German software colossus SAP shares will more than double by 2023!

I had recommended SAP, the German enterprise software colossus as a strategic buy at €82 in early 2018 to applaud its CEO Bill McDermott for his commitment to the digital transformation of the UAE on the occasion of the World Government Summit. SAP, Dubai’s strategic partner in Expo 2020 and preeminent software vendor to the crème de la crème of the Emirati government/corporate constellation, has built a state of the art regional head office in Dubai Internet City and also made a quantum investment in Dubai’s “smart city” ambitions.

I wanted to welcome Mr. McDermott to Dubai as well as highlight a money making opportunity in SAP shares at €82 for GCC investors. In retrospect, I hope my valued readers and fellow investors acted on my call to buy SAP at €82 in February 2018. By early July 2019, SAP shares had risen to €125. So my column achieved its twin purposes – thanked SAP for its belief in the UAE’s digital future and flagged a 52% profit in SAP shares in seventeen months.

SAP shares have fallen to €104 as I write due to recent panic selling in the German stock market and the firm’s slight decline in licenses, cloud booking growth slowdown and free cash flow yield dips in the first half of 2019. I do not want to get software geeky, but SAP has a range of game changer product suites in its pipeline – from S4HANA to C4HANA, HCM, Business Network, Ariba procurement, Concur travel software, Analytics and Leonardo.

I see SAP’s valuation discount to its global software peers as a strategic investment opportunity for myriad reasons . One, SAP plans to triple cloud revenue from €5 billion in 2018 to €15 billion on projected 35 billion global revenues in 2023. SAP is increasing cloud revenues faster than Oracle and Workday and could well become the world’s second largest CRM software vendor after Salesforce.com. Two, SAP’s business model is leveraged to accelerate growth in the most exciting frontiers of technology – artificial intelligence, machine learning, quantum computing, the Internet of Things, robotics, E-mobility and smart cities etc.

Three, SAP’s operating margins bottomed in 2018 and are targeted to rise to 34% in the next four years. Four, SAP has been serial acquirer of some of the world’s most exciting software startups, spending $44 billion since 2005. SAP acquired Silicon Valley (Provo, Utah) online survey software unicorn Qualtrics a week before its NASDAQ IPO for $8 billion in cash. This deal, despite its huge takeover premium, is transformational as it revolutionizes real time sales intelligence software, along with its earlier acquisition of sales performance software firm Callidus. The strategy is obvious – SAP will disrupt Salesforce in CRM software. Five, X-data is a paradigm shift in online business intelligence software and SAP Qualtrics can literally generate $3 billion global revenues in this CRM niche. Rome was not built in a day, true – but it was not built without marble either.

Six, Elliot Management, the world’s most respected activist hedge fund, has taken a €1.2 billion stake in SAP last April. Like me, Elliott believes SAP is undervalued relative to the sheer scale of its cloud applications growth potential. Elliot projects SAP can generate EPS of €8.50 by 2023. If this happens, SAP will rerate to 30 times earnings and trade at a price of €255. In other words, SAP shares will more than double from its current €104. And why not? Satya Nadella quadrupled Microsoft shares since 2013, a process I rhapsodized about ad infinitum in my media columns.

While SAP’s second quarter 2019 results showed reasonable operating on margins relative to expectations and progress in expense control, its shares plunged 6% in Frankfurt as nervous fund managers focused on less than blowout license growth amid a global economic slowdown, angst about IT spending budgets and organic new cloud bookings. This can all cause software sell side analysts to potentially tweak EPS and free cash flow forecasts lower for fiscal year 2020.

A 3% license slip was inevitable when there are storm clouds in the global macro cycle as in 2019. SAP needs to reassure the financial markets about the shortfalls in now cloud bookings, the growth ballast for a global business whose core strategic thrust is “a pivot to the cloud”. Organic cloud new bookings growth has decelerated to 15% in the first six month of 2019. After all, this metric was a stellar 30% in 2017 and 24% in 2018.

The market has concluded that 25 – 30% cloud booking growth is not sustainable in a world where Europe, Greater China and Japan face recession. This means SAP is not immune to the deflation big chill triggered by Trump’s trade war with China (and EU, Mexico, Canada, India, Andromeda Galaxy etc.). SAP’s cloud products are world class, innovative and competitive on a scale even beyond its legacy on premise application software/ERP franchise. So a sharp slowdown in 2019 is due to macroeconomic headwinds rather than any flaws in the execution or product cross selling model in a firm with 15,000 global sales executives.

The 3% fall in organic licenses is was a tad disappointing given the momentum in the S4 product cycle did not offset the nasty macro zeitgeist. Hence the negative impact on fiscal 2019 free cash flow, which is not surprising given the scale of cash settled stock options awarded and higher tax payments.

Cloud gross margins increased an incredible 400 basis points year on year and 170 basis points sequentially in second quarter 2019. It is significant that SAP’s sales/marketing and research and development expenses fell as a percentage of global revenues despite the flattish license bookings. Management has clearly succeeded in its quest for rational expense control, a positive omen for the success of the 2019 restructuring program and future operating margin growth. S/4HANA licenses (60% of the overall license mix in 2H 2019) rose at double digit rates and so the drag from legacy on premise licenses will fall in 2020.

Greater China was the Achilles heel behind the decline in license growth in the past six months, evidence that the fall in Chinese GDP growth to 6% amid trade war uncertainties has now taken its toll. A robust pipeline and SAP Ariba deals will hopefully boost the cloud booking growth rate to 18 – 19% in the second half of 2019.

As August’s post FOMC, post Trump’s tariff fireworks in the stock market deepens, investors will not rerate SAP in the near term, given the concerns about license declines, cloud booking growth rates and free cash flow dips seen in the first half of 2019. When Wall Street goes into a spasm of risk aversion, fund managers act like Victorian surgeons of the old school: when in doubt, cut it out!

Assume SAP can generate the consensus €4.9 per share estimate for fiscal 2020. In this macro cycle, I envisage valuations can range from 22 to 25 times 2020 earnings. This means a realistic trading range for SAP in the next twelve months is 108 – 123 Euros. My projected valuation ranges of 22 – 25 times earnings for a world class software firm like SAP are hardly euphoric – in fact, a steep discount to global software peers. So, in practical terms, I am an aggressive buyer of SAP anytime Mr. Market slams the shares down to €104, as it just did as I write. I can imagine SAP trading in the mid 90’s if there is a new spasm of selling in the German stock market or another Tweeter in Chief shock. Yet if my valuation ranges are correct, the time to buy SAP is below a €100 for a €255 strategic target in 2023. Time in the market is the ultimate winner, not market timing.