CoStar Group Inc (CSGP) 2006 Q3 法說會逐字稿

Welcome to the CoStar Group's third quarter 2006 conference call. Today we have with us Andrew Florence, President and CEO, Frank Carchedi, CFO, and Audra Capas, Vice President of Communications. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a quesiton and answer session.

[OPERATOR INSTRUCTIONS.]

I would now like to turn the call over to Ms. Capas.

Thank you, and good morning. I'm Audra Capas, Vice President of Communications for CoStar, and I'd like to welcome you to our third quarter 2006 conference call.

Before I turn the call over to Andy Florence, our President and CEO, 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 third quarter 2006 press release and any of CoStar's filings with the SEC, including its 10-K for the period ended December 31st, 2005 and 10-Q for the period ended June 30th, 2006 under the heading risk factors.

All forward-looking statements are based on information available to CoStar on the date of this call, and CoStar assumes no obligation to update these statements.

Today's conference call is also being broadcast live over the internet at www.costar.com/corporate/investor/. An audio replay will be available two hours after the last call concludes through midnight on November 2nd, 2006. The replay telephone number is 1-800-642-1687 within the United States, or 706-645-9291 outside the United States. Refer to conference ID 7922313. The replay will also be available over the internet at www.costar.com/corporate/investor/ for a period of time following the call.

Thanks for joining us, and now I'll turn it over to Andy.

Thank you, Audra. Welcome, everyone, to our third quarter 2006 conference call.

I'm very pleased to report another quarter of strong revenue and earnings growth, as we continue to successfully reinvest and to invest in CoStar's long-term future. CoStar's earnings per diluted share doubled from the previous quarter, from $0.12 per share in the second quarter of 2006 to $0.25 per share in the third quarter. We quadrupled earnings per diluted share YOY from $0.06 per share in the third quarter of 2005 to $0.25 a share for the third quarter of 2006.

This growth in profitability is driven by the combination of strong revenue and earnings growth in our core markets, coupled with the expanding profitability of the 21 expansion markets we entered in 2005 and 2006. Our revenues for the third quarter of 2006 were 40.6 million, up 18.2% from the third quarter of 2005.

Our average new contract value increased 37% from $7,855 in Q3 of 2005 to $10,796 in Q3 2006. This dramatic increase is attributable to price increases we put in place following the release of our new retail offering and an increase in new institutional clients subscribing to larger national data sets. Our average customer at the market level is now paying us $15,552 annually.

Our renewal rate remains steady at approximately 92% for the third quarter, the tenth consecutive quarter it has been above 90%. Since our renewal rate has been running so high, we have not expected to be able to increase it significantly and, in fact, it dropped very slightly from Q2 2006 to Q3 2006, from Q2 to Q3. While our renewal rates remain extremely high, we've seen anecdotal evidence to suggest non-renewals may be becoming disproportionately from residentially oriented firms. Residentially oriented firms are a very small percentage of CoStar' revenue base.

Next month we plan to launch a major new upgrade of CoStar Comps Professional, which is our second largest revenue driver behind Property Professional. We believe it is the most comprehensive source of verified commercial property sales comparable in the commercial real estate industry. Since we acquired the Comps product in 2000 our sales comparable database has more than doubled, from approximately 490,000 sales records to over 1 million with a total value of $2 trillion.

What makes this product unique? Research and lots of it. Every listing in our comps database is backed by fully researched and verified details. We have a veritable army of researchers who read SEC filings, press releases, and review deeds of trust, transfers documents, and courthouse filings at the state and local level. In addition, we are conducting site inspections of comparable sales. We believe no one else does as much to ensure the reliability of comparable sales information as we do. With this new upgrade we expect our subscribers will have even more fully verified comparables faster. We are very confident that we'll have better mapping capabilities and higher quality information, all with a more user friendly web interface.

On the back end, we're merging our two primary research systems into one more streamlined system, which should produce major efficiency gains for our researchers and help us produce more comps, more quickly and with even greater accuracy. Thanks to this integrated system we expect to have virtually unlimited flexibility to share information and make changes across product lines. Now, if a for sale record is taken off in Pittsburgh it will instantly go directly to our comps research process. With nearly 100 new features we expect this new upgrade will offer enormous productivity gains for our subscribers, along with a significant boost in our overall system performance. We look forward to unveiling it in November.

During the third quarter of 2006 we initiated a major sales force restructuring in order to better capture the significant revenue growth potential we believe this business has. I believe the primary regulator on sequential quarterly revenue growth is the size of our sales force, not the opportunity we have. Prior to 2005 the company relied predominantly on a widely and geographically dispersed direct field sales force for the vast majority of our sales. At the time, the company had a small inside telesales operation that was approximately equally productive as the field sales force, but at a lower per unit cost. In 2005 the company saw greater cost efficiency, and nearly tripled the size of our telesales group to between 50 and 60 telesales reps.

The direct field sales force remained largely unchanged in size throughout 2005 and into the first half of 2006. At the end of 18 months of this transition towards an emphasis on telesales, management concluded that the telesales group was not scaling effectively. At the same time, the field sales force was becoming dramatically more productive. By the second quarter of 2006 we saw that the average productivity of our sales representatives had shifted from parity between inside sales and field sales to a 300% higher per person productivity for field sales representatives. I believe this is because a field service representative has the greater opportunity to interact face-to-face with our customers and, hence, become more knowledgeable about their needs.

