2023-06-20 05:22:00 ET
Summary
- SAP has seen its share price increase by over 30% this year, with growth in its cloud business and a tailwind from foreign exchange movements.
- The company aims for €22 billion in cloud revenue by 2025, with a four-year CAGR of 21%, and has a prudent M&A strategy and €10 billion in cash reserves.
- However, concerns include temporary foreign exchange tailwinds, potential lagging in the AI race, and a relatively rich valuation.
This year, it has been no big surprise that tech stocks have led the market's recovery. And though in general the group had veritable cause to rally after last year's correction dropped valuations below intrinsic worths, in many cases the rebound has swung too far.
SAP SE ( SAP ), the German software vendor that is one of the most recognizable global brands in enterprise software, has seen its share price lift by more than >30% year to date. Amid a tough macro backdrop, SAP has continued executing on its long-term goals: growing its cloud business, simplifying its portfolio (in March, the company sold off Qualtrics, a company it acquired a few years back, at a neat profit), and enjoying a tailwind from FX movements unlike many other U.S.-based companies that have been hurt by the strengthening dollar. The question for investors now is: does SAP have any upside left?
I had been a long-term SAP bull before recently pivoting to neutral on the stock, which is where I remain now. At current valuations and in the current macro climate, I see SAP as a more balanced bag of positives and negatives.
Here are the positive, bull case drivers I see for SAP:
- SAP is dominating in enterprise ERP, and that is translating to admirable growth in the cloud. SAP has long marched toward a "2025 Ambition" plan, which calls for ~?22 billion in cloud revenue by 2025, representing a 21% four-year CAGR. It also recently upped its total revenue target from ?36 billion to ?37.5 billion by 2025, even after accounting for the divestiture of Qualtrics. This is a solid demonstration of growth at scale, despite SAP's existing global penetration.
- Managed for profitability. SAP is a software company in its mature stages, which means it benefits from generously high gross margins and a stable opex base. Operating margins in the ~25% range help the company generate consistent profits and cash flow.
- Prudent M&A strategy and rich cash reserves. SAP has ~?10 billion of cash on its books as well as a reputation as a savvy acquirer (Ariba, SuccessFactors, and Qualtrics are all examples of SAP deals that have integrated well into the company), unlike rival Salesforce ( CRM ) which is often criticized for making M&A a chief pillar of its growth strategy.
At the same time, however, I worry about the following:
- FX tailwinds are temporary. Right now, SAP's optical growth rates are boosted by the stronger dollar (and weaker euro), which will cause deceleration as currency movements settle.
- Potential laggard in the AI race. SAP was a relative latecomer to the cloud trend (which is a partial reason why its cloud growth rates are so high now: it's just catching up to the rest of its peers). Microsoft ( MSFT ) has OpenAI; Oracle ( ORCL ) has long applied machine learning in its new database products.
In addition, we have to consider SAP's relatively rich valuation. For FY23 and FY24 respectively, Wall Street analysts are expecting SAP to generate $5.71 and $6.77 in pro forma EPS, respectively, which puts SAP's valuation multiples at:
- 24x FY23 P/E
- 20x FY24 P/E
I don't disagree that SAP is performing well vis-a-vis other software companies in the current challenging macro, and that its double-digit cloud revenue growth rates remain enviable: but after this year's generous >30% rally, I don't see much further upside from here and prefer staying on the sidelines.
Q1 download
Let's now go through SAP's latest quarterly results in greater detail. The Q1 earnings summary is shown below:
SAP's total revenue grew 10% y/y to ?7.44 billion, beating Wall Street's expectations but decelerating from 15% y/y growth in Q4. FX is the main story here: Q4's constant-currency growth rate had been 10% y/y with five points of positive FX tailwinds; Q1 growth was 9% at constant currency with one point of favorable FX upside.
Underneath this, SAP's cloud revenue grew 24% y/y (22% on a constant-currency basis) to ?3.18 billion. S/4HANA, the company's flagship cloud ERP offering, was a major star here, growing 77% y/y to ?716 million in revenue (roughly a quarter of the cloud total and a tenth of the company total).
With so much saturation at the enterprise level, SAP's sales focus of late has been to capture more of the mid-market, specifically for ERP products. It notes that its new GROW with SAP initiative is performing well. Per CEO Christian Klein's remarks on the Q1 earnings call:
Let's start with our new offer Grow with SAP. We see significant growth potential with mid-market customers new to SAP. These are the companies that we expect to experience significant growth as they build their businesses. This new offering, Grow with SAP, provides them with a native ERP solution that can grow and scale with them with agility and speed. It includes our leading cloud-native ERP solution S/4HANA cloud. Through rapid adoption services and our modular stack, mid-market customers can go live and see rapid results within weeks at a fixed price.
Grow with SAP also includes SAP business technology platform so customers can design and automate business processes in a cloud-native way using SAP build and create industry or LOB-specific enterprise apps without writing code."
The company also noted that total cloud backlog grew 25% y/y to ?11.1 billion, almost a year's worth of revenue. And from a regional perspective, all three of SAP's reporting segments (Americas, Europe, and Asia Pacific) saw >20% y/y growth in the cloud.
From a profitability standpoint, pro forma cloud gross margins boosted 110bps sequentially and 250bps y/y to 71.4%, driven by efficiency gains and economies of scale. Pro forma operating margins, meanwhile, clocked in at 25.2%, a 40bps jump y/y, and pro forma EPS of $1.18 came in slightly ahead of Wall Street's $1.16 consensus.
Key takeaways
While I think SAP's push into the cloud as well as its conscious efforts to grow in the mid-market are core near-term growth drivers, I don't think SAP has much rope left to rally after this year's generous upside. Keep this stock on your watch list, but it's time to start locking in gains if you haven't yet already.
For further details see:
SAP: Strength Is Priced In