SAP Posts Strong 2014 Results, Cloud Business to Drive Future Growth

European software major SAP (NYSE: SAP) reported detailed fourth quarter and full year earnings on January 20th, following preliminary results released on January 12th (Read: Cloud Subscriptions Soar as SAP Achieves 2014 Guidance). The company beat its revenue guidance on the back of explosive growth in its cloud business and the continued success of SAP HANA. It also achieved its revised non-IFRS operating profit guidance despite the accelerating transition to a cloud-based business model, which typically results in lower margins during the transitional period.

Full year revenues were €17.56 billion, up 4% from 2013 revenues of €16.82 billion. The growth was led by a 56% spurt in Cloud Subscriptions and Support Revenue, which touched €1.1 billion in 2014. Software and support revenue, which includes revenue from new software subscriptions and technical support services, accounted for the bulk of the revenue and expanded by 4% year on year to reach €13.77 billion. The ongoing shift of focus to the cloud took a toll on Professional and Other Services Revenue, which fell by 6% year on year to €2.7 billion.

Operating profit was dragged down by TomorrowNow and Versata litigation charges and fell by 3% year on year to €4.3 billion. On a non-IFRS basis, which excludes such one-off items, operating profit grew by 3% to reach €5.63 billion in 2014. The non-IFRS operating margin declined by 34 basis points to 32%, primarily due to the focus on developing the cloud business, which involves higher deferred revenues compared to the current on-premise software business.

The company guides cloud and software revenue to grow by 8% to 10% in 2015, while operating profit is expected to be €5.6 billion to €5.9 billion on a constant currency basis.

We are currently revising our $86 price estimate for SAP to reflect 2014 results.

See our complete analysis of SAP here

The Future Lies in Cloud

SAP is firmly positioning itself for a complete makeover from a traditional on-premise software vendor to a cloud-based software vendor. The company’s shift of focus is evident from the fact that while its revenues from new software licenses declined, cloud subscription and support billings expanded by 104% year on year. Although part of this growth is attributed to the Concur and Fieldgrass acquisitions, the company still managed a substantial organic growth in cloud billings. This indicates that SAP is focused on acquiring new customers for its cloud business, even if it is at the expense of on-premise software licenses.

Accordingly, the company guides Cloud Subscription and Support revenues to increase to €1.95 billion to €2.05 billion in 2015 in constant currency terms, which is a growth of 77% to 86% compared to 2014. This astounding growth rate will be assisted by the cloud backlog (future revenues from executed contracts not yet booked) and deferred revenue (future revenues from booked contracts), which more than doubled to over €3 billion in 2014. By 2018, SAP expects cloud subscriptions to exceed sales of new software licenses.

Further, buoyed by the encouraging growth so far, SAP has pegged its cloud business to grow seven-fold from €1.1 billion in 2014 to €7.5 to €8 billion by 2020. Overall incremental revenue by 2020 is expected to be €10 billion. A substantial part of this growth is projected to trickle down to the bottom line also, with an incremental €3 billion in operating profits by 2020.

Highly Competitive Cloud Business May Inhibit Margin Improvement

SAP’s ongoing transition to the cloud resulted in a decline of 34 basis points in non-IFRS operating margin in 2014. This was because, unlike revenue from traditional on-premise software( which is mostly booked upfront), much of the revenue from cloud subscriptions is deferred over the life of the contract. High infrastructural investments for scaling up of the cloud business also resulted in lower cloud margin, although the margin erosion bottomed out by the end of the third quarter.

Although the company was able to contain the decline in margins in 2014, it has stated that it may not be able to retain the high level of margins which it enjoyed in the past. ^[1]  This is because of the highly competitive nature of the cloud industry, which will prohibit SAP from realizing high margins. Therefore, the company has effectively deferred its target of achieving a 35% operating margin by 2017 in favor of focusing on expanding operating profit in absolute terms.

Software and Cloud Subscription & Support to be Clubbed with Professional Services

With effect from 2015, SAP plans to implement a radical new approach in which all services, whether for on-premise software or for cloud subscriptions, will be provided under a common umbrella. As per this ‘ONE Service’ approach, all premium professional services, global support services and cloud subscriptions will be provided through a single organization under a common contract with a common rate. This plan extends SAP’s characteristic drive for simplification in its software products to its services also, which will now comprise of a single contract.

Consequently, the company will no longer distinguish between standard support services (currently included in Software Support Revenue line) and premium professional services (currently included in Professional and Other Services Revenue line). These will be clubbed along with revenue from cloud subscriptions into a single line item named Cloud and Software Services Revenue.

Cash Flow to be Used For Repayments as Debt Surges by 2.5x

SAP’s operating cash flow declined by 7% year on year in 2014 to €3.57 billion. The decline was mainly due to the payouts arising out of the TomorrowNow and Versata litigations, amounting to €555 million. Excluding this amount, the operating cash flow increased by 8% during the year. The company has stated that the cash flow will not be utilized for any further acquisitions in the near term, with the exception of a few minor ones of insignificant size.

Instead, SAP intends to trim down its debt which ballooned by over 2.5 times in 2014 to €11.5 billion, thanks to the leveraged acquisition of Concur. Its debt to equity ratio also doubled to 0.6x in 2014, which is slightly lower than Oracle’s ratio of 0.7x. The company now intends to stick to its conservative leverage policy and aims to bring down leverage over the next three to four years to the previous low levels.

Global Large Cap | U.S. Mid & Small Cap | European Large & Mid Cap
More Trefis Research

1. SAP Q4 2014 Earnings Call Transcript, Seeking Alpha, January 20, 2015 [↩]