SAP has released a third quarter financial statement for 2020 and given a summary of its performance for the last nine months. SAP News has published an overview of the financial statement underlining the double-digit growth in earnings per share and cash flow. SAP also used the occasion to publicise their intent to accelerate the transition to the cloud and achieve a target of “more than €22 billion” in revenue from cloud-based software services by 2025.
Here are some of the key points reported by SAP News:
- Current Cloud Backlog of €6.6 Billion, Up 16% At Constant Currencies
- IFRS Cloud Gross Margin Up 1.8pp; Non-IFRS Cloud Gross Margin Up 0.7pp At Constant Currencies
- IFRS Operating Margin Down 2.2pp; Non-IFRS Operating Margin Up 1.3pp At Constant Currencies On Strong Prior Year Comparison
- IFRS EPS Up 26%; Non-IFRS EPS Up 31%
- Operating Cash Flow Up 54%, Free Cash Flow Up 79% Year-To-Date
- Updates 2020 Outlook and Mid-Term Ambition
- Targeting Significant Expansion of Cloud Revenue to More than €22 Billion, Share of More Predictable Revenue of Approximately 85%, Non-IFRS Cloud Gross Margin of Approximately 80% by 2025
- Targeting Double-Digit Non-IFRS Operating Profit Growth from 2023 to 2025
Elsewhere on SAP News an “Updated Business Outlook” was published which reflects the “muted recovery”. The previous full year 2020 Outlook had been based on economies gradually reopening and population lockdowns easing but current events are forcing a reassessment.
In response to Covid-19 operating cash flow has been raised to about €6 Billion and a free cash flow to €4.5 Billion. This is part of a program of changes and investment designed to mitigate the impact on demand and adjust to customers’ move to the cloud and SAP’s acceleration of cloud delivery.
The updated mid-term ambitions will lead to “muted non-IFRS total revenue growth as well as flat or slightly lower non-IFRS operating profit over the next two years, followed by accelerated non-IFRS total revenue and double-digit non-IFRS operating profit growth from 2023 to 2025.”
Although the new mid-term trajectory will inevitably require a pause in the expansion of SAP as it consolidates its activities and cycles profits into further research and development, it is expected to deliver more than “€22 billion non-IFRS cloud revenue, €36 billion non-IFRS total revenue, €11.5 billion non-IFRS operating profit, [and] A significant expansion of the Company’s more predictable revenue share to approximately 85%.
While SAP’s stock experienced a sharp decline due to an initial overreaction in the stock market after the publication of the financial statement and revised mid-term ambitions, it has been (as of Tuesday 27/10/20) steadily climbing over last 24 hours, from a low of €97.5 to €100. This reflects the trader reaction to the 3rd quarter earnings call for Salesforce this year, which experienced a “seesaw’ as the markets adjusted to new information.
The focus on mid-term (2-5 year) ambitions rather than quarterly profits has pulled SAP out of sync with the markets but they are operating in an expanding market when viewed over the course of five years. The motivation for investors is determined by a shorter timescale than large corporations who must make decisions far ahead of anticipated outcomes. Piloting a company is like steering a large vessel and those on the bridge must have an eye for the horizon. Bad weather in the short term may cause a few passengers to jump ship but this should not be a reason to change course.
Hasso Plattner, chairman and co-founder of SAP bought shares worth €248.5 million yesterday and this may well have caused the markets to rethink the situation. It will take some time to recover the slump, perhaps even two years but as the companies largest shareholder, he stands to make substantial gains. This could be a public statement of confidence intended to influence the market but equally he is best placed to judge SAP’s recovery over the ensuing financial period.
A transcript of the Q3 2020 earnings call, with contributions from SAP CEO Christian Klein and CFO Luka Mucic drew attention to improved operating profits and margins compared with the previous year as well as an honest appraisal of the challenges facing SAP.
Luka Mucic: “…to summarise on Q3; this quarter, we showed tremendous resolve, as we continue to improve operating profit and margin, even against the strongest comparison. Based on a resilient top-line performance, paired with discipline on the cost side. We had high double-digit free cash flow growth, and exceptional earnings per share numbers. All of this and our resilient business model, position us well to emerge stronger out of the crisis and meet our new mid-term ambition.
