Earnings Quality & Fundamental Analysis: CoStar Group

Earnings Quality & Fundamental Analysis: CoStar Group Inc. (NASDAQ: CSGP) Nick Kunz Prof. Jonathan Glover Earnings Quality & Fundamental Analysis Columbia Business School Dec 15, 2018

Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

Contents 1. About the Company ○ ○ ○ ○

Background Corporate Strategy Business Environment Management

2. Financial Accounting Standards ○ ○ ○ ○

Revenue Recognition Cost of Revenues Acquisitions Goodwill & Intangible Assets

3. Financial Statement Analysis ○ ○ ○

Financials as Reported Common Size Financials Reformulated Financials

4. Earnings Quality ○ ○ ○

Cost of Revenues Capitalizing Costs Goodwill & Intangible Assets

5. Red Flag Analysis ○ ○ ○

Change in Management Research & Development Goodwill & Intangible Assets

6. Critical Accounting ○ ○ ○

Cost of Revenues Research & Development Goodwill & Intangible Assets

7. Concluding Remarks

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Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

1. About the Company Background Costar Group Inc. (CoStar) provides data, information, and analytics on commercial real estate assets.

Founded in 1987, the company is considered by many as the industry leader for online information on properties in North America and Europe. CoStar owns the largest database for most sectors of commercial real estate, which include: multifamily residential, office, retail, industrial, mixed-use, hospitality, and commercial land. The business operations are organized into two segments, North America (US and Canada) and Europe (UK, Spain, Germany, and France).

Corporate Strategy The company’s corporate strategy is mainly to provide listing data on commercial real estate with the highest range of availability, accuracy, timeliness, and standardization. CoStar’s customers are primarily industry professionals where they have established firm business to business relationships. The company prides itself on being the industry leader within the commercial real estate data listing services and offers a range of products on leasable space, comparable property sales, tenant information, online marketing, analytics, client information, and industry news. The core of CoStar’s business comes from their annual subscription-based service contracts.

Business Environment CoStar has several competitors, some of which are Real Capital Analytics, REIS, Reonomy, and others.

The competitive environment of commercial real estate data business is rapidly changing and the company has recently engaged in new ways of competing in this environment. ​One of the most important ways CoStar has engaged their competition is through business acquisitions. A ​ major long-term risk factor for CoStar is another company with greater capacity for data aggregation, such as Bloomberg, Google, or Zillow entering the marketplace and competing with their platform.

Management The executive management team of the company is lead by CEO Andrew Florance, CFO Scott Wheeler, and CTO Frank Simuro. Andrew Florance is the founder of CoStar and has served as its founding CEO since 1987. ​Scott Wheeler has more recently joined the company as CFO in 2015, where he had previously served as the COO at Purchasing Power LLC. ​Frank Simuro joined the company in 1999 as Director of Information systems, where he now serves as CTO. The most recent and important change in executive management with regard to timing and subject matter for this evaluation is CFO Scott Wheeler’s addition to CoStar in 2015.

“CoStar Group...today announced that it has named Scott Wheeler Chief Financial Officer. Mr. Wheeler will report to Andrew Florance, Founder and Chief Executive Officer of CoStar Group.”

- Nov. 19, 2015, Global Newswire, Washington 2

Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

2. Financial Accounting Standards Financial Accounting Standards - Revenue Recognition CoStar primary generates monthly revenues from its annual subscription-based service contracts.

Revenues are recognized on a straight-line basis over the term of the contract agreement. The company itemizes its revenues into two main categories, 1) information and analytics and 2) online marketplaces.

In addition, the company recognizes contracts that contain multiple elements. However, in the case where multiple elements cannot be accounted for, the revenues are recognized in a combined unit of accounting.

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Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

Financial Accounting Standards - Cost of Revenues The company’s Cost of Revenues are primarily the research labor costs direct to the core of its information, analytics, and online marketplace platform. However, Cost of Revenues also include processing fees and perhaps most importantly, the amortization of acquired trade names and other intangible assets. ​It is important to consider that there are costs traditionally associated with Research & Development (R&D), as well as Amortization, and Other Intangible Assets that are not allocated directly to their respective accounts, but rather included in Cost of Revenues.

Financial Accounting Standards - Acquisitions CoStar has conducted a number of business acquisitions. Many if not all require that the management team conduct subjective valuations and assumptions of Intangible Assets. These estimates can vary widely and contain the potential for overpayment in business acquisitions. In observance with the GAAP standard, any value in excess of the fair value of the acquisition is recognized in Goodwill. ​It is important to consider that the company has elected to record adjustments to the assets and liabilities related to business acquisitions in Revenues.

