SAP Q2 FY2019 - steady as she goes

SAP Q2 FY2019 results were announced today. And as can be seen from the summary SAP put out in its early morning release, the results were more or less in line with what SAP leadership has been saying over the last few months but as always the devil is in the detail. 

As might be expected, SAP focused on overall cloud revenue growth of 40% but could not hide the fact that license sales declined 5% year over year to €948 million, attributing this to 'trade related macro' factors impacting its Asia region, for which read the ongoing trade tensions between the US and China. Even so, total APJ revenue climbed 8%, the same as reported in EMEA.

One surprise for me was the growth in S/4 HANA, up 29% year over year to 11,500 customers, adding 600 customers in the quarter. SAP declares that:

SAP S/4HANA is at the core of the Intelligent Enterprise. It drives digital transformation and delivers instant business value. SAP offers customers a choice of deployment options including cloud, on-premise and hybrid so they can choose any scenario or combination that is right for them.

SAP reports that net new customers on S/4 runs at about 50%. These numbers indicate to me that the majority of these customers are not moving to SAP's cloud-based version but remains on-premises. 

Included in the company's presentation (PDF) is an extensive set of notes that provide more insight into SAP's results and projected outcome for the year. For example, in this quarter, SAP reported that acquired businesses generated €69 million (IFRS) but had operating losses of €221 million (IFRS.) Total adds for the half-year were €163 million (IFRS) with losses of €429 million (IFRS.) CX acquisitions are said to have generated €3 million in the current quarter and €24 million in the half. 

The impact of the earlier announced layoffs was evident in the detailed reports with R&D in the US notably taking a hit but compensated by expansion in EMEA and APJ. 

Elsewhere in the report, restructuring costs were pegged at €199 million for the quarter, a figure that on its own significantly dragged operating profit down in aggregate by €217 million from €1.044 billion to €827 million year over year, a decline fo 21%. 

In commenting on the results, SAP reiterated past projections with a profit growth outcome for the year of 9.5-12.5% and long term ambitions of total revenue of €35 billion and overall margin expansion of 5% by 2023. SAP also said that it was pleased with the four percent margin expansion in the fast-growing cloud business. 

My take

This is an early analysis and we have yet to hear from SAP leadership on the details, for which there is an investor call slated to start at 1pm BST, (2pm CET.)

The fact that SAP is not changing any of its projected metrics at this time is interesting given recent activist investor news. SAP is still absorbing the impact of restructuring as noted in the company's statement that investors cannot expect to see a significant operating margin improvement much before this time next year. How much that satisfies the market is an open question, some of the answers for which may not come for at least another quarter.

The fact that Germany was called out as a cloud revenue growth stand out has to be something of a relief but is predictable given the extent to which we have seen customers prepared to adopt cloud-based solutions in non-ERP areas as part of transformational change. What we're not seeing however are consistent patterns of adoption. 

There are a few niggling questions in my mind. Services grew 8% year over year but associated costs grew 12%. Why? My understanding is that this segment reflects the special project where SAP embarks on one-off innovations for select customers. Is this part of the business working as well as it could or are we seeing margin compression in S/4 projects?

There has been much speculation about the number of live S/4HANA customers. Today's earning announcement was silent on that topic. The universe of potential S/4 customers is about 35,000 but the reported numbers would suggest to me that S/4 is still proving a relatively difficult sale. As an aside, SIs see S/4 as representing the potential for rich pickings but it's not clear to me whether that's turning up in the number of reported case studies. 

Finally, I was surprised at the relatively small number of reported logos picking up SAP technology and the lack of any detail about deal sizes in any of the reported segments. Perhaps we will hear more, later today. 

Analyst call update

The markets are not liking the SAP Q2 2019 result, with the share price off some 6% at the time of this update.

I sense this is, in part because of the focus on a handful of metrics that financial analysts prefer, rather than fully comprehending the complex interaction between non-operational items that were outlined in the press statement and changes in regulation that, for a company like SAP, tend to have significant one-off impacts.

If that sounds like an excuse then you have to consider this in the context of the much talked about Qualtrics acquisition. On the one hand, CEO McDermott has no choice but to talk about eXperience Management (XM) as a category that SAP is carving out for itself, (with all the potential for incremental organic growth he envisages) underpinned by HANA. On the other hand and despite analyst call bigging up the numbers, there is a concern that not only is SAP's efforts to sell cloud business proving more difficult than expected but that the on-premises business is faltering. And to cap this off, when asked to talk to cross-sell specifics as it relates to Qualitrics, McDermott ducked the the opportunity to put numbers on this element answer. 

Then there is the question of the IaaS business. This has been a failure which SAP is correcting by laying bets across the hyperscalers Microsoft Azure, AWS and Google Cloud. If I've understood SAP's position correctly, the long term savings it gains from data center consolidation Mucic flagged up last year, along with renegotiated hardware maintenance and lower overall operating costs, then SAP should find margin expansion there. the open question is whether the hyperscaler relationships truly open the door to more cloud apps business. 

On the call, both McDermott and CFO Mucic did their best to dispell the negative line of thinking with McDermott emphasizing the 'robustness' of the pipeline and both Adaire Fox-Martin and Jennifer Morgan calling out expectations of strong regional performances for Q3. 

As I noted above, the service revenue cost rise was much higher than the incremental revenue which SAP attributes to growth in the S/4 business. Maybe so but I read that as representing something of a sacrifice to get customers over the S/4 line. 

Interestingly, SAP would not be drawn on the question of what revised capital allocations mean in terms of potential increased debt finance, reserving its position until the November Capital Market Day event. It would be wrong to speculate which way this goes but it is reasonable to assume that discussions with major investors and the Supervisory Board are far from concluded. 

The bottom line? SAP didn't really tell us much that could not have already been anticipated or for which there wasn't a plausible explanation, although I wish they'd been prepared to put out something concrete to cover the deal slippage question in China.