Christian Klein went on to describe the reasoning and some of the detail behind SAP’s strategy over the next five years:
“This crisis has created … a true catalyst to accelerate their transformation efforts, has put a spotlight on the resiliency, which is more than just about the underlying infrastructure, and it’s move to cloud. It is about changing the way our company wants to adapt to new digital business models and drive automation. Resiliency and sustainable long-term growth and profitability, comes only by transforming the company to the needs of the consumers and employees…all our main solutions will adopt the cloud platform and share one semantical data model, one AI and analytics layer, one common security and authorisation model, and same application business services, such as workflow management. With our cloud platform powered by SAP HANA, processes can be changed, enabling agile workflows. Innovations and extensions can be developed quickly by customers and partners, accessing our open platform, using exactly the same data model and business services, as our own SAP apps.
By accelerating the move into the cloud, we will even further increase the productivity improvements in our cloud delivery operations. We have decided to speed up the modernisation of our cloud-delivery to enable a more resilient and scalable cloud infrastructure. This will require additional investments in the next two years but allow us to largely complete the modernisation in this timeframe and achieve a cloud gross margin of approximately 80% in 2025… For our cloud business, we assume that the negative COVID-19 impact will start to ease in mid-2021.
The increasing customer preference for cloud is ultimately positive for SAP as we are already the second largest enterprise cloud application vendor, and we continue to grow rapidly even amid the COVID-19 crisis. With the journey to the cloud, as previously outlined, we are further addressing this market need, accelerate the cloud transition and tripling our cloud revenue to more than EUR22 billion by 2025. The ambition is based on moving our large on-premise ERP workloads to the cloud, and gaining market share for our leading cloud applications, firmly establishing our platform as the basis for business transformation in the cloud, winning in new markets, increasing our R&D invest to deliver new innovations in the Industry Cloud Business Network for sustainability, strong focus on our customer success to ensure adoption higher than usual, and ultimately lifetime value.”
The financial rationale governing the change in strategy was outlined by Luka Mucic:
“…we’ll be moving large parts of our ERP customer base from on-premise to the cloud, move them out of the upfront software licensing model and into the rateable subscription licensing model, a little bit like other players. For instance, Adobe have done it before, so it will not be as rapid in our case as we are talking about an option for the customers. Why does this make financial sense? That’s the second important point, because we are increasing customer lifetime revenue as we are expanding our role from a software vendor to a cloud provider for a significant part of our portfolio. This means we not only deliver software and support services but also the required IT infrastructure and operational services. But we are effectively expanding our share of wallet.
The potential uplift here is substantial, but even more important is the associated up-selling potential of the Business Technology platform, additional SAP solutions and partner applications developed on top of it. An important thing to keep in mind here is that we do not have to deliver all of that ourselves, but just like today, can also procure required capacities from our strategic partners, bundled and at scale. However, as we all know, there are timing effects because the license model is upfront and a subscription model is rateable.”
So we can see here that the principal change in SAP’s business model is the move from a focus on up-front fees for a software package to a licensing model, and the delay to revenue is in part due to the recycling of revenue to finance product development, and partly due to the fact that SAP will be maintaining the pre-existing provision for customers in order to give them an option to continue with the current model. This will maintain existing market share whilst opening up the new cloud market. Subscription based payment for software products delays the income in the short term but provides a company with long-term predictable income, with a consequent stabilising effect on revenue. The outcome of this strategy is that by 2025 SAP expects cloud revenue to become the primary revenue stream.
The market reaction is in part due to the performance of SAP over the last 9 months: whilst profitable, profits were down. The other aspect of this reaction is a distaste long-term investment over short term profitability. The self-affirming aspect of market behaviour will cause some inertia in the process of changing the perception of SAP’s strategy, but it will turn and the company’s valuation will rise. As the public awareness of cloud services increases, public acceptance of subscription-based cloud services and appetite for stock in these companies among investors will rise along with the cloud.