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Edited Transcript of CSGP earnings conference call or presentation 27-Apr-17 3:00pm GMT

Thomson Reuters StreetEvents

Q1 2017 CoStar Group Inc Earnings Call

WASHINGTON May 5, 2017 (Thomson StreetEvents) -- Edited Transcript of CoStar Group Inc earnings conference call or presentation Thursday, April 27, 2017 at 3:00:00pm GMT

TEXT version of Transcript


Corporate Participants


* Andrew C. Florance

CoStar Group, Inc. - Co-Founder, CEO, President and Director

* Richard Simonelli

CoStar Group, Inc. - VP of IR

* Scott T. Wheeler

CoStar Group, Inc. - CFO


Conference Call Participants


* Andrew William Jeffrey

SunTrust Robinson Humphrey, Inc., Research Division - Director

* Brandon Burke Dobell

William Blair & Company L.L.C., Research Division - Partner and Group Head of Global Services

* Brett Richard Huff

Stephens Inc., Research Division - MD

* Jackson Edmund Ader

JP Morgan Chase & Co, Research Division - Analyst

* Mayank Tandon

Needham & Company, LLC, Research Division - Senior Analyst of IT Services of Financial Technology

* Peter Corwin Christiansen

Citigroup Inc, Research Division - VP and Analyst

* William A. Warmington

Wells Fargo Securities, LLC, Research Division - MD and Senior Equity Analyst




Operator [1]


Ladies and gentlemen, thank you for standing by, and welcome to the CoStar Group First Quarter 2017 Earnings Call. (Operator Instructions) And as a reminder, this conference is being recorded.

I'd our now like to turn the conference over to our host, Mr. Rich Simonelli. Please go ahead, sir.


Richard Simonelli, CoStar Group, Inc. - VP of IR [2]


Thank you very much, operator, and welcome to CoStar Group's first quarter 2017 conference call. We're glad you're joining us today.

Before I turn the call over to Andy Florance, our CEO and Founder; and Scott Wheeler, our CFO, I have some new and important facts to convey to you.

Certain portions of our discussion may contain 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 include, but are not limited to, those stated in our April 26, 27 press release, on our first quarter results and in our filings with the SEC including our most recent annual report on Form 10-K 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 whether as a result of new information, future events or otherwise.

Reconciliation to the most directly comparable GAAP measure to all of the non-GAAP financial measures discussed on this call, including but not limited to, non-GAAP net income, EBITDA, adjusted EBITDA and forward-looking non-GAAP guidance are shown in detail in our press release issued yesterday, which is also available on our website located at costargroup.com.

As a reminder, today's conference call is also being broadcast live and in color on our website where you can also find CoStar's Investor Relations page. Please refer to yesterday's press release on how to access the replay of this call.

Also, during the question-and-answer session, you'll get one question, so make it a good one. Time permitting, you can always requeue.

At this time, I'd now like to now turn the call over to Andy Florance. Andy?


Andrew C. Florance, CoStar Group, Inc. - Co-Founder, CEO, President and Director [3]


Thank you, Rich. That was some riveting content. I'm sure our listeners will be talking about it for days.

So good morning, and thank you for joining us for our first quarter earnings call. We've got some great numbers to report to you today.

Revenue in the first quarter of 2017 was $227 million, up 13% versus the first quarter of last year. Brexit had an unfavorable foreign currency impact on our revenue growth, and if excluded, our revenues were up 14% year-over-year in local currencies.

Our flagship product, CoStar Suite, turned in solid organic revenue growth of 13% year-over-year. Multifamily revenue was up 22% over the first quarter of last year. Revenue growth in commercial property and land accelerated to 13% year-over-year.

With all of our key growth drivers turning in very strong results, we accelerated to our best quarterly sales bookings ever. Net new bookings rose 18% from the prior quarter to $35 million in the first quarter.

Our sales team has now reached 718 strong, up 40% from the first quarter last year. The commercial property and rural land advertising sales teams have seen the most dramatic growth in the past year. Those sales teams now have 135 sales professionals, up 73% from 1 year ago. As a result, the commercial property and land sales bookings number increased 77% year-over-year to reach $7.3 million in the quarter.

Sales bookings for the quarter in Europe and Canada increased 67% year-over-year to $1.2 million.

We added 81 customer relationship managers this past year. Our investment in CRMs is creating more time for our field sales team to hunt for new sales and cultivate clients with the most upside potential. Our relationship managers are aggressively meeting with our existing clients and have reached 36,000 clients this past year. These visits are directly resulting in more usage of our services. For example, we have seen a 24% increase in the creation of lease analysis models after training, and clients produced 13,000 more market analytics reports in the quarter. More usage is great for renewals. This new group of CRMs will play a key role in cross-selling LoopNet to CoStar clients and CoStar to LoopNet clients.

When we acquired Apartments.com, we introduced a new tiered advertising plan that has been very successful in driving revenue growth. We offer silver, gold, platinum and diamond ad levels. The advertisements sort by their ad level, and the ad level also determines the size of the ad along with various other advantages. Diamond ads receive orders of magnitude more exposure than do silver ads. Accordingly, a diamond ad might cost 5x what a silver ad costs.

