Welcome to the Ariba conference call. (Operator Instructions) It is now my pleasure to introduce your host, John Duncan, Director of Corporate Finance and Investor Relations.
Good afternoon and welcome everyone to Ariba’s conference call to discuss the results for the third quarter for 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 CEO; and Jim Frankola our CFO. For those in the call accessing the supplemental presentation please now advance to Slide 2.
Before we begin, I will read our required Safe Harbor statements. 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 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 10Q filed on May 7th, 2008 for the quarter ending March 31st, 2008.
During the course of this call we will reference historical non-GAAP financial measures. Management reviews non-GAAP financial information in evaluation 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 or superior to measures of financial performance prepared in accordance with GAAP. By reconciliation of historical non-GAAP to GAAP financial measures, please see the press release and supplemental analysis on the investor relations section of our website at www.ariba.com, or our form 8K filed this afternoon.
In addition we will reference certain forward-looking non-GAAP financial information including fiscal 2008 and fiscal 2009 revenues, expenses, and net income. We are unable to reconcile this forward-looking non-GAAP information to the corresponding forward-looking GAAP measures because we are unable to estimate without unreasonable efforts certain GAAP revenue and expense items. At this time I would like to turn the call over to Jim Frankola to review the financial highlights for the quarter.
Once again we are pleased with our performance in the quarter. Here are some of the highlights:
Ariba’s Q3 revenue came in ahead of our expectations. Non-GAAP revenue was $86.5 million versus guidance of $83 to $86 million. Non-GAAP EPF came in at the high end for Q3 and was $0.13 for guidance versus guidance of $0.10 to $0.13.
Our strategy for shifting to a volume and velocity business is working. This quarter we saw an increase in the number of transactions we closed. In particular we saw a 48% year-over-year increase in the number of on-demand transactions this quarter as we continue to see strong demand for our prescription software products across all market segments.
Please now refer to Slide 3.
Strong sales in Q3 allowed Ariba to post an increase in subscription software backlog for the fourteenth consecutive quarter. Twelve month backlog is now $107 million, and total subscription software backlog stands at $212 million. Backing up the contribution of the acquired Procuri backlog Ariba’s organic twelve month and total subscription software backlogs year-over-year growth was approximately 60%. Please now refer to Slide 4.
We posted a 76% year-over-year increase in our subscription software revenue, which gives us one of the fastest-growing software businesses today. On an organic basis without the impact of Procuri, subscription software revenues increased 43%.
We had another strong cash flow quarter generating cash flow from operations before the impact of lease loss, Procuri, and restructuring payments of $15 million for the quarter, and $38 million year-to-date. We now expect that we hit the high end of the $50 to $55 million targeted range for cash flow this year. We ended the quarter with $129 million of cash and investments which was at the upper end of our guidance.
Finally, we closed 247 transactions; added 34 new named accounts; and signed 151 on-demand deals, and closed 17 deals over $1 million in size. Now let me turn to more specific financial results for the June quarter.
Total revenues were $85 million for the second quarter of 2008 including a purchase accounting adjustment of approximately $1.4 million against Procuri’s revenue stream. Non-GAAP revenues were $86.5 million and came in ahead of our guidance range. On a GAAP basis subscription and maintenance revenue was $49.3 million; on a non-GAAP basis subscription maintenance was $50.7 million, slightly above our guidance. Non-GAAP software subscription revenues came in at $31.7 million, up 76% year-over-year on a reported basis, or 43% on an organic basis.
Please now see slide 5. In Q3 we recorded $7 million of network software revenue of which $5 million came from the supplier membership program. Given the year-to-date strength of the network business we are now on track to double total network software revenue from $13 million in 2007, to $26 million in 2008. Service and other revenue, including license revenue of $1.5 million came in at $35.7 million, compared to our guidance of $32- $34 million. We also continue to improve our operating margins. Non-GAAP gross margin increased to 63% this quarter and we remain on track to beat our full-year target of approximately 60%. As we previously noted the transformation of our business is driving these margin increases as we continue to see a more favorable mix of higher margin on-demand software revenue.
Looking at expenses, total expenses on a GAAP basis, including cost of revenue, were $89 million. Included in these GAAP results were a $4.9 million charge for the amortization of intangible assets; a $9.6 million charge for stock-based compensation; and a $694,000 credit driven my positive real estate developments. In Q3 we leased a floor of our Sunnyvale campus to E-Frontier and we received favorable news regarding a property tax assessment. Excluding these items non-GAAP expenses were $76 million for the quarter. As a result, GAAP net loss for the quarter was $4 million, or $0.05 per share. On a non-GAAP basis we have positive net income of $11 million, or $0.13 per diluted share. Included in these non-GAAP expenses were $2.3 million of IT related litigation expenses.
