CoStar Group (CSGP) is one of the premiere data providers to the commercial real estate market. It calls itself the Bloomberg of real estate, and I think the analogy, if not totally accurate, is rather helpful in understanding its business. I have recently shorted the stock for two main reasons: First, the commercial real estate market is slowing, and even though it’s not likely to go into the tank homies style, it did reach lofty heights and any downturn is likely to leave a dent throughout the industry. Second, CSGP may be very expensive. Here are the two sides of a tough company to read:

Hoofy:
 

• CSGP is assembling an impressive database of information for anyone involved with commercial real estate.
  
• To the extent that the investment stage of its growth is toward the end, there could be significant cash flow leverage in its model since expenses are relatively fixed and a fair amount of new revenues can drop to the bottom line.
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• Its recent investments give it a significant competitive advantage in a very fragmented market, and together with Loopnet (LOOP), CSGP is establishing itself as one of the gorillas.
  
• While the barriers to entry are not impenetrable, anyone who has ever used a Bloomberg station knows that there is tremendous stickiness once a customer becomes comfortable with the platform.
  
• Depending on which estimates you believe in for revenue and EBITDA margins growth, both may show a very fast ramp, which could make the multiples on CSGP stock look rather attractive.

Boo:
 

• The shape of the industry from CSGP’s CEO: “I think we may be seeing the end of one the great industry booms here... More recently the sales and leasing activity have continued to cool off. We are seeing lower net absorption levels occurring across both office and industrial type properties... [In the US office market] the amount of space absorbed was the second lowest total for a quarter in the last three and a half years... .Once potential problem that concerns us is that the amount of new office, retail and industrial space delivering across the country looks like it’s about to surge dramatically at a time of lower leasing activity... Going forward, the combination of high delivery with low absorption could lead to higher vacancy rates and declining rents. That in turn would likely cause the current exceptionally low cap rates, in particular in the current credit market, to erode, and it could bring property values down, perhaps dramatically. We believe the impact will be more severe on the investment/sales markets than on than the leasing markets.
• Kudos to management for telling it the way it sees it. Unfortunately, later management tells us that the company won’t be much affected by the slowdown because in a tougher market, professionals actually crave more and more information.
• Two comments on the above: First, when an industry slows down it is exceedingly rare that a company can benefit by swimming against the tide, unless it is a company like FTI Consulting (FCN), whose model benefits when things go bad. Second, even if a thorough information system becomes a competitive advantage in a tough market, part of CSGP’s business is based on licence sales, and if people get fired within the industry, the number of licences sold or renewed gets hurt.
  
• 3Q saw declines both in new customers and average contract value. Nothing major, but if it establishes a trend this becomes a serious problem.
  
• The future trend of the stock is not based on whether CSGP’s business will grow (it almost certainly will) but on whether it’ll grow fast enough to justify current multiples.
  
• On the call management stressed several times the risks of the slowing market, and how new sales representatives will need a bit of time to become productive. Nothing sinister about the latter until this answer on future hirings: “I think in particular in the light of some of the market uncertainty we don’t want to rush right up to the mark [of total new hires]. I’d like to get the 148 we’ve got up to a higher productivity level, but I am... confident that as we report upcoming quarters you... will see the number continue to creep on up.
• Put all the various cautionary statements together and it is prudent to view them as an effort to cover themselves ahead of future disappointments.

The Rub:

Sometimes nitpicking a company’s financial statements, growth rates, margins, etc., can causes one to lose sight of the big picture and of the potential business trends that can make those financial measures obsolete. Other times, however, there is such a discrepancy among guidance, Street estimates and current results that the only way to gauge where a stock may be heading is to try to figure out which way and how fast the financials are moving. I believe that is the case for CSGP. Boring as it may be, here is how I see things lined up:
 

• Here are CSGP’s current revenue estimates with recent revisions:
  
  
  Click here to enlarge.
  
  
• 3Q EBITDA margins were 16%; CSGP is targeting 30% by Q4 of ’08, or 25.5% for the entire year;
  
• But current Street estimates for ’08 EBITDA is $47.1 mln, implying 20% margins for all of ’08. So either the company or the Street is way off. At 25.5% margins, EBITDA would be closer to $57 mln;
  
• Rather than dealing with just revenue growth and EBITDA, I figured a span of possible Free Cash Flow (FCF) results (making certain assumptions for Capex, cash taxes and interest income) and corresponding Enterprise Value / FCF multiples. Here is the spreadsheet;
  
• I repeated the process for ’09, since at this point the ‘08/’09 FCF growth rate is pertinent to which EV/FCF multiple one should reasonably pay;
  
• At the current price CSGP trades at an EV/FCF multiple of about 81, on full FY ’07 FCF;

Bottom line: regardless which revenue estimate you subscribe to for ’08, at a 26% EBITDA margin for ’08, and at the current price of $57.50, the EV/FCF multiple on ’08 numbers is about 40 (green column). That’s high, but not absurd given the 70%-90% growth in ’08 versus ’07 FCF. However, that 40 multiple becomes more of an issue toward the end of ’08, when the ’09 vs. ’08 FCF growth will look to be in the 40’ish percent rate (red numbers).

My sense is that Street estimates for EBITDA will likely move up in the coming months, which generally would support the stock price. On the other hand, in this case an increase in estimates will simply bring CSGP’s multiples in a more stomachable range, and the flip side is that if the increases fail to materialize, the current price is very hard to justify. So CSGP must deliver some lofty results in the face of a difficult macro environment. I am planning to remain on the dark side of this one until it shows me that it can indeed swim against the tide.