Like many older, somewhat sclerotic software companies, SAP (NYSE:SAP) is often no longer considered as a growth stock. And to be fair, when compared to some of the current crops of software vendors who have grown up in the days since cloud architecture became regnant, it hasn't produced hyper-growth numbers, and at its scale, it would seem as though those days are behind it. On the other hand, this company has been making its transition to the cloud at a reasonable cadence and has been continuing to report growth in both revenue and EPS during the transition, unlike its principal rival, Oracle. (NASDAQ:ORCL) or IBM (NYSE:IBM).
The title for the article comes from the famous patriotic song, "Over There" by George Cohan. Of course, Over There in that case was related to the efforts of the American Expeditionary Force redressing the balance of Europe in favor of the democratic allies. Here we see a European business enjoying greater success in all areas of the world as a legacy IT vendor than is the case for both its principle rival and IBM, headquartered in the US.
And while SAP's dividend yield is nothing to write home about (1.52%), it has reached a position where dividend increases in the future are likely to be at a greater cadence than in the recent past. I was struck during the course of the earnings conference call on Friday by two things that are often not related. On the one hand, the CEO Bill McDermott was as positive as he has ever been in terms of his business outlook. But of equal interest were the comments from both the CEO and the CFO regarding dividend increases. The CEO described the outlook for dividend increases in his unique fashion as follows, "I said that SAP will remain an excellent dividend payer as we have consistently done now for year and years and years. So, put that in the win column for the shareholders." Further on, "The main thing is we are going to be extremely shareholder friendly. We believe that a growth company needs to also take care of its shareholders." Words - maybe - but I do think for readers/investors looking for a company in the enterprise IT space that has both growth potentials and a policy that favors shareholders regarding dividends, this is a better choice than many other alternatives. Finally, this from the CFO Luka Mucic, "As you know, we have a dividend policy of paying out more than 35% of net profit. Net profit is up significantly when you take a look at our IFRS numbers (YTD), so chances are that the dividend will also be up significantly."
I own SAP shares and have done so for some time now. I do so mainly because I see the company's transition to the cloud being managed in a reasonable fashion that is perhaps underappreciated by some. But I think other readers who like to see dividends and a share repurchase program might want to look at SAP as it is emerging from the constraints it faced in terms of capital returns in the wake of its acquisition of Concur.
During the course of the conference call, the company basically said there would not be any large acquisitions going forward to surprise shareholders. Management also said that it will be able to pay off the debt it took on to buy Concur sooner rather than later and that should give it room to buy back shares (2nd half of 2017) and raise the dividend, especially with the significant growth in free cash flow it anticipates and has achieved.
The company reported the results of its fiscal Q3 last Friday and the results showed a modest upside in terms of revenue and showed a beat as well in terms of non-IFRS operating profits. (IFRS is the European equivalent of GAAP and most earnings estimates published by analysts highlight a non-IFRS presentation.) In the wake of the beat, management increased its non-IFRS operating profit forecast marginally, at the mid-point and it raised its forecast for product revenue growth by 50 bps to 7.5% at the mid-point. Although the CEO, Bill McDermott has a background in sales and a record of having a bit more optimism than might always be warranted, the quote for which this conference call will be remembered was his comment that, "the pipeline is more robust than it has ever been going into the 4th quarter…We're in very good shape on the top line."
SAP's center of gravity is in EMEA - it is, after all headquartered in Walldorf, Germany although it has a significant US headquarters outside of Philadelphia - hardly a land of hope and glory these days. The company is notorious for being slow moving, cautious and for both overpaying and then having a difficult time in managing acquisitions. It doesn't get the highest marks in the world from consultants or from user satisfaction surveys. And yet, quarter after quarter, it cranks out reasonable numbers. Q3 turned out to be no exception.
Many Seeking Alpha readers tend to ignore this company because it is Over There although its long-time CEO Bill McDermott is as American as anyone in the software business. And yes, it gets a smaller proportion of its revenues in the US than its peers, and that can mean more substantial swings in terms of US constant currency results than would be the case for some other vendors. In recent years, that has been a headwind in terms of reported numbers.
But the company has an exceptionally broad footprint in the application software space, with offerings of various kinds both in many verticals and many infrastructure segments. Over the years, it has been able to buy solutions when it didn't develop appropriate and competitive capabilities internally. It has paid incredible sums for some of the companies it has bought - after all these years, I still wonder how the purchase of Sybase was ever justified to SAP's board at the price that was paid. (We all should have learned how to develop mobile apps and applied for large pensions for our work from SAP) And it hasn't been a particularly hospitable home for some of the leaders of the companies that it bought - although some of the individuals involved were surely stormy petrels at best.
