokers have gone down. With the strong absorption we saw this quarter that bodes well for the industry that seat counts might start going up. But the fact is that over the years gone by we didn't have nearly as transparent backend information systems we have today, and often we had under-reporting of the number of actual seats at client sites. We now have very clear information as the number of seats at client sites and a lot of the renewals we are doing today are showing increasing seat counts because we have greater transparency into what is going on in the system.

The pricing increases, I can't give you specific members, but I do know that more than half of our contracts are being renewed with some level of price increase. Many are on about an 8 percent price increase. In the area of 50 to 100 accounts each month are being targeted for a higher than normal price increases because they are paying well below our list price, and we're trying to move towards a day when we have all like clients with like products equally priced, so we are seeing some right pricing going on with roughly maybe 20 percent of the client base each month. And so it is similar to what we reported last quarter.

And then the prices for new markets, or for new clients, continues to hold steady or go up. The only price reductions you are seeing anywhere that are material are, we did release that lower end product, Property Express, which has only a piece of the functionality of Property Professional, and that, clients can buy at a lower price point and they sort of could buy (indiscernible) the Property Professional. But it's really targeted to a different market than we sell the Property Professional system to. So seat counts overall I think are trending up from a contractual basis, and pricing certainly is not going down. It's going up.

Did you have any clients cancel the professional product and sign up with Express during the quarter?

I asked that question of a couple different managers, sales managers, and none of them knew specifically. I intend to keep watching that and see if that occurs. One of our strategies was if someone is paying way below our list price and their renewal comes up, and they don't want to pay the 17 percent pricing increase to get them closer to what they should be paying, we could keep them at the same price and give them Property Express. So it's likely that a couple of people downgraded based on that without paying us any less than they were paying us before.

More realistically what I hear from our sales managers is happening is a small brokerage firm calls up, one or two person shop calls up, they’ve heard about our products, they like what our products can do for them, but they can't afford the higher end system, so they are prospects we would've lost entirely before, we are now keeping them or actually signing them up with this low end system.

And could you tell us of the 280 new clients in the quarter about how many were non-traditional or non-brokerage clients?

I am going to actually extend the definition of traditional to include owners and financial institutions and banks and appraisers. When I talk about non-traditional I mean more like the more marginal customers like an elevator maintenance company, a hotel that's looking to recruit corporate customers, that kind of thing. So the vast majority of those customers were traditional clients, the 280. I would say the overwhelming majority were traditional customers, which is something we want to focus on those sorts of customers because they have much higher renewal rates. I would not have hard data on what percentage were brokerage versus other. I would say that probably we are probably seeing more brokerage firms sign up because of Property Express, those 75 new Property Express contracts in the quarter probably are mostly brokerage.

Okay. Now that you've had four consecutive quarters of GAAP profitability do you expect to start showing estimated income tax on your GAAP statements?

Frank, let me answer that!

Dalton, I might let Andy answer that one! I don't know if I can answer that. I think we discussed it on the last call that the issue, what you're talking about is the issue of essentially lifting the reserve on the substantial net operating loss carryforward that we have, and that is an issue we are currently looking at if that reserve is lifted. As you know, we created a substantial onetime benefit, and then you have tax affected numbers going forward. And it is a judgment call. We have to study th at issue. It's obviously based on what our consideration is of past earnings and our future plan and future investments, and obviously our auditors are involved in that decision (ph) (technical difficulty). Probably have more information on that as we get out toward the end of the (technical difficulty).

Okay. Thanks a lot, guys.

Joe LaManna with William Blair.

You've mentioned before the retailing sector as a long-term opportunity for CoStar and I know you guys have a lot on your plate already, but I was wondering if you can give us your current thoughts on pursuing that opportunity.

The more we examine the space, we are very optimistic of what the retail sector could mean to CoStar over time. There is more retail commercial real estate in the United States than there is in office or industrial. You would probably (technical difficulty) know that just by driving around suburban cities nowadays.But one of the challenges in providing a retail product, information product, is that you've got a broader potential client constituency. And a lot of that client constituency or prospect constituency is nationally or super regionally oriented, not locally oriented. So in order to appeal to a Starbucks or a Best Buy you need to be in all of the major -- we believe you need to be in all the major markets or all the top hundred MSAs.