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Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

Financial Accounting Standards - Goodwill & Intangible Assets The company recognizes Goodwill based on a discounted cash flow model, which is subject to error and overpayment by way of a number of assumptions. Perhaps the most important three (3) of these assumptions contained in the discounted cash flow model that CoStar relies on for its Goodwill item are: 1) discount rate based on the weighted average cost of capital, 2) growth rate, and 3) future financial performance based on the company’s anticipated cash flow, business plan, and macroeconomic forecasts.

The items that are accounted for in Goodwill have been indicated by CoStar as acquired customer bases, acquired databases, acquired trade names, useful lives, and discount rates. ​It is important to consider that the company has recently conducted an impairment test of Goodwill where it found that it was not impaired. However, this may not be entirely accurate.

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Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

Financial Accounting Standards - Goodwill & Intangible Assets CoStar’s Intangible Assets contain a number of different capitalized items listed below. There are five (5) Intangible Asset categories; they are: 1) Capitalized Product Development, 2) Building Photography, 3) Acquired Database Technology, 4) Acquired Customer Base, and 5) Acquired Trade Names and Other Intangible Assets. Perhaps the most obvious suggestion indicated by both the nominal figures as reported and number of asset categories is the portion of Intangible Assets related to business acquisitions. ​It is important to consider the amount of accounted for Intangible Assets can be accounted for interchangeably within Finite and Indefinite Intangible Assets (depending on the subjectivity of management).​

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Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

3. Financial Statement Analysis Financials as Reported - Income Statement Exhibited below is the Consolidated Income Statements as reported by CoStar in their SEC 10-K filings from years end 2013 to 2017.

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Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

Financials as Reported - Balance Sheet Exhibited below is the Consolidated Balance Sheets as reported by CoStar in their SEC 10-K filings from years end 2013 to 2017.

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Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

Common Size Financials - Income Statement Exhibited below is the Common Size Income Statement on information gained from CoStar on their SEC 10-K filings from years end 2013 to 2017. ​The highlighted portion in the Common Size Income Statement below indicates a significant increase in Marketing and a subsequent decrease in Income from Operations as a percentage of Revenues in 2015 with a swift recovery in Net Income the years following.

Although there could be room for financial reporting manipulation, the possibility that capital misallocation, a bonafide need in boosting marketing activities, or a combination of both. There are no other dramatic irregularities immediately evident in the Common Size Income Statement.

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Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

Common Size Financials - Balance Sheet Exhibited below is the Common Size Balance Sheet on information gained from CoStar on their SEC 10-K filings from years end 2013 to 2017. ​The highlighted portion in the Common Size Balance Sheets below indicates the three largest operating asset categories. Goodwill contains over 50% of all operating assets for every year, except 2017. A ​ lthough there could be a number of reasons for Goodwill to warrant further investigation, CoStar’s case exhibits a need for special attention. This is evident in both nominal terms as reported in the Consolidated Balance Sheets, and in the Common Size Balance Sheet below.

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Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

Reformulated Financials - Income Statement Exhibited below is the Reformulated Income Statement on information gained from CoStar on their SEC 10-K filings from years end 2013 to 2017. ​The following table illustrates the partitioning of operating and financing activities in an effort to provide clarity on incomes and value creation by virtue of the core operating activity of the company. In addition, the tax rate on operating activity is exposed for evaluation.

Commensurate with the dramatic increase in Marketing and decrease in Net Income in 2015 evident by the Common Size Income Statements, the Reformulated Income Statements exhibit similar behavior in operating activity when financing activity is removed. However, the Reformulated Income Statement does reveal a small regular annual increase in Financial Income.

Reformulated Financials - Balance Sheet Exhibited below is the Reformul​ated Balance Sheet on information gained from CoStar on their SEC 10-K filings from years end 2013 to 2017. The following table illustrates the partitioning of operating and financing assets and liabilities in an effort to provide clarity on valuations with regard to the core operating activity of the company. Commensurate with the fluctuations in Total Assets exhibited in the Consolidated Balance Sheets as reported, the Reformulated Income Statements exhibit similar behavior in operating activity when financing activity is removed.

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Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

4. Earnings Quality Earnings Quality - Cost of Revenues The chart exhibited below highlights Revenues ratios to Gross Income, Net Income, and Core Operating Income - After Tax. The chart illustrates a slight decrease in Gross Margin, while observing a slight increase in Net Income and Core Operating Income - After Tax between years end 2016 and 2017. Based on this inconsistency, where Gross Margin and Net Income would traditionally coincide, there is reason to suspect some degree of financial reporting manipulation or otherwise. The decline in Gross Margin while recognizing an increase in both Net Income and Core Operating Income - After Tax, is outside of normal expectations. ​The highlighted portion of the following table explicitly demonstrates the inconsistency between Gross Margin to Net Income, and Core Operating Income - After Tax for years end 2016 and 2017.

