Master Copy CSGP-9.30.2013-10Q


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
[X]   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2013
 
OR
 
[  ]   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ______ to ______
 
Commission file number 0-24531
 
CoStar Group, Inc.
(Exact name of registrant as specified in its charter)
Delaware
 
52-2091509
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
 
1331 L Street, NW
Washington, DC 20005
(Address of principal executive offices) (zip code)
  
(202) 346-6500
(Registrant’s telephone number, including area code)
 
(877) 739-0486
(Registrant’s facsimile number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o
  
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x  No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Securities Exchange Act of 1934.
Large accelerated filer  x
Accelerated filer  o
Non-accelerated filer  o
(Do not check if a smaller reporting company)
Smaller reporting company  o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No x
  
As of October 18, 2013, there were 28,756,248 shares of the registrant’s common stock outstanding.




COSTAR GROUP, INC.

TABLE OF CONTENTS
 
PART I
 
FINANCIAL INFORMATION
 
 
 
 
 
Item 1.
 
Financial Statements                                                                                                    
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
 
 
Item 3.
 
 
 
 
 
Item 4.
 
 
 
 
 
 PART II
 
OTHER INFORMATION
 
 
 
 
 
Item 1.
 
 
 
 
 
Item 1A.
 
 
 
 
 
Item 2.
 
 
 
 
 
Item 3.
 
 
 
 
 
Item 4.
 
 
 
 
 
Item 5.
 
 
 
 
 
Item 6.
 
 
 
 
 
   Signatures                                                                                                                          



2



PART I — FINANCIAL INFORMATION

Item 1.
Financial Statements

COSTAR GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Revenues                                                                          
$
112,301

 
$
96,001

 
$
325,333

 
$
249,853

Cost of revenues                                                                          
31,724

 
30,882

 
97,431

 
83,388

Gross margin                                                                          
80,577

 
65,119

 
227,902

 
166,465

 
 
 
 
 
 
 
 
Operating expenses:
 

 
 

 
 

 
 

Selling and marketing                                                                       
23,625

 
22,010

 
74,139

 
57,576

Software development                                                                       
11,562

 
9,722

 
35,152

 
22,714

General and administrative                                                                       
21,940

 
19,617

 
74,457

 
59,602

Purchase amortization                                                                       
3,680

 
4,824

 
11,699

 
9,038

 
60,807

 
56,173

 
195,447

 
148,930

Income from operations                                                                          
19,770

 
8,946

 
32,455

 
17,535

Interest and other income
52

 
59

 
239

 
440

Interest and other expense
(1,736
)
 
(1,822
)
 
(5,249
)
 
(3,022
)
Income before income taxes                                                                          
18,086

 
7,183

 
27,445

 
14,953

Income tax expense, net                                                                          
7,034

 
404

 
10,510

 
9,752

Net income                                                                
$
11,052

 
$
6,779

 
$
16,935

 
$
5,201

 
 
 
 
 
 
 
 
Net income per share — basic                                                                          
$
0.40

 
$
0.25

 
$
0.61

 
$
0.20

Net income per share — diluted                                                                          
$
0.39

 
$
0.24

 
$
0.60

 
$
0.19

 
 
 
 
 
 
 
 
Weighted average outstanding shares — basic                                                                          
27,758

 
27,243

 
27,607

 
26,279

Weighted average outstanding shares — diluted
28,349

 
27,673

 
28,137

 
26,691


See accompanying notes.


3



COSTAR GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)
(unaudited)

 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2013
 
2012
 
2013
 
2012
Net income
 
$
11,052

 
$
6,779

 
$
16,935

 
$
5,201

Other comprehensive income, net of tax
 
 
 
 
 
 
 
 
Foreign currency translation adjustment
 
1,652

 
1,014

 
20

 
1,286

Net change in unrealized gain on investments, net of tax
 

 
727

 
63

 
672

Total other comprehensive income
 
1,652

 
1,741

 
83

 
1,958

Total comprehensive income
 
$
12,704

 
$
8,520

 
$
17,018

 
$
7,159


See accompanying notes.


4



COSTAR GROUP, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
 
September 30,
2013
 
December 31,
2012
ASSETS
(unaudited)
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
222,938

 
$
156,027

Short-term investments

 
37

Accounts receivable, less allowance for doubtful accounts of approximately
    $3,646 and $2,935 as of September 30, 2013 and December 31, 2012, respectively
22,960

 
16,392

Deferred income taxes, net
17,115

 
9,256

Income tax receivable
1,796

 
5,357

Prepaid expenses and other current assets
10,021

 
9,560

Debt issuance costs, net
2,740

 
2,934

Total current assets
277,570

 
199,563

 
 
 
 
Long-term investments
21,675

 
21,662

Property and equipment, net
55,703

 
46,308

Goodwill
718,039

 
718,078

Intangibles and other assets, net
150,800

 
170,632

Deposits and other assets
2,044

 
2,274

Debt issuance costs, net
4,543

 
6,622

Total assets
$
1,230,374

 
$
1,165,139

LIABILITIES AND STOCKHOLDERS’ EQUITY
 

 
 

Current liabilities:
 

 
 

Current portion of long-term debt
$
21,875

 
$
17,500

Accounts payable
6,347

 
6,234

Accrued wages and commissions
18,256

 
23,831

Accrued expenses
23,498

 
19,002

Deferred gain on the sale of building
2,523

 
2,523

Deferred revenue
34,904

 
32,548

Total current liabilities
107,403

 
101,638

 
 
 
 
Long-term debt, less current portion
135,625

 
153,125

Deferred gain on the sale of building
26,917

 
28,809

Deferred rent
22,713

 
17,305

Deferred income taxes, net
35,482

 
34,071

Income taxes payable
2,915

 
2,818

Other long-term liabilities

 
1,030

Total liabilities
331,055

 
338,796

 
 
 
 
Total stockholders’ equity
899,319

 
826,343

Total liabilities and stockholders’ equity
$
1,230,374

 
$
1,165,139

See accompanying notes.

5



COSTAR GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

 
Nine Months Ended
September 30,
 
2013
 
2012
Operating activities:
 
 
 
Net income
$
16,935

 
$
5,201

Adjustments to reconcile net income to net cash provided by operating activities:
 

 
 

Depreciation
9,174

 
7,203

Amortization
21,063

 
14,996

Amortization of debt issuance costs
2,273

 
1,235

Excess tax expense (benefit) from stock-based compensation
(15,405
)
 
57

Stock-based compensation expense
32,270

 
8,667

Deferred income tax expense (benefit), net
(6,448
)
 
11,828

Provision for losses on accounts receivable
1,819

 
1,418

Changes in operating assets and liabilities, net of acquisitions:
 

 
 

Accounts receivable
(8,305
)
 
(3,612
)
Prepaid expenses and other current assets
(533
)
 
(1,848
)
Deposits and other assets
220

 
1,286

Accounts payable and other liabilities
17,413

 
4,222

Deferred revenue
2,352

 
5,905

Net cash provided by operating activities
72,828

 
56,558

 
 
 
 
Investing activities:
 

 
 

Proceeds from sale and settlement of investments
87

 
14,620

Purchases of property and equipment and other assets
(15,331
)
 
(9,002
)
Acquisitions, net of cash acquired

 
(640,929
)
Net cash used in investing activities
(15,244
)
 
(635,311
)
 
 
 
 
Financing activities:
 

 
 

Proceeds from long-term debt

 
175,000

Payments of long-term debt
(13,125
)
 
(4,375
)
Payments of debt issuance costs

 
(11,546
)
Payments of deferred consideration
(1,344
)
 

Excess tax benefit (expense) from stock-based compensation
15,405

 
(57
)
Repurchase of restricted stock to satisfy tax withholding obligations
(7,563
)
 
(3,817
)
Proceeds from exercise of stock options and ESPP
15,846

 
7,667

Net cash provided by financing activities
9,219

 
162,872

 
 
 
 
Effect of foreign currency exchange rates on cash and cash equivalents
108

 
63

Net increase (decrease) in cash and cash equivalents
66,911

 
(415,818
)
Cash and cash equivalents at the beginning of period
156,027

 
545,280

Cash and cash equivalents at the end of period
$
222,938

 
$
129,462

See accompanying notes.

6



COSTAR GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

1.
ORGANIZATION

CoStar Group, Inc. (the “Company” or “CoStar”) provides information, analytics and marketing services to the commercial real estate and related business community through its comprehensive, proprietary database of commercial real estate information covering the United States (“U.S.”) and parts of the United Kingdom ("U.K.") and France, as well as its complementary online marketplace of commercial real estate listings. The Company operates within two operating segments, U.S. and International, and its services are typically distributed to its clients under subscription-based license agreements that renew automatically, a majority of which have a term of one year.

2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. Accounting policies are consistent for each operating segment.

Interim Financial Statements

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information. In the opinion of the Company’s management, the financial statements reflect all adjustments necessary to present fairly the Company’s financial position at September 30, 2013, the results of its operations for the three and nine months ended September 30, 2013 and 2012, its comprehensive income for the three and nine months ended September 30, 2013 and 2012, and its cash flows for the nine months ended September 30, 2013 and 2012. These adjustments are of a normal recurring nature.

Certain notes and other information have been condensed or omitted from the interim financial statements presented in this Quarterly Report on Form 10-Q. Therefore, these financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

The results of operations for the three and nine months ended September 30, 2013 are not necessarily indicative of future financial results.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Reclassifications

Certain previously reported amounts in the condensed consolidated statements of operations and condensed consolidated statements of cash flows have been reclassified to conform to the Company’s current presentation.

Foreign Currency Translation

The Company’s functional currency in its foreign locations is the local currency. Assets and liabilities are translated into U.S. dollars as of the balance sheet dates. Revenues, expenses, gains and losses are translated at the average exchange rates in effect during each period. Gains and losses resulting from translation are included in accumulated other comprehensive income (loss). Net gains or losses resulting from foreign currency exchange transactions are included in the condensed consolidated statements of operations. There were no material gains or losses from foreign currency exchange transactions for the three and nine months ended September 30, 2013 and 2012.


7

COSTAR GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (CONTINUED)

2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES — (CONTINUED)

Accumulated Other Comprehensive Loss

The components of accumulated other comprehensive loss were as follows (in thousands):
 
September 30,
2013
 
December 31,
2012
Foreign currency translation adjustment
$
(4,593
)
 
$
(4,613
)
Accumulated net unrealized loss on investments, net of tax
(1,842
)
 
(1,905
)
Total accumulated other comprehensive loss
$
(6,435
)
 
$
(6,518
)
 
Net Income Per Share

Net income per share is computed by dividing net income by the weighted average number of common shares outstanding during the period on a basic and diluted basis. The Company’s potentially dilutive securities include stock options and restricted stock. Diluted net income per share considers the impact of potentially dilutive securities except in periods in which there is a net loss, as the inclusion of the potentially dilutive common shares would have an anti-dilutive effect.

The following table sets forth the calculation of basic and diluted net income per share (in thousands, except per share data):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
Numerator:
2013
 
2012
 
2013
 
2012
 
Net income
$
11,052

 
$
6,779

 
$
16,935

 
$
5,201

Denominator:
 

 
 

 
 

 
 

Denominator for basic net income per share — weighted-average outstanding shares
27,758

 
27,243

 
27,607

 
26,279

Effect of dilutive securities:
 

 
 

 
 

 
 

Stock options and restricted stock
591

 
430

 
530

 
412

Denominator for diluted net income per share — weighted-average outstanding shares
28,349

 
27,673

 
28,137

 
26,691

 
 

 
 

 
 

 
 

Net income per share — basic 
$
0.40

 
$
0.25

 
$
0.61

 
$
0.20

Net income per share — diluted 
$
0.39

 
$
0.24

 
$
0.60

 
$
0.19

 
Employee stock options with exercise prices greater than the average market price of the Company’s common stock for the period are excluded from the calculation of diluted net income per share as their inclusion would be anti-dilutive. Additionally, shares of restricted common stock that vest based on Company performance conditions were not included in the computation of basic or diluted earnings per share. Other than the shares of restricted common stock that vest based on Company performance conditions, no other potential common shares were excluded from the calculation of diluted net income for the three and nine months ended September 30, 2013 and 2012.

Stock-Based Compensation

Equity instruments issued in exchange for employee services are accounted for using a fair-value based method, and the fair value of such equity instruments is recognized as expense in the condensed consolidated statements of operations.


8

COSTAR GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (CONTINUED)

2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES — (CONTINUED)

Stock-Based Compensation — (Continued)

Stock-based compensation expense is measured at the grant date of the stock-based awards that vest over set time periods based on their fair values, and is recognized on a straight line basis as expense over the vesting periods of the awards, net of an estimated forfeiture rate. For equity instruments that vest based on performance, the Company assesses the probability of the achievement of the performance conditions at the end of each reporting period, or more frequently based upon the occurrence of events that may change the probability of whether the performance conditions would be met. If the Company's initial estimates of the achievement of the performance conditions change, the related stock-based compensation expense and timing of recognition may fluctuate from period to period based on those estimates. If the performance conditions are not met, no stock-based compensation expense will be recognized, and any previously recognized stock-based compensation expense will be reversed.

