Banking

Ariba sets the bar higher

With license revenue growing by 85 percent in the fourth quarter of its fiscal year, Ariba is a good buy, according to Morgan Stanley Dean Witter analysts. See why the analysts say Ariba has risen above the crowd in the B2B space.


Prepared by Morgan Stanley Dean Witter analysts Charles E. Phillips and Mary Meeker
NASDAQ: ARBAPrice (Oct. 20, 2000): $127.0652-Week Range: $183.34-36.50
Summary and investment conclusion
Ariba grew licenses 100 percent sequentially in FQ3 and announced ahead of FQ2 that it would exceed expectations, so we were pleased, if not surprised, to see it report sequential license revenue growth of 85 percent for FQ4, and total revenues with more than 30 percent upside to consensus estimates.

Quick summary of the quarter
  • Total revenues of $134.9 million versus our $100 million estimate.
  • License revenues of $99.1 million, versus our estimate of $65 million—an increase of 85 percent sequentially and 908 percent year over year. No problem here—upside of $34 million.
  • Breakeven from operations a full year earlier than estimated. Imagine that—a B2B company about to turn a profit. We had been looking for a loss of $0.05 per share.
  • In total, the company reported 114 new customers for the quarter, 68 of which were marketplace deals. The total customer count is now 450.
  • The company reported lower DSO in FQ4, at 41, down from 49 in FQ3.
  • Continuing a two-year run of being cash flow positive, the company ended the quarter with $280 million in cash and investments, up from $215 million last quarter.
  • Deferred revenue finished at $200 million, up 30 percent from $154 million last quarter. This includes a $20 million downward adjustment to deferred revenue, due to more conservative accounting for the company’s recent acquisitions. Absent this adjustment, deferred revenue would have been $220 million, which would have represented sequential growth of 43 percent.
  • Headcount is currently at approximately 1,680 employees, up from approximately 1,273 last quarter and approximately 400 one year ago.
  • Raising EPS estimate to $0.15 for F2001 from $(0.09) on revenues of $750 million (up from our previous model of $550 million).
  • We are establishing a F2002 estimate of $0.45 per share on revenues of $1.2 billion.



Crossing a new threshold
Not too many companies can get from $9 million in license revenue to $99 million in four quarters. Not even Netscape did that. Netscape went from $22 million to $83 million in four quarters but only had $75 million in deferred revenue and twice the DSO. A new record has been set for the next Olympian to come along.

The company pulled in its break-even point by six months relative to expectations two quarters ago. We think Ariba is about to show that there is a sustainable business model for a B2B pure play. Assuming profitability matters, we would expect customers to take note of the seasoning of the business model as well.

The main competition in the quarter was investor expectations. Measuring up to last quarter’s extraordinary results was a tall order off a larger base of numbers.
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Issue spotlight
Most of the questions we received about the quarter revolved around deferred revenue and network revenue. For perspective, the change in deferred revenue compared favorably to the quarterly results from i2 Technologies (ITWO, $161, Outperform).

However, i2 has never operated with much backlog or deferred license revenue. It’s important to note that deferred revenue for Ariba this quarter is on an apples-to-oranges basis. License revenue plus the net change in deferred totaled $145 million in the quarter compared to $123 million the prior quarter, unadjusted. However, the $123 million figure was inflated by $15 million from an acquisition and, conversely, the accountants did not include another $22 million from acquisitions this quarter in deferred revenue. Adding back the $22 million to get to a comparable basis, license revenue plus the net change in deferred totaled $167 million—an increase of $44 million.

Total backlog consisted of deferred revenue plus deals that are not in deferred because cash has not been collected—the shadow backlog. Total backlog was up, in line with sequential revenue growth for the quarter. Given the traditional FQ4 ramp, FQ1 is a big cash collections quarter, which impacts deferred revenue bookings.

