SAP Q2’14 Preview: Cloud Revenues and Operating Margins in Focus

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SAP SE (NYSE:SAP) is scheduled to report its Q2’14 results Thursday, July 17. The company has a well diversified software product portfolio and its flagship Enterprise Resource Planning (ERP) software suites comprise almost 30% of our $96 valuation. Non-IFRS revenues last quarter (Q1’14) stood at approximately $3.9 billion, 6% ahead of revenues from Q1’13 on a constant currency basis.

Revenues from cloud subscriptions and cloud service support were the strongest contributors to total revenues, growing 38% between Q1’13 and Q1’14, driven by an industry-wide shift to Software-as-a-Service (SaaS) deployments. In turn, the strong demand for cloud has impacted the on-premise software segment, which has been posting sluggish growth rates for multiple quarters. Q1’14 software sales grew 1% over Q1’13. A year ago, on-premise software sales grew 5% over Q1’12.

In this pre-earnings note, we highlight key areas of focus in the upcoming Q2’14 results.

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Cloud and SCM Revenues in Focus

ERP application systems and management suites are SAP’s best-known software products. The company is the market leader in this domain, with a 24% market share in the $26 billion market. However, SAP has been aggressively diversifying its product base primarily through inorganic channels of late.

With its major competitor Oracle (NYSE:ORCL) acquiring companies in the Customer Relationship Management (CRM) vertical (digital marketing in particular), SAP has focused on building a robust portfolio in the Supply Chain Management (SCM) market by acquiring Ariba and FieldGlass. Given that these acquisitions are cloud-based SCM companies, we expect SAP to see an acceleration in revenue growth on a longer term. For FY14, we expect revenues from SCM software offerings to keep pace with the overall market growth.

Impact of Profitability Deferral in Focus

During the Q4’13 earnings conference call, SAP’s management announced a deferral in meeting its profitability target of 35% from 2015 to 2017. Heavy investing into the cloud platform was cited as the reason for the profitability target deferral. Since the Q4’13 earnings, SAP’s stock has declined 10% year-to-date, while its competitor Oracle’s stock gained 6%. However, SAP has been able to outpace both Oracle and Salesforce (NYSE:CRM) in cloud revenues since its profitability target deferral. For the first quarter in CY2014, SAP reported a 38% growth in revenues compared to 37% for Salesforce and 24% for Oracle.

In the upcoming earnings report, we are looking for updates on SAP’s margin performance. Second quarter operating profit margins (on an IFRS basis) over the past two fiscal years stood at 23.6% and 24.4% respectively. We expect operating profit margins to remain close to 25%, with rapid growth in cloud-based revenues offsetting the increased investments into R&D and S&M activities.

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