Description

ARI Networks is a high-quality business run by a high-quality CEO with a history of building and selling exactly this type of business. The stock trades at an absolute and relative discount due to its smaller size and “forced” selling by a large shareholder, both of which will dissipate in the near-term. In the meantime, we own a growing business that generates 90%+ high-margin subscription revenue, dominates its core space, generates cash, and has dramatically expanded its addressable market. A sum-of-the-parts analysis suggests that one of ARI’s segments by itself is worth more than the consolidated business, implying investors are being paid to own the remaining profitable and/or growth segments. Coupled with a more confident consumer and lower gas prices (important for downstream customers), we think an investment in ARIS is attractive. We believe ARI's shares are worth $7, roughly 120% above today's price. [Note: mitc567 wrote a solid report on ARI about a year ago. See that writeup for more detail]

The Company

eCatalog (36% of revenue)

Roy Olivier, ARI’s CEO and 5% owner, has been in the eCatalog (eCat) space for over 20 years. Roy founded Media Solutions International in 1993 to provide eCatalogs for technical documentation in the areas of automotive and industrial equipment. Roy sold the business to ProQuest in 2000 and joined as its VP of sales. When ProQuest was sold to SnapOn, Roy joined ARI as VP of sales, and was appointed CEO in 2008.

ARI‘s core eCatalog business provides hosted software that helps dealers, OEMs, and distributors in targeted markets operate their businesses. ARI’s is the largest repository of proprietary data (OEM and aftermarket) in its core markets and commands leading share. Key verticals for ARI’s eCat offerings are Powersports, Marine, and Outdoor Power Equipment; hence the loose correlation to consumer strength and fuel prices. ARI’s US market share among Marine dealers is close to 100%, Powersports nearly 90%, and Outdoor Power 37%.

The average dealer carries numerous OEM brands and ARI is likely to have data for all of them. The normalization and enhancement that ARI performs on data from over 1,500 OEMs are highly value-additive and serve as a barrier to entry, especially among multi-line dealers. For instance, Home Depot is an ARI customer for Outdoor Power (HD is a ~$20k/month customer). Home Depot carries dozens of brands of outdoor power equipment for which customers need maintenance, repair, and replacement parts. If a customer brings in a piece of a lawnmower, ARI’s software allows for quick lookup, locate, and order. Home Depot tried to build this solution internally but were referred to ARI from the OEMs. Further, due to standardization, ARI can display all parts that can fit for a certain application. An example here would be Harley Davidson, 80% of whose dealers run ARI’s software. ARI has Harley data going back to the 1940s. If a customer walks in and needs a part, ARI’s software has all of the related technical engineering, can lookup by VIN, and display all parts that can serve as a replacement; both OEM and aftermarket and in the matching color if applicable. ARI also powers motorcycle and fitment data at online channels including Ebay and Amazon.

Given the proprietary nature of ARI’s data, and the fact that they’re really the only ones that have the data, the eCatalog business is sticky. eCat is subscription-based with some upside on transaction volumes and boasts high margins. For just under $120 average per month per dealer, ARI can begin feeding data at the flip of a switch and the expense is minimal and easily justified by the benefits. While management doesn’t report EBITDA for the eCat segment, they’re quick to point to fiscal 2011 and 2012 during which ARIS was more of a pure-play eCat provider. Average EBITDA margin across 2011 and 2012 was 22%, which still includes some website (see discussion below). If we apply a 22% EBITDA margin to ARI’s reported eCat revenue, we get $3m of EBITDA. Melting ice-cubes trade for 5-7x EBITDA in this environment and CDK Global, ADP’s 2014 spin-off of its automotive workflow/MRO software business, trades at 20x. Having said that, we think 7x for a stable niche leader is fair for ARI’s eCat business, which would value it at $21m, or $1.23 per share. Note that ARI does have some capitalized R&D, but per management it is primarily tied to growth segments and so an EV/EBITDA on eCatalog is appropriate.