Moving to the balance sheet; Cash, cash equivalents, and investments at the end of Q3 were $129 million, which was up $4 million from $125 at the end of Q2. We generated positive cash flow from operations of $8.7 million excluding cash use for restructuring and lease losses cash flow from operations was $15 million. DSO declined to 31 days, down 2 days from the previous quarter. As we did last quarter we are also providing additional color on our cash balances in light of the continued concern regarding credit market conditions.
The $129 million cash balance is comprised of the following; $108 million in cash and equivalents, including $30 million of restricted cash which is invested in bank deposits and AAA money market funds; $21 million which are invested in option rate securities. All of these amounts are in triple AAA rated variable rate debt instruments and are backed by federally guaranteed student loans or commercial debt. These option rate securities are not liquid now, and we have classified them as a long-term asset. Slides 10 thru 15 in the investor slide deck provide additional details on these securities and how we value them.
Finally, in terms of headcount, Ariba ended the March quarter with 1,765 employees, up slightly from 1,744 at the end of March, and by the way that was the headcount at the end of the June quarter. We ended the quarter with 120 quota-carrying sales reps, up 20 from the beginning of the fiscal year, and 3 from the prior quarter.
Now let’s turn to Ariba’s outlook for the September quarter and the rest of fiscal year 08’. We will also be providing you with preliminary guidance for fiscal year 2009. Please see slide 6.
Focusing now on fiscal year 2008, we are updating the guidance we provided on our last earnings call. That is, total non-GAAP revenue is expected to be between $332million and $334 million and non-GAAP EPS is expected to be approximately $0.45. Note we have slightly tightened the revenue range from our previous guidance of $330 to $335 million.
Turning to cash flow outlook, with our strong year-to-date performance on cash flow, we are tracking to the high end of our guidance of $50-55 million of cash flow from operations before lease loss payments, SKII and Procuri related restructuring charges.
Turning to Q4, we expect the following non-GAAP revenue expense and net income performance. We expect total non-GAAP revenue to be in the $86 to $88 million range with subscription and maintenance revenues between $52 and $53 million including roughly $33.5 to $43 million for subscription software and roughly $18.5 million for maintenance. Services and other revenues should be in the $34 to $35 million range. Now that perpetual license revenue is an insignificant portion of Ariba’s revenue mix, I will not provide guidance on a going-forward basis. As a reminder, we will disclose actual performance revenue for the last time on our Q4 earnings conference call next quarter, and then we will no longer provide this metric.
There will be a purchase accounting adjustment of approximately $1 million to Procuri’s revenue stream, thus GAAP revenues are expected to be between $85 and $87 million. With respect to the rest of the P&L we expect total non-GAAP operating costs and expenses to be about $73 million. Contained within this expense are costs of revenues of roughly $31 million; R&D of approximately $10 million. As we continue to integrate Procuri and complete our transition to on-demand we are able to continue to maintain our pace of feature innovations at a lower cost. Sales and marketing expenses of approximately $25(million); G&A o$8.5 which includes roughly $1.5 to $2 million of IP litigation expenses, and a net benefit of approximately $1.5 million from interest income and exchange gains net of taxes. Please note that we have factored in the decline in market rates into our forecast.
On a non-GAAP basis we expect positive income of approximately $13 to $15 million, or roughly $0.15 to $0.18 based on 85 million diluted shares outstanding. In addition we expect to report expenses of $9 million for stock-based compensation; $1.6 million for the amortization of intangible assets; and $7 million for integration related restructuring charges. The bulk of this charge is related to the abandonment of ¾ of a floor at our Sunnyvale campus. As a result we expect to generate a GAAP loss of $4 to $6 million, or a loss of $0.05 to $0.08 per share.
Today we will also be providing preliminary targets for fiscal year 2009. Please note that we have not completed our annual planning process yet, so these estimates are preliminary. We expect to have a more detailed projection to share with you on our October call. Please now see slide 7. The model for 2009 is pretty simple, with the major driver being on-demand growth. We expect growth in subscription software revenue in the range of 32-40%, resulting in roughly $155 million to $165 million of subscription software revenue. Maintenance and perpetual license revenue are expected to decline by a few million dollars, and services are anticipated to be flat to up a few million dollars. Taken together, we expect total revenues in the $365 to $380 million range. I want to note again that these are preliminary numbers. Once we have completed our planning process we will be able to give you a better perspective on 2009, especially as to how it relates to how Jupiter or 9R1 upgrade cycle will impact services revenue.
