The last couple years, SAP earnings reports have had that tantalizing/frustrating "pick your own narrative" quality.
- Narrative 1 - A software giant struggles to evolve into a modern SaaS business
- Narrative 2 - A forward-thinking innovator continues a multi-year cloud transformation, bolstered by SaaS acquisitions
You can certainly pick your narrative with SAP's Q1 2019 results, released a couple of weeks before a pivotal Sapphire Now event. Not surprisingly, SAP's latest numbers are impacted by two developments:
- The January 2019 acquisition of Qualtrics (see our most recent Qualtrics analysis).
- The significant and controversial restructuring push.
Following the cloud transformation narrative, upbeat news included:
- SAP reported a 26 percent increase in new cloud bookings for the first quarter at constant currencies.
- SAP announced 324 new cloud bookings for the quarter, an improvement from 245 in Q1 2018, with cloud revenue exceeding €1.5 billion for the first time in a quarter. That's up 45 percent year-on-year.
- In a separate announcement activist investor Elliott Management Corporation disclosed they have taken a 1.2 billion euro stake in SAP (just under 1 percent), stating that SAP has been consistently undervalued relative to revenue growth.
That stake - and glowing endorsement - doesn't come without strings attached. Elliott will surely push their expectations regarding SAP's profit margins compared to other cloud software companies.
SAP billed the results as a stellar start to the year across core and cloud business
If you're wondering about the non-IFRS term, we could squander an article on that alone. But here's SAP's official non-IFRS language (PDF).
On the earnings call, McDermott was similarly upbeat:
Looking at our peer group comparisons, SAP is growing faster than our competitors in the core and in the cloud. The 48% growth in SAP's total cloud revenue is over 22 points faster than Salesforce, which is growing at 26%. This is equivalent to an 80% higher growth rate. And 10 points faster than Workday, which is growing at 37.5%.
As for the restructuring impact, SAP first warned investors in Q4 2018 that the majority of an €886 million restructuring charge would hit in Q1 2019. The impact? Despite SAP's Q1 2019 revenues of €6.09 billion IFRS, up 16 percent year-over-year, SAP reported an operating loss of -€136 million IFRS.
Elliott Management's announced stake in SAP comes in conjunction with other notable news. SAP has also announced a special capital markets day on November 12, 2019, which will provide an opportunity to address progress on continued restructuring and operating margin goals.
Via the eye-catching title, SAP Earnings: Company Pledges Root and Branch Operational Overhaul, CBR online writes:
SAP has pledged further sweeping changes at the German company, intended to “accelerate operational excellence” as it increasingly refocuses on its rapidly growing cloud business.
SAP emphasized this continued restructuring is not expected to include further job cuts on the scale of the 4,000+ layoffs this spring (SAP objects to the term layoffs as some employees were offered the chance to apply for new positions inside SAP, or chose to leave. McDermott has also said SAP intends to hire 5,000 in new cloud roles by the end of 2019).
However, the changes are not insignificant:
The root-and-branch overhaul will be led by a special executive board committee which will “identify, evaluate and execute on operational levers across all functional areas of SAP’s business” SAP said, pledging a focus on “growth, innovation and efficiency”.
What's behind this push? One big factor is clearly SAP's accompanied goal of achieving 75 percent cloud gross margins. SAP's official announcement, Special Capital Markets Day: Operational Excellence, explains that the November capital markets day will detail these new programs and financial goals. One statement jumps out:
SAP’s 2023 ambition will be driven by an organic growth strategy.
That would mark a big change from prior years, with SAP having spent $32 billion on acquisitions since Bill McDermott became (co)CEO in 2010. Bloomberg took something of a skeptical take on SAP's ambitions here, arguing that:
Investors have repeatedly called for SAP to improve the profitability of its cloud operations... the gross profit margin of SAP’s cloud business hit 66 percent in the three months through March. Other cloud-centric companies, such as Salesforce.com Inc. and ServiceNow Inc., enjoy a gross margin of 80 percent or more, though based on slightly different accounting standards.
