Germany’s SAP SE (NYSE:SAP) is a global leader in enterprise resource planning (“ERP”) and database management software. The company just reported its latest quarterly results, which represented continuing momentum in its strategic shift towards cloud-based solutions with customers including major multinational corporations transitioning to the new platforms. This was an overall mixed report with positive operational and financial trends balanced by soft guidance. The stock sold off on the earnings release, which is in the context that shares were already trading near an all-time high. We take a look at recent developments and our view on where the stock is headed next.
SAP Q4 Earnings Recap
SAP SE reported its fiscal 2019 Q4 earnings on January 28th with non-IFRS EPS of €1.82 that was €0.11 ahead of expectations, while IFRS EPS of €1.37 missed slightly by €0.07. The spread here was based on some restructuring charges and share-based compensation. Revenue in the quarter of €8.04 billion was up by 8.2% year over year and effectively in line with estimates, missing by just €50 million.
(Source: Company IR)
Q4 cloud bookings rose 19%, but below stronger trends from earlier in the year. Based on the adjusted non-IFRS measures, cloud revenue up 32% in Q4 and up 35% for the full year supported the weaker software licenses and support business, up just 1% in Q4. The company’s co-CEOs, Jennifer Morgan and Christian Klein, added the following comments in the press release:
“SAP’s strategy to be the experience company powered by the intelligent enterprise is resonating. More and more customers are turning to SAP and Qualtrics to close their experience gap. At the same time, we continue to see strong adoption of S/4HANA (cloud ERP) as the core of the intelligent enterprise across all deployment models.”
(Source: Company IR)
The firm-wide gross margin reached 75.3% in Q4, up from 72.3% in Q3 to end the year at 72.3%. Favorably, margins increased across all segments, with notable strength in cloud, which reached 68.2%, up 500 basis points from 63.2% last year. These trends also supported a higher operating margin. EPS for the full year at €5.11 was up by 18% compared to 2018.
(Source: Company IR)
Other notable items for the quarter and the year was operating cash flows pressured by restructuring charges and share-based compensating. Free cash flow for the year decreased by 20% year over year to €2.28 billion. At year end, gross debt reached €13.7 billion, supported by a cash position of €5.3 billion. Overall, the balance sheet and liquidity position are stable
SAP Soft 2020 Guidance
The company issued 2020 guidance with a range of revenue growth across the core segments below the 2019 results. Cloud revenue growth between 24% and 28% compares to the 35% growth in 2019. Similarly, the total revenue growth target for 2020 between 6% and 8% is also below the 9% result for 2019. This follows a revenue growth of 10% y/y in 2018 and 9% in 2017.
(Source: Company IR / author annotation)
Management includes guidance for longer-term targets with its “2023 Ambition”. A projection of total revenue of €35 billion by 2023 implies an annual growth rate of 6% on average over the 2019 result. The company expects cloud gross margin to reach 75%, compared to 68.2% in 2019. The trend is for a higher proportion of recurring “predictable” revenue and overall firming profitability.
Taking a look at the consensus revenue and earnings expectations, the market estimates revenue growth around 7.5% for the next two years, while EPS of $6.05 in 2020 and $6.73 in 2021 represents an increase of 8.2% and 11.3% year over year respectively. Keep in mind, these estimates have not yet been revised to incorporate the latest Q4 results and forward guidance. The broader point here is that the outlook is for a deceleration in earnings and top line growth compared to the latest 2019 results.
(Source: Seeking Alpha Premium)
Analysis and Forward-Looking Commentary
Recognizing what remains an overall positive outlook with steady growth and a path for higher profitability, the concern here comes down to valuation. Across multiples including a forward P/E of 23x and forward P/S of 5x on the 2020 consensus estimates, these ratios are in the context of relatively modest growth under 10% expected for both revenue and EPS. Other measures like EV-to-EBITDA and price-to-free cash flow is also at elevated levels relative to a longer 5-year and 10-year average for SAP.
The outlook suggests a valuations multiples expansion would be necessary for the stock to climb higher, or growth would need to significantly outperform expectations. We typically want to see growth and earnings accelerating to justify a multiples expansion. We see valuation as a headwind, with much of the positive trends potentially already priced in.
Intense Competition in Cloud ERP/HCM/SCM/CRM
Anecdotally, the size and scale of SAP as the largest in the segment is a hindrance to its growth outlook. On one hand, the company already counts on several multinational corporations as core customers, suggesting the low-hanging fruit for ERP systems and cloud-based solutions has already been captured.
There is also a consideration of intense competition between large and small competitors with similar solutions. Oracle Corp. (ORCL), for example, is fighting for much the same type of new cloud ERP business. SAP is the largest in what remains a highly dynamic and evolving space. Over the past decade, Salesforce.com (CRM) has taken the lead from SAP in the customer resource management applications market.
(Source: Company IR)
SAP’s other operating segments feature competition from emerging application software companies utilizing the software-as-a-service model for specialized niches that further challenge the company’s market position. We highlight Workday Inc. (WDAY) with revenue growth of 26% in the last quarter as a company essentially capturing market share from SAP in human capital management (“HCM”).
SAP ended 2019 with a continued trend of steady growth and firming profitability as the market transitions to its cloud-based solutions. Softer guidance for the year ahead, along with a broader deceleration compared to 2019, may weigh on sentiment in the near term in the context of an already pricey valuation.
We take a cautious view on shares at the current level. Going forward, monitoring points include trends in growth and the evolution of the products segment gross margin as a key metric. Beyond the risk of a global cyclical slowdown, we see intense competition from emerging software application players offering specialized and point solutions as a challenge for SAP’s growth outlook.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.