By the second quarter of 2006 the average telesales rep was generating $856 in gross sales per month compared to the average field sales representative generating $2,486 in gross sales per month. At this time, the telesales group was approximately 42% of our sales force, yet was producing about 19% of our sales. In addition, renewal rates for accounts sold by telesales reps were significantly lower than those sold by field sales reps.

Given the size of the opportunity the company has and the fact that the company's margins are very high in established markets with either the cost structure of field sales or telesales, management decided to restructure the sales force. The company intends to double the size of the field sales force by the second quarter of 2007, adding approximately 80 reps and managers to the field. Many of these field sales reps will be placed in regions of the country that currently have no local sales coverage. In order to efficiently achieve this goal the company is adding two additional regional sales recruiters and three sales training managers. More than half of these support positions have been filled already.

During the third quarter the company closed the San Diego telesales group and reduced and recapped telesales groups in Columbia and Bethesda, Maryland. In total, approximately 30 people were removed from pure selling roles in telesales. Obviously, this move reduced our sales production in the short term, but we believe that the move will take us to higher overall production by the first or second quarter of 2007. We believe the restructuring was necessary in order for us to achieve our goal of sequential growth rates at or beyond 5%.

Despite the restructuring the contract bookings remained strong in the third quarter at 5.5 million, down just slightly from 6.1 million in the previous quarter. The vast majority of those bookings came from our field sales force.

Our CoStar commercial MLS product, which contains the nation's largest collection of research commercial for sale property listings, is doing very well since we recently launched our paid subscription service in June 2006. We believe that this online product competes head-to-head with components of LoopNet service offering. In just five months we have signed up thousands of paying subscribers, brokers, sole practitioners, owners, residential agents who buy and sell occasional commercial properties. In the third quarter of 2006 our for sale listings more than doubled YOY and that's with minimal marketing effort. This big surge in listings growth clearly demonstrates the commercial MLS has greater revenue potential for us, and we plan to market this product more aggressively in the future.

Approximately 96% of our revenues today come from subscribers who are paying a fee to access our property information online. We believe there is significant revenue potential at the opposite end of the spectrum where instead of paying to access information, people pay to market and distribute their listings on the internet. We believe that companies, such as [City Feed], EG Property Link, LoopNet in the U.K. – I'm sorry, EG Property Link in the U.K., LoopNet in the States, [Prop-X] in the UK, and others, derive meaningful revenue from this type of business model.

With our huge inventory of listings and our industry relationships we believe CoStar is very well positioned to leverage in this new and significant stream of revenue. To capitalize on this opportunity we are building a new web product called [Showcase], which we intend to launch in 2007. Over the next few quarters we'll go into more detail about how we see this site translating into new revenue potential for us and our shareholders.

As we stated in the last earnings call, the 21 expansion markets we delivered in 2005 and 2006 are now profitable in aggregate and are continuing to show solid revenue growth and margin expansion. Many of these expansion markets that delivered at least a year ago, are showing very strong contribution margins that are as strong as or stronger than those in our original 45 markets. This reinforces and supports our belief that the smaller North American cities can achieve margin rates equal to and, in fact, better than those we enjoy in the largest U.S. cities. Overall, we believe that our investment needs expansion markets will yield a very attractive ROI.

Given the fact that all 45 of our original markets are individually solidly profitable and our recent 21 expansion markets are profitable in aggregate, we announced in last quarter's earnings call that we intend to expand into an additional 100 MSAs. These MSAs include cities, such as Buffalo, Albany, Rochester, Syracuse, New Orleans, Louisville, Fresno, Omaha, Albuquerque, Little Rock, Portland, Knoxville, and many others. Once we complete expansion of our coverage into these additional 100 MSAs we will have essentially complete geographic coverage of the U.S. commercial real estate market. We believe that this enhanced national coverage will increase our retail and our institutional revenues.

One important dynamic of our business model I want to highlight is that while in the short term adding more properties to our database may suppress our earnings growth, we believe that in the intermediate and long term not only does it enhance our earnings or high margin revenue growth, but it also should reduce our per unit research costs and drive even greater margin expansion.

I am very pleased for the very significant operational progress we have made towards this 100 MSA expansion goal in just three months time. We have designed, purchased, equipped, staffed and deployed 89 [Toyota Pre S] research vehicles across the country. In fact, we now have research vehicles operating in approximately 43 states.

Since the end of the second quarter, including offers extended and accepted, we have hired more than 200 additional researchers to date to handle the increased workload. We have leased additional office facilities just north of Baltimore in White Marsh, Maryland. We believe that the White Marsh area has significantly lower operating costs than either Bethesda, Maryland, Columbia, Maryland, or San Diego, California, where we currently have research centers.

Thousands of new properties a day are now flowing into our database from these new research teams. Jut last week, we crossed the 40 billion s.f. of commercial real estate tract threshold. In the past two weeks, we added as much inventory as exists in a city the size of Washington, D.C.

We launched a new retail dimension of our Property Professional product in May of this year. The product launch has been well received throughout the retail industry. We have signed approximately 100 contracts that we believe are attributable to the retail functionality within our product. The feedback that we are receiving on the product continues to be very positive. We continue to be very optimistic on the potential of the value in this product area.

In the initial months of selling, despite the fact that we directed a lot of marketing attention towards retailers, we were actually seeing more demand than we expected from retail owners and developers. Brokerage firms with a retail focus are also showing strong demand for the product. Retailers that subscribe to the product with the sales cycle of the mega retailers appears to be somewhat longer. With the sales to retailer and brokers and owners outpacing retailers five to one, we are retargetting and strengthening our marketing and sales efforts on these segments while continuing to pursue additional retailer subscriptions.

