Elliott Management and SAP - the background and Elliott playbook

News that activist shareholder/hedge fund Elliott Management took a $1.35 billion investment position in SAPportends significant, long-term and structural changes within the ERP behemoth. In this story, we look at Elliott Management, its background, and playbook.

Background

Elliott Management is an activist shareholder/hedge fund firm that was founded in 1977. They have substantial holdings in a number of companies and approximately $35 billion available for investment purposes. According to the Elliott Managementwebsite:

The firm employs a multi-strategy trading approach that encompasses a broad range of strategies, including, without limitation: distressed securities, equity-oriented, hedge/arbitrage, commodities trading, other debt, portfolio volatility protection, private equity and private credit, and real-estate-related securities.

In 2017, Fortune magazine published a profile of Elliott Managementand its founder Paul Singer. That story is an insightful and instructive analysis that helps explain how firms like Elliott work and specifically the kind of deals Elliott Management pursues. This is a must-read article because it describes a firm that is tough to beat and at the top of its game. Here are a couple of soundbites from that story:

Activists use their ownership stakes in public companies to pressure them to change in order to boost returns—whether by restructuring their businesses, shaking up management, or even putting themselves up for sale. Such shareholder agitation has become more common in recent years as a widening pool of global investors seek a competitive edge. And in that world, the 40-year-old Elliott has emerged as both the largest and most active of activist hedge funds, and one that almost always seems to get its way.

In the past five years, Elliott has launched activist campaigns at more than 50 companies—19 this year alone—in at least a dozen countries. During that span, the battle with Samsung is the only one that went all the way to a vote, and the only one in which the firm didn’t get what it wanted—a sign of just how effective Elliott is at pressuring management to agree to its demands. At the same time, Elliott’s assets have nearly doubled to roughly $39 billion, including $5 billion it raised in a 23-hour span in May, making it more than twice the size of the second-biggest activist hedge fund, Dan Loeb’s Third Point.

In this context, SAP is facing a board-level challenge of the highest level.

When a firm like Elliott makes an investment in a company, it indicates that the investor believes that the target company is underperforming and/or its stock price is not reflective of the real underlying asset value. In these situations, an activist shareholder firm takes an equity position in the target company and tries to insert its own board members. The purpose of this activity is to facilitate a number of changes which include:

• a recapitalization of the company
• a shift in the use of capital (e.g., away from R&D and more to shareholder payouts)
• the use of excess capital for stock repurchases
• the sale or spin out of underperforming assets
• the institution of improved cost controls and/or sales disciplines
• renewed focus on topline growth
• a refocus of planned capital, R&D or other major expenditures

For the leadership of the targeted company, the appearance of an activist shareholder becomes a material consumer of executive time. Pressure is placed on both the board and executive team to develop new financial models, evaluate capital structure options, create numerous and very different budgets and plans. A way to think of this is as operational and financial open heart surgery.

Rarely will the target company management team welcome an activist shareholder no matter what the press releases may state. Executives often find their jobs in jeopardy should they be unable or unwilling to agree to new operating/strategic terms as pressured by the activist shareholders. Again, Fortune tells us:

As Elliott ramps up its activism to an unprecedented scale, it is also accumulating a growing body count of deposed executives—not to mention ousted heads of state—who dared fight it.

Elliott’s management bench is deep and experienced. One of the key people, Jesse Cohn, is also a key player in the SAP effort. He was profiled by Fortune thus:

Cohn’s campaigns have resulted in the takeouts or buyouts of more than a dozen companies, including BMC Software, Informatica, LifeLock and, biggest of all, EMC, which Dell acquired for $67 billion in 2015. “I don’t know if anyone has any more experience than he does prosecuting activist campaigns,” says Chris Young, head of contested situations at Credit Suisse, who has known Cohn since the latter started at Elliott.

Sometimes, management of the affected company will try to meet the activist shareholder part way and then agree to purchase the activist shareholder’s stock holdings at some sort of market premium. These efforts can result in a quick and handsome financial reward for the activist shareholder while serving as a wake-up call for the management of the affected company.

However, in a large number of cases, the activist firm will continue to press for changes that result in more of the target company’s available cash or capital being returned to shareholders, including themselves in the short-term while also trying to drive an enduring increase in the target company’s stock price.

Companies that are no longer growing at an outsized pace or when innovation within that firm/industry has slowed to a crawl, present activist shareholders with the opportunity to begin angling for the target firm to harvest maximum capital and income. In short, when companies underperform in the market, activist shareholders want to scoop up as much of the value the company can generate. It is an exercise in financial engineering that Elliott has successfully deployed on many occasions.

In our mind, the fact that Elliott Management has made a move on SAP signals a material change in the market’s perception of this company as a growth or value generator for its own shareholders. Earlier this week, a reader of the Yahoo finance website saw these financial analyst recommendations regarding SAP stock.

In a research note following SAP's Q1 FY2019 results, Morgan Stanley said:

CEO Bill McDermott highlighted on the 1Q19 conference call that investor feedback post its February CMD had been that SAP needed to deliver on margin expansion - and we'd add capital allocation. However, at our own TMT conference in November 2018, a majority of investors thought SAP should focus on topline growth over margins.

The size and accuracy of such polls is always hard to gauge, but while we'd acknowledge that European investors are broadly more focused on margins/cash flow/capital allocation than their US peers, we think a part of SAP's challenge has been communication and guidance. The company has committed relatively vocally to margin expansion and an end to larger M&A but has then backtracked. We think the investor focus here is as much on the delivery vs. guidance as on the issues per se.

Our soundings elsewhere lead us to believe that financial analysts generally are not impressed with SAP’s bullish future state predictions. Indeed, the conversations we’ve most recently had support the generally confused conclusionsDen recently reached in his assessment of SAP CEO Bill McDermott’s outsized valuation prediction for 2023.

The really Big Picture issues

SAP may be the current Elliott Management target but we see this as a side effect of larger structural changes impacting an old ERP software business. Most ERP products were designed at a time when technology was expensive and heavily constrained. As a result, these solutions embraced a data model that was intentionally tight and limited. These products were never designed for an unconstrained technology world where volumes of data are orders of magnitude greater than those envisaged by the original ERP designers.

The new ERP world needs new leaders who build software solutions that start with big data and not view big data as an incremental bolt on to an old transaction processing system. Old ERP is dying and replacement solutions are desperately needed.

Additionally, vendors that have demonstrated deep capital commitment and operating savvy in a high data volume, rapidly changing world have names like Amazon AWS, Google and Microsoft. The ERP vendors missed critical turns, and even when confronted with the same have chosen to provide small scale incremental capabilities (e.g., IoT connectors) instead of newly rethought, radically reimagined, big data-driven and ML-enabled products.

Given these macro changes, Wall Street is ready to harvest the capital out of old solutions and redeploy it to those firms that are focused on the future and not those that are protecting the past.

Private equity firms have been circling the application software space for years and the number of application software companies with private equity ownership have been steadily growing. If big changes come to SAP, we shouldn’t be surprised. The fact that Elliott Management’s announcement helped push SAP’s stock price to an all-time high is not cause for celebration but a warning about the company's directional focus in the coming months.