How to handicap B2B winners amid the
chaos
With analyst ratings all over the place, it's hard to know whether recent prices
for B2B e-commerce stocks are bargains or rip-offs. Here are some key factors
to deciding what to do about Commerce One, Ariba, i2 and other sector
leaders.
By Jim Jubak
Here's the problem in a nutshell: On April 6, two major Wall Street brokerage
firms both issued "buy" recommendations on Commerce One, a
business-to-business (B2B) sector leader. The stock has traded as high as
$331 in the last 52 weeks. On April 6, it closed at a tad less than $129 a
share.
Donaldson, Lufkin & Jenrette reiterated its existing "buy" rating and put a $370
12-month target price on Commerce One (CMRC, news, msgs). CIBC started
coverage of Commerce One with a "buy" rating and put a $170 target price on
it.
Yep, all we've got is a little $200-a-share disagreement
between friends.
I'm not especially surprised. This is typically what
happens when Wall Street starts to question the
business model for a sector. One group of analysts defends the existing model and
stands by the target prices the numbers in that model produce. Another group of
analysts attacks the existing model, develops a new one and comes up with an
entirely different set of valuations for stocks in the sector. And that's exactly what's
going on across the B2B e-commerce sector right now.
About a week and a half ago, on March 31, two analysts at Prudential Securities,
Douglas Crook and Jeffrey Prestine, shook the entire B2B sector just when it was
already vulnerable due to the retreat in Nasdaq technology stocks. Thanks to
increasing competition among companies in the sector, the two analysts said, they
believed that Commerce One, Ariba (ARBA, news, msgs), i2 Technologies (ITWO,
news, msgs) -- and by extension, similar B2B firms -- would have to lower the
transaction fees they were collecting from the Internet marketplaces they and their
partners were setting up. For example, the analysts said, General Motors (GM, news,
msgs) was renegotiating its deal with Commerce One and instead of splitting
transaction-fee revenue 50/50, Commerce One would see only 10% to 25% of the net
revenue.
The Prudential analysts didn't suddenly decide these were terrible companies with
lousy software. They simply applied a new business model to these stocks and came
up with much lower valuations. Valuations had been based on a business model that
included substantial revenue from transaction fees in the future; the new business
model backed out much of that revenue. And that meant the stocks were simply not
worth as much.
Prudential cut its rating for each to
"accumulate" from "strong buy." It
reduced its 12-month target price for
Commerce One to $200 from $250, and
for i2 to $150 from $200. It left the
target for Ariba at $250 a share.
Prudential's call pummeled the stocks,
and in the heat of the moment, with so many stocks dropping like stones, I changed
my Jubak's Picks call on Commerce One from "buy" to "hold." I didn't want to
encourage bargain hunters to pick up damaged goods with the possibility that the
fundamentals of Commerce One and other B2B stocks have changed decisively for
the worse. On the other hand, I didn't want any readers to sell Commerce One at the
bottom because I thought that, at the least, these stocks would get a post-panic
bounce.
Decision time
The hold call was a way to postpone the hard decision on Commerce One and the rest
of the sector until later, when the technology market had stopped falling like a stone.
Well, now it is later. All three of these Wall Street firms can't be right, although all
three could be wrong. And it's unlikely that any change in business model -- if there
is one -- would affect all stocks in the sector equally. The odds are that for every
stock that might deserve a lower price, there is one that received an unjustified
haircut. To make the most profit, all an investor has to do is figure out:
Which stocks are candidates for selling if the market rallies a bit more. (After
all, if Commerce One is going to trade at just $170 a year from now, I should
sell if it reaches $150 in the next week or two. There's no use hanging on for 11
months to get a risky 13%.)
And which stocks are true bargains. (After all, Commerce One, Ariba, i2 and
BroadVision (BVSN, news, msgs) were off 58%, 44%, 39% and 40% from their
52-week highs as of the close on April 7.)
Let's start with the B2B e-commerce business model, since that's what the fuss is
about.
A business model is, roughly, a description of how a company is going to make
money. A traditional software company's basic business plan, for example, would
include revenue from licenses -- since software companies don't actually sell software
to users but instead sell the right to use the software -- and services. Service revenue
would include payment from users for consulting on customizing software, for
maintaining and supporting it and for such value-added services as a data feed.
Pretty straightforward.
That's what I'll call the "software part" of the B2B e-commerce model. A company like
Commerce One, for example, collected license revenues of $13.1 million in the fourth
quarter of 1999, and collected maintenance and service revenue of $3.8 million in the
same period.
Robertson Stephens projects that B2B e-commerce transactions in the United States
alone will grow from $43 billion in 1998 to an estimated $270 billion in 2000 and a
whopping $1.8 trillion in 2003. The global market could exceed $3 trillion in 2003.
