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SAP AG (NYSE:SAP)

Q3 2007 Earnings Call

October 18, 2007 8:00 am ET

Executives

Stefan Gruber - VP, IR

Werner Brandt - CFO

Henning Kagermann - CEO

Léo Apotheker - Deputy CEO and President, Global Customer Solutions & Operations

Analysts

Raimo Lenschow - Merrill Lynch

Marc Geall - Citi

Sarah Friar - Goldman Sachs

Charles Di Bona - Sanford Bernstein

James Clark - Credit Suisse

James Dawson - Morgan Stanley

Ross MacMillan - Jefferies

Michael Briest - UBS

Knut Woller - UniCredit

Operator

Welcome to SAP's Third Quarter Results Conference Call. This call is being recorded. Today’s call will be hosted by Henning Kagermann, Werner Brandt, and Léo Apotheker. I would now turn the call over to Stefan Gruber. Please go ahead, sir.

Stefan Gruber

Yeah. Thank you. Good morning or good afternoon. This is Stefan Gruber. Thank you for joining us to discuss SAP’s third quarter 2007 results. I am joined here in Walldorf by Henning Kagermann, Léo Apotheker and Werner Brandt.

Werner will discuss the Q3 financials in detail, Léo will comment on the current business environment and our regional performance, and Henning will then provide some further in-depth commentary on the quarter and SAP’s product successes.

As usual, I will now make a few remarks about forward-looking statements. Any statements made during this call that are not historical facts are forward-looking statements as defined in the US Private Securities Litigation Reform Act of 1995. Words such as “anticipate,” “believe,” “estimate,” “expect,” “forecast,” “intend,” “may,” “plan,” “project,” “predict,” “should” and “will” and similar expressions as they relate to SAP are intended to identify such forward-looking statements. SAP undertakes no obligation to publicly update or revise any forward-looking statements. All forward-looking statements are subject to various risks and uncertainties that could cause actual results to differ materially from expectations. The factors that could affect SAP’s future financial results are discussed more fully in SAP’s filings with the US Securities and Exchange Commission, including SAP’s Annual Report on Form 20-F for 2006 filed with the SEC on April 3, 2007.

Participants of the call are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their dates. In addition, in this call, we will report certain financial measures particularly free cash flow, constant currency, period-over-period changes in revenues and operating expenses and approximations of revenue growth on US dollar basis that are not prepared in accordance with US GAAP, and are therefore considered non-GAAP measures.

We report these measures to provide additional information that may be useful to investors in breaking down and evaluating sales volume and income growth. Our non-GAAP measures may not correspond to non-GAAP measures that other companies report. The non-GAAP measures that we report should only be considered as additional to and not as substitute for or superior to the respected US GAAP measures that we report.

Before we start, let me remind you that the focus of today’s call is on SAP’s Q3 results and our outlook for the full year of 2007. Also, I would like to remind you of our upcoming investor symposium, which will be held on Monday, November 12th at our headquarters in Walldorf, Germany, and invitations for this event will be sent shortly.

Now, I would like to turn the call over to Werner Brandt.

Werner Brandt

Yeah. Thank you, Stefan, for this introduction, and welcome to everybody on the call. We are very pleased to report another strong quarter, in which software and software related service revenues grew 16% at constant currencies. Let me take a moment to discuss the year-over-year change in exchange rates. The euro continued to strengthen significantly against most of the major currencies causing a currency headwind for SAP. Here are some key currency metrics.

If you look to the relation of the euro to the US dollar, the euro strengthened by 8% quarter-over-quarter. The euro strengthened relative to the yen 9% quarter-over-quarter, and the Canadian dollar weakened by 1% compared to the third quarter of 2006.

Currency had the following impact on the P&L in the third quarter: A negative effect of 3 percentage points on software and software related service revenues; a negative effect of 4 percentage points on total revenues; positive effect of 3 percentage points on operating expenses, resulting in a negative impact on operating income by 5 percentage points. The operating margin was negatively impacted by 40 basis points in the third quarter. Let me now continue with the quarter's results.

Software and software related service revenue for the third quarter of 2007 were over EUR1.7 billion, which represented a year-over-year increase of 16% at constant currencies. The increase was the result of the year-over-year constant currency increases of 15% in software revenues, 16% in support revenues, and 31% in subscription and other software related service revenues.

Of the latter, we signed one subscription deal on GEA contract in the third quarter. As we mentioned previously, for the full year 2007, we expect subscription and other software related service revenues to be in the range of approximately 2% to 4% of software and software related service revenues.

Third quarter support revenues of EUR978 million, increased 16% at constant currencies year-over-year, and were subsequently in line with our expectations. Third quarter professional services and other service revenues were EUR674 million, which was an increase of 6% at constant currency. Consulting revenues of EUR544 million, increased 4% at constant currencies, and training revenues increased 15% at constant currencies.

