10-Q 1 csgp-9302012x10q.htm 10-Q CSGP-9.30.2012-10Q


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, 2012
 
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 19, 2012, there were 28,259,893 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,
 
2012
 
2011
 
2012
 
2011
Revenues                                                                          
$
96,001

 
$
63,829

 
$
249,853

 
$
185,574

Cost of revenues                                                                          
30,882

 
21,175

 
83,388

 
66,153

Gross margin                                                                          
65,119

 
42,654

 
166,465

 
119,421

 
 
 
 
 
 
 
 
Operating expenses:
 

 
 

 
 

 
 

Selling and marketing                                                                       
22,010

 
17,467

 
57,576

 
44,993

Software development                                                                       
9,722

 
5,017

 
22,714

 
15,420

General and administrative                                                                       
19,617

 
16,631

 
59,602

 
43,375

Purchase amortization                                                                       
4,824

 
535

 
9,038

 
1,624

 
56,173

 
39,650

 
148,930

 
105,412

Income from operations                                                                          
8,946

 
3,004

 
17,535

 
14,009

Interest and other income (expense), net                                                                          
(1,763
)
 
194

 
(2,582
)
 
574

Income before income taxes                                                                          
7,183

 
3,198

 
14,953

 
14,583

Income tax expense, net                                                                          
404

 
887

 
9,752

 
5,103

Net income                                                                   
$
6,779

 
$
2,311

 
$
5,201

 
$
9,480

 
 
 
 
 
 
 
 
Net income  per share — basic                                                                          
$
0.25

 
$
0.09

 
$
0.20

 
$
0.42

Net income per share — diluted                                                                          
$
0.24

 
$
0.09

 
$
0.19

 
$
0.41

 
 
 
 
 
 
 
 
Weighted average outstanding shares — basic                                                                          
27,243

 
24,973

 
26,279

 
22,505

Weighted average outstanding shares — diluted
27,673

 
25,317

 
26,691

 
22,903


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,
 
 
2012
 
2011
 
2012
 
2011
Net income
 
$
6,779

 
$
2,311

 
$
5,201

 
$
9,480

Other comprehensive income (loss), net of tax
 
 
 
 
 
 
 
 
Foreign currency translation adjustment
 
1,014

 
(720
)
 
1,286

 
328

Net change in unrealized loss on investments, net of tax
 
727

 
(44
)
 
672

 
(98
)
Total other comprehensive income (loss)
 
1,741

 
(764
)
 
1,958

 
230

Total comprehensive income
 
$
8,520

 
$
1,547

 
$
7,159

 
$
9,710


See accompanying notes.


4



COSTAR GROUP, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
 
September 30,
2012
 
December 31,
2011
ASSETS
(unaudited)
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
129,462

 
$
545,280

Short-term investments
817

 
3,515

Accounts receivable, less allowance for doubtful accounts of approximately
    $3,391 and $2,524 as of September 30, 2012 and December 31, 2011, respectively
21,397

 
16,589

Deferred income taxes, net
15,145

 
11,227

Income tax receivable
6,560

 
850

Prepaid expenses and other current assets
7,999

 
5,722

Debt issuance costs
2,953

 

Total current assets
184,333

 
583,183

 
 
 
 
Long-term investments
21,561

 
24,584

Deferred income taxes, net

 
10,224

Property and equipment, net
42,962

 
37,571

Goodwill
718,080

 
91,784

Intangibles and other assets, net
178,205

 
20,530

Deposits and other assets
2,160

 
2,241

Debt issuance costs
7,358

 
918

Total assets
$
1,154,659

 
$
771,035

LIABILITIES AND STOCKHOLDERS’ EQUITY
 

 
 

Current liabilities:
 

 
 

Current portion of long-term debt
$
13,125

 
$

Accounts payable
3,718

 
6,010

Accrued wages and commissions
21,255

 
16,695

Accrued expenses
19,608

 
12,761

Deferred gain on the sale of building
2,523

 
2,523

Income taxes payable

 
978

Deferred rent
138

 
544

Deferred revenue
32,661

 
22,271

Total current liabilities
93,028

 
61,782

 
 
 
 
Long-term debt, less current portion
157,500

 

Deferred gain on the sale of building
29,440

 
31,333

Deferred rent
16,895

 
16,592

Deferred income taxes, net
38,142

 

Income taxes payable
2,826

 
2,151

Other long-term liabilities
977

 

Total liabilities
338,808

 
111,858

 
 
 
 
Total stockholders’ equity
815,851

 
659,177

Total liabilities and stockholders’ equity
$
1,154,659

 
$
771,035

See accompanying notes.

5



COSTAR GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 
Nine Months Ended
September 30,
 
2012
 
2011
Operating activities:
 
 
 
Net income
$
5,201

 
$
9,480

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

 
 

Depreciation
7,203

 
6,390

Amortization
14,996

 
3,253

Amortization of debt issuance costs
1,235

 

Property and equipment write-off
85

 
621

Excess tax expense (benefit) from stock options
57

 
(1,433
)
Stock-based compensation expense
8,667

 
6,110

Deferred income tax expense, net
11,828

 
(16,608
)
Provision for losses on accounts receivable
1,418

 
1,040

Changes in operating assets and liabilities, net of acquisitions:
 

 
 

Accounts receivable
(3,612
)
 
(6,864
)
Income taxes payable
6,205

 
12,083

Prepaid expenses and other current assets
(1,848
)
 
(581
)
Deposits and other assets
1,286

 
512

Accounts payable and other liabilities
(2,068
)
 
4,163

Deferred revenue
5,905

 
1,541

Net cash provided by operating activities
56,558

 
19,707

 
 
 
 
Investing activities:
 

 
 

Proceeds from sale and settlement of investments
14,620

 
815

Proceeds from sale of building, net

 
83,553

Purchases of property and equipment and other assets
(9,002
)
 
(12,172
)
Acquisitions, net of cash acquired
(640,929
)
 

Net cash provided by (used in) investing activities
(635,311
)
 
72,196

 
 
 
 
Financing activities:
 

 
 

Proceeds from long-term debt
175,000

 

Payments of long-term debt
(4,375
)
 

Payments of debt issuance costs
(11,546
)
 

Excess tax benefit (expense) from stock options
(57
)
 
1,433

Repurchase of restricted stock to satisfy tax withholding obligations
(3,817
)
 
(1,972
)
Proceeds from equity offering, net of transaction costs

 
247,924

Proceeds from exercise of stock options and ESPP
7,667

 
4,982

Net cash provided by financing activities
162,872

 
252,367

 
 
 
 
Effect of foreign currency exchange rates on cash and cash equivalents
63

 
65

Net increase (decrease) in cash and cash equivalents
(415,818
)
 
344,335

Cash and cash equivalents at the beginning of period
545,280

 
206,405

Cash and cash equivalents at the end of period
$
129,462

 
$
550,740


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, 2012, the results of its operations for the three and nine months ended September 30, 2012 and 2011, its comprehensive income for the three and nine months ended September 30, 2012 and 2011, and its cash flows for the nine months ended September 30, 2012 and 2011. 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, 2011.