At this point, I'd like to turn the call over to Frank Carchedi, CoStar's Chief Financial Officer, and he'll talk a little bit more about our third quarter results. Frank.

Thank you, Andy.

As stated in the press release last night, net income increased from 1.1 million or $0.06 per share in Q3 up from 2005, to 4.7million or $0.25 per share in Q3 of 2006. In addition, EBITDA increased 5.1 million from 3.7 million in Q3 of 2005 to 8.8 million in Q3 of 2006 on YOY revenue growth of 18.2%.

We're pleased with our YOY results to date, but today I'm going to focus principally on the third quarter of 2006 results compared to the second quarter of 2006 and on our outlook for the fourth quarter of 2006.

Total revenues grew sequentially by 4.2%, overall, from Q2 of 2006 to Q3 of 2006, increasing from 38.9 million to 40.6 million. The results of the third quarter was primarily due to continued solid growth in our core U.S. based subscription revenue, combined with a continued high renewal rate of approximately 92.5% for the quarter. We had a 4.1% sequential growth rate in the core U.S. subscription revenue areas, with stronger overall growth in the non-subscription areas and in the U.K. The U.K. accounted for approximately 8% of revenue and total subscription revenues for the company, including the U.K., accounted for approximately 96% of Q3 revenues.

The group of 21 newly opened markets, which has reached revenue of approximately 1.3 million quarterly or 3.1% of our overall revenue in Q3 2006, continues to present a significant opportunity. In aggregate the project is profitable on a direct basis before corporate overhead, and we continue to expect rapid growth at high margins in these markets. Revenue for the group of 21 markets grew 10% sequentially from Q2 to Q3 of 2006.

Gross margin increased by approximately 230,000 from 26.3 million in Q2 to 26.6 million in Q3 on a 1.6 million increase in revenues. Margin percentages decreased from 67.6% in Q2 to 65.5% in Q3, primarily as a result of initiatives related to the expansion of the research for retail building coverage and of the field research department in connection with our national expansion.

Overall, operating expenses decreased 3.2 million from 23.9 million in Q2 to 20.7 million in Q3, principally in the selling and marketing area. This decrease was related to a decline in marketing expense because Q2 included costs related to the ICSC Trade Show, the retail rollout, and the last of the 21 market openings, all discussed on our previous call. Corporate development, G&A, and purchase amortization expense remained relatively flat from Q2 to Q3.

As a result of revenue growth and decreased operating expenses, EBITDA increased 3.5 million, from 5.3 million in Q2 of 2006 to 8.8 million in Q3 of 2006. These results show the leverage in the core business. With an estimated 3 million in Q3 costs attributable to new initiatives we believe that the core platform is at approximately 30% EBITDA margins currently. That basis net income more than doubled from 2.3 million or $0.12 per share in Q2 of 2006 to 4.7 million or $0.25 per share in Q3 of 2006. Reconciliation of EBITDA to GAAP basis results is shown in detail on our press release issued yesterday, which is available on our web site.

Capital expenditures for Q3 of 2006 were approximately 5 million, of which 2.8 million was for our new hybrid field research vehicles, 1.1 million was related to research topography, and the remainder was for the support of our existing platform.

We closed the quarter with approximately 154.9 million in cash, cash equivalents, and short-term investments, an increase of 4.7 million during the quarter. In addition to cash flow from operations we generated an additional 570,000 from stock option exercises for approximately 26,000 shares during the quarter.

Now, I'll discuss the outlook for the fourth quarter. As indicated in our press release, for 2006 we are now expecting overall revenue growth of approximately 18 to 19%, putting revenue in the 159 million range for the year. We expect a sequential quarterly increase in revenue in the third quarter of 2006 to the fourth quarter of 2006 of approximately 3.5 to 5%. We continue to believe there is significant up side revenue growth potential from growth in sales force size and productivity, particularly in view of opportunities resulting from momentum in established markets, ramp-up from newly released market openings, the retail offering and the national expansion.

For the fourth quarter of 2006 we expect fully diluted net income per share of approximately $0.12 to $0.17. In the short term, as we ramp-up research staffing to support our continued expansion we expect that gross margin percentage will be under pressure and could decline to approximately 60%. Staffing and sales in other departments will likely result in growth in other operating expense lines in the upcoming quarter, and we expect that total operating expenses could grow by up to 10% overall.

We expect 2006 fully diluted net income per share of approximately $0.60, while EBITDA, which includes equity compensation charges, is expected to reach 23 to 25 million for the year.

Capital expenditures are expected to be in the range of 3 to 6 million in the fourth quarter. This is related to our new White Marsh, Maryland research facility, our 100 net MSA expansion, and the remainder to support our existing platform. We expect capital expenditures for the year to be 12 to 15 million, consistent with our original estimate for 2006.

In conclusion, organic growth remains solid, and we believe there's potential for substantial up side in revenue growth at high incremental margins for both established and new markets and services. Even with significant investments and expanding building coverage, the strength of our core business and business model is apparent in our third quarter results. We look forward to reporting our progress to you.

And, with that, I'll open the call for questions.

[OPERATOR INSTRUCTIONS.]

Your first question comes from Brad Eichler with Stephens Inc.

Hey, good morning, Andy and Frank.

Good morning.

Hi, Brad.

