SAPGF - SAP: Fairly Priced For Now AI Benefits Still Unclear

2023-09-15 04:28:32 ET

Summary

• SAP's stock has performed well this year, trading roughly in line with the NASDAQ Composite.
• The company's Q2 earnings report showed a significant miss against normalized non-IFRS EPS, but overall financials remained in line with historical norms.
• The share price experienced significant volatility around this event, ultimately settling where it was prior to earnings. I believe this was due to overly optimistic expectations around AI.
• While the market may have been a bit early, SAP's focus on generative AI technology shows potential for future impacts on its fundamentals.
• This should take some time to materialize, and the stock is fairly priced at present. I will be on the lookout for material shifts in top line growth or its cost structure before recommending it as a buy.

Overview

SAP SE (SAP) stock has had a solid run so far this year, albeit still marginally underperforming the NASDAQ Composite. The ERP software giant's stock has actually outperformed the NASDAQ's price return throughout a large portion of the year, including fairly recently. This trendline was interrupted by a sharp uptick in selling pressure as well as share price volatility, both of which increased markedly in the wake of the company's Q2 '23 earnings report in July.

This can be chalked up due to the company's significant miss against consensus expectations for normalized non-IFRS EPS in Q2: a full 47% less than median expectations. IFRS EPS significantly exceeded expectations, although that was due to the divestment of the firm's Qualtrics unit. Revenue also came in marginally below estimates.

While that may not have been the best showing, the choppy trading that we've seen in SAP shares since then indicates that the market may not have parsed the latest report as being purely negative. Shares are still down, but not overly so. The situation is also made more complex by the fact that SAP is in the process of reengineering its product base to leverage generative AI, akin to many other B2B software providers. Management is set on growing operating profit by 'double digits' y/y via these technology upgrades.

In this article I'll review SAP's financials and contextualize the company's recent quarterly performance. I will also evaluate how credible the firm's generative AI transformation is at this point and whether it can buoy the firm's fundamentals going forward.

Q2 Results Review

SAP demonstrated growth across several key metrics in its latest quarter . I will quickly note that the picture here is made murkier by the shifting Dollar/Euro exchange rate and the persistent strength in the Dollar. Nonetheless, revenues grew 8% y/y last quarter in constant currency and 5% netted out for foreign exchange effects. While this may have come in somewhat shy of expectations, I certainly don't consider it a poor top-line showing for a company of SAP's size. Gross margins remained steady at 71.6% on an IFRS basis, and basic IFRS EPS increased 15% y/y. Most notably, operating profits increased by 28% y/y, indicating progress on managements' initiative for growing operating profits.

All things considered, this doesn't strike me as an earnings report that should yield a sustained sell-off. There has not been a material deterioration across any key metric, and operating earnings as well as bottom line growth remain robust. My impression is that analysts had expected the benefits of generative AI to materialize a lot sooner than they are.

Ongoing growth in both operating and net profits indicate that progress is still continuing. A review of the numbers here leads me to conclude that the significant volatility in the stock in recent times has stemmed from mismatched market expectations as opposed to real changes in the fundamental picture.

Commentary On Generative AI Capabilities

SAP's value proposition appears opportune for leveraging generative AI, at least in a general sense. Enterprise Resource Planning technology, as well as associated B2B software such as Customer Relationship Management and Human Capital Management, is primarily workflow software. What I mean by 'workflow' is that these technologies map real-world business processes onto a digital format. The result is that customers conduct business operations digitally and can then also leverage the data generated for making improvements. The end result is a set of processes that generate data and can be conceptualized as a connected graph .

While somewhat complex, I wouldn't classify this type of software as being particularly so. Ultimately, optimizing paths from A/B through data is an area that is actually extremely amenable to artificially intelligent processing. This is because of something called 'combinatorial complexity'. Human beings aren't able to 'traverse' every possible path in a related set of nodes, which in this case are discrete tasks inherent in workflows. Generative AI can process these kinds of problems much more readily, problems which bear resemblance to the classic computing problem known as the travelling salesman .

Early-stage results here also appear encouraging. Unsurprisingly, the most directly analogous area to the travelling salesman problem - transportation - should see the greatest percentage yield from the utilization of generative AI technology.

Furthermore, SAP appears to be on its front foot generally as to this emerging technology trend. Its venture arm, Sapphire, is actively deploying capital into fast-growth intelligent computing startups such as Anthropic.

With that being said, financial improvements from integrating AI have not yet materialized on SAP's financial statements. This will take some time, with results likely to first become apparent roughly a year from now. At present we can say that there are very real efficiencies to be garnered, but we cannot yet quantify or precisely time these productivity gains. I will reiterate that I believe SAP's core area of focus is nonetheless relatively amenable to this emerging technology. R&D expenses have also continued to grow, indicating ongoing investment in this area. My eyes will be looking at statistically significant shifts in top-line growth as well as material changes in cost structure, at least one of which should change if generative AI is to truly alter SAP's business.

Valuation

To reiterate, we have a stock here which is continuing to produce financial results in line with historical norms. The latest quarter proved this across the board, inclusive of revenues, operating income, and earnings per share. We also have the added factor of AI hype, something which appears to have made its way into the perceptions of analysts covering the stock, as well. While this is again a very real thing to be concerned with, I'll reiterate that it will take several more quarters before we even see the beginning of material business impact from this new technology.

With that context put in place we can review SAP's valuation to see how the market has priced all of this. Due to the complexities involved in reconciling between GAAP and IFRS accounting standards, we can look to non-GAAP metrics for a more immediate perspective. At present SAP is trading at a significant premium on a trailing twelve months basis, but far less so on a forward basis. This indicates an opportune buying point for bullish investors; the forward price is fair and not reflective of upside considerations. Of course, we may not see too much upside in just one calendar year, as mentioned earlier.

Momentum metrics are also worth considering here. SAP stock has maintained its value well in recent periods. Indeed, it has had a far better trading history than other stocks in the IT sector over each period within the last year. While I am always careful to not read too far into momentum metrics in of themselves, these look good to me. Essentially, recent share price volatility is just that - recent.

Conclusion

At present, SAP looks like a fairly-priced stock that is also not pricing in any surprises. While we do have the recent run-up and subsequent sell-off as an interesting data point, I again believe that this was short-sighted as to fundamental impacts from generative AI. For investors that believe SAP should see gains from this within the next year, I would call this stock cheap. I believe that we will need roughly a year to see impacts from new technology, so I'm calling it a hold for now.

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