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Stock Strategist

CoStar Pairs a Wide Moat With Great Management

The real estate information provider is one of our favorites, but its stock looks pricey.

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Morningstar covers roughly 1,700 companies; of these, just over 200 have wide Morningstar Economic Moat Ratings, fewer than 140 have competitive advantages we deem to be improving, and fewer than 140 have Exemplary Stewardship Ratings.  CoStar Group (CSGP) is among an elite group of seven covered companies with all three--a wide moat, improving competitive advantages, and exemplary stewardship--making it one of Morningstar's favorite companies. Although we see a lot to like in CoStar's business, the shares trade at nearly twice our fair value estimate. We see more downside risk than upside potential in the stock.

Participants in the commercial real estate industry rely on accurate and timely data to perform their jobs. Lenders and appraisers require comparable sales data for underwriting and valuations. Brokers, property managers, and building owners require tenant information to track available space and tenant leasing needs. Roughly 1,000 researchers maintain CoStar's legacy database of information to support these functions, making upward of 120,000 updates to the database each day. All but its largest clients would be unable to replicate CoStar's research capabilities, and even commercial real estate service giants CBRE Group and Jones Lang LaSalle outsource large research functions to CoStar under multiyear contracts. By spreading the cost of its research staff and technology platform across a diverse client base, CoStar can price its service below the cost of collecting the data in-house. Its high customer retention rate (averaging 90% historically, with even higher levels recently) coupled with annual rate increases (usually in line with inflation) has led to a solid recurring revenue base that should increase modestly over time.

LoopNet Purchase Has Created Massive Value
The recent acquisition of one-time bitter rival LoopNet fits within CoStar's strategy of selling incremental functionality and services to its loyal customer base of commercial real estate professionals and trying to capture more commercial real estate industry business. The deal has far exceeded our expectations for potential cross-sales between CoStar and LoopNet. In a bit more than seven months of cross-selling efforts, the firm reports selling $12.4 million of legacy CoStar services to LoopNet's customer base, $2 million of legacy LoopNet services to CoStar's customer base, and $3.9 million in incremental sales of LoopNet services to LoopNet's customer base (through longer contract terms, otherwise modified pricing, or the addition of incremental users under firm- or site-wide licenses). CoStar is just scratching the surface of this opportunity, and we think it will take at least three to five years for it to effectively reach all 100,000 potential LoopNet contacts for cross-sales. CoStar reports that it has thousands of clients marketing through CoStar's legacy services that are prime candidates to expand to LoopNet's marketing services as well. We think this revenue synergy story has a long remaining shelf life.

In addition to the substantial revenue synergies from the LoopNet deal, CoStar has already achieved all of its projected $20 million in expense savings, a year earlier than its original target. Further expense synergies may yet be achieved, but the firm's focus is now clearly on cross-sales.

Also important from our perspective is the opportunity CoStar has to convert LoopNet's historically no-moat business into one with competitive advantages. We think the combination of CoStar and LoopNet starts this process by combining two former competitors into one integrated business. CoStar is making further inroads in this regard by converting LoopNet's historical monthly contracts with individuals into annual contracts at the firm or site level, while changing some pricing tactics to motivate clients to market more properties on LoopNet's platform. CoStar has already begun to achieve notable improvements in this regard, with more than half of new LoopNet deals recently sold under annual contracts (up from essentially zero before the merger) and lower LoopNet cancellation rates. We expect CoStar to continue making progress in this area, potentially "firing" customers it doesn't make sense to continue servicing under the legacy LoopNet monthly contract/high churn model.

Overall, we now view the LoopNet deal very favorably and believe it is creating massive value for CoStar shareholders, despite its high $800 million (net of estimated LoopNet balance sheet cash) price tag.

CoStar's Moat Defends Against Potential Startups
CoStar's wide economic moat stems from its position as a leader providing essential information to the commercial real estate industry. Collecting and maintaining accurate information on its database of millions of commercial real estate properties is a people-intensive business. CoStar employs roughly 1,000 researchers to collect, verify, and update its data, the cost of which is spread across its more than 20,000 client subscriber sites. Even multi-billion-dollar commercial real estate services firms such as CBRE Group and Jones Lang LaSalle have chosen to cut internal research costs by outsourcing much of their research to CoStar under multiyear contracts. We believe this speaks to the quality and breadth of data CoStar provides and the value of its service.

By leveraging the fixed cost of its researchers and technology platform over a large number of clients, CoStar enjoys scale advantages that even the largest commercial real estate firms can't match. We believe the chance of any of its clients taking these research functions back in-house is minimal as the price CoStar charges its largest client is a small fraction of the more than $100 million in data research costs CoStar incurs each year. Furthermore, CoStar estimates that it has invested more than 12,000 man-years and $1.2 billion in its data-collection efforts since 1987, and we believe this historical investment represents a significant barrier to entry for would-be competitors.

