We hear on a regular basis about the quality of work environments that some businesses provide for their employees. I understand the need to take care of good people lest the best leave for greener pastures. However, the primary reason for any business to exist and the most important function of management is to return value to the shareholders. Simply put, in my view, management that fulfills its primary duty should be richly rewarded; management that does not, should not be.
When a business is recognized as “One of the Best Places to Work,” most people probably assume that is a good thing. In the case of CoStar Group, Inc. (CSGP, Financial), it appears to be a superb place to be employed, especially if you are one of the top five executives in the business.
What is CoStar Group?
CoStar Group, Inc. describes its business as providing information, analytics, and online marketplaces services to the commercial real estate industry in the United States, Canada, the United Kingdom, and France. Its products include: CoStar Property Professional service that provides inventory of office, industrial, retail, and multifamily properties and land. In addition, it offers CoStar COMPS Professional, which provides coverage of comparable commercial real estate sales information; CoStar Tenant, an online business-to-business prospecting and analytical tool; CoStarGo, an iPad application that integrates its property, comparable sales, and tenant information; CoStar Advertising to market a space for lease or a property for sale; and CoStar Portfolio Strategy and CoStar Market Analytics. These products are designed to meet the research needs of commercial real estate owners, investors, and lenders. The company also offers CoStar Investment Analysis Portfolio Maximizer, CoStar Investment Analysis Request, CoStar Real Estate Manager Corporate Edition, and CoStar Real Estate Manager Retail Edition all of which are real estate management software solutions. Its CoStar Private Sale Network provides clients with custom-designed and branded Websites and CoStar Brokerage Applications help clients manage and optimize business operations.
The LoopNet Premium Lister and LoopNet Premium Searcher products are designed for commercial real estate professionals and other customers to market their listings. LoopLink is an online real estate marketing and database services suite; Apartments.com, an online apartment marketplace for renters; LandsofAmerica and LandAndFarm that are online marketplaces for rural land for sale; and BizBuySell and BizQuest, which are online marketplaces for operating businesses for sale.
The company serves commercial real estate and related business community. CoStar Group, Inc. was founded in 1987 and is headquartered in Washington, D.C. As you can see, the company’s products serve a wide range of markets and customers. As you will also see momentarily, the business is also profitable, although not excessively so.
How profitable is the business?
In the year ended December 31, 2014, according to its income statement Costar Group net after tax earnings of $45 million or $1.46/share excluding extraordinary items and $71 million pre-tax. These earnings were based on $576 million in sales meaning the business had a net after tax profit of 7.8% on sales. This is not a great performance, but it is certainly better than a loss.
As indicated in the table below, analysts covering the stock believe the company will earn $1.70/share during 2015, and those earnings will soar to $4.19/share in 2016.
|
Unfortunately, a good investment opportunity requires more than just a profitable business that has reasonable growth prospects in the present and future. Good investments must also be priced at a level that allows for a reasonable expectation that a fair profit will be produced if those projections are met.
How is the business currently valued?
With a share price that closed trading at $214.83/share on Friday, July 24, the stock is currently valued at just over 126 times this year’s projected earnings. Even if earnings rise by the analysts’ predictions of 146% to $4.19/share in 2016, the stock would still be priced at a very expensive level of 51.27 times earnings and a price to earnings growth rate (PEG) of more than 2.5 based on the five-year forward annual growth currently projected by analysts.
The generally accepted method of using PEG ratios for the purpose of establishing fair value is based on the current year’s anticipated earnings as they are typically believed to be more accurate than the earnings projected for years that are farther in the future. If we were to assign a value to the stock based upon an aggressive rate of 2.5 times the 20% anticipated forward growth rate using the anticipated 2015 earnings of $1.70/share, we would produce a current fair value estimate for the stock of (2.5 X 19.25) X $1.70 or $81.81/share. If we were to apply a PEG of 1 to the projected 2016 earnings of $4.19/share, we would end up with a current fair value estimate of $80.66/share.
| Growth Est | CSGP | Industry | Sector | S&P 500 |
| Current Qtr. | -93.80% | -0.30% | 27.50% | 8.40% |
| Next Qtr. | -41.40% | 16.80% | 45.20% | 9.10% |
| This Year | -48.50% | -17.70% | 10.90% | -0.50% |
| Next Year | 146.50% | 38.70% | 15.80% | 12.30% |
| Past 5 Years (per annum) | 49.54% | N/A | N/A | N/A |
| Next 5 Years (per annum) | 19.25% | 14.26% | 17.40% | 7.16% |
| Price/Earnings (avg. for comparison categories) | 126.37 | 25.17 | 25.16 | 17.35 |
| PEG Ratio (avg. for comparison categories) | 6.56 | -18.95 | -0.78 | 1.29 |
If all other information surrounding this business were neutral, it would appear to me that this business is fairly valued between $80 and $85/share or about 60% below the current share price.
But, I don’t see the rest of the information available on CoStar as being neutral.
