FreeMarkets Plunges on Disturbing Growth Signal

Forget the good news. Focus on the negative for a minute.

FreeMarkets (FMKT) didn't beat the oh-so-critical "transaction volume" estimate in the fourth quarter, so its stock is getting clobbered. Tuesday morning, shares of the Pittsburgh-based Internet auction services firm plunged $6.69, or 25%, to $20 before rebounding slightly. Lately, it was trading at $21.19.

Yet the company easily beat both the earnings and revenue projections. Monday FreeMarkets announced a loss of $10.4 million, or 27 cents per diluted share, excluding certain items, on revenue of $34.5 million. That was 4 cents better than consensus estimate tracked by First Call/Thomson Financial, and $3.3 million, or about 10%, more in revenue than that $31.2 million analysts had forecast. To top it off, the gross profit margin improved to 49.8%, up from 46.3% during the previous quarter.

All good things, but none of them kept the stock from plunging Tuesday.

The Issue

At issue was the transaction volume, or the value of goods sold over FreeMarkets' auction software. The number came in at $3.5 billion. Analysts, like Edward McCabe at Merrill Lynch, were looking for around $4.2 billion. The actual number was "meaningfully shy" of expectations, McCabe wrote in a report in which he downgraded FreeMarkets to accumulate from buy. (Merrill hasn't done underwriting for FreeMarkets.) Goldman Sachs also downgraded the stock Tuesday, to market outperform from buy. (Goldman underwrote the company's 1999 IPO.)

A FreeMarkets spokeswoman didn't immediately return a call to comment.

McCabe and others got spooked by the shortfall mainly because it's a signal of things to come. In FreeMarkets' business, customers sign contracts based on how much they think they'll spend over FreeMarkets software, and the company gets a percentage of that amount. If the customer ends up spending more than that amount, FreeMarkets can charge it more.

But with slowing growth in transaction volume, it looks like FreeMarkets' piece will become smaller in the quarters ahead, McCabe said.

"Auction volume is a kind of proxy for economic activity, and really of pricing for new and renewing contracts in the future," McCabe said.

Savings

Inside the transaction shortfall of $700 million, though, there was $200 million in additional savings that FreeMarkets delivered to its customers. The company said during the fourth quarter it saved its customers 18%, on average, over what they would have paid for their products otherwise. In the third quarter, the number was 14%.

So in other words, the more FreeMarkets saves for its customers, the less it will show in dollars of transaction volume, because those customers are paying less. For that reason, FreeMarket's stock could be paying the price, in part, for the company doing a better job for customers than expected. But McCabe said he isn't penalizing the company for this part of the shortfall.

"You've got to look at two parts of that shortfall. That $200 million in savings is fine, that's the value of the model to their customers. But it's the slowing in purchasing volume that concerns us," McCabe said.

Softness

He said the company was seeing softness in the automotive and manufacturing industries, a fallout of the slowing economy. He also noted that FreeMarkets signed up only 14 new customers in the quarter, which was just in line with his expectations.

All in all, with the stock trading at 6 times 2001 revenue, McCabe just didn't like the nuances that emerged from Monday's conference call.

"FreeMarkets is executing fairly well in a tough environment. [But] here we are in a slowing economy and demand may be waning for certain of their suppliers' products," McCabe said. "But if you were going to spend $100 and now you're spending $80, FreeMarkets gets the same percentage. The early commitments from customers may not be as high as they were."

FreeMarkets' stock sure wasn't as high as it was, that's for sure. Now, what was the good news?

>To order reprints of this article, click here: Reprints