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Executives

Elaine Kitagawa - VP, IR

Bob Calderoni - Chairman and CEO

Jim Frankola - CFO

Analysts

Greg Dunham - Deutsche Bank

Nathan Schneiderman - Roth Capital

Peter Goldmacher - Cowen and Company

Pat Walravens - JMP Securities

Brad Reback - Oppenheimer

Brad Whitt - Broadpoint

Brian Schwartz - Montgomery & Company

Robert Breza - RBC Capital Markets

Ariba Inc. (ARBA) F1Q08 (Qtr End 12/31/07) Earnings Call January 24, 2008 5:00 PM ET

Operator

Welcome to the Q1 Fiscal '08 Earnings Call. (Operator Instructions).

It is now my pleasure to introduce your host, Ms. Elaine Kitagawa, Vice President of Investor Relations for Ariba. Thank you, you may begin.

Elaine Kitagawa

Thanks, Rob. Good afternoon and welcome everyone to Ariba's conference call to discuss our results for the first quarter of fiscal year 2008. 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 Jim Frankola, our Chief Financial Officer.

For those on the call accessing the supplemental slides please now advance to slide two. Before we begin I will read the Safe Harbor statement. Statements that may be made on this call but are not historical facts may be forward-looking statement's including statements regarding the company's or managements intentions, hopes, believes, plans, expectations or strategies for the future.

These statements are subject to various risks and uncertainties, and 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 reports on Form 10-K for the year ended September 30, 2007.

During the course of this call we will reference historical non-GAAP financial measures. For a reconciliation of historical non-GAAP to GAAP financial measures please see the earnings press release and supplemental analyses on the investor relations section of our website, or our Form 10-K filed this afternoon.

In addition we will reference certain forward-looking non-GAAP financial information, including fiscal 2008 revenues, expenses and net income. We are unable to reconcile this forward-looking non-GAAP financial information due to the corresponding forward-looking GAAP measures because we are unable to estimate without and reasonable efforts certain forward-looking GAAP revenue and expense items.

At this time, I will like to turn the call over to Jim Frankola to review the financial highlights for the quarter. Jim?

Jim Frankola

Thanks, Elaine. Good afternoon, everyone, and thank you for joining us. Ariba is of to a good start in fiscal 2008. Here are some of the key highlights. We meet our revenue expectations and exceeded our earnings expectations. Q1 non-GAAP revenue was $77.4 million and Q1 non-GAAP EPS was $0.07 per share. We continue to see strong demand for on-demand products. A full 96% of software transaction this quarter was for subscription software products as it goes to perpetual licenses.

Please now refer to slide 3. This trend drove an increase in backlog for the 12th consecutive quarter. Our total subscription software backlog now stands at $146 million and our 12 month backlog is $80 million. Each of these amounts represent a 63% growth rate from Q1 of last year, which is the highest level of growth for us since we launched our on-demand journey over two years ago. By the way the 63% growth rate is an organic rate and does not include an impact from the Procuri acquisition.

Please move to slide 4. We now also saw strong sequential and record year-over-year revenue growth in our subscription software revenue. In Q1 of '08 non-GAAP subscription software revenue was $21.3 million, up 40% from Q1 '07 and up 13% from the previous quarter. Within our subscription software revenue our supplier paid network fees came in at $3 million ahead of our original expectation due to higher than expected renewals and collections.

We closed 181 transactions added 25 new name accounts, signed 85 on-demand deals. We closed 13 deals over $1 million of which four had a software compliant over $1 million. We closed the acquisition of Procuri and finally we settled our litigation with Sky.

Now let me turn to more specific financial result for the December quarter. Total revenues were $77 million for the first quarter of 2008, excluding $403,000 purchase accounting adjustment against Procuri's revenue stream, non-GAAP revenues were $77.4 million and came in within out guidance range.

Subscription and maintenance revenue was $40 million with maintenance revenue of $19.2 and subscriptions software revenue of $20.8. On a non-GAAP basis subscription and maintenance revenue was $40.4 million slightly above our guidance. Non-GAAP subscriptions offer revenue came in at $21.2 million up 20% year-over-year. Service and other revenues including license revenue of $2.4 million came in at $37 million at the lower end of our guidance of $37 million to $39 million.

We continue to see strong progress on the margin front. Overall non-GAAP gross margin increased from 54% in fiscal '07 to 59%, which puts us on track to achieve our full year target of approximately 60%. This increase in margin is driven by the change in mix to more profitable lines of business.

First and foremost the fast growing subscription software business carries a higher than average gross margin. With its rapid growth rate it is pulling up overall gross margins. Second within our services business the mix shifting to higher margin sourcing services offering and away from lower margin BPO and system implementation solutions.

Looking at expenses, total expenses on a GAAP basis including cost of revenue were at $95 million. Included in these GAAP results were $3.6 million charge for amortization of intangible assets. A $9.8 million charge for stock-based compensation and $3.5 million restructuring charge related to our server consolidation strategy, which has allowed to abandoned additional states in our Sunnyvale campus. A $300,000 restructuring charge relating to the Procuri integration and $5.9 million charge relating to the settlement of the Sky litigation.