The results of operations for the three and nine months ended September 30, 2012 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 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, 2012 and 2011.


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,
2012
 
December 31,
2011
Foreign currency translation adjustment
$
(4,604
)
 
$
(5,890
)
Accumulated net unrealized loss on investments, net of tax
(2,006
)
 
(2,678
)
Total accumulated other comprehensive loss
$
(6,610
)
 
$
(8,568
)
 
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:
2012
 
2011
 
2012
 
2011
 
Net income
$
6,779

 
$
2,311

 
$
5,201

 
$
9,480

Denominator:
 

 
 

 
 

 
 

Denominator for basic net income per share — weighted-average outstanding shares
27,243

 
24,973

 
26,279

 
22,505

Effect of dilutive securities:
 

 
 

 
 

 
 

Stock options and restricted stock
430

 
344

 
412

 
398

Denominator for diluted net income per share — weighted-average outstanding shares
27,673

 
25,317

 
26,691

 
22,903

 
 

 
 

 
 

 
 

Net income per share — basic 
$
0.25

 
$
0.09

 
$
0.20

 
$
0.42

Net income per share — diluted 
$
0.24

 
$
0.09

 
$
0.19

 
$
0.41

 
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.  The following table summarizes the potential common shares excluded from the diluted calculation (in thousands):

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Employee stock options

 
146

 

 
9


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.

Stock-based compensation cost is measured at the grant date of the stock-based awards 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.


8

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

2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES — (CONTINUED)

Stock-Based Compensation — (Continued)

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 $2.6 million and $442,000 for the three months ended September 30, 2012 and 2011, respectively.  Net cash proceeds from the exercise of stock options and the purchase of shares under the ESPP were approximately $7.7 million and $5.0 million for the nine months ended September 30, 2012 and 2011, respectively. The Company recorded a reduction of approximately $57,000 to its realized excess tax benefit from stock option and award exercises for the three months ended September 30, 2012 and recorded approximately $186,000 of excess tax benefits from stock option and award exercises for the three months ended September 30, 2011. The Company recorded a reduction of approximately $57,000 to its realized excess tax benefit from stock option and award exercises for the nine months ended September 30, 2012 and recorded approximately $1.4 million of excess tax benefits from stock option and award exercises for the nine months ended September 30, 2011.

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,
 
2012
 
2011
 
2012
 
2011
Cost of revenues
$
849

 
$
347

 
$
1,784

 
$
1,222

Selling and marketing
493

 
409

 
1,331

 
939

Software development
809

 
275

 
1,565

 
882

General and administrative
1,588

 
814

 
3,987

 
3,067

Total stock-based compensation
$
3,739

 
$
1,845

 
$
8,667

 
$
6,110

 
Options to purchase 76,542 and 13,418 shares were exercised during the three months ended September 30, 2012 and 2011, respectively. Options to purchase 224,382 and 135,891 shares were exercised during the nine months ended September 30, 2012 and 2011, respectively.

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 $350,000 and $493,000 as of September 30, 2012 and December 31, 2011, 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 and $32,000 for the three months ended September 30, 2012 and 2011, respectively. The Company amortized capitalized product development costs of approximately $143,000 and $32,000 for the nine months ended September 30, 2012 and 2011, respectively.   


9

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

2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES — (CONTINUED)

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's capitalized debt issuance costs were approximately $10.3 million and $918,000 as of September 30, 2012 and December 31, 2011, 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 $763,000 and $0 for the three months ended September 30, 2012 and 2011, respectively. The Company amortized debt issuance costs of approximately $1.2 million and $0 for the nine months ended September 30, 2012 and 2011, 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, 2011, including the expected dates of adoption and estimated effects on the Company’s condensed consolidated financial statements.

3.
ACQUISITIONS

Virtual Premise, Inc.

On October 25, 2011, the Company acquired Virtual Premise, Inc. (“Virtual Premise”), a Software as a Service (“SaaS”) provider of real estate information management solutions. Pursuant to the terms of the acquisition agreement, the Company paid approximately $17.2 million in cash, approximately 80% of which was paid on the closing date and the remaining 20% of which was held in escrow for approximately 270 days after the closing date. The funds held in escrow were subject to the prior use of such funds to satisfy any post-closing net working capital adjustments or indemnification claims made prior to the date the funds were released. The purchase price was reduced by approximately $200,000 after taking into account post-closing purchase price adjustments and this amount was paid to the Company from the escrow fund on March 1, 2012. The remaining escrowed funds were released to the former Virtual Premise stockholders on July 23, 2012.

The purchase price for the Virtual Premise acquisition was allocated as follows (in thousands):
Acquired trade names and other
$
740

Acquired customer base
3,740

Acquired database technology
810

Goodwill
12,205

Other assets and liabilities
(529
)
Total purchase consideration
$
16,966


This acquisition was accounted for using the acquisition method, which requires that, among other things, assets acquired and liabilities assumed be recorded at their fair values as of the acquisition date. The purchase price was allocated to trade names, customer base, database technology, goodwill and various other asset and liability accounts.  The acquired customer base for the acquisition, which consists of one distinct intangible asset and is composed of acquired customer contracts and the related customer relationships, is being amortized on a 125% declining balance method over 10 years. The identified intangibles are amortized over their estimated useful lives. Goodwill recorded in connection with this acquisition is not amortized, but is subject to annual impairment tests. The results of operations of Virtual Premise have been consolidated with those of the Company since the date of the acquisition and are not considered material to the Company's condensed consolidated financial statements. Accordingly, pro forma financial information has not been presented for the acquisition.


10

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

3.
ACQUISITIONS — (CONTINUED)

LoopNet, Inc.

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 United States. 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 in order to find a buyer or tenant. The acquisition combines the marketing solutions offered by LoopNet with the research capabilities of the Company 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 expected to be deductible for income tax purposes. The purchase accounting is preliminary and is subject to change.
 
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.


11

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

3.
ACQUISITIONS — (CONTINUED)

The Company's consolidated revenue for the three months ended September 30, 2012 and 2011, included $22.9 million and $0 from the LoopNet contributed business, respectively. The Company's consolidated revenue for the nine months ended September 30, 2012 and 2011, included $36.1 million and $0 from the LoopNet contributed business, respectively. The Company's consolidated net income for the three months ended September 30, 2012 and 2011, included a $1.7 million and $0 net loss from the LoopNet contributed business, respectively. The Company's consolidated net income for the nine months ended September 30, 2012 and 2011, included $5.7 million and $0 net loss from the LoopNet contributed business, respectively.

