(This is the first in a series that will appear over the next several weeks on Internet Information providers. With this report, we introduce you to the concept of Desired Monopolies and we offer a report on one such enterprise: Ariba, Inc. (ARBA)).
Desired Monopolies: Where Everyone Can Win
Remember the Yellow Pages? You know, the big fat business-focused telephone book that dropped on your doorstep once a year? Wasn’t that handy? A listing of every business in town, all in one book. And it was effectively free - paid via your telephone bill.
Then came the dark ages: the break-up of the Bell System and widespread de-regulation of the telecommunications industry. Suddenly, you had four or five companies dropping “Yellow Pages” directories on your doorstep. With some listings the same and some not; each one formatted slightly differently, but none really better than the others. They’d have weird names like, “Yellow Book,” “Super Pages," and “DexPlus.” Yeesh. That’s no good. Why can’t we go back to just one Yellow Pages, you’d ask?”
Conveniently, we did: it’s called Google (GOOG). One place to go to find any business on earth. Google is what we like to call a “desired monopoly,” which we’ll define as a service company where everyone agrees that we’re best served by having one company provide the service. Mind you, this isn’t a recommendation of Google (which we don’t own), and if another search engine could “nail it” the way Google seems to (65% market share doesn’t lie), then certainly GOOG could lose not merely its market lead, but also its existence See: AltaVista, Lycos, Infoseek, Excite ... RIP.
But it sure is a nice existence when your customers and suppliers actually like that you’re a monopoly. Let’s review the virtues for the desired monopoly itself:
- Lower marketing expenses: whatever you’re paying for advertising and marketing, you’re paying less. Because you either have few competitors, or none at all.
- Stable pricing: No (or ineffective) competition means you are a price maker, not a price taker. Set it and forget it. Just don’t raise it ... (more on this later).
- No messy government regulation: there’s nothing inherently illegal about a monopoly. The Feds only come calling when it looks like you’re abusing the situation. Keep your nose clean, transparently telegraph your competitive moves, and for the love of God, don’t send any e-mails about competitors claiming you’re going to “cut off their oxygen supply” (thanks, Microsoft (MSFT)) and you’ll be fine.
I could go on, but we’ll be much better served by discussing one of the best examples of a desired monopoly: Ariba, Inc. (ticker: ARBA).
Name: Ariba Inc.
Market Cap: $2.7 billion
Trailing 12-months Revenue: $447 million
Forward Price:Earnings Ratio: 29x
HQ: Sunnyvale, CA
Incorporated: September 1996
Description: Ariba Inc. is an Internet software and services company. Ariba’s essential business is in the category of “spend management.” This means Ariba’s software helps other companies manage their suppliers and pay them less, or at least more efficiently, by eliminating waste, combining orders and seeking economies of scale in purchasing and sourcing materials. Solutions for buyers include spend analysis, sourcing, contract management, procurement and expense, and supplier information and performance management solutions. Solutions for sellers comprise contract management for sales contracts solution; supplier sales and marketing programs; network catalog, order, and invoice collaboration; discovery for sellers.
Perhaps Ariba’s most valuable asset is the Ariba Network (AN). The AN is a scalable Cloud infrastructure that connects buying organizations with their suppliers to exchange product and service information as well as a broad range of business documents, such as purchase orders and invoices. Over 333,000 registered suppliers of a wide array of goods and services are connected to the AN. As a result, buying organizations can connect once to the AN and simultaneously access many suppliers. By using the AN, businesses can realize cost savings through greater process efficiencies, better employee and contract compliance, reduced inventories and fair pricing opportunities. Revenue flowing directly from usage of the AN represents 50% of Ariba’s subscription revenue (itself 60% of the company total), and this is the fastest growing and most profitable revenue stream for the company.
The AN allows buyers to send orders from procurement software programs (like Ariba’s own “Buyer” module) in one standard format that are then converted into the supplier’s preferred transaction format. These formats include industry standards like EDI, cXML and CIF, along with simpler technologies like e-mail or fax. Moreover, Ariba benefits from network effects in that, frequently, suppliers join the Ariba Network at the request of buyers who purchase goods and services using Ariba Spend Management solutions. This type of customer acquisition is cheaper by far than any other, including traditional advertising and even renewals of existing customers.
Market Size and Ariba’s Opportunity
In its most recent Cloud Services Forecast Report, Gartner Research, a third-party research firm, projected a five year growth rate of 20.5% for the worldwide market for cloud services, becoming a $148.8 billion market in 2014. Further, it noted that over the course of the next five years, enterprises are projected to spend $112 billion cumulatively on software-as-a-service and other cloud software infrastructure. Note by comparison that Ariba’s revenue run rate as of 6/30/11 was $466m, up 47% y/y (including the acquisition of Quadrem in January 2011).
During Ariba’s recent September 8, 2011, analyst day, the firm’s management put into perspective its market opportunity. As of the trailing 12 months ending in June 2011, Ariba managed the transaction of $186B in total merchandise volume (TMV). This represents less than 2% the $12 trillion in annual global TMV spending. Moreover, the Ariba Network has 330,000 suppliers today, and is adding 1,200 new suppliers every week. This is made easier by the fact that more than 45% of any given buyer’s suppliers are already members of the AN when that new buyer signs up. And this fact illuminates one of the desired monopoly virtues we noted earlier: lower marketing expenses, driven by the network effects inherent in the AN.