Network revenue matched our estimate of $20 million. Network revenue is the recurring revenue generated from marketplace subscriptions (term licenses on marketplace software) and transaction revenue. The mix shift within this line moved significantly toward transaction revenue as marketplaces began moving from initial licensing of technology platforms to transaction revenue. The transaction revenue builds slowly over time as marketplace participants get past their initial preallotment capacity. This category represents an early peek of the next phase of revenue growth driven by add-on network services.



Strong balance sheet
The company reported lower DSO in FQ4, at 41, down from 49 in FQ3. Management warned once again that it expects this to gradually level off in the long term to approximately 70. The company ended the quarter with $280 million in cash and investments, up from $215 million last quarter, chalking up another consecutive quarter of positive cash flow. The company has now been cash flow positive for more than two years.

Execution on all fronts
Sales cycles for the Ariba Buyer application have decreased to two to five months, according to the company. Management believes that decisions on e-procurement deals are coming faster, even for enterprise clients, due to the widespread acceptance of e-procurement as a viable and high-payback solution.

Delivering on cross-selling promises
Ariba reported that it is experiencing early success in cross-selling its products into its customer base and through its exchange communities. For example, Chevron and Cargill began their Ariba relationship with the Buyer product, then went on to establish marketplaces leveraging Ariba exchange applications. In addition, Kmart and Target, which began their relationship with Ariba through the Worldwide Retail Exchange, have moved on to purchase Ariba Buyer. The company reported having a strong quarter on the Buyer and Marketplace fronts, as well as several new deals involving the company’s sourcing applications, recently acquired as part of the SupplierMarket acquisition.

Customers
Ariba reported that almost half of the company’s 170 marketplaces are conducting live transactions. Several of the company’s live clients were showcased at the conference. Three of the live clients released the following results:



Mindtrac expects to reach $75 million in transactions by May 2001.

Ariba’s goal for new live marketplaces is to bring 30 or more online per month going forward. At this rate, the number of live marketplaces would increase more than six-fold over the next 12 months. During the last quarter, the company brought 60 new marketplaces live, or 20 per month, up from 17 per month during FQ3.

Partners
The company reported it had over 5,000 partner resources trained worldwide, influencing 16 percent of the company’s total revenues during FQ4. The company is on track to have approximately 4,000 IBM account reps trained by the end of the first quarter, calendar year 2001. There are approximately 1,500 IBM resources currently trained on Ariba.

Another important partner channel for Ariba is the middle market, which the company is pursuing with a series of alliance partners focusing on this space. Across all of Ariba’s alliances in the middle market there are approximately 500 salespeople who are trained on the company’s products and ready to sell.

In addition to the ASP and hosting channel, Ariba has forged relationships with resellers and hosting services that can also create private label marketplaces, taking advantage of all of the functionality of the Ariba platform. This model enables Ariba to derive licensing and ultimately services revenues from geographies and markets that the company does not plan on entering itself.

Acquisitions
The company closed the SupplierMarket acquisition on Aug. 30, 2000, and in September announced the availability of Ariba Sourcing, the company’s application based on technology acquired from SupplierMarket. During its quarterly conference call, Ariba reported that it had successfully closed several sourcing deals during the quarter (i.e., September). One of the early customers was reportedly Bristol-Myers Squibb, which had also opted to roll out the Buyer application to approximately 30,000 users.

International
The company reported that more than 20 percent of total revenues were from international, which is up from the historic range of 15–19 percent.

Headcount
Ariba reported that headcount is currently at 1,680 employees, up from 1,273 last quarter and 400 one year ago. Of these employees, approximately 500 are in professional services, 200 are in sales, and the remainder is split between research and development and general and administrative positions.

