SAP Q2 – the transition continues as profits weaker than expected

SUMMARY:

SAP is upbeat for the remainder of the year despite on-premises software sales continuing to fall. As you might expect, CEO Bill McDermott was in upbeat mood but pristine execution is critical going forward.

sapphiremcdermott
Bill McDermott, CEO SAP

SAP’s Q2 2014 results for the three months ended 30th June are in. Once again, they represent a mixed bag as SAP continues its transition to becoming a subscription based business.

First the good news. SAP turned in revenue of €241 million in its cloud defined business, up by 52% from the same period last year. As a result, SAP upped its full year cloud revenue number to around €1.05 billion. Now the bad news. The core on-premise software licensing business was down two percent at €957 million from €982 million. Support revenue – essentially the maintenance cash cow – grew five percent to €2.279 billion from €2.177 billion. On the services front, revenue fell a thumping 10% from €744 to €673 million, suggesting that the special projects that SAP keeps to itself are tailing off.

One nasty surprise comes in the shape of a €278 million provision in regard to the seven year old Versata litigation. Here, SAP is in the unfortunate position of having lost a retrial of a patent infringement suit only to have the damages uplifted in a second trial and then lose its appeal against that verdict.

Elsewhere, SAP pruned marketing expense but took a slight hit on re-organization costs. Net-net, and taking Versata into account, SAP operating profits were lower than expected at €698 million from €988 million.



As has become customary, I was able to speak with Bill McDermott only this time in advance of the general analyst briefing call. I raised the following questions:

Why was there no provision re Versata in Q1 when the result of the appeal came in January?

The case was pushed back to the state of Texas in this quarter. We still don’t believe in the merit of the case but had to make provision as soon as it became apparent as has been our custom in similar situations.

Are special project tailing off? That would seem to be the implication from the fall in services revenue?

Services revenue is actually a lagging indicator. So as the industry transitioned into the cloud last year, we think some services are better left to partners. We see a hockey stick for the end of the year as the cloud business continues to pick up. The same is true for the business network. As we sign deals on Ariba, there is a three to six month lag in the hockey stick.

Non IFRS results would suggest cloud business volumes softening in the Americas.

Cloud growth in the Americas has still got a ‘three’ on it – I see Latin America in triple digits. Interestingly, we had to make the biggest change in the Americas to change the mindset internally – that work’s done and we’re pressing ahead.

What percentage of deals are now multi-year?

Typically, we’re seeing five years on HANA Enterprise Cloud. Line of business (such as SuccessFactors) tend to be mid-term three years. Customers see ERP is a long term asset of the business which they prefer to keep on premises or in a private cloud for the time being even though I’d love to have them on subscription.

HANA sales were implied to be up but does that include Suite on HANA?

We still sell HANA as a standalone. One of the biggest areas is omnichannel but you just can’t carve out all the pieces in a sensible manner. Right now I’d say that 25% customers (of the 3,600 announced as on HANA) are live and that will come up to a third as we go on.

We hear there is strong interest in Smart Financials. How about other Suite components?

The vision on run simple is working. I actually think it is simple for other areas like Logistics. The beauty of it is you’re going to see it getting simpler. We’ve made it simple at the core and we can give it to customers in their industry flavor. We just won the largest omni-channel deal in Europe and we beat out Salesforce. The customer said I saw the Salesforce user interface, it is long in the tooth.

Retail and healthcare represent two areas of focus for SAP, how are you seeing demand in those verticals?

In retail, Carlsberg and Georgio Armani as examples, we beat out Salesforce. For personalized medicine, privacy and security are such big issues and should be a customer’s right so they should have the choice to put out their data wherever it is need. Government should not make those choices for them. I think people are dog tired of the mess and not having the choices they need to help keep them alive. That whole dynamic of healthcare is coming together in the cloud. Why shouldn’t you have prescriptions available in the cloud so you don’t have to waste time in the store?

How are recent concerns in Germany over the activities of US agencies on cloud growth in that area.

Germany is on a roll – we’re at an all time peak, SAP was the 12th man on the pitch at the World Cup, that’s really helped. That helps SAP a lot, we look at the cloud we have, it’s the most pristine available. We still give choice. Customers are asking very tough questions around operators in California so I think we’re in very good shape.

Cloud businesses are typically unprofitable and while I notice you reined back marketing expenses in general, I wonder how you will balance the need to market with a lower per quarter revenue model going forward?

We have a core business that grew at eight percent (in software and software related services) which is extremely profitable and that has a strong demand in 27 industries. We have 38 million users in the cloud and we upped the guidance. I see it hitting the hockey stick and in a four year time horizon we will be very profitable, perhaps more so than today. So when you have a mixture (of on-premises and cloud) then you have a very exciting company.

Verdict

  • A typically upbeat Bill McDermott parsing a mixed bag of results with some justification and with the benefit of the World Cup ‘halo’ effect. Lucky SAP? You might think that but one cannot blame them from capitalizing on the opportunity.
  • McDermott’s explanation for the fall in services is plausible given the changes in the overall business model but SAP will have to convince that overall subscription revenues are truly accelerating to outstrip the fall in on-premises sales we have consistently seen in the last couple of years.
  • Assuming McDermott is correct about resetting the mindset in the Americas, we will have to wait for Q3, but more importantly Q4 to better understand the impact of the changes he is bringing to the company. ‘Run Simple’ is certainly a great message but execution needs to be pristine.
  • The fact SAP is mentioning winning against Salesforce with increased regularity should not be a surprise. Despite what many might think, SAP’s CRM assets are extensive and more mature but they have been lacking focus on understanding how to beat out the competition. Given Salesforce recent Philips announcement and its strengthening of the enterprise focused sales bench, it will be interesting to see how SAP fares in presenting and winning the healthcare market.

Disclosure: both SAP and Salesforce are partners at time of writing