SAP Lowers FY14 Profit Guidance On Faster Cloud Expansion

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Shares of SAP SE (NYSE:SAP) trended lower after the company reported lower than estimated profit in Q3FY14, with shares declining about 5% on Monday, October 20. Q3’14 revenues stood at €4,256 million, marginally higher than consensus estimates of €4,246 million. However, non-IFRS operating profit for the quarter was slightly lower than estimated, at €1,355 million against consensus estimates of €1,360 million.

SAP cut its operating profit forecast range for full fiscal year 2014 by about €200 million to €5.6 – €6 billion to accommodate the higher cost structure of its accelerating cloud business. However, the company believes it can meet its operating profit margin (non-IFRS) target of 35% by 2017. Additionally, SAP also increased its cloud revenue run-rate from €1 – €1.05 billion to €1.04 – €1.07 billion for full fiscal year 2014.

We have a $96 Trefis price estimate for SAP and are in the process of incorporating the latest Q3FY14 earnings.

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Recap of Q3’14 Results

Total cloud revenues increased 39% to €334 million this quarter, supported by a strong increase in cloud subscriptions and support services. Customers continued to move from traditional on-premise applications into software-as-a-service modules. This resulted in a decline in year-on-year sales for on-premise software licenses. New license sales stood at €952 million in Q3’14 compared to €977 million from a similar period a year ago. Cloud subscriptions now account for 22.6% of new software deployments for SAP. Comparatively, the contribution from cloud in a year-prior period was 16.8%.

In addition to the rapidly expanding base in cloud subscriptions, software support remains an integral driver of sales for SAP. Software support sales account for nearly 56% of total revenues for SAP, and have grown 8% year on year to €2,371 million in Q3FY14. This robust growth in support revenues, along with strong cloud growth, has masked weaknesses in new on-premise software license sales and professional service sales for multiple quarters.

Gross margins and operating profit margins declined in Q3FY14 primarily due to higher costs relating to its cloud product portfolio. Costs associated with software and software-related services increased 14% year on year on a non-IFRS basis to €618 million. Similarly, costs associated with SAP’s cloud business expanded 97% year-on-year, and were the main source of the depressed operating profit performance for the quarter. The accelerated shift to cloud also resulted in higher sales and marketing expenses, which were 6% higher on a year-on-year basis at €994 million in Q3FY14.

Cloud Sales Accelerate at Expense of Margins

For the nine months into fiscal year 2014, SAP has been able to grow its total cloud and cloud-related professional service revenues to €894 million, up 33% from the January – September period in FY13. Cloud billings on a non-IFRS basis rapidly accelerated from the start of the year, increasing 23%, 41% and 51% on a year-on-year basis in Q1FY14, Q2FY14 and Q3FY14, respectively. Cloud billings include recognized revenues and the difference in deferred revenue reserves over a particular period that are yet to be recognized.

The growth in cloud subscriptions has also induced growth into SAP’s flagship in-memory database platform, HANA. The company states that it has more than 1,450 customers for its BusinessObjects Suite on HANA compared to 450 a year ago. [1] To further expand the reach of HANA, SAP forged partnerships with IBM and HP to deploy its software applications running on HANA on HP’s and IBM’s infrastructure-as-a-service platforms. In addition to providing customers with varied deployment options, the hosted cloud model could ease margin pressure on SAP as it doesn’t own these data centers.

In the near term, we believe margins are likely to remain under pressure due to its investments into sales and marketing and other costs to increase its cloud footprint. However, longer term margins will benefit from a rapidly expanding revenue base and the ratable revenue recognition model for cloud subscriptions.

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Notes:
  1. SAP AG (SAP) CEO Bill McDermott on Q3 2014 Results – Earnings Call Transcript, Seeking Alpha, October 2014 []