In 2012, the Company granted performance-based restricted common stock awards that vest upon the Company's achievement of $90.0 million of cumulative net income before interest, income taxes, depreciation and amortization ("EBITDA") over a period of four consecutive calendar quarters if such performance is achieved by March 31, 2017. As of September 30, 2013, the Company reassessed the probability of achieving this performance condition and determined that it was still probable that the performance condition for these awards would be met by the March 31, 2017 forfeiture date. As a result, the Company recorded a total of approximately $3.1 million and $0 of stock-based compensation expense related to the performance-based restricted common stock for the three months ended September 30, 2013 and 2012, respectively. The Company recorded approximately $17.5 million and $0 of stock-based compensation expense related to the performance-based restricted common stock for the nine months ended September 30, 2013 and 2012, respectively. The Company expects to record an additional estimated unrecognized stock-based compensation expense related to the performance-based restricted common stock of approximately $6.2 million during the remainder of 2013 and in 2014.

Cash flows resulting from excess tax benefits are classified as part of cash flows from operating and financing activities. Excess tax benefits represent tax benefits related to stock-based compensation in excess of the associated deferred tax asset for such equity compensation. Net cash proceeds from the exercise of stock options and the purchase of shares under the Employee Stock Purchase Plan (“ESPP”) were approximately $6.9 million and $2.6 million for the three months ended September 30, 2013 and 2012, respectively. Net cash proceeds from the exercise of stock options and the purchase of shares under the ESPP were approximately $15.8 million and $7.7 million for the nine months ended September 30, 2013 and 2012, respectively. The Company recorded an increase of approximately $5.7 million of excess tax benefits realized from stock options exercised and restricted stock awards vested for the three months ended September 30, 2013 compared to a reduction of approximately $57,000 to its realized excess tax benefit from stock options exercised and restricted stock awards vested for the three months ended September 30, 2012. The Company recorded an increase of approximately $15.4 million of excess tax benefits realized from stock options exercised and restricted stock awards vested for the nine months ended September 30, 2013 compared to a reduction of approximately $57,000 to its realized excess tax benefit from stock options exercised and restricted stock awards vested for the nine months ended September 30, 2012.

Stock-based compensation expense for stock options and restricted stock issued under equity incentive plans and stock purchases under the ESPP included in the Company’s results of operations were as follows (in thousands):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Cost of revenues
$
1,061

 
$
849

 
$
3,353

 
$
1,784

Selling and marketing
944

 
493

 
3,763

 
1,331

Software development
1,608

 
809

 
5,439

 
1,565

General and administrative
4,175

 
1,588

 
19,715

 
3,987

Total stock-based compensation
$
7,788

 
$
3,739

 
$
32,270

 
$
8,667

 
Options to purchase 150,560 and 76,542 shares were exercised during the three months ended September 30, 2013 and 2012, respectively. Options to purchase 340,599 and 224,382 shares were exercised during the nine months ended September 30, 2013 and 2012, respectively.


9

COSTAR GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (CONTINUED)

2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES — (CONTINUED)

Capitalized Product Development Costs

Product development costs are expensed as incurred until technological feasibility has been established, at which time such costs are capitalized. Costs are capitalized, to the extent that the capitalizable costs do not exceed the realizable value of such costs, until the product is available for general release to customers. The Company defines the establishment of technological feasibility as the completion of all planning, designing, coding and testing activities that are necessary to establish products that meet design specifications including functions, features and technical performance requirements. The Company's capitalized product development costs had a total net book value of approximately $159,000 and $302,000 as of September 30, 2013 and December 31, 2012, respectively. These capitalized product development costs are included in intangible and other assets in the Company’s condensed consolidated balance sheets. Amortization is computed using a straight-line method over the remaining estimated economic life of the product, typically three to five years after the software is ready for its intended use. The Company amortized capitalized product development costs of approximately $48,000 for each of the three months ended September 30, 2013 and 2012. The Company amortized capitalized product development costs of approximately $143,000 for each of the nine months ended September 30, 2013 and 2012.   

Debt Issuance Costs

Costs incurred in connection with the issuance of long-term debt are capitalized and amortized as interest expense over the term of the related debt using the effective interest method. The Company had capitalized debt issuance costs of approximately $7.3 million and $9.6 million as of September 30, 2013 and December 31, 2012, respectively. The debt issuance costs are associated with the financing commitment received from JPMorgan Chase Bank, N.A. (“J.P. Morgan Bank”) on April 27, 2011 and the subsequent term loan facility and revolving credit facility established under a credit agreement dated February 16, 2012 (the “Credit Agreement”). See Note 8 for additional information regarding the financing commitment with J.P. Morgan Bank and the Credit Agreement. The Company amortized debt issuance costs of approximately $760,000 and $763,000 for the three months ended September 30, 2013 and 2012, respectively. The Company amortized debt issuance costs of approximately $2.3 million and $1.2 million for the nine months ended September 30, 2013 and 2012, respectively.

Recent Accounting Pronouncements

There have been no developments to the Recent Accounting Pronouncements discussion included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012, including the expected dates of adoption and estimated effects on the Company’s condensed consolidated financial statements, except for the following:

In July 2012, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance to simplify how companies test indefinite-lived intangible assets for impairment. The guidance permits a company to first assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test. This guidance is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted. This guidance did not have a material impact on the Company's results of operations or financial position.

In February 2013, the FASB issued authoritative guidance to improve the reporting of reclassifications out of accumulated other comprehensive income. This guidance requires a company to present, either on the consolidated statements of operations or in the notes to the consolidated financial statements, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income, but only if the amount reclassified is required under GAAP to be reclassified in its entirety to net income. For other amounts that are not required under GAAP to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under GAAP that provide additional detail about those amounts. This guidance is effective prospectively for financial statements issued for interim and annual periods beginning after December 15, 2012. This guidance did not have a material impact on the Company's results of operations or financial position.


10

COSTAR GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (CONTINUED)

3.
ACQUISITIONS

On April 30, 2012, the Company acquired 100% of the outstanding stock of LoopNet, Inc. (“LoopNet”) pursuant to an Agreement and Plan of Merger dated April 27, 2011, as amended May 20, 2011 (the “Merger Agreement”). LoopNet owns and operates an online marketplace for commercial real estate in the U.S. The online marketplace enables commercial real estate agents, working on behalf of property owners and landlords, to list properties for sale or for lease and submit detailed information on property listings to find a buyer or tenant. The acquisition combines the research capabilities of the Company with the marketing solutions offered by LoopNet to create expected efficiencies in operations and provide more opportunities for the combined company's customers.

The following table summarizes the consideration paid for LoopNet (in thousands except share and per share data):
Cash
$
746,393

Equity interest (1,880,300 shares at $72.89)
137,055

Fair value of total consideration transferred
$
883,448


The Company has applied the acquisition method to account for the LoopNet transaction, which requires that, among other things, assets acquired and liabilities assumed be recorded at their fair values as of the acquisition date. The following table summarizes the amounts for acquired assets and liabilities recorded at their fair values as of the acquisition date (in thousands):

Cash and cash equivalents
$
105,464

Accounts receivable
3,021

Goodwill
625,174

Acquired trade names and other
48,700

Acquired customer base
71,500

Acquired database technology
52,100

Deferred income taxes, net
(32,623
)
Other assets and liabilities
10,112

Fair value of identifiable net assets acquired
$
883,448


The net assets of LoopNet were recorded at their estimated fair value. In valuing acquired assets and liabilities, fair value estimates are based on, but are not limited to, future expected cash flows, expected holding period of investments, market rate assumptions for contractual obligations, and appropriate discount rates.

The acquired customer base for the acquisition consists of one distinct intangible asset, is composed of acquired customer contracts and the related customer relationships, and has an estimated useful life of 10 years. The acquired database technology has an estimated useful life of 5 years and the acquired trade names have an indefinite estimated useful life. Amortization of the acquired customer base is recognized on an accelerated basis related to the expected economic benefit of the intangible asset, while amortization of the acquired database technology is recognized on a straight-line basis over the estimated useful life. The acquired trade names recorded in connection with this acquisition are not amortized, but are subject to annual impairment tests.

Goodwill recorded in connection with this acquisition is not amortized, but is subject to annual impairment tests. The $625.2 million of goodwill recorded as part of the acquisition is associated with the Company's U.S. operating segment. None of the goodwill recognized is deductible for income tax purposes.
 
Goodwill is calculated as the excess of the consideration transferred over the net assets recognized and represents the future economic benefits arising from other assets acquired that could not be individually identified and separately recognized. Specifically, the goodwill recorded as part of the LoopNet acquisition includes: (i) the expected synergies and other benefits that the Company believes will result from combining its operations with LoopNet's operations; and (ii) any intangible assets that do not qualify for separate recognition, such as the assembled workforce.

There were no acquisition-related costs recorded during the three and nine months ended September 30, 2013. There were no acquisition-related costs recorded during the three months ended September 30, 2012 associated with the LoopNet acquisition. The Company recorded $5.2 million in acquisition-related costs for the nine months ended September 30, 2012. These costs were directly related to acquiring LoopNet and were expensed as incurred and recorded in general and administrative expense.

11

COSTAR GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (CONTINUED)

3.
ACQUISITIONS — (CONTINUED)

Prior to completion of the LoopNet acquisition, on April 26, 2012, the Federal Trade Commission (the “FTC”) accepted a consent order in connection with the LoopNet merger that was previously agreed to by the Company and LoopNet. The consent order was subject to a 30-day public comment period, and on August 29, 2012, the FTC issued its final acceptance of the consent order. The consent order, which is publicly available on the FTC's website at www.ftc.gov, required, among other things, that the Company and LoopNet divest LoopNet's minority interest in Xceligent, Inc. (“Xceligent”). On March 28, 2012, the Company and LoopNet entered into an agreement to sell LoopNet's interest in Xceligent to DMG Information, Inc. (“DMGI”). The parties closed the sale of LoopNet's interest in Xceligent to DMGI on May 3, 2012. The Company received $4.2 million in proceeds from the sale, which reflected the fair value of the investment at the time of sale and resulted in no gain on the sale of the investment.

4.
INVESTMENTS

The Company determines the appropriate classification of debt and equity investments at the time of purchase and re-evaluates such designation as of each balance sheet date. The Company considers all of its investments to be available-for-sale. Short-term investments consist of government/federal notes and bonds with maturities greater than 90 days at the time of purchase. Available-for-sale short-term investments with contractual maturities beyond one year are classified as current in the Company’s condensed consolidated balance sheets because they represent the investment of cash that is available for current operations. Long-term investments consist of variable rate debt instruments with an auction reset feature, referred to as auction rate securities (“ARS”). Investments are carried at fair market value.

Scheduled maturities of investments classified as available-for-sale as of September 30, 2013 were as follows (in thousands):
Maturity
 
Fair Value
Due:
 
 
October 1, 2013 — September 30, 2014                                                                                                                
 
$

October 1, 2014 — September 30, 2018                                                                                                                
 
606

October 1, 2018 — September 30, 2023                                                                                                                
 

After September 30, 2023                                                                                                               
 
21,069

Available-for-sale investments                                                                                                                    
 
$
21,675


The Company had no realized gains on its investments for each of the three and nine months ended September 30, 2013 and 2012. The Company had no realized losses on its investments for each of the three and nine months ended September 30, 2013 and 2012.  

Changes in unrealized holding gains and losses, net of the related tax effect, on available-for-sale securities are excluded from earnings and are reported as a separate component of accumulated other comprehensive income (loss) in stockholders’ equity until realized. Realized gains and losses from the sale of available-for-sale securities are determined on a specific-identification basis. A decline in market value of any available-for-sale security below cost that is deemed to be other-than-temporary results in a reduction in carrying amount to fair value. The impairment is charged to earnings and a new cost basis for the security is established. Dividend and interest income are recognized when earned.

As of September 30, 2013, the amortized cost basis and fair value of investments classified as available-for-sale were as follows (in thousands):
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
 Unrealized
Losses
 
Fair
Value
Auction rate securities
$
23,517

 
$
164

 
$
(2,006
)
 
$
21,675

Available-for-sale investments
$
23,517

 
$
164

 
$
(2,006
)
 
$
21,675



12

COSTAR GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (CONTINUED)

4.
INVESTMENTS — (CONTINUED)

As of December 31, 2012, the amortized cost basis and fair value of investments classified as available-for-sale were as follows (in thousands):
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Government-sponsored enterprise obligations
$
37

 
$

 
$

 
$
37

Auction rate securities
23,567

 
101

 
(2,006
)
 
21,662

Available-for-sale investments
$
23,604

 
$
101

 
$
(2,006
)
 
$
21,699


The unrealized losses on the Company’s investments as of September 30, 2013 and December 31, 2012 were generated primarily from changes in interest rates. The losses are considered temporary, as the contractual terms of these investments do not permit the issuer to settle the security at a price less than the amortized cost of the investment. Because the Company does not intend to sell these instruments and it is more likely than not that the Company will not be required to sell these instruments prior to anticipated recovery, which may be at maturity, the Company does not consider these investments to be other-than-temporarily impaired as of September 30, 2013 and December 31, 2012. See Note 5 for further discussion of the fair value of the Company’s financial assets.

The components of the Company’s investments in an unrealized loss position for twelve months or longer were as follows (in thousands):
 
September 30,
2013
 
December 31,
2012
 
Aggregate
Fair
 Value
 
Gross
Unrealized
Losses
 
Aggregate
Fair
 Value
 
Gross
Unrealized
Losses
Government-sponsored enterprise obligations
$

 
$

 
$
37

 
$

Auction rate securities
21,069

 
(2,006
)
 
21,119

 
(2,006
)
Investments in an unrealized loss position
$
21,069

 
$
(2,006
)
 
$
21,156

 
$
(2,006
)

The Company did not have any investments in an unrealized loss position for less than twelve months as of September 30, 2013 and December 31, 2012, respectively.

5.
FAIR VALUE

Fair value is defined as the price that would be received in the sale of an asset or paid to transfer a liability in an orderly transaction between market participants. There is a three-tier fair value hierarchy, which categorizes the inputs used in measuring fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets for identical assets or liabilities; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs for which little or no market data exists, therefore requiring an entity to develop its own assumptions.