The software and software related service margin was 80.8% for the third quarter of 2007, which was a decrease of 180 basis points compared to the third quarter of last year. This decrease in the margin was a result of several factors: An increase in purchase licenses mainly driven by an increase in the amortization of acquired intellectual property and increasing cost of support due to additional headcount for our premium maintenance business and an increase in costs related to the new business, which alone accounted for a decrease of 50 basis points.

The professional services margin was 25.5% for the third quarter, which is an increase of 180 basis points compared to the same quarter last year. As we had previously mentioned throughout the year, our goal was to improve the professional service margin to 25%, and we are on track to achieve this objective. The increase in the professional service margin was mainly the result of a higher consulting margin particularly in the Americas and EMEA, and a significant increase in the training margin.

As a result of the mixed margin performance in product and services, our 2007 third quarter gross margin increased by 30 basis points to 65.4%. Operating expenses increased by 156 million to EUR1.8 billion, up 9% year-over-year. The higher operating expenses were mainly the result of additional personnel. We hired 4304 FTEs since the third quarter of last year.

For information, stock-based compensation expenses and acquisition related charges were 38 million and 18 million respectively for the third quarter of 2007. R&D expenses increased 8% for the third quarter, and represented 15% of total revenues compared to 15% of total revenues for the third quarter of last year. The increase in R&D was the result of additional personnel

We hired an additional 875 FTEs compared to last year’s quarter. Of that total, 66% were hired in low-cost locations. Sales and marketing expenses increased 14% for the third quarter, and represented 21% of total revenues compared to 20% of total revenues in the last year’s third quarter. The increase in sales and marketing expenses was mainly due to additional sales headcount year-over-year, more than 1100.

General and administrative expenses increased 8% for the third quarter and represented 5% of total revenues, the same as the prior year’s third quarter. The increase in G&A is driven by a continued investment in our transactional shared service centers, growth in administrative functions due to acquisitions and additional resources needed to manage the volume increase in the regions. We expect a more positive effect in G&A ratio in the mid-term.

Operating income was 601 million for the third quarter, representing an increase of 9% compared to the third quarter of 2006. The operating margin for the third quarter was 24.8%, which was flat compared to the same period last year.

At the beginning of the year, we spoke about accelerated investment for our new business centered around our new midmarket solution SAP Business ByDesign. We stated that we would keep you posted on the specific spending to this initiative. Therefore, operating expenses related to the new business for the third quarter totaled approximately EUR35 million.

To-date, we have spent roughly EUR85 million, and excluding this investment, our operating margin would be 150 basis points higher in the third quarter and 120 basis points higher for the first nine months. Third quarter 2007 net income rose 10% to 408 million, and earnings per share increased 13% to EUR0.34.

Our effective tax rate for the third quarter was 35.3% compared to 35% for the quarter of last year. For the full year, we continued to expect a tax rate of 32.5% to 33%. Free cash flow for the nine months period of 2007 was EUR1.1 billion, which was flat year-over-year. For the third quarter of 2007, primary use of free cash flow was for share buybacks, acquisitions and the investment in corporate bonds.

For the third quarter, we bought back 6.2 million shares for a total of approximately EUR250 million. At September 30, 2007, treasury stock stood at 42 million shares, which included the cancellation of 23 million shares from treasury, as announced by SAP Executive Board on September 7, 2007.

So the 42 million is after the cancellation of this 23 million shares. For the fourth quarter of 2007, we expect to spend roughly the same amount on share repurchases that we spent for the third quarter, so again around roughly EUR250 million. For the year, that would come to a total of approximately EUR1 billion in share repurchases.

Headcount in the third quarter increased by 853 FTEs, of which 47% were hired in low-cost locations. At the end of the third quarter, total headcount stood at 42,772 full time equivalents, which is an increase of 4,000 -- of 3,417 year-to-date. This includes 353 FTEs coming from acquisitions. For the full year, we are now targeting 4,000 additional FTEs, not including headcount coming via acquisitions.

We have refined our outlook for 2007. As you already have seen in our press release issued today, we indicated that we now expect growth in software and software related service revenues to increase at the upper end of the range of 12 to 14%. With that in mind, you maybe asking why we did not refine our margin outlook as well? Let me explain.

Number one, our operating margin guidance is not currency adjusted in contrast to the guidance for software and software related service revenues. The currency impact to the operating margin for the first nine months was a negative 40 basis points. Moreover, we would expect much larger currency impact on the operating margin in the fourth quarter resulting from a greater mismatch between revenues and operating costs compared to the first nine months.

Number two, we need to keep some flexibility for spending on SAP’s Business ByDesign, as we have begun to enter operational mode for the new business and as we get closer to volume readiness in 2008. Besides the new business, we continue to invest in the future growth of our established business and this requires additional risks. As you see, we raised our expectation for headcount this year from 3,500 to 4,000, excluding acquisition.

With that I would now like to pass it over to Léo.