With respect to non-GAAP costs and expenses we have a cost structure with a high degree of leverage. Most of our expenses should remain relatively flat in absolute dollars as compared to the Q4 run rate plus a few million for inflation, but should decline as a percent of revenue. The exception to this relates to sales and marketing expenses and the operational costs that support the growth in our on-demand business. As our subscription revenue software grows, we expect it to carry incremental sales and marketing expense, and cost and revenue, at a rate similar to our current cost structure. Specifically, the incremental revenue growth will have gross margins of around 80% and incremental sales and marketing expenses of 30% of revenue. We also expect that the net benefit of interest income, exchange gain and taxes will be approximately $750,000 per quarter in fiscal year 09’. As a result non-GAAP operating profit will be approximately 16% and non-GAAP EPS will be around $0.70.
Moving on to slide 8. The leverage associated with the subscription software model extends to cash flow. We anticipate that a Revis cash flow from operations will more than triple to approximately $60 to $62 million in 2009. In addition, we expect that the cash from operations before lease loss payments will be between $80 to $82 million, or roughly 22% of revenue, exceeding the targets we have previously established.
Finally I would like to update our long-term model. Please refer to Slide 9. When we were in the middle of transforming Ariba to an on-demand model we stated that we could achieve a 15% operating margin when we completed the transition. I am proud to say that we expect to get there in Q4 or Q1. Fortunately 15% is not a ceiling for Ariba. As we look ahead over the next few years, we believe that the growth in on-demand will increase overall gross margins to the 65% to 75% range, yielding in operating margins in the 15% to 20% range. 2009 is a good first step in this journey with gross margins in the mid sixties and operating margins starting in the 15% range and gradually increasing through the year.
To recap, it was yet another solid quarter for Ariba. As our financial results demonstrate, we continue to execute well against our strategy. We are more confident tin our outlook today than we were 90 days ago and believe that we have the right solutions to help our customers meet the demands of today’s environment. And with that, let me turn the call over to Bob.
I am also happy to report another strong quarter and continued strong evidence of our successful execution against our business strategy. As you know, our strategy has been to create a fast-growing highly profitable on-demand company and in it’s third quarter I believe we have made significant progress in all of our key metrics. To me the most important measures are growth and profitability, and as you can see from both the results and from Jim’s comments I believe we are doing very well on both fronts.
Q3 we have found that we have hit the growth phase at Ariba and we see signs of growth all around us. Subscription revenues growing 76% this quarter, and our backlog continues to show excellent growth at 81% year-over-year. Yet to me what makes Q3 so significant is that we really hit our stride with our on-demand sales model which is emphasizing volume and velocity. Rather than focusing solely on big deals we have a land and expanse strategy which we believe is necessary to fuel the kind of growth we have recently experienced. This means we need more new deals, more new customers, and Q3 results are very encouraging. We recorded a record high volume of 151 on-demand transactions in the quarter, which is up 48%, including 34 net new name customers which is up 36% year-over-year and the highest in recent times. Our on-demand strategy is to continue to penetrate the new accounts quickly with smaller deals, prove our value, and expand those accounts with additional subscription software and expert services, and oftentimes we find the expansion opportunity is quite significant and has become the source of our big deals.
On a profitability front we are making excellent progress there as well. This quarter we reported a significant increase in non-GAAP earnings-per-share, margins, and cash flows. Our EPS was $0.13, up from $0.09 last quarter and up 60% from the year prior. Driving this margin expansion from 2% in Q1 to 6% in Q2, and now 10% in Q3. This margin growth is driven by the strong margin growth in our high margin subscription revenues and looking forward to next quarter we should see this trend continue, if not accelerate. In addition to higher gross margins next quarter we expect to see the benefits from some of our operational excellence initiatives. In fact, earlier this month, we rolled out a project to balance our R&D resources around the globe which is going to enable us to maintain the innovation pace that we have seen recently, but at a much reduced cost.