13

COSTAR GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (CONTINUED)

5.
FAIR VALUE — (CONTINUED)

The following table represents the Company's fair value hierarchy for its financial assets (cash, cash equivalents and investments) and liabilities measured at fair value on a recurring basis as of September 30, 2013 (in thousands):

 
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
Cash
$
136,909

 
$

 
$

 
$
136,909

Money market funds
32,338

 

 

 
32,338

Commercial paper
53,691

 

 

 
53,691

Auction rate securities

 

 
21,675

 
21,675

Total assets measured at fair value
$
222,938

 
$

 
$
21,675

 
$
244,613

Liabilities:
 
 
 
 
 
 
 
Deferred consideration
$

 
$

 
$
1,208

 
$
1,208

Total liabilities measured at fair value
$

 
$

 
$
1,208

 
$
1,208


The following table represents the Company's fair value hierarchy for its financial assets (cash, cash equivalents and investments) and liabilities measured at fair value on a recurring basis as of December 31, 2012 (in thousands):
 
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
Cash
$
135,232

 
$

 
$

 
$
135,232

Money market funds
20,775

 

 

 
20,775

Commercial paper
20

 

 

 
20

Government-sponsored enterprise obligations

 
37

 

 
37

Auction rate securities

 

 
21,662

 
21,662

Total assets measured at fair value
$
156,027

 
$
37

 
$
21,662

 
$
177,726

Liabilities:
 

 
 

 
 

 
 

Deferred consideration
$

 
$

 
$
2,304

 
$
2,304

Total liabilities measured at fair value
$

 
$

 
$
2,304

 
$
2,304


The Company’s Level 2 assets consisted of government-sponsored enterprise obligations, which did not have directly observable quoted prices in active markets. The Company’s Level 2 assets were valued using matrix pricing.

The Company’s Level 3 assets consist of ARS, whose underlying assets are primarily student loan securities supported by guarantees from the Federal Family Education Loan Program (“FFELP”) of the U.S. Department of Education.

The following tables summarize changes in fair value of the Company’s Level 3 assets for the three and nine months ended September 30, 2013 and 2012 (in thousands):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Balance at beginning of period
$
21,675

 
$
24,976

 
$
21,662

 
$
24,584

Auction rate securities upon acquisition

 

 

 
442

Change in unrealized gain included in accumulated other comprehensive loss

 
735

 
63

 
735

Settlements

 
(4,150
)
 
(50
)
 
(4,200
)
Balance at end of period
$
21,675

 
$
21,561

 
$
21,675

 
$
21,561



14

COSTAR GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (CONTINUED)

5.
FAIR VALUE — (CONTINUED)

The following table summarizes changes in fair value of the Company’s Level 3 assets from December 31, 2007 to September 30, 2013 (in thousands):
 
Auction
Rate
Securities
Balance at December 31, 2007
$
53,975

Change in unrealized loss included in accumulated other comprehensive loss
(3,710
)
Settlements
(20,925
)
Balance at December 31, 2008
29,340

Change in unrealized gain included in accumulated other comprehensive loss
684

Settlements
(300
)
Balance at December 31, 2009
29,724

Change in unrealized gain included in accumulated other comprehensive loss
40

Settlements
(575
)
Balance at December 31, 2010
29,189

Change in unrealized gain included in accumulated other comprehensive loss
245

Settlements
(4,850
)
Balance at December 31, 2011
24,584

Auction rate securities upon acquisition
442

Change in unrealized gain included in accumulated other comprehensive loss
836

Settlements
(4,200
)
Balance at December 31, 2012
21,662

Change in unrealized gain included in accumulated other comprehensive loss
63

Settlements
(50
)
Balance at September 30, 2013
$
21,675


ARS are variable rate debt instruments whose interest rates are reset approximately every 28 days. The majority of the underlying securities have contractual maturities greater than twenty years. The ARS are recorded at fair value.

As of September 30, 2013, the Company held ARS with $24.3 million par value, all of which failed to settle at auction. The majority of these investments are of high credit quality with AAA credit ratings and are primarily student loan securities supported by guarantees from the FFELP of the U.S. Department of Education. The Company may not be able to liquidate and fully recover the carrying value of the ARS in the near term. As a result, these securities are classified as long-term investments in the Company’s condensed consolidated balance sheet as of September 30, 2013.  

While the Company continues to earn interest on its ARS investments at the contractual rate, these investments are not currently actively trading and therefore do not currently have a readily determinable market value. The estimated fair value of the ARS no longer approximates par value. The Company used a discounted cash flow model to determine the estimated fair value of its investment in ARS as of September 30, 2013. The assumptions used in preparing the discounted cash flow model include estimates for interest rates, credit spreads, timing and amount of contractual cash flows, liquidity risk premiums, expected holding periods and default risk. The Company updates the discounted cash flow model on a quarterly basis to reflect any changes in the assumptions used in the model and settlements of ARS investments that occurred during the period.

The only significant unobservable input in the discounted cash flow model is the discount rate. The discount rate used represents the Company's estimate of the yield expected by a market participant from the ARS investments. The weighted average discount rate used in the discounted cash flow model as of September 30, 2013 and December 31, 2012 was approximately 5.2% and 5.1%, respectively. Selecting another discount rate within the range used in the discounted cash flow model would not result in a significant change to the fair value of the ARS.


15

COSTAR GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (CONTINUED)

5.
FAIR VALUE — (CONTINUED)

Based on this assessment of fair value, as of September 30, 2013, the Company determined there was a decline in the fair value of its ARS investments of approximately $1.8 million. The decline was deemed to be a temporary impairment and recorded as an unrealized loss in accumulated other comprehensive loss in stockholders’ equity. In addition, while a majority of the ARS are currently rated AAA, if the issuers are unable to successfully close future auctions and/or their credit ratings deteriorate, the Company may be required to record additional unrealized losses in accumulated other comprehensive loss or an other-than-temporary impairment charge to earnings on these investments.

As of September 30, 2013, the Company held Level 3 liabilities for deferred consideration that it acquired as a result of the April 30, 2012 acquisition of LoopNet. The deferred consideration totaled $1.2 million as of September 30, 2013 and included potential deferred cash payments in connection with acquisitions LoopNet completed in 2010 including: (i) potential deferred cash payments due to the sellers of LandsofAmerica.com, LLC ("LandsofAmerica") on March 31, 2014 based on LandsofAmerica's achievement of financial and operational milestones, resulting in undiscounted deferred consideration as of September 30, 2013 of approximately $1.0 million; and (ii) potential deferred cash payments due to the sellers of Reaction Corp. ("Reaction Web") on March 31, 2014 based on Reaction Web's achievement of revenue milestones, resulting in undiscounted deferred consideration as of September 30, 2013 of approximately $344,000. On March 28, 2013, the Company made a payment of $1.0 million to the sellers of LandsofAmerica for the achievement of financial and operational milestones in 2012 and a payment of approximately $344,000 to the sellers of Reaction Web for the achievement of revenue milestones in 2012.

The following tables summarize changes in fair value of the Company’s Level 3 liabilities for the three and nine months ended September 30, 2013 and 2012 (in thousands):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Balance at beginning of period
$
1,146

 
$
2,072

 
$
2,304

 
$

Deferred consideration upon acquisition

 

 

 
2,011

Accretion for period
62

 
113

 
248

 
174

Payments made during period

 

 
(1,344
)
 

Balance at end of period
$
1,208

 
$
2,185

 
$
1,208

 
$
2,185


The following table summarizes changes in fair value of the Company’s Level 3 liabilities from December 31, 2011 to September 30, 2013 (in thousands):
 
Deferred
Consideration
Balance at December 31, 2011
$

Deferred consideration upon acquisition
2,011

Accretion for 2012
293

Balance at December 31, 2012
2,304

Accretion from January 1, 2013 – September 30, 2013
248

Payments made from January 1, 2013 – September 30, 2013
(1,344
)
Balance at September 30, 2013
$
1,208


The Company used a discounted cash flow model to determine the estimated fair value of its Level 3 liabilities. The assumptions used in preparing the discounted cash flow model include the discount rate and probabilities for completion of financial and operational milestones.


16

COSTAR GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (CONTINUED)

5.
FAIR VALUE — (CONTINUED)

The only significant unobservable input in the discounted cash flow model used to determine the estimated fair value of the Company's Level 3 liabilities is the discount rate. The discount rate used represents LoopNet's cost of equity at the time of each acquisition plus a margin for counterparty risk. The weighted average discount rate used as of September 30, 2013 and December 31, 2012 was approximately 23.5%. Selecting another discount rate within the range used in the discounted cash flow model would not result in a significant change to the fair value of the deferred consideration.

Concentration of Credit Risk and Financial Instruments

The Company performs ongoing credit evaluations of its customers’ financial condition and generally does not require that its customers’ obligations to the Company be secured. The Company maintains reserves for estimated inherent credit losses, and such losses have been within management’s expectations. The large size and widespread nature of the Company’s customer base and the Company’s lack of dependence on any individual customer mitigates the risk of nonpayment of the Company’s accounts receivable. The carrying amount of the accounts receivable approximates the net realizable value. The carrying value of accounts receivable, accounts payable, accrued expenses, and long-term debt approximates fair value.

6.
GOODWILL

The changes in the carrying amount of goodwill by operating segment consist of the following (in thousands):
 
United States
 
International
 
Total
Goodwill, December 31, 2011
$
67,465

 
$
24,319

 
$
91,784

Acquisitions
625,174

 

 
625,174

Effect of foreign currency translation

 
1,120

 
1,120

Goodwill, December 31, 2012
692,639

 
25,439

 
718,078

Effect of foreign currency translation

 
(39
)
 
(39
)
Goodwill, September 30, 2013
$
692,639

 
$
25,400

 
$
718,039


The Company recorded goodwill of approximately $625.2 million in connection with the April 30, 2012 acquisition of LoopNet.


17

COSTAR GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (CONTINUED)

7.
INTANGIBLES AND OTHER ASSETS

Intangibles and other assets consist of the following (in thousands, except amortization period data):
 
September 30,
2013
 
December 31,
2012
 
Weighted-
Average
Amortization
Period (in years)
Capitalized product development cost
$
2,140

 
$
2,140

 
4
Accumulated amortization
(1,981
)
 
(1,838
)
 
 
Capitalized product development cost, net
159

 
302

 
 
 
 
 
 
 
 
Building photography
13,566

 
12,474

 
5
Accumulated amortization
(11,830
)
 
(11,639
)
 
 
Building photography, net
1,736

 
835

 
 
 
 
 
 
 
 
Acquired database technology
77,325

 
77,328

 
5
Accumulated amortization
(38,284
)
 
(29,673
)
 
 
Acquired database technology, net
39,041

 
47,655

 
 
 
 
 
 
 
 
Acquired customer base
130,662

 
130,683

 
10
Accumulated amortization
(70,968
)
 
(59,218
)
 
 
Acquired customer base, net
59,694

 
71,465

 
 
 
 
 
 
 
 
Acquired trade names and other (1)
59,249

 
59,255

 
7
Accumulated amortization
(9,079
)
 
(8,880
)
 
 
Acquired trade names and other, net
50,170

 
50,375

 
 
 
 
 
 
 
 
Intangibles and other assets, net
$
150,800

 
$
170,632

 
 
 
(1) The weighted-average amortization period for acquired trade names excludes $48.7 million for acquired trade names recorded in connection with the LoopNet acquisition on April 30, 2012, which amount is not amortized, but is subject to annual impairment tests.

8.
LONG-TERM DEBT 

On February 16, 2012, the Company entered into a term loan facility and revolving credit facility pursuant to the Credit Agreement dated February 16, 2012, by and among the Company, as borrower, CoStar Realty Information, Inc. ("CoStar Realty"), as co-borrower, J.P. Morgan Bank, as administrative agent, and the other lenders thereto. The Credit Agreement provides for a $175.0 million term loan facility and a $50.0 million revolving credit facility, each with a term of five years. On April 30, 2012, the Company borrowed $175.0 million under the term loan facility and used those proceeds, together with net proceeds from the Company's equity offering conducted in June 2011, to pay a portion of the merger consideration and transaction costs related to the LoopNet merger. The carrying value of the term loan facility approximates fair value and can be estimated through unobservable inputs using an expected present value technique based on expected cash flows discounted using the current credit-adjusted risk-free rate, which approximates the rate of interest on the term loan facility at the origination.


18

COSTAR GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (CONTINUED)

8.
LONG-TERM DEBT — (CONTINUED)

The revolving credit facility includes a subfacility for swingline loans of up to $5.0 million and up to $10.0 million of the revolving credit facility is available for the issuances of letters of credit. The term loan facility amortizes in quarterly installments in amounts resulting in an annual amortization of 5% during the first year, 10% during the second year, 15% during the third year, 20% during the fourth year and 50% during the fifth year after the closing date. The loans under the Credit Agreement bear interest, at the Company's option, either (i) during any interest period selected by the Company, at the London interbank offered rate for deposits in U.S. dollars with a maturity comparable to such interest period, adjusted for statutory reserves (“LIBOR”), plus a spread of 2.00% per annum, or (ii) at the greatest of (x) the prime rate from time to time announced by J.P. Morgan Bank, (y) the federal funds effective rate plus ½ of 1% and (z) LIBOR for a one-month interest period plus 1.00%, plus a spread of 1.00% per annum. If an event of default occurs under the Credit Agreement, the interest rate on overdue amounts will increase by 2.00% per annum. The obligations under the Credit Agreement are guaranteed by all material subsidiaries of the Company and secured by a lien on substantially all of the assets of the Company and its material subsidiaries, in each case subject to certain exceptions.