We recently introduced tiered advertising pricing for advertisers listing properties on LoopNet. The early returns are in and they are really quite good. In the first quarter of 2017, we generated approximately $3 million of net new bookings from tiered ads on LoopNet. In the first quarter of 2017, our family of websites drew an all-time high of 33 million average monthly unique visitors. That's up 24% from the prior quarter and that is more than triple the traffic we were drawing just 3 years ago.

Our advertise -- or I'm sorry, our investments in multifamily space over the past 2.5 years have transformed Apartments.com into a very strong business with fantastic traffic. The competition is reeling and we are capitalizing as we continue to generate more revenue and take more share in multifamily advertising than any other competitor. Our annual multifamily revenue run rate is now approximately $260 million. We believe we are the clear #1 apartment Internet listing service based on a combination of traffic, SEM traffic, SEO, total advertised communities, leads delivered, brand recognition and revenue. In the first quarter of 2017, visits and unique visitor traffic reached all-time highs for Apartments.com and our multifamily network as we continued to expand our lead over the competition. We increased visits 26% year-over-year in the first quarter to nearly 42 million average monthly visits.

For the Apartments.com network, average monthly unique visitors increased 21% year-over-year to 23 million. According to comScore, Apartments.com has been #1 in visits for 25 months and unique visitors for 21 months.

We are beginning our third consecutive year of our major national Apartments.com marketing campaign. Our investment in these 3 years well exceeds $300 million. We have been highly successful in building a nationally-recognized brand with this investment, and you can see the traffic results.

As we begin the 2017 campaign, we feel we are going to get more value for the same advertising dollars. We're getting more efficient. We plan to run approximately 10,000 TV spots along with major digital campaigns and aggressive SEM campaign. We expect to run nearly twice the number of commercials we ran last year, spending roughly the same dollars.

We are also planning to continue to advertise on major TV networks for 20 weeks in 2017 compared to 14 weeks in 2016. In 2017, we expect to reach 90% of U.S. households, delivering over 5 billion impressions.

Recently, we commissioned an independent third-party research firm to conduct a survey of 500 property managers and advertising decision-makers involved in marketing apartment properties. This survey revealed a number of positive figures. When asked to list the top-of-mind listing services on an unaided survey, 2/3 of property managers named Apartments.com as the place to advertise their apartments for rent. At 66%, we have the highest unaided awareness of all the apartment marketing websites. We had risen from 54% the prior year to 66%. At 66%, our unaided awareness score was higher than Apartment Guide's 38%; ForRent's 31%; Craigslist 30%; and Zillow's 29%. Our score as the most effective site was the highest, nearly twice the second highest score and more than 5x the fifth-place site score. Our Net Promoter Score from property managers tripled from last year to a score of positive 30. Every other competitor had a negative Net Promoter Score and most of them were double-digit negative.

Final proof that our ad campaign is driving B2B awareness is measured by the fact that nearly 70% of the property managers surveyed knew our slogan, "Change Your Apartment, Change the World."

In February of 2017, we launched Apartamentos.com, a professional Spanish-language version of Apartments.com. We initiated a national TV campaign to promote the site on Telemundo and Univision combined with local TV in prime time in the top 10 Hispanic markets, running over 50 spots per week.

We have also used digital channels including social media display and retargeting ads in SEM support. We've also benefited from very positive coverage in the major Latino media. So far, the site has received over 1 million visits and 5 million property views.

As of April 17, 2017, in the top 30 Hispanic markets in the United States, we moved into the #1 search position for organic searches on Google using the word -- keyword Apartamentos. This is another value add that we are offering our clients and it's great news for the 32 million Hispanics who rent in the United States and who make up approximately 20% of the U.S. rental market. The client reaction to our Spanish site has been very positive.

Since closing on our acquisition of WestsideRentals in Southern California on January 31, we have added all of the WestsideRental availabilities to Apartments.com, making the site even more comprehensive and valuable to renters searching our site in Los Angeles. Conversely, paid advertising from Apartments.com is being displayed on the WestsideRentals site.

Organic WestsideRentals listings are up sharply by 25% since we closed the deal and up over 100% including the Apartments.com listings. Our primary objective is to increase our share of renter traffic in the valuable Southern California market. The Los Angeles market is the largest apartment market in the country based on either search or traffic or the number of apartment buildings. Since we closed the acquisition, we have seen visits to Apartments.com from Los Angeles climb over 46%, which is almost twice the growth pace of Apartments.com in the rest of the U.S.

Finally, I can share with you today a piece of news that illustrates the transformative impact of Apartments.com on our business. For the first time in 31 years, as of the first quarter of this year, our single largest client is no longer a commercial real estate brokerage firm. Our new largest client is a leading apartment owner property manager. None of these leading clients is individually more than 2% of our revenues.

As we stated previously, we continue to make significant investments in building even higher quality content and analytics in CoStar to capture greater market share and support the LoopNet CoStar cross-selling activity we're expecting to focus on later this year.