As part of our efforts to drive around the clock innovation and to grow our margins, we implemented a restructuring of our engineering organization. A few years ago I mentioned our investment in the engineering center and our center in Bangalore, India. Since then we have proven the efficiency and the effectiveness of this development center, and we have made the decision to shift even more of our engineering to that region. The move will provide us with around the globe development and lower our overall cost structure, and we expect this move to have a positive margin impact beginning here in this fourth quarter. In fact we expect our R&D costs to drop $2 million this quarter, and that combined with our subscription business will yield margins in Q4 of approximately 15%, and with 15% margins in Q4 we are in great position to not only achieve the fiscal year 08’ goal of $0.45, but we are positioned very well going into 2009. All of this is generating good cash flow, and as Jim highlighted earlier we expect to be at or above the high end of our expectations for operating cash flows before lease losses and acquisition costs for fiscal year 2008 and we expect with the trends in our business and the improving margins to generate significant cash flow increases next year, demonstrating our ability to execute on our strategy to drive profitable growth.
Let me get back to our land and expand focus to drive volume and velocity in our business. We have a number of examples of expanded deals this quarter and in aggregates, 70% of our bookings this quarter came from existing customers. One example is Heinz, an existing customer. This quarter we won a multi-year deal which includes our upstream on-demand solutions, spend visibility and sourcing, and in combination with our spend management services this deal represents one of our bigger deals for the quarter. It also reconfirms the unique advantage that we in Ariba have in the marketplace delivering both on-demand technology and expert services to accelerate results. Another similar example is another multi-year deal. This one is an on-demand procure to pay when in this quarter one of the world’s largest publishing companies here in the United States. This was an on-demand sourcing customer that this quarter came back to expand their spend management investment with us to include procure to pay and access to the Ariba supplier network with aggressive targets to put over $600 million of spend through the system and our network on an annual basis.
Let me give you a little color on our geographic mix. This quarter was an excellent quarter for our international business. International growth was very strong in Q3. Fueled by excellent results in both our European business and our Asian business. Two of our larges software and service deals occurred in Asia Pacific, and we also saw 62 software deals in Europe alone, including 14 net new customers in the region. In fact, net new customer acquisition and on-demand wins and pipeline in Europe are at all-time highs and through the first three quarters of 2008 we have added 26 new customers in the region, already out-pacing the net new customer addition in Europe for all of 2007.
For example, one of the largest pharmaceutical companies in France selected our on-demand solutions this quarter to address their spend visibility sourcing and contract management needs. Like many companies they want to drive real spend management improvements, but they lack the budget and the resources, and maybe more importantly the time commitment for a large scale IT project. Ariba on-demand fit the bill nicely and we won the business.
We have also continued to see strong cross-sell into the Procuri base pretty much across the board. For example, we signed our larges spend management deal ever in Europe to a major transportation company that is part of the legacy Procuri customer base. Our sourcing management services team will provide category and sourcing expertise and services on top of the Procuri solutions which the customer has been using for some time.
We also had some cross-sell into Procuri’s mid-market customer base including a multi-year on demand and services deal with JetBlue Airlines. Originally a Procuri customer for on-demand sourcing, JetBlue this quarter doubled down on it’s spend management strategy by subscribing to our entire full suite of solutions including the Ariba supplier network. This swing marks not only the evidence of cross-sell but it also marks continued evidence of the counter cyclical nature of spend management. We have big wins from some of the sectors that have been hardest hit by the current economic environment. In addition to wins in the airline industry we added new business in the financials sector with a very large U.S. financial institution who selected Ariba over a zero cost competitor due to the strength of our solutions, our sourcing expertise, and our expertise in the financial services sector.
We also saw continued success in the auto sector with a win for sourcing services from Dana Corporation, one of the leading tier one auto suppliers. We had additional Q3 wins in the troubled retail sector. For example, Sachs Inc., a long-time Ariba customer using our down stream solutions signed a multi-year subscription to on-demand, sourcing, and contracts. This marks a mind-set change we are seeing in a number of large enterprises beginning with the adoption of on-demand solutions, thanks in large part to improved total cost of ownership, lower risks, more rapid innovation cycles, and I think most importantly, time to savings.
While I will be clear that we are not immune to the long-term effects of the downturn, yet these recent wins and feedback from the customers and prospects that I am meeting with are not pulling back. They are not pulling back from investment spend management software and services, and I and the rest of the team remain very bullish about our near-term prospects and the momentum we have gives us a high degree of confidence in fiscal year 2009 which is already looking to be another really good year for Ariba.
In addition to our market performance Q3 also marks some significant accomplishments in other parts of the organization; first off the strategic channels and alliance program which we began talking about a few quarters ago continued to gain traction this quarter with the addition of three major channel deals with some of the largest financial institutions in the globe.
