ARIBA, AND ALL THAT JAZZ
by Robert Tracy
Eric J. Fry 12:00 PM 09|21|2000
[EDIT: Useful background piece on the "bear case" from Grant's Investor. Excerpt here does not include many useful tables from the actual article, which are referred to. Grant's has a free 30-day trial. To see full article go to grantsinvestor.com editorial page]
'Interprise' software juggernaut, Ariba Inc., held its gala 'Ariba Analyst Day 2000' in Miami earlier this week. Grant's Investor was not invited. We'll get over it... eventually. But it's a lot harder to overlook great big insider sales, share dilution and, oh yeah, losses.
Thirty-seven Wall Street analysts rate Ariba Inc. a "buy." But to judge from the actions of company insiders and numerous other investors close to this "Interprise" software company, Ariba is an outright sell. Everyone seems to love this thing, except the guys who run the show. Consider the numbers. Since Ariba became a public company on June 23, 1999, insiders have filed to unload about 13.2 million shares of stock, to realize about $1.8 billion. That's not a bad haul for officers and associated muckety-mucks of a profitless company that has amassed less than $200 million in total revenues since its inception in 1996. Not that we begrudge any of the insiders the good fortune that the bull market has rained down upon them. Hey, if Ariba were to acquire Grant's Investor tomorrow in a stock transaction valued at, say, $1 billion, we, too, would be sellers on the day our lock-ups expired. But the nouveau riche insiders are not the only sellers of note. Other investors crowding the exits include ARBA's lead underwriter, its two main venture capital investors and some of its initial multinational clients. What do they know?
Taking the other side of the trade are countless investors from the public ranks. Even if insiders do not see in ARBA the proverbial cup half full, public investors must imagine a cup that fairly runneth over with B2B potential. Since its initial public offering 15 months ago, the stock price has rocketed sixfold, expanding Ariba's market cap to a colossal $36 billion. To state the obvious, somebody's right and somebody's wrong. Intrigued, we set out to discover what inspired both the bids and the offers.
First, the bids. What, we wondered, is the investment story so spectacular that the company could command a market value of $36 billion, even while piling up a $463 million loss over the last 12 months? The answer begins with e-commerce software known as the Ariba Operating Resource Management System (ORMS). Per the IPO prospectus: "ORMS enables organizations to automate the procurement cycle within their intranets, lowering the costs associated with operating resources." So what if the early returns are poor, the future's gonna be great -- just you wait. The reigning "Queen of the Internet," Mary Meeker, and her Morgan Stanley Dean Witter colleague Charles E. Phillips lavished eloquent praise on Ariba in July 1999, just as the company began its public life -- a life sired, incidentally, by the bankers on the other side of the Chinese Wall at MSDW.
In their research report entitled, "Ariba (ARBA) A Star Is Born -- Pioneering Business-to-Business Electronic Commerce," Meeker and Phillips emote, "In the 1940's when bebop jazz pioneers like Dizzy Gillespie, Miles Davis, Bennie Golson, John Coltrane and Charlie Parker were playing with passion and genius into the wee hours of the morning, they knew they were part of a revolution that would change the way people think about music. It was just a matter of time. In much the same way, we're in a unique period for Interprise software. Like the bebop pioneers, several enduring corporate stars will emerge and make music for years to come. But it's usually difficult to identify the pioneers while they are going about the business of pioneering." Not so this time, we learn. In the informed opinion of Meeker and Phillips, "Ariba has become an icon for next-generation Interprise companies poised to deliver on the power of the Internet." Then, mixing metaphors, albeit within the same generation, the enraptured pair continue, "Sachel Paige, perhaps the greatest baseball pitcher of all time, said, 'Don't look back; someone may be gaining on you.' Ariba was first in the ORM market, and it hasn't looked back since."
