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Executives

Robert M. Calderoni – Chairman and Chief Executive Officer

Ahmed Rubaie – Chief Financial Officer

John Duncan – Director of Corporate Finance and Investor Relations

Analysts

Greg Dunham - Deutsche Bank Securities

Nathan Schneiderman - Roth Capital Partners LLC

Peter Goldmacher - Cowen & Co.

Matthew Hedberg - RBC Capital Markets

Sterling Auty - J.P. Morgan

Bradley Whitt - American Technology Research

Brad Reback - Oppenheimer & Co.

Richard Williams - Cross Research

Justin Bandy - KeyBanc Capital markets

Ariba Inc. (ARBA) F1Q09 Earnings Call January 29, 2009 5:00 PM ET

Operator

Welcome to the Ariba first quarter fiscal 2009 earnings conference call. (Operator Instructions). It is now my pleasure to introduce your host, John Duncan, Director of Corporate Finance and Investor Relations. Thank you, you may begin.

John Duncan

Good afternoon and welcome everyone to Ariba's conference call to discuss the results for the first quarter of fiscal year 2009. In today's call, we will make reference to supplemental presentation slides with our prepared remarks. To access these slides, please log on to the Investor Relations section of our website at www.ariba.com. Our speakers for the call today are Bob Calderoni, our Chairman and Chief Executive Officer and Ahmed Rubaie, our Chief Financial Officer. For those on the call accessing the supplemental information, please now advance to slide two.

Before we begin, I will read the safe harbor statement. Statements that may be made in this call and in the supplemental slides that are not historical facts may be forward-looking statements, including statements regarding the company's or management's intentions, hopes, beliefs, plans, expectations or strategies for the future. These statements are subject to various risks and uncertainties, and the actual results could differ materially from the company's current expectations. These risks and uncertainties are discussed in the company's SEC filings, including our most recent report on Form 10-K filed on November 19, 2008, for the year ended September 30, 2008.

During the course of this call, we will reference historical non-GAAP financial measures. Management reviews non-GAAP financial information in evaluating Ariba's historical and projected financial performance and believes that it may assist investors in assessing its ongoing operations. The presentation of this additional information is not meant to be considered in isolation or as a substitute for or superior to measures of financial performance prepared in accordance with GAAP. For a reconciliation of historical non-GAAP to GAAP financial measures, please see the earnings press release and supplemental analysis on the investor relations section of our website at www.ariba.com or our Form 8-K filed this afternoon.

In addition, we will reference certain forward-looking non-GAAP information including fiscal 2009 revenues, expenses, and net income. We are unable to reconcile this forward-looking non-GAAP financial information to the corresponding forward looking GAAP measures because we are unable to estimate without unreasonable efforts certain forward looking GAAP revenue and expense items.

At this time, I would like to turn the call over to Ahmed Rubaie to review the financial highlights for the quarter.

Ahmed Rubaie

Good afternoon everyone and thank you for joining us today. When we last spoke 90 days ago, Ariba had just posted a record bookings quarter, and we entered Q1 with a lot of momentum. Our software business continues to exhibit good growth this past quarter as evidenced by solid growth in our subscription revenue and backlog. Over the last 45 days, we saw the overall selling environment become increasingly more challenging and with longer cycles. We saw a decline in our services business which had an impact on the quarter’s revenue. We still grew, albeit at a lower rate than expected, and our revenue came in at the lower end of our guidance range. As we said we would do, we took cost actions during the quarter to preserve our operating margins which enabled us to come in at the upper end of our EPS guidance. In short, we had a solid quarter, and we continue to be positioned to deliver profitable growth even in an economic downturn. Let me now walk you through the highlights from the quarter.

Please go to slide 3. We increased our annualized backlog by 59% or $47 million year over year to $127 million. This was driven by strong renewal activity and continued demand for our subscription software products.

Please now refer to slide 4. We posted a 71% year-over-year increase in non-GAAP subscription software revenue. On an organic basis without the impact of procuring, subscription software revenues increased 49% in line with our expectations. Non-GAAP revenue was $86.4 versus guidance of $86 to $89 million dollars. Non-GAAP operating EPS was $0.21 for the quarter. Included in this amount is a net benefit of $0.07, which comprises a $0.09 benefit from an insurance reimbursement of legal expenses and a $0.02 hit from a one-time devaluation of non-US dollar cash account. Excluding these two items, our operating EPS was $0.14 versus the guidance of $0.12 to $0.14.

We had another strong cash flow quarter, generating cash flow from operations before the impact of lease losses and restructuring payments of $17 million. We ended the quarter with $143 million of cash and investments which was also above our expectations. As part of cash risk management and in response to the uncertain financial markets, we have moved significant amounts of our cash into US treasury to ensure our cash is both safe and liquid. This is expected to result in lower interest income in future quarters, which I will cover later on when I talk about the full year guidance.

From a customer perspective, we closed 218 unique customer transactions, added 27 new named accounts, signed 109 on-demand deals, and closed 15 deals of over $1 million.

Now, let me turn to more specific financial results for the December quarter. Totally revenue was $86.1 million for the first quarter of 2009 including a purchase accounting adjustment of approximately $350,000 against Procuri’s revenue stream. Non-GAAP revenues were $86.4 million and came in within our guidance range, albeit at the lower end of our expectations.

On a GAAP basis, subscription and maintenance revenue was $54.1 million. On a non-GAAP basis, subscription and maintenance revenue was approximately $54.4 million in line with our guidance of $54.5 million. Non-GAAP subscription software revenues came in at $36.2 million, at the upper end of our guidance of $35.5 to $36.5 million, and up 55% year over year on a reporting basis or 44% on an organic basis. Services and other revenue came in at $32 million at the low end of our guidance range.