The Credit Agreement requires the Company to maintain a Debt Service Coverage Ratio (as defined in the Credit Agreement) of at least 1.5 to 1.0 and a Total Leverage Ratio (as defined in the Credit Agreement) that does not exceed 2.75 to 1.00 during each of the three months ending September 30, 2013, December 31, 2013, March 31, 2014 and June 30, 2014; and 2.50 to 1.00 thereafter. The Credit Agreement also includes other covenants that were effective as of April 30, 2012, including covenants that, subject to certain exceptions, restrict the ability of the Company and its subsidiaries (i) to incur additional indebtedness, (ii) to create, incur, assume or permit to exist any liens, (iii) to enter into mergers, consolidations or similar transactions, (iv) to make investments and acquisitions, (v) to make certain dispositions of assets, (vi) to make dividends, distributions and prepayments of certain indebtedness, and (vii) to enter into certain transactions with affiliates. The Company was in compliance with the covenants in the Credit Agreement as of September 30, 2013.
  
Commencing with the fiscal year ended December 31, 2012, the Credit Agreement requires the Company to make an annual prepayment of the term loan facility equal to a percentage of Excess Cash Flow (as defined in the Credit Agreement) to reduce the principal amount outstanding under the term loan facility. The prepayment percentage is 50% when the Total Leverage Ratio exceeds 3.00 to 1.00; 25% when the Total Leverage Ratio is greater than 2.50 to 1.00 but equal to or less than 3.00 to 1.00; and 0% when the Total Leverage Ratio is equal to or less than 2.50 to 1.00. This prepayment requirement is reduced by the amount of prior voluntary prepayments during the respective fiscal year, subject to certain exceptions set forth in the Credit Agreement. The Excess Cash Flow payment, if required, is due within ten business days of the date on which the annual financial statements are delivered or required to be delivered to the lenders pursuant to the Credit Agreement. For the fiscal year ended December 31, 2012, the Company was not required to make an Excess Cash Flow payment.
  
In connection with obtaining the facility, the Company incurred approximately $11.5 million in debt issuance costs, which were capitalized and are being amortized as interest expense over the term of the Credit Agreement using the effective interest method. The debt issuance costs are comprised of approximately $9.2 million in underwriting fees and approximately $2.3 million primarily related to legal fees associated with the debt issuance. 

As of September 30, 2013 and December 31, 2012, no amounts were outstanding under the revolving credit facility. Total interest expense for the term loan facility was approximately $1.7 million and $1.8 million for the three months ended September 30, 2013 and 2012, respectively, and $5.2 million and $3.0 million for the nine months ended September 30, 2013 and 2012, respectively. Interest expense included amortized debt issuance costs of approximately $760,000 and $763,000 for the three months ended September 30, 2013 and 2012, respectively, and $2.3 million and $1.2 million for the nine months ended September 30, 2013 and 2012, respectively. Total interest paid for the term loan facility was approximately $1.3 million and $1.1 million for the three months ended September 30, 2013 and 2012, respectively, and $3.3 million and $1.8 million for the nine months ended September 30, 2013 and 2012, respectively.

9.
INCOME TAXES

The income tax provision for the nine months ended September 30, 2013 and 2012 reflects an effective tax rate of approximately 38% and 65%, respectively. The higher effective tax rate for the nine months ended September 30, 2012 was primarily due to costs related to the LoopNet acquisition that reduced income from operations but were not deductible for tax purposes.


19

COSTAR GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (CONTINUED)

9.
INCOME TAXES — (CONTINUED)

The Company is subject to taxation in the U.S. and various states and foreign jurisdictions. The Company is currently under Internal Revenue Service ("IRS") audit in the U.S. for tax year 2010 and its subsidiary LoopNet is under IRS audit for tax years 2009, 2010, 2011 and the four months ended April 30, 2012. While no formal assessments have been received, the Company believes it has provided adequate reserves related to all matters in the tax periods open to examination. Although the timing of income tax audit resolutions and negotiations with taxing authorities is highly uncertain, the Company does not anticipate a significant change to the total amount of unrecognized income tax benefits within the next 12 months.

10.
COMMITMENTS AND CONTINGENCIES

The Company leases office facilities and office equipment under various non-cancelable operating leases. The leases contain various renewal options.

On February 16, 2012, the Company entered into the Credit Agreement. The Credit Agreement provides for a $175.0 million term loan facility and a $50.0 million revolving credit facility, each with a term of five years. See Note 8 for additional information regarding the Credit Agreement.

In May 2011, LoopNet, the Board of Directors of LoopNet (“the LoopNet Board”) and/or the Company were named as defendants in three purported class action lawsuits brought by alleged LoopNet stockholders challenging LoopNet's proposed merger with the Company. The stockholder actions alleged, among other things, that (i) each member of the LoopNet Board breached his fiduciary duties to LoopNet and its stockholders in authorizing the sale of LoopNet to the Company, (ii) the merger does not maximize value to LoopNet stockholders, (iii) LoopNet and the Company have made incomplete or materially misleading disclosures about the proposed transaction and (iv) LoopNet and the Company aided and abetted the breaches of fiduciary duty allegedly committed by the members of the LoopNet Board. The stockholder actions sought class action certification and equitable relief, including an injunction against consummation of the merger. The parties have stipulated to the consolidation of the actions, and to permit the filing of a consolidated complaint. In June 2011, counsel for the parties entered into a memorandum of understanding in which they agreed on the terms of a settlement of this litigation, which could result in a loss to the Company of approximately $200,000. On March 20, 2013, the California Superior Court declined to grant preliminary approval to the proposed settlement and issued an order scheduling a hearing on June 11, 2013 to show good cause why the case should not be dismissed. Shortly before the hearing plaintiffs filed a third supplemental submission in support of their motion for preliminary approval of the proposed settlement, and the Court has rescheduled the show cause hearing for February 11, 2014.  

On January 3, 2012, LoopNet, the Company’s wholly owned subsidiary, was sued by CIVIX-DDI, LLC (“Civix”) in the U.S. District Court for the Eastern District of Virginia for alleged infringement of U.S. Patent Nos. 6,385,622 and 6,415,291. The complaint seeks unspecified damages, attorneys' fees and costs. On February 16, 2012, LoopNet filed an answer to Civix’s complaint and filed counterclaims against Civix seeking, among other things, declaratory relief that the asserted patents are invalid, not infringed, and that Civix committed inequitable conduct during the prosecution and re-examination of the asserted patents. On or about May 14, 2012, Civix filed a motion for leave to amend its complaint against LoopNet in the U.S. District Court for the Eastern District of Virginia seeking to add the Company as a defendant, alleging that the Company's products also infringe Civix's patents. The Company filed a motion opposing Civix's motion, and on June 21, 2012, the district court denied Civix's motion to amend its complaint. On June 21, 2012, the Company filed an action in the U.S. District Court for the Northern District of Illinois seeking a declaratory judgment of non-infringement and invalidity against Civix. On August 14, 2012, the Company amended its complaint against Civix to assert an affirmative claim for breach of contract against Civix for Civix's violation of its license agreement and covenant not to sue with one of the Company's technology licensors. On August 30, 2012, the Eastern District of Virginia transferred Civix's case against LoopNet to the Northern District of Illinois, where both cases are now pending. On October 29, 2012, Civix filed a separate action against LoopNet in the Northern District of Illinois alleging infringement of U.S. Patent No. 8,296,335. That case was later consolidated with Civix's original lawsuit against LoopNet. Civix amended its complaint against the Company on November 8, 2012 to add claims under Patent No. 8,296,335 as well. On November 15, 2012, LoopNet filed an amended answer and counterclaim against Civix, asserting an affirmative claim for breach of contract against Civix for Civix's violation of its license agreement and covenant not to sue with one of LoopNet's technology licensors. The U.S. District Court for the Northern District of Illinois construed the language of the patent on September 23, 2013, and has issued a schedule providing for expert discovery and dispositive motions in this case through April 2014, but no trial date has been set. At this time, the Company cannot predict the outcome of either case involving Civix, but the Company intends to vigorously defend itself against Civix's claims.


20

COSTAR GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (CONTINUED)

10.
COMMITMENTS AND CONTINGENCIES — (CONTINUED)

Currently, and from time to time, the Company is involved in litigation incidental to the conduct of its business. In accordance with GAAP, the Company records a provision for a liability when it is both probable that a liability has been incurred and the amount can be reasonably estimated. At the present time, while it is reasonably possible that an unfavorable outcome may occur as a result of one or more of the Company’s current litigation matters, management has concluded that it is not probable that a loss has been incurred in connection with the Company’s current litigation other than as described above. In addition, other than as described above, the Company is unable to estimate the possible loss or range of loss that could result from an unfavorable outcome in the Company’s current litigation and accordingly, the Company has not recognized any liability in the condensed consolidated financial statements for unfavorable results, if any, other than described above. Legal defense costs are expensed as incurred.

11.
SEGMENT REPORTING

The Company manages its business geographically in two operating segments, with the primary areas of measurement and decision-making being the U.S. and International, which includes the U.K. and France. The Company’s subscription-based information services consist primarily of CoStar Suite and FOCUS services. CoStar Suite is sold as a platform of service offerings consisting of CoStar Property Professional®, CoStar COMPS Professional® and CoStar Tenant® and through the Company's mobile application, CoStarGo®. CoStar Suite is the Company's primary service offering in the U.S. operating segment. FOCUS is the Company's primary service offering in the International operating segment. Additionally, the Company introduced CoStar Suite in the U.K. in the fourth quarter of 2012. CoStar's and its subsidiaries' subscription-based services consist primarily of similar services offered over the Internet to commercial real estate industry and related professionals. Management relies on an internal management reporting process that provides revenue and operating segment EBITDA, which is the Company's net income before interest, income taxes, depreciation and amortization. Management believes that operating segment EBITDA is an appropriate measure for evaluating the operational performance of the Company's operating segments. EBITDA is used by management to internally measure operating and management performance and to evaluate the performance of the business. However, this measure should be considered in addition to, not as a substitute for or superior to, income from operations or other measures of financial performance prepared in accordance with GAAP.


21

COSTAR GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (CONTINUED)

11.
SEGMENT REPORTING — (CONTINUED)

Summarized information by operating segment consists of the following (in thousands):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Revenues
 
 
 
 
 
 
 
United States
$
107,230

 
$
91,153

 
$
310,762

 
$
235,606

International
 

 
 

 
 

 
 

External customers
5,071

 
4,848

 
14,571

 
14,247

Intersegment revenue
131

 
388

 
277

 
1,154

Total international revenue
5,202

 
5,236

 
14,848

 
15,401

Intersegment eliminations
(131
)
 
(388
)
 
(277
)
 
(1,154
)
Total revenues
$
112,301

 
$
96,001

 
$
325,333

 
$
249,853

 
 
 
 
 
 
 
 
EBITDA
 

 
 

 
 

 
 

United States
$
30,855

 
$
22,688

 
$
66,609

 
$
46,302

International
(1,063
)
 
(3,047
)
 
(3,917
)
 
(6,568
)
Total EBITDA
$
29,792

 
$
19,641

 
$
62,692

 
$
39,734

Reconciliation of EBITDA to net income
 
 
 
 
 
 
 
EBITDA
$
29,792

 
$
19,641

 
$
62,692

 
$
39,734

Purchase amortization in cost of revenues
(2,954
)
 
(3,027
)
 
(9,007
)
 
(5,607
)
Purchase amortization in operating expenses
(3,680
)
 
(4,824
)
 
(11,699
)
 
(9,038
)
Depreciation and other amortization
(3,388
)
 
(2,844
)
 
(9,531
)
 
(7,554
)
Interest income
52

 
59

 
239

 
440

Interest expense
(1,736
)
 
(1,822
)
 
(5,249
)
 
(3,022
)
Income tax expense, net
(7,034
)
 
(404
)
 
(10,510
)
 
(9,752
)
Net income
$
11,052

 
$
6,779

 
$
16,935

 
$
5,201


Intersegment revenue is attributable to services performed for the Company’s wholly owned subsidiary, Property and Portfolio Research, Inc. (“PPR”) by Property and Portfolio Research Ltd., a wholly owned subsidiary of PPR. Intersegment revenue is recorded at an amount the Company believes approximates fair value. U.S. EBITDA includes a corresponding cost for the services performed by Property and Portfolio Research Ltd. for PPR.

U.S. EBITDA includes an allocation of approximately $300,000 and $0 for the three months ended September 30, 2013 and 2012, respectively. U.S. EBITDA includes an allocation of approximately $600,000 and $0 for the nine months ended September 30, 2013 and 2012, respectively. This allocation represents costs incurred for International employees involved in development activities of the Company's U.S. operating segment.

International EBITDA includes a corporate allocation of approximately $100,000 and $2.3 million for the three months ended September 30, 2013 and 2012, respectively. International EBITDA includes a corporate allocation of approximately $300,000 and $4.5 million for the nine months ended September 30, 2013 and 2012, respectively. The corporate allocation represents costs incurred for U.S. employees involved in management and expansion activities of the Company's International operating segment.