Could you spend a little bit more time talking bout the restructuring of the sales force from a financial perspective? What are the implications from an expense perspective associated with the termination of a lot of the in-house people, and then the expansion of the field sales force?

Brad, I'll give some comments, and Andy can jump-in, as well. From a financial perspective that change had relatively little impact on Q3. I don't remember the exact timing, sort of the tail end of Q3. And in an overall sense there was a reduction in telesales staffing as people went into other departments, and that number, that headcount in that group came down. At the same time, the field research group's is coming up. So I think the overall financial impact is that you're going to see growth in selling and marketing expense in the upcoming quarter.

Just to be a little bit more specific, on average what does a person, a telesales person make?

The telesales people were making approximately in the $60,000 to $70,000 range. A field salesperson is generally making a little over $100,000. But the thing you have to keep in mind is that is directly related to production. So the base pay structure, I believe the field salesperson's initial base pay might be $10,000 to $15,000 more per month. So if you transition, if you shift 30, to 30, you're talking about a pretty small number there.

And then you've got an incremental 50?

And then you have an incremental 50.

Okay. And what – how long does it take you to ramp-up a salesperson? To get them to where they're productive?

Well, historically we've looked for them to get productive within about six months. If I look at field sales productivity rampup versus the telesales rampup, I believe that in the first six months a telesales person was averaging about $600 per month gross sales and a field sales representative was averaging about $1,700 per month gross sales in the first six months. So that we don't expect anything from them in the first two months. And then thereafter they're at about half productivity or maybe 6% productivity. And then after six months they are generally fully productive. And then you're going to have some failure rate in that first six months, as well, so possibly some 20% failure rate for new salespeople.

Okay. And then maybe just one quick followup question, on the 100 market new expansion, or the 100 market expansion, what was the cost that you incurred in the third quarter associated with that?

It's -- Brad, it's probably in the half a million dollar range, half a million, possibly as much as a million. And basically most of that being in the tail end of the quarter as we ramped up the field research, got the vehicles, hired those people, trained them, you know, held training camps and got them out on the road.

Great. Thank you. Good looking numbers.

Thank you.

Your next question comes from Brandt Sakakeeny of Deutsche Bank.

Thanks. Hi, Andy and Frank.

Good morning.

Frank, what was the net contribution of the 21 new markets in the quarter? Do you have that broken out?

The revenue contribution?

Yes.

It's about 1.3 million.

Okay, great. And then in terms of sales, sales force, what was the total number of salespeople in the quarter? And then, and ultimately how should we project that going forward on a sort of quarterly basis here?

At the end of the quarter we had about between 80 and 90 field salespeople. And Andy mentioned earlier that we're essentially planning to double that by the second quarter of '07. And then on the telesales side there's still a group there that's scaled down, and by the end of the quarter with managers, there's probably a total of about 30 people there.

I should point out that of those 30 people I think about 12 of them are no longer engaged in sales, they're engaged in proactive training, going into existing customer accounts and targeting brokers who don't use our product and try to convert them to active users to increase renewals and to spread viral marketing.

Okay.

You don't want to put a – so of those 30, you don't want to put quota on 12 or so of them.

Okay. And do you have the number in the U.K.?

The U.K. had, I believe, 14 quota carriers active at the end of the quarter.

Okay, great. And I guess just, too, in terms of effort to sort of cut the cost of research, I think you've been looking at selective offshoring or outsourcing, can you maybe give us an update on those initiatives?

Sure. I believe we have approximately 150 people offshore currently. But we did try some experiments in the Philippines with making telephone calls into brokerage firms to add listings, which we were not pleased with the results of. So we shifted those to [updates], so it's working effectively there.

So we're going to continue to try to look for opportunities for things like geo coding, processing SEC documents, CMBS filings, reading deeds, web tenant research, confirming locations of tenants, moving all of that offshore. And so that's going fairly well. We have put a senior person in the senior management team fully accountable to that function, and are constantly looking for opportunities to offshore there. So we'll see continued growth in our offshoring operations, but obviously a dramatically lower per person cost than what we're seeing in Bethesda, Maryland, California, and London.

Great, great. And I guess just, Frank, in terms of the '07 revenue expectations, don't want to get out ahead of you guys, but I mean given the 100 new markets and plus the sales force changes should we expect something above 5% beginning in '07 for sequential growth?

Well, we haven't given any '07 guidance but, you know, as Andy said, we had the 3.5% to 5% target out there for quite awhile. And we're not giving specific guidance for '07. Obviously, we think there's a huge opportunity out there. In my view it is not an opportunity issue, it's a productivity issue, and with the plans we have for the sales force I think that number can go higher.

Great. Okay, perfect. Thank you.

Thank you.

Your next question comes from John Neff of William Blair.

Hey, guys. A couple of questions for you. The sales and marketing expense of 8.8 million was the lowest since 2004, and it includes stock comp. How does this jive, if at all, with the top line failing to decelerate at this point or not likely to accelerate in the fourth quarter? Is there, is there an explanation or reflection somehow?

John, it's principally, if you look at it sequentially or compared to any number of quarters, four quarters or six quarters back, it is largely a function of the marketing expense in that line item. Sequentially it is very directly the marketing expense related to the IPS and the retail launch. Keep in mind as you go back four or six quarters you had four to six market launches throughout that period. So the marketing expense captured in that, in this quarter, the third quarter, is probably one of the lowest in six quarters or more.