As I mentioned in my opening remarks, we experienced a slowdown in our business this quarter due to the weak macroeconomic backdrop. This weakness manifested itself primarily in our services business where we saw customers either slow or halt existing projects and put new projects on hold. Both our system implementation and sourcing businesses came in lower than expected in Q1, and we expect this trend to continue for the rest of the fiscal year if the current macroeconomic conditions persist.

A more favorable revenue mix due to lower services contribution coupled with cost actions in services and other areas of business allowed us to preserve our operating margins. Overall, non-GAAP operating margins were approximately 21% this quarter. Excluding the net $0.07 cent benefit I spoke of earlier, the margin was 14%.

Looking at expenses, total expenses on a GAAP basis including the cost of revenue were $82.7 million. Included in these GAAP results were $1.6 million charge for amortization of purchased technology and intangible assets, $9.5 million charge for stock-based compensation, a $1.4 investment write down of our option rate securities and $1.7 million severance restructuring change related to some head count reductions we made during the quarter.

Excluding these items, non-GAAP expenses were $68.4 million for the quarter. As a result, GAAP net income for the first quarter was $3.4 million or $0.04 per share. On a non-GAAP basis, we had a positive net income of $18 million or $0.21 per diluted share.

Moving on to the balance sheet, cash, cash equivalents, and investments at the end of Q1 were $143 million, which was up $6 million from $137 million at the end of Q4. We generated positive cash flow from operations of $10.8 million. Excluding cash used for restructuring charges and lease losses, cash flow from operations was $17 million. DSO improved to 29 days, down one day from the previous quarter, and we had no collection issues during the quarter.

Now, let us turn to Ariba’s outlook for fiscal year 2009 and the March quarter. Please see slide 7 and 8. Since we spoke to you last quarter, we have seen a significant change in market conditions as applicable to our business. In October, we guided full year revenue at $355 million to $370 million, and EPS at $0.70. Although we were pleased to meet our Q1 guidance targets, today’s realty requires more conservative modeling assumptions for the rest of the year. While we still expect continued growth in the software business, we are lowering our bookings assumption to assume a more conservative close rate. We have also factored in further decline in our services business.

Accordingly, we are modeling lower revenue at $342 million and lower non-GAAP EPS at $0.65. Given the fluid economic environment, we are bracketing the guidance to plus or minus $5 million in revenue and in turn plus or minus $0.05 in non-GAAP EPS. Included in our $0.65 EPS target is a net benefit of $0.05 from 3 nonrecurring charges comprising the positive $0.09 from the insurance reimbursement, the $0.02 hit from the one-time devaluation of non-US dollar cash accounts, and an additional $0.02 from lower interest income related to the cash risk management changes I discussed earlier in the call. On an apple-to-apple basis without these items, our EPS guidance would have been $0.50, which is $0.10 lower than our prior guidance.

To give you more color on the specific client items in our model, we expect sub software revenue to be $148 million to $152 million versus our previous guidance of $152 to $162 million dollars. This translates to a 25% to 30% year over year growth. Maintenance revenue will be $70 million compared to our previous guidance of $69 to $70 million dollars. Services and other revenue are now expected to be $120 to $124 million compared to our previous guidance of $133 to $138 million. As I mentioned in my earlier remarks, we are being proactive in managing our cost structure and have already made the necessary cost reductions to support this model and are prepared to do more if necessary.

Turning to slide 9 and our cash flow projections, we still expect that our subscription model will continue driving strong cash flow results. We expect cash flow from operations before lease losses and restructuring to be $64 to $69 million in fiscal year 2009 as compared to our prior guidance of $80 to $82 million. We also expect to have a net charge of $2.5 to $3 million per quarter throughout the rest of the fiscal year, which encompasses interest, taxes, and foreign exchange impact.

Now turning to Q2, we are taking a similar approach as we did for the full year and expect the following non-GAAP financial performance: Total revenue in the range of $84 to $86 million. Note that there will no longer be any purchase accounting adjustments related to the Procuri acquisition. Subscription and maintenance revenue will be approximately $54 to $55 million including roughly $36.5 to $37.5 million for subscription software and $18 million for maintenance. Like we are modeling for the full year, we are assuming services and other revenues to continue trending down and now target them in the range of $29 to $31 million.

With respect to the rest of the P&L, we expect a total non-GAAP operating cost and expense to be about $73.5 million, down from $76 millions in Q1. Contained within this range are cost of revenue of approximately $30 to $31 million, R&D of roughly $9.5 million, sales and marketing of approximately $23.5 million, G&A of $7.5 million, and a net charge of approximately $2.5 million encompassing interest, taxes, and FX impact.

On a non-GAAP basis, we expect positive net income of approximately $11 to $30 million or approximately $0.12 to $0.15 based on 86 million diluted shares outstanding. In addition, we expect to record expenses of $12 million for stock-based compensation, amortization of intangible assets, and restructuring. As a result, we expect to break even on GAAP net income with plus or minus $2 million.

To recap, it was a solid quarter for Ariba despite the weak macroeconomic conditions. We executed well, and our operational and cost discipline allowed us to manage our bottomline performance at the high end while realizing revenues at the low end of guidance. We believe we are taking significant risks out of our full year model by lowering top line expectations and driving further cost actions to perfect the bottom line. While we cannot control the overall market conditions, I believe we can successfully manage through this downturn and come out ahead on the other side. More than ever, businesses today need to reduce operating cost and improve working capital, and we are positioned to help them get there. Now, let me turn it over to Bob.

Robert M. Calderoni

While I am very pleased without our performance this past quarter and how could you not be with revenues up 12% in total, subscription revenues up 71%, backlog up nearly 60% including a nice sequential increase, and a more than doubling of our non-GAAP earning per share even after you ignore some of the net one-time benefits that we talked about in the quarter? I think this would be good performance in any market and especially so here in this macroeconomic environment we all find ourselves in today.