22

COSTAR GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (CONTINUED)

11.
SEGMENT REPORTING — (CONTINUED)

Summarized information by operating segment consists of the following (in thousands):
 
September 30,
2013
 
December 31,
2012
Property and equipment, net
 
 
 
United States
$
51,781

 
$
42,480

International
3,922

 
3,828

Total property and equipment, net
$
55,703

 
$
46,308

 
 
 
 
Goodwill
 

 
 

United States
$
692,639

 
$
692,639

International
25,400

 
25,439

Total goodwill
$
718,039

 
$
718,078

 
 
 
 
Assets
 

 
 

United States
$
1,285,779

 
$
1,215,949

International
41,963

 
40,933

Total operating segment assets
$
1,327,742

 
$
1,256,882

 
 
 
 
Reconciliation of operating segment assets to total assets
 

 
 

Total operating segment assets
$
1,327,742

 
$
1,256,882

Investment in subsidiaries
(18,344
)
 
(18,344
)
Intersegment receivables
(79,024
)
 
(73,399
)
Total assets
$
1,230,374

 
$
1,165,139

 
 
 
 
Liabilities
 

 
 

United States
$
326,850

 
$
335,855

International
77,209

 
70,108

Total operating segment liabilities
$
404,059

 
$
405,963

 
 
 
 
Reconciliation of operating segment liabilities to total liabilities
 

 
 

Total operating segment liabilities
$
404,059

 
$
405,963

Intersegment payables
(73,004
)
 
(67,167
)
Total liabilities
$
331,055

 
$
338,796



23



Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains “forward-looking statements,” including statements about our beliefs and expectations. See “Cautionary Statement Concerning Forward-Looking Statements” at the end of this Item 2. for additional factors relating to such statements, and see “Risk Factors” in Item 1A. of Part II of this Quarterly Report on Form 10-Q for a discussion of certain risk factors applicable to our business, financial condition and results of operations.

All forward-looking statements are based on information available to us on the date of this filing and we assume no obligation to update such statements. The following discussion should be read in conjunction with our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and other filings with the Securities and Exchange Commission and the condensed consolidated financial statements and related notes included in this Quarterly Report on Form 10-Q.

Overview

CoStar Group, Inc. (the “Company” or “CoStar”) is the number one provider of information, analytics and marketing services to the commercial real estate industry in the United States ("U.S.") and the United Kingdom ("U.K.") based on the fact that we offer the most comprehensive commercial real estate database available; have the largest research department in the industry; own and operate the leading online marketplace for commercial real estate in the U.S. based on the number of unique visitors per month; provide more information, analytics and marketing services than any of our competitors and believe that we generate more revenues than any of our competitors. We have created and compiled our standardized information, analytics and marketing platform where members of the commercial real estate and related business community can continuously interact and facilitate transactions by efficiently exchanging accurate and standardized commercial real estate information. Our integrated suite of online service offerings includes information about space available for lease, comparable sales information, tenant information, information about properties for sale, internet marketing services, analytical capabilities, information for clients' websites, information about industry professionals and their business relationships, data integration and industry news.

LoopNet, our subsidiary, operates an online marketplace that enables property owners, landlords, and commercial real estate agents working on their behalf to list properties for sale or for lease and to submit detailed information about property listings. Commercial real estate agents, buyers and tenants also use LoopNet's online marketplace to search for available property listings that meet their criteria.

We also provide market research and analysis for commercial real estate investors and lenders via our Property and Portfolio Research (“PPR”) service offerings, portfolio and debt management and reporting capabilities through our Resolve Technology service offerings, and real estate and lease management solutions, including lease administration and abstraction services, through our Virtual Premise service offerings.

Our service offerings span all commercial property types, including office, industrial, retail, land, mixed-use, hospitality and multifamily.

Subscription-Based Services

Our subscription-based information services consist primarily of CoStar Suite and FOCUS services. CoStar Suite is sold as a platform of service offerings consisting of CoStar Property Professional®, CoStar COMPS Professional® and CoStar Tenant® and through our mobile application, CoStarGo®. CoStar Suite is our primary service offering in the U.S. operating segment. FOCUS is our primary service offering in the International operating segment. Additionally, we introduced CoStar Suite in the U.K. in the fourth quarter of 2012.

Our subscription-based services consist primarily of similar services offered over the Internet to commercial real estate industry and related professionals. Our services are typically distributed to our clients under subscription-based license agreements that renew automatically, a majority of which have a term of one year. Upon renewal, many of the subscription contract rates may change in accordance with contract provisions or as a result of contract renegotiations. To encourage clients to use our services regularly, we generally charge a fixed monthly amount for our subscription-based information services rather than fees based on actual system usage. Contract rates are generally based on the number of sites, number of users, organization size, the client's business focus, geography and the number of services to which a client subscribes. Our subscription clients generally pay contract fees on a monthly basis, but in some cases may pay us on a quarterly or annual basis.


24



As of September 30, 2013 and 2012, our annualized net new sales of subscription-based services on annual contracts were approximately $13.7 million and $9.3 million, respectively, calculated based on the annualized amount of change in our sales resulting from new annual subscription-based contracts or upsales on existing annual subscription-based contracts, less write downs and cancellations, for the period reported. We recognize subscription revenue on a straight-line basis over the life of the contract. Annual and quarterly advance payments result in deferred revenue, substantially reducing the working capital requirements generated by accounts receivable.

For the twelve months ended September 30, 2013 and 2012, our contract renewal rate for existing CoStar subscription-based services was approximately 93% and 94%, respectively, and therefore our cancellation rate for those services was approximately 7% and 6%, respectively, for the same time periods. Our contract renewal rate is a quantitative measurement that is typically closely correlated with our revenue results. As a result, management also believes that the rate may be a reliable indicator of short-term and long-term performance. Our trailing twelve-month contract renewal rate may decline if, among other reasons, negative economic conditions lead to greater business failures and/or consolidations among our clients, reductions in customer spending, or decreases in our customer base.

Expansion and Development

We expect to continue to develop and distribute new services, improve existing services, integrate products and services, cross-sell existing services, and expand and develop supporting technologies for our research, sales and marketing organizations. We are also committed to supporting and improving our existing core information, analytic and marketing services. We currently intend to increase the size of our field sales force to support sales and marketing of our existing, new and enhanced services.

In October 2013, we introduced significant technology enhancements to CoStar Suite, our platform of service offerings consisting of CoStar Property Professional, CoStar COMPS Professional and CoStar Tenant. The enhancements provide improvements to the user interface, search functionality and reporting and analytic capabilities, as well as integrated workflow tools that provide our clients with greater functionality. These enhancements allow clients to leverage the information available in our comprehensive database in multiple ways, and include the CoStar Lease AnalysisTM tool and CoStar MultifamilyTM information. We believe this greater functionality will make our services valuable to an even broader audience and we believe we will increase our penetration with brokers, banks, owners and institutional investors. Further, these technology enhancements are expected to drive continued revenue growth in 2014 and for the foreseeable future. Selling and marketing activities will be aligned with our new product enhancements resulting in increased expenses commencing towards the end of the fourth quarter of 2013 with the majority of these expenses to be incurred during the first quarter of 2014.

Further, in October 2013, we released CoStarGo® 2.0, the next generation of our mobile application, which was launched in the U.S. on August 15, 2011 and introduced in the U.K. on November 5, 2012. CoStarGo is our iPad application that integrates and provides mobile access to subscribers of our comprehensive property, tenant and comparable sales information from CoStar Suite. CoStarGo 2.0 combines mobile access to the information from CoStar Suite with a fully integrated set of customizable property and market analysis tools.

In addition, we expect to continue our efforts to integrate the combined capabilities of CoStar's property and market-level information and PPR's analytics and forecasting expertise with Resolve Technology's real estate investment software expertise. We also plan to continue efforts to integrate CoStar's business with Virtual Premise's real estate and lease management solutions. These integration efforts include providing additional tools that make our research and analytics even more valuable to subscribers. In order to implement these initiatives, we have incurred, and expect to continue to incur, additional costs. We also expect to continue to offer our core products and services individually.

We continue to integrate, develop and cross-sell the services offered by the companies we acquired most recently, including LoopNet, Virtual Premise, Resolve Technology and PPR. In some cases, when integrating and coordinating our services and assessing industry needs, we may decide, or may have previously decided, to combine, shift focus from, de-emphasize, phase out, or eliminate a service that overlaps or is redundant with other services we offer.


25



Our sales and marketing efforts have been and will continue to be focused on cross-selling and marketing our services. For example, after the acquisition of LoopNet, we launched a sales and marketing campaign directed at cross-selling CoStar's information services to LoopNet customers and cross-selling LoopNet's marketing services to CoStar customers. We recently implemented an automatic cross-selling initiative within the LoopNet marketplace. As searchers view properties within the LoopNet marketplace, a message may appear indicating that there are additional listings available within CoStar Suite with the same search criteria that they are not able to access under their current subscription. The message provides contact information, so that the customer can reach their customer service or sales representative and review the most appropriate service for their needs. Our goal is to upsell clients to the services that best meet their needs and to create further cross-selling revenue synergies. In addition, we have added a comparison feature to CoStarGo, which allows our sales force to demonstrate how many more properties a prospect could see with respect to a particular search area if that prospect were using CoStar rather than the prospect’s current subscription with LoopNet.

As a result of the cross selling of CoStar's and LoopNet's complementary services, we began to achieve increased revenue synergies in 2013. We incurred increased expenses associated with the marketing and sales campaign in 2012 and during the first half of 2013. These initiatives have resulted in revenue growth, and we anticipate that these initiatives will continue to position the company for revenue growth during the remainder of 2013 and for the foreseeable future. In addition, our investments in LoopNet, Virtual Premise, Resolve Technology, and PPR have increased, and may continue to increase; however our revenues have also increased as a result of these acquisitions, due to revenue from the acquired businesses, as well as our ability to take advantage of cross-selling opportunities among the customers of CoStar and the acquired companies.

We continue to integrate our international operations more fully with those in the U.S. Previously, as part of our integration efforts, in 2007, we introduced the “CoStar Group” as the brand encompassing our international operations, and in early 2010, we launched Showcase, our internet marketing service that provides commercial real estate professionals high quality internet lead generation, in the U.K. In addition, we intend to continue to upgrade the platform of services and expand the coverage of our service offerings within our International segment. To further develop those initiatives, we introduced CoStar Suite in the U.K. during the fourth quarter of 2012. CoStar Suite is sold as a consistent international platform of service offerings consisting of CoStar Property Professional, CoStar COMPS Professional and CoStar Tenant and through the Company's mobile application, CoStarGo. We believe the product launch has been well received and a significant marketing and sales effort is currently in progress. CoStarGo 2.0 was released in the U.K. in October 2013 simultaneous with the release in the U.S. Additionally, we have upgraded our back-end research operations, fulfillment and Customer Relationship Management (“CRM”) systems to support these new U.K. services. In order to implement these services in the U.K., we incurred increased development costs through 2012; however, development costs incurred by the International segment have decreased in 2013.

In 2014, we expect to expand further internationally by offering services in Toronto, Canada. We believe that our continued investments in U.S. and international products, internationalization of our U.S. products and integration efforts have created a platform for long-term revenue growth. We expect these investments, including the expansion of coverage of our international service offerings, to result in further penetration of our international subscription-based information services and the successful cross-selling of our services to customers in existing markets.

We intend to continue to assess the need for additional investments in our business, in addition to the investments discussed above in order to develop and distribute new services within our current platform. Any future product development or expansion of services, combination and coordination of services or elimination of services could reduce our profitability and increase our capital expenditures. Therefore, while we expect current service offerings to remain profitable, driving overall earnings in 2013 and providing substantial cash flow for our business, it is possible that any new investments, changes to our service offerings or other unforeseen events could cause us to generate losses and negative cash flow from operations in the future. Further, our credit facilities contain restrictive covenants that restrict our operations and use of our cash flow, which may prevent us from taking certain actions that we believe could increase our profitability or otherwise enhance our business.

LoopNet Acquisition

On April 30, 2012, we completed the acquisition of LoopNet, which is included within our U.S. operating segment. The acquisition combines the research capabilities of CoStar with the marketing solutions offered by LoopNet. The acquisition has created efficiencies in operations resulting in the elimination of redundant expenses and the achievement of expected cost synergies in 2013. We expect the acquisition will continue to create efficiencies in operations and provide greater tools for the combined company's customers. To acquire LoopNet, we paid stock and cash consideration with an aggregate value of approximately $883.4 million as of the closing date.


26



We funded the cash portion of the consideration payable to LoopNet stockholders in the merger through a combination of cash on hand, including the net proceeds of approximately $247.9 million from an equity offering we completed in June 2011 and the proceeds of a $175.0 million term loan facility available to us under a credit agreement (as amended, the “Credit Agreement”), dated February 16, 2012, by and among CoStar, as borrower, CoStar Realty Information, Inc. (“CoStar Realty”), as co-borrower, JPMorgan Chase Bank, N.A. (“J.P. Morgan Bank”), as administrative agent, and the other lenders thereto.

Prior to completion of the LoopNet acquisition, on April 26, 2012, the Federal Trade Commission (the “FTC”) accepted a consent order in connection with the LoopNet merger that was previously agreed to by LoopNet and CoStar. The consent order, which is publicly available on the FTC's website at www.ftc.gov, requires us to maintain certain business practices that the FTC believes will promote competition. For example, the consent order requires us to maintain our customary practice of selling our products separately and on a market-by-market basis. It also requires us to license our products to customers who have bought our competitors' products on a non-discriminatory basis, which we have always done in the past. In addition, we are required to maintain our customary licensing practices with respect to the length of our contracts, to allow customers with multi-year contracts to cancel with one year's advance notice, and to agree to reduce the cost of any litigation with customers by offering to arbitrate certain disputes.

While, as discussed above, we expect current service offerings to remain profitable, providing substantial cash flow for our business, costs associated with the integration of CoStar and LoopNet's businesses could reduce our profitability.

