Earlier today, SAP published its Q1 FY 2016 results (PDF) following the pre-announcement earlier on the month. As I said at the time, the miss was hardly noteworthy, but now we've had the opportunity to get into the detail, it is clear a good chunk of the miss came out of the Americas and from the on-premises business. I am not surprised. It is election year in the US and that always plays havoc with buying decisions especially in the public sector. SAP says that it is not especially concerned because deals that fell out of Q1 are either being signed off in Q2 or have already been completed. In addition, SAP is satisfied that it has enough of a mixed portfolio to overcome any short term market disruption, despite uncertain conditions in Brazil.
For its part, SAP is behaving as though the decline in the on-premises businesses is almost an irrelevance because the presentation concentrates attention onto the cloud metrics. Luka Mucic, CFO has always been convinced that the cloud model for SAP is solid. He likes the predictable nature of cloud revenue (and ongoing maintenance) and also the fact he believes he can get good margins from that business. The results say otherwise for the moment.
For example, cloud subscription and support gross margin is stated as 57.5%, a bump up from 55.3% Y-o-Y while the on-premise business shows a margin of 84.2% compared with 82.8% Y-o-Y. On that basis, SAP has to run 46% faster in terms of annualized cloud deal value to achieve the same gross margin number on a like for like replacement basis. Given that the shortfall in revenue came almost solely from on-premises deals, the best we can say is that SAP is standing still on license growth. Even so, to achieve its stated targets, SAP has to model growth in cloud at much higher levels, hence the push in that part of the portfolio. In conversation with Luka Mucic, he argued that my thesis is too simplistic because there are two principle sets of levers that are ignored.
First, SAP is investing in data center consolidation in what Mucic termed a 'converged infrastructure.' Second, as SAP migrates users away from third party and legacy databases, the unit cost of delivery falls. The savings from these are:
Mid triple digit million euros but we will not realize these all at once and we will see some rebalancing of cost through the investments we are making to improve efficiencies and increase the capacity for cloud operations. But I agree that in the long term we expect to see cloud revenues outpacing the traditional on-premise revenue and at higher margins than you see today. But that is some way off from where we are today.
SAP does not disclose those specific margin predictions but the sense I got is that SAP is carefully managing the cost structure to ensure that it can confidently present overall margin expectations within fairly tight bands. Regardless of general business issues, that's good fiscal prudence for which Mucic should take a lot of credit.
The good news is that despite my reservations, SAP is still modeling for a respectable outcome as follows:
- Full year non-IFRS cloud subscription and support figures of €2.95-3.05 billion (FY 2015, €2.3 billion)
- Full year cloud and software revenue in the region €18.26-18.61 billion (FY 2015, €17.23 billion)
- Operating profit €6.4-6.7 billion (FY2015 €6.35 billion)
Returning to this quarter, SAP must be happy to see EMEA cloud subscriptions climb 49% and to see Germany doing better overall at +8% compared to +6% for the rest of EMEA. But I was concerned to better understand the go live situation for S/4 HANA. Mucic agrees that so far the numbers are relatively small - some 150 out of 3,200 sales - but he believes that as the November 2015 release gains traction we should expect to see an accelerating go live situation. On the question of functional availability, Mucic said:
Apart from a few smaller areas like project management the comparable ERP is in place, I can tell you it is a lot faster and nicer to use and you can see that in our own use of S/4...but we are looking to partners like Accenture to help us build out the industry solutions so that we can accelerate the time to market for our customers. On performance, I can assure you that S/4 HANA has enjoyed double digit growth.
For our part, we will be looking for good S/4 HANA reference cases at SAPPHIRE as evidence that customers are starting to 'get' what S/4 HANA can bring to the table.
One small note in the press release caught my attention. That relates to the portfolio being taken on by Steve Singh, executive board member and the former CEO of the acquired Concur business. Singh now has all the SMB solutions (B1, ByDesign, SAP Anywhere) along with Concur and the Ariba Business Network plus what Mucic described as a 'startup' in healthcare solutions. The hint is that SAP may well break out this segment in future reporting so as to mirror the way SAP manages its lines of business internally.
This is interesting because SAP has a somewhat checkered recent history of serving the SMB and mid-market. Why? Because this is one area where SAP can confidently expect to find greenfield growth that is missing from the large enterprise market.
I will have more to say about this in my pre-SAPPHIRE preview.
SAP's transformation to a cloud company is far from over. There are many years of on-premise and hybrid deployments in front of it. The fact that 69% of revenue is now in what Mucic calls a 'predictable' bucket provides him with a solid base with which to manage the P&L such that the market doesn't get too many surprises. This is smart thinking for a company that continues to transition its business.
I remain concerned that despite the sales number, users have yet to buy into S/4 HANA in large numbers and I still think there will be a downward tipping point for the on-premise business that may require SAP to rethink. Whether that happens in 2016 is an open question but right now, SAP seems confident enough for me to hold off from being too dogmatic.
The fact SAP is considering a new reporting line for Singh's portfolio should tell you that SAP is taking SMB seriously and that the anticipated revenues from those sources are not insubstantial. I look forward to digging into these elements in the coming months.