SAP’s Profit Takes a Beating Even as Cloud Business Continues to Grow

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Software giant SAP SE (NYSE:SAP) reported its fiscal 2015 second quarter results on July 21st. The company achieved a strong revenue growth of 21% year on year, helped along by favorable currency movements. However, SAP’s operating margin fell sharply by 4 percentage points due to the transition from the legacy on-premise software licenses model to the subscription-based cloud business model. [1] Heavy restructuring expenses also took a toll on SAP’s net profit margin, and the trend is expected to continue for the rest of the year. [2]

We believe that the ongoing shift from an on-premise to a cloud-based business model is likely to take a toll on SAP’s operating margin in the near to medium term. (Read: Currency Tailwinds Expected to Lift SAP’s Q2 Results, But Tough Times Lie Ahead?) The impact of the transition is likely to be severe enough that marginal improvements in gross margin of SAP’s cloud business may not be adequate to offset the decline in the company’s total operating margin. Further, the higher-than-expected restructuring costs are expected to drag down SAP’s net profit margin in fiscal 2015, but are likely to benefit the company in the following years through cost savings.

We are currently in the process of revising our price estimate of $80 for SAP SE to reflect the second quarter earnings.

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See our complete analysis for SAP SE here

Cloud Business Continues to Grow, But at What Cost?

SAP’s relentless growth in the cloud computing business continued in the second quarter. Its cloud revenues expanded by a tremendous 129% year on year in the second quarter, following the same growth rate in the first quarter as well. Cloud bookings expanded by 162% in the second quarter, underscoring the success of SAP’s cloud products. However, the high growth rates may be partly due to a low-base effect. SAP is currently on a run-rate of achieving $2 billion in revenues from cloud in fiscal 2015, which pales in comparison to Salesforce.com’s (NYSE:CRM) current year run-rate of over $6 billion. (Read: Salesforce Posts Robust Q1 Results, Raises Fiscal 2016 Guidance)

But the rapid growth of SAP’s cloud business comes at a cost. Its operating margin (IFRS as well as non-IFRS) has plunged in recent quarters, and the growth of revenues from on-premise software licenses is beginning to slow. The company has rejected any connotation that the slowing growth of the on-premise software business is due to cannibalization of revenues by the cloud business. [2] Nevertheless, it is a familiar phenomenon that is occurring with another software company in the middle of a transition to cloud: Oracle Corp. (NASDAQ:ORCL). (Read: Currency Headwinds Dampen Rapid Growth of Oracle’s Cloud Business in Q4)

Further, the transition from the legacy on-premise software licenses business model to a subscription-based cloud business model is also dragging down SAP’s operating margin. This is because in the legacy business model, most of the revenues from a new contract are booked upfront. On the other hand, in a cloud model, the revenues from a new contract are spread out over the life of the contract. Therefore, while the costs incurred in acquiring a new customer are booked upfront, the corresponding incremental revenues are not. Therefore, until a critical mass is achieved, a rapid uptick in bookings results in lower margins for the company. This is exactly the scenario playing out at SAP, as is evident from the contraction of 4 percentage points year on year in its operating margin. [1]

Restructuring Costs Taking a Toll on Net Profit

SAP’s restructuring costs shot up by almost 10 times in the second quarter compared to the same period previous year. The higher restructuring costs are on account of the voluntary and early retirement plan for SAP’s European employees. The program has been met with far higher acceptance rates than expected by the company, resulting in the higher restructuring costs incurred so far. The company expects the program to wind down in the current fiscal year itself, incurring costs of €470-€530 million in the process. This is likely to drag down SAP’s net profit in IFRS terms, although the company guides non-IFRS operating profit to expand by up to 5% year on year in fiscal 2015.

The restructuring costs incurred during the current fiscal year is expected to pay off dividends in the form of cost savings from the next year onwards. SAP expects incremental cost savings from this restructuring program to be slightly under €500 million in fiscal 2016, which could provide some relief to the company’s net profit margin next year.

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Notes:
  1. SAP Fiscal 2015 Second Quarter Earnings Press Release, July 21, 2015 [] []
  2. SAP Fiscal 2015 Second Quarter Earnings Conference Call Transcript, Seeking Alpha, July 21, 2015 [] []