SAP's Q2 shows core weakness

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Key takeaways

• Core applications showing clearest signs yet of long term decline
• HANA growth not as impressive as expected confirming field reports
• Cloud growth impressive but that includes a large contribution from Ariba
• Free cashflow steady

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SAP's second quarter 2013 results show genuine weakness in the core business for the first time. Results, which were posted this morning showed a decline of seven percent in year over year software sales from €1,059 to €982 million. The company attributes the bulk of this decline to weakness in its Asia Pacific and specifically its China market of seven percent. That cannot be the whole story because Asia Pacific represents a small fraction of whole company revenue.

Back in April and prior to the launch of diginomica, I said:

My initial analysis suggests that SAP’s core ERP, BusinessObjects and Sybase businesses are declining. There was a fall of around six percent in revenue for these core items on a year over year basis. This amounted to some €38 million. In an analyst call, the company attributed this entirely to activities in Asia Pacific.  I have to take SAP at its word but I have been predicting that without a significant refresh, SAP runs out of steam on core ERP by 2017.

It appears that trend is continuing.

Until recently, growth guidance on the top line numbers has consistently been in the 12-14 percent range across the board. In the press release, overall year over year growth of four percent got translated into: "We continued our double-digit growth momentum, we are leading the transformation of the industry, and our market opportunity is bigger than ever. We are gaining market share in a challenging macroeconomic environment, and with the HANA Enterprise Cloud, we are resolute to capture the future as the cloud company."

That should not surprise as SAP's biggest quarters are yet to come.

As expected the company made the most of 206 percent year over year growth in cloud revenue from €52 million to €159 million. However, it should be noted that in the non-IFRS numbers €86 million was attributed to Ariba. Making the same comparison with the previous year, i.e. SuccessFactors plus Business ByDesign and we see growth from €69 million to €97 million. The company continues to hold a full year top line cloud revenue guidance number of around €950 million or more specifically €932 million. That's a few percentage points above last quarter's 'run rate' of around €900 million.

One slight surprise was reported HANA growth. In Q1, SAP reported a tripling of HANA related revenue to €86 million. This time around, the company reported HANA related revenue climbing to €102 million, a 21 percent year over year increase. That's a secular decline on the previous quarter which does not surprise given what I was hearing from the field. Even so, the company continues to maintain full year HANA guidance in the €650 million range.

Bloomberg reports that on a conference call, Werner Brandt, SAP's CFO has abandoned specifics on growth but, as noted above, is confident of maintaining 'double digit growth' for the full year.

More important, SAP is clearly focusing on delivering bottom line results in line with forecast with tight control over costs as its main lever for satisfying market expectations.

The company provided some detail on cash flow:

Operating cash flow was €2.48 billion (2012: €2.40 billion), an increase of 3%. Free cash flow was €2.22 billion (2012: €2.13 billion), an increase of 4%. Free cash flow was 29% of total revenue (2012: 29%). At June 30, 2013, SAP had a total group liquidity of €3.53 billion (December 31, 2012: €2.49 billion), which includes cash and cash equivalents and short term investments. Net liquidity at June 30, 2013 was -€1.49 billion compared to -€2.50 billion at December 31, 2012.

I need to review this in more detail but the fact cash flow is tracking revenue and earnings suggests that contract periods for subscription services are not growing. However, I did notice a jump in year over year deferred revenue from €2.862 billion to €3.125 billion.

Initial verdict

I have a call with the company later today so will flesh out detail on this post at that time.

In the meantime, I continue to take the view that SAP is in the middle of a radical transformation from on-premise, single license to subscription based service player.

The much vaunted notion that SAP can make more money from cloud based services than its competitors is not a done deal. While it certainly has a large installed base into which it can sell cloud services, there are plenty of competitive pressures. It must continue investing in the development of HANA, both as a platform and as the basis for whatever the 'new' Business Suite will look like in 2015-17. That alone puts enormous pressure on cost that is hard to reign back without hurting product. The same goes for its cloud HR efforts. The results show that SAP continues to grow its marketing spend. I find that something of a surprise when there is inbuilt momentum behind most of its lines of business. Again - more detail is needed.

Note: I am only interested in IFRS numbers and take little or no notice of non-GAAP earnings as I consider these a fiction.