2023-07-04 04:31:26 ET
Summary
- SAP has underperformed the market in the last decade, as increased competition has contributed to relatively unattractive growth. Despite this, SAP has maintained a good commercial position.
- It has invested heavily in its Cloud solutions, contributed to reduced margins. This investment is now broadly over, with improved growth and margin expansion expected.
- We believe AI and the general digitization of society, as well as M&A will support SAP's growth prospects in the coming years.
- SAP is unattractive relative to other software businesses, but when adjusting for valuation, the stock looks to be at its fair value.
Investment thesis
Our current investment thesis is:
- SAP's investment in its cloud products looks to be generating improved returns, with growth accelerating and the scope for margin improvement enhanced.
- We see further industry tailwinds that can support future growth, as well as the scope for M&A through cash utilization.
- SAP is highly attractive due to its range of products and deep integration within businesses, allowing for accretive returns over time.
- SAP looks unattractive relative to its peers but when adjusted for revenue, we believe the company is priced correctly.
Company description
SAP SE ( SAP ) is a German multinational software corporation that specializes in enterprise software solutions. With a global presence, SAP offers a wide range of products and services to help organizations streamline their operations, manage business processes, and make data-driven decisions.
Share price
SAP's share price has noticeably underperformed the market, as the company's growth trajectory has softened and its profitability weakened.
Financial analysis
SAP financials (Tikr Terminal)
Presented above is SAP's financial performance for the last decade.
Revenue & Commercial Factors
SAP's revenue has grown at a CAGR of 7% in the last 10 years, with only a single period of negative growth (Covid-19). This is a reflection of SAP's impressive resilience and the attractive nature of the software industry.
Business Model and Competitive Positioning
SAP follows a software licensing and support business model, providing customers with licenses to use its software solutions and ongoing support and maintenance services. SAP offers a comprehensive suite of enterprise software products, including enterprise resource planning (The primary of which is S/4HANA), customer relationship management ((CRM)), supply chain management ((SCM)), and human capital management ((HCM)), among others. SAP's revenue is currently divided into 4 segments, which can be split into 2 primary categories: More Predictable and Other. "Other" represents Software licenses, which is where a customer takes ownership of a software package, and "Services", which are consultancy services.
Revenue profile (SAP)
Software subscriptions are highly attractive as it creates a degree of certainty over revenue. A client will usually pay upfront annually for years if the product is good enough. The recurring revenue means SAP's objective is to win new customers, as its "base" level is more or less protected (this is slightly oversimplified as we must account for Churn, which is low in the case of SAP). Of SAP's €30.9bn of revenue, it defines €24.5bn of it as "More Predictable", or 79%.
Predictable revenue (SAP)
SAP's objective is to be a Corporate's one-stop shop for operational services, supporting businesses of all sizes and importantly, at an increasing level as they progress in size and complexity. Included within this are industry-specific services, again maximizing the company's reach. Corporates are focused on convenience and usability, as well as cost, and function. SAP provides a solution to this at a holistic business process level (via several of its offerings). For its customers, this means digitization and optimization of its processes, enhancing productivity, and providing actionable insights.
The benefit of this related service approach is that SAP has significant scope for upselling / cross-selling, as products work collectively as part of a wider "eco-system". This streamlines the manual aspect of the Corporate, enhancing value. Further, increased integration reduces the ability to easily "untangle" SAP from its clients, contributing to stickier revenue and the ability to consistently apply inflationary price increases.
Given the reliance on providing a market-leading solution to its client, SAP continues to invest heavily in R&D. Spending has increased from 14% of Revenue in FY13 to 20% in LTM Mar23, illustrating its commitment to R&D.
Enterprise Solution Software Industry
Competition is fierce in the Enterprise Solution segment, as the potential for lucrative returns has encouraged many innovative businesses into the market. Companies differentiate themselves based on factors such as solutions, product functionality, scalability, and integration capabilities.
SAP's primary competitors are the major software businesses, including Oracle Corporation ( ORCL ), Microsoft Corporation ( MSFT ), Intuit ( INTU ), and Salesforce ( CRM ), as well as the growing list of younger market entrants such as Workday ( WDAY ) and ServiceNow ( NOW ).
The demand for Enterprise Solutions has rapidly increased in the last 2 decades, as organizations worldwide are undergoing digital transformation, with the objective of improving operational efficiency and decision-making processes. This trend has only increased, as more and more industries integrate software into their operations. It is now a requirement for most businesses of a certain size. For this reason, we suspect the industry trajectory will continue.
The shift towards cloud-based software solutions presents opportunities for growth, as companies increasingly embrace the flexibility, scalability, and cost-effectiveness offered by cloud platforms. This trend has been driven by the increased globalization of companies' operations, as well as the declining cost of cloud solutions. SAP has invested heavily in the development of its Cloud-based solutions, which is its largest business segment and the fastest growing, seeking to accelerate its growth trajectory through the development of a superior product. Cloud revenue and backlog are up 24% and 25%, respectively, in Q1-23, with S/4HANA cloud revenue up 77%. This underpins a strong trajectory in recent years, as Management believes they are at an inflection point, with outsized growth ahead.