Outlook
Ariba seems to be mastering the management controls aboard its balanced business model of license, subscription, transaction, and services revenues. We believe that Ariba’s strong growth in revenues, very strong partnering execution, solid customer growth, two years of positive cash flows, and ramping transaction volumes all underscore the power of its strategy. Ariba has risen above the crowd in the B2B space, and we expect it to continue to put more distance between itself and its competition going forward. Our fiscal 2002 estimate of $0.45 per share on revenues of $1.2 billion reflects this momentum.
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Review of Ariba’s strategy
Company management has consistently pounded out the following “five-pronged” strategy, which represents the company’s roadmap to achieving long-term success as the B2B e-commerce network and platform of choice:
  • Capture buying power: Attract buyers to the e-commerce platform, achieved through the success of Ariba Buyer as the ideal solution for procurement.
  • Attract and enable suppliers: Attract suppliers to the platform using buying power as the draw and by adding value for the suppliers.
  • Build out the network: Expand the network, increasing the attraction to both buyers and suppliers, supported by the announcement during the quarter of Network Connect.
  • Create a marketplace platform: Develop a platform that includes multiple buyers and multiple sellers, including horizontals, verticals, geographies, dot coms, and corporate consortiums.
  • Provide network and commerce services: Enable and provide services that are required by participants in the network. This will be further supported by the forthcoming Commerce Services Integrator program, also announced during the quarter.

Measuring against the strategy: How is Ariba doing?
Taking Ariba’s strategy one step at a time, we are more than a little impressed with management’s record of execution, even in these early innings:

Leadership in e-procurement. We think the company clearly leads the market for buy-side e-commerce, or e-procurement, software. Industry analysts will measure this market many different ways, but Ariba is most certainly the company to beat. Ariba pursued an initial strategy of focusing on very large buying organizations to help attract a lot of suppliers. Now it is marching down market, armed with its 30,000 registered suppliers and a cadre of hungry alliance partners targeting the market of potential companies with less than $1 billion in sales.

Frictionless supplier registration. Ariba has focused on a strategy that minimizes friction for new suppliers interested in joining its network. Suppliers can register with full “punch-out” functionality to their sites from the buyer application, or they can opt for simple fax or e-mail notification from buyers. This strategy has enabled the company to build a network of 30,000 suppliers, a number that the company expects to rise significantly over the coming months. In a virtuous circle, Ariba’s huge network of suppliers in turn serves as a draw in attracting new buyer clients.

The Universal Description Discovery and Integration (UDDI) initiative launched by Ariba, Microsoft, and IBM, and supported by a broad representation of key players in the B2B e-commerce market, should further facilitate the integration of new buyers and suppliers with the Ariba network. Part of an open architecture project known as project Aurora, UDDI represents another step in Ariba’s strategy to build liquidity through openness and integration.

Openness means goodness for the network. To further increase the power of Ariba’s network, the company announced during the quarter the Network Connect program to enable non-Ariba applications to integrate with the Ariba Commerce Services Network using a collection of technologies from IBM, Tibco, and webMethods. The connection of third-party procurement, marketplace, and ERP technology likely will increase the value of the network and the value that is driven back to both the buy side and the sell side, making Ariba more attractive as the e-commerce platform of choice.

Making markets gets easier. The company announced during the quarter the AribaLive Web-based knowledge repository and toolkit for implementing marketplaces; it is expected to be available in November of this year. The tool will incorporate a series of methodologies, templates, best practices, and process management tools to allow implementation partners and customers to better manage the creation of new marketplaces. The product will also support knowledge sharing communities, and will serve as a communications channel for Ariba to keep its “ecosystem” informed of any upcoming enhancements or upgrades.

Bring on the services. During the quarter, Ariba also announced the creation of the Commerce Services Integrator program, which is expected to be available in the first quarter of calendar 2001. This program is designed to facilitate the integration of third-party commerce service providers with the Ariba network. This positions the company to begin building out the crown jewel of its five-pronged strategy. The company indicated that Bank of America already has identified approximately 65 commerce services that it plans to provide on its own portal as well as on the network. Ariba expects over time that there will be thousands of services available on its network.

In an effort to put some size to the commerce services market, company management presented the following estimates:



Ariba estimates that the company will be able to charge between 15 and 40 basis points for the various financial services and payment services provided to the marketplace platform.

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�Copyright 2000 Morgan Stanley Dean Witter & Co.

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