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The Ride Is Over: Sell Ariba Inc. (ARBA)

Tuesday, February 22nd, 2011

Up over 150% over the past year and about 225% over the past 5 years (the S&P500 is up 0% in the past 5 years), Ariba Inc. (ARBA) has given investors a great ride and made them lots of money. Over the past 10 years, ARBA appears as quite a success story and one of the few ‘internet bubble’ companies to survive and reach profitability, on a GAAP accounting basis at least. Looking beyond the reported accounting results, however, reveals that ARBA is not quite as profitable a company as it seems, and its valuation has out-grown its profits by a wide margin – the required combination of factors for making February’s list of most dan­ger­ous stocks.

Making matters worse, ARBA’s competition comes from two of the most successful business software companies in the world: Oracle (ORCL – neutral rating) and SAP AG (SAP – not rated). In particular, ORCL has long been known as a category killer that ruthlessly runs smaller competitors out of business. ARBA’s apparent success may be just enough to catch the attention of ORCL and SAP. And since both ORCL and SAP provide software that helps manage companies’ receivables and payables, they are well-positioned to direct their clients’ payments systems away from ARBA and to another e-commerce system…perhaps, one they have subsidized. Both ORCL and SAP have much deeper pockets than ARBA. Because we also cover ORCL, we know that company’s business model is very strong with an ROIC of over 20% and economic profits of over $4,700mm in its last fiscal year. ORCL is one of very few companies in the world that has generated economic profits every since 1998. They are a formidable competitor.

ARBA, on the other hand, has enjoyed more superficial success. It has never generated economic profits (our model begins in 1999). And over the past 5 years, while showing a rise in accounting profits, the economic earnings trend is more flat with a significant decline during its last fiscal year (2010). Specifically, for fiscal year 2010, ARBA reported an $8mm increase in GAAP earn­ings while eco­nomic earn­ings declined by $10mm (a dif­fer­ence of $18mm or 5% of 2010 revenues).

ARBA’s overstated accounting profits have, in no small part, contributed to the stock’s excessively high valuation: our discounted-cash-flow analysis of the current stock price of around $31 shows ARBA must grow its net operating profit after tax (NOPAT) at over 20% com­pounded annu­ally for at least 25 years. A 25-year growth appre­ci­a­tion period with a 20% com­pound­ing growth rate sets expectations for future cash flow performance quite high. Historical growth rates are much lower.

These high expectations do not compare well to management’s poor capital allocation track record. Since 1999, ARBA’s management has written down $1,721mm in assets, over 300% of reported net assets. Given that management is supposed to create value, not destroy it, writing-down over $3.00 for every $1 on the company’s balance sheet does not bode well for their ability to create shareholder value. Our recent article on Management Failures explains why investors need to beware large asset-write-downs like those incurred by ARBA.

Our report on ARBA, available here, has detailed appendices for you to see how we perform all calculations.

Over­all, the risk/reward of invest­ing in ARBA’s stock looks “very dan­ger­ous” to me. There is lots of down­side risk given the mis­lead­ing earn­ings while there is lit­tle upside reward given the already-rich expec­ta­tions embed­ded in the stock price.

In a business where investors make money by buying stocks with low expectations relative to their future potential, ARBA fits the pro­file of a great stock to short or sell.

Note: Stock pick of the week is updated every Tuesday.

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3 Comments

  1. varadha says:

    Terrific, yet simple analysis. I’ve always been a fan of ROIC as a measure of capital efficiency and believe that no size/growth outperformance can replace the quest for efficiency.

    Sort of like a big gas guzzling v8 that needs ever increasing gallons of fuel to keep its engine running

  2. David says:

    But Angie’s $90 per user acquisition cost is going to go away. That’s what their approach probably is. How would their outlook be if that $90 cost dropped down to a total cost of $3 per user?

  3. David:

    That would be great, but cost per user acquisition is not something that’s very easy for a company to fix. ANGI can slash their marketing budget to the bone, but then they would stop acquiring new members. They would probably lose members in fact, as their membership renewal rate is at ~75% and declining. If they cut marketing expense by ~95% as you seem to be suggesting, ANGI might be able to eke out 1 year of slight profits, but they would start shedding members and losing money very quickly. ANGI’s only hope is to keep its marketing budget high and hope it can reach the scale and brand awareness to be able to sustain its business while scaling back marketing costs enough to turn a profit. The fact that ANGI’s revenue growth is slowing down even as its marketing costs keep increasing makes it very unlikely it will achieve that goal.

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