The integration of AI and ML technologies into software applications is driving automation, predictive analytics, and intelligent insights, enhancing the value proposition for customers. We believe this to be the natural next step in technological development within the industry, following the mass incorporation and Cloud phase. SAP has a fantastic foundation upon which to build a superior offering (its products are already used by clients such as Accenture ( ACN )), with our belief that AI could be the avenue to invest in. Oracle, for example, is already a leader in the use of machine learning but generative AI in particular is ripe to be exploited.
Margins
SAP has historically boasted strong margins, reflecting the attractive economics of this industry. In recent years, however, margins have noticeably declined. The company currently has an EBITDA-M of 19% and a NIM of 6%.
Margins have due to the need for investment in its cloud offering, materially impacting SAP's operating profitability post-FY20. This investment is clearly seen in R&D, which has increased at a CAGR of 12.7% between FY19 and LTM Mar23. Management is of the belief that the investment required is broadly made, with double-digit operating profit growth ahead. In the most recent quarter, SAP's S&A and R&D spending declined QoQ for the first time in several quarters, supporting this view. It is critical, however, that GPM improvement is delivered consistently, given the following implies a degree of volatility that is materially impacting OPM/EBITDA-M.
GPM development (SAP)
Balance sheet & Cash Flows
SAP is a conservatively financed business, with almost €10bn in cash and a net cash position. We would like to see the business turn aggressive with its capital allocation, conducting further M&A to support its current growth trajectory.
As a SaaS-based software business, its cash flow generation is extremely good and consistent.
Distributions to shareholders have been strong, with dividends growing at a CAGR of 12%, accompanied by periodic buybacks.
Outlook
Outlook (Tikr Terminal)
Presented above is Wall Street's consensus view on the coming 5 years.
Analysts are forecasting a slight uptick in growth, with a CAGR of 8% into FY27F. This appears to be conservative relative to Management's expectations but we deem them reasonable given the lack of reliable visibility going forward. We must not forget that cloud is only 40% of revenue.
Margins are expected to gradually improve over the coming 5 years, as Management turns its focus on cost savings following the large investment. Given the shaky GPM in Q1 despite the Opex cutback, we believe hesitancy is reasonable and so these forecasts look appropriate. Note, this is adjusted revenue and so a portion of the improvement will be hidden in definitions.
Peer analysis
SAP relative performance (Tikr Terminal)
Presented above is a comparison of SAP to a cohort of its directly comparable peers.
SAP quite noticeably underperforms, which is likely the reason for its poor share price performance relative to the market.
From a profitability perspective, the company trades at a noticeable deficit to the majority of its peers, only comparable to Salesforce, which generates far better FCF. Further, Workday and ServiceNow are already comparable in FCF generation while still in the growth phase, implying a concerning superiority.
Growth historically has been the biggest area of concern, as SAP's 5% is only comparable to Oracle, with all other businesses in the healthy double digits. We believe this reflects SAP's inability to respond to increased competition, which likely drove the decision to invest heavily in its cloud capabilities. This market share loss will not be easily won back despite the strong early growth. On a forward basis, the delta looks to be closing but SAP remains a lagging performer.
Based on this, we believe SAP should be trading at a noticeable discount to its peer group.
Valuation
SAP Valuation (Tikr Terminal)
SAP is currently trading at 24.4x LTM EBITDA and 14x NTM EBITDA. This is a premium to its historical average.
Given the margin improvement ahead purely from cutting costs, these multiples will quickly decline, implying markets are pricing SAP at about its average historical level. Our view is that this is a reasonable assessment. The significant improvement in its cloud products should support growth at a level historically achieve (at a SAP level, Cloud will outperform). Further, the margin improvement analysts are pricing in will bring SAP back in line with its historical level, again suggesting a reversion to the mean.
SAP valuation (Tikr Terminal)
In order to value SAP, we have applied a 25% discount to the comparable peer group, so as to reflect the weakness in financial performance. Based on this, we target an upside of 11%, comparable to analysts' consensus of 4%.
SAP's share price is up 47% in the last year, with investors seemingly taking the majority of the upside available from the improvement in performance ahead.
Final thoughts
SAP is a high-quality business, owing to its broad range of products, lucrative business model, and competitive positioning. 99 of the world's largest companies are SAP's customers, illustrating its integration. This said, the company has struggled with increased competition in recent years, and based on its outlook, its large investment will act as a reversion to the mean.
We see some upside with SAP on a relative basis but we believe on a risk-adjusted basis, a hold is an appropriate rating. SAP still needs to execute on its cost-cutting exercise and margin improvement.
For further details see:
SAP SE: Business Transformation Begins