As you know, the macroeconomic environment has become very challenging over the past 90 days, and what was once limited to the banking and automotive sector just a little more than a quarter ago has pretty much spread to nearly every company and every industry and every geography around the globe. Yet despite the challenge, Ariba executed well, and we delivered comparatively strong performance this past quarter.

I think this performance is further evidence of the strength of our fast delivery models and of course in our spend management solutions, on demand deals closed in the past quarter were up 28% over the prior year. In fact, we added 27 net new customers in the quarter, and we closed 15 deals greater than $1 million in value. With that said, as Ahmed noted, we did see weakness in our services business, which caused the total Q1 revenues to come in at the low end of expectations, but we got ahead of the curve, we lowered our cost structure in advance, so we were able to deliver strong operating earnings per share at the high end of expectations.

So before I get into some more details about the operations in the quarter, and I do want to talk about some of our sales and marketing initiative. Let me expand on Ahmed’s comments and provide my color on the economic environment, how we are reacting, and most importantly, how we are positioning the company for the rest of 2009. In the last 45 days, we did see a marked change in customer behavior. It seems today that every company is either in the middle of planning or they are executing layoffs, and as a result, most companies are distracted and programs and projects, even projects involving cost reduction right now are put on hold, if not just for a temporary hold. In addition, there are new approval requirements that are established within almost every organization, and that is contributing to what I would call a lengthening of closing cycles.

On a positive side, we see an increase in interest around spend management, and good demand continues to build. Our pipeline actually increased this past quarter, and it is at a new all time high, and a number of our marketing metrics from inbound enquiries to attendance at our spend management base to attendance in we demos, they are all pointing up. So, I would say demand for spend management is up, which is good, but I believe the time that it will take to convert that demand into sales is going to lengthen as we progress through 2009.

On the services side of the business, demand is softer. Some companies are delaying services work as it is considered more discretionary in the near term, and we did see that line in our business decline some in the past quarter.

So, I do believe the demand trends, the indicators in our business, are promising for the long term, and I believe the performance we achieved in Q1 is a good sign for us, but with that said, it is hard for me to ignore what I see in the overall macro environment, and I now believe it makes sense for us to take a more conservative outlook and model lower growth in the near term. Even though we grew bookings year over year in the first quarter and we grew our backlog not only year over year but sequentially, I do not think it is prudent to assume this trend will continue in the near term. Rather, I think it makes more sense to have a more cautious outlook given the instability in the economy today.

Our updated full year model assumes a continued slowdown in our services business and a lower conversion rate and consequently, a lower growth rate for our subscription software business. Given the growth we have been driving in the past year or two, including the past two quarters, I would normally be optimistic on growth, but this is clearly not a normal time. This more conservative top line model just seems like the right thing for these times.

Between the details that Ahmed had provided and the color I am adding, I hope you have a good sense for why we updated our model. The most recent trends of the past two quarters would suggest higher growth, but I believe assuming those trends continue would be somewhere between risky and foolish. Instead, we will assume less, and we will take out cost in a precautionary move, most of which we have already completed, and this will allow us to get back to the business at hand and focus on customers, so let me talk about some of the things we are doing on the marketing and sales front.

There are a few things we can do to speed the velocity of today’s slower buying cycles, and I will share some of those insights with you. We have been fortunate that we have been able to compensate for a lag in closing cycles with an increase in the volume of opportunities we see, thanks to an increased and more dynamic marketing approach.

Our trending data shows that it now takes twice as many enquires, what you might call a lead, to generate $1 million in pipeline, twice as many as it did last year. Luckily, our volume and velocity approach to sales and marketing has allowed us to adjust. We have increased the volume and the mix of our marketing initiatives. Balancing online demos and social media, we targeted real world events, and this has resulted in a higher level of inquiries or leads that have allowed us to compensate for some of the negative forces in the market and has resulted in the highest ever pipeline for our subscription software business.

Interest in spend management and in Ariba is an all-time high with record enquires and attendance at our events. For example, in the past week, we were able to generate nearly 1500 enquires through a series webinars, web-to-lead conversions, and real world events such as our spend management day in Palo Alto, and last week our financial services summit in New York City, both of which caused significant increases in attendance over last year.

While we are taking appropriate actions to address the tightening market dynamics, we still feel Ariba’s position to weather the economic storm, regardless of the duration. Executives around the globe are looking for new ways to maintain profitability and control on their business, and in this challenging economy, there are 2 key levers they are focusing on. One is managing cost and the second is managing cash, and we are uniquely positioned to help with both. We sell cost reduction at a time when cutting cost is job number one.

You might ask why am I telling you about all this marketing stuff. Well, I want to give you a sense of what we are doing and what the team is working on. We are not heads down internally focused trying to figure out how to cut cost and wringing our hands over the economy. The market is tougher today than ever, but in response I met with my team in late December and decided rather than reacting to the market, we would be proactive, we would take some calls out now ahead of seeing any impact on our business, and quickly return to what we need to do, which is focus on customers and marketing events.

A lot of companies are paralyzed by the state of the economy. They have become too internally focused. I believe the approach that we have taken by taking a conservative top line approach in the cost out in advance of any declines is going to give us an added edge over out competitors.

On the ERP side, SAP and Oracle have muddled their message and delayed enhancements to the spend management life solutions. Their offerings in this arena continue to suffer from a high cost delivery model. A few years ago, it seemed like every CIO was championing a single system strategy, but now with years of disappointments from the ERP company coupled with the reality that it costs lots of money to deploy those solutions, CIOs realized the benefits of our on-demand approach, and for our niche competitors, I think they are even worse off today, having a narrow solution footprint and mounting cash constraints.

I do not think anybody likes a downturn, but the truth is downturns create winners and they create losers, which only makes winning even more rewarding. Our competitive position has never been better, and I believe when the economic clouds pass, Ariba emerges even stronger thanks to our people and our solutions, thanks to our solid financial condition, and perhaps thanks to our philosophy of assuming the worst today, dealing with it upfront so we can get back to doing the things that make us long term winners.

