SAP’s Successful Run in Cloud Continued in Q3, Future Growth Rests on Broader Product Portfolio

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SAP SE (NYSE:SAP) posted detailed third quarter results on October 20th, [1] after releasing preliminary results a week ahead of schedule on October 13th. (Read: SAP Q3 Preliminary Earnings: Cloud Business Continues to Expand But at a Slower Pace) The company continued its triple-digit cloud revenue growth rate in the third quarter, albeit the pace slowed slightly compared to the first half of the year. Perhaps more importantly, SAP appears to have achieved the critical mass required to derive economies of scale in its cloud business. Its Cloud non-GAAP gross margin improved by an impressive 9 percentage points year on year. Combined Cloud and Software (including on-premise) non-GAAP gross margin expanded by 80 basis points, which suggests that SAP’s on-premise software non-GAAP gross margin may also have improved. [2]

In the legacy on-premise software licenses business, SAP continued to rack up new customer wins in the third quarter for its S/4HANA ERP platform. However, revenue growth of the on-premise software licenses business slowed slightly compared to the previous quarter. This may be because the revenue cycle for the new customers may not have commenced yet. Regardless, if SAP is able to sustain the momentum in the adoption of its S/4HANA platform, it may be able to revive the growth of its on-premise software business.

Our price estimate of $80 for SAP SE is slightly higher than its current market price.

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See our complete analysis for SAP SE here

Future of Cloud’s Dream Run Rests on New Markets

SAP has defied the rapidly expanding scale of its cloud business and continued to expand revenues from cloud subscriptions and support by triple digits every quarter. To be fair, beneficial foreign exchange movements provided 10 to 30 basis points of tailwind for the cloud revenues every quarter. For fiscal 2015, the company guides revenues from cloud subscriptions and support to grow by up to 86% year on year in constant currency terms. [1]

SAP’s cloud products have achieved reasonably good adoption rates so far. However, in order to maintain the growth in bookings that the company has seen so far, it is crucial that its expansion into new territories is met with similar enthusiastic response from customers. SAP recently entered the lucrative cloud analytics market to compete head on with the likes of Salesforce.com (NYSE:CRM). It is also rapidly expanding its presence in the Internet of Things (IoT) industry with new products and partnerships. These are mult-billion dollar markets which could very well be responsible for driving the next phase of SAP’s cloud revenue growth. (Read: SAP Kills Two Birds With One Stone, Integrating Predictive Analytics with Big Data & IoT)

Was The Third Quarter a Herald of an Era of Margin Accretion?

SAP achieved impressive improvement in non-GAAP gross margin across the board in the third quarter. The company-wide non-GAAP gross margin stood at 72% in the third quarter, which is almost flat compared to the same period previous year. However, it represents an improvement of 140 basis points compared to the previous quarter. The highlight was the 9 percentage points improvement in non-GAAP gross margin of the cloud business.

The company attributed part of the margin expansion to the company-wide transformation program, which yielded cost savings in the “mid-double digit million euro range”. [2] We believe that lower capex in the third quarter may also have contributed to the improvement in the cloud’s gross margin, since depreciation on data centers is a major component of this account line. Further, the company may also be benefiting from economies of scale associated with a rapidly expanding customer base. If this is indeed the case, SAP’s cloud gross margin is likely to improve further in the following quarters.

The strong improvement in gross margins trickled down to the bottom line also, as non-GAAP operating profit grew by 19% year on year and non-GAAP EPS by 16% year on year in the third quarter.

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Notes:
  1. SAP Investor Relations [] []
  2. SAP Fiscal 2015 Third Quarter Earnings Call Transcript, Seeking Alpha, October 20, 2015 [] []