The key financial terms of the Sky settlement are as follows: Ariba will make a one time settlement payment of $5.5 million and agreed to pay a maximum of $400,000 in Sky's legal expenses for a total of $5.9 million. Additionally, Ariba entered into a settlement agreement of behalf of Procuri for $2 million. The cash payments of approximately $7.9 million will be made in Q2.

Excluding these items, non GAAP expenses were $72 million for the quarter. Included in these non-GAAP expenses were the following items, first we received the final $566,000 benefit in operating profit from Softbank. Going forward there will be no further P&L and tax from Softbank.

Second, we incurred almost $4 million of IT related litigation expenses in Q1. As a result our GAAP net loss in the third quarter was $18 million or $0.25 per share on a non-GAAP basis we had positive net income of $5 million or $0.07 per diluted share, which exceeded our guidance range of $0.04 to $0.06 per share.

Moving to the balance sheet: Cash, cash equivalents and investments at the end of Q1 were at $128 million, which was down as expected from $183 million at the end of Q4. The primary reason for the $55 million decrease was $54 million in cash payments for the Procuri acquisition. We generated positive cash flow from operations of $1 million and free cash flow before lease loss payments of $4.7 million. Our DSO declined to 34 days, down four days from the previous quarter.

Finally, in terms of headcount Ariba ended the September quarter with 1,800 employees, up from 1,669 at the end of September driven by the Procuri acquisition. We ended the quarter with 111 quota-carrying reps, up 12 from the beginning of our fiscal year.

Now, let me highlight key business trends and share our outlook for the March quarter and the rest of fiscal year with you. Please see slide 5, titled Updated Fiscal Year '08 Outlook.

Ariba is transforming to an on-demand company and is proceeding very well. It is happening more quickly than we anticipated. We continue to see our revenue shift increasingly towards subscription software. The shift in mix should yield margin expansion opportunity extending into cash flow benefits.

We are very pleased with the growth in customer demand for our subscription software products. From a micro sense we continue to release more mature products, increase the functionality for our customers, build sales and marketing expertise and continue to grow the Ariba Supplier Network.

From a macroeconomic standpoint Ariba's on-demand Spend Management solutions can help customers react to an environment of rising prices and focus on reducing costs. These solutions are offered in a selectable and in an affordable manner and they allow the customer to get tangible return on investments much faster than many other IT investments. In this sense, we believe we have a counter cyclical element to our business model.

Given the strong subscription backlog growth in Q1, we believe we should see accelerated growth in the subscription software revenue line, thus raising our expectations for the full year to $115 million to $120 million, compared to our previous guidance of $113 million to $118 million.

So Q1 licenses revenue met our expectations, we now believe that the growing demand in subscription software will shift revenue away from perpetual license more quickly than we originally thought. This also means that our perpetual license revenue for the remainder of fiscal year '08 is likely to be lower than our previous guidance. We now expect perpetual license revenue to be approximately $6 million to $9 million for the year compared to our previous guidance of $8 million to $10 million.

Despite the shift in demand towards subscription our maintenance renewal rates continue to run well above our target rate of 90%. We now expect maintenance revenues to end up between 73 and 75 for the full fiscal year compared to the previous expectation of 72 to 73.

Complimentary to this trend in the software business, we are seeing a shift in mix in our services business as well. As most of you know we have three major components to our services revenue; sourcing services, system integration and BPO. First of all sourcing services has emerged as a growth opportunity for us in the service revenue line. Sourcing services is our business line that helps customers find suppliers under their commodity markets and improve their sourcing processes. The nature of this offering, our unique knowledge and expertise and improved execution has driven bookings up by more than 50% over the past year.

This growth is occurring in almost all verticals and all regions around the world. We are even seeing growth in verticals that are facing significant economic challenges like the auto sector and private equity. Sourcing services now represent our largest services offering and carry a higher than average margin due to leverage built into the delivery model.

As our mix shift more the subscriptions we expect to see implementation work to be flat or slowly declining. This is a natural element of our transformation and is built into our business model.

Finally at the end of Q1, one of our two remaining BPO customers shifted to a subscription software model. We expected it to cause our BPO services revenue to fall from about $2 million a quarter to about $1 million a quarter. Subscription software revenue and overall profitability should increase modestly. Taken together, the accelerating shift to the subscription software validates our strategy and is positive to Ariba.

Overall the impact to our model is subscription software backlog and revenue will increase, perpetual license revenue, system integration and BPO services revenues will decrease, cost will fall and profit will be neutral in the short run and positive in the long run.

To summarize we are raising our 2008 non-GAAP subscription software target to $115 million to $118 million, lowering total non GAAP slightly to $330 million to $335 million and holding non-GAAP EPS at $0.45 per share.

Please now refer to slide 6. This is the slide that outlines cash flow projections. The final element of our financial model is cash flow, with strong operating profits, low taxes and the working capital benefit from the subscription model, Ariba is well positioned to generate robust cash flow from operations.

Last July, we guided to $50 million of cash flow from operations before lease loss payments for the fiscal year '08. We are on track to deliver $50 million to $55 million of cash flow from operations before lease loss, Sky settlement and the Procuri acquisition.

Focusing on the near term for the March quarter, we expect the following non-GAAP revenue expense and net income performance. We expect non-GAAP revenues in the $80 million to $83 million range with subscription and maintenance revenues between $48 million to $49 million including roughly $30 million for subscription software and $18 million to $19 million for maintenance.

