Can dinosaurs find living space in a new world?
About 65 million years ago, or so it is said, a comet impacted the planet somewhere in the vicinity of the Yucatan. The resulting ash and volcanic activity apparently caused an extensive cloud to cover the planet and caused significant cooling. The dinosaurs, as they were cold-blooded, were unable to survive the change in the environment, and all of them, with the possible exception of a sub-species such as birds and some reptiles like crocodiles, were swept to extinction. We, Homo sapiens, are apparently an indirect product of what is called the fifth great extinction.
Honestly, what is going on in the IT world these days is of a ferocity little different than what is described as a great extinction event. In my time as both an industry observer and participant, I have seen mainframes and time sharing give way to mini-computers and then to networking with relatively dumb terminals, which was then supplanted by distributed data processing architectures and then client/server topologies followed by thin clients. There were always companies in the IT space that were rising and falling as the technologies changed, but for the most part, there were more companies being born than those on the cusp of extinction.
I suppose that at some point in the future, business historians will date the great IT extinction event to 2006 when Amazon (NASDAQ:AMZN) first decided to build a network for its own compute requirements and started to sell extra blocks of capacity to customers and christened the offering as Amazon Web Services. If ever there were a case of "might oaks from little acorns grow," this would be a prime example. Here we are barely a decade into the transition, and leading industry consultant Gartner says that already $111 of IT spending/year has migrated from on-premise to the cloud and that the transition is actually accelerating with $216/billion of revenue moving from on-premise to the cloud by 2020. Gartner says by 2020, 100% of 1,000 enterprises will be using the cloud in whole or in part for their computing, and that by that year, something in excess of 90% of new applications will be deployed in the cloud.
But unlike the geological mass extinction events, there are still some significant dinosaurs roaming the IT planet. For many years, there has been one of the great blood feuds of all time raging between SAP (NYSE:SAP) and Oracle (NYSE:ORCL). Successful investing at one level is a matter of making choices. Many years ago, investors had a choice of buying either IBM (NYSE:IBM) or the seven dwarves. No prize for figuring out the right choice. Then, there were a host of mini-computer vendors with names that are less well-known these days than the long departed automobiles like Pierce-Arrow or Packard.
Personally, I think I would try to avoid choosing between different dinosaurs. It isn't that they will not survive. After all, birds fill modern skies and they are apparently the descendants of dinosaurs. But there may be other choices in the IT world that might produce greater alpha.
But many investors like to invest in dividend-paying companies with conservative financials and long operating histories. As I recently wrote, for my money, the best of those is Microsoft (NASDAQ:MSFT). But for those who want to take a walk down memory lane to find an investment, the choice really boils down to IBM, Oracle and SAP. I have written recently regarding my views with regard to IBM and enough was said. So this time out, I will try to contrast and compare between Oracle and SAP and try to pick a winner in that confrontation. Just to relieve any aura of suspense, my conclusion is that despite its issues - and it has more than a few - SAP is likely to make its cloud transition with a bit less financial pain than is the case for Oracle. And to put the conclusion before the argument, the basic reason is that Oracle has a huge base of what is essentially an un-protectable underbelly in terms of its erstwhile semi-monopoly in the data base area, and while quantitative substantiation is lacking, it is likely that the continued decline in Oracle's on-premise license revenues is a function of the decline in that revenue source while SAP's S 4/Hana and its incorporated database will almost certainly enjoy increasing market share as the platform is gradually adopted.
A very nice snap-back indeed
I think that it is apparent that on balance, Q2 was for most software companies a much easier quarter in which to do business than was the first quarter of the year. That was particularly surprising for a company like SAP that is basically centered in Central Europe.
SAP is a German company and it reports in euros. It also reports using the IFRS standard, which is essentially the same as US GAAP. Most of my comments are going to be based on non-IFRS and on euros using a constant currency growth rate. In some instances, that hasn't proven to be feasible, for which I apologize in advance.
SAP reported its earnings on July 20, 2016. Just for the record, the results were a modest beat compared to prior expectations with EPS of E .82 compared to prior expectations of E .78. Earnings grew from E .80 in the 2015 period. I think what stands out in the operating results in two of the last three quarters including this one is that the company has been able to achieve growth in legacy license as well as rapid growth in the cloud, which has allowed it to achieve both top- and bottom-line growth in the midst of its transition. Cloud bookings rose by 33% in constant currency, but software license and support also rose by 7%. Cloud revenues in the last quarter were E 720 mil or $792 million out of total revenues of $5.3 billion. And so, total revenues grew by 9%, quite different than comparable results coming from Oracle. Cloud revenues for SAP were 15.1% of the total. SAP's cloud gross margins were 65%.