Market Conditions

In general, the current economic recovery has been slower than past economic recoveries. Job growth, in particular, has recovered more slowly than in past economic recoveries, and as a result, the improvement in the commercial real estate industry has been slower, especially with respect to the rental rate growth.  Continuing near-term risks related to lower-than-expected job growth, government fiscal challenges, and uncertainty over U.S. and global economic issues may impede the ability and willingness of clients to purchase services from us or result in reductions of services purchased. Additionally, since many of our clients use debt to finance a portion of their real estate purchases, material changes in interest rates and risk premiums could harm their ability to complete transactions, especially if the change was relatively rapid and unexpected.
 
As is typical of this point in the economic cycle, business consolidations, and in some circumstances, business failures, continue to occur. If cancellations, reductions of services, and failures to pay increase, and we are unable to offset the resulting decrease in revenue by increasing sales to new or existing customers, our revenues may decline or grow at lower rates. We compete against many other commercial real estate information, analytics, and marketing service providers for business, including competitors that offer rapidly changing methods of delivering real estate information. If customers choose to cancel our services because of cost cutting, desire to access real estate information through other delivery methods, or other reasons, our revenue could decline.

Financial Matters

Our financial reporting currency is the U.S. dollar. Changes in exchange rates can significantly affect our reported results and consolidated trends. We believe that our increasing diversification beyond the U.S. economy through our international businesses benefits our stockholders over the long term. We also believe it is important to evaluate our operating results before and after the effect of currency changes, as it may provide a more accurate comparison of our results of operations over historical periods. Currency exchange rate volatility may continue, which may impact (either positively or negatively) our reported financial results and consolidated trends and period-to-period comparisons of our consolidated operations.

We currently issue stock options and/or restricted stock to our officers, directors and employees, and as a result we record compensation expense in our consolidated statements of operations. The amount and timing of the compensation expense that we record depends on the amount and types of equity grants made. We plan to continue the use of stock-based compensation for our officers, directors and employees, which may include, among other things, restricted stock, restricted stock units or stock option grants that typically will require us to record additional compensation expense in our consolidated statements of operations and reduce our net income.


27



In February 2012, the Compensation Committee (the “Committee”) of the Board of Directors approved grants of restricted common stock to our executive officers that vest based on the achievement of CoStar performance conditions. Specifically, these shares of performance-based restricted common stock vest upon our achievement of $90.0 million of cumulative net income before interest, income taxes, depreciation and amortization ("EBITDA") over a period of four consecutive calendar quarters, and are subject to forfeiture in the event the foregoing performance condition is not met by March 31, 2017. These awards support the Committee’s goals of aligning executive incentives with long-term stockholder value and ensuring that executive officers have a continuing stake in the long-term success of CoStar. In May and December of 2012, we granted additional shares of restricted common stock that vest based on the achievement of the same performance conditions to other key employees. We granted a total of 399,413 shares of performance-based restricted common stock during the year ended December 31, 2012. All of the awards were made under the CoStar Group, Inc. 2007 Stock Incentive Plan and pursuant to our standard form of restricted stock grant agreement.

As of September 30, 2013, we reassessed the probability of achieving the performance condition for the performance-based restricted common stock awards issued in 2012 and determined that it was still probable that the performance condition for these awards would be met by the March 31, 2017 forfeiture date. As a result, we recorded a total of approximately $3.1 million and $0 of stock-based compensation expense related to the performance-based restricted common stock for the three months ended September 30, 2013 and 2012, respectively. We recorded a total of approximately $17.5 million and $0 of stock-based compensation expense related to the performance-based restricted common stock for the nine months ended September 30, 2013 and 2012, respectively. We expect to record an additional estimated unrecognized stock-based compensation expense related to the performance-based restricted common stock of approximately $6.2 million during the remainder of 2013 and in 2014.

Application of Critical Accounting Policies and Estimates

The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the period reported. The following accounting policies involve a “critical accounting estimate” because they are particularly dependent on estimates and assumptions made by management about matters that are highly uncertain at the time the accounting estimates are made. In addition, while we have used our best estimates based on facts and circumstances available to us at the time, different acceptable assumptions would yield different results. Changes in the accounting estimates are reasonably likely to occur from period to period, which may have a material impact on the presentation of our financial condition and results of operations. We review these estimates and assumptions periodically and reflect the effects of revisions in the period that they are determined to be necessary.

Fair Value of Auction Rate Securities

Fair value is defined as the price that would be received in the sale of an asset or paid to transfer a liability in an orderly transaction between market participants. There is a three-tier fair value hierarchy, which categorizes assets and liabilities by the inputs used in measuring fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs for which little or no market data exists, therefore requiring an entity to develop its own assumptions. Our Level 3 assets consist of auction rate securities (“ARS”), whose underlying assets are primarily student loan securities supported by guarantees from the Federal Family Education Loan Program (“FFELP”) of the U.S. Department of Education.

Our ARS investments are not currently actively trading and therefore do not currently have a readily determinable market value. The estimated fair value of the ARS no longer approximates par value. We have used a discounted cash flow model to determine the estimated fair value of our investment in ARS as of September 30, 2013. The assumptions used in preparing the discounted cash flow model include estimates for interest rates, credit spreads, timing and amount of contractual cash flows, liquidity risk premiums, expected holding periods and default risk of the ARS. We update the discounted cash flow model on a quarterly basis to reflect any changes in the assumptions used in the model and settlements of ARS investments that occurred during the period.

The only significant unobservable input in the discounted cash flow model is the discount rate. The discount rate used represents our estimate of the yield expected by a market participant from the ARS investments. The weighted average discount rate used in the discounted cash flow model as of September 30, 2013 and December 31, 2012 was approximately 5.2% and 5.1%, respectively. Selecting another discount rate within the range used in the discounted cash flow model would not result in a significant change to the fair value of the ARS.


28



Based on this assessment of fair value, as of September 30, 2013, we determined there was a decline in the fair value of our ARS investments of approximately $1.8 million. The decline was deemed to be a temporary impairment and recorded as an unrealized loss in accumulated other comprehensive loss in stockholders' equity. If the issuers of these ARS are unable to successfully close future auctions and/or their credit ratings deteriorate, we may be required to record additional unrealized losses in accumulated other comprehensive loss or an other-than-temporary impairment charge to earnings on these investments, which would reduce our profitability and adversely affect our financial position.

We have not made any material changes in the accounting methodology used to determine the fair value of the ARS. We do not expect any material changes in the near term to the underlying assumptions used to determine the unobservable inputs used to calculate the fair value of the ARS as of September 30, 2013. However, if changes in these assumptions occur, and, should those changes be significant, we may be exposed to additional unrealized losses in accumulated other comprehensive loss or an other-than-temporary impairment charge to earnings on these investments.

Stock-Based Compensation

We account for equity instruments issued in exchange for employee services using a fair-value based method, and we recognize the fair value of such equity instruments as an expense in the consolidated statements of operations. We estimated the fair value of each option granted on the date of grant using the Black-Scholes option-pricing model, which requires us to estimate the dividend yield, expected volatility, risk-free interest rate and expected life of the stock option. These assumptions and the estimation of expected forfeitures are based on multiple factors, including historical employee behavior patterns of exercising options and post-employment termination behavior, expected future employee option exercise patterns, and the historical volatility of our stock price. For equity instruments that vest based on performance, we assess the probability of the achievement of the performance conditions at the end of each reporting period, or more frequently based upon the occurrence of events that may change the probability of whether the performance conditions would be met. If our initial estimates of the achievement of the performance conditions change, the related stock-based compensation expense and timing of recognition may fluctuate from period to period based on those estimates. If the performance conditions are not met, no stock-based compensation expense will be recognized, and any previously recognized stock-based compensation expense will be reversed.

We do not expect any material changes in the near term to the underlying assumptions used to calculate stock-based compensation expense for the nine months ended September 30, 2013. However, if changes in these assumptions occur, and, should those changes be significant, they could have a material impact on our stock-based compensation expense.

Valuation of Long-Lived and Intangible Assets and Goodwill

We assess the impairment of long-lived assets, identifiable intangibles and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Judgments made by management relate to the expected useful lives of long-lived assets and our ability to realize any undiscounted cash flows of the carrying amounts of such assets. The accuracy of these judgments may be adversely affected by several factors, including the factors listed below:

    Significant underperformance relative to historical or projected future operating results;
    Significant changes in the manner of our use of the acquired assets or the strategy for our overall business;
    Significant negative industry or economic trends; or
    Significant decline in our market capitalization relative to net book value for a sustained period.

When we determine that the carrying value of long-lived and identifiable intangible assets may not be recovered based upon the existence of one or more of the above indicators, we test for impairment.

Goodwill and identifiable intangible assets that are not subject to amortization are tested annually for impairment by each reporting unit on October 1 of each year and are also tested for impairment more frequently based upon the existence of one or more of the above indicators. We consider our operating segments, U.S. and International, as our reporting units under Financial Accounting Standards Board (“FASB”) authoritative guidance for consideration of potential impairment of goodwill.


29



To determine whether it is necessary to perform the two-step goodwill impairment test, we may first assess qualitative factors to evaluate whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If we conclude that it is more likely than not that the fair value of a reporting unit is less than its carrying amount or if we elect not to assess qualitative factors, then we perform the two-step process. The first step is to determine the fair value of each reporting unit. We estimate the fair value of each reporting unit based on a projected discounted cash flow model that includes significant assumptions and estimates including our discount rate, growth rate and future financial performance. Assumptions about the discount rate are based on a weighted average cost of capital for comparable companies. Assumptions about the growth rate and future financial performance of a reporting unit are based on our forecasts, business plans, economic projections and anticipated future cash flows. Our assumptions regarding the future financial performance of the International reporting unit reflect our expectation as of October 1, 2012, that in 2013 the expenses for our International reporting unit will decrease upon the completion of our initiatives to upgrade the platform of services and expand the coverage of our service offerings within our International segment by the end of 2012. Additionally, our assumptions regarding the future financial performance of the International reporting unit reflect our expectation that revenues will increase as a result of further penetration of our international subscription-based information services and the successful cross-selling of our services to our customers in existing markets due to the release of our upgraded international platform and expansion of coverage of our international service offerings. These assumptions are subject to change from period to period and could be adversely impacted by the uncertainty surrounding global market conditions, commercial real estate conditions, and the competitive environment in which we operate. Changes in these or other factors could negatively affect our reporting units' fair value and potentially result in impairment charges. Such impairment charges could have an adverse effect on our results of operations.

The fair value of each reporting unit is compared to the carrying amount of the reporting unit. If the carrying value of the reporting unit exceeds the fair value, then the second step of the process is performed to measure the impairment loss. We measure impairment loss based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk in our current business model. As of October 1, 2012, the date of our most recent impairment analysis, the estimated fair value of each of our reporting units substantially exceeded the carrying value of our reporting units. There have been no events or changes in circumstances since the date of our impairment analysis on October 1, 2012 that would indicate that the carrying value of each reporting unit may not be recoverable.

To determine whether it is necessary to perform the quantitative impairment test for indefinite-lived intangible assets, we may first assess qualitative factors to evaluate whether it is more likely than not that the fair value of the indefinite-lived intangible assets is less than the carrying amount. If we conclude that it is more likely than not that the fair value of the indefinite-lived intangible assets is less than the carrying amount or if we elect not to assess qualitative factors, then we perform the quantitative impairment test similar to the test performed on goodwill discussed above.

As of October 1, 2012, the date of our most recent impairment analysis, the estimated fair value of our indefinite-lived intangible assets substantially exceeded the carrying value. There have been no events or changes in circumstances since the date of our impairment analysis on October 1, 2012 that would indicate that the carrying value of the indefinite-lived intangible asset may not be recoverable.

Accounting for Income Taxes

As part of the process of preparing our condensed consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process requires us to estimate our actual current tax exposure and assess the temporary differences resulting from differing treatment of items, such as deferred revenue or deductibility of certain intangible assets, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our condensed consolidated balance sheets. We must then also assess the likelihood that our deferred tax assets will be recovered from future taxable income, and, to the extent we believe that it is more-likely-than not that some portion or all of our deferred tax assets will not be realized, we must establish a valuation allowance. To the extent we establish a valuation allowance or change the allowance in a period, we must reflect the corresponding increase or decrease within the tax provision in the condensed consolidated statements of operations.


30



Non-GAAP Financial Measures

We prepare and publicly release quarterly unaudited financial statements prepared in accordance with GAAP. We also disclose and discuss certain non-GAAP financial measures in our public releases, investor conference calls and filings with the Securities and Exchange Commission. The non-GAAP financial measures that we may disclose include EBITDA, adjusted EBITDA, non-GAAP net income and non-GAAP net income per diluted share (also referred to as "non-GAAP EPS"). EBITDA is our net income before interest, income taxes, depreciation and amortization. We typically disclose EBITDA on a consolidated and an operating segment basis in our earnings releases, investor conference calls and filings with the Securities and Exchange Commission. Adjusted EBITDA is different from EBITDA because we further adjust EBITDA for stock-based compensation expense, acquisition- and integration-related costs, restructuring costs and settlements and impairments incurred outside our ordinary course of business. Non-GAAP net income and non-GAAP net income per diluted share are similarly adjusted for stock-based compensation expense, acquisition- and integration-related costs, restructuring costs, settlement and impairment costs incurred outside our ordinary course of business as well as purchase amortization and other related costs. We may disclose adjusted EBITDA, non-GAAP net income and non-GAAP net income per diluted share on a consolidated basis in our earnings releases, investor conference calls and filings with the Securities and Exchange Commission. The non-GAAP financial measures that we use may not be comparable to similarly titled measures reported by other companies. Also, in the future, we may disclose different non-GAAP financial measures in order to help our investors more meaningfully evaluate and compare our results of operations to our previously reported results of operations or to those of other companies in our industry.