Website (50% of revenue)

ARI leveraged its relationships with OEMs, eCatalog installed base, and proprietary data to migrate into dealer website design, maintenance, and hosting. ARI’s websites aren’t static properties, rather they’re managed turnkey platforms integrated with inventory, accounting, and eCommerce systems. Switching costs are high.

Although ARI got into the website design business with the acquisition of VertX Commerce in 2003, it remained a small and mostly project-oriented business. For example, ARI’s subsidiaries worked on an hourly basis to build the eHarmony website. When Roy took the helm, he phased out the lumpy project business and steered the segment toward web development that was relevant to ARI. The Company made a couple of small tuck-ins, but it wasn’t until the acquisition of 50 Below nearly quadrupled ARI’s customer base that websites became a major contributor.

50 Below was bought out of bankruptcy for pennies on the dollar. Management was attracted to the nearly $9m of recurring revenue they could scoop up for the $5m purchase price, and were willing to undergo the agony associated with fixing the business including depressed consolidated margins and significant management bandwidth. Roy showed his mettle however, by cleaning up the business and taking consolidated margins back to the mid/high-teens. Management then began looking for additional website acquisitions, which culminated in the purchase of TCS Technologies, a provider of websites to the automotive wheel and tire customers. The TCS acquisition solidified ARI’s competitive position in wheel and tire, a vertical with 18k dealers, of which ARI now how 3k. Today ARI has more than 7k website customers across all verticals paying an average of $230 per month.

Management expects the website segment vertical to grow as high as 20% as ARI pursues new/underpenetrated verticals. Aside from the significant runway in Wheel & Tire, ARI has expanded into:

Home Medical Equipment (HME): When ARI purchased 50 Below, there was a small effort within that business to build a Home Medical Equipment Business, or HME. Once under the ARI umbrella, management took a look at the opportunity and decided it had all the characteristics of a business that could benefit from ARI’s expertise: 1) products with complex requirements requiring maintenance, repair, and replacement; 2) large base of disparate manufacturers; 3) complicated distribution with thousands of small dealers likely to be independently owned. ARI estimates there to be 25k potential dealer customers for catalog-driven websites and has invested significantly in catalog content and marketing / trade shows.

Aftermarket Automotive: on its most recent call, in commentary during its most recent equity raise at $3, and cryptically in its recently updated investor presentation, ARIS indicated its  intention to enter the aftermarket automotive space. With 80k US dealers, this vertical is nearly double the size of ARI’s already expanded opportunity. ARI sold 1.5m shares at $3 to provide ammunition for an acquisition here. [Note, the acquisition of DCi was announced today as I was writing this report]

We expect ARI’s website business to continue to grow both organically and via acquisition at a rate of between 10-20%. On the low end of the valuation spectrum, ARI bought TCS for 2.0x sales. Web.com, a generalist website resource for small businesses has declining revenue and trades for 3.2x sales. Wix.com is growing nicely and trades for 5.5x sales. Given ARI’s solid competitive positioning, expanded market opportunity, and organic and acquisitive growth, I think a multiple within the range is fair. Applied to 2016 revenue, the average multiple of the above values ARI’s Website segment at $103m, or $6.00 per share. At this price, one is effectively paid to own the eCatalog segment and several other businesses and salient opportunities (described below).

Additional Growth Drivers

Point of Sale Solutions: The acquisition of TCS brought with it a Point of Sale solution installed in 1,200 acquired wheel & tire customers. The POS technology represents an additional high value solution that ARI can cross-sell to verticals outside of wheel & tire, With nearly 20k dealers in its core and growth verticals that are entirely unpenetrated (not to mention aftermarket automotive), POS represents meaningful potential upside.

Digital Marketing: This is a small business for ARI representing sub-5% of revenue. Nonetheless, this is a large opportunity. ARI’s customers are paying it to build/host/maintain their websites, yet to date have spent very little to optimize the sites’ performance and drive traffic. As website marketing spend can often times eclipse the buildout and hosting, this is a significant opportunity. Conversations with management indicate that digital marketing is a priority for them.