One other comment, and then we will move on to questions. We have continued to deepen our relationships with existing customers, and this past quarter, renewal rates were strong and actually improved across the board. This points to the fact that our spend management solutions are “part of our customer’s business process.” We have a very strong installed base, and our customers span all verticals, geographies, and sizes. This diversification, I believe, reduces the risk profile for Ariba and our business as we are not beholden to health of any one given sector.

That said, we continue to penetrate and support verticals that we believe offer even more potential for growth, such as healthcare. We had a handful key wins this sector last quarter including several in the healthcare, including Children’s Medical Center of Dallas and Community Health Systems. All told, our solutions support the spend management and contract initiatives of more than three dozen healthcare organizations, and this has been a growing segment for us over the past few quarters.

Another recent growth sector which we continue to expand in is with private equity groups, most of which have been forced to shift from how to sell their portfolio companies to how to operate their companies through the current economic crisis. We already have a position of strength in this marketplace, and we count a half dozen large and mid-cap PE firms among our customers, and through these relationships, we are working with more than 20 of their portfolio companies to improve their spend management performance and hold down their cost.

So, in summary despite the tough environment, we are managing to do well. We have positioned our business model to continue to do well, even if the economy negatively impacts our growth rates that we have enjoyed in the most recent quarters, and furthermore, we are well positioned to accelerate when the economy does improve.

With that, let me open up the call to your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question is from the line of Greg Dunham with Deutsche bank. Please go ahead with your question.

Greg Dunham - Deutsche Bank

I really want a hit on kind of the end results from the net and demand perspective. Clearly, if you look at the million dollar deals, your commentary on pipeline, and also the fact that renewal rates have actually improved even in this environment, what is the net effect? We are seeing increased signs of deflation, yet companies are forced to be cutting costs. You see that as a demand driver overall or is the hold up effect negating any kind of need to implement these solutions here near term?

Robert M. Calderoni

Greg, without a doubt, this current economic environment is creating a greater need for our solutions, and we see that from all of the things we do, whether it be our pipeline of deals and again from all the marketing metrics we measure, attendance at spend management days, you just have to go to any one of our spend management days, and you would see the crowd there and the interest level there, so this economic has clearly, clearly put pressure on companies to do more of this. To date, I feel very, very good that it has translated into excellent demand. I mean, think back this quarter and the quarter before. The last two quarters have been very good quarters for us. The demand has been good, the growth in our subscription business has been very good, but what I see happening at the same time is what I call there is chaos in a lot of organization. If a company is in the middle of executing layoffs or if a company is in the middle to trying to plan layoffs and reorganization, it is a major distraction for that organization, and I believe that that is going to translate into a lengthening of sale cycles, and while the demand is there, it may be harder for us to convert that demand into sales in the near term given the economic headwinds. Now, to date, we have not seen it.

The numbers that we talk about, the number of deals, the bookings, etc., in our subscription business have continued to be strong. I just think that to assume that going forward would be risky, and hence we are not signaling weakness of demand for Ariba, we are signaling that we think it is better for us to assume the worst, take out cost, and be pleasantly surprised in the future rather than react to any impact it may have on the business, and that is I think an important characterization that I would like to make.

Greg Dunham - Deutsche Bank

That makes sense. A couple of followup for Ahmed on the metrics side. You guys gave a total backlog number this quarter first off, and then the other piece is when we model out other income going forward. If I heard you correct, you are saying that should be a $2 to $3 million hit for the next three quarters, is that right?

Ahmed Rubaie

That is right. So, let me answer your first question, Greg. There should be a slide on there, but our annualized backlog is $127, our total backlog is $240. And you are correct in your second assumption that in the other income line, you should assume $2.5 rounded to $3 million for every quarter going forward.

Operator

The next question is from Nathan Schneiderman of Roth Capital Partners LLC. Please state your question.

Nathan Schneiderman - Roth Capital Partners LLC

Bob, I understand from your comments that you felt good about your ability to book business during Q1, but you are worried because some of the dynamics, you are saying, we may see some slow down in that ability going forward, and I would understand that that should likely hit your software subscription line as a Q3-Q4 kind of phenomenon, but I am little confused why you think the subscription software revenue would just be up about 500,000 sequentially in the March quarter, given that it pretty much reflects what you have already done, rather than what you might do in the future.

Robert M. Calderoni

I think we probably should do better than just half a million or one, but maybe that is just the boundaries of just trying to make the model work and hold the total on the bottom line. The software business has been doing pretty well. You can see it in the backlog growth quarter to quarter. While internally, I would continue to plan that to go forward with good growth, we are not forecasting lower demand or assuming lower demand in the future, just so we can take cost out of the model and be positioned just in case. On the subscription side, I feel like I am being conservative, and on the services side, we did see a decline this quarter in that business, so we are going to model that going down still; perhaps more discretionary, and I think customers are clearly delaying projects and that slow down in that business probably will persist; and therefore, I feel like I am being realistic on services and conservative on the subscription software piece of business, and I think it is the conservativeness that is reflected in the forecast in the current quarter.

Nathan Schneiderman - Roth Capital Partners LLC

To be clear, did you have a problem with churning your base of subscription customers that would cause maybe a little bit of a step function down?

Robert M. Calderoni

No, renewals were strong this quarter, in fact, stronger. They have been trending up the last couple of quarters as we put in place a renewals team, and that has looked good. Bookings were up quarter to quarter, the backlog was up. I think I will have to go back and check. There might have been a little catch-up in the last quarter’s revenue that might be hurting the sequential nature of it, but now, there is no churning there, so it is either we just holding the number back a little bit or the sequential trend might be distorted a little. We might have had half a million or so benefit in the prior quarter. Ahmed will have to check that up.