As previously mentioned in second section ‘2. Financial Accounting Standards - Cost of Revenues’, there are costs traditionally associated with R&D, as well as Amortization, and Other Intangible Assets that are not allocated directly to their respective accounts, but rather included in Cost of Revenues. ​This could one reason for the unusual behavior found in the Cost of Revenues exhibited here.

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Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

Earnings Quality - Capitalizing Costs The chart exhibited below highlights the relationship between Net Operating Assets and Revenues. The table below exhibits this relationship explicitly by denoting a percentage ratio expressed as Net Operating Assets Turnover. The chart exhibits this relationship implicitly, but more appropriately illustrates the relationship. The relative consistency between Net Operating Assets and Revenues between years end 2013 and 2017, indicates prudent capital allocation to operating expense activities. Moreover, the consistency and general increase in value creation metrics such as RNOA and ROCE indicate prudent returns on Revenues. Because of this, there is less concern for manipulation, as it relates to appropriately expensing costs, rather than capitalizing them. However, it is also important to recognize that the opposite could be true in the case of CoStar.

As previously mentioned in the second section, ‘2. Financial Accounting Standards - Cost of Revenues’, there are costs traditionally associated with Research & Development (R&D), as well as Amortization, and Other Intangible Assets that are not allocated directly to their respective Balance Sheet accounts, but rather included in the Income Statement as Cost of Revenues. The company could potentially expense accounts that should more appropriately be capitalized.

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Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

Earnings Quality - Intangible Assets The chart exhibited below highlights the comparison between ratios of Research & Development to Revenues, Goodwill to Revenues, and Intangible Assets to Revenues. ​The highlighted portion of the table below indicates reductions in the ratio between R&D and Revenues and Intangible Assets to Revenues.

The chart illustrates decreases in all categories. Although perhaps less meaningful in the case of Goodwill to Revenues, Intangible Assets to Revenues decreasing indicates that less of the company’s earnings are being allocated to Intangible Assets.

As previously indicated in the second section ‘2. Financial Accounting Standards - Goodwill & Intangibles’, Intangible Assets include: Capitalized Product Development, Building Photography, Acquired Database Technology, Acquired Customer Base, and Acquired Trade Names and Other Intangible Assets. The chart indicates a slight reduction in the ratio between R&D to Revenues. ​This means that R&D is decreasing relative to the company’s earnings, which suggests that the company could be shortsightedly reducing short-term expenses at the mercy of long-term internal growth. In addition, it is important to mention the decrease of Goodwill could serve as a healthy indicator of prudence in the size reduction relative to Total Assets.

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Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

5. Red Flag Analysis Red Flag Analysis - Change in Management As previously mentioned in the first section “1. About the Company”, there was a recent change in executive management. In 2015, CoStar had introduced Scott Wheeler as the company’s new CFO. Although more dramatic and strategic shifts in business activity would likely arise from a company with a new CEO, a strategic change in executive management, especially a CFO, could likely mean potential for financial reporting driven manipulation. The timing of the dramatic increase in Marketing and decrease in Net Income made evident in the Common Size Income Statements could potentially be driven by new corporate leadership responsible for financial reporting. In addition, other unusual financial activity beginning at years end 2015 (the first financial reporting year for Scott Wheeler as new CFO of CoStar) occurred such as: the inconsistency of Gross Margin to Revenues and the reduction in R&D to Revenues, as well as other less mentioned financial activities such as a significant increase in Cash and Cash Equivalents in year end 2017, and significant decreasing trend in Goodwill from year end 2015 to 2017.

These could all be driven in part by a change in executive management directly responsible for financial reporting.

“CoStar Group...today announced that it has named Scott Wheeler Chief Financial Officer. Mr. Wheeler will report to Andrew Florance, Founder and Chief Executive Officer of CoStar Group.”

- Nov. 19, 2015, Global Newswire, Washington

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Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

Red Flag Analysis - Research & Development The chart exhibited below highlights the ratio between Research & Development and Revenues and indicates a regular reduction. ​The first highlighted portion of the table below explicitly denotes reductions in the ratio between R&D and Revenues. This suggests that the company could potentially be shortsightedly reducing short-term expenses at the mercy of long-term internal growth.