The following unaudited pro forma amounts present consolidated information as if the acquisition had been completed as of January 1, 2011 (in thousands except per share data):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Revenue
$
97,612

 
$
86,043

 
$
285,154

 
$
250,120

Net income
$
6,282

 
$
3,971

 
$
8,299

 
$
9,192

Net income per share — basic
$
0.23

 
$
0.15

 
$
0.31

 
$
0.34

Net income per share — diluted
$
0.23

 
$
0.15

 
$
0.30

 
$
0.34


This information is based on historical results of operations, adjusted for the allocation of purchase price and other acquisition accounting adjustments, including: (i) the amortization associated with the acquired intangible assets; (ii) interest expense associated with debt used to fund a portion of the acquisition; and (iii) reduced interest income associated with cash used to fund a portion of the acquisition. The unaudited pro forma results do not include: (i) any potential synergies, cost savings or other expected benefits of the acquisition; (ii) the revenue impact of the non-recurring purchase accounting adjustment to reduce the acquisition-related deferred revenue; (iii) the non-recurring acquisition costs incurred on the date of acquisition; and (iv) the non-recurring tax impact of an unusually high tax rate in the second quarter of 2012 due to costs related to the LoopNet acquisition that reduce income from operations but are not deductible for tax purposes. Accordingly, the unaudited pro forma amounts are for comparative purposes only and may not necessarily reflect the results of operations which would have resulted had the acquisition been completed at the beginning of the applicable period and may not be indicative of the results that will be attained in the future.

The Company recorded no acquisition-related costs for the three months ended September 30, 2012 and recorded $5.8 million in acquisition-related costs for the three months ended September 30, 2011. The Company recorded approximately $5.2 million and $11.1 million in acquisition-related costs for the nine months ended September 30, 2012 and 2011, respectively. These costs include expenses directly related to acquiring LoopNet. These costs are expensed as incurred and recorded in general and administrative expense.

The Company estimates that the total amount of severance costs for LoopNet employees related to the acquisition will be approximately $2.4 million, of which approximately $300,000 and $0 were recorded in general and administrative expenses for the three months ended September 30, 2012 and 2011, respectively. Approximately $2.3 million and $0 of severance costs for LoopNet employees related to the acquisition were recorded in general and administrative expenses for the nine months ended September 30, 2012 and 2011, respectively. Approximately $200,000 and $0 of such severance costs were paid during the three months ended September 30, 2012 and 2011, respectively. Approximately $2.2 million and $0 of severance costs for LoopNet employees related to the acquisition were paid during the nine months ended September 30, 2012 and 2011, respectively. The remaining severance payments for LoopNet employees related to the acquisition are expected to be made by June 30, 2013.
 
Prior to completion of the LoopNet acquisition, on April 26, 2012, the Federal Trade Commission (the “FTC”) accepted a consent order previously agreed to by the Company and LoopNet. The consent order was subject to a 30-day public comment period, which has passed. 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, requires, 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 a Purchase 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.


12

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

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 and corporate obligations 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, 2012 were as follows (in thousands):
Maturity
 
Fair Value
Due:
 
 
October 1, 2012 — September 30, 2013                                                                                                                
 
$
777

October 1, 2013 — September 30, 2017                                                                                                                
 
442

October 1, 2017 — September 30, 2022                                                                                                                
 
40

After September 30, 2022                                                                                                               
 
21,119

Available-for-sale investments                                                                                                                    
 
$
22,378


The Company had no realized gains on its investments for each of the three and nine months ended September 30, 2012 and 2011. The Company had no realized losses on its investments for each of the three and nine months ended September 30, 2012 and 2011.  

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, 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
Corporate debt securities
$
777

 
$

 
$

 
$
777

Government-sponsored enterprise obligations
40

 

 

 
40

Auction rate securities
23,567

 

 
(2,006
)
 
21,561

Available-for-sale investments
$
24,384

 
$

 
$
(2,006
)
 
$
22,378


As of December 31, 2011, 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
Corporate debt securities
$
3,397

 
$
64

 
$

 
$
3,461

Government-sponsored enterprise obligations
55

 

 
(1
)
 
54

Auction rate securities
27,325

 

 
(2,741
)
 
24,584

Available-for-sale investments
$
30,777

 
$
64

 
$
(2,742
)
 
$
28,099



13

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

4.
INVESTMENTS — (CONTINUED)

The unrealized losses on the Company’s investments as of September 30, 2012 and December 31, 2011 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, 2012 and December 31, 2011.  See Note 5 for further discussion on the fair value of the Company’s financial assets.

The components of the Company’s investments in an unrealized loss position for more than twelve months were as follows (in thousands):
 
September 30,
2012
 
December 31,
2011
 
Aggregate
Fair
 Value
 
Gross
Unrealized
Losses
 
Aggregate
Fair
 Value
 
Gross
Unrealized
Losses
Government-sponsored enterprise obligations
$
40

 
$

 
$
54

 
$
(1
)
Auction rate securities
21,119

 
(2,006
)
 
24,584

 
(2,741
)
Investments in an unrealized loss position
$
21,159

 
$
(2,006
)
 
$
24,638

 
$
(2,742
)

The Company did not have any investments in an unrealized loss position for less than twelve months as of September 30, 2012 and December 31, 2011, 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.

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, 2012 (in thousands):

 
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
Cash
$
99,164

 
$

 
$

 
$
99,164

Money market funds
30,277

 

 

 
30,277

Commercial paper
21

 

 

 
21

Corporate debt securities

 
777

 

 
777

Government-sponsored enterprise obligations

 
40

 

 
40

Auction rate securities

 

 
21,561

 
21,561

Total assets measured at fair value
$
129,462

 
$
817

 
$
21,561

 
$
151,840

Liabilities:
 
 
 
 
 
 
 
Deferred consideration
$

 
$

 
$
2,185

 
$
2,185

Total liabilities measured at fair value
$

 
$

 
$
2,185

 
$
2,185



14

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) measured at fair value on a recurring basis as of December 31, 2011 (in thousands):
 
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
Cash
$
75,688

 
$

 
$

 
$
75,688

Money market funds
220,996

 

 

 
220,996

Commercial paper
248,596

 

 

 
248,596

Corporate debt securities

 
3,461

 

 
3,461

Government-sponsored enterprise obligations

 
54

 

 
54

Auction rate securities

 

 
24,584

 
24,584

Total assets measured at fair value
$
545,280

 
$
3,515

 
$
24,584

 
$
573,379


The Company’s Level 2 assets consist of corporate debt securities and government-sponsored enterprise obligations, which do not have directly observable quoted prices in active markets.  The Company’s Level 2 assets are 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, 2012 and 2011 (in thousands):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Balance at beginning of period
$
24,976

 
$
29,014

 
$
24,584

 
$
29,189

Auction rate securities upon acquisition

 

 
442

 

Unrealized gain included in accumulated other comprehensive loss
735

 

 
735

 

Settlements
(4,150
)
 
(600
)
 
(4,200
)
 
(775
)
Balance at end of period
$
21,561

 
$
28,414

 
$
21,561

 
$
28,414



15

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, 2012 (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

Settlements
(50
)
Balance at March 31, 2012
24,534

Auction rate securities upon acquisition
442

Balance at June 30, 2012
24,976

Change in unrealized gain included in accumulated other comprehensive loss
735

Settlements
(4,150
)
Balance at September 30, 2012
$
21,561


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, 2012, the Company held ARS with $24.4 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, 2012.  