Nathan Schneiderman - Roth Capital Partners LLC

You can say just the idea that with the up less than one million sequentially in the context of the other positive comments is a little confusing.

Robert M. Calderoni

I will go back and take a look and see whether it is something in the last quarter that is distorting that or if we just plugged that number a little bit lower.

Nathan Schneiderman - Roth Capital Partners LLC

Ahmed, in the past, you all have given us the total network fees and then the component that was supplier network fees. Could you give us that this quarter?

Ahmed Rubaie

Yes. The SMP was 5 million, and the supplier membership piece was 8.2.

Nathan Schneiderman - Roth Capital Partners LLC

The other way around, 8.2 for the network and 5.0 for the supplier?

Ahmed Rubaie

Nate, the other way around, 5.0 and 8.2.

Nathan Schneiderman - Roth Capital Partners LLC

Bob, you mentioned actions you have taken on the cost side. Can you talk about that in some detail? Did you have some headcount reductions? If so, what was the magnitude, and in what areas, and then what are the other areas of cost containment that you put in place during the December quarter, and what do you have planned going forward, if anything, for the March quarter?

Robert M. Calderoni

Yes, from a cost containment point of view, we had already implemented cost avoidance things like freezing salaries and not doing any merit increases, not doing any promotions that we had previously done. We have been reducing discretionary cost including project related cost inside the company, anything that we could delay or defer or take out of the budgets, we have done that. Then, toward the latter part of December as part of our modeling of the company going forward, we decided we would take some fixed cost out of the business as well just to reduce the cost profile and part of it reflects the decrease in our services business. We want to take the capacity out for that business there, but in aggregate, we will take out about 70 or 75 people, a little bit more than that in total, but the net change will be about 7 people of which the majority is already out the door.

Nathan Schneiderman - Roth Capital Partners LLC

Okay, the final question for you, and I will break off. I was little confused just what was in the interest in other income line, which I understood was a hit of $5 million, and the last couple of quarters it has been fairly flat. Can you explain that?

Robert M. Calderoni

Sure Nate, are you referring to actual Q1 or in terms of the forecast?

Nathan Schneiderman - Roth Capital Partners LLC

Q1, the December quarter

Robert M. Calderoni

In Q1 the fluctuation you saw, we had given you guidance in terms of the foreign exchange hit we had in the fourth quarter, and we attributed that largely to the receivables retranslation on the balance sheet. Quite frankly, the only thing that changed, everything was on target in terms of our hedging strategy and so on, the only that is changed is a process breakdown on our side as the currency relatively continued, we should have been sweeping our cash balances much more frequently than we had in the past, and we got on top of that. In the meantime, it cost us an extra couple of million dollars, so that is something we noticed in late November or early in December, and going forward, we are sweeping cash on a daily basis, so it should not recur, and you will go back to 2.5 to 3 million for every quarter going forward.

Operator

The next question is from Peter Goldmacher with Cowen & Company. Please state your question.

Peter Goldmacher - Cowen & Co.

If the services business is slowing down, and I think Nate might have hinted at this, if the services business is slowing down, I am surprised that your guidance does not really change your margins. I would think that you would be trimming some of the headcount in the services group, so if you could help me understand that, and then also, a little more color on the subscriber network. It looks like you had a pretty strong quarter, and any color you could offer on traction and particularly in the downturn, if it is accelerating, any more rapid adoption?

Ahmed Rubaie

On the first part of your question regarding the services business, our services margin this quarter is, I believe, in the high 30% or 40%, so we have always modeled that at 35% to 40%. In fact, I think it is a little bit higher than 40%, and that is despite the fact that our revenue came down a couple of million dollars, so the answer is we did take out cost, and we sort of, it is like refueling the plane in flight; we did it during the quarter, and we were not only able to absorb the decline in our revenues, but we saw an increase in margins during the quarter, so our model for services is 35% to 40%. We did 41% last quarter. We expect that to trend down; we are modeling that to trend down, and that is part of the resource reductions that I talked about earlier. We have got that cost down, and so we expect to keep service margins in that 35% to 40% range and probably toward the higher end of the range is how we are modeling it. So, operationally, that is something that has a high degree of focus. We recognize that service revenue in a market like this is going to be a little bit volatile and could change, and so we are monitoring utilization levels very, very closely, and we will adjust on the fly so that we do not fall behind that curve.

Peter Goldmacher - Cowen & Co.

You said that the earnings for the March quarter should be between $0.12 and $0.15, so that implies that earnings in the back half of year are going to be flat to down relative to your guidance at the midpoint, is that the message you are trying to send?

Robert M. Calderoni

We said the earnings would be $0.65 for the full year, including a net benefit of $0.05 for the one-time items, so that would say an operational $0.60. We did $0.14 this quarter. You know, somewhere in the mid point to high end of the mid point is what we think we could run the business at on a regular basis going forward, but it is total $0.01 or $0.02 range out there. In a volatile market like this, we think is too tight. So we just widened the range this quarter. I prefer to have tighter ranges, to be honest with you Peter, but it just does not make sense in this market because we wake up every day and read the newspapers and we think we are in a stable period, and suddenly it is not stable any longer with a couple of news headlines.

Peter Goldmacher - Cowen & Co.

Yes, you’ve got to stop reading newspapers.

Robert M. Calderoni

I do not know how to forecast that, so what we do is we just widen the range just in case.

Peter Goldmacher - Cowen & Co.

Then the supplier network traction?

Robert M. Calderoni

The supplier network, there is two sides to that one. You got the buyer’s side and the sell side of the supplier fees. That is growing. We had modeled that to grow between 20% to 30%. We think that is going to grow at the lower end of that range this year, and I think what we are seeing is a little impact of the economy in there. The number of suppliers and chargeable relationships are growing nicely as we expected, but the number of dollars that people are spending with each supplier is down, and we can only assume that is because of the economy. So the basis points that we earned are down. So we are going to probably be at the lower end of the 20% to 30% range this year. On the buy side where we are getting revenues from the people that are utilizing the network applications, namely e-invoicing, the demand for that is growing. We had our first win through our Citibank relationship. I do not think we can disclose the company’s name.

