Last weekend, SAP's CEO Bill McDermott was quoted by Reuters as saying that he is looking to double SAP's current market cap to achieve a valuation of €250-300 billion by 2023. When I saw the headlines I was left head scratching. I wasn't alone. The market was unimpressed, marking the company down a smidge to around €120 billion. What's going on here and why, as a buyer should you care?
McDermott has been stressing the cloud part of SAP's business for a while and has made similar bullish statements in the past. At the last capital markets day, for example, he was careful to emphasize that SAP is a growth company and, as a consequence, he wants to see the firm getting valuations that reflect that narrative. Right now, the market is finding it difficult to figure out whether the stated ambition is realistic.
While it is part of a CEOs job to market the stock and its underlying valuation assumptions, I can't find anyone who comes to the same conclusion as McDermott except in the most optimistic of circumstances that might also cause buyers to wince. I spoke with a senior investment analyst who thinks that what McDermott is really trying to do is get the market to value SAP across two vectors - the S/4HANA business (as mostly on-premises in revenue terms) at something akin to existing valuation metrics while at the same time rateably recognizing the acquired and developed cloud revenues at a much higher multiple. Even taking those together, the numbers don't stack up without another or more aggressive and big acquisition. SAP has not signaled any intention of taking such an action.
The question then comes - what might SAP choose to acquire given that it already has a burgeoning cloud-based but motley assortment of front-facing applications? No one I speak with can readily think of suitable candidates although there could be a bunch of related tuck-in additions. And even if SAP can, the likely cost of acquiring rocketship growth is...expensive. While SAP throws off plenty of cash, it would need to be much more aggressive in ramping existing margins. Current estimates I've seen suggest those will move up 10% from current levels by 2023. That's not enough to move the needle as far as McDermott would like in order to achieve the enterprise value he's talking about. Of greater concern though is how any price ramps would impact customer sentiment.
I don't believe there's much wiggle room here. The ongoing indirect access story which while it has died down has certainly not gone away left many buyers hesitant to increase investments with SAP. Will they pay a premium for the newer C/4 'stuff?' Even where customers are prepared to make investments, their understanding of C/4 is spotty and as for McDermott's latest mot du jour XO (that's experience and operational data types to you and me) - well you can forget that one. So what else could the company do?
McDermott says that he's putting every part of the business under the proverbial spotlight and yes, we already see evidence of that in the current round of layoffs, designed to achieve a leaner operation. Say what you want, and plenty has, like any large company, achieving optimal operational performance is a delicate balancing act between ensuring you have the right mix of resources to achieve goals while at the same time running like a well-oiled machine. Inevitably, a degree of bloat creeps in and has to be constantly guarded against. But 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.
The integration nemesis
The problem SAP faces is that despite its best efforts, there isn't another R/3 on the horizon that can act as the killer app to conquer the world. Some trade analysts argue that SAP's rich, deep portfolio works to help both customers and in turn SAP. Maybe. But then SAP is faced with another problem - integration.
As readers know, SAP differentiated itself by saying that when correctly assembled, its ERP system offered an integrated process approach. This was (and remains) an attractive proposition for buyers - when it works. The latest martech slides tell a different story. Now it looks like customers have a best in class integrated (sort of) ERP suite alongside a bunch of best of breed apps.
In February, Holger Mueller described the situation elegantly when he laid out how the then triumvirate of Muller, Klein, and Enslin would likely operate. A point he made that many appear to have ignored:
He [Klein] and the development organization have to make the Intelligent Enterprise real, SAP's big news from Sapphire 2018. No easy task, since I largely contribute the departure of Leukert to the lack of resources dedicated to S/4HANA. SAP realized in spring of last year that it cannot deliver on the SAP S/4 value proposition – which was R/3: The integrated end to end ERP+ suite. It was taking Leukert and team too long, Salesforce was gaining, C/4HANA was created. All this is history – but it does not make Klein's job easier. S/4HANA will likely be the SAP Finance system, everything more is on the test stand.
Since then, Rob Enslin has joined a procession of high profile and experienced leaders out of SAP's door (albeit for unrelated and different reasons) and that, once again, opens up the debate as to whether SAP still has the R&D chops to get the integration work done. I was reminded that it took Oracle 10 years - SAP has barely started. In those circumstances, I can certainly see AEs opening up a smorgasbord of solution options - perhaps under the guise of Leonardo - but when it comes to the technical evaluation crunch, what will the integration story look like?
You can argue that it doesn't matter so much because we currently live in a world where the expanse of choices inevitably means that integration is an afterthought at best. But it does raise an important question. I'm with HfS which most recently said:
The biggest problem with enterprise operations today is the simple fact that most firms still run most of their processes exactly the same way as they did 20/30/40 years ago, with the only “innovation” being models like offshore outsourcing and shared service centers, cloud and digital technologies enabling those same processes to be conducted steadily faster and cheaper. However, fundamental changes have not been made to intrinsic business processes – most companies still operate with their major functions such as customer service, marketing, finance, HR and supply chain operating in individual silos, with IT operating as a non-strategic vehicle to maintain the status quo and keep the lights on.
Contrary to what others think, this is NOT an endorsement for the customer to go out and spend oodles of cash on SIs. Quite the opposite. It's a call to rethink business models, the required processes and resources that go behind that evaluation. In that context, HfS analysis is aligned with Brian Sommer's exhortation to do Digital with Impact.
SAP would likely go along with that premise but when you look at the portfolio of solutions, it is hard to imagine how that works out unless SAP goes down a road that looks an awful lot like bespoke development at premium prices. Isn't that where an SI normally fits in?
Having crunched a bunch of numbers and taken soundings from a variety of sources I still come back to the central question - if McDermott is to deliver on his bullish rhetoric how will the underlying technology play get him there? It's really a problem of scale. Competitors get outsized valuations in part because they can post eye-catching growth numbers well into double-digit range. That's not so easy for a business already guiding at €35bn p.a. and where even 10% would be pretty darned good. But 10% doesn't get to where McDermott is aiming.
Short of a compelling and hugely ambitious acquisition story, or in the alternative aggressive pricing and margin management, the numbers don't add up. The range I've seen is about €20bn short of what I think is doable in favorable circumstances and comes in at roughly €170bn. €200bn at best? By any measure, that's a long way short of €250-300bn. But then as I have often said, betting against SAP is not something I'd do with any degree of conviction. They've defied gravity before.