While the Company continues to earn interest on its ARS investments at the contractual rate, these investments are not currently 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, 2012.  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 on these securities. The weighted average discount rate used as of September 30, 2012 based on the fair values of the ARS was approximately 5.2%. 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.


16

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, 2012, the Company determined there was a decline in the fair value of its ARS investments of approximately $2.0 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, 2012, the Company held Level 3 liabilities for deferred consideration acquired as a result of the April 30, 2012 acquisition of LoopNet. The deferred consideration totaled $2.2 million as of September 30, 2012 and included potential deferred cash payments resulting from acquisitions completed by LoopNet in 2010 including: (i) potential deferred cash payments due to the sellers of LandsofAmerica.com, LLC ("LandsofAmerica") on March 31, 2013 and March 31, 2014 based on LandsofAmerica's achievement of financial and operational milestones, resulting in undiscounted deferred consideration as of September 30, 2012 of approximately $2.0 million; and (ii) potential deferred cash payments due to the sellers of Reaction Corp. ("Reaction Web") on March 31, 2013 and March 31, 2014 based on Reaction Web's achievement of revenue milestones, resulting in undiscounted deferred consideration as of September 30, 2012 of approximately $700,000.

As of September 30, 2011, the Company held no Level 3 liabilities. Prior to September 30, 2011, the Company held Level 3 liabilities for deferred consideration related to the October 19, 2009 acquisition of Resolve Technology, Inc. (“Resolve Technology”). The deferred consideration included (i) a potential deferred cash payment due approximately two years after closing based on the incremental growth of Resolve Technology’s revenue as of September 2011 over its revenue as of September 2009, and (ii) other potential deferred cash payments for successful completion of operational and sales milestones during the period from closing through no later than October 31, 2013, which period was subject to extension by the parties to a date no later than December 31, 2014.  On June 24, 2011, the Company made a payment of $500,000 for the successful completion of one of the operational milestones.  On September 8, 2011, the Company entered into an agreement to settle all remaining potential deferred cash payments due under the acquisition agreement.  Under the terms of the settlement agreement, the Company made a payment of $1.6 million on September 14, 2011 to settle the entire obligation.  The Company reversed the remaining $1.2 million of deferred consideration as a reduction to general and administrative expense during the three months ended September 30, 2011.

The following tables summarize changes in fair value of the Company’s Level 3 liabilities for the three and nine months ended September 30, 2012 and 2011 (in thousands):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Balance at beginning of period
$
2,072

 
$
2,786

 
$

 
$
3,222

Deferred consideration upon acquisition

 

 
2,011

 

Accretion for period
113

 
21

 
174

 
85

Payments made during period

 
(1,600
)
 

 
(2,100
)
Adjustments made during period

 
(1,207
)
 

 
(1,207
)
Balance at end of period
$
2,185

 
$

 
$
2,185

 
$



17

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 liabilities from December 31, 2010 to September 30, 2012 (in thousands):
 
Deferred
Consideration
Balance at December 31, 2010
$
3,222

Accretion for 2011
85

Payments made in 2011
(2,100
)
Adjustments made in 2011
(1,207
)
Balance at December 31, 2011

Activity from January 1, 2012 – March 31, 2012

Balance at March 31, 2012

Deferred consideration upon acquisition
2,011

Accretion from April 1, 2012 – June 30, 2012
61

Balance at June 30, 2012
2,072

Accretion from July 1, 2012 – September 30, 2012
113

Balance at September 30, 2012
$
2,185


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

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, 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, 2010
$
55,260

 
$
24,342

 
$
79,602

Acquisitions
12,205

 

 
12,205

Effect of foreign currency translation

 
(23
)
 
(23
)
Goodwill, December 31, 2011
67,465

 
24,319

 
91,784

Acquisitions
625,174

 

 
625,174

Effect of foreign currency translation

 
1,122

 
1,122

Goodwill, September 30, 2012
$
692,639

 
$
25,441

 
$
718,080



18

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

6.
GOODWILL — (CONTINUED)

The Company recorded goodwill of approximately $12.2 million in connection with the October 2011 acquisition of Virtual Premise. The Company recorded goodwill of approximately $625.2 million in connection with the April 2012 acquisition of LoopNet.

7.
INTANGIBLES AND OTHER ASSETS

Intangibles and other assets consist of the following (in thousands, except amortization period data):
 
September 30,
2012
 
December 31,
2011
 
Weighted-
Average
Amortization
Period (in years)
Capitalized product development cost
$
2,140

 
$
2,140

 
4
Accumulated amortization
(1,790
)
 
(1,647
)
 
 
Capitalized product development cost, net
350

 
493

 
 
 
 
 
 
 
 
Building photography
12,342

 
12,031

 
5
Accumulated amortization
(11,535
)
 
(11,122
)
 
 
Building photography, net
807

 
909

 
 
 
 
 
 
 
 
Acquired database technology
77,328

 
25,140

 
5
Accumulated amortization
(26,778
)
 
(21,477
)
 
 
Acquired database technology, net
50,550

 
3,663

 
 
 
 
 
 
 
 
Acquired customer base
130,685

 
58,576

 
10
Accumulated amortization
(54,630
)
 
(45,055
)
 
 
Acquired customer base, net
76,055

 
13,521

 
 
 
 
 
 
 
 
Acquired trade names and other (1)
59,255

 
10,376

 
7
Accumulated amortization
(8,812
)
 
(8,432
)
 
 
Acquired trade names and other, net
50,443

 
1,944

 
 
 
 
 
 
 
 
Intangibles and other assets, net
$
178,205

 
$
20,530

 
 
 
(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 along 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.


19

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 issuance of letters of credit. The term loan facility will amortize 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) not exceeding 3.25 to 1.00 during the first two full fiscal quarters after the closing date, 3.00 to 1.00 during the third and fourth full fiscal quarters after the closing date, 2.75 to 1.00 during the period from the fifth to the eighth full fiscal quarters after the closing date and 2.50 to 1.00 thereafter. These financial covenants are effective beginning with the first full fiscal quarter commencing after the closing date, which was the third quarter of 2012. 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, 2012.
  
