Veteran software tools vendor Software AG reported Q4 FY2020 earnings earlier this week, capping a year that's seen encouraging progress amidst a challenging landscape. The uncertainties of the pandemic have struck midway through a multi-year transformation journey for the company, which also faced a nervous few weeks in the fall in the wake of a malware attack. To its credit, this 51-year-old software company has ended the year with its transformation goals on track, and investors responded positively to the results.
The results give an opportunity to review the successes and challenges the year has brought. In comments to financial analysts, CEO Sanjay Brahmawar spoke about Software AG's progress in building up revenue from its digital business products, potential M&A targets, development of its partner channel, and the ongoing transition from a traditional on-premise licensing business model to recurring revenues from subscriptions and SaaS.
As we've seen with many other enterprise software companies, this transition is not without financial pain. Even with strong bookings growth across all product lines, the shift to recurring revenue defers the impact of those bookings. Total revenue for 2020 came in slightly down on the previous year, although at the top end of guidance. A quick round-up of the numbers:
- Q4 product revenue was €201.0 million, 3.3% down on the same quarter a year ago. FY2020 revenue was €671.1 million, down 1.6% on last year.
- Total Q4 revenue came to €237.8 million, down 1.6%, while FY2020 revenue totaled €834.8 million, down 3.8%, affected by the disposal of the company's Spanish professional services business.
- FY2020 operating profit margin (non-IFRS) was in line with guidance at 21.2%, while net income (non-IFRS) was €125.4 million.
- Free cash flow for FY2020 was €87.6 million, down from €145.8 million in 2019 due to the impact of investments and other factors.
On the plus side, this year's bookings got an unusually strong boost from the company's longstanding Adabas and Natural product lines, where a number of large deals closed during the year — but this feat won't be repeated next year. The company is guiding for bookings of these products to shrink by 20-30%. Nevertheless, a forecast of 15-25% growth in bookings for the Digital Business product line, which encompasses integration, IoT, cloud and business transformation, is expected to keep the company's transformation plan, dubbed 'Helix', on track.
That plan sees Software AG reaching €1 billion revenue by 2023 at 25-30% operating margin, with 85-90% recurring product revenue and 15% compound annual growth in the digital business product line.
Product investment may include M&A
Meanwhile the shift to recurring revenue continues at pace. At the end of 2020, annual recurring revenue (ARR) reached €508.1 million, with net churn at 103%, and 60% of expected 2021 revenues already contracted. 81% of FY2020 bookings for digital business contracts were on a subscription or SaaS basis, up from 51% in 2019 and just 27% when Helix began in 2018. Software AG is also acquiring new customers in numbers, signing 82 new logos in the fourth quarter, and 239 in FY2020 as a whole.
Confidence in the shift to subscription is such that the company is pulling forward €30-€40 million in planned Helix investments into 2021, with a focus on go-to-market and M&A spend. This impacts the 2021 guidance for operating profit margin (EBITA, non-IFRS), which sits at 16-18%, compared to 21.2% in FY2020, while guidance for product revenue in 2021 is for a 0-5% increase on FY2020.
The digital business product mix is also proving itself. Brahmawar cited examples of how customers are using IoT and integration products in combination:
Early in 2020, we won a massive deal with our client, Schindler, you remember that I shared this with you. Now Schindler's connecting 1 million elevators and escalators using our IoT platform, but then it is linked into the hybrid integration platform — Webmethods, and the API management capabilities — to be able to then bring that data together with the rest of their systems and applications. So effectively, the solution that we provide to them is both IoT and hybrid integration together.
Another example is Eppendorf, a medical technology company, the lab equipment that they provide, again, they're connecting all the lab equipment in the field, collecting the data on the IoT platform, and then using hybrid integration technology.
The company is set to double down on its product offering here, with Brahmawar promising "a more proactive stance" on M&A in the coming year. Any extra revenue from acquisitions will be over and above the organic target of €1 billion by 2023. Rather than looking for a single big hit, the plan is to look for a series of smaller targets. He explains:
We are very focused on two key areas where we believe M&A will help us. And this is expanding into hybrid integration/API management, and the IoT analytics.
Brahmawar also noted that the company is doing better at working with partners, citing as an example the 16 new deals brought in through its partnership with Microsoft. Partners brought in 11% of deals in FY2020, up from just 3% in 2018 and on track to reach 20-25% by 2023, he says, adding:
Developing this partner momentum has been quite laborious for us in Software AG. We, in the past, were creating a list of partners and not really driving significant revenue from them. What we have now done is focused on much fewer partners.
Coming through challenges
On the list of challenges during the year, the most notable is the malware attack in October, which caused some serious business interruptions, such as preventing the issue of invoices for a period. But there was also a silver lining in that the halt to operations provided an opportunity to accelerate some technology migration plans, as CFO Matthias Heiden explains:
This event showed us that all companies are vulnerable. But, as strange as this might sound, it has also created an opportunity to pull forward planned migration to different environments, and avoid typical challenges caused by doing so during ongoing operations.
This month has also seen the departure of Chief Revenue Officer John Schweitzer, appointed in 2018 to drive US sales and with a background at SAP, Datastax and Oracle. His global sales role will now be filled by Scott Little, who currently heads the Americas region, and who according to Brahmawar "played a major role in the successful turnaround of our North America business."
Finally, there was the COVID-19 pandemic, although its impact appears to have benefited trusted brands like Software AG in a 'flight to safety', as Brahmawar discussed with us at the time of its Q2 results in the summer. There is still strong demand for 'must-have' enterprise technology, as he reiterated this week:
I would say COVID-19 is truly showing us that, actually the pandemic leads to an acceleration on digital spend, as long as you're in the critical and must-have bucket of software. If that's how the customers define your software, then you are definitely getting the funding. If you're in the nice-to-have, then you're getting postponed.
The transition from traditional software contracts to the recurring revenue model is a difficult journey that we've watched many longstanding vendors negotiate over the years. It's never plain sailing, but Software AG seems to have planned its course well and is navigating the waters with considerable success, despite the substantial challenges thrown up in the past year.
It's particularly notable that the vendor has decided to bring forward investment plans to follow through on its planned evolution. Its willingness to consider acquisitions to build out its offerings in API-centric integration and IoT analytics in particular shows welcome confidence and ambition in its product strategy.