First, over the past year and a half, we have dramatically improved and expanded our analytic capabilities. We have added 40 new analysts to track, analyze and write submarket and market reports. This team is doing a great job and has enabled us to increase the number of written market analyst reports from 1,250 to 2,400. So it basically doubled. We have moved from quarterly updates of market conditions to daily updates with all reports and forecasts updated every day to reflect the latest market conditions. We have decreased the amount of time it takes to produce our 18,000 forecasts from 3 weeks down to 3 days.

We have also decreased the amount of time it takes to update our market reports from 6 weeks to a few hours. We've gone from producing historical apartment data in quarterly increments to daily increments. We have engineered a same-store rent series that allows us to report true rent growth versus changes in rents that could be due to changes in the mix of what's being reported.

Finally, we are now harnessing the billions of user searches we have to define via collaborative filtering which buildings are truly competitive with one another. Our white paper on same-store rent series and collaborative filting -- filtering was recognized by the American Real Estate Society as a Best Paper this year. Our authors of the paper were also recognized with the Association's Scholar Practitioner prize.

We expanded our research operations by opening our new global research headquarters in Richmond, Virginia on December 1, just 5 months ago. We expected it would take us 18 months to take the center to 500 staff. Through a tremendous team effort, we have reached that level 1 year ahead of plan. Richmond is now one of our top-performing centers -- one of our largest centers and is making a major contribution to building the highest quality CoStar products possible. The esprit de corps, the enthusiasm and morale in Richmond is very strong. I firmly believe that this center will be pivotal to our success in capturing the full potential we have to upsell LoopNet information users to CoStar information services.

We now have 1,068 researchers supporting the CoStar product, up from 701 staff and 50 contractors back in December of 2015. The 304 additional headcount give us the capabilities we need to convert the LoopNet database, improve our data quality, increase our update frequency and improve our tenant-tracking databases.

More importantly, our productivity gains in the past year are remarkable. We're conducting 144% more direct broker interviews than we were back in December of 2015. The average researcher is conducting 122% more daily interviews than in the prior time period. This means we are cycling and updating our massive property database at 3x the frequency we were in December of 2015. More importantly -- much more importantly, we're capturing 172% more new listings a month, in aggregate, than we were at the end of 2015. This translates to hundreds of billions of dollars of additional potential deal value to our clients. So we're creating real value in the product that we believe we'll be able to monetize.

The establishment of our Richmond center is enabling us to build a much more accurate, comprehensive and timely database of tenants in the market occupying commercial space. This information is valuable to people analyzing market demand drivers, to owners looking for tenants to lease their buildings and brokers looking for new clients.

We have replaced our outsourced contract tenant researchers with 178 full-time employee staff in Richmond. Our in-house team is collecting broader data, but more importantly, they're on pace to interview and verify 2.8 million tenants in a year. This is an increase of 240% over what the outsourced team had produced.

I firmly believe that we have never had better content quality than we do right now. We're going to continue to improve, but I'm very happy with the progress we've made. You can't imagine how hard those researchers work to cycle these massive databases, and I want to give them a big thank-you -- a big thank-you goes out to the best research team in the world.

Our software teams are working hard to integrate the LoopNet and CoStar databases into one unified database on the back-end. That work is going really well.

We recently launched a new iPhone mobile app for CoStar in the first quarter this year and 16% of our users have already downloaded the new app. Brokers are raving about the new app. We plan a similar release for Android in the second quarter of 2017.

We're about to initiate our plan, LoopNet information to CoStar conversion. I estimate it will begin the main cross-selling effort late in the summer or early fall. We remain confident about this pacing and have a detailed go-to-market strategy in place including a combination of in-product marketing, in-product result comparisons, retargeting, direct mail and direct sales.

I believe the opportunity to sell CoStar information to LoopNet-only clients along with the opportunity to sell LoopNet marketing to CoStar-only clients is massive. Today, only 18% of the CoStar client base is utilizing LoopNet's industry-leading marketing service, Premium Lister. Conversely, only 26% of LoopNet's paying client base is subscribing to CoStar's industry-leading information service. This means there are 153,000 cross-selling opportunities within our client base.

In addition, there are hundreds of thousands of prospects that use LoopNet without paying for anything for the service that we can prospect as well. We believe that there is a revenue opportunity of hundreds of millions of dollars here, that's why we're investing so much time, effort and money into building up the quality of our content to improve our capture of this opportunity. We feel we have one solid crack at it and we want to make sure we do it right.

I'm proud that we could report a 32% year-over-year increase in net income, while at the same time making such significant investments in our sales force, our research team and our continued marketing blitz.

Rural land is a multitrillion dollar real estate asset class in the United States. It is actually about 95% of the country. CoStar currently owns and operates 2 of the leading for-sale sites in this space: landsofamerica.com and LandAndFarm.com. We believe that this is a huge area with lots of future potential and we're taking steps to increase our leadership position.

Earlier this month, we signed a definitive agreement to acquire LandWatch, another top online leader in marketing rural properties and land for sale, including hunting land, timberland, farms and ranches. The acquisition of LandWatch solidifies our position as the #1 online network of marketplaces for rural real estate as we believe the addition of LandWatch will nearly double the scale of our existing land marketplace business in terms of revenue, leads and SEO footprint. The deal is expected to close in May of 2017. In fact, I'm so excited about the potential for this land -- these land businesses, for these farm businesses, that I, in fact, went out and bought a farm. Why, I don't know. Been looking at too many farms in our land business.