Commencing with the fiscal year ending 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 repayment 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 repayment 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.
 
In connection with obtaining the facility pursuant to the Credit Agreement, the Company incurred approximately $11.5 million in debt issuance costs, which are capitalized and 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, 2012 and December 31, 2011, no amounts were outstanding under the revolving credit facility. Total interest expense for the term loan facility was approximately $1.8 million and $0 for the three months ended September 30, 2012 and 2011, respectively. Total interest expense for the term loan facility was approximately $3.0 million and $0 for the nine months ended September 30, 2012 and 2011, respectively. Interest expense included amortized debt issuance costs of approximately $763,000 and $0 for the three months ended September 30, 2012 and 2011, respectively. Interest expense included amortized debt issuance costs of approximately $1.2 million and $0 for the nine months ended September 30, 2012 and 2011, respectively.


20

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

8.
LONG-TERM DEBT — (CONTINUED)

Maturities of the Company's borrowings for each of the next five years as of September 30, 2012 are as follows (in thousands):

Year ending September 30,
Maturities
Due in:
 
2013
$
13,125

2014
21,875

2015
30,625

2016
52,500

2017
52,500

Long-term debt, including current maturities
$
170,625


9.
INCOME TAXES

The income tax provision for the nine months ended September 30, 2012 and 2011 reflects an effective tax rate of approximately 65% and 35%, respectively. The increase in the effective tax rate is primarily due to costs related to the LoopNet acquisition that are not deductible for tax purposes; this increase was partially offset by a decrease in income tax expense resulting from a change in local tax law.

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 and 2010. 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 noncancelable-operating leases. The leases contain various renewal options.  See Note 13 for further details on the lease entered into by CoStar Realty and GLL L-Street 1331, LLC (“GLL”) on February 2, 2011.

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.  The Company anticipates that the payment will be made by December 31, 2012 upon the court's final approval of the settlement.


21

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

10.
COMMITMENTS AND CONTINGENCIES — (CONTINUED)

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 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. 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.

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 as 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 Property Professional®, CoStar Tenant®, CoStar COMPS Professional® and FOCUS™ services. CoStar Property Professional, CoStar Tenant, and CoStar COMPS Professional are generally sold as a suite of similar services and comprise 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. CoStar's and its subsidiaries' subscription-based services consist 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.


22

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

11.
SEGMENT REPORTING — (CONTINUED)

Summarized information by operating segment was as follows (in thousands):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Revenues
 
 
 
 
 
 
 
United States
$
91,153

 
$
59,192

 
$
235,606

 
$
171,768

International
 

 
 

 
 

 
 

External customers
4,848

 
4,637

 
14,247

 
13,806

Intersegment revenue
388

 
327

 
1,154

 
805

Total international revenue
5,236

 
4,964

 
15,401

 
14,611

Intersegment eliminations
(388
)
 
(327
)
 
(1,154
)
 
(805
)
Total revenues
$
96,001

 
$
63,829

 
$
249,853

 
$
185,574

 
 
 
 
 
 
 
 
EBITDA
 

 
 

 
 

 
 

United States
$
22,688

 
$
6,828

 
$
46,302

 
$
26,451

International
(3,047
)
 
(821
)
 
(6,568
)
 
(2,799
)
Total EBITDA
$
19,641

 
$
6,007

 
$
39,734

 
$
23,652

 
 
 
 
 
 
 
 
Reconciliation of EBITDA to net income
 
 
 
 
 
 
EBITDA
$
19,641

 
$
6,007

$
39,734

 
$
23,652

Purchase amortization in cost of revenues
(3,027
)
 
(339
)
(5,607
)
 
(954
)
Purchase amortization in operating expenses
(4,824
)
 
(535
)
(9,038
)
 
(1,624
)
Depreciation and other amortization
(2,844
)
 
(2,129
)
(7,554
)
 
(7,065
)
Interest income (expense), net
(1,763
)
 
194

(2,582
)
 
574

Income tax expense, net
(404
)
 
(887
)
(9,752
)
 
(5,103
)
Net income
$
6,779

 
$
2,311

$
5,201

 
$
9,480


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.

International EBITDA includes a corporate allocation of approximately $2.3 million and $100,000 for the three months ended September 30, 2012 and 2011.  International EBITDA includes a corporate allocation of approximately $4.5 million and $200,000 for the nine months ended September 30, 2012 and 2011, respectively. The corporate allocation represents costs incurred for U.S. employees involved in management and expansion activities of the Company’s International operating segment.


23

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

11.
SEGMENT REPORTING — (CONTINUED)

Summarized information by operating segment was as follows (in thousands):
 
September 30,
2012
 
December 31,
2011
Property and equipment, net
 
 
 
United States
$
39,138

 
$
35,044

International
3,824

 
2,527

Total property and equipment, net
$
42,962

 
$
37,571

 
 
 
 
Goodwill
 

 
 

United States
$
692,639

 
$
67,465

International
25,441

 
24,319

Total goodwill
$
718,080

 
$
91,784

 
 
 
 
Assets
 

 
 

United States
$
1,201,065

 
$
808,930

International
41,402

 
38,061

Total operating segment assets
$
1,242,467

 
$
846,991

 
 
 
 
Reconciliation of operating segment assets to total assets
 

 
 

Total operating segment assets
$
1,242,467

 
$
846,991

Investment in subsidiaries
(18,344
)
 
(18,344
)
Intersegment receivables
(69,464
)
 
(57,612
)
Total assets
$
1,154,659

 
$
771,035

 
 
 
 
Liabilities
 

 
 

United States
$
335,751

 
$
107,776

International
66,281

 
53,221

Total operating segment liabilities
$
402,032

 
$
160,997

 
 
 
 
Reconciliation of operating segment liabilities to total liabilities
 

 
 

Total operating segment liabilities
$
402,032

 
$
160,997

Intersegment payables
(63,224
)
 
(49,139
)
Total liabilities
$
338,808

 
$
111,858


12.
LEASE RESTRUCTURING CHARGES

Effective July 18, 2011, the Company consolidated its White Marsh, Maryland office with its Columbia, Maryland and Washington, DC offices. The consolidation of the facility resulted in a lease restructuring charge of approximately $1.5 million recorded in general and administrative expense in the third quarter of 2011. The third quarter lease restructuring charge included amounts for the abandonment of certain lease space as well as the impairment of leasehold improvements, furniture and other equipment totaling approximately $500,000.