Citibank is going to private-label the Ariba E-Invoice payment and presentment solution into it’s own offering to deliver enhanced invoice and payment solutions to it’s extensive client base around the globe. The Bank of Montreal will provide a channel for Ariba invoice and the network solutions to it’s large enterprise and public sector and mid-market customer base and Bank of Montreal is also going to use our on-demand sourcing solution internally. And finally we also signed a deal with another large bank here in the United States to sell Ariba invoice and network solutions to their large enterprise and their mid-market plant base.
These are important new relationships for us and a part of our strategy to build volume and velocity in the business. So in closing I feel very good about the momentum we have build over the past few quarters. We are executing well against our strategy, and we have seen a shift in attitudes in the market favoring on-demand solutions that positions Ariba very well for continued high margin growth. 2008 is not yet over, but with the progress we have made to date and the visibility we have in our business we expect that this will prove to be a tremendous year for us, and as you can see we have a number of initiatives in this company, and I am proud of the team that they are executing well on most fronts, from customer acquisition to driving our land and expanse strategy, to signing up new channel partners, to driving efficiencies in our internal operations. This is a team that aims to do a lot and then it executes. I am confident we can finish the year on a high note and go into 2009 with great momentum. This is what has led us to forecast strong profitability for the full year and it has also enabled us to provide targets for 2009 that represents significant improvements over what is already a very good 2008.
Let me talk a little big about the CFO transition that we announced earlier today. Jim Frankola has been my partner as CFO for the past seven years, and I can’t express how valuable he has been to me and how instrumental he has been to the successful transition of our business. I have known Jim for many years; I knew Jim for many years prior to our working together at Ariba, and I can’t think of a better partner. Jim has been there with me in the good times and in the challenging times, and it is rare to have one CFO for seven years and I consider myself quite lucky. The good news is that Jim is going to continue to be my partner and continue to be part of the management team as we take Ariba to the next level. Now is a good time to make this change, the hard part of the transition is behind us and we can bring in someone to lead the finance organization into the next phase of our growth and allow Jim to focus his energy in some new areas and help me drive the growth strategy for the business. So today’s announcement is really about an addition to the team. Ahmed is a guy I have had some prior experience with; in fact I hired him once before about 8 years ago. He is a proven financial executive, he has the intellect, the passion, and the commitment to excel that is a required part to be successful here at Ariba and I am confident that he will take the reins from Jim and continue to support us in our growth and our execution.
Ahmed will be transitioning in over the next few weeks. Jim and I and Ahmed will get out and meet many of you in the coming month or two, and with that let me open the call to your questions.
(Operator Instructions) Your first question comes from Peter Goldmacher - Cowan & Company.
Peter Goldmacher - Cowan & Company-
I would like to hear a little more detail on the supplier networks. Specifically how successful were you in signing up new suppliers? Are suppliers pulling in new buyers? Some more thoughts on incremental ways you are monetizing the network and traction among existing suppliers who have not reached their minimums. Have you seen any of your customers start to transact and get above the minimums so they can actually start paying you?
This was a good quarter on a number of the network metrics. I think we had a record quarter in the number of new suppliers that we enabled and are up to around 175,000 suppliers, and that is up around 10,000 suppliers from last quarter. It was a very good quarter in terms of enabling suppliers. That indicates a number of customers are pushing more and more suppliers and spend to the network. The number of transacting suppliers also went up nicely this quarter. The chargeable suppliers are increasing and the pipeline in terms of the network metrics looks good.
The number of customers that we are working with to enable more suppliers is very strong. We have a couple of very significant go-lives in the next one to two quarters with a couple of very large organizations that could be driving lots of new chargeable suppliers for us. We feel pretty good about that and all the underlying metrics give us confidence. Previously I have said we see 30% in organic growth in our network revenues and I think all the underlying metrics give us confidence that we should be able to see at least a 30% growth in 2009.
On the sell side, that is us selling network solutions to customers, we created a separate sales force for that a couple of quarters ago so we have been building pipeline. Pipeline trends have looked very good and they are now seasoned and we think Q4 is going to be a good quarter for closing a number of new invoice related deals which is tied right into the network strategy. We think things are going pretty well on that front.
Your next question comes from Robert Breza - RBC Capital Markets.
Robert Breza - RBC Capital Markets
If you look at 09’ could you give us some kind of flavor about how we should think of the geographic contribution? Should we expect an increased mix from Europe or how should we think about the regions trending for 09’?
It is too early for me to give that level of insight on it. We are still in the middle of putting our operating plans together. Some of that will come together over the coming month or two. If I just look at most recent trends the European business is looking very good for us. I think the European business had a slower pickup in on-demand. I think they were about a year behind the pickup in our North American business but it seems like they are hitting stride right now and we just had a very good quarter and a record number of net new customers in Europe and the pipeline looks good. Without the plan closing it wouldn’t surprise me if we see a slightly bigger contribution in 09’ from Europe, but we will give more color on that in the next call.