Once again, we have recently successfully defended our intellectual property and have prevailed against theft of our data. As we previously announced at the end of March, we obtained a permanent injunction in litigation against Apartment Hunters. The judge ordered Apartment Hunters, which owns ApartmentHunterz.com, to pay damages of $10,000 per stolen listing and $10,000 per infringed image for a total of $760,000 which we have now received.

The courts continue to come down pretty harshly on data stealers. A couple of weeks ago, Craigslist -- and I would say justifiably. A couple of weeks ago, Craigslist won a $60 million judgment against RadPad in a copyright and breach of contract suit with Craigslist alleging unlawful collection of Craigslist's apartment data by RadPad and its third-party agents. RadPad had hired scrapers in India to harvest listings and contact data from Craigslist. After the litigation began, RadPad wound up ceasing operations.

We believe that there are similarities with cases we're involved in. You will recall we are suing Xceligent because we've uncovered tens of thousands of instances of their copyright infringement of our content. We have also brought suit against its agent, MaxVal in India and its agent Avion in the Philippines. We have collected more than 100 terabytes of evidence in connection with the case, which we believe significantly strengthens our case against them. We believe that the evidence clearly shows that Xceligent's and its agents willfully and illegally stole massive volumes of valuable content from CoStar and LoopNet. When faced with industrial scale theft of our content, we take all reasonable steps to protect our shareholders' and clients' interests. We anticipate incurring significant cost in connection with this litigation over the course of the next 2 years. We believe that it is a vital and prudent investment.

The commercial real estate markets are at a healthy level, with strong occupancy rates across the apartment, office, industrial and retail property types. That said, new construction is on the rise and it's beginning to make an impact on property market fundamentals in the apartment sector and office markets.

Also, recent job growth has been strong, which bodes well for commercial leasing activity as well as the apartment household formation that drives the apartment sector. Fortunately, CoStar is an integral part of the leasing and marketing program for building owners and managers. Therefore, the combination of a healthy economy and the need to lease space is a good situation for us.

In the office sector, vacancy rates were essentially stable at 10.3%, up slightly from 10.2% in the fourth quarter of 2016 with absorption of 10 million square feet. This level of office leasing was lower than the previous 3 quarters, which may stem from the fact that some of the companies had pushed off leasing decisions until after the presidential election.

At 19 million square feet, deliveries of new space were higher than the average of 15 million over the previous 4 quarters. That makes sense, as many markets now have rents that support new construction activity. With the rise of construction, rent growth has slowed to 2.3% for market cycle peak near the 5% level in most of 2015. So we're tracking around inflation now.

As we reported in prior quarters, apartment markets are showing signs that they're becoming increasingly competitive. Effective rent growth has dropped to 2.3% from 4.4% a year earlier, and lease up on new constructions is -- construction is slowing somewhat. The slowdown stems partly from the 225,000 new units delivering over the past 12 months, which is 50% more than the 10-year historical average, making apartments the only real estate sector in which construction is outpacing the short-term historical supply. The supply numbers we're seeing now are well below supply levels we saw in the 1960s or 1970s.

And there's also a little bit of bifurcation there where there is an abundance of supply in the upper end of the market and a real shortage in the lower end. Fundamentally, when you look at household formation and new home deliveries and new apartment construction, we have a housing shortage, if anything.

The rush of deliveries has pushed vacancies up from 6.1% to 5.6% a year earlier. Since increased apartment advertising spending is highly correlated with weaker apartment markets, a more competitive apartment market would be very good news for Apartments.com ad sales.

Investment sales activity declined slightly in the first quarter, reflecting a trend that started in 2016 with annual real estate trading volumes down about 10% from the year earlier. Investment sales activity is still at the high level compared to long-term average, about 40% above the average of the past 10 years.

We are off to a tremendous start in 2017 in all aspects of our business. We remain committed to reaching $1 billion in revenue as we [lead] 2018, Scott might say, for the year, and reaching our 40% target margin numbers.

But to give you more color and detail on this, I'm going to turn the call over to our ever-competent CFO, Scott Wheeler.


Scott T. Wheeler, CoStar Group, Inc. - CFO [4]


Why, thank you, Andy. It seems like that farm purchase has really got you confident.


Andrew C. Florance, CoStar Group, Inc. - Co-Founder, CEO, President and Director [5]


You got to be committed to your business. You got to be committed. I'm a farmer now.


Scott T. Wheeler, CoStar Group, Inc. - CFO [6]


I can't wait to see it. Yes, so we certainly had a strong start to 2017 and we're definitely excited about the trajectory of the business as we go into the year.

As Andy mentioned, the revenue for the first quarter increased 13% over the prior year, 14% excluding the impact of foreign currency movements.

Sequentially, our revenue increased $8 million in Q1 versus the fourth quarter of 2016, fueled by our strong multifamily sales results in both the fourth quarter and the first quarter of 2017. This compares to an average sequential quarterly increase of $6 million for the year in 2016.

Looking at our revenue performance by services, CoStar Suite revenue grew 13% in the first quarter of 2017 versus the first quarter of 2016, and 14% on a constant-currency basis.