24

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

12.
LEASE RESTRUCTURING CHARGES — (CONTINUED)

The amounts of the lease restructuring charges recorded were based upon management’s best estimates of amounts and timing of certain events that are expected to occur in the future. It is possible that the actual outcome of these events may differ from estimates.  The Company reassesses the expected cost to complete the consolidation of the facilities at the end of each reporting period and adjusts the restructuring accrual as necessary to reflect any changes.  As a result of reassessments due to changes in the Company's assumed sublease income over the remaining lease term, adjustments of approximately $75,000 and $137,000 were recorded for the nine months ended September 30, 2012 and 2011, respectively. Any future changes will be made to the restructuring accrual when any such differences become determinable.

The following table summarizes the amount included in accrued expenses related to these restructuring charges from December 31, 2010 to September 30, 2012 (in thousands):
 
Lease
Restructuring
Accrual
Accrual balance at December 31, 2010
$
931

Original charge
959

Rent payments made in 2011
(1,319
)
Adjustment for assumed sublease income and accretion in 2011
262

Accrual balance at December 31, 2011
833

Rent payments made from January 1, 2012 – March 31, 2012
(344
)
Adjustment for assumed sublease income and accretion from January 1, 2012 - March 31, 2012
54

Accrual balance at March 31, 2012
543

Rent payments made from April 1, 2012 – June 30, 2012
(280
)
Adjustment for assumed sublease income and accretion from April 1, 2012 - June 30, 2012
39

Accrual balance at June 30, 2012
302

Rent payments made from July 1, 2012 – September 30, 2012
(208
)
Adjustment for assumed sublease income and accretion from July 1, 2012 - September 30, 2012
27

Accrual balance at September 30, 2012
$
121

 
13.
SALE OF BUILDING

On February 2, 2011, 1331 L Street Holdings, LLC (“Holdings”), a wholly owned subsidiary of the Company, and GLL, an affiliate of Munich-based GLL Real Estate Partners GmbH, entered into a purchase and sale agreement pursuant to which (i) Holdings agreed to sell to GLL its interest in the 169,429 square-foot office building located at 1331 L Street, NW, in downtown Washington, DC, and (ii) CoStar Realty, a wholly owned subsidiary of the Company, agreed to enter into a lease expiring May 31, 2025 with GLL to lease back 149,514 square feet of the office space located in this building, which the Company continues to use as its corporate headquarters. The closing of the sale took place on February 18, 2011. The aggregate consideration paid by GLL to Holdings pursuant to the purchase and sale agreement was $101.0 million in cash, $15.0 million of which was designated to fund additional build-out and planned improvements at the building. Approximately $12.5 million of the $15.0 million additional build-out is recorded as a leasehold improvement in property and equipment. The carrying value of the building at the time of the sale was approximately $47.5 million. Pursuant to the purchase and sale agreement, Holdings entered into an assignment and assumption agreement with GLL regarding the existing ground lease.

The office lease will expire May 31, 2025. The initial base rent is $38.50 per square foot of occupied space, escalating 2.5% per year commencing June 1, 2011. Minimum lease payments will be approximately $6.0 million, $6.1 million, $6.3 million, $6.4 million and $6.6 million for fiscal years 2012 through 2016, respectively, and a total of $62.6 million from 2017 to the end of the lease term.


25

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

13.
SALE OF BUILDING — (CONTINUED)

The transaction qualified for sale-leaseback accounting under an operating lease as all of the risks and rewards of ownership were transferred to the buyer upon closing of the transaction and the leaseback arrangement did not include any form of continuing involvement, other than a normal leaseback. The $36.0 million gain on sale has been deferred and is being recorded as a reduction in rent expense over the term of the lease in accordance with the accounting guidance for sale-leaseback transactions. The Company recorded approximately $631,000 from the gain on sale for the three months ended September 30, 2012 and 2011, respectively. The Company recorded approximately $1.9 million and $1.6 million from the gain on sale for the nine months ended September 30, 2012 and 2011, respectively. The closing costs incurred in connection with the sale-leaseback agreement were approximately $2.4 million, primarily due to legal costs, broker commissions and transfer costs which were recorded as a reduction to the gain in the first quarter of 2011.

14.
EQUITY OFFERING

During June 2011, the Company completed an equity offering of 4,312,500 shares of common stock for $60.00 per share.  Net proceeds from the equity offering were approximately $247.9 million, after deducting approximately $10.4 million of underwriting discounts and commissions and offering expenses of approximately $500,000.  The Company used the net proceeds from the sale of the securities to fund a portion of the cash consideration payable in connection with its acquisition of LoopNet. See Note 3 for additional information regarding the acquisition of LoopNet.


26



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 U.S. and the 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 a 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. Our subsidiary, LoopNet, Inc. (“LoopNet”), 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 commercial real estate criteria. We also provide market research and analysis for commercial real estate investors and lenders via our Property and Portfolio Research, Inc. (“PPR”) service offerings, portfolio and debt management and reporting capabilities through our Resolve Technology, Inc. (“Resolve Technology”) service offerings, and lease management solutions, including lease administration and abstraction services, through our Virtual Premise, Inc. (“Virtual Premise”) service offerings. Our service offerings span all commercial property types, including office, industrial, retail, land, mixed-use, hospitality and multifamily.

Expansion and Development

We expect to continue to develop and distribute new services, expand existing services within our current platform, integrate, coordinate and cross-sell existing services, and expand and develop our sales and marketing organization. For example, new modules, or tools, and services that we are currently developing and expect to introduce to customers include a mobile platform for delivery of Virtual Premise's lease management service; multi-family data and analytics services from CoStar and PPR; and PPR's CompassFLEX™, a customizable analytic tool for evaluation of various credit scenarios.  Our expansion initiatives also include continued development of CoStarGo®, which was launched in the U.S. on August 15, 2011, Lease COMPS™, a database of comparable lease transactions and enhancements to our core information services, including our suite of online services. CoStarGo is an iPad application that integrates our comprehensive property, tenant and comparable sales information from our suite of online products - CoStar Property Professional®, CoStar Tenant® and CoStar COMPS Professional®.

We are also integrating, developing and cross-selling the services offered by the companies we have most recently acquired, including LoopNet, Virtual Premise, Resolve Technology and PPR.  Our sales and marketing efforts are and will continue to be focused on cross-selling and marketing our services.  After the acquisition of LoopNet, we launched a sales and marketing campaign directed at cross-selling CoStar's information services to LoopNet customers and LoopNet's marketing services to CoStar customers.  We have incurred significant expenses associated with this sales and marketing campaign and expect to continue to incur significant, additional expenses for the campaign during the fourth quarter of 2012 and first quarter of 2013.  We anticipate that these initiatives will position the company for revenue growth in 2013 and beyond.  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 its acquired companies.