Robert Breza - RBC Capital Markets
When you look at the overall margin structure and the contribution of the on-demand you look at sales efficiencies and looking at the lever, how much more efficiency do you think you have when you hear it is coming up at 15% and raising the goal from 15% to 20%. Clearly you are rating a lot of the efficiencies out. Would you expect as you integrate Procuri and leverage that more, where are you seeing leverage?
The fastest growing part of our business is subscription software. That is a high margin business as Jim pointed out in his model. It has a lot of leverage and should drive gross margins up and our operating margins up and continue to drive them up. We had originally set our bar at 15% and we are now there and we think the next long-term range for us is 15% to 20%. We will make progress on that throughout the year. We probably got more leverage in our business than what we will commit to in 09’ because we are also reinvesting in this business and we are very bullish on our network opportunity. I spoke about it in the last call, the Ariba Discovery business; that is going to take some investment. We think that next year is a year where we have continued good leverage; we reinvest some of that into the business and we let some of it fall to the bottom line as improved margin. Where in that 15% to 20% range will be a balance and I think the guidance Jim gave would suggest 16% to 17%. That is net of investment in the network business. I don’t have details on the size of that investment yet, we are still finalizing those plans. We feel great about the leverage on business that is going to afford us margin expansion and dollars to invest at the same time.
Your next question comes from Analyst for Brad Whitt - Broadpoint Capital.
Analyst for Brad Whitt - Broadpoint Capital
How many of the seven-figure software deals were renewals, and of those renewals how many were Procuri vs. Ariba?
Jim I am going to let you answer the first part of the question because I don’t have the stats on how many were renewals vs. new business. How many were Procuri vs. Ariba? We are not selling any Procuri solutions, so if the question were for Procuri solutions the answer would be “0”. If it was how many went into Procuri accounts then we would have one or two of those big deals would have been into Procuri accounts.
And regarding the four large software deals, one of the four was with a brand new new-name account. Three of the four I would characterize as new sales vs. just a large renewal. So most of those represent either new name accounts or expansion within our current account base.
Your next question comes from Greg McDowell - JMP Securities.
Greg McDowell - JMP Securities
Can you just talk a little bit about how the market has changed since you bought Procuri? In other words, is there less pressure to give excessive discounts in deals, can you talk about that for a minute?
There clearly has been a trend towards customers preferring on-demand solutions. We were in the market and Procuri was in the market. There are others in the market without on-demand solutions. Ever since Ariba and Procuri have come together, if a customer prefers on-demand we oftentimes find ourselves in a very strong competitive position. If a customer is indifferent we are in a strong position again because we have a much lower total cost of ownership. I think that the fact Ariba and Procuri have come together has given us a very strong competitive position because we are offering what the customers want and others out there are promoting yesterday’s architecture and yesterdays delivery model.
Greg McDowell - JMP Securities
Could you give us an update on Citibank and the invoicing stuff, and whether there are other deals like that coming in the pipeline?
Citibank is going to re-sell our E-Invoice Solution. E-Invoice is typically, not exclusively, a decision made by a finance organization oftentimes accounts payable part of the shared services part of the organization of finance. We traditionally have been very well connected with procurement organizations, not finance organizations, so Citibank, Bank of Montreal, and a third bank that we cannot disclose yet all are going to sell our invoice solutions system and the reason we like it is that they already have relationships with the finance organization of every company. And we think that is going to open up a number of doors that would probably have taken us a long time to open given where we are starting from. We are pretty optimistic that that is going to add significantly to our traction in the market, specifically around E-Invoicing in 2009. Citibank should be a big contributor there.
Your next question comes from Anada Namaldi - Deutsche Bank.
Anada Namaldi - Deutsche Bank
Is there any specific verticals where you are seeing specific strengths or weakness?
We see good business pretty much across the board. We have a horizontal solution, we have a lot of history in almost every vertical and we had good results in most verticals, particularly stronger this quarter was CPG retail financial Services and telecom space. We did quite a bit of business in manufacturing, pharmaceutical, and in the auto and transportation sector as well, but it was a little stronger in the first three that I mentioned.
Anada Namaldi - Deutsche Bank
In looking at your preliminary 2009 guidance. Clearly the maintenance [inaudible] is tied to the perpetual licenses which you are modeling going down. But why are services flat?