So the potential for effectively tapping into the retail market for us really comes as we complete this 21 market expansion and we are then in the top 70 some MSAs, top 80 MSAs in the United States. And then we take the next smaller step of adding the next level, we will be in a very strong position of again going at this entirely new revenue stream. We have been -- our researchers have been working hard to add more retail properties in our existing cities, and we have been getting some client recognition from that. Read some emails recently from clients saying there are things like traditionally where a customer would have retail databases in various cities, our retail databases are now becoming fairly effective and pretty useful.

And in the new cities we are photographing and detailing and databasing every property, not just the office industrial property. So in all of those 21 expansion cities we are collecting all the retail data from day one, which means we're bringing in something like 1000 retail, 1000 plus retail properties per week into our database. So our retail database I believe is becoming one of the largest retail databases in the country. And I think an 18 month, 24 month horizon we are going to have an outstanding product to offer the retail real estate industry.

Gary Shenaro (ph) of J.P. Morgan Fleming.

Regarding the cost of goods sold increase of 700,000 for the new market expansion, it sounded like some of that was onetime for the travel and training. Can you elaborate on that?

Approximately half of that is onetime, although -- let me give you an example, Gary, a substantial training session for field research in Q2, that was hundreds of thousands of dollars. That is essentially not an ongoing part of field research cost structure. However, in Q3 as Andy mentioned, you have a similar although somewhat smaller training session happening this quarter in Nashville. So what you are seeing in the cost of sales number is, in part, is the ramp up of the ongoing cost structure that will relate to ultimately these planned 21 markets, and you are also seeing some of the early phase costs just to get that big wheel turning.

And in terms of, Andy mentioned regarding online advertising growth -- how the volume for the first half of the year was greater than all of last year. What does that equate to? That's not necessarily revenue, is it?

Those are -- the advertising is booked often well in advance, so an advertising contract might extend for a month, six months or a year and a half. So what Andy is talking about is the total volume of contract bookings that we've been awarded. As far as actual reported revenue advertising revenue is growing. And we expect that to continue to show good sequential growth rate. But it is also right now it fell from a high of 2 million annually to something in the neighborhood of 400,000 annually, so (technical difficulty) small part of the revenue (technical difficulty) fill that back.

Can you remind me what is in your nonsubscription revenue number?

It is things like advertising. Also ad hoc revenue that comes off the Internet, in other words people going in and leaving a credit card and grabbing data for comps or property as well as market reports and those types of things that are not necessarily (technical difficulty).

Finally, by backing out the third-quarter guidance, your yearly guidance you’re looking at 20 to 22 cents for the fourth quarter, (inaudible) the low end of the range is equal to the third quarter. So can you just elaborate on that? I assume you expect similar top line growth, so that is just another kind of a pump up in expense and what category is that?

Well, we have not obviously given anything specific on Q4 or any details on Q4. But you're right, you can obviously infer some information from the annual levels. I think the point of it, Gary, is that we believe that sure, the cost structure is going to grow in relationship to 21 new markets; that cost structure is already as you can tell being established. But at the same time, we expect continued leverage in the core platform. And keep in mind that the core platform is by far much larger in terms of size and revenue and operations than the 21 market expansion. So we will continue to invest and move forward. You will see elements in the cost structure; I’ll do the best I can to explain them to you as they occur. But obviously the big news is that we have continued earnings and expect continued earnings and leverage in the core platform.

When do you expect meaningful revenue to hit for these 21 new markets?

As Andy mentioned, we expect the first of the markets could be open in November, though you will see at that time if that happens you would see some revenue. As far as meaningful I think you probably would have something meaningful to report, meaningful financially. I mean in Q4 if we get that revenue it will be certainly interesting, whether it will be meaningful and move the dial, you’re probably looking out to Q1.

Great, I will loop back to you for your definitions of interesting and meaningful.

We think any revenue from a new market opening is interesting.

Right. Okay, thanks guys.

John Neff, William Blair.

Just to be clear on this point, the preselling that is taking place, you're actually getting contracts as opposed to commitments?

We are getting binding contracts.

Yes.

And you cited in your prepared comments that a lot of these were local clients in the market. Has there been any preselling taking place with existing larger clients that have an interest in these new markets?

