E-Procurement Knowledge and Help Customers Achieve Faster Savings While Controlling Larger

Overview

Ariba, Inc. is a provider of Enterprise Spend-Management (ESM) solutions. These solutions enable the user enterprise to appraise and manage all its cash expenses (excluding payroll) and thereby, implement effective cost control and augment profits. The company’s solutions include software applications, services, and an access to Ariba’s network. The integrated product suite assists companies to analyze and organize their various expenditures such as raw materials, services, operating resources, travel, repair, and, maintenance.

The company announced its acquisition of Alliente, Inc. on 7th January 2004. Alliente is a Business Service Provider (BSP), managing indirect e-procurement solution for business activities like catalog order management, supplier management, e-enablement, and payment services. This company’s sole business is outsourcing procurement solutions. The Alliente acquisition is expected to enhance Ariba’s

e-procurement knowledge and help customers achieve faster savings while controlling larger areas of expenditure.

On 23rd January 2004, Ariba announced its merger plan with FreeMarkets. This move is expected to enable Ariba’s vertical growth as the company at present focuses on retail and financial verticals, while FreeMarket’s forte is in the automotive and manufacturing-based industries. Though the acquisition will lead to some degree of overlapping of customers, the product lines of the two companies are complementary and are expected to help the company provide a more complete ESM solution package. Also, the merger may lead to cost synergies to the tune of $25 million during the year ended September 2005.

Management feels Ariba is finally on the path to stability, and as such its focus is now on growth and expansion. The above acquisitions underpin these aspirations. There is, however, some cause for concern. The highly competitive macro environment and declining growth in procurement/sourcing market poses a high hurdle for the company. If Ariba can differentiate itself from larger Enterprise Resource Planning (ERP) vendors that are embedding procurement functionality into their software, low Street expectations would begin to revise upwards; but most analysts are doubtful of such an occurrence in the near future.

Sales

Ariba recorded sales of $56.0 million for the second quarter (ended March 2004) of the year ending September 2004. Total revenue spiraled down by about $3.3 million from that recorded in the quarter ended March 2003, resulting in a year-over-year (Y-o-Y) decline of 5.5%. However, sequentially sales rose 6.2%, from $52.7 million in the quarter ended December 2003.

The decline in year-over-year sales was primarily due to apprehensions regarding the FreeMarket merger.As the integration proceeds smoothly, the customers are expected to get over their hesitancy. Ariba closed only 2 deals of over $1 million during 2Q04, compared to 5-7 deals in each of the last two quarters. However, it was heartening to note that the company had lot of new customers during the quarter.

The company’s revenue is bifurcated into license revenue and service & maintenance revenue.

License revenue

License sales added $15.9 million to the total revenue for the quarter ended March 2004. The quarterly sales from this segment declined 15% sequentially and 43% Y-o-Y. The contribution of license revenue to total revenue came down to 28% during the quarter, from 35% in the prior quarter and 40%-43% in the preceding four quarters. The continued problems with Softbank continue to affect the segment’s revenue.

Management forecasts a low revenue of $10-$14 million from this segment for the quarter ending June 2004. It blames the pending FreeMarket merger as the primary reason for deteriorating top-line performance. Our digest average revenue for the forthcoming quarter, at $12.9 million, is approximately the average of management guidance.

(In million dollars)

Revenue - License

Service & Maintenance Revenue

This segment totaled sales of $40.1 million for quarter ended March 2004. Unlike the downslide in the license segment, the sales in this segment exhibited commendable growth. The quarterly sales reflected an 18% sequential and 27% year-over-year growth. Service & maintenance contracts have been responsible for the greater part of the revenue earned by Ariba in the recent past, accounting for almost 72% of the total revenue in 2Q04, compared to 65% in the previous quarter. Our digest average predicts revenue of $40.5 million.

(In million dollars)

Revenue – Service & Maintenance

International sales, however, declined to about 25% of total revenue in the quarter ended March 2004, compared to approximately 30% in the prior quarter and 45% in the one before that. Asia Pacific (APAC) contributed only 5% to total revenue due to the closure of Softbank partnership. Europe contributed the balance 20%, same as that contributed in the preceding quarter. However, Ariba has hired a new APAC manager and is making efforts to improve operations in the region.

For the forthcoming quarter, management expects a revenue of $50-$55 million. Our digest average for the period is $53.3 million.

(In million dollars)

Total Revenue

Margin

Gross margins are under pressure as the revenue mix shifts unfavorably from low-cost license to high-cost service & maintenance. Cost of license was 4.4% of revenue in year ended September 2003, whereas cost of service & maintenance ran up to 34% for the same period. This unfavorable shift seems to be continuing through the current year ending September 2004. For the quarter ended March 2004, Ariba recorded gross margin of 71%, falling 450 basis points (bp) sequentially from 75.5% in 1Q04, and declining 700 bp from 78% recorded in the year ago quarter.

Operating margin for the quarter ended March 2004 was –6.7%, down from 10.3% in the previous quarter, and from –3.3% a year ago. A $3 million litigation charge added to the downslide in the quarter’s margins. If the effect of this charge was removed, operating margin would still be negative, but much lower at -1.4%.

Given below is our digest average margin estimates for the forthcoming quarter.