Companies like Commerce One, Ariba, i2 and BroadVision will sell a lot of software
and services to the firms taking part in that $3 trillion in transactions. Every company
that buys or sells will need software to connect it to the electronic marketplace, to
unify its inventory and purchasing systems and to make sure that information about
every order or sale is sent to everyone in the company with a need to know, from
sales people to warehouse managers. The biggest of those software packages will sell
for a hefty price. The average deal at i2 carried a price tag of $1.4 million in 1999, for
example.
Where the real money is
Even so, selling software to enable that $3 trillion in transactions isn't where the big
money is. And software is not the only part of the business model at Commerce One
and many other B2B electronic-commerce companies. The real cash is in capturing a
fee for each transaction. Suppose that B2B companies aren't software makers that
collect licensing and service revenue for enabling all these transactions. Instead, let's
say they are middlemen who collect a commission on each transaction. These
companies would then essentially own toll booths that collect a fee for every dollar of
goods and services traded by businesses on the Internet. Even just a 3% commission
on every electronic B2B transaction would add up to $90 billion in global revenue in
2003. That's an especially impressive hunk of change when you realize that Ariba will
report revenue of about $40 million for its most recent quarter.
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This second part of the B2B model, one I call the "electronic middleman," is
valuable even beyond that raw dollar figure. The $90 billion in revenue would fall
to the bottom line as almost pure profit. Once the marketplace was built, there
would be no sales and marketing costs, no manufacturing or shipping costs,
no raw materials costs to deduct from revenue. Deduct a little something for
service, for research and development of new generations of the software than
runs the marketplace, and for some salaries, and the rest is profit.
The revenue and profit from the middleman part of the business model also is
exceptionally valuable because it is extremely predictable. No worries about
whether the company will close 74 deals in the quarter, as i2 did in the fourth
quarter of 1999, or just 70. As long as the economy as a whole kept humming
and as long as the sector that the marketplace served didn't go through any
upheaval, those fees would keep flowing quarter after quarter.
No wonder, then, that the stocks of B2B electronic-commerce companies had
achieved astronomical valuations. On the day of the Prudential downgrade,
Commerce One sold at 109 times estimated calendar year 2000 revenues and
Ariba sold at 126 times estimated 2000 revenues.
I'm using price-to-sales ratios to demonstrate how expensive these stocks
were, but revenue -- even estimated revenue for the current year -- wasn't the
basis for their valuations. Commerce One and Ariba were at the forefront of the
B2B land grab. The more partners a company could sign up now, and the more
marketplaces it could create, the bigger the future cash stream the company
would claim. Ariba, for example, had signed deals for 28 active electronic
marketplaces as of the end of January, and a contract with a partnership of
Electronic Data Systems (EDS, news, msgs) and A.T. Kearney would put
Ariba's software platform at the core of 12 more markets. Revenue sharing from
transaction fees was a part of almost all of these deals.
The difference in valuation between the stocks of companies that were
expected to see substantial future revenue from the electronic-middleman
market and those that were built solely around the software model was
extreme. Siebel Systems (SEBL, news, msgs), which would certainly never
qualify as a cheap stock, traded at about 20 times estimated calendar year
2000 revenue -- a valuation one-fifth that of Commerce One and one-sixth that
of Ariba. And that's for a company that dominates the market for customer
relationship management software with a better-than-20% market share. No
other company can claim more than a 4% share.
That difference also partly explains (the size of the potential market plays a
role here, too) why companies like i2 were so interested in entering the B2B
e-commerce arena. i2 traded at 28 times estimated calendar year 2000
revenue just before the Prudential downgrade. But the stock had started to pick
up "strong buy" recommendations from analysts who noted that i2, which had
recently moved to become a B2B player, traded at a multiple well below those
of other B2B stocks.
Assessing the damage
Any B2B e-commerce stock with a valuation that is built at least partially on
the middleman model, and which then loses the support of that model, should
take a severe loss in valuation.
An investor at this point has two tasks:
Deciding if the damage to the middleman model is as severe as the
Prudential analysts think;
And deciding how much of a haircut, if any, is appropriate.
To back up their warning, the Prudential analysts offer a couple of examples
and some speculative logic. The examples are splashy, but not numerous or
utterly convincing: General Motors renegotiating the fees that would go to
Commerce One, as I've already mentioned above; Oracle (ORCL, news, msgs)
and MSN MoneyCentral publisher Microsoft's (MSFT, news, msgs) stated
intention not to ask for a piece of the transaction fee when they set up a
marketplace; a belief that i2 is experiencing a resistance to transaction-sharing
that has slowed down the rate at which deals close. To buttress their case, the
analysts argue that it's logical that fee-sharing agreements will get less
generous because there is more competition in the market.