Overall, operating profit grew by 11% in constant currency and was E 1.5 billion or $1.7 billion. The operating margin for SAP in the last quarter was 29%, up from about 28% in the 2015 period. The 2016 tax rate was 34.5%, which was up from 31% the prior year.
Overall, the reaction to the operating performance and the guidance that SAP published and provided was positive. The consensus EPS forecasts increased by 6% this quarter and by 6% for the current year and by 9% for 2017. Since the day before the earnings release, the shares have appreciated by more than 6% and are at a high for the year. By comparison, the IGV, also now at a high for the year, rose 2%. Oracle's shares enjoyed about the same level of performance in the few days after the company released its numbers for its May ending quarter. On the other hand, the consensus earnings estimates for Oracle declined marginally. A bit of a "puzzlement."
Comparable operating numbers for Oracle in its May ending quarter were total cloud revenue of $860 million, a growth rate of 51%. Overall total revenues of $10.7 billion, which were flat with the prior year, with operating profits of $4.8 billion, a 45% margin and also flat with the prior year. Oracle's tax rate for the quarter was 29.2%, approximately unchanged from the prior year. Cloud revenues for Oracle are about 8% of the total. Oracle's cloud gross margins were 40%.
Unlike Oracle, which typically only forecasts one quarter at a time, this company forecasts both the next quarter and expectations for the full calendar year. At this point, SAP is forecasting a growth of 33% in terms of overall cloud revenues and for all software revenue to increase by 7% at the midpoint and to achieve a 3% increase in operating profits.
The analyst consensus for SAP, which is based on the forecast of 14 analysts, is for revenue growth of 16% this year and 6% next year, and for EPS to grow by 15% this year and by 10% in 2018. The difference between SAP's forecast and that contained in the analyst consensus essentially reflects adjustments for currency impact. The analyst consensus is comparable to the analyst consensus for Oracle shown below while the company forecast is not.
Comparable forecasts for Oracle, which cover its next 12 months through 5/31/17 and are based on analyst consensus estimates of 37 analysts, are as follows: revenue growth of 2.4% this year and 2.8% next year, and for EPS growth of 25% this year and by 9% in the year following.
SAP's reported cash flow in dollars declined for the most part, falling from $5.3 billion to $4 billion over the past three years. The change in constant currency however is much smaller and now appears to be reversing. Some of the change in cash flow relates to revaluation of assets which has been not insignificant. Most of that relates to the decline in the dollar amount of GAAP net income and changes on the balance sheet. The results for this past quarter showed a growth of 5% in terms of operating cash. The growth was mainly a function of higher GAAP income and a reduction in the relationship between cash taxes and taxes reported on its income statement. That being said, the company does pay a significant level of cash taxes. Deferred revenue growth is modest.
In Q2, the company's operating cash flow margin was 29%, flat with the prior year. The company had free cash flow for the period $2.5 billion-plus, more or less comparable to the $2.5 billion of 2015. At this point, and perhaps surprisingly, the company has not spent a lot of money on creating a massive cloud infrastructure.
Cash flow is best measured by the year, I believe. SAP's cash flow for the year ended 12/31/15 was $4 billion (E 3.6 billion). The company's cash flow margin for the year was about 18%. Its free cash flow for the year was E 3 billion, up 9% compared to the prior year as capex declined by 14%.
The company has been a serial acquirer over the years although Q2 was not a period of great activity in terms of M&A. The company pays a dividend, but the yield of 1.56% on the recently increased dividend is barely more than negligible. The most recent payout rate is 41%. As might be anticipated, the shares are mainly held outside of the US - the company is headquartered in Walldorf, Germany. US institutions hold 19% of the shares. A significant amount of the shares are still held by charitable institutions controlled by the original founders.
Primarily as a function of the company's numerous and sometimes substantial acquisition, SAP has a net cash position of $4 billion, far less than would otherwise be the case.
