SAP SE (NYSE: SAP), the German enterprise software conglomerate, replaced its chief executive officer of nine years, Bill McDermott, last week, with a pair of co-CEOs, board members Jennifer Morgan and Christian Klein.
During his tenure, McDermott led SAP’s pivot to cloud software and grew the company’s market share in Europe. His last quarter with the company, the third quarter of 2019, was SAP’s first quarter reporting non-IFRS operating profits in excess of €2 billion (€2.086 billion), up 20% year-over-year. (One euro is equal to $1.12.)
Basic non-IFRS earnings per share grew 14% year-over-year to €1.30/share, up from €1.14/share in the third quarter of 2018.
Total revenues were up 2.1% sequentially from the second quarter, growing to €6.79 billion.
“In April we promised a stronger focus on profits and here we go – Q3 markets yet another milestone in delivering on this comment,” said Luka Mucic, chief financial officer, in a statement. “Q3 is also a manifesto of us keeping our second promise – continued strong top line momentum.”
But SAP’s proportion of ‘more predictable revenue,’ i.e., revenue generated by subscription-based cloud software sales, has hit a wall. SAP has consistently guided that the ‘share of more predictable revenue’ would reach 70-75% in 2020. In the third quarter, the company’s share of predictable revenue was 69%, up 2% from the prior year, but flat sequentially (it was also 69% in the second quarter).
“The Q3 details show that SAP’s focus on margins and cash flow may be beginning to yield results,” wrote John P. King, equities research analyst at Bank of America Merrill Lynch, in an October 21 investor note. “Cloud gross margins rose more than 5 ppt, but importantly this was buttressed with free cash flow doubling year-over-year. Guidance was reiterated for the full year and all outer years. We retain our Neutral stance in the belief that SAP’s current drive for margin upside puts at risk the growth, and thereby margin.”
The business segment that experienced the fastest growth in cloud revenue, Customer and Experience Management, which includes SAP C/4HANA and recently acquired Qualtrics, saw its profits plummet. Customer and Experience Management grew its cloud revenue by 95% year-over-year to €294 million; comparisons were helped by the Qualtrics acquisition. Overall segment revenue grew 75% year-over-year, but only 1.6% sequentially, to €371 million.
Yet with all that growth, Customer and Experience Management operating profits fell 84% year-over-year to €2 million.
SAP is a company that, when it makes an acquisition, immediately starts counting the new revenues in its year-over-year comparisons but continues to add back restructuring charges quarter after quarter. So far in 2019, SAP has made €2.99 billion in adjustments to its bottom line, compared to €1.3 billion in the first nine months of 2018.
SAP’s two other business units, Applications, Technology & Services and the Intelligent Spend Group, both grew profits by double digits. Applications, Technology & Services contains SAP’s most mature products, including SAP S/4HANA, Human Capital Management Solutions and its Business Technology Platform.
Applications, Technology & Services reported segment profits of €2.475 billion in the third quarter, up 17% year-over-year. Cloud revenues of €813 million represent just 14.7% of that segment’s overall revenues of €5.5 billion, but the cloud business grew 35% year-over-year against the larger segment’s revenue growth of 9%.
The Intelligent Spend Group includes SAP’s collaborative commerce capabilities (SAP Ariba), effortless travel and expense processing (SAP Concur) and flexible workforce management (SAP Fieldglass). Intelligent Spend recorded €828 million in segment revenue, €699 million of which came from the cloud (up 24% year-over-year) at a 78% gross margin, which narrowed by 40 basis points year-over-year.
Overall, SAP reiterated its full year guidance for 2019: non-IFRS cloud revenue should grow 33-39% at constant currencies; and non-IFRS operating profit should grow 9.5-12.5% at constant currencies. By 2023, SAP wants more predictable revenue to have an 80% share and achieve a non-IFRS cloud gross margin of 75%. This quarter, cloud gross margins were 69%, 500 basis points better than the prior year.