There are lots of things that SAP doesn't do that have been issues in the past, but are now considered benefits. Most particularly, the company doesn't try to pretend that it has capabilities in the IaaS market or that it needs to take on Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT) in that space. (Maybe the Sybase merger was actually cheap at just a dead loss over a bit more than $5 billion.) Microsoft, indeed, is a customer and has chosen to implement SAP's SuccessFactors HR solutions. And SuccessFactors is available on the Azure platform. It is a reasonable strategic decision for both companies and it is the kind of thing that is making the transition to cloud easier for SAP than has been the case for Oracle or for IBM. Note on IBM's conference call, its CFO proclaimed that its Watson technology would never be available on anyone else's cloud. In other words, if an IBM user wants or has Azure or AWS, then Watson will not be available. On the other hand, if a user wants SuccessFactors, it is available on Azure. Frankly, SuccessFactors is stronger in its space than is Watson, but there are very different cultures at work - and in this case, the German culture is far more open and flexible and congruent with user expectations.
It is lots easier to co-exist in the world than it is to pick fights. (That is not a political commentary, though I suppose some might think it so.) And that has been one of the principal factors that has allowed SAP to be able to achieve growth when its rivals have not grown and are not likely to return to growth. Not having to protect a huge installed user base of database customers turns out to be a very nice place to be in the wake of trying to deal with both Microsoft SQL Server and Amazon's multiple database offerings such as Aurora. At this point, and with numbers that somehow seem a bit more credible than those of rivals, about 15% of SAP's revenues come from cloud services. That is quite a bit higher than the percentage of Oracle's revenues coming from the cloud and it is against a backdrop of stable revenues in terms of on-premise licenses and some modest growth in support.
Like all companies in transition, the transparency of the company's financial presentations could be significantly improved. The company has continued to acquire a significant amount of cloud revenue through acquisition. The acquisition of Concur, which closed just before the end of 2014 continues to have impacts on reported growth percentages, although this should be the last year in which that company's prior seasonality distorts comparisons. This year SAP has acquired 3 cloud vendors although the scale of the acquisitions is not enormous compared to the company's acquisitions in 2014.
But overall, I think if I were to attempt to distill the company's secret sauce, it would turn out to be execution. There are many times in the past decade in which I and others have thought this company had lost its relevance. But somehow, in the last decade, the company has more than doubled its revenues and it has increased its operating profits from 598 million euros to 1638 million euros. CFFO has climbed consistently with earnings rising from 1267 million euros for the first 9 months of the long ago 2006 year to 3391 million euros just reported.
In terms of USD returns, the shares have doubled in value over the past decade including the dividends that have been collected. As the euro has declined by 13.5% over the period, the company's share price increase record for Europeans has been quite strong indeed.
This year is really not all that much different than the company's long-term track record. So far YTD, the shares have increased by 12% compared to the IGV which is up a bit less than 9% over the same span. Most of the share price increase is based on the fact that consensus estimates have been steadily rising and will self-evidently continue to do so because the company has increased guidance. The company has had one poor quarter over the course of the last 12 months; it is lots harder to forecast in multi-dimensions which is what it means when it becomes necessary to forecast not just what deals close, but what deals close in the cloud or in on-prem. (Also note that analysts forecast earnings for the ADRs, which are of course denominated in dollars and not euros which is what is reported by SAP) The current quarter showed a noticeable decline in IFRS profits, ironically caused because stock-based comp, calculated in accordance with the IFRS formula, showed a noticeable increase in last quarter that was a product of the share price appreciation. I really did not make that up. The share price increase of 20% in the quarter, led to a 300 million euro increase in reported stock-based comp - I suppose most shareholders would find the trade-off acceptable.
I think that it is interesting that management has already given analysts a nudge when it comes to expectations for 2017 expectations. Again, from the CEO:
You will see substantial increase in 2017…history is a relative guide for the future when you look at the competition down in double digits in their core and propping up…"
The CFO, who actually has to deliver numbers said:
Well, first of all, on the outlook for 2017, we have just raised the outlook for 2016 and we will attend to 2017 when we outlook (sic) our numbers for Q4. So, I think there you need to hang in a little bit with us."
I think the observation by the CEO regarding Oracle is quite apt, but this is not the place to discuss precisely how Oracle develops its percentage cloud growth numbers.
Why is SAP having such different results than the other older technology companies?
There is a hoary saying about wishing to be luckier than smart. Not that SAP doesn't have smart people, and the same can be said about Oracle and IBM. But SAP simply doesn't have to deal with defending the indefensible in a database area. Both IBM and Oracle have enormous revenue sources coming from database and middleware software. SAP doesn't. And for better or worse, that is a big part of the different results that are being achieved by SAP and Oracle.
