SAP Q3’14 Preview: Sales Likely To Arrive Lower Than Estimates

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SAP SE (NYSE:SAP) is scheduled to report third quarter results on Monday, October 20. The first half of fiscal year 2014 has been robust in dollar terms. Half-yearly revenues stood at $10.76 billion, about 7% higher from a comparable period in FY13. Software and software-related service (SSRS) revenues posted a healthy 10% growth in dollar terms, reaching $8.95 billion so far in FY14. However, revenues from its professional services, which include various consulting and other services, continued to decline year over year on the back of an industry-wide contraction. In the first half of FY14, professional service sales declined 5% to $1.8 billion.

Gross margins for SAP contracted mildly by about 40 basis points in H1FY14. Divisionally, the SSRS segment witnessed a contraction of about 80 basis points to 79.4% in H1FY14. Gross margins in the professional services segment continued to spiral downwards, reaching 10% in H1FY14 from nearly 16% in H1FY13. Operating margins in H1FY14 were heavily impacted compared to H1FY13 by a $398 million litigation reserve relating to its TomorrowNow and Versata lawsuits. Excluding this litigation reserve, core operating profit margins for SAP have shown an uptick of about 40 basis points despite a contraction in gross margins in H1FY14.

In this pre-earnings note, we highlight key areas of focus in the upcoming Q3’14 results. We will be revising our $96 Trefis price estimate for SAP after the company files its interim report on October 20, 2014.

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Cloud Revenue Run-rate and Growth Rate in Focus

With the cloud software and software-as-a-service market heating up dramatically in recent times, SAP and other legacy software vendor have been forced to make various acquisitions to bolster their own product portfolios. Cloud revenues on a non-IFRS basis have grown by 38% and 39% year over year in the first two quarters of FY14, respectively. This revenue growth rate from SAP is higher than the growth rate reported by Salesforce, the largest cloud company, during the same period.

For the upcoming quarter, cloud revenues are likely to grow at near 40% growth rates in non-IFRS terms. Previously, SAP had acquired companies in the Supply Chain Management, Vendor Management and Networked Economies areas, giving it a decent advantage in the SaaS SCM market. Through the latest acquisition of Concur, which is expected to be fully consolidated into SAP in Q4FY14 or Q1FY15, SAP should be able to diversify its market position in the SaaS market by strengthening its presence in the Enterprise Resource Planning and Expense Management silos. [1]

Moreover, the company has recently announced a partnership with IBM to accelerate enterprise cloud adoption. [2] According to the partnership, IBM will provide cloud infrastructure services for business critical applications from SAP on its in-memory HANA platform. Previously, the company had a similar agreement with Accenture and Hewlett-Packard to accelerate adoption of enterprise grade application software suites in the cloud through HANA. [3] We believe SAP could potentially create an ecosystem in the long term that provides its customers the option of deploying its own application suites through these partnerships with infrastructure-as-a-service (IaaS) providers.

Impact of Eurozone Slowdown in Focus

Since the conclusion of H1FY14, most Eurozone economies are quickly turning sour. Recently, the German government cut its GDP growth forecasts for 2014 and 2015 from 1.8% to 1.2% and 2% to 1.3% respectively. [4] This slowdown in SAP’s domestic market and other European economies should lead to a slowdown in sales growth from the Europe, the Middle East and Africa (EMEA) market. As an enterprise software vendor, SAP relies on the performance of other industries for its growth, with companies upgrading software suites in a competitive growth environment.

Consensus revenue estimates stand at €4.25 billion, about 5% higher from a year-prior period. However, we expect deceleration from the slowing EMEA market to weigh on overall sales growth in constant currency non-IFRS terms for the quarter. Additionally, the depreciating Euro against the U.S. Dollar should depress dollar-based revenues. In the third quarter of FY14 alone, the Euro depreciated nearly 7.8% against the U.S. Dollar. This should result in lower reported revenue numbers from SAP in dollar terms, further dragging overall sales for the quarter. We will closely track constant currency sales numbers to gauge the impact of a slowdown on SAP and incorporate these trends into our forecast after earnings.

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Notes:
  1. SAP to Acquire Concur, Expanding the World’s Largest Business Network, Concur Press Release, September 2014 []
  2. IBM and SAP Partner to Accelerate Enterprise Cloud Adoption, SAP News Center, October 2014 []
  3. Accenture, HP and SAP Collaborate to Accelerate the Deployment of SAP HANA, SAP Newsroom, June 2014 []
  4. Germany cuts 2014 growth forecast from 1.8% to 1.2%, BBC News, October 2014 []