Services and other revenues are anticipated to be in the $32 million to $34 million range, including roughly $1 million to $2 million of license revenue. There will be $3 million purchase accounting adjustment to Procuri's revenue stream, thus GAAP revenues are expected to be between $77 million and $80 million.

With respect to the rest of the P&L, we anticipate total non-GAAP operating costs and expenses to be roughly $76 million. Contained within this expense are cost of revenue of $31 million to $32 million, R&D of roughly $13 million, sales and marketing of approximately $23 million, G&A of $10 million, which includes almost $2 million of IT related litigation expenses, and a net benefit of approximately $1.5 million from interest income and exchange gains net of taxes.

On a non-GAAP basis, we expect positive net income of approximately $4 million to $7 million or roughly $0.07 a share plus or minus a penny or two, based on 82 million diluted shares outstanding.

In addition, we expect to report expenses of $11 million for stock-based compensation, $5 million for amortization of intangible assets, $1 million of restructuring related to the Procuri integration. As a result, we expect to generate a GAAP net loss of $13 million to $16 million or a loss of $0.17 to $0.21 per share.

Overall, Q1 results validated the progress we are making in the transformation of our business model. On the growth side, we demonstrated rapid growth in both subscription software revenue and backlog. On the costs side, we saw a fair step improvement in our gross margins. Non-GAAP gross margin increased from 50% in 2006 to 54% in 2007 to 59% in Q1 of '08.

The subscription software model gives us leverage to grow revenues through 2008 with a modest increase in expense yielding significantly higher operating profit like Q4 and allowing us to stay on track to our $0.45 non-GAAP EPS target for the year.

Please advance to slide 7, this is a target operating model slide. No we are not immune to the macro economic environment. Ariba has two strategic benefits that most technology companies do not have. The unique combination of what we sell and how we deliver value.

First we sell Spend Management Solutions that is technology and services that help companies save money. Second we deliver the solutions in an on-demand approach that significantly lowers our customers total cost of ownership, reduces the risk of technology adoption and reduces their time to achieve return on investments.

We believe that these strategic benefits coupled with the successful execution of our major business initiatives will position us to achieve our long-term financial objective, of non-GAAP gross margins of 60% to 65% and non-GAAP operating profit margins of approximately 15%, and finally, with cash flow from operations before lease loss of approximately 20% of revenue.

And with that let me turn the call over to Bob.

Bob Calderoni

Thanks Jim and thanks to everyone for joining us this afternoon. For the past few years we have worked tirelessly to transform our product, financial and operating models to a leading on-demand solution company and we have made tremendous progress on all fronts and our solid Q1 is actually an acceleration of the trends we have experienced with even faster growth in both subscription revenues and subscription backlog.

As I've outlined in prior calls our strategy is build upon three major growth drivers, on-demand, mid-market, expansion and our network business. So let me touch on each of these drivers and talk about the good progress we're making on each front.

On the on-demand front, we are clearly the undisputed leader in delivering on-demand Spend Management solutions and that is true by a very wide margin. We recorded 40% year-over-year growth in subscription software revenues, which is up from the 22% levels we experienced for all of fiscal year 2007 and with strong bookings and our backlog is growing even faster with the backlog growth of 64% in our 12 month backlog and approximately the same rate of growth in our long term backlog.

This acceleration in our growth is a very positive sign and it's encouraging as we look forward towards the full year. Our continued innovation and our on-demand product is fueling this growth, it has opened up new markets and presented opportunities that were unavailable under the installed software model.

It also affords us new ways to reach and provide additional value to ERP customers and for example in Q1, we signed a three year subscription deal with Hubbell for both Ariba on-demand sourcing and contract management. This was competitive against SAP at a very big SAP shop and Hubbell elected the partner with Ariba due to our rich functionality, the ease of use and the fact that our solutions were integrated and available for deployment immediately.

This deal signaled something that we are seeing more and more of and that is customers are growing frustrated with continued delays in their ERP's SRM functionality and they are looking for on-demand solutions that can help them achieve their spend management goals today.

On the mid market front, on-demand has also helped to fuel growth allowing us to bring enterprise class spend management solutions to a broader range of companies. 70% of our new name accounts came from companies with annual revenues below $5 billion and these are not small deals. In fact, out of our top 20 deals this quarter, 30% came from the mid-market segment. For example; we closed a $3 million plus on-demand deal for Ariba Sourcing and Procure-To-Pay solutions with a mid-market manufacturer in Canada. And the deal with Hubbell was another example of a large new name customer in the mid-market. These wins illustrate that mid-market companies have enterprise size requirements and that on-demand is the key to enabling the business.

On the network front. The Ariba Supplier Network business continues to grow as we continue to innovate in this area and focus on the opportunity. Overall, network revenues showed strong growth in Q1 validating the value both buyers and sellers are receiving from the network. The restructuring of our SMP program got off to a good start and we are doing better than we originally planned.

Transaction volumes continue to grow at double digit levels. The number of transacting suppliers continues to grow and we are seeing 30% growth in the spend volume on the network. As I mentioned earlier, we are increasing our focus in this area. In this quarter, we launched the dedicated sales organization focused exclusively in this area and that new team got off to a fair start with four eInvoicing wins with new customers.