As we previously discussed, we expect CoStar Suite growth rates to continue within a 12% to 13% range throughout 2017.

Revenue growth rates in the Information Services sector remained negative in the first quarter of 2017, as expected, as we continue to wind down the LoopNet information products ahead of the planned integration with CoStar Suite. We expect Information Services revenue to decline at mid- to high-single-digit rates in the second quarter of 2017 and in the low-double-digit rates in the second half of the year. We expect full-year revenue in Information Services to decline in the 9% to 11% range as we communicated in February.

We had a great first quarter in multifamily as revenue increased 22% year-over-year. This is consistent with our 2016 full-year pro forma growth and is at the high-end of our guidance range.

Revenue contributions from WestsideRentals of approximately $0.5 million in the quarter was not material, as expected, and this will wind down as we complete the transition of WestsideRentals to the Apartments.com advertising model.

Based on our very strong sales performance, we're raising our full-year 2017 growth expectations for multifamily revenue to a range of 21% to 23%, up 100 basis points from our previous guidance.

Rounding out our service performance. Commercial property and land grew 13% year-over-year in the first quarter of 2017, which is an increase above the 11% revenue growth we reported in the full year and in the fourth quarter of 2016. The improved growth rates are a result of our investment in additional sales resources that Andy mentioned and they're focused on selling our LoopNet Premium Lister and our tiered advertising products to property owners. We expect the growth trajectory in this business to continue to accelerate organically to a range of 12% to 14% for the full year of 2017, an increase from our previous guidance range of 10% to 12%.

When we include the revenue from the pending acquisition of LandWatch, we expect the commercial property and land sector to now grow in a range of 15% to 18% for the year.

Our gross margin came in at 77% in the first quarter, down from 79% in the fourth quarter of 2016 and slightly above our expectations. The vast majority of our cost of revenues relates to our research operations, which we continue to expand with our new research center in Richmond, Virginia. The improvements in our research performance have been impressive, and we expect to reach our research staffing goals by the end of the second quarter. Accordingly, we expect gross margins to moderate in 2017 within the 75% to 78% range that we communicated previously as we scale up our team in Richmond.

Operating expenses for the first quarter were in line with our expectations and reflect the continued investments we're making in the business. This includes the cost of our expanded sales force, additional technology resources, focused both on our products and our research processes and the addition of operating costs for WestsideRentals.

Now let's take a look at some of the performance metrics for the quarter. As Andy mentioned, our sales force delivered $35 million in net bookings in the first quarter of 2017, despite continued negative net bookings from Information Services. We're making great progress towards our planned integration and cross-sell efforts of LoopNet and CoStar, which we expect to commence in late summer or early fall. Consistent with the guidance we provided in February, the cross-selling of LoopNet users to CoStar is not expected to have a material impact on our 2017 sales and revenue results, but represents a huge opportunity for the business going forward.

The renewal rates on annual contracts was 90.3% in the first quarter of 2017, so it's up slightly from the 90.1% in the first quarter of 2016, and 10 basis points below the renewal rate achieved in the fourth quarter of 2016. We expect the renewal rates to moderate slightly in future periods due to the increased scale of our multifamily products, which currently have a lower renewal rate as compared to CoStar Suite contracts. The renewal rates for CoStar Suite remain strong and continue to perform at a high 93% to 94% rate, very consistent over time.

The renewal rate for customers who've been subscribers for 5 years or longer was an impressive 97.4%. Subscription revenue on annual contracts accounts for 78% of our revenue in the quarter, and this is up from 74% at this time last year.

I will now discuss our outlook for the full year and the second quarter of 2017. Based on the strong sales and revenue performance in the first quarter, along with the expected LandWatch acquisition, we're raising our top line outlook by $10 million. We now expect revenue in the range of approximately $945 million to $955 million for the year, representing an increase in the expected growth rate to 13% to 14%. This revised outlook includes an organic revenue increase of $5 million and an increase of approximately $5 million in revenue associated with the expected LandWatch acquisition. Our guidance estimates assume the acquisition closes in May.

We expect revenue for the second quarter of 2017 in the range of $233 million to $235 million, representing top line growth of around 13% at the midpoint. This outlook includes approximately $1 million of LandWatch revenue for a partial quarter.

In terms of earnings, we're raising our guidance range for the full year 2017 to approximately $4.30 to $4.40 for non-GAAP net income per diluted share. This is based on 32.7 million shares. This includes an increase of $0.10 per share related to the strong organic revenue increase, substantially all of which is converting to earnings. Also included in the increase is an additional $0.02 per share for the expected LandWatch acquisition.

For the second quarter of 2017, we expect non-GAAP net income per share in a range of $0.58 to $0.64, and adjusted EBITDA in the range of $40 million to $43 million. We expect the second quarter to be the low point for adjusted EBITDA margins for the year as we increase our marketing spend for the start of the peak apartment rental season.

As in prior years, our marketing spend fluctuates from quarter-to-quarter and we expect total marketing costs for the year to be in line with the guidance we gave in February and similar to our marketing spend in 2016. Margins are expected to increase sequentially through the third and fourth quarters and we expect to exit 2017 with adjusted EBITDA margins above 35% and above the Q4 2016 margins.