Some comparable data for Oracle are as follows: The company generated $3.7 billion of operating cash flow in its last reported quarter. That was down from year-earlier levels. Oracle's results are very seasonally weighted, and the last quarter was a Q4. The company sees maximum cash flows in Q1, minimum cash flows in Q2 and average cash flows in the two other quarters.
Because of that, I will use annual figures carrying forward. For the year, the company generated $13.6 billion of operating cash flow, which was a decrease of about 6% from 2015. Cash flow margin was 36%, down from 37% in fiscal 2015. Oracle has managed to avoid heavy expenditures for the build out of its clout. CapEx was $1.1 billion last year compared to $1.3 billion the prior year. The historical free cash flow yield for fiscal 2016 was 9.2%.
Oracle also pays a negligible dividend, which was not increased this past year. Its yield is 1.46, and its payout ratio is 29%. 87% of Oracle's shares are held by insiders (mainly Larry Ellison) and by institutions. The company has a net cash of $12 billion, most of it held outside the US. It has needed to borrow within the US to fund share buybacks and acquisitions.
Lots of numbers - some analysis please!
Oracle is 35% larger than SAP in terms of revenue. Oracle's market cap is 68% higher, and its enterprise value is 40% greater. SAP based on consensus earnings estimates as compiled by 14 US brokers has an estimated P/E of 19X while Oracle has a P/E of 15X. I should point out that SAP grew its IFRS (essentially GAAP) profitability by 81%. While that is not often the key point of an analysis, it will ultimately show up in terms of operating cash flow. SAP is growing quite a bit faster than Oracle although the rate of difference is obscured by constant currency adjustments. Oracle generates three times the cash flow of SAP.
Oracle's profitability has meant that at times it can and has chosen to buy strategic businesses more aggressively than SAP, and I have every confidence that it will continue to utilize that tactic in the future. This is a very high-stakes game and Oracle will not go quietly into the night.
Perhaps surprisingly, SAP has almost double the percentage of revenues coming from its rapidly growing cloud solution offerings compared to Oracle, and that is one of the principal factors in the company's higher growth rate and higher growth rate expectation when compared to Oracle. Lots of what SAP reports as cloud revenues come from its acquisitions - that was its cloud strategy for a while and it certainly has work to do in providing its users a soup to nuts suite of re-architected cloud applications. SAP bought some exceptionally strong cloud apps vendors, albeit at monster valuations. And the success of companies such as Ariba and Concur and particularly SuccessFactors has continued to grow at rapid rates since they have become part of SAP's suite of cloud offerings.
The other major factor that is crucial in terms of the difference between SAP and Oracle is that SAP's legacy revenue sources are growing and ORCL's are shrinking. Oracle has the albatross of its hardware business and SAP does not. And Oracle's on-premise database business is falling significantly although the company does not report that metric specifically. SAP has a negligible amount of on-premise data base revenues.
Clearly, Oracle is a significantly more profitable business than SAP. There are several factors that at least statistically explain Oracle's profitability advantage. One of these is that SAP has significantly lower gross margins on its sales of software and maintenance revenues. It also makes a very modest gross margin on services, particularly when compared to Oracle. And it spends much more in terms of ratios on both R&D and on sales and marketing. Last year, operating margins fell for SAP by more than 400 bps compared to the prior period. Overall, operating expenses rose from 73% of revenues in 2013 to 80% of revenues last year.
SAP spends 26% of revenues on sales and marketing and it spends 14% of revenues on R&D. Oracle spends 21% of revenues on sales and marketing and 12% on R&D (non-GAAP). Although it is not often expressed this way, it would appear that the basic difference in profitability between Oracle and SAP is one of trading off expenses for growth. SAP is focused on achieving greater top-line growth and it does so by spending more on both development and marketing at the cost of operating margins.
How do dinosaurs dance?
I think the simplest answer is that dancing is not a skill readily learned by middle-aged vendors that have to both ensure the satisfaction of their large users with their massive installations and compete for new workloads in the cloud while trying all the while to maintain a reasonable level of profitability. I think that SAP has, over the years, been willing to pay a bit more, i.e. pay higher valuations and to acquire somewhat larger companies in the cloud overall and that is why its cloud revenues are comparable to those of Oracle despite being a significantly smaller company.
