Up over 150% over the past year and about 225% over the past 5 years (the S&P500 is up 0% in the past 5 years), Ariba Inc. (NASDAQ:ARBA) has given investors a great ride and made them lots of money. Over the past 10 years, ARBA appears as quite a success story and one of the few ‘internet bubble’ companies to survive and reach profitability, on a GAAP accounting basis at least.
Looking beyond the reported accounting results, however, reveals that ARBA is not quite as profitable a company as it seems, and its valuation has out-grown its profits by a wide margin – the required combination of factors for making February’s list of most dangerous stocks.
Making matters worse, ARBA’s competition comes from two of the most successful business software companies in the world: Oracle (ORCL – neutral rating) and SAP AG (SAP – not rated). In particular, ORCL has long been known as a category killer that ruthlessly runs smaller competitors out of business. ARBA’s apparent success may be just enough to catch the attention of ORCL and SAP. And since both ORCL and SAP provide software that helps manage companies’ receivables and payables, they are well-positioned to direct their clients’ payments systems away from ARBA and to another e-commerce system…perhaps, one they have subsidized.
Both ORCL and SAP have much deeper pockets than ARBA. Because we also cover ORCL, we know that company’s business model is very strong with an ROIC of over 20% and economic profits of over $4,700mm in its last fiscal year. ORCL is one of very few companies in the world that has generated economic profits ever since 1998. They are a formidable competitor.
ARBA, on the other hand, has enjoyed more superficial success. It has never generated economic profits (our model begins in 1999). And over the past 5 years, while showing a rise in accounting profits, its economic profits are mostly flat with a significant decline during its last fiscal year (2010). Specifically, for fiscal year 2010, ARBA reported an $8mm increase in GAAP earnings while economic earnings declined by $10mm (a difference of $18mm or 5% of 2010 revenues).
ARBA’s overstated accounting profits have, in no small part, contributed to the stock’s excessively high valuation: our discounted-cash-flow analysis of the current stock price of around $31 shows ARBA must grow its net operating profit after tax (NOPAT) at over 20% compounded annually for at least 25 years. A 25-year growth appreciation period with a 20% compounding growth rate sets expectations for future cash flow performance quite high. Historical growth rates are much lower.
These high expectations do not compare well to management’s poor capital allocation track record. Since 1999, ARBA’s management has written down $1.721mm in assets, over 300% of reported net assets. Given that management is supposed to create value, not destroy it, writing-down over $3.00 for every $1 on the company’s balance sheet does not bode well for their ability to create shareholder value. Our recent article on management failures explains why investors need to beware large asset-write-downs like those incurred by ARBA.
Overall, the risk/reward of investing in ARBA’s stock looks “very dangerous” to me. There is lots of downside risk given the misleading earnings, while there is little upside reward given the already-rich expectations embedded in the stock price.
In a business where investors make money by buying stocks with low expectations relative to their future potential, ARBA fits the profile of a great stock to short or sell.