Description

We are long SAP as multi-year transformational changes begin to drive inflections in numbers. A product cycle is accelerating organic revenue growth from ~5% pre-COVID to 10%+ p.a. And after a decade+ of cost bloat and M&A fueled empire building under its former CEO, SAP’s new management team has re-focused the organization around its crown jewel assets, implemented multiple efficiency initiatives, and demonstrated more disciplined capital allocation.

SAP continues to trade only slightly above pre-Covid multiples relative to the index on consensus numbers that we believe are too low. We are ~25% above consensus on 2028 FCF/sh.

We believe shares can trade to €330 incl. dividends on 25x our 2028 FCF/sh fully burdened for stock comp. This represents a 19% IRR and 1.9x vs. ~35% near-term downside. We think this risk/reward is attractive considering the low probability of permanent capital impairment given the mission critical nature of SAP’s products.

Key thesis points:

(i) S4/HANA product cycle reaching a tipping point

SAP’s core ERP business is a crown jewel asset. IDC market share estimates for ERP (SAP 29%, ORCL 19%, no other vendor above 5%) use a broad market definition and include a long tail of niche vendors. We believe this meaningful understates SAP’s dominance in F500 and G2000 core general ledger ERP deployments; nearly 80% of the world’s electronic business transactions happen on SAP.

Investors have been promised an S/4HANA product cycle for over a decade and are generally skeptical after numerous false starts. Our customer and partner checks have grown incrementally encouraging over the past 12-18 months and we think that there are emergent fundamental reasons why companies are beginning to migrate now:

·          More than half of SAP’s on-prem revenue today comes from ECC, for which support expires in 2027. SAP’s large customers understand that RISE is a multi-year endeavor and we see increasing evidence that migrations off ECC are accelerating ahead of this deadline. While the company pushed out the deadline once already (in early 2020 – extending it from 2025 to 2027), we do not expect an additional extension given management’s more consistent messaging around holding this deadline, and we’ve observed a growing consensus from customers and SI’s that this is the case. Furthermore, we believe the market is overlooking that 30-50% of the ECC installed base is on older versions of ECC (EHP5 or earlier), where support expires in 2025 (i.e. the extension to 2027 does not apply).

·          SAP has invested significantly in post-McDermott years to integrate its sprawling cloud solutions to reduce technical debt and smooth the upgrade path. The company undertook a nearly 2-year endeavor to migrate the underlying databases for its acquired cloud applications (SuccessFactors, Ariba, etc.) to HANA, and has added resources for customers to expedite and simplify the RISE upgrade journey via the acquisitions of Signavio, LeanIX and WalkMe.

·          With AI front-of-mind for CIOs, and in many cases crowding out net new software budgets, we believe there’s a greater imperative to modernize internal data infrastructure in order to run accelerated compute workloads. This is a more tangible version of the fluffier “post COVID modernization push” as one of the first steps is to clean and modernize old disparate on-prem ERPs. This narrative has been corroborated both by the company (emphasizing a lack of macro impact thus far YTD, in contrast to growing pressure at other large-cap peers) and by SI’s whose feedback YTD has implied an acceleration in SAP pipeline. Most SI’s we have spoken with expressed that they are becoming resource constrained and expect that trend to only increase into the 2027 EOL. 

While it’s hard to distinguish which of the above narrative shifts is most directly impacting numbers today, we are seeing it in our data and 3p checks, as well as in SAP’s reported numbers.

Source: Customer surveys.

Source: SAP disclosures. Q1/24 is estimate based on total cloud bookings.

As S/4HANA bookings accelerate, we believe there will be three meaningful impacts to revenue:

·          Cloud revenue comes at a 2-3x uplift (1.5-2.5x gross profit dollar) to server maintenance. With RISE, software licenses are now bundled with cloud infrastructure and managed services.

·          RISE is often accompanied by high-margin incremental PaaS revenue – the company has achieved >80% attach rates on PaaS in RISE migrations. A core part of the S/4HANA product upgrade cycle was the shift from running ECC on third-party databases to running S/4 on SAP’s purpose-built HANA real-time database.

·          Growing evidence that customers spend more organically / NER improves once on cloud. S/4HANA customer cohorts grow revenue at 28% p.a. starting in their first full year, 27% in their first 3 full years, and an additional 20% in years 3-5.  

(ii) Significant opportunity to bring margin and cap allocation to industry average

We also believe that a significant change in tone has taken place with management at SAP. Through the 2010s under its previous management team, we believe SAP was run as a company stuck with a large monolithic legacy ERP business that needed inorganic horizontal expansion to grow. While McDermott recognized  the imperative for SAP to modernize toward cloud and SaaS, evidenced by some excellent early acquisitions, we think he was too slow to push to modernize the core ERP business and increasingly overpaid for shiny objects with questionable strategic fit.

We view current CEO Christian Klein as almost the perfect foil. Whereas McDermott was described by formers as the ultimate salesman, Klein is known for being an operations and product focused “numbers guy”. As an illustrative example, Klein’s claim to fame early in his SAP career was his initiative to calculate and catalog the fully loaded developer cost across SAP’s various projects.