The majority of our focus -- there has been some, but the majority of our focus right now is on the more strategic selling. When we sell some of these major firms our product in a new market, that is getting us participation in data, help from them in defining submarkets and the like. So we don't anticipate hitting the sweet spot of nationally-oriented sales until probably first, second quarter. A lot of the folks we're selling to in these local markets are actually extensions of the national firms, like CV (ph) Grubb & Ellis, Cushman & Wakefield, but the local presence.

In terms of I was wondering if you can give any kind of a breakdown of the nonsubscription revenue which has been accelerating year-over-year pretty significantly in the last few quarters. Could you give a percentage of what advertising is in terms as a proportion of that total?

Advertising -- I don't know the number off the top of my head, John. Advertising is a small part of -- you are talking about the 6 percent that is not.

Yes.

Advertising is a small part. The vast majority of it is ad hoc revenue for constant property, where people are going into the database with a credit card doing a search or a survey and leaving a credit card number behind. That is, that area right now is (technical difficulty) the vast majority of (technical difficulty).

Right. Thank you.

Scott Matagrano, Fort Point Capital.

I was hoping to get a little bit of a better sense for what type of capital expenditures we are going to look at going forward. It sounds like the bulk of those have been focused on buying new trucks and the new markets you are going into -- just curious as to what's going on with that.

Let me just talk about the existing platform first and what type of capital expenses. Historically we've had in the say half million to a million and a half range (technical difficulty), and just ongoing things that you would expect in a service like ours and (technical difficulty) workstations (technical difficulty) equipment, laptops, (technical difficulty) all that kind of stuff. Not particularly capital intensive (technical difficulty) ongoing noise level of desks and chairs and (technical difficulty). As far as the expansion, we've seen a very large part of the capital investments for the expansion come through Q2 of $3 million.

A large part of that was (technical difficulty) we will still have a substantial capital expenditure going forward in those markets. (technical difficulty) further equipment, photography (technical difficulty) build up our photography library, a (technical difficulty) purchases data, so it could be a variety of things. But we've already -- out of the roughly $5 million capital component of the investment in the (technical difficulty) planned 21 markets already (technical difficulty) chunk of that (technical difficulty).

And back on the sales and marketing costs, I know they went down a little bit, or at least they were down relative to where most of the street it had been modeled out. I would have expected that too, you would have had to invest quite a bit in hiring new salespeople. In advance of going into these 21 new markets, are we going to start to see that number go up on a book on an absolute and a relative proportion of revenues going forward, just to hire more people to get some new accounts, or --?

Initially we are using our more experienced salespeople in close-by regional markets. So for instance in selling to Richmond, Virginia, we are using either sales managers or we are assigning that territory to a seasoned Washington account executive, and that is because we do not want to be going into a new market and using brand-new personnel right now. Over time as the revenue begins to build up in those expansion markets, we may devote dedicated personnel to those markets; but we're going to initially rely a little bit more on our centralized call center outbound sales group based in Bethesda. They are effectively going out there prospecting and closing deals using WebEx and basically just cold calling remotely.

So we're going to try to balance the investment in -- a fairly expensive investment sales infrastructure in these new markets with what revenues we're seeing and use more experienced people and the call center, which is a much more cost-effective way to sell. And we're lucky in that when we select these markets and we look at these markets, they are all generally easily reachable by some of our existing established sales infrastructure. And salespersons who have been with us for five years can do a lot better job selling a major firm on a new evangelical kind of new concept on a new city than someone we just hired last week. Over time you would add more bodies in there, but you will see that at the later end of the cycle.

Last question on the expansion on your pricing going into the new cities would you expect it’s going to be at the same level that you’re pricing accounts in existing cities at? Or are you going to kind of be discounting it in order to build up a base of business and then start to try to increase prices going forward?

I don't anticipate that we would be discounting it significantly. Additionally what we will do -- initially what we -- at the end of the day you want to be able to go in there and look at these firms and say this is the price it’s going to be ongoing, and not and just have a fairly level pricing experience for them and make sure you are pricing all firms on a like basis.

What we do do is for the firms that sign up first we give them some additional benefits. They get to participate on our research advisory board. They get price caps on a longer-term period on their contracts. They get one or two bonus services thrown in like possibly CoStar Connect or something like that. We use their research departments in producing our commentary, local commentary from the markets which gives them a PR benefit. So the benefits are that we give them for signing up earlier are more strategic than financial.