We view EBITDA, adjusted EBITDA, non-GAAP net income and non-GAAP net income per diluted share as operating performance measures and as such we believe that the most directly comparable GAAP financial measure is net income. In calculating EBITDA, adjusted EBITDA, non-GAAP net income and non-GAAP net income per diluted share, we exclude from net income the financial items that we believe should be separately identified to provide additional analysis of the financial components of the day-to-day operation of our business. We have outlined below the type and scope of these exclusions and the material limitations on the use of these non-GAAP financial measures as a result of these exclusions. EBITDA, adjusted EBITDA, non-GAAP net income and non-GAAP net income per diluted share are not measurements of financial performance under GAAP and should not be considered as a measure of liquidity, as an alternative to net income or as an indicator of any other measure of performance derived in accordance with GAAP. Investors and potential investors in our securities should not rely on EBITDA, adjusted EBITDA, non-GAAP net income and non-GAAP net income per diluted share as a substitute for any GAAP financial measure, including net income. In addition, we urge investors and potential investors in our securities to carefully review the GAAP financial information included as part of our Annual Reports on Form 10-K and Quarterly Reports on Form 10-Q that are filed with the Securities and Exchange Commission, as well as our quarterly earnings releases, and compare the GAAP financial information with our EBITDA, adjusted EBITDA, non-GAAP net income and non-GAAP net income per diluted share.

EBITDA, adjusted EBITDA, non-GAAP net income and non-GAAP net income per diluted share may be used by management to internally measure our operating and management performance and may be used by investors as supplemental financial measures to evaluate the performance of our business. We believe that these non-GAAP measures, when viewed with our GAAP results and the accompanying reconciliation, provide additional information that is useful to understand the factors and trends affecting our business. We have spent more than 25 years building our database of commercial real estate information and expanding our markets and services partially through acquisitions of complementary businesses. Due to the expansion of our information, analytics and marketing services, which has included acquisitions, our net income has included significant charges for purchase amortization, depreciation and other amortization, acquisition- and integration-related costs and restructuring costs. Adjusted EBITDA, non-GAAP net income and non-GAAP net income per diluted share exclude these charges and provide meaningful information about the operating performance of our business, apart from charges for purchase amortization, depreciation and other amortization, acquisition- and integration-related costs, restructuring costs and settlement and impairment costs incurred outside our ordinary course of business. We believe the disclosure of non-GAAP measures can help investors meaningfully evaluate and compare our performance from quarter to quarter and from year to year. We also believe the non-GAAP measures we disclose are measures of our ongoing operating performance because the isolation of non-cash charges, such as amortization and depreciation, and other items, such as interest, income taxes, stock-based compensation expenses, acquisition- and integration-related costs, restructuring costs and settlement and impairment costs incurred outside our ordinary course of business, provides additional information about our cost structure, and, over time, helps track our operating progress. In addition, investors, securities analysts and others have regularly relied on EBITDA and may rely on adjusted EBITDA, non-GAAP net income or non-GAAP net income per diluted share to provide a financial measure by which to compare our operating performance against that of other companies in our industry.


31



Set forth below are descriptions of the financial items that have been excluded from our net income to calculate EBITDA and the material limitations associated with using this non-GAAP financial measure as compared to net income:

Purchase amortization in cost of revenues may be useful for investors to consider because it represents the use of our acquired database technology, which is one of the sources of information for our database of commercial real estate information. We do not believe these charges necessarily reflect the current and ongoing cash charges related to our operating cost structure.

Purchase amortization in operating expenses may be useful for investors to consider because it represents the estimated attrition of our acquired customer base and the diminishing value of any acquired trade names. We do not believe these charges necessarily reflect the current and ongoing cash charges related to our operating cost structure.

Depreciation and other amortization may be useful for investors to consider because they generally represent the wear and tear on our property and equipment used in our operations. We do not believe these charges necessarily reflect the current and ongoing cash charges related to our operating cost structure.

The amount of interest income we generate may be useful for investors to consider and may result in current cash inflows. However, we do not consider the amount of interest income to be a representative component of the day-to-day operating performance of our business.

The amount of interest expense we incur may be useful for investors to consider and may result in current cash outflows. However, we do not consider the amount of interest expense to be a representative component of the day-to-day operating performance of our business.

Income tax expense may be useful for investors to consider because it generally represents the taxes which may be payable for the period and the change in deferred income taxes during the period and may reduce the amount of funds otherwise available for use in our business. However, we do not consider the amount of income tax expense to be a representative component of the day-to-day operating performance of our business.

Set forth below are descriptions of the financial items that have been excluded from our net income to calculate adjusted EBITDA and the material limitations associated with using this non-GAAP financial measure as compared to net income:

Purchase amortization in cost of revenues, purchase amortization in operating expenses, depreciation and other amortization, interest income, interest expense, and income tax expense as previously described above with respect to the calculation of EBITDA.

Stock-based compensation expense may be useful for investors to consider because it represents a portion of the compensation of our employees and executives. Determining the fair value of the stock-based instruments involves a high degree of judgment and estimation and the expenses recorded may bear little resemblance to the actual value realized upon the future exercise or termination of the related stock-based awards. Therefore, we believe it is useful to exclude stock-based compensation in order to better understand the long-term performance of our core business.

The amount of acquisition- and integration-related costs incurred may be useful for investors to consider because they generally represent professional service fees and direct expenses related to the acquisition. Because we do not acquire businesses on a predictable cycle we do not consider the amount of acquisition- and integration-related costs to be a representative component of the day-to-day operating performance of our business.

The amount of restructuring costs incurred may be useful for investors to consider because they generally represent costs incurred in connection with a change in the makeup of our properties or personnel. We do not consider the amount of restructuring related costs to be a representative component of the day-to-day operating performance of our business.

The amount of material settlement and impairment costs incurred outside of our ordinary course of business may be useful for investors to consider because they generally represent gains or losses from the settlement of litigation matters. We do not believe these charges necessarily reflect the current and ongoing cash charges related to our operating cost structure.


32



The financial items that have been excluded from our net income to calculate non-GAAP net income and non-GAAP net income per diluted share are purchase amortization and other related costs, stock-based compensation, acquisition- and integration-related costs, restructuring costs and settlement and impairment costs incurred outside our ordinary course of business. These items are discussed above with respect to the calculation of adjusted EBITDA together with the material limitations associated with using this non-GAAP financial measure as compared to net income. We subtract an assumed provision for income taxes to calculate non-GAAP net income. In 2012 and 2013, we assumed a 38% tax rate in order to approximate our long-term effective corporate tax rate.

Non-GAAP net income per diluted share is a non-GAAP financial measure that represents non-GAAP net income divided by the number of diluted shares outstanding for the period used in the calculation of GAAP net income per diluted share.

Management compensates for the above-described limitations of using non-GAAP measures by using a non-GAAP measure only to supplement our GAAP results and to provide additional information that is useful to understand the factors and trends affecting our business.

The following table shows our EBITDA reconciled to our net income and our net cash flows from operating, investing and financing activities for the indicated periods (in thousands):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Net income
$
11,052

 
$
6,779

 
$
16,935

 
$
5,201

Purchase amortization in cost of revenues
2,954

 
3,027

 
9,007

 
5,607

Purchase amortization in operating expenses
3,680

 
4,824

 
11,699

 
9,038

Depreciation and other amortization
3,388

 
2,844

 
9,531

 
7,554

Interest income
(52
)
 
(59
)
 
(239
)
 
(440
)
Interest expense
1,736

 
1,822

 
5,249

 
3,022

Income tax expense, net
7,034

 
404

 
10,510

 
9,752

EBITDA
$
29,792

 
$
19,641

 
$
62,692

 
$
39,734

 
 
 
 
 
 
 
 
Cash flows provided by (used in)
 

 
 

 
 

 
 

Operating activities
$
31,261

 
$
25,980

 
$
72,828

 
$
56,558

Investing activities
(6,410
)
 
1,267

 
(15,244
)
 
(635,311
)
Financing activities
7,858

 
(1,187
)
 
9,219

 
162,872


Comparison of Three Months Ended September 30, 2013 and Three Months Ended September 30, 2012

Revenues. Revenues increased to $112.3 million for the three months ended September 30, 2013, from $96.0 million for the three months ended September 30, 2012. The $16.3 million increase was primarily attributable to further penetration of our subscription-based information services and successful cross-selling of our services to our customers in existing markets, combined with continued high renewal rates.

Gross Margin. Gross margin increased to $80.6 million for the three months ended September 30, 2013, from $65.1 million for the three months ended September 30, 2012. The gross margin percentage increased to 71.8% for the three months ended September 30, 2013, from 67.8% for the three months ended September 30, 2012. The increase in the gross margin amount and percentage was due to an increase in revenue partially offset by an increase in cost of revenues of approximately $842,000 primarily due to an increase in certain research personnel costs.

Selling and Marketing Expenses. Selling and marketing expenses increased to $23.6 million for the three months ended September 30, 2013, from $22.0 million for the three months ended September 30, 2012, and decreased as a percentage of revenues to 21.0% for the three months ended September 30, 2013, compared to 22.9% for the three months ended September 30, 2012. The increase in the amount of selling and marketing expenses during the three months ended September 30, 2013 was primarily due to an increase of stock-based compensation expense of approximately $451,000, branding initiatives of approximately $400,000 and recruiting fees resulting from initial efforts to increase the size of our field sales force of approximately $400,000.


33



Software Development Expenses. Software development expenses increased to $11.6 million for the three months ended September 30, 2013, from $9.7 million for the three months ended September 30, 2012, and increased as a percentage of revenues to 10.3% for the three months ended September 30, 2013, compared to 10.1% for the three months ended September 30, 2012. The increase in the amount and percentage of software development expenses was primarily due to increased personnel costs to support enhancements and upgrades to our products and services.

General and Administrative Expenses. General and administrative expenses increased to $21.9 million for the three months ended September 30, 2013, from $19.6 million for the three months ended September 30, 2012, and decreased as a percentage of revenues to 19.5% for the three months ended September 30, 2013, compared to 20.4% for the three months ended September 30, 2012. The increase in the amount of general and administrative expenses was primarily due to an increase of stock-based compensation expense.

Purchase Amortization. Purchase amortization decreased to $3.7 million for the three months ended September 30, 2013, compared to $4.8 million for the three months ended September 30, 2012, and decreased as a percentage of revenue to 3.3% for the three months ended September 30, 2013, compared to 5.0% for the three months ended September 30, 2012. The decrease in the amount and percentage of purchase amortization expense was primarily due to the accelerated amortization of the acquired customer base from our April 30, 2012 acquisition of LoopNet.

Interest and Other Income. Interest and other income remained relatively consistent at approximately $52,000 for the three months ended September 30, 2013 compared to approximately $59,000 for the three months ended September 30, 2012.

Interest and Other Expense. Interest and other expense remained relatively consistent at $1.7 million for the three months ended September 30, 2013 compared to $1.8 million for the three months ended September 30, 2012.

Income Tax Expense, net. Income tax expense, net increased to $7.0 million for the three months ended September 30, 2013 compared to approximately $404,000 for the three months ended September 30, 2012. This increase was primarily due to higher income before income taxes as a result of our increased profitability during the three months ended September 30, 2013 and a lower effective tax rate for the three months ended September 30, 2012 due to a change in local tax law that occurred in 2012.

Comparison of Business Segment Results for Three Months Ended September 30, 2013 and Three Months Ended September 30, 2012

We manage our business geographically in two operating segments, with our primary areas of measurement and decision-making being the U.S. and International, which includes the U.K. and France. Management relies on an internal management reporting process that provides revenue and operating segment EBITDA, which is our net income before interest, income taxes, depreciation and amortization. Management believes that operating segment EBITDA is an appropriate measure for evaluating the operational performance of our operating segments. EBITDA is used by management to internally measure our operating and management performance and to evaluate the performance of our business. However, this measure should be considered in addition to, not as a substitute for or superior to, income from operations or other measures of financial performance prepared in accordance with GAAP.

Segment Revenues. CoStar Suite is sold as a platform of service offerings consisting of CoStar Property Professional, CoStar COMPS Professional and CoStar Tenant and through our mobile application, CoStarGo, and is our primary service offering in our U.S. operating segment. U.S. revenues increased to $107.2 million for the three months ended September 30, 2013, from $91.2 million for the three months ended September 30, 2012. This increase in U.S. revenue was primarily due to further penetration of our subscription-based information services and successful cross-selling of our services to our customers in existing markets, combined with continued high renewal rates. FOCUS is our primary service offering in our International operating segment. Additionally, we introduced CoStar Suite in the U.K. in the fourth quarter of 2012. International revenues increased to $5.1 million for the three months ended September 30, 2013 from $4.8 million for the three months ended September 30, 2012. This increase was primarily due to further penetration of our subscription-based information services resulting from sales of CoStar Suite. Intersegment revenue decreased to approximately $131,000 for the three months ended September 30, 2013, compared to approximately $388,000 for the three months ended September 30, 2012. Intersegment revenue is attributable to services performed for our wholly owned subsidiary, PPR, by Property and Portfolio Research Ltd., a wholly owned subsidiary of PPR. Intersegment revenue is recorded at an amount we believe approximates fair value. Intersegment revenue is eliminated from total revenues.
 