As enthralling as the Ariba ORMS' "new-world processes" may be, insiders and other investors with a close-up view seem to find the story less compelling at the stock's current valuation than do their public counterparts. And a few others in the know, like Credit Suisse Asset Management, for example, apparently agree. Although Credit Suisse First Boston analyst Brent Thill initiated coverage of Ariba on Sept. 24, 1999, with a buy rating, and followed up with 13 reiterations of his rating over the past 12 months, CS Asset Management was not completely persuaded. It sold nearly 800,000 shares, or 43% of its original stake, in the quarter ended June 30. The names of the company's lead underwriter, its venture-capital backers and many of its initial investor-clients can be found on the list of selling insiders, as well.
Besides its various direct sales, management bandies the stock about like a high roller with a wad of Franklins at the $100 baccarat table. It has used its stock to buy companies and to purchase intellectual property. In addition, it has used warrants on its stock to sweeten "alliances" with companies that, by the way, are also customers. Some of the lucky allies include Telefonica and IBM. Probably, these satisfied customers do not give a second thought to their warrants when conducting business with Ariba. But just in case they need a little nudge, it might help to know that "the warrants vest upon attainment of certain milestones related to revenue targets," according to the latest Ariba 10-Q.
Such extensive and repeated co-opting of ARBA shares as currency suggests that the informed insiders consider the shares a better sell than a buy. In all, the M&A tab run up by the company so far this year totals $3.6 billion for three acquisitions. Expressed in the coin of the realm, Ariba's acquisitions year-to-date cost 53.8 million split-adjusted shares (including those used in options exchanges). Not surprisingly, the share count has exploded an astounding 36%, excluding outstanding warrants and employee options, during Ariba's brief, 15-month public life. And management is not finished yet. It seeks to boost the authorized shares to 1.5 billion from 600 million, according to a recent preliminary proxy statement. The dilution of losses bothers almost no one, but diluting future prospective earnings per share is another matter. The expanding share base will greatly impede the march toward any kind of meaningful per-share earnings performance.
Even without the dilution, Ariba's run-and-gun M&A strategy would be financially baffling even if conceptually dazzling. Take its $900 million purchase of SupplierMarket.com, for instance. The purchase price equates to 3,354 times total life-of-enterprise revenues through March 30. No value-investing awards on the horizon here. In announcing the transaction, Ariba gushed, "SupplierMarket.com brings innovative, highly scaleable and Internet-based technology to Ariba to automate the sourcing process, dynamically match buyers and suppliers, and negotiate price and value-added services through real-time reverse auctions." It also brings almost no revenues.
According to the S-1 registration for SupplierMarket.com (an IPO was planned before Ariba stepped in to buy the company), revenues from its February 1999 inception through last March 30 totaled $268,332. And this meager total may be even less than it appears. The S-1 indicates that 57% of the dollar bids made on its exchange platform came from companies owned by related funds or shareholders of SupplierMarket.com. "Since the launch of our marketplace in October 1999, we have substantially relied on a small number of buyers to post a significant majority of requests for quotation on our marketplace," says the S-1. "Some of these buyers are portfolio companies, or companies owned by investment funds that are either principal stockholders or affiliates of our principal stockholders or directors. For the three months ended March 31, 2000, these portfolio companies have accounted for 57% of the dollar value of requests for quotation that have resulted in bidding events." Perhaps these affiliates would have conducted business on SupplierMarket.com even if they had been operating somewhere beyond arm's length. Then again, perhaps not.
Additionally, SupplierMarket.com conducts an amazingly Ariba-like customer affinity program. Like indulgent parents paying their children to finish homework on time, SupplierMarket.com dispenses warrants on its shares to many of its customers. Even more interesting is that the warrants vest in accordance with the transaction volumes originated by the warrant-holders, as explained in note No. 12 of the company's audited financial statements: "The Company has executed non-binding letters of intent with several strategic partners ('Partners') whereby the Partners receive consideration, in the form of common stock purchase warrants, in exchange for utilizing the Company's service for their direct materials purchasing. It is expected that the majority of the warrants, if issued, will vest during the final three calendar quarters of 2000 and each calendar quarter of 2001, contingent upon the quarterly volume of each Partner's RFQs [request for quote] submitted to the Company's marketplace which result in an executed purchase order between the Company and the supplier for the RFQ." We can't wait to see what kind of transaction volumes this new Ariba subsidiary will rack up from companies having no financial connection to it.