Léo Apotheker

Thank you, Werner. And I am pleased, you can all join us today on this call. The market environment in the third quarter remained unchanged, as we report our 15th consecutive quarter of double-digit growth in software and software related services. We continue to see consistent demand for our products and services. This consistency comes from our ability to provide true value to the businesses of our customers. The key sources of this value are our superior products and technology, our industry leading innovation, as well as the safety and reliability of our customers’ investments in SAP products.

The strong financial results we have consistently reported are proof of our ability to provide superior value to our customers. Our leading solution portfolio, in combination with our value driven go-to-market approach, enables us to maintain a high win rate against our competitors. Let me now provide you with some customer metrics for the third quarter.

In the third quarter, the number of contracts signed increased 22% year-over-year, the share of new customers based on order entry was 26%, but as we continue to sign more deals with midmarket customers, it is also important to talk about the share of new customers based on number of contracts, which was 34%. Deals greater than EUR5 million accounted for 20% of order entry in the third quarter, down from 33% in the third quarter last year; while deals less than EUR1 million accounted for 46% of order entry, up from 36% in third quarter of last year.

The higher percentage of deals greater than 5 million in the 2006 third quarter was the result of an unusual high number of deals in the 10 to EUR20 million range. The 20% number, we reported for the third quarter of this year is more typical for SAP, if you compare it to the past couple of years.

I would like to highlight two very important customers that we won in the third quarter. I am very pleased that we can announce today the successful signing of a Global Enterprise Agreement with Apple. SAP had already been a software partner for Apple in the past. However with this GEA, we will bring the relationship to a completely new and strategic level.

I am also pleased to announce that in the third quarter we won Wal-Mart, the largest retail company in the world. This is a significant competitive win for SAP in the US, and in the retail sector, which clearly shows our leading position and superior value proportion in the strategic industry. A decisive factor in Wal-Mart decision for SAP was not only our ability to prove that the SAP solution can best support their business today, but that it also provides unsurpassed adaptability and flexibility for future growth.

We continue to maintain our strength and market leadership with an unmatched portfolio of 26 end-to-end industry solutions. Our marketing leading position in these industries is derived from many years of experience, in-depth industry expertise, and strong long-term customer relationships, the latter being something you can definitely not buy into.

Based on software and software related services revenues, the top performing verticals in the third quarter were oil and gas, automotive, consumer products, retail, and financial services. Our success in banking is the result of the investments we made in the business process platform for banking, which allows us to grow organically and through co-innovation with partners.

A couple of the announcements we made in the third quarter include a partnership with Callataÿ & Wouters to offer an end-to-end core banking solutions for midsize banks, and the partnership with Misys to create an integrated universal banking solution. Both partners will migrate their solutions over time on to our banking platforms.

Let’s now take a look at the regional performance. We once again reported double-digit growth rates in all regions based on software and software related services revenues at constant currencies. Software and software related service revenues in EMEA were up 15% at constant currencies. Germany’s growth of 3% was within our expectation, driven predominantly by SME, but the rest of EMEA maintained its second quarter momentum by growing 22% at constant currencies.

EMEA software revenues at constant currencies were also up 15%. The performance in EMEA was well-balanced across all the countries. The standouts that I would like to point to were once again Russia, as well as France and UK. Also SME was again a strong contributor and growth driver for EMEA in the quarter. Key contract wins in the EMEA region were Barmer Ersatzkasse, Thames Water Utilities Limited, [Inscate] Management, Louis Vuitton Moët Hennessy and El Corte Inglés in Spain.

The Americas region reported another strong quarter, with 15% growth in software and software related service revenues at constant currencies. The US grew 18% at constant currencies, while the rest of Americas was 6% higher. The performance in the rest of Americas was actually better than the growth rate indicates, as you’ll remember, we had an exceptional performance in Latin America in Q3, 2006, making for a very tough comparison.

Based on software revenues at constant currencies, the Americas was up 11%. Key contract wins in the Americas region included Southwest Airlines, Goodyear Tire & Rubber Company, the Royal Bank of Canada, Miami-Dade CountyPublic Schools, [Elektro] Services Company and Bancolombia S.A. The strong growth in Asia-Pacific/Japan continued into the third quarter with software and software related service revenues increasing 24% at constant currencies.

Japan was up 16% at constant currencies, and the rest of the Asia-Pacific/Japan region reported 30% growth at constant currencies. Based on software revenues at constant currencies, Asia-Pacific/Japan was up 28%. The key growth markets in APJ were India and Japan. A stronger leadership team, solid execution, and an unwavering commitment to customer value have been the driving forces in Japan’s turnaround. Key contract wins in the Asia-Pacific region were Samsung SDS, Charmant Inc., Ayoka Systems, KAO Corporation, LIG Insurance, and Myer Pty Limited in Australia.

Let me conclude by saying that our 2007 outlook for software and software related service revenues implies that we closed as much business in the fourth quarter as our next largest competitor does in a whole year. Having said this, I would now like to pass it over to Henning.