27



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 Virtual Premise's lease management solutions with CoStar's business. These integration efforts include providing additional tools that make our research and analytics even more valuable to subscribers. For example, we are developing a lease discounted cash flow (“LDCF”) forecasting and valuation solution that effectively integrates the combined capabilities of CoStar's property and market-level information and PPR's analytics and forecasting expertise. One of our newest initiatives under development is an enhanced platform called CoStar Fusion™ that will combine and deliver multiple services, including the CoStar Suite® services: Property Professional®, COMPS® and Tenant®, analytics from PPR, and financial tools in a fully integrated service.  We believe CoStar Fusion could become a revenue driver for CoStar in the future.  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.

In addition, we intend to continue to upgrade the platform of services and expand the coverage of our service offerings within our International segment and to integrate our International operations more fully with those in the U.S. In furtherance of those initiatives, we intend to introduce a consistent international platform of service offerings by the end of 2012. 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. We expect to introduce CoStarGo, our iPad application, CoStar Property Professional, CoStar COMPS Professional, and CoStar Tenant in the U.K. by the end of 2012. Additionally, we have upgraded our back-end research operations, fulfillment and CRM systems to support these new U.K. services. In order to implement these services in the U.K., we have incurred, and expect to incur increased development costs through 2012, and subsequently expect that development expenses incurred by the International segment will decrease in 2013. We believe that our continued investments in U.S. and international products, internationalization of our U.S. products and integration efforts have created and will continue to create a platform for long-term revenue growth. We expect these investments 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 due to the planned release of our upgraded international platform and expansion of coverage of our international service offerings.

Any future product development or expansion of services could reduce our profitability and increase our capital expenditures. Therefore, while we expect current service offerings to remain profitable, driving overall earnings throughout 2012 and providing substantial cash flow for our business, it is possible that any new investments could cause us to generate losses and negative cash flow from operations in the future.

LoopNet Acquisition

On April 30, 2012, we completed the acquisition of LoopNet. The acquisition combines the marketing solutions offered by LoopNet with the research capabilities of CoStar. We expect the acquisition will 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.

The LoopNet transaction was subject to customary closing conditions, including expiration or termination of the waiting period under the Hart-Scott-Rodino Antitrust Improvement Act of 1976 (the “HSR Act”). On April 26, 2012, the Federal Trade Commission (the “FTC”) accepted a consent order previously agreed to by LoopNet and CoStar. The consent order was subject to a 30-day public comment period, which has passed. 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, 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.

28




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.

We plan to continue to assess any plans for additional investments in our business in the foreseeable future. At this time, as discussed above, we expect to continue to develop and distribute new services within our current platform. While we expect current service offerings to remain profitable, providing substantial cash flow for our business, the costs associated with our merger with LoopNet and the integration of our two businesses has reduced our profitability and has caused us to generate losses in the second quarter of 2012. 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.

Market Conditions

We continue to see clear signs of improving conditions in the commercial real estate industry, including falling vacancy rates and positive net absorption in the four main types of property that we track (office, industrial, retail and apartments).  However, the extent and duration of continued improvement in the economy and the commercial real estate industry is unknown. Further, the current economic recovery has been slower than past economic recoveries. Job growth, in particular, has recovered more slowly than in past economic recoveries. Improvements in the commercial real estate industry are largely dependent upon employment trends, which drive demand for real estate space.  Continuing 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.   

In some cases, the business operations of some of our clients continue to be negatively affected by challenging economic conditions in the U.S. and the world, resulting at times in business consolidations and, in some circumstances, business failure.  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 reduced rates.  We compete against many other commercial real estate information, analytic and marketing service providers for business.  If customers choose to cancel our services for cost-cutting 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. 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 compensation expense in our consolidated statements of operations and reduce our net income.


29



Subscription-Based Services

Our subscription-based information services consist primarily of CoStar Property Professional, CoStar Tenant, CoStar COMPS Professional and FOCUS services. CoStar Property Professional, CoStar Tenant, and CoStar COMPS Professional are generally sold as a suite of similar services and comprise our primary service offering in our U.S. operating segment. FOCUS is our primary service offering in our International operating segment. Our subscription-based services consist 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.

We recognize this 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, 2012 and 2011, our contract renewal rate for existing CoStar subscription-based services was approximately 94% and 93%, respectively, and therefore our cancellation rate for those services was approximately 6% and 7%, 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 negative economic conditions lead to greater business failures and/or consolidations among our clients, further reductions in customer spending, or decreases in our customer base.

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 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, 2012.  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.


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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 on these securities. The average discount rate used as of September 30, 2012 was approximately 5.2%. 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.

Based on this assessment of fair value, as of September 30, 2012, we determined there was a decline in the fair value of our ARS investments of approximately $2.0 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, 2012. 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.

Fair Value of Deferred Consideration

As of September 30, 2012, we held Level 3 liabilities for deferred consideration acquired as a result of the April 30, 2012 acquisition of LoopNet. The deferred consideration totaled $2.2 million as of September 30, 2012 and included potential deferred cash payments resulting from acquisitions completed by LoopNet in 2010 including: (i) potential deferred cash payments due to the sellers of LandsofAmerica.com, LLC ("LandsofAmerica") on March 31, 2013 and March 31, 2014 based on LandsofAmerica's achievement of financial and operational milestones, resulting in undiscounted deferred consideration as of September 30, 2012 of approximately $2.0 million; and (ii) potential deferred cash payments due to the sellers of Reaction Corp. ("Reaction Web") on March 31, 2013 and March 31, 2014 based on Reaction Web's achievement of revenue milestones, resulting in undiscounted deferred consideration as of September 30, 2012 of approximately $700,000.

As of September 30, 2011, we held no Level 3 liabilities. Prior to September 30, 2011, we held Level 3 liabilities for deferred consideration related to the October 19, 2009 acquisition of Resolve Technology. The deferred consideration included (i) a potential deferred cash payment two years after closing based on the incremental growth of Resolve Technology's revenue, and (ii) other potential deferred cash payments for successful completion of operational and sales milestones during the period from closing through October 31, 2013, which period was subject to extension by the parties to a date no later than December 31, 2014. On June 24, 2011, we made a payment to the seller of Resolve Technology of $500,000 as a result of the successful completion of one of the operational milestones. On September 8, 2011, we entered into an agreement to settle all remaining potential deferred cash payments due under the acquisition agreement. Under the terms of the settlement agreement, we made a payment of $1.6 million on September 14, 2011 to settle the entire obligation. We reversed the remaining $1.2 million of deferred consideration as a reduction to general and administrative expense during the three months ended September 30, 2011.

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

The only significant unobservable input in the discounted cash flow model used to determine the estimated fair value of our Level 3 liabilities is the discount rate. The discount rate used represents LoopNet's cost of equity at the time of each transaction plus a margin for counterparty risk. The average discount rate used as of September 30, 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.

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.

