German software developer SAP SE (NYSE:SAP) delivered a mixed set of second quarter earnings, reporting higher than estimated bottom line numbers while missing consensus revenue estimate. Non-IFRS revenues of €4.15 billion fell short of analyst estimates by approximately €70 million. However, the revenue shortfall this quarter was relatively smaller than the shortfall in Q1FY14, when SAP missed estimates by approximately €150 million.
Gross profit margins slipped to 68.9% from 69.5% in Q2FY13 due to a 1% and 6% drop in the software and software-related service (SSRS) and professional service segments. The professional services segment is currently witnessing an industry-wide margin contraction phenomenon, with gross margins having declined by 10% over the last six years. However, the gross margin contraction in the SSRS segment could be a result of increased investments into the growing cloud division.
In addition to the declining gross margins, operating margins were hit this quarter due to a $289 million litigation provision for the ongoing TomorrowNow and Versata lawsuits against SAP. The litigation provision also impacted net income for the quarter, with earnings per share (EPS) dropping to €0.47 from €0.61 a year ago. Excluding the litigation provision and appropriately adjusting for taxes, Q2FY14 EPS for SAP stands marginally higher at €0.66 compared to Q2FY13. Non-IFRS earnings per share (EPS) for the quarter stood €0.04 higher over consensus estimates at €0.79.
SAP expects full fiscal 2014 SSRS revenues to grow between 6-8% on a constant currency non-IFRS basis. Additionally, non-IFRS constant currency operating profit is expected to range between €5.8-6.0 billion for FY14 compared to €5.5 billion last fiscal year.
Software-related Service and Cloud Segments to Dominate Future Top Line Growth
New license sales of software products, which account for nearly 27% of SAP revenues, continued to drag down growth. Continuing from the 1% growth last quarter, on-premise software registered a 1% growth in constant currency non-IFRS revenues in Q2FY14 to reach €957 million. The weakness in software license sales, caused by the ongoing IT migration to on-demand computing, was masked by an acceleration in cloud revenues. The cloud division posted a 39% growth in constant currency non-IFRS revenues, marginally ahead of the 38% posted in Q1FY14. SAP upped its guidance for FY14 to €1-1.5 billion from its earlier guidance of €0.95-1 billion in view of the accelerated cloud revenue growth.
In addition to the growing cloud contribution, software-related services continue to remain a pivotal part of revenue growth for SAP, amounting to about 52% of overall SAP sales. Constant currency software-related service revenues increased 9% to reach €2.37 billion this quarter in non-IFRS terms. Software-related services from SAP include custom software development and maintenance & support, of which we believe custom development of software solutions accounts for a higher share. Going forward, we expect custom development revenues to trend higher from the surging demand for cloud computing solutions.
Within the maintenance & support division, support contract renewals rates for SAP have consistently remained in the high 90% range and its enterprise support offering continues to be the de facto industry standard.  Going forward, we expect software-related service revenues to remain a strong contributor to top line growth, driven by custom software development services, even as new license sales of on-premise software continue declining.
HANA Adoption Builds Pace; Partnerships Could Lend Further Support to Growth
Through fiscal year 2013, SAP has focused exclusively on improving HANA adoption rates by offering SAP Business Suite powered by SAP HANA. The bundled offering combines CRM, ERP, HCM, PLM and SCM software packages and provides businesses with an all-in-one package to capture and analyze data points from various departments. During the Q2FY14 earnings conference call, SAP reported having more than 1,200 customers on Business Suite powered by SAP HANA. The company reports having gained customers such as eBay, Siemens, Bosch, Carlsberg and Giorgio Armani as customers for SAP HANA powered solutions this quarter.  Additionally, the number of deals that exceed €5 million have increased by 7% on a comparable basis for the quarter, and is expected to attract bigger deals as the Suite on HANA offering matures. 
Furthermore, the company’s new strategic partnerships with Accenture, HP and VMWare are expected to drive HANA adoption higher. In the first partnership with Accenture and HP, SAP would be deploying HANA suites on-demand through HP’s Converged System Infrastructure while Accenture is the primary contact and manager for customer implementations of the HANA system. The partnership with VMWare leverages HANA’s real-time enterprise platform to empower customers to innovate, simplify and move towards a software-defined data center architecture. ((SAP and VMware Announce SAP HANA(R) for Production Use on VMware vSphere 5.5, VMWare Newsroom, May 2014))
In the near term, these partnerships should boost bookings for SAP HANA that is already building scale. Additionally, the ramp up of Cloud Infrastructure and roll out of the HANA Enterprise Cloud are expected to cumulatively drive overall HANA revenues higher.
We are in the process of updating our $96 Trefis price estimate for SAP to reflect the most recent Q2FY14 performance.Notes:
- SAP AG’s (SAP) Management Discusses Q2 2014 Results – Earnings Call Transcript, Seeking Alpha, July 2014 [↩] [↩] [↩]