Separately, during its recent analyst day, Ariba management stated it believed it was only 10% penetrated (on average) with its existing customer base. In short: the market opportunity is immense. And the acceleration in transactions and participation in the Ariba Network supports our belief that Ariba’s customers, both suppliers and buyers, desire that Ariba serve in this middleman role, so long as Ariba doesn’t abuse that monopoly position.
The eBay Thesis
So why might eBay be interested in Ariba? Consider that with its traditional “market places” segment (i.e., auctions, on-line catalogs, storefronts), eBay processes $58.7B annually in Gross Merchandise Value (ex-autos). Impressive as this number is, it’s dwarfed by the $193B in annual Total Merchandise Volume transacted across the Ariba Network. Yet Ariba’s enterprise value is only $2.5 billion. Thus, eBay could use just a portion of their cash on hand (they have $4.4B - currently earning next-to-nothing) and buy Ariba outright. This would add the dominant business-to-business marketplace to eBay’s existing dominant franchises in consumer-to-consumer and business-to-consumer commerce. And with PayPal, eBay already has a profitable consumer payment platform generating over $4 billion in annual revenue. Moreover, eBay management has been quite clear that it wants PayPal to be a ubiquitous payment option, in use well beyond eBay’s own Marketplace. Now imagine PayPal as a native payment option across a transaction network four times the size of eBay’s Marketplace segment.
And eBay could do this sooner rather than later, so as to minimize anti-trust concerns. Needless to say, trading do-nothing cash for debt-free Ariba and its 15% operating cash flow margins would be instantly accretive to eBay. We never invest in a company solely on the likelihood of being the subject of a takeover. But the natural fit of eBay and Ariba’s businesses is a possibility that is too tantalizing to ignore.
Meanwhile, it has been business as usual for Ariba. In its June quarter, revenues were up 27% year over year and subscription bookings were up 32%, suggesting accelerating revenue growth. Ariba management officially raised subscription revenue growth estimates from 24% to 26%. As of June 30, dollar volume on the Ariba Network had grown 22% year-over-year.
Concerns and Issues
No company or investment is perfect, and Ariba has three issues that concern us.
1. Pricing Power: In late 2010, Ariba raised its Ariba Network fee from 10 basis points of transaction value to 15.5 basis points, apparently with little customer push-back. As we noted earlier, the ability to be a price maker is a virtue of a desired monopoly. While pricing power is usually an unalloyed good, Ariba’s rising profile in the business-to-business world means they are probably under increasing regulatory scrutiny. We noted earlier that monopolies aren’t inherently illegal. But raising your prices by 55% is no way to win friends down at the Federal Trade Commission.
2. Tax Rates: Ariba took years to burn off Net Operating Loss Carry-forwards incurred while they rode out the bursting of the dot.com bubble. Now, however, they are paying taxes again, which will be a drag on earnings growth as they go from an effective tax rate of 1-3% last fiscal year to 5% in F2011 to ~10% in F2012.
3. Decreasing Operational Leverage: In their most recent quarter, management raised fixed expense expectations (primarily driven by increased sales efforts). This takes away some (though by no means all) of the operating leverage the company ought to see from accelerating revenue growth. We’ll be eyeing this trend carefully.
Ariba is the dominant player in Spend Management. Other ERP firms (Oracle (ORCL), SAP (SAP), etc) have some of the features in various software applications and modules, but nobody addresses the whole landscape like Ariba. Some smaller, private software-as-a-service companies are offering some of Ariba’s functionality, including Perfect Commerce, cc-Hubwoo, Ketera Technologies, Coupa and Iasta. For example, Coupa is competing well in the narrow “procurement” space. But again, while some of these vendors can clip off business from customers who don’t need Ariba’s soup-to-nuts offering, none can hook them up to the Ariba Network.
As part of our analysis of Ariba, we built a Discounted Cash Flow (DCF) model for the company. We used the following parameters and values to arrive at our DCF value:
- Term: Five years;
- Initial Cash Flow: $48.730m (this represents the annualized free cash flow for the current fiscal year);
- Short Term Cash Flow Growth Rate: 12% (conservative considering that Ariba’s Free Cash Flow CAGR for the past five years = 22%);\
- Long Term Cash Flow Growth Rate: 8%;
- Discount Rate: 9% (relatively high – and more conservative – owing to Ariba being on the border between small- and mid-cap;
- Current Share Count: 93.350 million.
Using these inputs, our calculated DCF value per Ariba share is $67.41. This is more than double Ariba’s current $29 share price. It also reflects extremely conservative assumptions, as noted above. So even if eBay doesn’t come calling with its checkbook, there is still plenty of valuation “headroom” to foster substantial appreciation in Ariba shares.
Ariba is an almost perfect embodiment of a desired monopoly: increasing market share and cash flow driven by network effects. Recent order trends indicate business is accelerating, which supports the conservative assumptions leading to our $67 DCF value. Plus it trades at a valuation that leaves plenty of room for eBay to offer a premium to Ariba’s shareholders, while still making a deal accretive to eBay’s earnings.
Disclosure: I am long ARBA.
Additional disclosure: I am long Ariba in a) my personal portfolio and in b) a model portfolio that my investment advisory firm, Crabtree Asset Management, sub-advises for clients. I began this long position in November 2009.