SAP Q1 FY2017 touts cloud acceleration, continues long game play

Profile picture for user gonzodaddy By Den Howlett April 24, 2017
Summary:
SAP did OK on its top line and is signaling rapid cloud growth. The bottom line will disappoint but you have to look behind the numbers to understand where SAP is going.

SAP top line numbers
SAP Q1 FY2017

Trawling through SAP Q1 FY2017 earnings statement, it appears the company is setting analyst expectations just about right. Short sellers won't see it that way but heh, SAP has always played the long game, sometimes in defiance of what analysts want to hear.

Concentrating attention on the fast growth in cloud revenue however masks an underlying deterioration in gross margin that falls through to the bottom line after increased sales and marketing costs. This should not surprise for the weakest quarter in the company's financial year. On to selected numbers.

Operating profit was €673 million compared to €813 million year over year, off 17%, despite cloud revenue climbing by 34% to €905 million. That last figure is tantalizingly close to €1 billion, a number SAP must surely be eyeing with anticipation as it conservatively predicts cloud revenue of €3.8-4 billion for the full year.

In a phone conversation this morning, Luka Mucic, SAP's CFO, reminded me that SAP had telegraphed substantial investments across the entire solutions portfolio but acknowledged investments in PaaS that include migrations away from technologies like third party databases would continue to have something of a drag on margins through 2017 but with the goal of stabilizing the cost base for 2018. That suggests margin improvement in 2018 and beyond.

As an aside, Mucic noted that:

Margins in HANA cloud and business applications are now 77%, close to the 80% we have targeted for 2020.

Taken together, Mucic agreed that the revenue mix will not be so much of a drag on margins in 2018.

Playing for the long haul

I was particularly interested in understanding where SAP sees the future of the business model.

In the most recent past, most analysts have taken the view that SAP has concentrated upon protecting its core business in the face of stiff competition from pure play cloud providers - Workday and Salesforce naturally spring to mind, but increasingly from Oracle's 'all in the cloud' push.

But then it didn't go un-noticed that CEO Bill McDermott addressed attendees at the recent Ariba Live event. What does all this mean?

We are not neglecting the assets that we’ve built over the years and it should be beyond doubt that SAP is solid in its core. But if you want to differentiate as a business then you need a truly innovative platform but not in the old clunky way of maintaining things. So now our value proposition goes far beyond classical ERP. We can shift our focus from protecting the core and we are effectively doing so with the business networks and other assets like the omni-channel offering. We can provide references to show it (S/4 HANA) is truly transformative and adaptable in things like having way more freestyle reporting than the old approach.

According to Mucic, this translates into a model that permits value selling rather than the transactional means of sealing say a finance deal. In turn, that moves the sales conversation away from a price sensitive point solution to one where the customer sees value evidenced from customer references. Is it working?

We are not seeing any real price pressure.

Buried in the detail is this number: Share of orders greater than € 5 million based on total software order entry volume (in %) 27%, up from 17% year over year and only a slight decline from 29% sequentially. So deal value isn't under pressure either in those larger contracts.

The top line numbers are certainly good enough, the long game makes sense and the fact SAP added 400 customers in the quarter of which a tad under half were net new speaks for itself. The fact SAP has no plans to make further significant acquisitions suggest the company is comfortable with its trajectory. Put another way:

We have invested significantly to ensure we have that mix right. We have what I call 'happy expenses' coming from the share growth. €1 in share price equals about €20 million in stock based compensation so yes, there are plenty of incentives.

Absent from our discussion was any meaningful reference to topics du jour like machine learning and AI. The closest we got was to a passing reference that SAP views its platform and portfolio as the foundation upon which it can experiment in those areas as customer demand dictates.

Personally I find that refreshing. The tsunami of press releases and claims about all things IoT/AI is worrying and I would be concerned if SAP made too much of these topics beyond its ongoing work around 'smart cities.' Having said that, a number of its core industries like automotive and retail are ramping investments in those areas, so SAP cannot afford to be too laggardly.

My take

Despite the fall in operating profit, SAP had a good enough growth quarter that was well managed in the context of a shifting revenue mix and cost profile. Focusing attention on cloud bookings at +49% is eye catching but a distraction. What matters is not what you book in but what you contract.

Building for the long haul means taking your bumps along the way but then SAP has good explanations for the key figures, including the large uplift in sales and marketing costs - SAP added 7,500 new head over the year and 1,500 in the quarter - many of whom are being brought online for that all important value sales approach. This is important because traditionally, SAP has the best salesforce bar none in the software business. Reshaping that for cloud has to go beyond the value and brand so we will see in Q3/4 how well, the SAP sales academy is working.

Past acquisitions are now playing their part in allowing SAP to flesh out a value proposition it considers unique as it endeavors to move away from the perception of being that back office megalith to one where it enables the whole of business. It's a giant ambition for sure but one which its extraordinarily loyal customer base shows enough signs of buying to make a credible story. We will test that later at SAPPHIRE.

Lurking in the background though are issues around the impact of audit and echoes around the SAP v Diageo case. I had been pre-briefed that Mucic would not field questions on that topic but that I will get an update soon. It leaves open the question - could SAP have produced an even better result if that sour note was not hanging in the air?

Onwards to my next call, which will be with Marcus Schwartz, and who will talk in detail about cloud adoption. That comes later today.