If spending $900 million in stock to buy a company with less than $300,000 in revenues does not give investors pause, Ariba's own IPO prospectus provides reason aplenty to lighten up. For starters, the prospectus acknowledges that the barriers to entry are low and that the list of competitors reads like a who's who of the Nasdaq. We quote: "We primarily encounter competition with respect to different aspects of our solution from Captura Software, Clarus, Commerce One, Concur Technologies, Extensity, GE Information Services, Intelysis, Netscape Communications and TRADE'ex Electronic Commerce Systems. We may also encounter competition from several major enterprise software developers, such as Oracle, Peoplesoft and SAP. In addition, because there are relatively low barriers to entry in the operating resource management software market, we expect additional competition from other established and emerging companies as the operational resource management software market continues to develop and expand."
Indeed, the competition has intensified greatly since the company penned this warning more than a year ago. A knowledgeable, extremely successful hedge-fund manager who wishes to go unnamed told us that he would steer clear of the stock. Asked whether Ariba possesses any sustainable competitive advantage, he replied, "Not really." Rather, he characterized Ariba's primary strength as the tenuous sort that accrues to a first mover. "They've got incumbency in a few places," our man notes. "I would say it's more the first-mover and the head-start advantage that they have right now -- not necessarily some other kind of lock-in."
What is more, even good news for Ariba may not be great news for the share price. Industry consultant AMR Research Inc. predicts that online marketplaces will conduct some $3 trillion in sales by 2004. Even so, the revenues accruing to infrastructure providers like Ariba will total no more than $4 billion of that, AMR predicts. Thus, even in the improbable event that Ariba captures 100% of the market, its stock at today's prices would be selling for nearly 10 times estimated 2004 revenues. Even in a sector where exuberance and wide-eyed optimism reign supreme, Ariba's valuation stands out.
The stock's rich valuation is not lost on CEO Keith Krach. He may profess indifference to short-term stock market trends, but he clearly is not oblivious to them. In an interview on RadioWallStreet.com back on April 12, when a volatile Nasdaq was buffeting the Ariba share price, Krach stated, "I don't pretend to know what happens on Wall Street, but I can tell you that we're building a great company in the 21st century and we are focused on the long term." Later, he reiterated: "The No. 1 thing that we have here at Ariba is the great culture that's focused upon building a great sustaining company into the 21st century.... That is why people are here and the focus is on the long term." Just so, Krach has filed to sell 2.2 million shares (split-adjusted) over the last 12 months, netting $179 million. (Bulls, please note that the CEO still holds 18.6 million shares.)
ARBA is a quintessential new-economy company. Its software promises to lead the cutting edge of B2B e-commerce, yet the company runs up millions of dollars of losses each quarter. And even as the red ink mounted to almost a half-billion dollars last year, top management pocketed more than $1 billion from stock sales. Meanwhile, the share price soars to the delight and enrichment of minority shareholders as well. And if watching the share price go up every trading day does not bring sufficient joy to shareholders, they can read all about their favorite stock twice each year in Ariba Magazine. So what's not to like? Well, even if management deserves a round of applause for its efforts to date, that does not mean investors will want to continue holding, much less buying, the very same shares the insiders are selling so relentlessly.
When two investors espouse opposing views about a particular stock, one will often volunteer the familiar "well, that's what makes markets." Yes, indeed. But when legions of insiders join the offers while the presumably less-informed public buyers toss in the bids, the market that is made is the kind a long-term investor would do well to avoid. John Coltrane, Miles Davis et al. are cool, but so are profits. For our part, we find the actions of the insiders far more persuasive than any well-crafted sell-side investment thesis. We called the company repeatedly to get its take on the size of the market it is pursuing and, further, to learn why we should buy the stock that insiders are selling. But no one returned our calls. Time to join the offer. But be patient, there may be stock ahead. |