Klein was in an unenviable position when named co-CEO in late 2019 and then sole CEO shortly after in Spring 2020. Under prior leadership, acquired assets were only loosely integrated, eventually resulting in significant technical debt and a confusing go-to-market. To our surprise, Klein announced a plan that we thought would have been the perfect answer to “what would you do differently if SAP was a private company?” Reset margins materially lower for multiple years to harmonize the code base, divest problematic acquisitions, one-time reset the end-of-support deadline for ECC to a more realistic timeline, and re-focus on SAP’s crown jewel ERP assets and the S/4HANA product cycle.

Public market investors rewarded Klein’s long-termism by sending SAP stock tumbling >30% when the plan was announced during the bull market of 4Q 2020.

The good news for investors is that we are coming out on the other side of this painful but necessary transition period. So what can investors potentially look forward to?

·          Significant margin expansion: SAP’s trailing “GAAP” EBIT margin of 19% significantly trails that of large-cap software peers (“GAAP” in quotes since SAP reports in IFRS, and its “non-IFRS” numbers are now fully burdened for share-based payments). While SAP’s large European employee base and underlying product mix makes it difficult to fully close the gap, our work suggests that SAP’s GAAP EBIT margins can improve at least 10 percentage points over our forecast period. Management has committed to “decoupling revenue growth from cost growth”, and we think evidence currently leans in favor of this trend following a ~7% RIF announced at the end of FY23. We expect meaningful leverage on both the S&M and R&D lines, but our assumptions may prove conservative – our forecast has R&D intensity declining from 20% to 16% of revenue as we pass the heightened investment of harmonizing the codebase/retiring technical debt; this is still above scaled software peers in the low-teens and >200bps above SAP’s own run-rate R&D intensity pre-2020.

·          Shareholder friendly capital allocation: >80% of FCF was used for M&A during McDermott’s tenure, whereas thus far ~65% of FCF during Klein’s tenure has been returned to shareholders through dividends or share repurchases. Over the next five years we believe management can increase dividends at a compounded high-teens rate (based on recent guidance on payout ratio), and execute €25bn+ of repurchases, representing 12% of shares at today’s price.

·          Improve FCF conversion: Historically, SAP has booked multi-year contracts but billed most customers quarterly, resulting in relatively low contract liability balances. We believe the company is prioritizing a move toward annual billing cycles (more typical in the industry, with some of SAP’s enterprise peers billing multi-year deals entirely upfront). Under previous management, from 2014 to 2019, FCF conversion from post-SBC operating income averaged ~50%. This has already improved to ~70% under the current management team, but we see room for this to approach 90% in our forecast period without heroic assumptions on contract liabilities as a percentage of backlog.

Note: Other Software Vendors >$10bn Revenue includes MSFT, ORCL, CRM, ADBE and INTU.

Valuation

 In our base case, we model >€14 in reported FCF/sh in 2028, at which point we see revenue still growing double-digits and FCF/sh and EPS growing high teens+. We use 22x on 2028 FCF (25x FCF fully burdened for SBC) to underwrite a base case target price of €330/sh including dividends, and a near-term downside price of €115/sh based on 20x our below-consensus 2025 bear case non-IFRS EPS (fully burdened for SBC).

The market has started to catch on to the inflection at SAP with the stock +27% YTD and screens at 33x NTM P/E, but adjusting for the accounting change at year-end 2023 (treating SBC as a real expense), SAP’s multiple hasn’t re-rated nearly as much as it appears on Bloomberg.

Most likely ways we’re wrong

Margin pressure on private cloud gross margins: SAP pricing and packaging is opaque. The company has consistently messaged that it expects cloud gross margins, even private cloud gross margins, to improve from current levels as the platform scales. With blended cloud margins in the mid-70s today but private cloud ERP gross margins closer to 60%, we see downside risk to consensus blended cloud gross margins. As SAP moves customers to the cloud, we expect the company to extract incremental gross profit dollars, however we expect it to be meaningfully dilutive to the 90% gross margins the company has historically realized with on-prem license/maintenance. We model cloud gross margins several hundred basis points below street.

Higher share of customers opt for extended maintenance: While we believe customers are taking the 2025/27 ECC expiry deadlines as final, we expect some customers to maintain ECC on-prem deployments via third parties well beyond the 2030 extended deadline. We expect most customers to migrate through RISE, but we don't model a large wave of customers to migrate by 2027, instead assuming that migrations continue along their current trajectory through the end of the decade.

Operating costs grow faster than we expect and operating leverage doesn’t come through: We assume absolute dollars of non-IFRS operating costs added per year roughly in line with the previous 10-years’ average going forward, which we view as conservative under this management team.

Near/medium-term bookings deceleration from macro: Management and channel partners (as recently as the user conference in early June) insist that they are not seeing the same headwinds that peers like WDAY or CRM have seen in recent quarters. We believe this suggests a higher level of priority customers are now putting on their migrations to S4/HANA. However, this is counter to conventional software specialist heuristics that ERP deployments are delayed during periods of macro headwinds. It is possible that enterprise headwinds / longer deal cycles are taking longer to reach SAP and will have more of an impact on 2H.  

Catalyst

- accelerating top line

- incremental margin expansion whereas consensus expect flat margins post-2025