Costs associated with the Xceligent litigation were approximately $3 million in the first quarter. We continue to expect costs in the range of $10 million to $20 million for the year. Our guidance ranges have not changed from what we communicated in February and they include $15 million in legal costs for the year, and $4 million in the second quarter related to this matter.

Overall, I'm very pleased with the pace of our sales improvements and the success of our investment programs in the first quarter of 2017. We certainly remain on track to reach our stated goal of achieving a 40% adjusted EBITDA margin exiting 2018.

With that, I will now open the call to questions and start searching for my own farm.


Questions and Answers


Operator [1]


(Operator Instructions) And we'll go to the line of Bill Warmington with Wells Fargo.


William A. Warmington, Wells Fargo Securities, LLC, Research Division - MD and Senior Equity Analyst [2]


So for my one question, I wanted to ask about the apartment market. In 2 parts, the first being, you have this theory that with the slower apartment market would be positive for advertising. And I wanted to see whether you actually were seeing a pick-up in spend as vacancies go up? And the second was, you're sitting on almost $600 million in cash, are you thinking about deploying it into the apartment market?


Scott T. Wheeler, CoStar Group, Inc. - CFO [3]


Can you say it one more time? So first of all, Bill, keeping it all in context, so yes, we see correlation -- we've looked at this in different ways and we have seen correlation where -- when occupancies are weak in apartments, people spend more to market them. What they're spending to market their apartment communities is de minimis relative to the value (inaudible). And you need to keep those occupancy levels in order to make your mortgage commitments and you'll be pretty aggressive to make sure you drive lead flow in a soft market. So we do feel there's a correlation. However, putting this in context over the last 30 years, the apartment market is still very, very robust. The vacancy levels we're talking about now are very low. They're well below long-term averages. I actually think that we bring new inventory in at the top of the market, then it filters down to the lower-income units over time. And the rates at the lower income end of the market are climbing at 5% year-over-year right now and the vacancy rates there are very, very low. So I think that -- and we're also -- I think we're delivering about 0.6 of housing units across a single home and multifamily right now for every household formed. So I think we are still in a pretty significant housing shortage overall. So while you see some softening, it's really de minimis. In terms of our belief that there's more value for us in the multifamily industry, absolutely. We're thinking we're at the very beginning of this opportunity and we've made some investments. We think they've paid off. We do have $600 million in cash and we would look for ways to take advantage of our strong market position, enhance that position, add more value on top of that or solidify it. So it is something we keep an eye on.


Operator [4]


And our next question in queue will come from Andrew Jeffrey with SunTrust.


Andrew William Jeffrey, SunTrust Robinson Humphrey, Inc., Research Division - Director [5]


It sounds, Andy, like you're pretty bulled up, and rightly so on the returns, you think you can get from the Richmond research center and the investments you've made there. Could you just talk a little bit about sort of whether or not we've seen any of those benefits to date in bookings? I think you touched on it a little bit. And how that might progress in 2017 and into 2018? Just in the core business, even forgetting about the cross-sell opportunity. I'm just wondering stand-alone, how you think about the returns on that investment and what it might mean for growth.


Andrew C. Florance, CoStar Group, Inc. - Co-Founder, CEO, President and Director [6]


Sure. So yes, I think we do. So as I have been looking at some of the really strong sales results we've had in last quarter so, I can't definitively create a formula that proves X resulted in Y. But I have thought on multiple occasions that this dramatically better research quality, which has come with an investment, has resulted in these higher sales. And one of the things that's happening is just the volume of communication our researchers are having with people in the industry and the higher quality training they and the better job they do at branding the value of our marketplaces. Just positions CoStar and LoopNet higher in the minds of these prospects, which I think translates to sales.

So our research operations, when they're having these conversations with people about how they can put their listings in front of the biggest market of buyers and lessors of real estate ever created, it sparks the imagination of that person with the listing and I believe that shows up in those people buying product from either LoopNet or CoStar down the road. So I think our research department is not a research department.

I think it's actually a marketing department of some nature. So the -- and when we go into 2017 and 2018 -- when we go into later half of 2017 and 2018, I still think it can't be separated from the LoopNet, CoStar cross-sell opportunity. These folks build relationships with people in commercial real estate. They will help position our products for the cross-selling. We can quickly adapt any positioning we need to do overnight with tens of thousands of communications a day through that research department. And then, ultimately, when we present someone who's been using LoopNet as an information product for years with a strong value proposition to upgrade now to CoStar information having just infinitely better information that CoStar product, with really good tenant information, I believe will result in dramatically higher sales. So did that -- was there a second part of the question I missed there? I got so excited about our research department, I started droning on.


Andrew William Jeffrey, SunTrust Robinson Humphrey, Inc., Research Division - Director [7]


No, that was the question.


Operator [8]


The next question line will come from Sterling Auty with JPMorgan.


Jackson Edmund Ader, JP Morgan Chase & Co, Research Division - Analyst [9]


Great, this is Jackson on for Sterling this morning. You guys mentioned the integration between LoopNet and CoStar on the back-end is going well. Can we just quickly get some more detail on that on what has already been done, what still needs to be done, and any kind of time frame you can put around what needs to be done?


