German software developer SAP AG (NYSE:SAP) is the global leader in Enterprise Resource Planning (ERP) software products and the fourth largest software developer in the world. Annual revenues for FY2013 for the company were more than $22 billion, and the company has a market capitalization of about $91 billion. In addition to commanding market leadership in the ERP market, SAP has a decent share in the Business Intelligence and Analytics and Supply Chain domains.
Over the last two quarters, SAP has been mulling ways to break into the cloud services space, primarily through its flagship HANA product. Although the HANA in-memory database accounted for about €664 million ($882 million) or 4% of FY13 revenues, SAP has bundled many of its product offerings across verticals to boost bookings for its HANA platform. Recently, the company announced the launch of subscription-based deployments of various SAP solutions powered by the HANA platform. In the recently concluded Q1FY14, the company posted revenues of $316 million which were 38% higher on a non-IFRS (International Financial Reporting Standards) basis from SAP solutions deployed over the HANA powered SAP cloud. Comparatively, its rival Oracle (NASDAQ:ORCL) posted cloud revenues of $292 million with a year-on-year growth rate of 24%.
Despite the relative outperformance for SAP against Oracle in the cloud space, the company's stock has fared poorly this year. SAP lost 11% of its stock value since December 31, 2013, while Oracle gained 10% in value during the same period. In part, the fall in stock price is a result of the deferral in its 35% operating profit target from 2015 to 2017. This deferral is because of the company's higher investments into its cloud business, which has fared relatively better than the cloud businesses of its peers in recent times. In addition to the weak performance from SAP's stock, the string of high-level executive exits recently has further impacted investor sentiment. The company's head of cloud business, Shawn White, and the key architect of its flagship HANA platform, Vishal Sikka, left the company last month, fueling speculation of lapses with its cloud-led growth strategy.
In this article, we present our rationale for the 25% premium we have on SAP and take a look at potential downsides that could impact our valuation. We have a $95 Trefis price estimate for SAP against its current market price of $76.
Rationale For Our $95 Valuation For SAP
Our valuation for SAP is strongly substantiated by the executional strength of its senior management team. The management, previously led by chief executive officers, Jim Hagenmann Snabe and Bill McDermott, along with chief technology officer, Mr. Sikka, have provided strong historical performances for SAP in the past. The company has a revenue target of €22 billion (~$29 billion at FY13 EUR-USD conversion rate) and an operating profit margin target of 35% for 2017.  From fiscal 2013 levels, this target presents a 7% annualized growth in revenues. Additionally, non-IFRS operating profit margins need to expand from their 2013 level of 32.8%. We believe the company's management team has the capability to drive revenue growth and execute margin expansion in parallel through fiscal 2017.
The company's strategy is to push its enterprise software solutions bundled with the HANA platform, so as to improve the operational functionality and business efficiency of its customers. That it is working has boosted, and should continue to boost, HANA sales. Actual on-premise licenses could see revenue acceleration from the bundled offering with HANA. Given the disruptive in-memory technology behind the HANA platform, we should see good adoption from business for the bundled offerings in the near term. We expect this adoption of in-memory technology from business to be fueled by its faster processing rate and lower latency in comparison to traditional memory and hard-disk drive architectures.
Moreover, the launch of subscription-based deployments, both for its software solutions such as Business Suite and Business Warehouse, as well as the HANA in-memory database module, should resonate well with its customer base. Although a greater transition to cloud subscriptions should lead to a slowdown in overall revenue growth in the near term, this trend should see a reversal as SaaS subscriptions have fewer subscription periods than on-premise deployments. This lower subscription period for on-demand licenses should drive incremental revenues higher over the course of the actual on-premise license.
The company's margin targets are expected to be met from lower cost of revenues and a realigned business structure to accommodate the increasing shift to cloud offerings. As reported by the Wall Street Journal on May 13, management plans modest work force changes, reducing the number of employees supporting on-premise deployments and adding employees with different skills to support SaaS offerings. This should lead to lower selling expenses, boosting operating margins. Additionally, cloud offerings have higher gross margins compared to on-premise offerings. This is because despite the data center costs involved for cloud offerings, other associated costs are lower. This is evident from Salesforce's gross profit margins, which stand at 85% compared to 81% for SAP.
Downside Risk Associated With Our Valuation
One of the key downside risks associated with our valuation is the ability of the company to execute on its 2017 top line and margin targets. With the departure of key senior executives from its most important business divisions such as cloud and HANA, the risk attached to a further deferral in its target has increased some. In recent Q1FY14 results, quarterly revenues fell short of analyst estimates. This particular trend could continue in the near term, particularly as a result of the departure of key executives in its management team. We believe the company's Q2FY14 performance pivots on the execution skills of Mr. McDermott, who is expected to become the sole CEO of SAP on May 21, and his team.
We are cautiously optimistic on our current valuation for SAP and expect to factor in these downside risks post the company's performance in Q2FY14.
Disclosure: No positions.