From a product point of view, we released the new version of our network just a few weeks ago, which has a number of enhancements and innovative features that both buyers and suppliers can enjoy.

Getting back to the Q1 results: From a total bookings perspective demand for software continues to shift towards subscription with an all-time high mix this quarter. We also saw strong demand for our sourcing services, which is an early indicator of how tightening economics factors increased the appetite for such services.

As a matter of fact our top four deals this quarter all had a sourcing services component in it, many of them long time customers, companies like Pfizer have expanded their spend management program this quarter by leveraging our sourcing services and our expertise.

This is the unique offering we have against our competitors where companies are looking for accessed ROI and improvements in our operating margins. We see a lot of growth potential in this area in both new and existing customers and in many cases it's proving to be an entry point for us which allows us to deliver savings today and then transition to a software relationship in order to institutionalize the processes and the savings.

From a regional perspective Europe had a very strong quarter, North America fell back a little from last quarter's high, but still did well and we saw a little bit of softness in APAC in Asia Pacific region but that was following several quarters in a row where they did exceptionally well.

From an industry sector standpoint CPG retail financial services and manufacturing continued to be our top performing verticals. We also did well in the auto sector this quarter with a number of wins in both the United States and European markets. From a competitive point of view we are doing extremely well and I believe we are gaining share.

Against the larger competitors ERP player that is I see a growing sentiment among buyers that the ERP companies cannot meet their needs. Not only do they lack the functionality needed to soft in depth spend management problems, but they are proving to be an unreliable suppliers of innovation with repeated delays and promised offerings.

While the focus of many companies over the past few years has been on consolidating around a single ERP system, I do see a noticeable shift towards a settlement around: “what can you do for me today?” I've had a number of conversations lately with some very large companies that previously would not even consider doing anything other than with their ERP provider, not only are they willing to talk to us, but they are also saying things like: “I will only consider an on-demand solution”.

All of this is very good for Ariba and of course its one of the primary reasons why I believe we are doing so well and why you can see the tremendous growth in our subscription software business. Not only are the market trends moving in our direction versus the ERP players we're also doing well against the smaller niche providers. Most of our competition in this space is going to market with old fashioned, single tenant CD-based solutions. Not only the customers see that these providers lack functionality versus Ariba, more importantly they are seeing its having yesterday's technology.

More and more we are engaged in deals where the requirement from the customer is very clear and very specific, offer me a flexible multi-tenant on-demand solution or simply don't bid. We like this trend, its serving us well and I think it's a reason why you see the success we have enjoyed over the past year in our business.

While many of our competitors are scratching their heads, wondering what has suddenly happened, we're rapidly innovating and we're pushing the edge of the envelope further and further. Early next months we will release our latest version 9s5. This is the fifth release of our on-demand offerings and a time span when our competition has announced several delays.

This is an important release for us. It marks a point where we have achieved virtual parity with our CD-based solutions and we have done this in three years which I believe is quiet remarkable and even some of the largest pure play on-demand companies in other segments took much longer to reach parity with the traditional leading CD-based offerings in the market.

Today, we are delivering enterprise class functionality, not promising yet. We are delivering it today and we are delivering it on-demand. 9s5 also marks an acceleration in application innovation with planned releases at least two times per year allowing us to be even more responsive to changing customer and market needs.

This rapid development and innovation process is feeding off each other. Later this summer, our CD customers will also benefit from our on-demand transition with the 9r1 CD release. This will incorporate coding features from our on-demand product that on day one will have already been battle tested by 100s of on-demand customers. This is a tremendous advantage we have and is something that is allowing us to serve all of our customers new and old quite well.

Finally, let me just touch on the Procuri acquisition. When we closed the acquisition in mid-December, I emphasized how we expected to benefit from the experience in successfully targeting mid-market companies.

We are already starting to reap the benefits of this know-how. For example; one of our new reps from Procuri closed a three-year subscription deal for Ariba On-Demand Sourcing for $100 million manufacturing in the Nordics and he did it within seven days of the closing of our transaction.

While I don't think it's reasonable to expect many deals to happen at this space, I do think it's an encouraging sign that we are bringing together a great set of Ariba applications with a solid organization that knows how to sell to the mid market. While it’s still early I believe the acquisition of Procuri is going well and the customer feedback is very positive.

So on closing I am very pleased with the progress we are making on all our growth initiatives. With a momentum we have built over the past few quarters coupled with the shift in attitude favoring on-demand solutions, we remain optimistic about 2008 and believe we are off to a good start. To what should be a very good year for Ariba. With that let me turn the call over to your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question comes from the line Greg Dunham with Deutsche Bank. Please proceed with your question.

Greg Dunham - Deutsche Bank

Yes, thank you very much. I guess the first question here is for Bob and I want to hit on the corners that was a major of your offering. A common question that I get is what's the ROI on the product, what's the pay back period and so if could hit on that and also how is this environment and what you are offering today different than kind of the period that you went through in 2001 when there was also a weak economic environment?

Bob Calderoni

Let me touch the first point. We have an offering that really is focused on plain and simple on cost reduction. I mean, everything we sell is about getting your hands around your spend managing to spend and proactively influencing it before it happens with the ultimate object of saving money and with an on-demand deployment of our software coupled with our sourcing services. We have solutions that not only drive substantial savings, but we drive it. Nothing is immediate, but I would say pretty quickly, we contact customers, realizing savings in 60 days in some of our applications out there.

