Bill McDermott likes to use metaphors from the automotive world. “The machine is running full blast,” the chief executive of the world’s third-largest software manufacturer said earlier this year when announcing SAP’s annual earnings.
And the top-line numbers make his point. SAP is a money-printing machine that likes to keep its investors happy. Free cash flow from its business activities grew by 27 percent year-on-year to €4.6 billion ($5.07 billion) in 2016. Its share price is at a record high and the board is proposing a dividend of €1.25 for the year, up 9 percent from 2015.
On closer inspection, however, Mr. McDermott’s “machine” could have been a bit more frugal in 2016.
SAP has been spending billions in a costly retooling over the past few years. As a result, the company’s operating profit margin is far removed from what it once was. That should be a topic among shareholders at the company’s annual meeting Wednesday. Another likely bone of contention: High bonuses for executives like Mr. McDermott, the highest-paid CEO in Germany.
The IT world for companies is changing, and SAP is fighting – and spending billions – to change with it.
SAP has a tremendous history to fall back on. For decades, it has sold computer-programming packages that companies use to steer their internal processes. Indeed there’s hardly a company today that doesn’t use SAP software in some form. The company also gets about half its revenues from offering product and customer support, as well as business intelligence (data analysis).
That impressive track record may have given SAP a reliable source of revenue, but it’s no longer enough. Profit margins are falling for a simple reason: The IT world for companies is changing, and SAP is fighting – and spending billions – to change with it.
At the source of SAP’s challenges is “the cloud.” Rather than installing their own data centers, more and more companies these days are renting their IT services from internet-based software systems. It marks a paradigm shift from both a technical and business point-of-view, and one that has forced companies like SAP into a massive rethink about how they do business.
It’s not as if SAP isn’t aware of the challenge it faces. In fact, SAP started transforming its business model back in 2010. The company hasn’t shied away from expensive takeovers and investments in technology to retool. For example, SAP purchased the American travel-cost software specialist Concur in 2014 for $7.4 billion, its largest investment in cloud computing to date.
The new strategy has already had a positive impact. Revenues posted solid growth last year of 6 percent to €22.1 billion. That growth had almost exclusively to do with the boom in its cloud business, which surged 31 percent and earned €3 billion. The company forecasts revenues from the cloud to reach €8.5 billion by 2020, which would represent an average annual growth rate of 23 percent. In a letter this week to the company's 85,000-odd employees, Mr. McDermott said he expects cloud computing to make up more than half of SAP’s revenue from software processing as early as next year.
SAP has been cleverly retooling its traditional software platforms for the new online age.
In the meantime, the company continues to build new data centers. With revenues of €4.9 billion, the old model of selling software licenses still earned more in 2016 than the cloud business, though it didn’t grow much at all and could even shrink this year by mid-single digits, according to some forecasts. The declining trend will also have an effect on software support, which is linked to license selling. Last year this division still grew by 5 percent, to €10.6 billion, but that isn’t likely to hold up.
Even here, SAP is not positioned as poorly as its arch-rival Oracle, where the traditional license business suffered double-digit percentage losses during the same time frame. The California-based software firm also reported only a slight plus in its product support business.
SAP’s relative stability in the traditional software space can be attributed to a new program package called S4/Hana, which displays company processes in real time and is replacing SAP’s standard product R3. By the end of 2016, 4,500 companies had signed a contract for the new software – companies like Siemens, Bosch and Airbus – but new customers signed up as well, which bodes well for the future.
But even this strength is partly due to the fact that SAP has been cleverly retooling its traditional software platforms for the new online age – offering a hybrid of sorts to customers. For example, a new version of S4/Hana launched in February lets you run the software completely in the Cloud, meaning in the data centers built by SAP rather than installing your own. In other words, even SAP’s core product has staked its future on the growing cloud business.
So far, so good. But the solid growth in revenues comes with a price: SAP’s profit margin is weak. While it improved by almost a quarter to 16.4 percent in 2016, this was far below levels in 2013, and in any case much of the improvement was because some costs for restructuring were off the books in 2016. Competitors like Microsoft and Oracle offer much more here with margins of 19.7 percent and 28.6 percent respectively.
A deeper look at SAP’s costs bears out the problem. Overall, costs for generating sales grew a moderate 5 percent to €6.6 billion ($7.26 billion), but the future cloud computing business contributed disproportionately with a plus of 29 percent. Because demand for cloud services is so high, SAP is building new data centers, one of them at SAP’s German headquarters in Walldorf for €65 million and one in Colorado Springs, Colorado, for €122 million. Investment in R&D also rose by 7 percent in 2016 to about €3 billion, while sales and marketing cost €6.3 billion, an increase of 8 percent year-on-year.
SAP is effectively reinventing the entire company. That includes reorganizing the board of directors and putting the lion’s share of its cloud business into a single unit called the Cloud Business Group. The harmonization of its technical platforms will also cost more money before it will ever allow the company to save money.
But costs have also risen in part due to lavish bonuses for managers, which doesn't only apply to generous payments for the executive board members that have recently created a major stir. The company invested €785 million last year in share-based payments for all employees – more than what was already a generous payout the year before. With SAP’s stock hitting record highs, these payouts may grow this year to as much as €1.1 billion.
Some of SAP’s employee expenses were also hidden by accounting effects last year. In 2015, when 3,000 employees were let go with a compensation and early-retirement package, costs for restructuring rose to €621 million. Most of these costs were not on the books in 2016, but shareholders can expect these costs to appear again in 2017. The board also recently announced a restructuring of the service division, which will cost €250 to €300 million.
To be sure, the cloud business is becoming more profitable the bigger it gets. Indeed that’s the only reason SAP has been able to ensure the machine keeps running at full steam despite pumping so much fuel into it. But SAP still has work to do to put the company into a higher gear. The gross margin from its cloud business was 56.1 percent last year, which is far below that of the traditional software license business, at 85.1 percent. SAP equity yields rose slightly to 15 percent, but that is still far below levels from 2013. Purchases costing billions for companies like Concur are also not yet earning as high profits as SAP’s core business.
The good news is that SAP’s massive cash flow still leaves it plenty of room to maneuver. SAP has also taken its foot off the pedal when it comes to big takeover deals. In 2016, it only bought four small companies that cost the company €106 million. Management has been using the cash reserves not just for investments in restructuring but paying off debts that arose from its takeover of Concur. This has had an impact on SAP’s equity ratio, which grew last year to 60 percent. As long as the SAP cash engine keeps running full blast like this, shareholders’ anger about its efficiency will probably be limited.
Christoph Kerkmann is a correspondent cover Handelsblatt covering software and technology firms for Handelsblatt in Düsseldorf. Christopher Cermak of Handelsblatt Global contributed to this article. To contact the author: [email protected]