Like many companies, SAP provides a slide deck to go with its earnings call. I think it is worth considering the numbers on the slide deck and compare them to consensus forecasts and overall valuation. The company describes its forecasts as ambitions. The company is forecasting operating profit ambition for 2017 of about E 6.9 billion at the midpoint and that is $7.6 billion translating at current exchange rates. For 2017, SAP is forecasting revenues of about E 23.3 billion or $25.6 billion at current €/$ exchange rates. Cloud subscription revenues at that point are expected to be about 17% of total revenues. Assuming that the ratios between operating profit and EPS remain consistent, SAP's forecast in EPS for 2017 works out to be $4.65, a bit less than the current consensus for the period.
I'm inclined to believe that given the extreme macro uncertainties that certainly seem to be focused within the EU, the company's current forecast is likely based on overwhelmingly conservative expectations. Luka Mucic, CFO said:
"We did what we said we would do - we delivered a strong Q2. I am proud how SAP is navigating with extraordinary success across all business. Dimension…we outperformed the competition in top and bottom line growth."
When looking at how dinosaurs dance, I think it is important to assess how nimble these beasts are. So far, the prize for nimbleness simply has to go to SAP at this point in its transition.
SAP's management even took a shot at a projection for 2020. At that point, it is forecasting that cloud revenue will double from 2017 and will reach $E 7.8 billion or about 29% of total revenues. While cloud revenues are forecast to double in euros and grow by E 3.8 billion, total revenues are forecast to grow by E 3.7 billion, which implies that the company's legacy revenues will be flat over the period. That would be a profound accomplishment if it actually happens and is far different than Oracle's expectations, which are that its legacy business is going to continue to contract over the next few years.
Dinosaurs dance far more effectively if they do not have to carry around obstreperous monkeys that bite and scratch. Oracle has to deal with its hardware business and its huge legacy cloud business, and it bites and scratches every chance it gets.
By 2020, SAP's "ambition" forecast implies that EPS will reach about $5.80-6.00 at exchange rates comparable to present values. At this point, it is hard to imagine that Oracle is going to be able to achieve a 30% increase in EPS between now and its 2020 year. It is lot harder to increase operating margins from the level at which Oracle is already functioning than it is to take up operating margins that are at far lower levels at which SAP is currently operating, I believe.
Why believe SAP and not believe Oracle? Does SAP have particular technology advantages or does it sell better? Where's the substance?
I haven't got second sight. Is Bill McDermott of SAP congenitally more trustworthy than the folks running Oracle? I have no way of answering that. Mr. McDermott has had a career marked by success, initially in various sales capacities at Xerox (NYSE:XRX), then as president of Gartner and finally as VP of Sales at Siebel. Working in a senior role at Siebel would not necessarily be a position from which to observe the more honorable side of dealing with stakeholders. Those of us who had to cover that company... well listening to its guidance was one of the more fraught exercises even by the standards of the IT world. Tom Siebel was often rumored to be running for political office. Very few analysts thought he was unfitted for the role given that he had an almost inexhaustible store of self justification, and when the truth didn't suit his purpose, it got dropped by the wayside.
Mr. McDermott has been a senior executive at SAP since 2002 during which time the company has had its share of ups and downs. Over the years, the company's track record in terms of meeting its forecasts is far from perfect. Was Mr. McDermott part of that process? I would be terribly surprised if on more than a few occasions he found it necessary to be economical with the truth. Like the GEICO ad says, it is what CEOs of IT companies do! If nothing else, it was no lay-down for Mr. McDermott, as American as is possible, to become the CEO of a very German enterprise. So, I do not necessarily suggest that Mr. McDermott has more or less credibility with me going back a decade or more than do the folks at Oracle.
So why do I find it a bit easier to believe the longer-term forecasts made by SAP on its quarterly call while finding that Oracle presentation more or less completely strains my credulity? I really do think that carrying and chain of trying to defend its database turf is a bridge too far. There is just too much headwind to deal with. Too much SQL, too much Amazon Aurora, too much Microsoft. The numbers that have to be defended are just a task that would be worthy of the efforts of Hercules to clean out the Augean stables, and to use the line Lloyd Bentsen used with such great effect in a different presidential election season, Mark Hurd - who essentially runs sales at Oracle - is just not Hercules (And no, I am not old enough to claim that I knew Hercules). And if Oracle cannot maintain revenues from non-cloud software and maintenance at constant levels, it is simply not very likely to be able to show much if any growth over the years during which SAP is planning to achieve a revenue CAGR of between 6% and 7%.