So, I believe, and I have always believed, that in an environment where it is a neutral or balanced economic environment to slightly negative that offering like ours would actually be more attractive down. You referenced a period in 2001, I wouldn't call that a slightly negative. I think that was a bubble bursting and many companies simply responded by just shutting off the spicket on any kind of saving for a period of time.

But in an environment where there is pressure on commodities, pressure on price increases, inflation and bottomline earnings pressure, I think we have something good for our customers. The other thing we didn't have in 2001 was an on-demand offering. So, I think we're pretty bullish about 2008.

We certainly read all the headlines that are out there. But right now, things feel pretty good for us. And with the predictability of our subscription business, we have good visibility, and we're confident. And that's the reason why Jim raised many of the metrics within our full-year guidance.

Greg Dunham - Deutsche Bank Securities

Great! And then I guess one question for Jim. I understand the lowering of license revenue -- obviously, the professional license was in that 2 million range this quarter. Could you talk a little bit more about the services dynamic you mentioned in the BPO customer?

Jim Frankola

Yes, so very specifically, we had at the end of December one of our two remaining BPO customers decide to go from BPO model of getting spend management value towards primarily a software model with some traditional or rebate services attached to it.

So, this is the same thing we saw in 2007 where that will cause our services revenue to fall by almost $1 million a quarter. So, add a couple of hundred thousand dollars to subscription software as well as a couple of hundred thousand dollars to profit since our subscription software offering is much more profitable than our BPO offering.

So at this point, we now have one remaining customer in our BPO business, generating about $1 million of revenue a quarter. Greg, does that answer your question?

Operator

Next question is from the line of Nathan Schneiderman with Roth Capital. Please proceed with your question.

Nathan Schneiderman - Roth Capital

Hi, thanks very much. Hi, Bob. Hi, Jim. A handful of questions for you: What was the percent of revenue from international?

Jim Frankola

Percent of revenue from international was about 35%-40%.

Nathan Schneiderman - Roth Capital

35% to 40%. It looks like since the EPS view at $0.07 is a little lower than a lot of s1 working for it for Q2 that you still expect to achieve $0.45 for the year. You're going to have to end up at a little higher operating margin.

I am wondering: what sort of margin do you think you need to achieve in Q4? And: do you think that positions you to achieve your target margin level at 15% in fiscal '09? Because it looks like you have to get pretty darn close to that in Q4.

Bob Calderoni

Yes. Nathan, let me break that into a couple of different pieces. First, we closed the Procuri transaction a little bit later than we originally anticipated. That's one reason why we have the positive upside on EPS in Q1, but they also shift some of the early costs of the model and integration into Q2.

So, you have somewhat of right pocket between Q1 and Q2 relative to expectations. To your longer-term model, we still expect that our operating margins should be rising to the low teens by the end of the fiscal year, which will position us well to hit our long-term model.

And long-term model was not a fiscal '09 guidance, but something that we can achieve in the mid-term beyond 2008. So, overall, our business is pretty much tracking as expected with the new ones. The Procuri closed the date, shifted some costs from Q1 to Q2.

Nathan Schneiderman - Roth Capital

Okay. And then just a follow-up on the services side to make sure I understand that the guidance was it basically reduced the outlook for the year by $8 million. The one customer shifting off BPO is $3 million of that $8 million, but it sounded like you were starting to get some pretty strong growth in backlog on the sourcing services. Bob, you had said 50% I believe. So: why the other 5 million reduction? If you get some lift from sourcing services. I am all confused here.

Jim Frankola

Part of that is the nature of revenue recognition. So, for example, in many of the large deals that we closed and there is one just yesterday here, we signed a three-year software agreement, and we signed a thirteen-month sourcing services agreement that's going to get recognized over the life of the three-year software agreement.

So, since we sell solutions, and that's partly what makes us unique, much of our services bookings even when we earn it get recognized radically over time in some cases, and even longer period than when we deliver it. So what you are seeing in the model is the combination of sourcing services up. But as sourcing services increase, they cannot move the needle as quickly as system implementation, which tends to ramp up and ramp down more quickly.

Bob Calderoni

Nathan, maybe I can add some more color to that. Within the services business, if you think of the two major components just in implementation and then sourcing services, clearly, sourcing services is growing.

In the last three quarters, we have seen significant upticks, both on the sequential basis and significant growth on a year-over-year basis. In bookings, we won't see the revenue for the reasons Jim pointed out as quickly as the bookings are coming in. But the other and it's happening on the system implementation part of the business, the reason why that is slow right now is partly because we're selling more on-demand versus CD software.

But most of those services are coming from existing customers that already have CD software. And we are about to release a new version of our CD software in the summer. So, in the six months or so prior to a new release, often times what you'll see is customers not doing anything on their existing platform, because they know there is a new release coming, and they just kind of wait till the new release comes out. So, we're seeing a little bit of a low in that system implementation business, which is expected just prior to a big release.

And when we look at the pipeline and the types of deals we're talking to customers on in the services business, we think that picks up middle part of the year when the new CD release is out there. So, we are encouraged by the good strong growth in the services, sourcing services business and we think that's going to be a complemented when the new CD release comes out on the system implementation side middle of the year.

Nathan Schneiderman - Roth Capital

Okay, thank you.