Peter Goldmacher - Cowen & Co.

It is probably Citibank.

Robert M. Calderoni

We did have a win with Citibank, but we had our first win as reseller through Citibank to a third party company, so we did sell Citibank internally, that is in there. We see some good demands, and I think that is why that trended up this quarter. I said in my comments earlier, cost reduction and cash management seemed to be a topic of discussion at every company and e-invoicing with the supplier discounting and working capital management has got a high degree of interest, and how much and how fast that interest turns into sales will dictate how much revenue we get there, but we still think the total network revenues are going to grow 20% to 30% this year.

Operator

The next question is from Robert Breza with RBC Capital Markets. Please state your question.

Matthew Hedberg - RBC Capital Markets

This is actually Matthew Hedberg sitting in for Rob. Just to drill down a little bit more on the headcount and the cost cutting initiatives thus far, what actually is the total headcount at the end of the quarter and then may be how many sales reps did you guys end the quarter with?

Ahmed Rubaie

Sure Matt. Headcount at the end of the quarter was about 1720. The numbers Bob summarized earlier includes actions we took in Q1, but they have not gone out the door yet, so I expect headcount to level off 1700 at some point in Q2, and in terms of the sales rep headcount, we leveled off at 119 at the end of Q4, we are at 109 at the moment. So in short, our headcount reduction were across the board, both in terms of the points Bob just made to Peter a few minutes ago on the services side, but we have also taken some out on the sales side.

Matthew Hedberg - RBC Capital Markets

Bob, a question for you kind of reflecting back on the last cycle that we through back in 2000. It seems like you guys are taking the risk out of the model this time, protecting earnings, lessons learned from back then. How conservative is this model, maybe, on a scale of 1 to 10? Are you taking a more aggressive approach this time around, may be just a little color on that.

Robert M. Calderoni

I think we are being pretty conservative across the board, even more so on the software business, and the reason I say that is right up until the end of this past quarter, the metrics in the subscription software business have been strong. The number of new customers continue to trend well, the backlog trends well, the bookings were up nicely year over year, not at the level of growth we had seen in prior quarters, but still solid growth, and our forecast and our assumptions, and I want to call them assumptions because we are really modeling that going forward internally; there is nobody forecasting any slow down in our subscription business. We are going to model and, believe me, we are pushing the team as hard as ever internally. We are conservatively modeling less growth in that business. In fact, a pretty good change in the trajectory in that business. I just think it is a realistic thing to do. On the services side, we are seeing a decline, so it is not like we came out of a quarter with a lot of strength, we are modeling that decline to continue. I believe it is conservative, but I would to say it is reasonably conservative. I think we have taken the risk out of that line, but we have probably taken may be too much risk out of the other line, and in total, I feel pretty good about the balance, and I would put it in a highly conservative category in total.

Matthew Hedberg - RBC Capital Markets

Then, maybe a little bit of color on the verticals this quarter. I assume we can probably guess how they were, but maybe a little bit of color would be good there.

Robert M. Calderoni

The strongest verticals were CPG and retail. Maybe it should not be surprising but some of the sectors that are the hardest hit like retail, we are doing very, very well in. Services continue to do well. Companies like ADP, Allied Waste, A.P. Moller-Maersk, the shipping company in Denmark are some wins we had there amongst many others, but those are the two strongest sectors, I would say moderate with moderate being maintained at historical relative contribution was in the financial services and healthcare, pharmaceutical and tech, as well as the automotive industry, so that is a sector with large companies like Peugeot and others, and we continue to have good business with them. It was not as strong as it had been in the past, but it still remains a good contributor in the manufacturing scene this quarter. From a geography point of view, I would say it was good balance across the North America and Europe. The area of the geography where it was weaker than the others was clearly in Asia Pacific, a small part of our business on a sequential basis and relative to the others where they fell off where North America and Europe continued to grow.

Matthew Hedberg - RBC Capital Markets

That is helpful. One last question on the competitive environment on the spend management side. Any changes or do you guys think you are taking share? A lot of companies that we talked to, they are obviously taking the necessary steps on the expense line, but they also see an opportunity to take share. Could you talk a little bit about competitive market?

Robert M. Calderoni

I think we have been taking share. I look around, and just look at those results over the last 12 months to 15 months, we are growing our subscription business on an organic basis, near 50%. I think we had as many quarters above 50 as we did over the past year. I do not think the market is growing that fast, so clearly we are taking share, and I think we are taking share on both ends of the spectrum, from the bigger companies as well as from the niche companies. The bigger companies, I have commented in the prepared remarks earlier about some of the changing attitudes of the CIO. You know, three years ago, there was not a company I spoke to where I had to challenge that prevailing CIO strategy of “we are going to one system” be it SAP or Oracle. Cannot mention the name of the company but a very, very large pharmaceutical company that two years ago made the decision that they had every intention of taking Ariba out and using SAP. It was going to take them two years to do it. Well guess what, 30 to 45 days ago, they just did a $3 plus million deal with us, and they are going to expand with Ariba, and they are going to roll out our complete on-demand solutions because what they have learned is even though they have free solutions from SAP, put aside the fact that the solutions are not as good or as broad, it is going to cost them a multiple of $3 million just to deploy that free software, so that CIO actually was putting together a presentation to talk to the CEO later that afternoon while I was down there about how much money they are saving by using Ariba instead of SAP, and this is the same gentleman that two years was adamant that he had to go to one system. I think that that attitude is clearly changing across the board, and I think the large ERP guys have worn out their welcome with their promises of new features, and I think the realization that on-demand is an effective and efficient way to deploy some of these horizontal applications versus costly roll out big ERP modules is something that is working for us. On the other end of the spectrum, the economy is actually helping us because many of our niche competitors are very, very small, and I do not believe they are well capitalized, and there is a pretty darn good chance, this is the view of a lot of customers, they become victims of this economy right now, so I like our competitive position. Wish the economy were better, but I like our competitive position.

