There’s an old salesman’s adage that every product needs a story, and Bill McDermott, chief executive of German software maker SAP, has taken it to heart.
At the business technology fair Sapphire Now in Orlando, Florida earlier this month, he pitched the key advantage of SAP’s new software S4/Hana: it makes companies digital. The American executive is well aware that this is a huge topic in boardrooms right now. “With S4/Hana you’ll run your business in absolute real time,” he said with arms outstretched.
The world’s biggest supplier of business software is putting all its eggs in one basket with the product. Its launch failed to gain much media attention outside the United States even though SAP gave a decent presentation on the New York Stock Exchange in early February.
The muted reception comes as a surprise because the new software with the unwieldy name is nothing less than the successor of SAP’s core product for many years, the top-selling R/3.
S4/Hana isn’t just slimmer and simpler than its previous software suite, it’s also faster and far more flexible, partly thanks to the new database platform Hana. The software is available for fixed installation onto clients’ computers but also as a cloud computing service, which can be rented and downloaded from the Internet.
SAP doesn’t just need to reinvent its core product - it needs to reinvent itself.
The new core product is having a fundamental impact on SAP. If it wants to seize all the opportunities offered by S4/Hana, the company itself will have to change.
Forty-three years after it was founded, SAP doesn’t just need to reinvent its core product - it needs to reinvent itself.
For example, in this brave new world of subscription software and programs constantly beefed up with new capabilities, SAP will no longer need its armies of specialists who spend weeks installing and fine-tuning systems in their clients’ offices.
That means that for the first time in SAP’s history, it faces the prospect of redundancies. The management has announced plans to cut the workforce by 3 percent this year and industry analysts expect that redundancy programs will be an annual occurrence at SAP from now on.
“Our industry is so dynamic that I can’t say in detail what will be necessary in five years,” Chief Financial Officer Luka Mucic said recently, adding: “But it’s clear that every company has to continuously adapt its structures to market conditions.”
Shareholders will need to become accustomed to the item “restructuring costs” featuring regularly in SAP’s profit-and-loss account from now on. Last year those costs rose to €126 million, or $143.5 million, from €70 million. SAP’s reinvention is also being reflected in the group’s total cost of sales which rose 5 percent to €5.272 billion in 2014. That figure includes outlays for setting up and running the data centers needed to offer cloud computing.
The costs in turn are having an impact on operating profit which fell last year to €4.33 billion from €4.48 billion. The operating margin worsened to 24.6 percent from 26.64 percent.
The big question is whether cloud services will be as profitable in the long term as the traditional sale of software licenses. In its 2014 annual report, SAP was surprisingly reticent about the profitability of its cloud business. In 2013, the company had provided a breakdown of earnings per segment. But the management stopped doing so for 2014.
In its annual report, SAP noted that it had merged its on-premise sales forces and support units with its cloud sales and support teams. “We run our operations as a single business operation due to the functional organization. Since this integration, our cloud-related activities are no longer dealt with by separate components in our company,” the report said. That doesn’t answer the question investors are posing.
Another item that stood out in the balance sheet was the high level of goodwill which surged to €20.95 billion in 2014 from €13.69 billion. The increase was driven by the takeover of Concur, a U.S. expenses software maker, to strengthen its position in cloud computing, in a €6.2 billion deal that was the most expensive in SAP’s history.
The goodwill reflects how high the purchase price was above the actual assets of the company acquired. As a result, goodwill is seen as vulnerable to writedowns, for example if the new subsidiary doesn’t live up to expectations.
At first glance, SAP has a risk in its balance sheet that exceeds its total equity. In the worst-case scenario of SAP being forced to write down all its goodwill, the group would become over-indebted.
That’s unlikely to happen, though. In the past, SAP has never had to make unplanned writedowns on corporate assets. Business software is seen as a stable business, and that’s borne out by the cash flow — it totaled €3.5 billion last year, and €2.8 billion excluding capital expenditures. That’s down from 2013, but it’s still high by comparison with other companies in the DAX, the index of Germany's top 30 blue-chip firms.
Even if SAP had to make writedowns, it could handle them because it has relatively low debt. Its net liquidity, defined as group liquidity less total financial debt, worsened to a negative €7.7 billion in 2014 from minus €1.5 billion. But that’s still just 39 percent of total equity, which doesn’t pose any concerns.
Nevertheless, SAP’s debt and its goodwill have reached levels that will make further big takeovers far more difficult. It’s little wonder that the chief financial officer Mr. Mucic has stressed that big takeovers aren’t on the agenda. So SAP won’t be able to bid for the really big players such as cloud specialist Salesforce, which is up for grabs and worth some $50 billion. Shareholders are unlikely to be disappointed by that though, given the risks such a purchase would entail.
Jens Koenen leads Handelsblatt's coverage of the aviation and IT industry and heads the Frankfurt office. Christof Kerkmann is an editor for Handelsblatt Online writing about the technology sector. To contact the authors: [email protected], [email protected]