Operator

Our next question comes from the line of Peter Goldmacher with Cowen and Company.

Peter Goldmacher - Cowen and Company

Hi, guys. A couple of quick questions on the sales force productivity. You mentioned how many reps you have. Can you talk a little bit about their longevity and their productivity? Also, when a company switches from a perpetual view of subscription model: what's sort of a ratio is that today if they switch on?

Bob Calderoni

I'll take that, Jim. I don't have the stat.

Jim Frankola

Yes. I don't have the stats in front of me either. We have a decent turnover in our sales force, I would say, for similar growing companies with private similar mix of some very successful, very long-standing employees as well as newer sales reps that are still ramping up on the productivity curve.

And what we generally see is in the first two or three quarters if they are with the company, productivity is relatively light. As such our productivity on a per sales rep basis has been rather flat over the past several quarters. And part of that is due to the number of new reps that we've been adding over the past year or so. You said quite a few, Peter was what?

Peter Goldmacher - Cowen and Company

Well, so Jim let's finish the first one. So, I knew that you guys have been adding. And I was wondering: if part of your numbers are based on improved productivity from the guys that you have been hiring over the last few quarters?

Jim Frankola

Are they partly forecasted for '08?

Peter Goldmacher - Cowen and Company

Yes.

Jim Frankola

Internally, we certainly plan for increased productivity in terms of what is built into the external business model. I generally don't like to bank on a whole lot of growth in productivity. So, internally, we are always looking to drive more productivity. Externally, we have a whole modest assumption built into our model.

Bob Calderoni

I think it's fair to say that, Jim, that with overall productivity holding relatively flat as we have been adding more sales resources implicitly in the more experienced salespeople seeing improved productivity. You can't add a lot of new guys on the whole productivity flat unless you are getting some gains somewhere else.

So, we are seeing better productivity, but it's being offset by the fact that we are seeding into the organization the number of new salespeople right now. So, our internal plan is obviously higher, but over external view here kind of assumes relatively flat productivity going forward. And if we do better than that, I think that should translate into better guidance.

Peter Goldmacher - Cowen and Company

Great! And the next question was on, when a customers transitions from either services or perpetual license, probably subscription model: what's the ratio? So, if they were spending $1 million on perpetual license: what would they spend on equivalent functionality on a subscription model?

Bob Calderoni

Well, it's really a hard comparison to make, Peter, because today we are not offering the perpetual model. So if there is an existing customer that brought perpetual license a while ago, what they are looking at today is cost, and they are going to make the comparison based on their total cost of ownership.

And their cost today is a couple of things. It is maintenance that they pay to us, but that's often times a smaller element of it. There is all of the application maintenance and support costs that come out of their internal operations, IT operations and hardware et cetera. And so, they compare that total cost of ownership to our subscription price.

We offer them a pretty substantial savings on the total cost of ownership, but many times, the price that they pay Ariba for the subscription will be higher than what they are paying us for maintenance. So, we like it, because we get a higher share of the customer spend, and the customer also gets to see a lower total cost as well.

If we didn't get a customer to shift from an installed piece of software to our subscription on-demand software, we will see a revenue increase and the customer will see a cost decrease.

Jim Frankola

And, Peter, let me put that in the context. Once again, we are not seeing a significant movement of our existing perpetual license customers to the subscription model. So, that change is happening very infrequently. It's measured in a handful per year, and that it separates that up from BPO. So the three BPO customers that went from the services model to software model, I'd say we saw revenue reduced by a factor of 3 to 4 on average.

Peter Goldmacher - Cowen and Company

Okay, thank you.

Operator

Our next question is from the line of Pat Walravens with JMP Securities.

Pat Walravens - JMP Securities

Great! Thank you very much. Could we start with sort of Procuri and what sorts of steps you have to take on the integration side and where you are on those?

Bob Calderoni

Yes, so we've done quite a bit of work with their product and our product, and we've laid the product side-by-side and talked to a lot of customers and understand whether the particular features that are very important for their existing customers, and we have a plan to embed those features into say upcoming release of the Ariba-based application.

And we've been communicating that with the Procuri customers, and I've told them a couple of things. The first thing is we're going to continue to support the Procuri platform for 12 to 18 months at a minimum. We haven't put a firm date on that, but we've given them a certain level of assurance that they are not going to have to make a premature change.

And we've also given them some insights into our product plans in terms of wanting to move the key features into Ariba platform and that we would be looking to make that transition only after we have incorporated those changes into the Ariba platform.

So, the feedback has been pretty good from the customers. They feel like we are working with them. And many of them, after they get a chance to see the Ariba software, they are pretty excited about it, and some of them are actually talking to us about moving early, because we've got a number of capabilities and a number of things we can offer them that are over and above what they are currently used to doing out there.

So, I would say it's going pretty well. We don't expect many of the transitions to happen for another year, but all the conversations with customers feel good right now.

Pat Walravens - JMP Securities

Okay. Great! Bob, when you have kind of got a lot of the pieces that you've been working on over the last three years to sort of gel with this point. So, when you look at other sort of functionality or other acquisitions that might make sense to add on to what you got now, what are some of the areas that might be interesting?