And we've got – so you're coming off of a major marketing push at ICSC, and you're stepping down off of that. We're doing a lot of the initiatives right now are things like our new e-mail newsletter, that's going out to several hundred thousand people weekly, which has little to no direct cost. We're doing a lot of event marketing right now, and where we're having retail luncheons in various cities, like one starts in Dallas, Texas in an hour. So it's a little bit of a lull before something of a step-up most likely next quarter. And we're doing a lot more paper-click and SGO marketing, as well, which doesn't have nearly the sort of cost structure you saw at an ICSC event.

Great. Just so I'm clear, the – you estimated 3 million in costs in connection with the new retail effort and the MSA expansion?

Yes, the marketing component alone of the, it's like a Q2 moving to Q3, the out-of-pocket marketing, which is principally ICSC and retail launch, as well as ramp-up of 21 markets and other, you know, general market activities, that number went from about a $4 million total out-of-pocket marketing spend to about $1 million, which is sort of a noise level of marketing for the third quarter. But, John, we do expect the sales and marketing line to grow. You won't be troubled by this for long.

The 3 million in incremental costs in the quarter, does that in any way represent, is that an acceleration of your expansion spending or I guess, I mean I knew you were buying the cars and hiring the researchers but I guess I assumed most of that was going to be hitting in the fourth quarter, so where you had talked about an incremental 4 million in expense?

Well, let's make sure everybody understands what, you know, the intention there. The incremental 4 million is the rampup in the fourth quarter related to the 100 MSA projects. The 3 million that I identify is what's already happening in the cost structure related to the retail expansion, as well as the very beginnings of the sort of 100 MSA, which Brad Eichler had asked about, you know, right in September there. So the two different things, the 3 million largely being the ongoing quarterly investment in the retail project, and that's been in the P&L for awhile, you know, during 2006. And then the 4 million you're talking about for Q4 is the 100 MSA expansion.

Okay. You had given the retail annual subscription value at about 1.2 million in the second quarter, what is that today? And I think you said you signed 100 contracts, and I believe that was up from 71 in the second quarter?

We have approximately 100 contracts. Some of them are somewhat challenging when you look at like if [it is down], what component is retail and what component is office or industrial, so you sign-up a brokerage firm in St. Louis that has been a long-term holdout and you're fairly certain it's because half of their workers are retail. So it's a little tough to allocate directly, but – do you have the number?

I actually don't have a value for those.

Okay. We don't have an actual dollar value on those. But anecdotally it's definitely strong. We continue to see brokerage firms that had not been good prospects before signing up, so we think the number is fairly strong.

Okay, great. Last question and I can get back into queue. Renewal rate decline quarterly, the last three quarters, 94%, 93%, and now 92%. DSOs are holding steady, though. Is this a reflection of the sales force restructuring, is it a reflection of the macro climate in any way? Thanks.

John, I'm always very careful to sort of watch those renewals or cancellations and see what they look like. As I look at them anecdotally, you know, when you're at 94% renewal rate, it's a little bit like being at a 19 days receivable or 12 days receivable, it's hard to get better than when you consider that that is, the 94% renewal rate includes people retiring, going out of business, so on and so forth. So it's hard to go up from 94%, and as we move between 92 to a 94% I don't actually attach a lot of meaning to that.

Our pricing, you know, in some areas has been moving up. I did notice that some of the cancellations in the last two or three months were residential firms that looked like they're nearly, you know, 75% plus residential, and that is not a big part of our business. I would expect that, you know, as the housing market gets worse that those people on the residential side of the business would not be flush. The good news is I think our residentially oriented customers are single digit. But I'm not attaching a terrible amount of meaning to that right now. It appears to be, you know, individually examining them, as I've done, they appear to be traditional [noise].

Great. Thank you.

Your next question comes from [Robert Briggs] of Credit Suisse.

Yes, I just wanted to get a sense of when you're going out and looking at new retail spaces, how much extra office industrial are you capturing when you're doing that?

I would say that we're not so much looking at, we're not targeting either office industrial or retail as we go into a new geography. We're just targeting straight across-the-board.

Okay.

Full commercial inventory, and including multifamily listings. And what we're seeing is probably approximately 40% retail and 60% office industrial multifamily, that'd be an approximate number.

Okay.

But, you know, the numbers that are coming in right now is really stunning. I mean I've been watching our [RB accounter], a building area counter, for what we've got in the database. And just last week I was looking at the number and it was somewhere around 39.7 million, I'm sorry, 39.7 billion. And I guess today it's at 40.5 billion, just looking at our web site, and I see it right now. That's a huge jump. I mean that's, the amount of inventory that's coming in is really massive, and I think it's going to continue to climb dramatically over the next several quarters. But you're looking at adding as much inventory every fortnight as we added the first 10 years of operations.

Great. Thanks a lot.

Thank you.

Your next question comes from Jim Wilson of JMP Securities.

Thanks. Good morning, guys.

Good morning, Jim.

Good morning, Jim.

I was wondering if, I don't know, this might be a little hard, but if you could attempt to put into potential perspective, as you think about the incremental revenue or revenue growth potential of the original 45 markets, the 21 most recent that you've entered and then, obviously, the [cities], the 100 expansion markets, you know, how to – obviously, the old ones are the biggest cities, and the most recent ones the midsized cities, and the new ones are all much smaller cities. How can we think about what that could do, not just in '07 but over the course of time?