Henning Kagermann

Yeah. Thank you, Léo. I am pleased to report another strong well-balanced quarter in which we continued to gain share in the core enterprise application software market. At the end of the third quarter, our share based on this US$35.9 billion market was 27%, representing an increase of 1 percentage point compared to the second quarter of 2007, and an increase of 3.5 percentage points compared to the third quarter of 2006.

As you know, we do not report our numbers in US dollars, and we have not made detailed calculations about how our performance would be if we were reporting in US dollars. But based on an approximate calculation, we believe that our growth in the third quarter in software and software related services revenues would be above 20% year-over-year on a US dollar basis.

As you know, we have been working hard and have been quite successful to-date in getting an increasing number of customers to transition to enterprise SOA by adopting the business process platform. We have the only ERP suite in the industry that is services-enabled, and we remain on track in our roadmap to have the entire business suite and all industry solutions services-enabled by the end of this year.

In the third quarter, we continued to see strong adoption of SAP ERP and SAP NetWeaver increasing NetWeaver sales and continued contract migration from our suite. These critical metrics help us track the progress of our business process platform success. In the third quarter, we had 11,200 SAP ERP customers, of which 6,800 were productive. We also saw an additional 142 R/3 contract migrations.

The growth in contract migrations has declined somewhat as expected, but it was more than compensated for by an increase in new additional repurchases. The number of NetWeaver customers increased to 14,400, with 9,800 of them being productive. NetWeaver sales for the nine months period were EUR585 million representing an increase of 42% compared to the same period of 2006. Of the total, 34% represented standalone NetWeaver sales.

Additional progress on the transition to enterprise SOA can be demonstrated by some of the recent announcements we made. We announced the newest version of SAP Discovery System. First launched in 2006, the system provides companies with the opportunity to experiment with enterprise SOA, by prototyping service-enabled composite applications specific to their business without disrupting existing productive systems.

More than 400 companies have taken advantage of the system in just 12 months. We also announced a global release of the SAP NetWeaver Composition Environment and enterprise services repository.

Our ecosystem which is critical to the success of enterprise SOA continued to be strengthened by the success of the SAP communities, which were featured at our recent TechEd event, where more than 6,000 people attended. Our industry-wide networks, which help identified industry-wide trends has grown to 13.

Our enterprise services communities translates concepts into enterprise services has increased to over 240 members. Our business process expert community which helps close the gap between business and IT has grown to over 200,000 members, and our SAP developer network which helps optimize IT assets in the central community has increased to over 900,000 members. All these numbers of SAP community member and networks represent significant gains year-over-year.

On the product side for our established business we continue to move forward with new innovations. For the SAP business suite, we recently released the second enhancement package for SAP ERP, which includes new enterprise service bundles, improvement to the core applications within SAP ERP, and specific industry related innovations. For the business user, GRC Risk Management entered ramp up in the third quarter.

CFOs can use this application to develop a comprehensive risk profile for the organization, establish the corporate appetite for risk taking, and outline response strategies for loss events. For the small and midsize enterprise segment, the number of customers for SAP Business One increased 39% year-over-year to a total of 15,830. The number of channel partners for SAP Business One decreased slightly to 1,343. The decline is the result of a strict focus on our most active partners that are the most capable in helping us in our drive to meet volume targets.

Therefore, it’s only natural that growth in the SAP Business One partner channel slows. For SAP All-in-One, the number of customers grew by 18% to 10,555, and the number of channel partners increased 23% to 1,107. As you know, we launched in September the branding of our new breakthrough innovation product, Business ByDesign. In a nutshell, SAP Business ByDesign is the right solution for midsize companies with 100 to 500 employees, who are focused on improving core business processes with a low cost of entry and a low total cost of ownership and who are interested in an on-demand solution.

The solution combines the benefits of integrated end-to-end business applications with low risk and low total cost of ownership of an on-demand solution. It wasn’t designed with traditional categories, such as enterprise resource planning, customer relationship management, and others in mind. It was designed for business processes across the entire organization, whose user interface was tailored to people's [routes]. SAP Business ByDesign offers end-to-end processes for the workplace of the future.

Finally, let me reiterate our growth strategy. Our plan is to continue to grow faster than the market, and we expect the growth to come by expanding our addressable market, and our coverage of that addressable market. Stable growth will come from our traditional business of horizontal and vertical applications, and accelerated growth will come from leveraging the segments of the business process platform, the SME and the business user.

For the business process platform, we will see primarily organic growth. In SME, organic growth is also the key driver, but as you know we did make an acquisition in the past namely TopManage that brought us SAP Business One. The business user segment is where acquisitions along with organic growth play a bigger role in our strategy.

As you can see by the recent small acquisitions of OutlookSoft and Pilot Software, and the recent large offer for Business Objects, and while the offer for Business Objects is for a much larger acquisitions than we have done in the past, the concept behind this acquisition remains the same, enabling our customers to benefit from an even richer portfolio of innovative products and solutions.