Other important information in assessing value
As previously stated, estimates provided by analysts related to the projected future earnings of any business are going to be the most accurate the closer they are to the current date. One of the ways to judge the future prospects for the performance of a business is to look at the recent trends in changes to the opinions and forward estimates supplied by the analysts covering a particular business.
| EPS Trends |
Current Qtr. Jun 15 |
Next Qtr. Sep 15 |
Current Year Dec 15 |
Next Year Dec 16 |
| Current Estimate | 0.05 | 0.51 | 1.70 | 4.19 |
| 7 Days Ago | 0.05 | 0.51 | 1.70 | 4.19 |
| 30 Days Ago | 0.06 | 0.52 | 1.77 | 4.20 |
| 60 Days Ago | 0.13 | 0.70 | 2.07 | 4.33 |
| 90 Days Ago | 0.25 | 0.70 | 2.07 | 3.99 |
In the case of CoStar, over the last 90 days, the projected earnings for 2015 have fallen by 17.9%, from $2.07/share to $1.70/share. While the projected earnings number for 2016 has increased by about 5% over the last 90 days, it peaked at $4.33/share 60 days ago and has fallen by $0.14/share (-3.2%) since then.
We are seeing a clear trend in the nearest term earnings projections, and it is not moving in a favorable direction for existing shareholders. I find that to be somewhat disturbing.
But this is more disturbing than the earnings trend
If you look back and review the title of this piece and the second paragraph of the opening, you will get a couple of solid clues about what is coming next. As I state over and over in analysis work I produce, the primary function of a business and the management team is to return value to shareholders and that means more than just a higher share price. I have also consistently been a supporter of management teams that are well compensated in direct proportion to the profits a business produces that benefit the shareholders. After all, it is the shareholders who are the owners and have allocated their hard-earned capital that allows the business to exist in the first place.
One thing I have found through analyzing hundreds, if not thousands, of businesses over the years is that the more difficult it is to find the compensation packages of the top company executives, the more outrageous the compensation tends to be in proportion to the profitability of the business.
As previously stated, in 2014, CoStar earned net, after tax profits of $45 million, or 7.8% of gross revenue. Buried on page 63 of the 2015 Proxy Statement of the company, we can uncover exactly how highly the board of directors values the executive management of the company compared to the shareholders who have invested their hard-earned money in the business.
| NAME/ TITLE | SALARY | STOCK AWARDS | OPTION AWARDS | NON-EQUITY INCENTIVE PLAN | ALL OTHER COMPENSATION | TOTAL |
| Andrew C. Florance, Pres/CEO | $638,142 | $5,119,648 | $1,952,832 | $1,310,000 | $15,362 | $9,035,984 |
| Brian J. Redecki CFO | $372,175 | $1,699,848 | $645,132 | $487,500 | $14,733 | $3,219,388 |
| Francis A. Carchedi Ex. VP Ops | $349,752 | $1,700,474 | $645,132 | $432,000 | $15,382 | $3,142,740 |
| Matthew F.W, Linnington Ex.VP, Sales | $222,669 | $1,500,146 | - | $254,500 | $12,539 | $1,989,854 |
| John L. Stanfill Sr.VP Sales & Cust. Serv. | $199,014 | $1,190,736 | $453,336 | $26,128 | $12,018 | $1,881,233 |
| Total | $1,143,610 | $11,210,852 | $3,696,432 | $2,510,128 | $70,034 | $19,269,199 |
It seems that the board of directors and the “Compensation Committee” of CoStar believe, as indicated in the table above, that the top five executives at this business deserved total compensation in 2014 of over $19 million, an amount equal to 42.8% of the net profits for the entire business. Do you believe any management group, much less just the top five executives of a public company deserves compensation equal to almost 43% of the net profits for the entire business? I don’t. But, I do understand why they didn’t put it in the annual report to shareholders and chose to bury it on page 63 of the 2015 Proxy Statement.
This is the only thing I found more surprising than the current high valuation of the business.
So, what is the real fair value of CoStar?
Earlier in the analysis, I displayed a couple of quick approaches to establishing a fair value for CoStar Group and came up with a rough estimate between $80 and $85/share using price-to-earnings growth rate multiples.
Other common metrics used for the purpose of estimating fair value are a comparison of the business’ current valuation to historic median values. The chart below shows the current share price (green line) in relation to where the price would be based on historic median valuations of price to earnings (red line) and price to sales (dark blue line).
This chart provides an excellent visual representation of how shortly after the stock began its three year run higher, the price became very “stretched” compared to its historic relationship to these metrics.
The chart also shows that, even though the stock would be about 38 to 50% higher than the $80 to $85 range we estimated earlier, it would still be almost 50% below the current price.
It seems pretty clear that based upon just about any reading of fair value applied by most investors, this stock is current 45% to 60% overvalued.
Final thoughts and actionable conclusions
Based upon everything I have seen in my analysis, it appears that both the management team and the stock price at CoStar Group are substantially overvalued by the business and the market at current levels.
At the very least, prudent investors wishing to guard their capital should stay far away from the shares of this business. For those investors who might be looking for overvalued stocks to sell short as a hedge against a long-biased portfolio, CoStar would make an excellent candidate to consider as a short-sale. When markets correct, excessively valued stocks with over-priced management groups tend to lose their luster and tarnish very quickly.