A second point also deserves more attention than it got in the heat of a
technology-market meltdown. In the rush to sign marketplace deals, B2B
e-commerce companies may be promising more than they can deliver given
the size and complexity of each contract and the limited resources these very
young companies can marshal. Ariba has signed up Chevron (CHV, news,
msgs), Cargill and a dozen other major companies as anchor clients; i2 has
inked Toyota Motor (TM, news, msgs), Compaq Computer (CPQ, news,
msgs) and others; Commerce One has signed General Motors and Royal
Dutch Petroleum (RD, news, msgs) and about a dozen others. "We believe
each of these customers will demand levels of service from their technology
partners that assumes no other customers exist," the Prudential analysts
wrote. And that raises the risk that some of these deals will run into trouble
because the e-commerce companies can't deliver what they've promised on
schedule.
I don't think any of this evidence is enough to guarantee that the B2B stocks
will disappoint investors over the next year. But it is enough to convince me
that the risk in these stocks is higher now than it was a year ago when
valuations were lower and when the only thing investors could see were the
positive parts of the story.
When risks go up across a sector I look for two things in a stock: a lower price
that reflects the heightened risk and company-specific factors that limit the
risks.
Figuring out the 'right' price
No doubt prices are down across the sector. But the stocks with the biggest
stake in the B2B land grab are still selling at a huge premium to the other
stocks in the sector. BroadVision closed on April 7 at 60 times estimated 2000
revenue, i2 traded at 30 times 2000 revenue, Siebel Systems and Oracle both
traded at 21 times estimated 2000 revenue, and a turnaround situation such as
Manugistics (MANU, news, msgs) traded at eight times estimated 2000
revenue.
To decide which of those prices are justified, they have to be adjusted for the
company's potential and for its risk. Commerce One and Ariba, for example, do
have a shot at collecting transactions fees, and they have grabbed potentially
valuable marketplaces. Even if only some of that potential revenue comes
through, the stocks should trade at some premium to a stock like Siebel
Systems, since Siebel isn't really a player in the marketplace land grab.
But paying a multiple nine times Oracle's seems a bit much. I have my doubts
about the current versions of Oracle's applications software for e-commerce,
but they are clearly better than the previous versions, and Oracle is intensely
committed to doing whatever is required to compete head-to-head with
Commerce One and Ariba. All an investor is really getting for that premium is
whatever revenue will come to Commerce One and Ariba from the middleman
model, since Oracle at this point is not including transaction fee sharing in its
deals. That seems a bit steep to me given the risk that the middleman model
won't pan out.
And it seems even steeper when you consider the execution risk in Commerce
One and Ariba. Oracle's a big company that can handle two or more big
installations at once. Commerce One and Ariba's capability in this area
remains untested.
Jubak's Archive
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More?
Here's how I'd handicap these stocks given their combinations of price,
potential and risk.
A nod to Ariba over Commerce One. The partnership with IBM gives
Ariba access to one of the industry's best sales and service
organizations. That should reduce execution risk.
A nod to i2 over both Ariba and Commerce One on price and risk. i2's
TradeMatrix electronic-marketplace product is playing catch-up in this
area, but the company has a depth of expertise in procurement and
supply-chain management that should open doors. The partnership with
IBM and Ariba is a good example of this, I believe. The recent
acquisitions of Aspect Development (ASDV, news, msgs) and
Supplybase add huge databases of standard and custom products to
i2's procurement software. On these strengths alone I think i2 is a
"buy." If the company can manage to get a penny of transaction fees,
that's a bonus.
A nod to Oracle if you want a way to buy into the B2B sector with
relatively little exposure to its problems. No need to worry about the
middleman model or execution risk. But as a big company selling a
number of products, Oracle's stock won't get as big a boost from growth
of the B2B market as Ariba or Commerce One would if everything goes
right for the companies.
A nod to Siebel on unjustified punishment. The stock got hammered
along with the B2B commerce sector even though it doesn't share the
sector's problems. The recent dip gives investors a chance to pick up
the dominant company in software to manage a company's sales force
and its customers.
A nod to Manugistics purely on price. The turnaround at the company
seems to be going well and Manugistics is just starting its move into
B2B e-commerce. I don't think this is going to become one of the
top-tier companies in this area, but the price and a solid product make
the stock very cheap here and could make the company an acquisition
target in the consolidation of the sector.
Factoring in market volatility
Looking at the handicapping above, if I wasn't dealing with today's very volatile
market, I'd simply sell Commerce One today and buy i2. Simple as that.
But I think Commerce One could pick up a few points as it heads into its April
19 earnings report. I'd like to get the advantage of that rise. If I can sell around
$150, I'd consider this a reasonable salvage job.
i2 reports earnings on April 18 and it's likely to climb into earnings, too. But I
expect both stocks to fall back after earnings reports, much as Ariba has. And
a post-earnings trough would be a good time to buy the stock. So I'll wait.
I don't think either the potential of the sector or its problems are going away
soon.
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