It’s not about acquiring customers, market share or maintenance. With the acquisition of Business Objects, we instantly become the market leader in a high growth area that we were not the leader in previously. SAP’s direction has always been clear delivering innovative and market leading products to our customers and profitable growth to our shareholders. In the end, our 2010 ambitions will be reached primarily through organic growth as organic growth remains the primary driver for growing of our businesses. SAP has shown that we can outperform the market with significant organic growth, and we will continue to do so.

Thank you, and we will now be happy to take your questions.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions). Thank you. Our first question comes from Mr. Raimo Lenschow of Merrill Lynch. Please, go ahead.

Raimo Lenschow - Merrill Lynch

Hey, hello, good afternoon. I’m sorry I have to apologize before I ask the question, but as I am a bit of a number cruncher and nerd. Could we maybe talk a little bit about the growth rates in the US business? If I look at last year we had a very healthy [escrow] and we had to adjust it down then with the accounting adjustment we announced in January. So, if I then look at the organic clean growth rate we achieved in the US or in the Americas business that looks like we had pretty much the second quarter of single-digit license growth in US. Can we maybe talk a little bit about the reasons there? Is that market driven? Is that because you actually guided the sales force on kind of the slightly lower-based growth numbers, so they are actually quite happy with the double-digit they achieved. Maybe some more color on that? Thanks.

Werner Brandt

Maybe, I would just reiterate what we did. You are right, we had reduction in our license revenues for the third quarter by about EUR30 million and, but it didn’t impact the value of licenses sold in US. And we stated that we expect to restate a portion of that, which we did in the first quarter, it was about 19 million. I think, we don’t expect to recover any further amount of that. So, that does effect behind and I think if we look to the US I feel business is still strong there, Leo.

Léo Apotheker

Yes, maybe I can add a few comments to that. If you look at the situation in US, the environment is rather unchanged compared to the second quarter. We are performing well relative to the competition in US, and we do continue to take market share. And if you re-look at metrics then we continue to have nice double-digit growth in US moving forward. I don’t expect the US to be the number one growth engine for SAP for the entire year, but I do expect the US to continue to grow double-digit.

Raimo Lenschow - Merrill Lynch

Thank you.

Stefan Gruber

Thank you. We will take the next question please.

Operator

Thanks. The next question comes from Mr. Marc Geall of Citi. Please, go ahead.

Marc Geall - Citi

Hi, good afternoon everyone. A couple of questions, if I may. Can you sort of go into a little bit more detail, into sort of how the 85 million Business ByDesign spend how that breaks down, sort of more interested in from a sales and marketing standpoint on where you are. Then a comment on (inaudible) you are sort of going up into ramp up and its operational now. So I just want to understand how that profile maybe builds out. And then a second question, just on the acquisition announced yesterday of YASU Technologies, how does that effect things like your relationship with IDS Scheer? How strategic could that be, am I missing something in the BPM space, that’s clearly important, I just really want to understand how that product would fit into the NetWeaver strategy?

Henning Kagermann

Thank you, Marc. Let me start with YASU. It’s old engine system which we need for NetWeaver. Its part of, you are right -- our BPM strategy, our business process management strategy, we discussed this with IDS Scheer. You know that we have acquired some IP from them in order to complete the design part. So here I think we are aligned, that is not a shift in strategy. We continue to up sell, so our sales force, the entire or suite. So, no changes here and no surprise; from SAP Business ByDesign, I will try to answer where we are, and then may be Werner gives you some color on the breakdown.

We have to launch this in different phases as we all know it. It was a very important milestone to having the first client live which we achieved in September and it was just 20 live clients. The next one is end of the year. We want now to come to the hundred plus clients. This is important because in the first quarter there will also be an upgrade of the software so we learn to seamless upgrade on the fly. Then we come to next year first quarter is to push the product that it can run, I would say in thousands in terms of performance and we will over the year improve cost of ownership.

On the go-to-market side it’s clear that we then ramp up more and more our marketing, our telemarketing, our internet sales. We measure very carefully how much cost is involved in making a customer productive, that goes down. We will see first up-sell into existing clients. We expect them to move up with the users. So, at the end of the day it’s still the same plan that at the end of 2008, we expect that we have a business plan. Well, we can make this business profitable as we announced earlier.

Léo Apotheker

Yes. You will remember that in New York we announced our next phases, to illustrate this with one example, we are now opening for business in two additional countries, ramping up country-after-country. We are also ramping up certain number of marketing and sales expenses to prepare for the launch of the product in these countries.

Werner Brandt

Some figures related to what you had before, if you look to sales and marketing including our own volume business readiness internally, then we are talking about roughly $44 million, on the $18 million and the rest, bit more than $20 million is related for charges of existing consulting and other support activities.

Marc Geall - Citi

So are you saying that $20 million, should we think of that as more CapEx related cost or is it still...?

Werner Brandt

No, no this is, nothing is CapEx related.

Marc Geall - Citi

Okay.

