Description

What a difference 3 years makes. Ariba Inc, a niche enterprise software maker has fallen from its high of $170 per share in 1999 to a low of $1.35 per share in late 2002.

Today, it sells for about $2.00 per share and $1.30 per share net of cash And it is a far better company today than in 1999 and is likely worth double this price. Here is a quick glance at the numbers. With the pending acquisition of FreeMarkets (FMKT), another software maker in a very similar space, the combined entity is expected to have revenues in the $360m range this year and next year should reach sales of $400m. Their operating margins – and they of course expect some cost structure reductions with this acquisition of FMKT – will likely come in around 8-10% - giving them a net profit of around $35m to $40m in FY 2005. These are not huge margins – as a benchmark, margins in the mid teens low twenties should be attained eventually.

At these prices, Ariba is priced extremely fairly (I think unfairly) and future positive results aren’t factored in much at all. Here is what they do and why I think this area of the software market they compete in has an opportunity to grow significantly – that is, continue to grow – in the coming years.

Company Description:

Ariba Inc. is a leading software company that specializes in designing software for companies to manage and streamline their spending and materials procurement process. Essentially, Ariba is a company that is in the business of driving down internal costs and inefficiencies in materials purchasing for larger companies. Their costomers include some of the largest in the world – Merck, ABB, Diageo and Axa were a few mentioned in the last quarterly announcement. As a long term trend – they make a package of software solutions that meet the serious desire for all companies to lower their costs in a competitive economic environment. Over the shorter term – and certainly since the bubble burst – it has been a tough sell. Ariba has managed through this quite well and have a stronger company today in terms of software and balance sheet to substantially grow in the coming years. The stock price doesn’t reflect any good news.

An Acquisition and a Weak Quarter = Opportunity.

With Ariba recently announcement to acquire another leading software maker in its specialy niche area, FreeMarkets Inc. (Symbol: FMKT), the new company plans cut costs of new software development, to piggyback off of fewer salespeople pitching more solutions and to reduce overhead costs throughout the company. This list includes the usual suspects of “synergy” candidates promised by most acquisitions announcements. In this case, I feel they are real and that Ariba and Freemarkets are better off together than apart. In fact, at the start they expected $25m in cost savings with the combination – they have now increased that figure to $35m.

Last quarter’s announcement by Ariba disappointed analysts a bit – showing there is continued softness in corporate investment projects. In other words, software is still a tough sell and it is expect it to remain that way for some time to come. Still, I feel this company is poised for profit margin expansion, increased sales opportunities and now have a wider solution for companies interested in driving down costs.

It will likely take some time, but downside is limited.
Ariba is an opportunity that has limited downside at these levels. As a combined entity, of the nearly $2 per share in price – about $0.70 per share is net cash. FreeMarkets had substantial cash – and is profitable and the combined company will likely end the next quarter with around $250m in excess cash. They will also have around 370m shares outstanding once the FMKT deal is done. As a profitable company, this cash pile helps to limit the stocks downside – it doesn’t eliminate it – but along with turing a profit next year – it will certainly help a great deal to limit downside. The upside catalysts are somewhat unknown – but if the downside is limited by the above factors– likely only good things can happen to investor’s at this low price.

It is trading at about $1.30 per share net of cash – expected EPS is around 8-10 cents – it trades at around 14x earnings estimates – and has an EV to Sales ratio of only 1.25x. Aside from valuation – a potential buyout buy a larger software company is certainly a possibility. Who? I have no idea – but a much higher price to gain a strong foothold in their specialty niche is quite possible.

Given enough time and the required patience, Ariba is more likely to positively surprise in its integration with FreeMarkets and realize the strengths of working together. I see an EV to Sales ratio of 2.5x as a very reasonable value for a company like Ariba – or about $3.25-$3.50 per share. It traded at nearly $4 prior to this past quarter’s announcement. At $2.00, I think investors will get paid well to wait for good news to happen.

Catalyst

Valuation of 14x est. EPS, 1.25 EV/S, pending acquisition and general negative sentiment.