I am inclined to believe that one of the reasons that Oracle was tardy in starting to develop its cloud was the desire on the part of its then CEO to avoid the problems inherent in attempting the consumption of one's children. By that I mean that the CEO realized that if the cloud became the computing standard, Oracle's database monopoly was doomed and there would eventually little that could be done about it. If you don't want something to happen, call it a foul name and maybe it will go away. So, some of the advantages SAP has are historical, almost accidental.
SAP is a venerable company as software vendors go. 45 years old at this point. It has dominated the applications world for many, many years, and today it faces a raft of new competitors with purpose built cloud applications. I think attempting to analyze whether SAP has a better solution in one particular part of the applications world or the other is a bootless undertaking. It is more or less inevitable that companies like Workday (NYSE:WDAY) have more "modern" architecture in whole or in part.
But since the middle of the last decade, the company has been willing to spend unparalleled sums to buy cloud solutions - and other solutions as well - and while the amounts were staggering at the time in terms of valuation metrics, they have allowed the company to deal with some of the challenges of the cloud a little bit more easily than would otherwise have been the case. Again, I don't propose to rate all of the company's acquisitions against those of either Oracle or IBM. It really doesn't matter all that much at this point. In all, the company has done 61 acquisitions according to Wiki, and starting with Business Objects, some of them have been major. But none of them were done for "financial" reasons particularly and although I still wonder about the Sybase acquisition, what SAP did was to buy the best technology that it could regardless of the cost.
Some of the companies that it has bought were domiciled in Europe and were less well known in North America and in EMEA. Some have been leaders in areas that are hot these days, but weren't quite so when they were bought. A typical SAP acquisition might be said to have been Hybris. Hybris was a German software company that might be said to have been one of the pioneers in the digital commerce world. It is still very European-centric with 84 customers in Germany and 90 in the US. But it is the leader in the Gartner MQ survey for Digital Commerce this year compared to some better-known names.
Then there have been companies such as SmartOps, which was the brainchild of American visionary Sridhar Tayur, who describes himself as the Academic Capitalist and dreamed up a company that essentially does real time supply chain analysis.
The acquisitions that are well known because of their size include Business Objects, Sybase, Ariba, SuccessFactors, SeeWhy, and Concur. Sybase is still a headscratcher, at least for me. The others were the category leaders and part of the reason that SAP can grow when its two largest rivals are shrinking in that list. SuccessFactors is the 600-pound gorilla in the HCM space. Concur is probably the 900-pound gorilla in the Travel and Expense management space. Ariba is surely the 600-pound gorilla in the supplier management space.
I think the point of the list is to suggest that part of the explanation for the different results that SAP is able to enjoy these days, is that it has been willing to spend money to buy companies that have been passed on by its competitors who simply were unwilling to pay the price either in funding start-up losses or in terms of valuation premiums. SAP has been willing to believe in revenue synergies in a way that its two rivals have not wanted to deal with, and the results are what is being seen these days.
Some luck, a better batting average with acquisitions, the willingness to take bigger risks and better sales execution have allowed Sybase to get more growth out of its space than have its two primary rivals.
Valuation & Financial Metrics
No one has ever confused SAP shares with deep value. The company has a current enterprise value of about $111 billion. The company's revised revenue projection is a bit more than $24 billion using the current exchange rate of 1 Euro = $1.09. So, that is an EV/S of 4.6X. Analysts are forecasting 6% growth next year. I think that is likely to prove to be significantly lower than the actual result based on the company's track record and the specific comments of the CEO and the CFO cited above. At this point, I would think that the company might achieve 9%+ growth at constant currency. I won't count on any meaningful share repurchase. But at over $26 billion in expected sales, the EV/S will be 4.2X. Not value territory, but reasonable enough for the growth rate I think to be a reasonable expectation.
The analyst consensus for SAP EPS had been $4.37. With the increase in guidance, I expect that the consensus numbers - and the actual earnings to reach $4.50-$4.60. That suggests that the current P/E is a bit under 20X and that based on revised expectations for 2017, the P/E is likely in the range of 17X. Again, not deep value territory, but reasonable for a GARP company.
As I have mentioned on other occasions, I prefer using free cash flow yield as the most objective metric with which to compare investments. The free cash flow yield does away with anomalies as charging earnings because of the strong share price performance of a company in a particular quarter and it cuts through other anomalies that are non-operational in nature. Through the first 9 months of the year, the company produced 3,628 million euros from operations, up 12% from the prior year cash flow of 3,241 million euros. That is a CFFO margin of 23.5% - reasonable, but certainly not an outlier. CFFO is exceeding reported operating profits by a significant amount primarily because of deferred revenue increases and because of depreciation. Given the strong growth in cloud bookings, it is reasonable to assume that the increase in deferred revenues will continue to grow more rapidly than revenues for some time to come.
