SAP ditches 2023 'ambition' as Q3 FY2020 signals overall weak demand

Profile picture for user gonzodaddy By Den Howlett October 25, 2020
Summary:
SAP ended Q3 FY2020 unsurprisngly down on estimates and has pushed out its 2023 ambition to 2025. It's not looking good out there.

Much to my surprise, SAP released Q3 FY2020 earnings a good 12 hours earlier than usual, accompanied by a revised outlook. SAP also announced that the earnings call, scheduled for 2pm CET on Monday 26th October will run 90 minutes instead of the usual 60 minutes. Looking at the numbers, there's not as much detail to go on as is usually the case but there's enough to give analysts pause for thought and sharpen up their questions. 

While Q3 FY2020 was not as bad as might have been expected (SAP didn't pre-announce so not surprising), the company revised downward its forecast for the remainder of the year. Again, no surprise albeit market makers will no doubt be disappointed. Depending on which segment you focus upon, the revenue revision is negative in the range €0.1 to €0.7bn. The operating margin is expected to be more or less flat, reflecting a shrinking in staff and marketing costs. The detail is as set out in the table below:

SAP outlook 2020
(by the author)

The previous 2023 ambition has been ditched in favor of a fresh forecast for 2025 with cloud revenue pegged at €22bn from a total of €36bn. The company also said that accelerating customers to the cloud would likely negatively impact gross margin by an additional 4-5% from previous guidance. In coming to this conclusion, SAP believes the impact of COVID-19 has been to effectively push back customer investments in its offerings anywhere between one and two years. 

In the earnings statement, SAP found comfort in presenting a relatively robust quarter, albeit there are some ominous details to report:

SAP Q3 FY2020 highlights
SAP Q3 FY2020 highlights (via SAP earnings release)

Getting into the detail, SAP focused on weakness for Concur, it's T&E offering which it reported as 14% down at €357 million or 10% at constant currency. 

Qualtrics segment revenue was up 22% to €169million year over year (up 28% at constant currencies.)

The overall drift in software license revenue has yet to be fully compensated by cloud revenue, despite the fact SAP reported that 45% of the S/4HANA sales are coming from net new customers and that the total additions for S/4 were 500 (total now 15,100 customers,) and up 20% - YoY. Interestingly, SAP reports 8,100 are live. 

EMEA was reported as chalking up cloud revenue growth up 22% (24% in constant currency.) Germany, the Netherlands and Switzerland were singled out as highlights but we have not yet seen the regional breakdown for euro value numbers. Overall, EMEA recorded sales up 2% (3% in constant currency), suggesting a sharp decline in software license sales. The same was not so great in the Americas where overall software sales and licensing fell 5% while cloud revenue increased a much smaller 4% (9% in constant currency.) APJ saw cloud revenue climb 14% (19% non-IFRS at constant currency) but an overall decline of 1% (up 4% at constant currency.)

My (initial) take

Let's not get too despondent or concerned. Q3 for any software company is often comparatively weak as both vendors and buyers gear up for the final Q4 negotiations. Given SAP had a good quarter in 2019 and the fact that COVID-19 has been with us all for six months, the overall result is likely as good as it gets.

It worries me that it took so long for SAP to capitulate on its 2023 ambition given that as far back as June/July, the company was thinking the pandemic will be with us at least until the end of Q1 2021. I suspect it is now appreciating the extent to which its account control cannot compensate for the lack of ability to invest when customers are in distress. 

SAP will likely make a great deal of noise about its cloud growth but compared with its peers, this looks decidedly anemic. Qualtrics up 22% might look good on paper but in reality, it's only slightly ahead of Medallia, its nearest competitor which reported revenue growth of 21% in September. You would have thought that it could have done better with a strong and effervescent management plus the backing of SAP's large customer portfolio. 

Competitors who are on a different earnings release cycle will paint a fuller picture but the fact remains that SAP isn't cloud competitive in its core S/4HANA offering. I am genuinely surprised that its only real cloud offering, Busines ByDesign doesn't warrant a mention. SuccessFactors, SAP's HR offering ia now pitched as HXM - Human Experience Management - but again, there was a lack of any substantive detail around numbers. Why?

In the earnings release, CEO Christian Klein is quoted as saying:

COVID-19 has created an inflection point for our customers. The move to the cloud combined with a true business transformation has become a must for enterprises, to gain resiliency and position them to emerge stronger out of the crisis. Together with our customers and partners we will co-innovate and reinvent how businesses run in a digital world.

Will they? If so then I'd like to know how that will be achieved given that there has been plenty of criticism of S/4 as little more than a well overdue technical simplification, there is a long way to go as regards industry-specific updates and precious little talk of the much vaunted and promised integration work. Those are questions for the analyst call though I expect those folk will be far more focused on getting into sales specifics rather than concerning themselves about the 'how' of the future. 

I'd like to see analysts press SAP upon the 2025 projection. For me, that is so far into an uncertain future that includes extreme volatility until at least the middle of 2021. While I welcome a pushing back of numbers from 2023, I'd like to know more about the assumptions upon which the €22 billion fall out. I'd also like to know what 2021 Q1 looks like. This is the quarter when maintenance contracts are due for settlement. It's also the time when we expect something of a cash crunch among smaller and mid-sized firms as government pandemic support runs out in certain territories. There are two elements to my question. What is the renewal rate and what is the cash deferral rate? As an aside, it's perhaps worth noting the company upped its free cashflow for 2020 by a healthy €1bn. 

Sales cycles have been disrupted. Unless SAP has come up with a factory approach to implementation we don't know about that could justify the forecast, coupled with a genuine fast-tracking of getting S/4HANA genuinely cloud-capable as opposed to lift and shift, then it is hard to understand the robustness of the current forecast. That last point might be explained by the backtracking on margin expansion. Oh - and SAP was silent on my current pet topic - pricing. 

Depending on what happens during the analyst call, this story will either be updated or a fresh story written.