We are lowering our rating on SAP SE (NYSE: SAP). Our downgrade is based not just on one or two weak, COVID-19-affected quarters but rather on management’s warning of multiyear revenue and margin compression as it seeks to transform the company into a cloud service provider. SAP has gotten a late start in its new cloud strategy, and while management may eventually succeed in its ambitious transformation plans, we also expect prolonged pain along the way.
SAP’s primary goal is to enable its enterprise customers to improve their own customers’ experiences through digital transformation. SAP is looking to leverage powerful secular business trends around digital transformation into revenue growth for its platform and applications. This is occurring as enterprise customers increasingly focus on the migration of on-premise workloads to the hyper-scale cloud.
SAP has coupled S4 HANA with a powerful set of business process applications, many of which it acquired and integrated into its platform. SAP’s platform has the ability to deliver cloud-only or hybrid cloud on-premise solutions that appeal to a wide range of enterprise customers. With its latest acquisitions, Callidus and Qualtrics, SAP has bolstered its customer relationship management offerings.
SAP competes with cloud-based competitors like Salesforce and Workday that have capitalized on the efforts of IT departments to get more value from cheaper, scalable cloud solutions and to reduce their reliance on traditional on-premise systems. It is also competing with established incumbents like Oracle. While the cloud business is growing quickly, it still represents a relatively small proportion of total sales.
SAP missed the consensus revenue estimate by 376 million euros but beat the consensus EPS forecast by 0.52 euros due to below-the-line items. The big story was SAP’s lowering of its 2020 guidance for the second time this year. In addition, SAP expects COVID-19 to negatively impact market demand through mid-2021, setting back its medium-term financial targets by 1-2 years. The company lowered 2020 revenue guidance to a new constant-currency range of 27.2-27.8 billion euros from 27.8-28.5 billion euros. It also lowered its pro forma operating profit forecast to 8.1-8.5 billion euros from 8.1-8.7 billion euros. In addition, management offered long-term guidance as the company transitions to a cloud service business model, which SAP expects will depress margins over the next two years.
Pro forma 3Q revenue fell 4% to 6.54 billion euros, decelerating sharply from 13% growth in 3Q19 and 3% growth in 2Q20. Management attributed the revenue deceleration to a slower-than-expected recovery from the COVID-19 business slowdown. SAP’s cloud transactional business has been hard hit by the pandemic, especially its Concur travel and expense management services business. Concur revenue fell 14% in 3Q and management does not expect a ‘meaningful recovery’ in the business for at least the remainder of 2020. As has been typical, Cloud revenue growth of 10%, to almost 2 billion euros, was the primary revenue growth driver in the quarter. In the core software licenses and support segment, pro forma revenue declined 7% (down 4% in constant currency), to 3.56 billion euros as software license revenue fell 23%. Services revenue fell 15% to $992 million. While the operating margin expansion in 3Q was certainly laudable, management also warned that it would pursue new opportunities that could depress margins in the future.
Pro forma EPS attributable to SAP rose 31% to 1.70 euros from 1.30 euros in 3Q19. Earnings benefited from below-the-line items, including a large positive swing in financial income and a large negative swing in income tax expense. The large swing in financial income to 616 million euros in 3Q20 from 42 million euros in 3Q19 came from the company’s limited partnership in venture capital company Sapphire Ventures. The effective tax rate fell to 21.3% from 26% in 3Q19. Including all items, and based on International Financial Reporting Standards (IFRS), SAP reported EPS of 1.32 euros, up from 1.04 euros in 3Q19.
As noted above, SAP updated its medium-term guidance. Aside from the longer-than-expected negative impact of COVID-19 on market demand through mid-2021, SAP is also transitioning to a ratable cloud subscription business model, essentially moving its customer base to the cloud. SAP expects ‘muted’ pro forma revenue growth and flat to slightly lower pro forma operating income through 2022, followed by accelerating revenue and double-digit operating income growth in 2023 and subsequent years. Management is guiding to over 36 billion euros in revenue and 11.5 billion euros in operating income in 2025. Management’s guidance implies a 5% revenue CAGR and 7% operating income CAGR over the next five years.
On July 26, SAP surprised investors by announcing an initial public offering of a minority interest in its Qualtrics subsidiary. SAP completed the acquisition of Qualtrics only 19 months ago in January 2018. The size and timing of the offering are unknown. SAP currently has no plans to completely spin off Qualtrics and intends to remain its majority owner. SAP’s stated objective is to enable Qualtrics to expand into the rapidly growing customer/employee experience market outside of SAP, though Qualtrics will continue to integrate with SAP’s software and cross-sell to SAP’s large installed base. With the IPO, Qualtrics will also be able to pursue its own acquisition strategy and presumably attract/retain high-level talent with its own stock options. Further, at least some of the IPO proceeds will flow back to SAP, which may use them to pursue its own growth strategies, including tuck-in M&A.
We view the Qualtrics IPO announcement as a surprise given that SAP completed its acquisition of the company relatively recently, in January 2019. Qualtrics calls itself an ‘experience management’ platform. It uses a software-as-a-service subscription model that enables enterprise clients to ‘collect, manage and act on experience data.’ This data consists primarily of customer and employee feedback from online surveys, and other information related to customer relationships, employee retention, and ‘brand resonance.’ At the time of the acquisition, SAP believed that Qualtrics had an addressable market of more than $44 billion and was poised for rapid growth. Presumably that addressable market has only expanded since the acquisition.