There are a number -- Jim, it's really an educated guess because there are a number of different metrics you can look at. You can look at rental building area, a number of businesses, city level, GDP, things like that. But the general sense of it is that maybe the 21 expansion markets increased the size of opportunity by, the ultimate size of opportunity by 20, 25%. And I think these 100 markets probably take it up, you know, 25 to 35%. So the latter expansion should yield approaching a million buildings a year.

And a lot of the expansion that's occurring are fringe markets to existing cities which are a pretty big growth areas. So like, you know, Hagerstown, Maryland or Fredericksburg, Virginia, or Colorado Springs, north of Denver. Now, these are pretty big market areas when, you know, when you look at statistics like 30% job growth occurring 10 miles outside of the largest MSAs. So I think the 100 markets is larger than the 21 expansion markets in total opportunity. Certainly, neither one of these are big as the original core markets.

Okay. And maybe just a follow-up to that, I guess Frank had mentioned that 21 new markets contributed 1.3 million in the quarter, and I was just trying to think through growth rate of new versus old. Is – do you have that or do you have at least what they contributed a year ago, which I assume was not much?

Yes, Jim, if you think about the core platform, the pre-2003 group of markets, I mean that is the lion's share of the 4.1% sequential growth for the quarter, in the core, which also includes the 21 markets. But, as I said, the 21 markets are about 3% of the revenue right now. Now, the 21-market group grew at 10% sequentially and they have, of course, grown much more rapidly on a sequential basis, of course, off smaller numbers.

As Andy mentioned earlier, in terms of the sales force and the coverage we have, I think one of the issues is that if you look at that sequential growth, particularly Q2 to Q3, while it was strong and obviously a much bigger number than the core, it does not have the sales force coverage today that it needs to have. And I think that as we get the sales force up-to-speed and get the coverage right we will see more dramatic numbers coming out of the 21 markets.

Jim, I think it's about a 400% YOY increase from those 21 markets, and then the 11% sequential quarterly. The – and you're in a bit of a transition phase where we use some of our more experienced field salespeople to open those markets initially. They're going back into the core markets and we're replacing them with new hires over the next two quarters. They had a little bit of a lull in those markets, but I fully expect that you'll have a very healthy sequential quarterly growth rate in those markets for some time to come here and a re-energizing sequential quarterly growth rate over the next two, three quarters. So I think those markets have performed very well.

Okay, that makes sense. But that was only, so that was probably, I think maybe 300,000, 400,000 is what they contributed in the third quarter of '05.

Right, exactly.

Yes, got it. Okay, great. Thanks.

Thank you, Jim.

[OPERATOR INSTRUCTIONS.]

There is a follow-up question from Brad Eichler of Stephens Inc.

Just a follow-up question on the sales. I constructed a simple little Excel model, and it looks like net of revenues the sales change next year could cost you guys a couple of million bucks, does that seem in the ballpark?

Well, again, the big differential is base pay which, between fields, that's 300 sum, and then the additional 50, you could be about right.

Yes, I mean I assumed about $5,000 a month for an internal guy, about $6,500 a month for an external guy, and that the external guys would ramp their sales to about $2,100 a month.

And then, obviously, the purpose of all this is associated revenue acceleration.

Exactly. Okay. Is that incremental expense something that you guys had factored into the $4 million of incremental expense associated with the 100 new markets or is that something that we should look at as incremental?

The 4 million includes expenses on all P&L line items, Brad. I mean it's mostly up in research but, you know, when I'm thinking about the 4 million per quarter. And, again, we'll learn more about that as we go forward, it's just an estimate, but as I think about the 4 million it included the research efforts as well as sales requirements to cover that geography.

And, you know, the challenge, obviously, is with execution to get those numbers of people and get them out there physically into those markets and start to sell. And, as you know, ultimately the investment that we make, you know, we'll go along – we'll have that 4 million a quarter and over the longer term that investment is obviously dependent on ramping up revenue from that new part of the platform.

Right. So we shouldn't think about this sales restructuring as an incremental set of costs then?

Well, let me, you know, we – I want to be careful here, we have had a plan to expand the sales force all along, okay. And a large part of that expansion, as Andy said earlier, was happening on the telesales side. We're shifting that to the field. So I don't want to say that we never had any growth in the sales and marketing line for sales personnel. We knew that the sales group would have to grow, and it has to grow even further, I believe, for the 100 MSA project.

Okay.

So if you think about the 4 million being incremental to your model for the 100 MSA, you should have already had cost escalations in the core cost structure.

And then another factor to consider are things like we used to put out 75,000 copies a quarter of a print magazine called [Customer Advisor], which probably cost us just under a million a year. Now we're doing a weekly very sophisticated e-mail distribution system. So you have some, with more internet oriented marketing you have some cost efficiencies in the marketing line that could be shifted to the sales line.

Okay, and that makes sense. One final question is did you mention the number of people that you've converted over from the free subscription you were offering, the trial subscription on the multi list through the paid? And where do you stand now in the number of people that are signed up for the trial membership?

I don't have those numbers in front of me. We've got several thousand people that have signed up for the CLMS product. I don't have the exact breakdown on it and, in fact, one of the challenges is people can sign-up under one name and then go for the trial and then sign-up for the actual taped product under a different ID. So it's a little tough to track what was actually what, you know, and trial they did some fake members' names because they didn't have to put it on a credit card, but when they have to buy they have to put it on a credit card, then you get a different name. But it's in the several thousand now, and it's – we're enjoying it because it's not driven by direct field sales force, and every day, Saturday and Sunday included, we're getting a little pickup in revenue.

Thanks, Andy.

Thank you.