Valuation

ARI’s stock has been under pressure over the past several months largely as a result of the TCS acquisition. While the acquisition has proven more successful than management had initially anticipated, conflicts of interest with TCS’ point of sale business forced Dwight Mamanteo to step down from ARI’s board. Mamanteo is the PM of Wynnefield Capital, which was a >10% holder of ARIS. Wynnefield also owns 25% of MAMS, and Mamanteo has been on its board since 2007. TCS’ POS system overlaps with MAMS and its customer base. Thus, Mamanteo stepped down from ARI’s board Wynnefield began selling its shares to get below affiliate status. When ARI began vocalizing its intent to more formally enter the aftermarket automotive space (i.e. directly compete with MAMS), shares came under even more pressure. In the last three quarters, Wynnefield has sold more than 1 million shares of a stock that trades less than 15k shares per day, which would effectively be 100% of the volume for an entire quarter! There is light at the end of the tunnel, however: Wynnefield has sold its ownership down to ~4% of the company and Jones Trading has been reaching out to a number of funds, we conjecture to place Wynnefield’s remaining shares.

Meanwhile, the usual micro-cap, sub $5 arguments are likely at play, but as ARIS pops above the $50m revenue mark, which we expect will be soon, we think that more investors may begin paying attention. To that end, ARIS announced the acquisition of DCi this morning, which management expects will add $4m of revenue. Organic growth together with recently announced acquisitions will likely put ARIS at $51m of revenue in 2016.

On a sum of the parts basis, we estimate that ARIS is conservatively worth $7.00, representing 120% upside:

Website Segment: We model $21.3m of sales in 2015, representing 26% growth over 2014. For 2016 (June FYE), we model 15% organic growth and add $5m for the recent Tasco acquisition and today’s DCi announcement. The result is $29.5m of revenue in 2016 for the Website segment. At a 3x multiple, the value would be $103m, or $6.01 per share.

eCatalog Segment: We model $13.8m of revenue in 2016, flat relative to 2015. If we apply the 7x EBITDA multiple discussed above, we arrive at a value of $21m, or $1.23 per share.

Digital / Other Segments: Lead Management and Digital Marketing are running at $1.2m each, while the miscellaneous revenue is on a $3.1m run rate. If we hold Lead Management and Other constant (i.e. $4.3m), and assume progress on the Digital Marketing front bringing revenue from $1.2m to $3.0m in 2016, we arrive at aggregate revenue of $7.3m for this bucket. Simply putting a 1x multiple on this results in $0.42 per share. Back out $0.63 per share for net debt (pro forma for the recent equity raise and today’s DCi acquisition), and we’re at $7.03 per share based on 17.2m fully-diluted shares.

Meanwhile, we think consolidated ARIS will generate $8.5m of EBITDA in 2016, implying a 14x EBITDA multiple at our target price. This is coincidentally in line with MAMS’ multiple, which is a smaller company with declining sales and lower margins.

Risks

The largest concern is churn, which is a drag on organic revenue and ticked up slightly in F3Q15 (Mar). Management attributes the uptick to a manufacturer that had directly contracted with ARI for multiple dealer licenses putting the responsibility on the dealers to go direct. This will take a few quarters to burn off and will impact the churn over that timeframe. To improve churn rates, management is: 1)  moving personnel into customer retention from other parts of the organization (i.e. no incremental expense); 2) articulating product roadmap to customers and accelerating development. Management has already released new software enhancements in May and June, and they’re anticipating August and September releases as well.

Catalyst

Near-term - Major shareholder selling to abate once they run out of shares to sell or get to a low enough level that conflicts of interest become a non-issue.

F2Q16 (Dec) - Full quarter of Tasco + DCi contribution

FY16 (Jun) - Achieve $50m of revenue with improving margins. Potential for further acquisitions once recent M&A is digested.