Andrew C. Florance, CoStar Group, Inc. - Co-Founder, CEO, President and Director [10]


Sure. So the most, to me, the most important thing -- sure, there is a technical and component where everything in the LoopNet product has to be rewritten to address a new back-end database. There are hundreds of routines and systems that had to be rebuilt to look at a common system. You had to come up with methodological standardization between what was in LoopNet and CoStar. It's a pretty big technical load. We are through the majority of that. One of the more challenging things we had to do -- not to just do the integration, but to do the integration really well and capture as much value as possible, is we had to increase our research firepower and make sure that what went into that conversion, that the quality of the product that people were evaluating was as good as possible. So I think the biggest accomplishment is having nearly tripled the research flow by hiring hundreds of new people, standing up new centers, negotiating tax breaks, multiple leases, so on and so forth. That was a lot of work. We've interviewed thousands and thousands and thousands of people to build that team. So that one is in place, and I think that you'll get the peak value of that research investment in quality. We'll start to get to where we want to be in June of this year -- is where you really hit the full stride of that investment.

You probably will want cycle for a month or so at that level before you really unleash the sales force to go have 50,000 demos. And we also have built the CRM system -- the CRM team, which is important to do the integration and trainings that we expect will happen. And then, we have gotten the sales force up dramatically and scaled to be able to address the opportunity. We are adding some additional features to CoStar to make the product even more attractive to people considering investing more to get the CoStar information solution. We've probably completed -- we've completed a significant amount of the marketing to support it and we're going to do a little bit more there. We are in a place where there's nothing magical about April 30th or June 10th or July 5th. This is a once-in-a-lifetime opportunity to try to pull together 2 major ecosystems of commercial real estate and design it such that you have the best possible outcome and we're more concerned with doing it really, really well than doing it really, really quickly. So we are editing now, basically. We're not authoring, we are editing. And we're editing and good writing, as you know, would be editing, editing and editing. So that's where we are.


Operator [11]


And our next question will come from Brandon Dobell with William Blair.


Brandon Burke Dobell, William Blair & Company L.L.C., Research Division - Partner and Group Head of Global Services [12]


Focusing on the information suite, the core business, for a second. Given the net new momentum and recognizing the currency headwind, what's to stop that business from seeing an acceleration in organic growth as you work through the year? And I guess, maybe include that a little broader lift up, keep the combination of I guess, Information Services and kind of the core suite business from seeing acceleration to work through this year into next year?


Andrew C. Florance, CoStar Group, Inc. - Co-Founder, CEO, President and Director [13]


I love the way you say net new momentum. We call it the NNM. The nice thing is we are getting this increase in momentum before we actually launch the main effort, right? So this is in advance of what we felt would be the real net new momentum driver, which is the formal LoopNet integration execution. So there is -- if that integration is successful, you could see some momentum gains. But in addition, you also -- it's a pretty big landmark here that now an owner is our biggest client, rather than a broker. So as that trend continues and as our analytics improve and we get deeper penetration in the owner audiences, lender audiences, investor audience, that also is a potential accelerator.


Scott T. Wheeler, CoStar Group, Inc. - CFO [14]


And just putting some context to the financial side, Brandon. In the second quarter last year, the currency started to move. So we won't see much movement in Q2, but obviously, that drops away for Q3 and we'll pick up that percentage point and so the whole business will then see momentum in the back half as we start doing cross-sell. Although we really haven't built-in any cross-sell uplift at all in the numbers in the back half and we're going to let the business get the software done and ready to go and in the market and then we'll see what happens to the fourth quarter.


Andrew C. Florance, CoStar Group, Inc. - Co-Founder, CEO, President and Director [15]


And if Frexit occurs, we have de minimis exposure to the French (inaudible).


Operator [16]


And our next question will come from Brett Huff with Stephens.


Brett Richard Huff, Stephens Inc., Research Division - MD [17]


I have a bigger picture question on margin. One of the things in talking with investors that some -- that folks are trying to figure out is, what happens to the 40% pro forma EBITDA margin give or take exiting 4Q 2018 as we go forward? As folks are trying to work on their DCFs, there's some debate as to whether or not that remains at 40%. If it goes up a little bit, if it goes down a little bit depending on investments. But I think that's one of the things that folks are really trying get their head around. And I'm wondering if you guys could just give us some color on it. Or maybe even a more precise answer?


Andrew C. Florance, CoStar Group, Inc. - Co-Founder, CEO, President and Director [18]


I'd be happy to take a shot at that and let Scott also address it. But the natural state of our business, if you look at every component of the business we're addressing, right here, is a very high incremental dollars -- of EBITDA or margin dollars on each sale. So as we add another ad contract, as we add another information subscription, the super high margin sales. So the natural state of the business -- when you're at that 40% margin in 2018, that margin would naturally grow to 50%, 60%, 70% and higher. I'm not sure that -- we, by no means, have run out of things to do in the business or ways to reinvest that capital and create more value. So we would be looking for good investment opportunities with the margin growth above that 40%. I don't think this is a time to sort of stop when we're 1/3 of the way through the opportunity and clip coupons. But at the same time, the scale of the margins we're talking about at 40%, 5% -- the spread between 40% and 45% margins gives you an awful lot of firepower to invest in the business. And I'll let Scott say something completely different.