Bob Calderoni

Well, I won't limit it to an M&A type of question. I'll just talk about where I see us moving as a company. And then whether we do it organically or we do it through M&A, time will tell. But we've laid out the three initiatives: on-demand, mid-market and the network.

On-demand, we feel pretty good from an enterprise point of view. We've got a broad platform. We now have CD parity, and we feel very good from a product point of view in that area.

In the mid-market, we think there is more we could do in the mid-market to make it even easier to get going with us, even though we have an on-demand product, so that we could even start pushing down the smaller and smaller companies. I would say, today, the sweet spot in the mid-market for us is below $5 billion, but I would say it's in the $1 billion to $5 billion, it's the larger mid-market business, larger mid-market customers that we seem to be focused on today. We think we could make some of our solutions little bit easier to deploy that will enable us to sell through channels to even smaller companies. So we are looking to do that from a product point of view.

The third one is in the network. And the way we describe it and it goes back to the Analyst Day conversation around this, as we find ourselves with our applications today in between buyers and sellers who are engaging in business, measured in the many hundreds of billion of dollars. And what buyers want is information and access to more and more suppliers and what suppliers want is simply more business from those buyers.

Now we call it internally we are calling it buyer and supplier matching, it's about providing information to buyers so that they can have access to more suppliers and giving suppliers an opportunity to present themselves and gain more business. We think there are some very interesting business models that can come out of allowing Ariba to help match buyers with supplier.

We think business models that will pay a lot more money than perhaps helping them facilitate transactions and reducing cost and that's an area that we working on internally. And I think we will look at that both organically from a product development and we will look at that from a M&A point of view. So that's really in those last two areas, network getting revenue streams associated with matching buyers with suppliers and then pushing our on-demand products down to even smaller companies. That's were you will see our future activity.

Pat Walravens - JMP Securities

Great, that actually leads to my last question which is: what do the prospects look like for partnering with an Oracle or an SAP? And so: you could see an answer in the application side, but they don't really have a network, right? What are the prospects for partnering with someone like that to drive just a much larger volume through the network?

Bob Calderoni

Well, it's certainly something that we think is a big opportunity. Obviously it takes two to tango there. And today Ariba is viewed as a competitor and I think that is what has may be prevented us from capturing more of that opportunity. I think over time we'll see that we are not replacing ERP's we're complementing ERP's and I think that is going to help pave the way to where that potential is realized.

But we're not sitting around waiting for that, we think there is a other good channel partners, we're investing in the channel program, Kevin, recently hired a Vice President of channels, a very experienced industry veteran and has 20 years experience in developing channels for software and technology companies.

We see a lot of opportunity in working with financial service companies, particularly in eInvoicing space a number of the banks are very interested in this area and they are very interested in talking to us. So we don't think its just Oracle and SAP that have the opportunity to get partnership value, there is a number of other companies out there that we can and we're working, we're working both fronts investing in the channel business. Which is new for us, I would say prior to six months ago, we were exclusively a direct sale business and we're looking to change that.

Pat Walravens - JMP Securities

Great, thanks very much guys.

Bob Calderoni

Okay, Pat.

Jim Frankola

Thanks Pat.

Operator

Our next question is from the line of Brad Reback with Oppenheimer.

Brad Reback - Oppenheimer

Hey guys, how are you?

Bob Calderoni

Hi, Brad.

Brad Reback - Oppenheimer

Bob, I think as you had talked about sort of a competitive situation out there taking market share: is that broad based? The big guys: Are you also seeing some of the smaller guys coming under pressure here?

Bob Calderoni

It's broad base, it's both. The interesting thing I try to bring out in my prepared remarks is the shifting sentiment. I will tell you certainly two years ago there was a clear sentiment in the market consolidating around a single system and a single platform inside a company and that was, we weren't losing business, we were prevented from wining business in many accounts because of that.

It's clear that shift is occurring with a number of customers today. Now recognize that, complementing nobody is throwing out their ERP system I am not suggesting that. But they are starting to recognize that doing it with ERP alone just simply is not going to work. They are going to have to complement that particularly in this space and the message of on-demand complementing their ERP system I think is resonating and it's resonating for a number of reasons mostly because; A, they can solve their problems today and they can do it quickly.

I think that's the primary reason. On-demand is clearly lead to a shift in thinking with the number of customers and I think that's gathering some steam and that's the reason why we see 60% growth in our backlog and 40% growth in our revenues, clearly, a different market environment than two years ago.

Brad Reback - Oppenheimer

Great. Thank you very much.

Bob Calderoni

Okay, Brad.

Operator

Our next question comes from the line of Brad Whitt with Broadpoint. Due to our running short on our allotted time we ask that you ask our speakers to only one question. Please proceed Mr. Whitt.

Brad Whitt - Broadpoint

Okay. You can't give me one question now. That's not fair. Let me just get a couple little quickies first Jim: did you give guidance on the cash on the balance sheet for next quarter?

Jim Frankola

Cash should be about a $120 million to $125 million.

Brad Whitt - Broadpoint

Okay so you got the: there is litigation settlement coming out?

Jim Frankola

Yeah that's the big driver for next quarters drop.

Brad Whitt - Broadpoint

Okay, and with that settlement: are you still forecasting $2 million in G&A for litigation expenses?

Jim Frankola

Yes, because we are suing Emptoris, and they, as part of their tactics against us have counter-sued us, so we think litigation is going to be roughly $1.7 million next quarter plus or minus a few $100,000.