Matthew Hedberg - RBC Capital Markets

Don’t we all? Thanks for the color of that Bob, and great execution in the health environment.

Operator

The next question is from Sterling Auty with J.P. Morgan. Please state your question.

Sterling Auty - J.P. Morgan

Can you give us, Bob, a little bit more color in terms of exactly the weakness that you are seeing in the services line and what we might able to read into that as a precursor of things to come or can we use that as an indicator of maybe when things stabilize and turn up later?

Robert M. Calderoni

Yes, I think in all our services business, we really have two lines of business. We have the, I call it the system implementation business, which we might be doing upgrades with our CD customers or maybe some modular deployments and some process work them, and then we have the sourcing services business as our other leg of that, and I think on the system implementation business, it is just some customers are just viewing those projects as not time critical. Things they probably want to do, things they will do, but some think they could either slow it down, delay it, cancel it, temporarily put it on hold, so we are seeing some of that in that business, and that is why it declined this quarter and why we modeled it to decline a little bit more in the forward look going over the next few quarters. On the sourcing services side, there is different dynamics there. There is a whole lot of activity with customers as the customers see a need to cut cost and that is tied to cutting cost. I think that is more a victim of the distraction factor that companies have right now, and I am probably more hopeful that even though the economy will not improve in the next one or two quarters, I think the disruption factor will ease, and we should see that business, maybe, come back a little bit sooner than the implementation business, but there are really two different dynamics there.

Sterling Auty - J.P. Morgan

Just may be in a rough sense, how is the services revenue kind of split between the two at this point?

Robert M. Calderoni

It is almost pretty evenly split.

Sterling Auty - J.P. Morgan

When you are talking to the customers and you are talking about some of the lengthening sales cycle, is it that CIOs, CPOs, CFOs are saying that they want a shorter return on investment? Is it that they just are unwilling to fund new projects even if it saves them more money on the backside, or is it some kind of combination?

Robert M. Calderoni

I think it is the distraction factor first and foremost. It is not the lack of attractiveness of the business case at all, so I think it is the distraction factor first and foremost, and then go back a couple of quarters and I would always get the question, the economy was a much different economy than the one we have now, but 6 months ago, the economy was not robust, and there was pressure on companies, and I was asked how does spend management do in a down market, and I always said spend management should do well in a down market to point, slow to a moderate declining market would be good for spend management solutions because it puts cost pressure on companies, but that is good to a point, and then you hit a tipping point, and you get into a deep recession environment like this, and companies initially act with a bit of a kneejerk, and they just turn the entire spigot off. I understand that back in the days when I was a CFO, when I was at IBM during our darkest days, we were just saying no to everything until we sort of had some stability in the business. Then, we would go back to prioritization, and obviously, we prioritized the better returning projects. Our projects are better returning projects. I think we just need to see some companies get into a mode where the spigot is not closed, it might be turned pretty tight, and letting just a little bit through and only the good projects through, and I think we will do well. I think we are dealing and every company out there that is somewhere between the state of disruption and chaos right now, and they just need to get a little stability in the business.

Sterling Auty - J.P. Morgan

Lastly, can you give me little bit more detail about the $0.09 insurance reimbursement. I do not quite understand why that is being left in for non-GAAP results and non-GAAP guidance.

Robert M. Calderoni

Well, as you know from tracking us the last few quarters, we spend money on legal expenses, and I believe that is always part of the operations of the business. Sometimes those legal expenses would be insurable, if you will, they should be covered by some of the insurance that we have, and ordinarily, you would like to have insurance in the same period when you incur it, but that does not always happen, and in this case, it was for money that we had spent in the past, so all the litigation expense we had over the past year was always in our operating results. If we are to get any of that back, it should just be just be a net against that. It is just that the timing is never going to be perfect, so we are clearly calling it out, and we are clearly saying it is obviously not a recurring item in our results, and that is why we say we are at $0.65 for the year, but if you were to compare it to our prior guidance on an operational basis, we are actually off lowering guidance by $0.10. We take that out plus a couple of the others. We have one big good guy and two small nonoperational bad guys netting $0.05, so full disclosure in giving that, and I don’t view it as a recurring item, but on the other side of it, when we are incurring that cost, we always keep that in the P&L as well.

Sterling Auty - J.P. Morgan

Okay, I appreciate the transparency.

Operator

The next question is from Bradley Whitt with Broadpoint AmTech. Please go ahead with your question.

Bradley Whitt - Broadpoint AmTech

Bob, your subscription revenue forecast here, does that assume that some of the subscriptions deals you have already booked will be delayed in being implemented, therefore, delay your ability to recognize the revenue.

Robert M. Calderoni

No, I think we are just being conservative on future bookings and future growth rates in bookings. Our contracts and our backlog and our waterfall, we do not put it in the waterfall unless it is airtight without any exceptions, any conditions whatsoever. So no, there is none of that in the forecast, nor is that in the business risk. We are not counting on that happening or not happening.

Bradley Whitt - Broadpoint AmTech

You may have given this metric, but specifically a software deals over $1 million?

Robert M. Calderoni

Total deals over $1 million were 15. I believe the software deals over $1 million were 6. This is obviously down sequentially, this last fiscal quarter, where we always do the most, is up from 4 in the same period last year.

Bradley Whitt - Broadpoint AmTech

It does not sound like it was lead generation activity that you are seeing, but we have seen some companies cancel user conferences. You plan on going forward with yours?