Werner Brandt

Its CapEx based. But we are talking about actual cost here.

Marc Geall - Citi

But, if we take a look at the CapEx that you’ve sort of taken through this year, would any of that also be associated with the Business ByDesign ramp up?

Werner Brandt

Yes, it is. It is.

Marc Geall - Citi

And, now are you able to...

Werner Brandt

On the hardware side.

Marc Geall - Citi

Yeah. Are you able to give any indication? I’m just trying to get a feel for as we look at CapEx going into ‘08 ...?

Werner Brandt

Look to the CapEx spending it is roughly $240 million and I would say hardware related is roughly $80 million for the first nine months, so that’s not a huge investment we have done here. It’s more really expense related what we are talking about.

Marc Geall - Citi

Okay, thank you.

Stefan Gruber

Let’s take the next question please.

Operator

Thank you. Our next question comes from Ms. Sarah Friar of Goldman Sachs. Please, go ahead with your question.

Sarah Friar - Goldman Sachs

Good afternoon everyone. Henning, I think you have tried to be very explicit about your acquisition strategy both on this call and on the call last week with Business Objects and in particular, where you are more focused on inorganic growth from where you prepare to go organically. I think of NetWeaver as an area that’s much more organic growth, but does the Oracle bid for BEA change your thinking at all here and in particular does it force you to perhaps have to add more technology tuck-in acquisitions, the speed and time to market for that platform?

Henning Kagermann

Yeah, thank you. That is a good question. Let me reiterate, we are pretty happy with our business process platform because it’s to some extent, unique in a market, you know we are not growing for pure technology platform but we bundle, executable services and making it a more application type platform. To give you some flavor in addition to what I did already, we had, at TechEd yesterday, I gave a key note and so we add per month now 900 productive NetWeaver systems per month. What it tells you is that there is a huge reduction weight, the system is well underway.

You are right, smaller tuck-in acquisitions will happen. Marc asked about it, YASU was such a one, Identity Management was another one. But these are not big ones and it’s, in no means buying overlapping -- completely overlapping technology. We don’t want to do this. So, if there is a smaller area where we feel, we have to rush expect some tuck-in acquisitions, but not a large one. This is entirely different than what we did for Business Object. I think I explained in lengthwise this is a very strategic important move for SAP.

Sarah Friar - Goldman Sachs

Got it. And then I just want to follow-up on the macro-environment. You did call out financial institutions as a vertical of strength, but obviously what we see going on here in the US, is definitely financial pushing out some deals third quarter into fourth quarter, and some concerned broadly about their spending. Could you give us anymore color on what you saw particularly in the US financials vertical?

Léo Apotheker

Yes, hello Sarah. We have been progressing steadily our financial services business, and again in Q3 we had good results in financial services. Now, we are also doing business in North America with financial institutions, and we have not yet seen any impact of the turmoil in the financial industries in Q3. I guess that’s because we don’t have a confusing strategy.

Sarah Friar - Goldman Sachs

Okay, great. Thanks a lot Léo.

Stefan Gruber

Thank you. Let’s take the next question please.

Operator

Thank you. Our next question comes from Mr. Charles Di Bona of Sanford Bernstein. Please, go ahead with your question.

Charles Di Bona - Sanford Bernstein

Yeah, Henning thanks very much for the milestones that you gave us on Business ByDesign, but could we maybe take a moment to map that back to the projected spending? When you are almost halfway through the sort of two year cycle of 3 to EUR400 million, wondering if maybe you can refine that range, and maybe to the extent that you are also with Business Objects, acquiring a channel to the middle market, or at least a number of channel partners as they are already developed. Does that impact the spending? Does that impact the timing of the spending? Can you maybe comment on that a little bit?

Henning Kagermann

Yeah, thank you. You are right there is a level which we can get from Business Objects, they have a very strong channel. Also some of their products would fit nicely into the Business ByDesign offering. You can understand that I don’t want to speculate now we have just made an offer. We have not closed the deal. We cannot dig too deep into the technology for few reasons. So, but you are right, this is an opportunity for, let’s say taking some of the investments out, we planned on our site. Let’s see next year when we, let’s say come closer here.

The investments so far are expected to be more back-end loaded. We said this several times. The reason is that now where we are in an operational mode, its not just accelerated R&D, not just the, I would say still too high sales and marketing cost which will go down because it is the beginning, we have to build up its fix -- also build a Telus Center etc. But now, we also come to operate these clients and we are not with our cost of ownership where we want to be, let’s say once we really earn the money we want to earn. I think that’s not a surprise to you. We work on this next year, but therefore it depends a little bit also on how many clients we get in which sequence and with how many users, and forgive me, if I don’t know this exactly, so therefore, I cannot be more precise in this point in time.

Charles Di Bona - Sanford Bernstein

Can I just interpret that then to be, that you are certainly with the initial customers because of the cost ownership you are going to be essentially subsidizing the purchases?