There is a follow-up question from John Neff of William Blair.

Hey, just piggybacking off of that, Andy, is it several thousand paying subscribers or several thousand registered users?

Several thousand paying subscribers. And we did take the price up recently from $19 to $29. So we've also taken the price up, as well, but we're happy with it, and we'll put a little more marketing behind it as we go into '07.

John, paying subscribers is the only kind we count.

Okay! The tax rate during the quarter, lower than it has been recently, Frank. Just was wondering if you could give us any color on that? What we might expect going forward?

Did you want Andy to answer that, or?

No! I wanted you to answer.

The reason that the effective rate is declining is that the earnings numbers are exceeding our expectations. And within the P&L there's a certain level of nondeductible expense, nondeductible expense items, which is relatively fixed. As the earnings grow and exceed our expectations that nondeductible part becomes a smaller part of the pie and that reduces the effective rate. So that's basically what happened in Q3. So that's good news.

So we can expect…

I think you can generally continue to model in the very high 30s or 40% range. We started out the year a little bit higher.

Great. Thank you.

Thank you.

Your next question comes from [Arthur Weiss] with Bank of New York.

Yes, I just have a quick question on the large retail opportunities, do we have any sense of what a dollar amount would be compared to the commercial? Has that been something you've figured out yet? And is that part of the reason why the sales cycle might be longer than you've experienced in the commercial side?

You're in the right area. The – you've seen the average new contract price come up 30 some percent, you know, 35, 37% YOY, the retail contracts are higher dollars. At the, targeting the mega retailers, the numbers are somewhere probably around 10, 15, 20 times the average contract size. So they're significantly larger. And, also, you're just simply selling into larger or much larger organizations. So as we bring in more experienced salespeople who have sold into this retailer space before, they talk about historically seeing six to 12-month sales cycle going to these complex larger organizations. So…

And are you seeing that the first rung you're getting, you're getting through the first rung, and they just need to get approvals on up? Is that what the issue is, or…

We're getting through the 20th and 30th rung, and then – but in some of these organizations we've actually met with the presidents of retail names you would recognize, you know, four times. And things are progressing.

But one of the things we're watching is we're not getting terribly hung-up on the six to 12-month sales cycle for the mega retailers because if you've got, you know, we put a lot of marketing effort on the retailer, themselves, but what you're seeing is the retail owners, who I did not expect to be big buyers for this product, are very enthusiastic for the product. And we didn't put out a marketing effort towards the owners.

And then there are, also, we're loving the reaction we're getting from the retail brokers who have a disproportionate, you know, disproportionate set of their listings from retail. So if those two components are working without a six to 12-month sales cycle, we're going to go after more of that. And we're going to be very happy with that because it's sort of new revenue growth, it's breakthrough revenue growth for us. And we'll continue working those larger retail accounts because they're sexy in name and marketing and potentially revenue, but we can make a lot of hay on the owners and on the brokers.

And if you look at the mega industry event, ICSC, and you look at the actual participation lists of that, it's something like 3,700 different owners participating and less than a thousand retailers participating. So you start looking at that and you're like, well, if the owners want to buy our product let's put it in owner wrapping and sell it to them.

Great. Thank you.

Your next question comes from [Rick Leggett] of [Barber Capital].

Good morning, guys.

Good morning, Rick.

It's not clear to me whether or not you're guiding us to increase our assumptions for operating expenses, or not. Last quarter we made adjustments. Are you now telling us there is going to be an incremental addition to spend, primarily sales and marketing, versus what we heard last quarter?

I don't think so, Rick, so let me go through it again. There, before the 100 MSA expansion got on the table, there was always an assumption of cost escalation because the retail rampup was already happening and there was already a plan to ramp-up the sales force. And there are other cost escalations in the P&L but those are the principal things occurring. That is all still occurring.

But if you look out into Q4 we have identified an additional, call it $4 million per quarter throughout the P&L, but mostly up in the cost of sales line because it's mostly research related to the 100 MSA expansion.

That was also disclosed in last quarter's call.

Right. So the 100 MSA expansion and the $4 million per quarter, starting in Q4 that I identified on the last call, was on top of other cost escalations that were already in process.

Okay, and so when you talk about the reorg of the sales force, the doubling of the sales force by June of '07, that's in numbers that we were talking about last quarter?

There's no dramatic new news in overall spend here.

No. It was in cost expectations we had going all the way back to the beginning of '06, if not earlier, in terms of the need to ramp-up the sales force. Now, I've guided to additional dollars, because I think the sales force has to be even bigger related to 100 MSA expansion.

But the difference is that when we started out on the front-end of '06, that rampup was to occur principally on the telesales side, which on a per person basis does have a somewhat smaller unit cost, but it's kind of irrelevant because you have to get the revenue. And so now we're transitioning that to principally a field research, I'm sorry, a field sales expansion.

And you'd also like to know that I was pleasantly surprised from the Minneapolis revenue performance when I was reviewing the 21 expansion markets last night.

You're winning them over! Good for you. Thank you.

Thank you.

You have a follow-up question from Brad Eichler of Stephens Inc.

Hi. I just wanted to ask a couple of questions on the retail business. What was the retail sales in the quarter, and how many new clients have you added during the third quarter?

Again, we're somewhere at about 100 retailer related deals, or retail related deals. We are – it is difficult to attribute some of these sales specifically. I think the actual number of sales is probably higher than that because you've got brokerage firms that do office and retail that have not bought, even though we've tried to pitch to them for years, who are now buying.