Bloomberg warns that Elliott's expectations are high:
Elliott is targeting earnings per share of 8.50 euros by the end of the program. Analysts currently forecast EPS of 6.80 euros by then. Even after taking into account the improvements to profitability announced Wednesday, Singer’s goal will likely require significant buybacks, perhaps more than 10 percent of outstanding shares.
Of course, buybacks aren't necessarily a bad thing for stockholders:
Investors already seem to be anticipating improved returns – the stock rose the most since 2008.
Right on cue, while writing this piece, Yahoo Finance alerted me that SAP's stock price had risen to an all-time high of $128.62 per share. More on the good news side for SAP: there is no indication that SAP's notable leadership changes - including the recent departure of cloud chief Rob Enslin to Google Cloud - are impacting investor sentiment.
I don't believe that's true for SAP customers and community members, however. They'll be looking hard at the leadership on display at Sapphire Now, trying to understand how the Qualtrics acquisition fits into a rapid succession of SAP buzzwords on digital transformation, customer experience (C/4HANA) and the so-called "intelligent enterprise." Throw the elusive Leonardo in there too.
These latest earnings announcements fit into McDermott's ambitions to double SAP's market cap by 2023 - an objective Den Howlett analyzed in Bill McDermott's outsized SAP valuation ambition - a Rubicon crossed or a bridge too far?
I find the financial analyst talk frustrating. My experience is that financial analysts tend to place too much faith in next-gen tech (e.g. bullish comments on everything from Leonardo to Data Hub) and less emphasis on customer realities, which may not be clear to them from the numbers. As Howlett wrote:
What concerns me is how McDermott reshapes the business such that his much-vaunted talk of customer empathy is delivered in terms of customer value. That’s both a marketing message and an R&D issue.
I didn't see any comments from Elliott Management about hot button issues like indirect access and the future of SAP software licensing, data access, and application integration. Despite SAP's notable changes in stated licensing and auditing practices, this issue is still something customers care about. DSAG is pushing integration as one of the top issues SAP must tackle. The financial analyst community doesn't seem to understand or factor in what those issues mean.
A prime example is SAP's quoting of 10,900 S/4HANA customers, up 30 percent. But user group data from important voices like DSAG (German-speaking customers) and ASUG (North America) indicate that the number of completed projects S/4HANA projects remains modest. Meanwhile, customers continue to ask hard questions about how to build an S/4HANA business case.
As ASUG CEO Geoff Scott reported, ASUG's 2019 State of the Community survey found:
- 56 percent have plans to move to SAP S/4HANA in the future
- 16 percent have started to move
- 16 percent are live;
- 12 percent have no plans to migrate.
What's holding migrations back? Scott says:
The top reasons customers told us they are waiting 24 or more months are:
- Lack of resources
- Waiting for the product to mature
- Needing a business case to make the move
This is critical information for ASUG and SAP.
DSAG's 2019 survey results indicate a similar pattern:
5 percent aim to migrate this year, and 39 percent plan to in the next three years (+6 percentage points). A further 30 percent want to do it after this period (+10 percentage points). "All but one-quarter of companies have made the decision to migrate," says DSAG's Marco Lenck, highlighting the results. "Despite this, the number of those having actually completed such projects remains stagnant at 3 percent."
Perhaps what accounts for the optimism of Elliott Management Corporation is that only a small minority of SAP ERP customers seem to have definitively ruled out moving to S/4HANA. But if I'm SAP, I find this data concerning.
I personally believe that the next 10,000 S/4HANA customers will be tougher to achieve than the first group, which included early adopters and those in severe IT or database contract pain. I'll pick this topic up with Scott at the ASUG side of the upcoming show.
SAP's acquired cloud products are all competitive in their various areas. Therefore, cloud revenue growth should continue. But SAP's future as a dominant cloud company is dependent on the bulk of its on-premise customers buying into SAP's next-gen platform, and making the S/4HANA move.
Each year they don't move is another year of opportunity for various SaaS competitors to make their case for a different transformation model, usually involving "ring fencing" older ERP systems until they gradually shrivel away as workloads shift to cloud offerings (Third party maintenance providers are more than eager to step in here as well). Infor and Oracle face a different version of the same challenge; I'd argue the jury is still out on all three.
Our team at Sapphire Now will be on the ground digging in - we'll report back on what we learn in Orlando soon enough.