Robert M. Calderoni

We are actually going to modify our approach this year because we believe that in the environment we are in, we may be the only ones in the room, many of the people that would like to go may not be able to make the trip, a lot of companies are saying no to travel, so what we are going to do is modify rather than having one central one and a big bang show, we are going to have 3 or 4 where we take it to the customers and do it in one day, we will do near New York, one near Atlanta, one near the West Coast, you know, a place were everybody can just drive to from the day, and we think we will get more out of it because more people will be able to attend, so we are just going to change the approach this year.

Bradley Whitt - Broadpoint AmTech

The final question is around the Emptoris litigation. Does that impact your competitive position at all? Are you seeing any potential business from that?

Robert M. Calderoni

I’ve got to be careful what I say since there is litigation involved here. I would say it has been real positive. Over the past year, we have had an extraordinarily good win rate there, and we have had a significant number of net takeaways, which has been good for us. I think there are a couple of factors to that. The first is, people are very concerned that this is a pretty important process that they are managing the business, and they are pretty concerned about who is their provider, and in times like this, people are even more concerned about that, and if you have read any of the court documents, these are public records, not some of the analysts’ reports that was information was not provided under oath, but if you look at the stuff that was provided under oath, one would be very, very concerned about the long term viability, and I think that has been a positive. The other positive is that their records that they provided in the court said that 80% to 90% of the auction events that their largest customers ran, they were utilizing the features that they have an injunction now that they have to take out of their product, and I think customers do not like the idea that something that was so important that they used 90% of the time, they cannot use anymore, and that has been another source of interest in Ariba.

Operator

The next question is from Brad Reback with Oppenheimer & Co.

Brad Reback - Oppenheimer & Co.

I just want a real quick question. Did you accrue for bonuses in the quarter or was that part of the expensing?

Ahmed Rubaie

I believe the answer is yes. In the current quarter, yes, we did Brad.

Operator

The next question is from Richard Williams with Cross Research. Please state your question.

Richard Williams - Cross Research

Most of my questions have already been answered, but just wondered if you are seeing any customers that are getting into financial duress, any bad debt expense building up?

Ahmed Rubaie

The answer, Richard, is no. Actually, I was quite pleased with our ability to collect in this last quarter, particularly as you point out in a very difficult economic period, so we are doing quite well on our receivables, and as a result, we hardly have any bad debt write off.

Operator

The next question is from Justin Bandy with KeyBanc Capital markets. Please state your question.

Justin Bandy - KeyBanc Capital markets

Hi guys, this is actually Justin Bandy on for Steve. I was wondering if we could drill down just a little bit into your different products and how they performed in the quarter, you sourcing, procurement, and expense visibility, and embedded in guidance, what is your assumption for your different product lines. Do you think certain lines are going to be stronger than others? Close rates for certain products will be better, etc.?

Robert M. Calderoni

We do not give guidance at that level, Justin, and what we have seen is an ebb and flow of all our products, not a constant trend. In some quarters, we do better on what we call the downstream, which would be the procure-to-pay products and contract management products. In other quarters, we see more strength on the sourcing and analytics products or e-invoicing products. In this quarter, it looks stronger on sourcing than P to P; last quarter, it was stronger on P to P than sourcing. So, I do not think there is any trend there. It does ebb and flow. There is a lot of interest in the pipeline, which is a more steady indicator from a pipeline, all of them are trending up, all of the solutions; I do not see any weakness in any one solution.

Justin Bandy - KeyBanc Capital markets

Just one followup question. I was wondering about some of your recurring revenue sources. I noticed you took down revenue guidance for everything except for maintenance. I am just wondering why you are keeping maintenance revenues the same. Some companies we cover are seeing pressures on maintenance renewals or maintenance pricing, and then also some of your other recurring sources, do you anticipate pricing pressures on renewals or may be customers holding on to the cash more, paying more frequently rather than a lump sum?

Ahmed Rubaie

Justin, I think we are actually seeing the opposite. We are seeing a record number of renewals and record number or multiyear agreements, and there might be an initial push for a price concession, but overall, that is not how it is turning out. So, we saw a pretty strong quarter in Q1 both in terms of improving the renewal rates as well as locking up longer agreements for the renewals, so we feel pretty good about our number.

Robert M. Calderoni

Yes, just to give you a little color on that one, I think throughout the industry customers and companies are out looking for step-downs and reductions in maintenance. I am sure I have heard that in comments on a lot of software companies recently. A number of customers attempted that, but certainly asked for it. Nobody is shy in this market asking for something like that, but that is not something we are particularly interested in entertaining right now, and I think it really comes down to value and may be leverage to some degree, and the fact that we have a supplier network, and the supplier network and access to the supplier network requires them to be under a maintenance contract, I think gives us a much higher result in terms of renewals. Historically, we have been renewing somewhere near 93% to 94% on our TSS. This quarter was even higher than that, in fact we were 100% we reported two quarters ago, so I know that is a trend in the industry, I know that is a concern in the industry, and I know that is something our customers would like to see, but we have not been doing that. We actually have more multiyear agreements renewed in the last two quarters than we traditionally did, so we are moving at a different direction and may be some of our customers might be thinking lock up a multiyear agreement, so that we do not raise prices in the future, and that has been the way we stand. We are glad we are in the position we are in, but I do not want you to think we do not see what you hear from other companies, that customers would like to see that come down, so that is pretty solid, thanks for the network.

Operator

There are no further questions in queue. I would like to turn call back over to management for closing remarks.

Robert M. Calderoni

I will just wrap it up by saying thanks for joining us today. We are happy so far with the way we have navigated through this economic environment that we are in right now. We think we are taking the right actions by assuming less so that we are in a position of being ahead of the curve should it turn out to be the case, but we are working feverishly to prove ourselves wrong on the revenue assumptions, of course. Thanks for joining us. We look forward to seeing and talking to many of you over the next 90 days.

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Source: Ariba, Inc. F1Q09 (Qtr End 12/31/08) Earnings Call Transcript
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