Henning Kagermann

Not subsidizing, but at the end of the day, if it’s too low number of users, at the beginning you don’t make money, you are right. Once we get the up selling effect, we start making money and the question is now, we have two impacts, one is the time to get the up-sell and the second, is how fast are we improving our internal TCO. We are working on both.

Charles Di Bona - Sanford Bernstein

Thank you.

Stefan Gruber

Thank you. Next question please.

Operator

Thank you. Our next question comes from Mr. James Clark with Credit Suisse. Please, go ahead sir.

James Clark - Credit Suisse

Good afternoon gentlemen. I have a couple of questions. First if I could ask about the R/3 migration. And again, thank you for giving some of the basic points there. And you made some deceleration in the number of customers moving up from R/3 but how many customers on your analysis remain on that platform that could potentially move on to your newer technologies?

Henning Kagermann

Yes, thank you. First, let me say I’m happy about this low figure because it was sometime ago concerns in the analyst community that once the migration is gone SAP cannot sustain with the growth and the opposite is happening. I think people have to have in mind, with the refined guidance from [Walnar], we will end up this year with the highest growth in four years, just to remind you, and the migration is very low. So it tells that we successfully can substitute the migration we had three years ago by additional sales of new products and new customers, that was the reason why I am happy if the number is not too high. I think we have left a few thousand as we contract. I expected that in 2009 we will have less than 1,000 but let’s say that still is the case.

James Clark - Credit Suisse

Thank you very much. The other question is a technical one for Werner. Could you give us a breakdown of your costs by functional currency, so that we can perhaps model more accurately the currency impact on your cost base going forward?

Werner Brandt

James, the functional currency of SAP is euro and this is across all top-line and all operating expense lines. I do not understand exactly what you are looking for?

James Clark - Credit Suisse

Well, your functional cost therefore is euro, but in the company operations clearly there is a mismatch between your costs in local currency and your revenues in local currency which as you highlighted, has cost you 40 basis points so far this year. And you hinted that, that would be significantly greater drag on margins in the fourth quarter. Could you a) quantify that without giving away your fourth quarter margin ambition, but equally give us a sense of the percentage of your cost in dollars, in Yen and perhaps in other currencies that you feel you are sensitive to?

Werner Brandt

Yeah, that’s something we do not disclose, but the majority if you look to it, is related to the US dollar. That’s something we can say.

James Clark - Credit Suisse

And your fourth quarter margin drag at current rates?

Werner Brandt

No, we do no disclose this.

James Clark - Credit Suisse

But they’re significantly higher than the 40 basis points so far this year?

Werner Brandt

It will be higher.

James Clark - Credit Suisse

Okay, thank you.

Stefan Gruber

Thank you. Let’s take the next question.

Operator

Thank you. Our next question comes from Mr. [Patrick Standaert] of Morgan Stanley. Please, go ahead with your question.

James Dawson - Morgan Stanley

Hi there, it’s James Dawson here for Morgan Stanley, just a couple of questions. Just looking at some of the countries here, I wonder if you could talk a little bit more about Germany. Looked a little soft, I know you said (inaudible) with your expectations, but certainly versus Q2 it was like that. Can you just talk about maybe some of the fundamentals we should expect from Germany in the next 18 months say? And perhaps if you could talk -- in Q2 you talked about the BRIC economies and gave have a pretty bullish data point. I wonder if you could talk about what’s going on in those markets in Q3. And then maybe lastly, if you could just give us a bit more on the Wal-Mart contract which is reasonably interesting. And what exactly you are selling into them and what the longer-term opportunity could be? Thanks.

Léo Apotheker

Let me start with Germany so we get that out of the way. Germany has a year-to-date performance in mid single-digits which is as we expect, as we always said, that we expect Germany to be in the mid single-digits. And the third quarter was again single-digit. We see a mixed change in the business we do in Germany. We do a little bit more SME, little bit less large enterprise which is to be expected given our very high market share here in Germany. So, you should expect Germany to stay at single-digit. We have always indicated that would be the case, and we expect that to continue to be the case.

As to the BRIC countries, they are performing extremely well. And if I look at some of them they are hovering near triple-digit growth be it year-to-date be it Q3. I would like to point out extraordinarily good performance of Russia now for several quarters in a row. India has same situation. So, we are very happy with the performance we have in the BRIC countries. They are true growth drivers for the company, and we have no reason to believe that this trend will change in the near future. On the contrary, we see lot of things coming through same for the investments we have made in the past in these countries, paying off very handsomely. Last but not least to Wal-Mart, you have to forgive me that I can’t give you all of the details of that deal. It is, however, a very significant transaction it was one head-to-head with a competitor, I will let you guess who that was. You know that Wal-Mart is a very challenging and demanding buyer, but it has ample opportunities to look at those architecture functionality, capability to support and trust its relationship, I think we have won on all of these aspects and it covers a significantly important part of Wal-Mart’s business, it covers all of their financial business -- all of the financials and it will be a global rollout and we will keep you abreast on the future events at Wal-Mart.