We could easily criticize SAP’s decision to pursue an IPO less than two years after the acquisition. On the other hand, the IPO may help Qualtrics to take market share and grow more rapidly, which would also benefit SAP as its majority owner. We certainly think that the retention of Qualtrics CEO Ryan Smith and his executive group was probably a major factor in the IPO decision, as their fortunes will now be tied directly to Qualtrics success rather than to the likely slower growth of SAP. Mr. Smith called the IPO decision ‘innovative.’ Well, that is one way to put it. Perhaps another way is to call it a hybrid arrangement that may or may not work and that could easily lead to an eventual full spinoff.
EARNINGS & GROWTH ANALYSIS
SAP is looking to leverage the COVID-19 crisis to accelerate the movement of its on-premise customer base to cloud services, which appear better suited to the new work-from-home paradigm. The cloud backlog rose 16% to 6.6 billion euros in 3Q20. The company’s more mature core software license and support business (52% of total revenue) fell 4%. We note that although the cloud business is cannibalizing the on-premise license business in the near term, it should also provide greater lifetime value for SAP.
We think that SAP rightly sees cloud computing as its future. However, cloud computing is not an end in itself but rather the most efficient way to support SAP’s primary goal of enabling customers to improve their own customers’ experiences through digital transformation and what SAP calls the Intelligent Enterprise. By cloud computing, SAP means both cloud-delivered software services and its business networks based on Ariba. Management has pointed to the Hybris e-commerce platform as a growth engine, and has touted the combination of SuccessFactors and Fieldglass as a differentiated end-to-end solution in workforce management for both regular and temporary employees. However, SAP’s partnership deal with Microsoft and closer SAP/Azure integration could begin to make Azure the preferred provider. SAP made a clear strategic decision to choose the path of running its applications on top of the hyperscale cloud providers rather than competing against them.
SAP’s S4 HANA in-memory computing system business applications suite is central to the company’s go-to-market strategy — with SAP touting integrated applications platforms running off the HANA system. S4 HANA enables customers to improve business processes by making IT simpler, despite the complexity that has come with the data explosion of the last few years. As usual in tech, more computing power leads to lower costs, with SAP claiming that customers lower their total cost of ownership by 30%-50% after HANA adoption. S4 HANA also responds to the revolution in big data analytics, as it was designed for the superfast computing of large amounts of data and is able to give clients real-time insight into their businesses. We believe that SAP showed prescience in its early exploitation of in-memory computing, and note that Oracle and other competitors have now developed their own in-memory computing solutions. SAP is leveraging the HANA computing architecture not just in its core businesses of applications, analytics, and database, but also in the newer growth areas of mobile enterprise and cloud.
SAP launched S/4 HANA in February 2015 and appears to have reached a positive inflection point in sales. The S/4 HANA customer base is now 15,100. This includes 500 additions in 3Q20, with 45% of new S/4 HANA customers new to SAP.
SAP launched C/4 HANA, directed at the customer experience/CRM market, in June 2018. As is typical of SAP software, C/4 HANA does more than provide visibility into the sales function; it also provides end-to-end integration of sales with the supply chain and other back-office functions, with the company’s machine-learning-driven business analytics application, SAP Leonardo, powering the analytics functions. The Qualtrics integration also boosts this solution.
FINANCIAL STRENGTH & DIVIDEND
SAP paid an annual dividend of $1.73 in June 2020. The company has suspended share buybacks for the remainder of 2020.
MANAGEMENT & RISKS
With approximately 45% of the company’s revenue derived from the EMEA region, SAP is highly sensitive to economic conditions in Europe. While technology acquisition budgets often have their own cycle, a general economic retrenchment in Europe could lead businesses to cut spending on new projects. COVID-19 could lead to such a retrenchment as businesses could cut technology spending to husband cash and financial resources.
As more and more IT workloads move to the cloud, this legacy provider of data services is in danger to either losing business to new hyper-scale cloud providers or of having its own cloud services cannibalize its incumbent on-premises business.
SAP’s old management stepped boldly with a string of significant strategic acquisitions including Sybase, SuccessFactors, Ariba, Concur, Callidus, and most recently Qualtrics, though we think the company often paid up for these businesses. New management will have to finish the job of integrating these acquisitions, and drive revenue growth over the next few years. New management has expressed a desire for organic (internal) growth rather than further growth by M&A.
Investors face considerable losses if the company fails to meet expectations. Global demand for enterprise software could weaken as companies in hard hit industries due to the pandemic may seek to cut IT expenses. Also, the company could fail to execute its business plan. Adding complexity to the company’s operations, SAP’s business is seasonal, with the fourth quarter being relatively strong and the first quarter weak. U.S. investors must also accept currency risk; SAP is based in Germany and obtains about 68% of its sales from outside the U.S.
SAP faces increased competition from mature rivals, including Oracle and Microsoft, as well as from smaller, relatively newer upstarts, such as Salesforce.com and Workday.
Based in Walldorf, Germany, SAP has a base of over 440,000 customers worldwide. Products are maintained through product support services and option upgrades.
We are downgrading SAP to HOLD.