So the number, the actual number is pretty hard to put a finger on. So we aren't doing a lot of hyping on what the actual sales number is. But in terms of the accounts, we feel very comfortable being, you know, because specifically of this retail product. It's 100 plus, and I think the number will continue to be fairly healthy over the next 12 months or so here.

Is that 100 plus, is that all retailers or is that brokers that have a heavy retail concentration? And is that 100 plus incremental or is that a 100 YTD, you know, inception to date?

That would be from June of '06 to today, and it would be a mix of retailers, retail advisory groups, owners, and brokers. So when you look at these, like you're talking about owners who have nothing but shopping centers, who have had zero interest in our products prior, and are now picking up our products.

Interesting thing, I had pulled a list of 55,000 brokerage firms the other day, that don't yet buy our product, you know, from the one person on up, very small firms on up. And 33% of their listings were retail, as opposed to our existing customers having something closer to 10% of their listings being retail. So you've got firms who are, brokerage firms that are 100% retail, where clearly the only reason they're now buying from us is because of this retail product. And then you've got firms who may be 30% retail who the only reason they weren't buying from us before was because we didn't, couldn't meet all their brokerage needs.

So you've got this sort of continuum, but overall the trend is that we're reaching a lot of new brokers, very effectively, because of this new retail price. It's going to be hard for us to say that the broker that had 20% retail listings, that sale is attributable to the retail product, because we might [because] of the office component. But I don't think I gave you tremendous clarity, but the 100 new customers you should feel comfortable only because of the retail since the launch in basically the last week of May.

When you talk about the, just the retailer only focus, you know, selling through a retailer, it sounds like the sales process might be a little more challenging than you guys originally thought. A, could you talk a little bit about the feedback, and then, b, are you at all disappointed with kind of the rollout? I mean this seems like something that was a really big focus a couple of quarters ago and it has not been as big a focus on today's call. And I'm just curious to get your temperature on that?

Well, no, we're not disappointed. What we're doing is the reality here is we've released a product that we're getting very positive feedback on from people we have not had high relationships with in the past.

So, for instance, I hosted 100 some people at a luncheon in Atlanta, I guess the day before yesterday, that were mostly retail owners and brokers. About half of them were not yet clients. And we had people right after that luncheon contact us and want to subscribe. These are people we couldn't have sold to before without this product. And so we're, you know, [Chris Pellier], head of sales, in Dallas today doing the same thing, you know, 100 or so retail oriented brokers and owners in Dallas. So this is great. This is good stuff.

But with the sales force you launch a new product like this and you're going to get your retail specialists going immediately out after the elephants. So, you know, CBS, Wal-Mart, Walgreen's, these kinds of folks. And they go right after the elephants. They have not been sold on this product before. The customer has never seen a product like this before. They're going through the sales cycle and we're – I'm not really aware of anyone saying no, we don't think this product works for us. And, obviously, if you're meeting four times with the president of some of these major organizations, there's a lot of very unique interest here.

So I think what we're saying is that we are, for us it's about trying to get that 5% or better sequential quarterly revenue growth, and if that's going to come from owners and brokers, well, we're not going to fight that. We're going to go there. And we'll continue to develop over time the retailer segment. We are probably a disproportionate amount of our sales effort has gone after the top 50 retailers in the United States, but it's the retailer number 1,000 to retailer number 3,000 that's buying it on a short sales cycle.

So we're going to sort of adapt and look at these different sales cycles, and deploy our salespeople where we get the right mix of revenue and timing. But this is a great product, and I think it's – we're very happy with it, and it's great for the company's intermediate and long-term future.

Thanks a lot, Andy.

Thank you.

Your next question comes from Brandt Sakakeeny with Deutsche Bank.

Thanks. Just a quick follow-up, Andy. Back on, I think it was John's quesiton regarding the renewal rate, clearly 94% is a high level. So in that 200 basis point change did you say, was that due to just sort of consolidation, or any bankruptcies or anything else? Can you give us a little more color on that, and then specifically should we presume sort of 92% going forward? Or could that drift down a little bit?

I think it was 150 basis point change, something like that. And I have nothing to indicate that the number would revert down. I think as soon as I saw a 100 basis point change here I started looking at individual accounts, and it looked like very small firms. And the biggest single one I noticed was a firm in Los Angeles that, went to their website, they're purely residential, there was no English on their website, I think it was all Korean. I tried translating the site, and I think probably we lost the account because of a combination that they don't generally operate in the English language and they're residential.

Okay.

So I don't really derive a trend from that.

Brandt, let me give you just a couple of numbers to give you a sense of what the reality of that change is. It is moving from Q1 to Q3 about 150 basis points. What it's represented by is about $50,000 in monthly subscriptions, canceling during the quarter, you know, 50 on a monthly revenue number, subscription revenue number in the 13 million. So the number can be lumpy, it's dependent on the timing of those cancels with specific accounts. It'll move around, and I don't see anything here, and I'm looking at it every quarter, actually every month, don't see anything alarming in terms of the direction.

And I'd also throw-in that the rate is about 500% higher than any other public company in the space.

Yes, yes, okay. No, that's fair. Thanks.

Okay.

Ladies and gentlemen, we have reached the end of the allotted time for questions and answers. Mr. Florence, are there any closing remarks?

I would just like to thank everyone for joining us on this third quarter 2006 conference call. We look forward to chatting with you again on the yearend numbers. And thank you very much.

This concludes today's CoStar Group conference call. You may now disconnect.