34



Segment EBITDA. U.S. EBITDA increased to $30.9 million for the three months ended September 30, 2013, from $22.7 million for the three months ended September 30, 2012. The increase in U.S. EBITDA resulted primarily from an increase in revenues for the three months ended September 30, 2013 compared to the three months ended September 30, 2012, partially offset by an increase in personnel costs, including the stock-based compensation expense we recorded for the three months ended September 30, 2013. International EBITDA changed to a lower loss of $1.1 million for the three months ended September 30, 2013, from a loss of $3.0 million for the three months ended September 30, 2012. This lower loss was primarily due to a decrease in personnel costs. U.S. EBITDA includes an allocation of approximately $300,000 and $0 for the three months ended September 30, 2013 and 2012, respectively. This allocation represents costs incurred for International employees involved in development activities of the Company's U.S. operating segment. International EBITDA includes a corporate allocation of approximately $100,000 and $2.3 million for the three months ended September 30, 2013 and 2012, respectively. The corporate allocation represents costs incurred for U.S. employees involved in management and expansion activities of the Company's International operating segment. The corporate allocation for the three months ended September 30, 2012 consists primarily of development costs incurred for services of U.S. employees to upgrade the international platform of services and expand the coverage of service offerings within the International reporting unit.
 
Comparison of Nine Months Ended September 30, 2013 and Nine Months Ended September 30, 2012

Revenues. Revenues increased to $325.3 million for the nine months ended September 30, 2013, from $249.9 million for the nine months ended September 30, 2012. The $75.4 million increase was primarily attributable to increased revenue of approximately $46.9 million from our April 30, 2012 acquisition of LoopNet as well as the further penetration of our subscription-based information services and successful cross-selling of our services to our customers in existing markets, combined with continued high renewal rates.

Gross Margin. Gross margin increased to $227.9 million for the nine months ended September 30, 2013, from $166.5 million for the nine months ended September 30, 2012. The gross margin percentage increased to 70.1% for the nine months ended September 30, 2013, from 66.6% for the nine months ended September 30, 2012. The increase in the gross margin amount and percentage was due to an increase in revenue partially offset by an increase in cost of revenues of $14.0 million primarily due to an increase in research personnel costs of approximately $5.4 million and an increase of approximately $3.5 million in purchase amortization from our April 30, 2012 acquisition of LoopNet.

Selling and Marketing Expenses. Selling and marketing expenses increased to $74.1 million for the nine months ended September 30, 2013, from $57.6 million for the nine months ended September 30, 2012, and decreased as a percentage of revenues to 22.8% for the nine months ended September 30, 2013, compared to 23.0% for the nine months ended September 30, 2012. The increase in the amount of selling and marketing expenses was primarily due to the additional selling and marketing expenses from our April 30, 2012 acquisition of LoopNet.

Software Development Expenses. Software development expenses increased to $35.2 million for the nine months ended September 30, 2013, from $22.7 million for the nine months ended September 30, 2012, and increased as a percentage of revenues to 10.8% for the nine months ended September 30, 2013, compared to 9.1% for the nine months ended September 30, 2012. The increase in the amount and percentage of software development expenses was primarily due to increased personnel costs to support enhancements and upgrades to our products and services.

General and Administrative Expenses. General and administrative expenses increased to $74.5 million for the nine months ended September 30, 2013, from $59.6 million for the nine months ended September 30, 2012, and decreased as a percentage of revenues to 22.9% for the nine months ended September 30, 2013, compared to 23.9% for the nine months ended September 30, 2012. The increase in the amount of general and administrative expenses was primarily due to an increase of stock-based compensation expense.

Purchase Amortization. Purchase amortization increased to $11.7 million for the nine months ended September 30, 2013, compared to $9.0 million for the nine months ended September 30, 2012, and remained relatively consistent as a percentage of revenue at 3.6% for the nine months ended September 30, 2013 and 2012. The increase in the amount of purchase amortization expense was due to additional purchase amortization expenses from our April 30, 2012 acquisition of LoopNet.


35



Interest and Other Income. Interest and other income decreased to approximately $239,000 for the nine months ended September 30, 2013 compared to approximately $440,000 for the nine months ended September 30, 2012. The decrease was primarily due to our lower cash and cash equivalent balance during the nine months ended September 30, 2013, compared to the period during the nine months ended September 30, 2012, resulting from the net cash paid for our April 30, 2012 acquisition of LoopNet.

Interest and Other Expense. Interest and other expense increased to $5.2 million for the nine months ended September 30, 2013 compared to $3.0 million for the nine months ended September 30, 2012. The increase was due to the additional interest expense incurred for the nine months ended September 30, 2013, compared to the nine months ended September 30, 2012, resulting from the $175.0 million borrowed under the term loan facility on April 30, 2012 and used to fund a portion of the merger consideration and transaction costs for the LoopNet acquisition.

Income Tax Expense, net. Income tax expense, net increased to $10.5 million for the nine months ended September 30, 2013, compared to $9.8 million for the nine months ended September 30, 2012. This increase was primarily due to higher income before income taxes for the nine months ended September 30, 2013 as a result of our increased profitability, partially offset by a lower effective tax rate for the nine months ended September 30, 2013. The higher effective tax rate for the nine months ended September 30, 2012 was primarily due to costs related to the LoopNet acquisition that reduced income from operations but were not deductible for tax purposes.

Comparison of Business Segment Results for Nine Months Ended September 30, 2013 and Nine Months Ended September 30, 2012

Segment Revenues. U.S. revenues increased to $310.8 million for the nine months ended September 30, 2013, from $235.6 million for the nine months ended September 30, 2012. This increase in U.S. revenue was primarily due to increased revenue of approximately $46.9 million from our April 30, 2012 acquisition of LoopNet as well as the further penetration of our subscription-based information services and successful cross-selling of our services to our customers in existing markets, combined with continued high renewal rates. International revenues increased to $14.6 million for the nine months ended September 30, 2013, compared to $14.2 million for the nine months ended September 30, 2012. This increase was primarily due to further penetration of our subscription-based information services resulting from sales of CoStar Suite. Intersegment revenue decreased to approximately $277,000 for the nine months ended September 30, 2013, compared to $1.2 million for the nine months ended September 30, 2012. Intersegment revenue is attributable to services performed for our wholly owned subsidiary, PPR, by Property and Portfolio Research Ltd., a wholly owned subsidiary of PPR. Intersegment revenue is recorded at an amount we believe approximates fair value. Intersegment revenue is eliminated from total revenues.
 
Segment EBITDA. U.S. EBITDA increased to $66.6 million for the nine months ended September 30, 2013, from $46.3 million for the nine months ended September 30, 2012. The increase in U.S. EBITDA resulted primarily from an increase in revenues for the nine months ended September 30, 2013, compared to the nine months ended September 30, 2012, partially offset by an increase in personnel costs, including the stock-based compensation expense we recorded for the nine months ended September 30, 2013. International EBITDA changed to a lower loss of $3.9 million for the nine months ended September 30, 2013, from a loss of $6.6 million for the nine months ended September 30, 2012. This lower loss was primarily due to a decrease in personnel costs. U.S. EBITDA includes an allocation of approximately $600,000 and $0 for the nine months ended September 30, 2013 and 2012, respectively. This allocation represents costs incurred for International employees involved in development activities of the Company's U.S. operating segment. International EBITDA includes a corporate allocation of approximately $300,000 and $4.5 million for the nine months ended September 30, 2013 and 2012, respectively. The corporate allocation represents costs incurred for U.S. employees involved in management and expansion activities of the Company's International operating segment. The corporate allocation for the nine months ended September 30, 2012 consists primarily of development costs incurred for services of U.S. employees to upgrade the international platform of services and expand the coverage of service offerings within the International reporting unit.

Liquidity and Capital Resources

Our principal sources of liquidity are cash, cash equivalents and debt from our term loan and revolving credit facility. Total cash and cash equivalents increased to $222.9 million as of September 30, 2013 compared to cash, cash equivalents and short-term investments of $156.1 million as of December 31, 2012. The increase in cash and cash equivalents for the nine months ended September 30, 2013 was primarily due to net cash provided by operating activities of $72.8 million.
  

36



Changes in cash, cash equivalents and short-term investments are dependent upon changes in, among other things, working capital items such as accounts receivable, accounts payable, various accrued expenses and deferred revenues, as well as changes in our capital structure due to stock option exercises, purchases and sales of short-term investments and similar events.

Net cash provided by operating activities for the nine months ended September 30, 2013 was approximately $72.8 million compared to approximately $56.6 million for the nine months ended September 30, 2012. This $16.2 million increase in net cash provided by operating activities was primarily due to an increase of approximately $11.0 million in net income plus non-cash items as well as a net increase of approximately $5.2 million in changes in operating assets and liabilities due to differences in timing of collection of receipts and payments of disbursements.

Net cash used in investing activities for the nine months ended September 30, 2013 was approximately $15.2 million compared to approximately $635.3 million for the nine months ended September 30, 2012. This $620.1 million decrease in net cash used in investing activities was primarily due to $640.9 million of cash used for the acquisition of LoopNet on April 30, 2012, partially offset by a decrease in the proceeds from the sale and settlements of investments of approximately $14.5 million.

Net cash provided by financing activities was approximately $9.2 million for the nine months ended September 30, 2013 compared to approximately $162.9 million for the nine months ended September 30, 2012. This $153.7 million decrease was primarily due to the proceeds of $175.0 million received from the term loan facility on April 30, 2012 less payments of debt issuance costs of $11.5 million associated with the debt which did not occur in 2013.
 
Our future capital requirements will depend on many factors, including, among others, our operating results, expansion and integration efforts, and our level of acquisition activity or other strategic transactions.

During the nine months ended September 30, 2013, we incurred capital expenditures of approximately $15.3 million. We expect to make aggregate capital expenditures in 2013 of approximately $18.0 million to $22.0 million, primarily related to the build out of leased office space.

To date, we have grown in part by acquiring other companies and we may continue to make acquisitions. Our acquisitions may vary in size and could be material to our current operations. We may use cash, stock, debt or other means of funding to make these acquisitions.  

On April 30, 2012, we acquired LoopNet pursuant to an Agreement and Plan of Merger dated April 27, 2011, as amended May 20, 2011 (the “Merger Agreement”). Prior to completion of the LoopNet acquisition on April 26, 2012 the FTC accepted a consent order in connection with the LoopNet merger that was previously agreed to by CoStar and LoopNet. The consent order, which is publicly available on the FTC's website at www.ftc.gov, required, among other things, that CoStar and LoopNet divest LoopNet's minority interest in Xceligent. On March 28, 2012, CoStar and LoopNet entered into a Purchase Agreement to sell LoopNet's interest in Xceligent to DMGI. The parties closed the sale of LoopNet's interest in Xceligent to DMGI on May 3, 2012. We received $4.2 million in proceeds from the sale, which reflected the fair value of the investment at the time of sale and did not result in any gain on the sale of the investment.

We funded the cash portion of the consideration payable to LoopNet stockholders in the merger through a combination of cash on hand, including the net proceeds of approximately $247.9 million from an equity offering we completed in June 2011, and $175.0 million in proceeds from a term loan facility pursuant to the Credit Agreement, dated February 16, 2012, by and among CoStar, as borrower, CoStar Realty, as co-borrower, J.P. Morgan Bank, as administrative agent, and the other lenders thereto. We made principal payments of approximately $13.1 million and $4.4 million for the nine months ended September 30, 2013 and 2012, respectively. As of September 30, 2013, maturities of our borrowings under the Credit Agreement for each of the next four years ended September 30, 2014 to 2017, are expected to be $21.9 million, $30.6 million, $52.5 million and $52.5 million, respectively.

The Credit Agreement requires us to maintain a Debt Service Coverage Ratio (as defined in the Credit Agreement) of at least 1.5 to 1.0 and a Total Leverage Ratio (as defined in the Credit Agreement) that does not exceed 2.75 to 1.00 during each of the three months ending September 30, 2013, December 31, 2013, March 31, 2014 and June 30, 2014; and 2.50 to 1.00 thereafter. The Credit Agreement also includes other covenants that were effective as of April 30, 2012, including covenants that, subject to certain exceptions, restrict our ability and the ability of our subsidiaries (i) to incur additional indebtedness, (ii) to create, incur, assume or permit to exist any liens, (iii) to enter into mergers, consolidations or similar transactions, (iv) to make investments and acquisitions, (v) to make certain dispositions of assets, (vi) to make dividends, distributions and prepayments of certain indebtedness, and (vii) to enter into certain transactions with affiliates. We were in compliance with the covenants in the Credit Agreement as of September 30, 2013.


37



Commencing with the fiscal year ending December 31, 2012, the Credit Agreement requires us to make an annual prepayment of the term loan facility equal to a percentage of Excess Cash Flow (as defined in the Credit Agreement) to reduce the principal amount outstanding under the term loan facility. The prepayment percentage is 50% when the Total Leverage Ratio exceeds 3.00 to 1.00; 25% when the Total Leverage Ratio is greater than 2.50 to 1.00 but equal to or less than 3.00 to 1.00; and 0% when the Total Leverage Ratio is equal to or less than 2.50 to 1.00. This prepayment requirement is reduced by the amount of prior voluntary prepayments during the respective fiscal year, subject to certain exceptions set forth in the Credit Agreement. The Excess Cash Flow payment, if required, is due within ten business days of the date on which the annual financial statements are delivered or required to be delivered to the lenders pursuant to the Credit Agreement. For the fiscal year ended December 31, 2012, we were not required to make an Excess Cash Flow payment.
 
In connection with obtaining the term loan facility, we incurred approximately $11.5 million in debt issuance costs, which were capitalized and are being amortized as interest expense over the term of the Credit Agreement using the effective interest method. The debt issuance costs are comprised of approximately $9.2 million in underwriting fees and approximately $2.3 million primarily related to legal fees associated with the debt issuance. 

As o