Brad Whitt - Broadpoint

That's going to be on going?

Jim Frankola

That now is scheduled to occur in October, so we'll have that in the next two quarters.

Brad Whitt - Broadpoint

Okay and how much revenue I don't know if you gave this, but: how much revenue did you get from Procuri during the quarter?

Jim Frankola

We got about $1 million in Q1 from Procuri in our non-GAAP results, we think Q2 will probably be 6 may be 6.5.

Brad Whitt - Broadpoint

Okay, and that's mostly in the subscription?

Jim Frankola

Yes.

Brad Whitt - Broadpoint

Okay and if I am looking at this backlog correctly this 12 month subscription backlog $80 million, so it's up $15 million sequentially?

Jim Frankola

Yes.

Brad Whitt - Broadpoint

I mean: that's more than you had based almost as much in the last three quarters combined?

Jim Frankola

Yes.

Brad Whitt - Broadpoint

So and that will typically convert to revenue over the next probably by Q3?

Jim Frankola

By definition that will all convert to revenue over the next 12 months, so that will be Q2, Q3, Q4 and Q1.

Brad Whitt - Broadpoint

Right.

Jim Frankola

Okay, thanks that's all I have, thanks.

Bob Calderoni

Let me just add one thing. Piece of that backlog growth this quarter came from the SMP program, we have a big renewal cycle that occurs in November and as Bob mentioned we were successful in restarting that renewal process both in terms of renewal rates and collections and that caused the component of that backlog growth. So with the strong backlog growth quarter of both are organic business and our SMP business.

Brad Whitt - Broadpoint

And Jim you might want to clarify: those backlog numbers do not include any impact from Procuri.

Jim Frankola

Correct. The 65 to 80 is pure organic Ariba.

Operator

(Operator Instruction). Our next question comes from the line of Brian Schwartz with Montgomery & Company.

Brian Schwartz - Montgomery & Company

Great, thank you. Just had a quick questions here Bob: are you seeing any changes in the pricing environment in the mid market, now that Procuri is part of Ariba?

Bob Calderoni

Well, it's only been a month since the transaction closed. So it would be hard to get any read on that at this point of time, but the whole reason for the merger was not about price, its really was about, we thought they had mid market capabilities and we had products that we could drive down into that organization and that's been the focus of it. What's going to happen in the market environment from pricing is plenty of competitors out there, so I don't think its going to change the pricing environment very much.

Brian Schwartz - Montgomery & Company

Okay.

Bob Calderoni

We will really see that the real, a real plus to take our applications to a big group of customers that we just had limited reach there.

Brian Schwartz - Montgomery & Company

Okay, and just a quick follow-up, you mentioned that the financial services vertical was strong this quarter which I thought might be surprising considering the market condition. Are you seeing any softening in that vertical in the backlog or in your pipeline or anything noticed, any noticeable change from the past?

Bob Calderoni

No, the financial services has always been one of our big verticals, continue to be this quarter top three. Look at the pipeline near-term and the mid-term pipeline I don't see any change in that. Again, I think the reason for that is we are driving cost reduction and we are doing it in an on-demand delivery model which enables them to get a cost without having to make very big upfront investments.

So years ago, well, financial services companies might have shut-off their investments even in cost reduction if they had to spend $5 million or $8 million or $10 million just to prime the initiative. With on-demand there is no large upfront and not like that to deal with and so they see the attractiveness of the cost reduction without having to make too big of an upfront investment.

So I don't think it's going to slowdown. If anything, we actually may see a little more business in financial services, particularly in our sourcing services as companies are looking to increase their cost reduction over the next six to nine months.

Jim Frankola

That's right.

Brian Schwartz - Montgomery & Company

Great. Thank you for taking my question.

Operator

Our final question of today, ladies and gentlemen will be from the line of Robert Breza with RBC Capital Markets.

Robert Breza - RBC Capital Markets

Hi, good afternoon. Just real quickly, Jim, can you talk to us about headcount? You said it ended at 1,800. Where you see that at the end of the year and how should that progress?

Jim Frankola

The overall cost model which includes headcount should be relatively stable over the course of this year. So, what we have done is, we've brought on the Procuri employees. Over the course of the year we will make modest changes to our operating model, but basically we have a cost to expense structure that would be relatively stable so that as revenue grows over the course of the year, most of that revenue growth would be able to fall down to profit and cash flow. So I don't expect significant changes in that number.

Robert Breza - RBC Capital Markets

Great, thank you.

Operator

Gentlemen there are no further questions at this time, I'd like to turn the floor back over to management for closing comments.

Bob Calderoni

Hey, thank you very much. Thanks everyone for joining us again. Just a recap as Jim pointed out and I pointed out earlier we are certainly very pleased with the progress we've made over the past several quarters. In fact that Q1 is a continuation of the trend if not an acceleration of some of the positive trends we've seen over the past year. We feel good that we're executing well on all of the major growth initiatives and we have a high degree of confidence. In 2008 we think it should be a very good year for us and continuing to build upon our strength. So we look forward to seeing many of you over the next 90 days and be back again to report on our progress then. Take care.

Operator

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you.

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Source: Ariba Inc. F1Q08 (Qtr End 12/31/07) Earnings Call Transcript
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