We modeled services flat at this point because we just came through a product transition on our CD customers and so 2008 was a softer year for services because many of our CD technology has been in the market. We just released a new one. We expect that to generate good pipeline for us next year and it is early in the process right now so we are just forecasting flat, but I will tell you that any of my people in the organization that work in services are listening rest assured your target is not flat for next year.
Your next question comes from Nathan Schneiderman - Roth Capital Partners.
Nathan Schneiderman - Roth Capital Partners
I was just curious on the CFO transition. We are certainly sorry to see Jim leave that role but why did you decide to bring in someone without prior CFO experience, and can you talk about your decision to bring someone in from Avery? You have a number of executives with that background, so why not bring in someone from a different firm and maybe a different set of backgrounds that could be additive?
On the first point when you say someone hasn’t been a CFO you mean a sitting public company CFO. Ahmed’s CFO for a $2 billion + business, so a very large organization but he has not been a CFO at the public role. I would just remind everybody that when I brought Jim into the organization Jim was a CFO of a $2 billion business unit and didn’t have public experience. I don’t see that as a key attribute. I look for people like Jim who have a lot of intellect, a lot of passion, a lot of business acumen. Ahmed fits that bill. I was a public CFO for the first time at one time. Jim was a public CFO for the first time at one time. And now Ahmed will be. I won’t speak for myself, but Jim handled that transition pretty well. I think Ahmed has a good shot. Why Avery?
I knew Jim Frankola before we worked together at Avery Dennison. I brought him into Avery. I brought Ahmed into Avery Dennison so I deal with this more as a group of people who have a proven track record with me. I think of it that way rather than I looked to Avery Dennison for specific individuals or specific experiences. It was really about the individual and I liked the ones before and still like them. That was the thinking there.
Nathan Schneiderman - Roth Capital Partners
And on supplier network fees; about $5 million in Q3. What would you expect that to be in Q4 and in 2009 for the full year?
With respect to Q4 it will be roughly $5 million again. As we head into 2009 we have given our guidance that we expect network revenues including SMP fees to increase by at least 30% on a year-over-year basis.
Nathan Schneiderman - Roth Capital Partners
But no sense as to the actual dollar amount for supplier fees?
I haven’t done the math, but you could take the full year number for 08’ and multiple it by 1.3.
We expect the supplier fees to grow 30% as well. Total network revenues grow 30%; the SMP fee should grow 30%; we will do more detailed planning over the next 30 days but we have a high degree of confidence that with those broad strokes we are going to be at that range.
I was a little confused on one of your charts. It detailed SMP fees and it looked like it dropped from $12 million in Q1 to $10 million in Q2 to $8 million in Q3. I am not sure if I am interpreting that right, or if you could clarify what was going on there?
That is Slide 3, and that describes our backlog. As we have discussed we have our largest set of suppliers renew in the December quarter; which means that the backlog increases dramatically in Q1 and over the course of the year that backlog gets earned down. The backlog converts into revenue and in the December quarter of the subsequent year you are going to see an increase again. Part of the approach in Slide 3 was to start giving more visibility to the 12 month backlog breaking out the contribution from Procuri, from the SMP fee backlog which has that saw-tooth pattern from the application backlog which grows on a more normal sequential quarter for quarter basis.
May I just point out Nate that the chart you were referring to was a backlog chart, not a revenue chart?
Nathan Schneiderman - Roth Capital Partners
Final question on the annual fiscal year 2008 EPS guidance of $0.45. That would imply a $0.16 number for next year and historically you talked about a $0.17 number so I wasn’t sure if there was anything going on maybe beyond being conservative there, or if there are any sort of stepped-up investments that you would highlight or anything else?
We have consistently been saying $0.45 for the year. We haven’t changed anything in that we are just as bullish or more bullish about Q4 than we were ninety days ago. I didn’t hear a specific number for Q4 Jim, is it $0.16 or $0.17?
Yes. And Nate mathematically to achieve $0.45 on the dot would require $0.165 of EPS so our range is $0.15 to $0.18 and most of the consensus is around $0.17. That is the mid-point so to speak.
If you were at $0.16 or $0.17 I would say you were in the range. We are not signaling any softness in our expectations about our pipeline going to this quarter. It is as good or better as it was ninety days ago. Things are looking as good or better at everything we see right now.
Your next question comes from Lauren Ye - JP Morgan.
Lauren Ye - JP Morgan
I wanted to get an update first on on-demand kind of upgrade cycles. I wanted to more understand the strategy there around maybe Procuri if there is some incentive plan going on there to move those customers on to the on-demand product? Or is there still two platforms going on?