Scott T. Wheeler, CoStar Group, Inc. - CFO [19]


Of course, we haven't laid out our investment or spending plans for 2018 yet, and that will come down the road. And of course, I haven't done anything for 2019. But you certainly can expect that the seasonal pattern of margins will continue, given the size and the scale of apartments business will continue to grow. And so you'll always see this lower margins in the first quarter dropping in the second and then picking up to the latter half of the year. So after the 40% hits in Q4, you'd expect it would naturally go down a couple of quarters and come back up even if we kept the average for the year the same. As Andy said, there's a lot of leverage that will come through when you're growing $120 million in revenue a year with very high drop-throughs and you'll have a lot of acquisition firepower from the cash that brings in. Or else, we can continue to invest organically. So we'll lay those plans out. We'll let you know. But there's certainly potential to let margins continue after that, or if we fail, there's great investments either organically or acquisition-wise, we'll talk about those and make sure everyone understands why they are more valuable for us in the long term than trying to sustain a margin for the short term.


Operator [20]


And the next question will come from Peter Christiansen with Citi.


Peter Corwin Christiansen, Citigroup Inc, Research Division - VP and Analyst [21]


I was wondering if you could give us a sense of -- in the multifamily side, if we look at revenue growth there, how much of that is -- given the occupancy trends -- is that revenue per building versus actually attracting new buildings onto the platform? And then as a follow-up, given the fact that you are taking quite a bit of market share in recent times, have you seen any changes in the behavior from some of your competitors as it relates to pricing?


Andrew C. Florance, CoStar Group, Inc. - Co-Founder, CEO, President and Director [22]


Yes, we -- when you look at where that growth is coming from, I would say first and foremost, the traffic advantages we have right now over other sites -- the traffic advantages are huge. And the change that's occurred in the last 5 years, 3 years, 2 years, is dramatic. So Apartments.com has more than doubled, tripled its traffic. So people have large budgets assigned to or allocated to marketing solutions that are no longer the best value for their dollar. So I think a lot of what's happening is basically people shifting from older, less effective solutions over to Apartments.com. And there's a lot -- there's tens of thousands of properties that are [still back], spending more money to get less exposure. I do think that puts downward pressure on pricing -- competitor's pricing. And when you look at the exact mix for us, it's about the 22% year-over-year organic growth, 15% is volume, people switching from older, less effective solutions to Apartments.com and 7% of that growth is price mix. People bringing up the exposure level of their property and trying to drive more leads in the door. So it's about 66% or 2/3 share gain and 1/3 price gain. And I think that will continue for a while.


Operator [23]


And our last question we have in queue at this time will come from Mayank Tandon with Needham and Company.


Mayank Tandon, Needham & Company, LLC, Research Division - Senior Analyst of IT Services of Financial Technology [24]


I had a quick question on apartments, sort of high-level. Andy, if you could just talk about where you are in terms of penetration today, whether it's in terms of number of units or in dollar value terms? And especially in light of the fact that you now have presence in the smaller units segment, what does that mean in terms of market share for you today?


Andrew C. Florance, CoStar Group, Inc. - Co-Founder, CEO, President and Director [25]


Sure. You can get me rolling on a really certain -- a nerdy discussion of penetration at each level. But some real important trends here. When we acquired Apartments.com, 98% of their revenue was from properties with 130 units or more, which is the upper, upper half of the apartment industry. So if you have 44 million units out there, 17 million -- I'm sorry, 24 million might be institutional, maybe 12 million are in the -- in that larger unit mix size. So that traditionally, the businesses, because they had that print history of expensive fixed costs of print, the industry really addressed the 130 unit-plus area. We are seeing tremendous growth in the -- all the way down to the 40 units, 30 units and that's a huge piece of the market. So I was looking at some stats the other day where a lot of our growth was in that lower area. And I think we can be successful all the way down to 10 units, 15 unit properties. So that'll go for a long time and that doubles the size of the market ultimately. The other thing is that as we get deeper penetration in the apartment space and we have a bigger and bigger share of that institutional market, say the 100 units-plus, we have a fantastic opportunity to layer additional services on top of that user flow. So if you have -- we now have a very significant share of apartment hunters in the United States using our product to find their apartment. Millions and millions of people are finding their apartments on Apartments.com. That is 110 million Americans and growing, that's $700 billion plus of spending. Folks are in the market every 18 months typically to find a new apartment. There's a lot we can do with that traffic in that position that doesn't require us to sign up new apartments, though I'm pretty confident we will continue to sign-up lots and lots of new communities over the years to come.


Operator [26]


And currently, we have no more further questions in queue.


Andrew C. Florance, CoStar Group, Inc. - Co-Founder, CEO, President and Director [27]


Great. Well thank you, everyone, for joining us for this first quarter earnings call, and we look forward to updating you on our progress next quarter.


Operator [28]


And that does conclude our conference for today. Thanks for your participation, and thank you for using AT&T Executive Teleconference service. You may now disconnect.