Gross Margin

Earnings Per Share

Ariba and the analyst community report Ariba’s EPS results exclusive of certain charges, including in-process research & development, amortization charges, warrant expenses, and restructuring changes. While this treatment is not unusual, it seems to mask significant issues in Ariba’s particular case. For instance, many of the “one-time” charges have been more frequent and larger than expected by the analyst community.

The company’s financial results for the quarter ended March 2004 were below the consensus estimates. Ariba ended the quarter with a loss of $0.01 per share, below the Street expectation of break even. Ariba recorded a positive pro-forma EPS for the past four consecutive quarters. However, for 2Q04, earnings were sequentially down by 137%.

For 3Q04, management forecasts the EPS to be around -$0.02 to -$0.04. Expectation of increasing losses is on account of increased costs due to the recent acquisitions and downside in revenue due to apprehensions surrounding the FreeMarket merger. Our digest average of -$0.02 is at the lower end of the management guidance.

Target Price/Valuation

Our digest average target price is $2.12.

Ariba, at present, has not much to offer to the investor. Hence, its discounted valuation to its peer group appears quite justified. Its merger with FreeMarket is expected to considerably strengthen its position in the spend management market. According to JP Morgan, the merger should make it the most complete solution provider and leader in the spend management industry. However, before the company can attain any sort of leadership, it has to successfully complete the merger and reduce its costs.

Long-Term Growth

Management believes Ariba is at last nearing stability. It justifies this belief on the basis of four consecutive profitable quarters, diminution in cash burn, and phasing out of reductions in deferred revenue. Nonetheless, the lackluster performance of 2Q04 and the uninspiring guidance for 3Q04 have most analysts worried about the long-term prospects of Ariba.

Analysts express substantial concern that the company will face increasing competition from larger, stronger firms. In the declining growth atmosphere of the procurement/sourcing market, major ERP vendors like Oracle, PeopleSoft and SAP are embedding procurement functionality into their software suites and marketing the “one-stop-shop approach”. This is leading to fierce competition and forcing out smaller and specialty vendors like Ariba. Hence, for the smaller companies who are just beginning to spread their wings, there are trying times ahead.

Another factor causing concern is the unfavorable shift in the revenue mix – a trend that analysts expect will continue. Also, the loss of deferred revenue over the quarters is not only cited as an issue that may force brutal year-over-year comparisons, but also as an indication that Ariba is experiencing difficulty closing deals.

These negatives are to some extent diluted by Ariba’s attempts to expand and grow. The recent acquisitions of Alliente, Softface, and FreeMarket are evidence of the company’s endeavor to carve a niche for itself in the increasingly competitive market.

Also, according to JP Morgan, ESM potentially represents a $2 billion market. However, this section is the most under penetrated at present. Once the IT spending starts picking up in earnest, and companies complete their spending on the important areas like security and storage, control over corporate expenditure should become a priority. It is then that Ariba should actually be able to spread its wings.

Our digest average long-term growth is 10%.

Additional Conversation

1)Asian operations – The ongoing litigation with Softbank, Ariba’s Japanese partners, is expected to be resolved soon. The deteriorating relationship with Softbank has been responsible for the declining sales in the APAC region. The company has taken steps to revive its sales from this region by appointing a new APAC General Manager. Also, FreeMarkets has a 2:1 presence in Japan. However, it will take some time and considerable efforts to rebuild the channel relations and improve top-line growth in the region.

2)SoftFace Acquisition – On March 31, 2004, Ariba acquired SoftFace, which is a privately held company with around 20 employees. The acquisition was in lieu of SoftFace’s technology that provides classification and categorization solutions to cleanse and classify problematic spend data.

Individual Analyst Opinions

POSITIVE RATINGS

None

NEUTRAL RATINGS

CIBC World Markets – Sector Perform

The analyst feels Ariba's increased emphasis in services helped to offset the soft license revenue. However, the revenue mix shift negatively affected margins, which is unlikely to change over the next few quarters. Despite the rise in IT spending, he feels the procurement space remains soft as ARBA's license revenue hit the low end of revenue guidance ($15.9m), and management provided a soft 3Q04 license outlook.

Friedman, Billings – Market Perform ($2.00)

The analyst believes that the integration of FMKT represents short-term risk for the company. Integration among software entities is always challenging, and in his opinion this one will be no different. He looks forward to receiving more details on the product roadmap and integration timeline once the deal closes in June so that he can put some of his concerns to rest. In the long run, he remains cautious about the company’s prospects, as he believes ARBA’s ability to differentiate itselffrom the larger ERP suite players remains limited.

JP Morgan – Neutral ($2.00)

The analyst is of the opinion that software applications to manage and control spending in enterprises are the most under penetrated area in ERP solutions. He feels that IT spending has picked up, and, as we get to the later phase in the cycle for IT purchases, organizations will look for solutions that can control costs in the next downturn. He believes ESM solutions will be a key component of that cost control strategy. Ariba is the only vendor focused solely on this area, and he feels its broader and deeper solution should help it win against traditional ERP vendors. Because he expects spending in this area to be later in the cycle, he thinks the opportunity for Ariba, as a stock will come late in 2004 and into 2005.

NEGATIVE RATINGS

Shareholder Value Management – Sell ($2.23)

The analyst feels company has probably made fatal strategic mistakes in market segmentation and product development. Based on industry experience, he believes he could run the company better than existing management.