Let me talk about the Procuri question. I may have to have you clarify the first question about the operating cycle. On Procuri we have had a number of meetings with our Procuri customers who are still using the Procuri solutions. We have plans in place with all of them to upgrade them to future Ariba solutions. I think that the feedback from customers has been very positive and we weren’t planning on doing any of that until we come out with 10S1 which is our next release of our on-demand solution which is going to be in late winter or early spring. But surprising to us a number of Procuri customers have actually made the decision to switch over to our solutions because they want to expand to other offerings that Procuri didn’t offer. We see things going well there. On track or if anything maybe sooner than later. We have a number of special programs out there in terms of training, adoption and best practices and just trying to drive even more success with those customers. We learned a lot a few years ago the first time we did an acquisition and we have a number of things in place now to give us confidence that we think we got this right on this acquisition. This one seems to be going pretty well from a customer point of view. Certainly going well so far.
Lauren Ye - JP Morgan
To move forward I wanted to understand more the CD upgrade? I think it is in the middle of next year and I wanted to know how that would impact your numbers. Have you put in some assumptions that customers will upgrade and if there is a change in seasonality from these two upgrade cycles that are going on?
Right now we don’t have any plans in place to encourage customers to go from the CD method of delivery to an on-demand method. Most of our CD customers as evidenced by the extremely high renewal rates are delighted with the software; they have heavily customized it; it works extremely well to their needs and not that on-demand would be worse, it is just different. Any change difference is painful. For the foreseeable future and that includes fiscal year 09’ we are definitely not planning for any significant change in our CD customers moving to an on-demand model. With that said, we do see a handful of CD customers go to on-demand. We saw that in 08’ and we will probably see a few more in 09’, but it is not strategic and it is not significant.
I think maybe another way to phrase it would be if there is any meaningful migration in 09’ that would be in addition to any guidance Jim gave on subscription software revenue. We are not planning or expecting any of that. If it does happen it will be an upside. One more thing to note that is for the benefit of our CD customers we have delivered our newest release of CD based software. It is the first new release in three or four years. We call if Jupiter, or 9R1. That was just released in June so we have a very attractive upgrade pack for existing CD customers that if we don’t expect the to move to on-demand we expect them to move to Jupiter At this point the only question is how fast.
Lauren Ye - JP Morgan
Has the contract length this quarter changed from the past quarters where it has been 24-26 months?
This quarter was a little bit shorter, averaging about 23 months this quarter.
Your next question comes from Richard Williams - Cross Research.
Richard Williams - Cross Research
Could you give a little color on the ARS portfolio because we saw that you exited last quarter I believe the position $25 million or so, but not sure what the process was that you used to determine that it made sense to exit rather than to hang onto those securities given their higher yields. Any color that you can offer would be helpful.
We actually did not make a decision there. We had at par value last quarter $27 million of option rate securities and it is now down to $25 million. Two million were redeemed and they were student loans, and what happens is that as students pay back their loans that money goes back to the security holder, which then passes it back to us. We have $2 million of redemptions and the rest of the option rate portfolio essentially stayed static for the quarter.
Richard Williams - Cross Research
And any color on the competitive front? Any new players and along those lines, any new finance partners that you are seeing out there in the marketplace?
On the competitor front things look very good for us. Probably the best way to capture that would be the market for on-demand spend management solutions is estimated to be growing 20% to 25%. We are growing 70 odd %, 50% organically. That suggests to me that we are doing ok on a competitive front there. On an actual deal basis we feel very good about our competitive position. We have breadth of solutions; we have depth of expertise; and we have an on-demand delivery model. We either face large software companies who don’t have an on-demand delivery model, don’t have the depth of expertise in this particular business area so we are vey well-positioned against them, and for those on the other end of the spectrum, the smaller niche companies they don’t have our breadth, they don’t have our expertise in terms of our service capability and many of them lack the on-demand delivery model. I said last quarter of the quarter before that I have never felt better about our competitive positioning. I remain with similar feelings today about that.
There are no further questions in the queue at this time.
Just to wrap up things, a final thank you to Jim for seven years as my partner as CFO. I look forward to working with him going forwarding in the new capacity. I look forward to introducing you to Ahmed over the next couple of quarters and from a business point of view things are looking very strong here. We are far enough into 2008 to know that we are going to close out what will prove to be a very successful 2008 and we are close enough to 2009 to have the confidence to know that 2009 is going to be a very good year on top of an already good 2008. With that, I look forward to interacting with many of you over the next couple of months. Thank you.
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