James Dawson - Morgan Stanley

Thank you very much.

Léo Apotheker

Thank you.

Stefan Gruber

Thank you. Next question please?

Operator

Thank you. Our next question comes from Mr. Ross MacMillan of Jefferies. Please, go ahead sir.

Ross MacMillan - Jefferies

Yeah, thank you. Just on the guidance, so we have grown on a cost and currency basis by 16% on software and software related revenues for the first nine months of the year, you have raised the guidance to the high end of the range, that still implies a pretty significant deceleration in Q4 especially on license revenue. Can you just outline maybe your thinking around that and whether you think this year is going to be even less seasonal than we have seen over recent years? Thanks.

Henning Kagermann

You know that we always give the guidance for the year and I want to reiterate that this is important. We are not giving guidance for the quarters and I think people should not look, let’s say to the environment from SAP’s performance quarter-over-quarter. Let me reiterate we feel Q4 is an extremely large one. With our refined guidance again we would grow more than in the last three years, so it’s really an ambitious target and I think let’s first make it and then let’s discuss again about the year.

Stefan Gruber

Thank you very much. Let’s take the next question please.

Operator

Thank you. The next question comes from Mr. Michael Briest of UBS. Please, go ahead.

Michael Briest - UBS

Thank you very much. In terms of the hiring target you have now listed that to 4,000 for the year, can you say where the extra 500 people will be going and by implication is this a sign of confidence on 2008 outlook? Should we expect hiring to moderate in 2008 as a consequence?

Werner Brandt

It’s Werner here. Michael I think the accelerated hiring this year will be in the areas of sales and marketing and R&D. As throughout the first nine months of this year, and with regard to 2008 ,that’s something we will talk about when we provide our guidance for 2008 that’s by the end of January next year.

Michael Briest - UBS

Thank you. And if I could just have one more, in terms of your ability or willingness to do large deals, you have obviously flagged that in the business user category, you would be willing to, but in terms of the timing, if Business Objects close in Q1 would you feel happy to do one soon after that or should we expect to lag before any further large deal?

Henning Kagermann

It’s an interesting question. I get it very often these days. Let me answer differently. Timing is important. You are right. We have indicated that SAP was not prepared for example two years ago because we first wanted to deliver on our business process platform and on SAP business by design. Therefore, you can understand that our appetite this year was larger because we delivered both successfully. For me it’s pure strategic question. It’s a question of opportunity. It’s a question of strategic fit and it’s a question of -- if you really can, can create value and not destroy value in bringing two entities together? That’s at the end what drives us. And now, we are 100% focused on making this transaction happen and then making it successful.

Michael Briest - UBS

So, you are not ruling out doing another large deal soon after, if you felt it was the right thing to do?

Henning Kagermann

I cannot rule this out. If, coming back, if there is an opportunity which is a perfect strategic fit, it would be wrong to rule something out.

Michael Briest - UBS

Okay. Thank you very much.

Stefan Gruber

Thank you. We have time for one further question.

Operator

Thank you. The final question comes from Mr. Knut Woller of UniCredit. Please, go ahead with your question.

Knut Woller - UniCredit

Yeah, hello, if I can just two quick ones hopefully not too long for final one. And Werner you were indicating $56 million in pro forma adjustments on the operating margin due to acquisition related and stock-based compensation. Did I get that correctly implying an operating pro forma margin of 27.1% and could you give us the details for Q1 and Q2, I think you did not disclose them there? And a short question for Henning on the NetWeaver target, I think you were looking for roughly 1 billion in NetWeaver license sales for the full year in ‘07, is this still valid? Thanks.

Henning Kagermann

I can answer this. I think that is something what you misunderstood. I have never said a billion NetWeaver in 2007. Our guidance was always the ambition 2010. And if I look to, at the figures we have, I think we will come close. We will, in euro, I am not so sure in dollar, significantly beyond. So, therefore I would say let’s see, if we continue in the fourth quarter, put it this way, if we continue with the same pace we had in the third which was absolutely fantastic in NetWeaver we will get there but let’s see. But we can get close.

Werner Brandt

And I will provide you the numbers here. If you, again stock-based compensation expenses in Q3 this year was $38 million, year-to-date was $87 million and acquisition related charges in Q3 this year, $18 million and year-to-date, $42 million and if you add it together then you come to 56 in Q3 compared to 29 in Q3 last year and year-to-date it’s 129 compared to 111.

Knut Woller - UniCredit

Okay. Thanks very much.

Stefan Gruber

Okay. Thank you. This closes our conference call today and we look forward to seeing you here in Waldorf at our Analyst Day, on the 12th of November. Thank you very much. Good bye.

Henning Kagermann

Good bye.

Werner Brandt

Good bye.

Léo Apotheker

Good bye.

Operator

Ladies and gentlemen that concludes today’s conference call. Thanks for participating and you may now disconnect.

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Source: SAP Q3 2007 Earnings Call Transcript
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