CoStar's large number of property listings and sizable number of subscribers represent a valuable resource for commercial real estate industry participants. With an established market position, we believe additional industry professionals are motivated to join CoStar's service, as it is in their best interest to be connected to the industry's largest database of property listings and largest collection of paying subscribers. As more subscribers join CoStar's service, the firm enjoys a network effect, increasing the value of its data and service to all subscribers. Combining LoopNet's business with CoStar's adds additional property listings and broadens its professional network, further reinforcing CoStar's standing in the industry.

We think CoStar's moat defends it against future startups, as its formidably large historical database, sticky client roster, brand, network effect, and scale advantages make challenging the firm a daunting task.

We Think Costar Is an Exemplary Steward of Shareholder Capital
Chairman Michael Klein and CEO and president Andrew Florance founded CoStar in 1987. They took the firm public in 1998 at a price of $9 per share, and with shares recently trading around $168, they have created massive value for shareholders by cobbling together acquisitions with homegrown database expansion to compile the only true national third-party information service of its kind and expand revenue of roughly $10 million around its initial public offering to a more than $435 million run rate recently.

The firm has allocated capital between acquisitions and internal product developments well, in our opinion. While we were originally skeptical of the high price CoStar paid for LoopNet, it is now clear that merger expense and revenue synergies will deliver much more value to CoStar than the premium paid. Furthermore, we think management structured the LoopNet deal well in hindsight, with a minimal share-based component, given the 21% appreciation in CoStar's stock price during the lengthy time required for closing and the continued rise in its shares since. We're also impressed by management's early success converting the legacy no-moat LoopNet business model into one with competitive advantages.

In early 2011, CoStar sold its corporate headquarters building, which it had purchased in 2010 for $41 million, for a net $86 million.

We like management's strategy of adding additional functionality and services to its information platform and preparing its technology for further international expansion, as we think these investments can result in incremental, high-margin revenue.

Client Weakness, Competition Pose Threats
CoStar depends on the strength of its clients, which were hurt in the commercial real estate downturn. CoStar's revenue may be at risk if clients go bankrupt, get acquired, reduce subscription levels, or negotiate better terms. Mid- to late 2000s investments in secondary U.S. markets may fail to generate revenue or profitability on par with larger, more developed markets in main commercial centers. Recent product acquisitions may prove more difficult to integrate and cross-sell than anticipated. Industry consolidation among CoStar's clients or prospects could hurt CoStar by creating larger firms that can bargain for better pricing under larger contracts.

We view CoStar's biggest potential competitive threat as coming from an organization that develops a commercial real estate data collection capability that reduces the need for feet-on-the street researchers. Such a threat could conceivably emerge from the likes of Bloomberg, Google, Zillow, Trulia, a commercial real estate broker industry group, or a technology startup. If successful, such a data-collection capability could allow a potential competitor to provide data at a lower cost than CoStar could.

Also, LoopNet had an investment in Xceligent, a small, regional CoStar competitor. As part of its acquisition of LoopNet, CoStar was required to sell this interest and Xceligent also received incremental capital for growth, potentially positioning it to become more of a competitive threat.

As Much as We Like the Company, the Stock Is Overvalued
We believe CoStar has established itself as the leading provider of information, research, analytics, and marketing services to the commercial real estate industry, positioning itself as a one-stop shop for the vital tools industry participants need to do their jobs. As the clear leader providing necessary data and services, CoStar enjoys a wide moat with the opportunity to expand its influence by broadening its service offerings.

Our $85 fair value estimate represents 36 times our 2013 adjusted EPS forecast of $2.37 per share, and implies a market cap of $2.4 billion, which is 5.5 times our 2013 revenue forecast of nearly $440 million. At its current price around $168, CoStar's stock looks materially overvalued to us.

We expect CoStar's organic revenue growth rate, which was 13% in the first quarter of 2013, to range between 11% and 13% on average across our five-year forecast, driven by continued success cross-selling products and services between LoopNet's and CoStar's customer bases and fueling margin expansion. This puts our near-term forecasts slightly ahead of management's goal of exiting 2014 on an annualized run rate of $500 million in revenue at an adjusted EBITDA margin of at least 30%. Our five-year forward forecast is consistent with management's goal of hitting $800 million in annualized run-rate revenue by the end of 2017; however, we incorporate incremental acquisitions that contribute roughly $80 million in annual revenue at a cost of 2 times sales to assist the firm in hitting this target.

It is difficult to peg CoStar's long-term operating metrics, given its high growth and huge margin expansion potential, so we assign the firm a high fair value uncertainty rating. In our scenario analysis, we consider a range of more bearish and bullish assumptions that result in possible fair value estimates between $51 and $131 per share.

Todd Lukasik does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.