Were these deals you signed up in San Diego that you took away from Xceligent purportedly, were they at commensurate price levels of existing business? Or did you have to -– did you pursue them reasonably aggressively to get it? And I think you had said that they were five-year contracts or five-year contracts with an option. Could you give me a little bit more detail on the details behind that?

The contracts were all -- when you look at all the San Diego deals, the signing of those firms in that time period had a lot more to do with something that was external to CoStar than something that was internal to CoStar. We gave them fair pricing. It definitely wasn't steeply discounted. But it was more -- it was a phenomenon that we don't entirely understand where all of a sudden these firms all came out of the woodwork and came at us. And we were grateful for that and gave them reasonable deals, but it is -- they were – it’s good revenue. It is good additional revenue that is boosting our San Diego operations.

The nature of the contracts are they -- I am not going to get into specifics on that. They range up to 5 years, which is pretty dramatic. Our typical contract period, our average contract period was probably 1.4 years, 1.2 years. Some of these firms, again external to CoStar, requested five-year fixed, five-year commitment contracts, which is, we take as very good news.

Tom Varin (ph), Colby (ph) Partners.

If you are explaining the 110 basis point decrease in gross margins due to the expansion effort, what is going on with the pricing rationalization? You mentioned that it was going to be 15 to 20 percent on a monthly basis. You said that many were at 8. Can you explain that?

Let me speak to that a little bit. The 8 percent, if you look at about half the customer base, they have built-in escalators on their contract paper, and it's not necessarily 8 percent. It ranges up to 8 percent, it is just negotiated contract escalation. Historically, so if you take an average of somewhere between 1 and 8 percent and you assume those contracts are rolling over time, you’re actually from that, call it half the customer base, you’re actually getting a relatively small amount of ongoing pricing included in our organic growth, just look at it (technical difficulty) time it’s maybe 2 percent of annual organic growth number. The other part of it is actually scouring through the customer base and rightsizing, rationalizing the pricing where we might be looking for customers with legacy pricing at (technical difficulty) that needs to be fixed for whatever reasoning (technical difficulty) out of date, they’ve added seats, whatever that may be. And those price increases on those customers could be -- maybe Andy could comment more, but they could easily be (multiple speakers).

Typically it’s 15 to 17.5 percent.

Those are, just so we're clear on that, otherwise you -- based on your question, you've seen a lot more organic growth. Just so we're clear on that those are targeted price increases. That is not an overall ratchet on the customer bases (technical difficulty). Those are (technical difficulty)

If that is the case, then why are margins going down? I mean --

Margins are going down, as I mentioned, because in the quarter because of the new costs associated with the expansion of markets. As you saw, revenues are up a little over 4 percent sequentially. Core business margins, if you peel away the costs of doing new markets, which everybody understands we've been doing and we have been talking about it for six months, if you peel that cost away, margins in the core markets actually went up. They are up over 70 percent, and even with the new costs for Q2 those margin levels of 66 to 67 percent are higher margins than we were experiencing in the core at this time last year. So margins are not going down, but as I think I explained earlier --

What are the assumptions through the end of the year for gross margins?

As I mentioned earlier, I gave guidance for Q3. I believe that gross margins increased sequentially by 1 percent (technical difficulty). So as I’ve said, we moved into this 21 market expansion; you are seeing new costs associated with that. Costs are not going up forever, they are just new costs associated with that expansion (technical difficulty) continue to leverage the core markets and we’ll continue to see that leverage on margins and bottom line.

And regarding the pricing, I mean it's pretty apparent that the larger customers are getting much better deals. I mean, you’ve mentioned Colliers in San Diego. It's pretty apparent that they were given a deal where they could renegotiate annually, and you guys have spun it as a five-year deal. And in Atlanta, how come you guys didn't take the business? Why did Dooreys (ph) buy it?

Actually I would characterize your statement of us re-signing our major firms on sweetheart deals as inaccurate and not true. In the Colliers contract in San Diego we have not characterized anything specifically about that contract being any specific term one way or another. It is a typical CoStar contract yielding good, net new revenue for CoStar Group. It is a major win for CoStar that we are very happy with.

Were they an existing customer previously?