Capex was higher this year than last year although it is still a relatively small cost relative to the other items in free cash flow. Overall, free cash flow through the first 9 months of the year was about 2960 million euros compared to 2815 million euro the prior year, an increase of 5%. Based on the commentary of the CFO, I expect that capex will decline in Q4 and will show little or no growth next year.
SAP's cash flow is often lower in Q4 than in its other quarters because of the growth in receivables due to the elevated sales results in the last quarter of the year. That seasonality will likely diminish over the years as the company moves to more recurring revenue sources, but it will still be a factor in Q4-2016 cash flow. Last year, the company had CFFO of 398 million euros in Q4; I think it is reasonable to assume that CFFO this year will be between 450-475 million euros with capex for the period of about 150 million euros leaving free cash flow of 300 million euros for the period and bringing the estimate for full year free cash flow to just shy of 3.3 billion euros or $3.6 billion at current exchange rates. That is a free cash flow yield of 3.2%. Based on the glimmerings of guidance, we have been given for expectations next year within management's commentary on the call, I think that free cash flow will increase significantly faster than the increase in operating profits in 2017 because of strong increases in deferred revenue and some increases in depreciation. So, I think free cash flow ought to be in the neighborhood of 3.8 billion euros during 2017, and that would bring the current free cash flow yield to 3.4%. Again, that isn't deep value when compared to say MSFT, which has a free cash flow yield of 6.5%, but which has a noticeably lower growth rate.
SAP reports many numbers in many ways, and I am sure that management actually believes it does so in the interest of transparency. This writer begs to differ. Some of the metrics are interesting, and some of the metrics are marginally relevant, but few of them provide any significant light in terms of providing the basis for forward-looking expectations. In particular, the way the company chooses to present revised guidance expectations is maddening - at least to this writer. And while the breakouts by product and region may be interesting to some, I am not too sure how much I ought to make of them in formulating a view about the success of the company vis-a-vis expectations. I will not discuss most of the many metrics that the company presents - it really would enhance no one's ability to forecast SAP's operating performance and would certainly have not be correlated with the company's share price. I will just touch on a few that might be of interest to some readers.
There has been a premium that European investors have been willing to pay for SAP, primarily because of the scarcity of large cap software names in Europe. Given that the company still retains that status, it makes the current valuation metrics seem reasonable indeed and leaves room for significant share price appreciation in the context of continuing execution.
As has been commented earlier, Q3 saw a significant expansion of IFRS expense, primarily because of the rapid growth in share-based comp coupled with a growth in operating expenses driven by a growth in headcount. The company does not break out stock-based comp specifically in its reconciliation of IFRS earnings to non-IFRS calculations. My comments regarding stock-based comp came from the information provided by the CEO during the course of the conference call.
In the quarter, headcount grew by 2500 and grew by 7000 for the year with the most rapid growth coming in the APJ region where headcount grew by a bit more than 12% compared to 5.6% in EMEA and a bit over 10% in the Americas. Management suggested that Q3 was a heavy quarter for hiring and that the cadence would diminish going forward.
Overall, non-IFRS expense ratios were flat year on year for research and development, increased by 170 basis points for sales and marketing and declined by 70 basis points for general and administrative cost. The increase in sales and marketing was the result of a strong percentage increase in bookings, some of which is not reflected in revenues during the period. Non-IFRS margins had shown particularly strong growth in Q3 of 2015.
SAP is forecasting that its non-IFRS operating profit in Q4 will grow by 100 million euros, or about 4.5% at the mid-point while its overall revenues are forecast to grow about 6-7% overall. The decline in constant currency operating margins is likely to be a function of stronger bookings than reported revenues, which will continue to pressure the sales and marketing expense ratio as was the case in Q3.
Revenue growth was more or less consistent in all of the company's regions with the company's European region showing 6% revenue growth, the Americas region up by 7% and APJ up by 6%.
Margin growth, based on the progression of margins this year, is likely to be greater in 2017, which is consistent with the current forecast. I think the mismatch between bookings and reported revenues is likely to decrease to some degree and the rapid growth in headcount will also abate.
When I look at SAP, I see a company still in transition, but one where the end point is in view and the interim numbers will not require some huge leap of faith in determining the end point. The company may not reach double-digit revenue growth even as the transition continues. It sells lots of ERP and that is simply not a growth market. I think it reasonable to expect that operating margins will rise over time at a noticeable rate and the company will reduce its share count and increase its dividend payout. Perhaps not the most exciting investment, but one that can produce a modest amount of positive alpha and some level of dividend income in the intermediate term.
Disclosure: I am/we are long SAP.
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.