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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, 2012. 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.

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 that in 2013 the expenses for our International reporting unit will decrease, as we expect to complete 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, 2011, 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, 2011 that would indicate that the carrying value of each reporting unit may not be recoverable.


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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.

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, headquarters' acquisition- and transition-related 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, headquarters' acquisition- and transition-related 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 and Quarterly Reports on Forms 10-K and 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.


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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 24 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, headquarters' acquisition- and transition-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.

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 net interest income (expense) we generate (incur) may be useful for investors to consider and may result in current cash inflows or outflows. However, we do not consider the amount of net interest income (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, net, 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.


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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 headquarters' acquisition- and transition-related costs incurred may be useful for investors to consider because they generally represent the overlapping rent and building carrying costs, legal costs and other related costs incurred to relocate our headquarters. We do not believe these charges necessarily reflect the current and ongoing charges related to our operating cost structure.

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.

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, headquarters' acquisition- and transition-related 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 along 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 2011, we assumed a 40% tax rate, and in 2012, we assume 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,
 
2012
 
2011
 
2012
 
2011
Net income
$
6,779

 
$
2,311

 
$
5,201

 
$
9,480

Purchase amortization in cost of revenues
3,027

 
339

 
5,607

 
954

Purchase amortization in operating expenses
4,824

 
535

 
9,038

 
1,624

Depreciation and other amortization
2,844

 
2,129

 
7,554

 
7,065

Interest expense (income), net
1,763

 
(194
)
 
2,582

 
(574
)
Income tax expense, net
404

 
887

 
9,752

 
5,103

EBITDA
$
19,641

 
$
6,007

 
$
39,734

 
$
23,652

 
 
 
 
 
 
 
 
Cash flows provided by (used in)
 

 
 

 
 

 
 

Operating activities
$
25,980

 
$
4,423

 
$
56,558

 
$
19,707

Investing activities
1,267

 
(1,703
)
 
(635,311
)
 
72,196

Financing activities
(1,187
)
 
433

 
162,872

 
252,367



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Comparison of Three Months Ended September 30, 2012 and Three Months Ended September 30, 2011

Revenues. Revenues increased to $96.0 million in the third quarter of 2012 from $63.8 million in the third quarter of 2011. The $32.2 million increase was primarily attributable to the additional revenue of approximately $22.9 million from our April 2012 acquisition of LoopNet as well as 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 $65.1 million in the third quarter of 2012 from $42.7 million in the third quarter of 2011. The gross margin percentage increased to 67.8% in the third quarter of 2012 from 66.8% in the third quarter of 2011. 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. Cost of revenues increased to $30.9 million in the third quarter of 2012 from $21.2 million in the third quarter of 2011. The increase in the cost of revenues was principally due to the additional cost of revenues from our April 2012 acquisition of LoopNet.

Selling and Marketing Expenses. Selling and marketing expenses increased to $22.0 million in the third quarter of 2012 from $17.5 million in the third quarter of 2011, and decreased as a percentage of revenues to 22.9% in the third quarter of 2012 from 27.4% in the third quarter of 2011. The increase in the amount of selling and marketing expenses was primarily due to the additional selling and marketing expenses of approximately $6.4 million from our April 2012 acquisition of LoopNet as well as an increase in personnel costs of approximately $900,000. These increases are partially offset by approximately $3.4 million related to the launch of CoStarGo during the three months ended September 30, 2011 that did not recur in 2012.

Software Development Expenses. Software development expenses increased to $9.7 million in the third quarter of 2012 from $5.0 million in the third quarter of 2011, and increased as a percentage of revenues to 10.1% in the third quarter of 2012 compared to 7.9% in the third quarter of 2011. The increase in the amount and percentage of software development expenses was primarily due to the additional software development expenses from our April 2012 acquisition of LoopNet.

General and Administrative Expenses. General and administrative expenses increased to $19.6 million in the third quarter of 2012 from $16.6 million in the third quarter of 2011, and decreased as a percentage of revenues to 20.4% in the third quarter of 2012 compared to 26.1% in the third quarter of 2011. The increase in the amount of general and administrative expenses was primarily due to the additional general and administrative expenses of approximately $6.1 million from our April 2012 acquisition of LoopNet as well as an increase in personnel costs of approximately $1.6 million. Additionally, during the three months ended September 30, 2011, we recorded a deferred consideration adjustment of approximately $1.2 million to reduce general and administrative expenses related to the October 19, 2009 acquisition of Resolve Technology that did not recur in 2012. These increases are partially offset by expenses incurred during the three months ended September 30, 2011 that did not recur in 2012, including approximately $5.8 million in acquisition related costs in connection with the LoopNet acquisition and approximately $1.5 million in lease restructuring charges related to the consolidation of the White Marsh, Maryland office with the Columbia, Maryland and Washington, DC offices.
 
Purchase Amortization. Purchase amortization increased to approximately $4.8 million in the third quarter of 2012 compared to approximately $535,000 in the third quarter of 2011, and increased as a percentage of revenue to 5.0% in the third quarter of 2012 compared to 0.8% in the third quarter of 2011. The increase in the amount and percentage of purchase amortization expense was due to the additional purchase amortization expenses from our April 2012 acquisition of LoopNet.

Interest and Other Income (Expense), net. Interest and other income (expense), net changed to approximately $1.8 million expense in the third quarter of 2012 compared to approximately $194,000 income in the third quarter of 2011. The change was primarily due to the interest expense for the term loan facility incurred in the third quarter of 2012.

Income Tax Expense, net. Income tax expense, net decreased to $404,000 in the third quarter of 2012 from $887,000 in the third quarter of 2011.  This decrease was primarily due to a change in local tax law.


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Comparison of Business Segment Results for Three Months Ended September 30, 2012 and Three Months Ended September 30, 2011

We manage our business geographically in two operating segments, with our primary areas of measurement and decision-making being the United States (“U.S.”) and International, which includes the United Kingdom ("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 Property Professional, CoStar Tenant, and CoStar COMPS Professional are generally sold as a suite of similar services and comprise our primary service offering in our U.S. operating segment. U.S. revenues increased to $91.2 million in the third quarter of 2012 from $59.2 million in the third quarter of 2011. This increase in U.S. revenue was primarily due to the additional revenue of approximately $22.9 million from our April 2012 acquisition of LoopNet as well as 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. International revenues slightly increased to $4.8 million in the third quarter of 2012 from $4.6 million in the third quarter of 2011. Intersegment revenue slightly increased to approximately $388,000 in the third quarter of 2012, compared to approximately $327,000 in the third quarter of 2011. 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 $22.7 million in the third quarter of 2012 from $6.8 million in the third quarter of 2011. The increase in U.S. EBITDA was due primarily to an increase in revenues in the third quarter of 2012 from the