To answer your next question, in Atlanta, Georgia, we had no interest in taking over the board contract. With contract like that you can gain market share pretty quickly by signing up a bunch of firms relying on a single point contract with the Board of Realtors, but if things go wrong with that relationship with the board you can lose a major swath of customers overnight and be in a very precarious position. The CoStar Group is, as you can read in some of the press down there, has apparently the largest market share in Atlanta by a significant margin. And really want to just keep focusing on doing the business working for us in Atlanta the way we're doing it. And we do think we can pick up a number of those firms that are going to be in transition from the board contract falling through directly rather than contracting through a third party to pick them up.

Where is the relationship stand with Cushman & Wakefield?

Actually I was just with Tony Marano, their COO yesterday, and they are very heavy users of our product. We have about 1000 brokers at Cushman & Wakefield, 1000 personnel at Cushman & Wakefield using our product monthly, about 10 million page views a year.

Why did they cancel Site Solutions?

I do not know what you are talking about. We do not sell anything called Site Solutions. That is their internal --

Right, that you guys were powering.

No, we don't have anything to do with anything called Site Solutions or do anything with them on that.

And how is the renewal rate being calculated in respect to your CoStar Express?

I'm glad you asked that question. The CoStar Express does not figure into the renewal rate at all, and actually I think Dalton or somebody asked an earlier question about customers that might potentially migrate from CoStar Professional to CoStar Express, and you know we do not include customers that might migrate against the renewal rates. In other words the renewal rate is purely anybody that cancels out of the (technical difficulty) customer (technical difficulty) --

Is that a seat calculation or a dollar calculation?

A dollar calculation, which we (technical difficulty). The Property Express is not a factor (technical difficulty)

Jim Wilson, JMP Securities.

I was wondering if you are rolling out to the new markets, I know you’ve sort of given color that impact might start in the first quarter but how are you seeing the opportunities -– is it very competitive with anybody in these markets? Is the, are some of your larger customers saying great, you can go into markets, we will add onto existing contracts? Could you color it a little bit as you’re thinking moving forward?

Sure. It's going to be different city by city. I think at the highest level, probably when we were faced, looking at it six, nine months ago, I would have expected more of a challenge than we so far seem to be facing. The last expansion ‘99, 2000, going into a lot of these markets there were a lot of questions that major brokerage firms would raise in these cities, like what is this going to do to the brokerage industry? Will clients buy directly from you? There were a lot of challenges to selling into a new city. This time around it appears to be very different. One of the things that's really struck me and surprised me is that the -- a lot of these brokerage firms are viewing this as a major economic development benefit for their city.

So across the board having met with -- me personally having met with dozens and dozens of firms in these markets have not received a negative response from anybody on the fact we are coming to market; they are excited about it. The kinds of newspaper commentary you see on it are things like CoStar is putting Memphis on the map or CoStar is bringing national exposure to Richmond's commercial real estate market, and we're getting a very positive response. And I think maybe of all the markets we are dealing with right now -- and one of the things is that our product has changed so much since 1999 or 1998, when we go into a San Antonio and sit down with a brokerage firm and show them what our products can do today they are generally blown away and we're getting really good response.

I think we have one or two cities, maybe three cities out of 21 where we expect a tougher competitive battle where there is somebody there who has been preparing for years for us to expand to that market, and they are going to have been doing precompetitive selling before our arrival. We look forward to that. We think that we go into some of those tougher cities and two or three tougher cities -- I can only count to two in my mind right now but I am sure there’s one or two more I will come up with -- but we go into those cities, and our products really speak for themselves. And we have strong national relationships with a number of firms, which gets us to the first couple of customers. And then from there we rely on references, positive references.

So Nashville would be a competitive market. And what we are doing there is we are just focusing on producing the best database that Nashville has ever seen. We clearly have a major software advantage, and we are concentrating a lot of customer service resources there. And so all told on a scale of one to ten if you asked me last year I would have thought, 10 being extraordinarily competitive, one being not that competitive, last year I thought the challenge rate was going to be somewhere around 7 going into these markets. I feel it is more like a 2 or 3 at this point.

Good quarter. Thanks.

At this point we're going to wind up the conference call. I’d like to thank you all for joining us on this call. We were pleased to report another quarter of good earnings growth, and good top line revenue growth. And we look forward to updating you on our market expansion with the next quarterly market conference call.

This concludes today's CoStar Group second-quarter earnings conference call. You may now disconnect.