As previously mentioned in second section ‘2. Financial Accounting Standards - Cost of Revenues’, there are costs traditionally associated with R&D, as well as Amortization, and Other Intangible Assets that are not allocated directly to their respective accounts, but rather included in Cost of Revenues. ​It might also be reasonable to assume that CoStar could have potentially made financial reporting driven decisions to move units between R&D and Cost of Revenues. This could one reason for the unusual behavior found in R&D exhibited here.

In addition, the second highlighted portion of the table below indicates the changing relationship between Goodwill and Intangible Assets, where Goodwill regularly grows in excess to Intangible Assets.

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Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

Red Flag Analysis - Goodwill & Intangible Assets The chart exhibited below illustrates the average asset composition contained within the Common Size Balance Sheets over the previously investigated 5 year time horizon from years end 2013 to 2017. ​The highlighted portion of the table below details the year end ratio of the respective asset category to Total Assets for each year contained in the 5 year average time horizon. I​ t is evident by the chart below that Goodwill is roughly double the next largest asset category, Cash and Cash Equivalents. This indicates a number of things. However, perhaps the most obvious suggestions are that CoStar could likely be paying too much for companies, they have been acquiring too many companies, or a combination of both.

Revisiting the second section, ‘2. Financial Accounting Standards - Goodwill & Intangible Assets’, ​it was mentioned that the company recognizes Goodwill based on a discounted cash flow model. The model utilizes a discount rate based on the weighted average cost of capital, growth rate, and future financial performance based on the company’s anticipated cash flow, business plan, and macroeconomic forecasts. W ​ hat this means is that acquisition are subject to error and overpayment by way of a number of necessary assumptions. It stands to reason that the company has likely taken aggressive steps in financial reporting to conceal overpayment beyond what is already obvious in its reported financial statements.

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Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

6. Critical Accounting Cost of Revenues It is likely that CoStar’s Cost of Revenues account has the potential for financial reporting manipulation.

Based on the company’s Financial Accounting Standards as of year end 2017, which allows R&D, Amortization, Other Intangible Assets to be recognized in the Cost of Revenues, as well as evidence throughout the previous analysis that has suggested this may have taken place, it stands to reason that the Cost of Revenues should be viewed with greater criticism in further analysis and future valuations.

Research & Development It is likely that CoStar’s R&D account has the potential for financial reporting manipulation. Based on the company’s Financial Accounting Standards as of year end 2017, which allows R&D, Amortization, Other Intangible Assets to be recognized in the Cost of Revenues, as well as evidence throughout the previous analysis that has suggested this may have taken place, it stands to reason that R&D should be viewed with greater criticism in further analysis and future valuations.

Goodwill It is likely that CoStar’s Goodwill account has the potential for financial reporting manipulation. Based on the company’s Financial Accounting Standards as of year end 2017, which allows wide ranging fair value estimates in business acquisitions and adjustments to acquired assets and liabilities to be recognized in Revenues, as well as evidence throughout the previous analysis that has suggested overpayments in business acquisitions with relaxed impairment tests, it stands to reason that Goodwill should be viewed with greater criticism in further analysis and future valuations.

Intangible Assets It is likely that CoStar’s Intangible Assets account has the potential for financial reporting manipulation.

Based on the company’s Financial Accounting Standards as of year end 2017, which allows for closely related business activities to be nearly interchangeable between Intangible Assets and R&D in combination with interchangeability between Finite and Indefinite Lives of Intangible Assets, and evidence in the previous analysis that this has occurred, it stands to reason that Intangible Assets should be viewed with greater criticism in further analysis and future valuations.

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Earnings Quality & Fundamental Analysis: CoStar Group Inc.

Nick Kunz

7. Concluding Remarks Costar Group Inc. (CoStar) is considered by many to be the industry leader for providing data, information, and analytics on commercial real estate assets throughout North America and Europe. The competitive environment of the commercial real estate technology business is rapidly changing and the company has recently engaged in new ways of competing in this environment. ​One of the most important ways CoStar has engaged their competition is growth through aggressive business acquisitions, rather than through internal development.

By virtue of this analysis, it has been postulated that the aggressive business acquisition behavior of the company, has by in large resulted aggressive financial reporting behavior. The analysis conducted here has demonstrated four (4) potential sensitivities in financial reporting subject to potential manipulation because of this; they are: 1) Cost of Revenues, 2) R&D, 3) Goodwill, and 4) Intangible Assets. Although this analysis is not a complete or exhaustive view of the quality of the company’s financial reporting, it does provide insight into potentially aggressive financial reporting that could negatively affect business and investment decisions.

Overall, the quality of the financial reporting appears to prudent and reliable. However, it is important to maintain a critical view of CoStar now and into the future. As with any company, CoStar will face new challenges and new ways of financially reporting them.

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