And why do I think SAP's mid-term ambitions are reasonable to use in computing a valuation. Firstly, SAP doesn't suggest, as does Oracle that it is going to need hyper-growth in the cloud to achieve its numbers. SAP is forecasting that its CAGR for cloud revenues is going to be about 28% and will reach close to E 8 billion by 2020 at which time it will be about 28% of revenues.
Oracle's expectations - well they are harder to tell. I believe during the call that Mr. Ellison suggested that Oracle would achieve hyper-growth levels for several years into the future. What that means in dollars is hard to say. From time to time, Mr. Ellison is guilty of speaking about numbers without thinking first. But just to come within distance of what SAP's goal is, Oracle is going to have to achieve a CAGR of something above 40% for its cloud through 2020 and that is going to be very hard to achieve.
The other matter is trying to compare what SAP is offering in the cloud versus what SAP calls its cloud offering. I don't think it is totally relevant to try to compare and contrast S/4HANA and the HANA Cloud Platform with the specifics of Oracle's products. But the big thing that needs to be understood here is that S/4Hana is an integrated business suite. If you want SAP's cloud applications, you are going to have to buy the database that supports those applications and that is SAP's HANA S/4. This is very, very different than the past world. Most SAP applications have run on Oracle databases since time out of mind. Over time, that will simply not be possible. This is going to be a process, and it isn't going to happen in a year or two, but it will happen. Oracle database is highly likely to lose share and some of that share is going to be absorbed by S/4Hana.
So while I might not believe Bill McDermott's projections on their own, the strategy here is such that I think SAP has the cards specifically and the hand overall in order to ensure that it will outgrow Oracle for the next several years, regardless of how a quarter or two might work out. I have referenced a paper presented by the Managing Director of a firm called OXYA, a subsidiary of Hitachi. For readers with the interest to see what an industry has written about the future and how it is going to affect Oracle vs. SAP, this is an industry study that is completely accessible, I believe. And it has the further advantage of not being filtered by my poor brain. There are other articles and analysis that suggest Oracle's applications in the cloud are probably slightly ahead of what SAP offers and that SAP is committed to a more step-wise approach. I really do not think the specifics matter terribly much if the point of view is that of an investor and not an industry commentator.
I think for readers, the likelihood is that SAP has done what it needs to do in order to ensure that the vast preponderance of its users will move with it into the cloud and not go with some competitive suite of cloud applications. Market share stability in applications, market share growth in data base and market share growth in some of the many products that can't be neatly categorized (Concur and Ariba are prime examples) mean to me that SAP is going to grow faster than Oracle. And if it can grow faster than Oracle, it is going to have the opportunities to leverage its growth into higher margins.
I think the odds favor SAP achieving and quite possibly beating its ambitions both for 2017 and for 2020 as forecast in its slide presentation, and those goals will, I believe, achieve performance that is quite a bit superior to what Oracle is going to be able to achieve.
- SAP recently announced its Q2 financial results and they were a significant snapback from rather disappointing Q1 levels.
- The SAP earnings presentation led to a decent share price run and also led to a series of revisions in terms of forward expectations for EPS and for revenue.
- The SAP earnings release suggests that it is able to sustain rapid cloud growth while maintaining some modest growth in its on-prem portfolio.
- The company's operating margins and its cash flow also appear to be growing.
- While on some metrics, particularly including free cash flow yield, Oracle's shares are cheaper than those of SAP. The forward outlook for SAP looks to be far more positive than Oracle's outlook.
- I think that SAP's longer-term predictions are more likely to be realized than those of Oracle because there are significant differences in the business environment that favor SAP.
- SAP is headquartered in Walldorf, Germany, and has more international exposure (international for us in the US) than does Oracle and will continue to do so for the foreseeable future.
- SAP can and might be expected to significantly improve its operating margins which are far below those of Oracle. It is essentially a matter of choice and of timing.
I do not expect stack vendors to become extinct. Many software vendors have aspirations of building their own stacks and it is financial prudence to wish to do so. While both SAP and Oracle are often referred to as industry dinosaurs, that does not imply that they will become extinct. Some investors like to dance with dinosaurs. If that is a preference, I believe SAP is a more suitable dance partner.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.