SAP Is Walking the Walk in Q1 '23
And here we go! SAP kicks off big tech earnings for Q1 2023, and they have set the bar high. As we slowly slide into a deteriorating macroeconomic environment that has seen material layoffs and declining growth rates across most of the tech superpowers (e.g., MSFT, AMZN, GOOG, and many others), SAP (along with Oracle) are ironically bucking the trend. While SAP did undertake a restructuring late last year in Q4 to the tune of 2.5% or 3,000 employees (note that they still have 1,000 open positions), I view this as an opportunistic play to optimize their staffing and cut loose resources that did not contribute to revenue growth or margin expansion.
Growth rates for the up-and-coming tech companies and the hyperscalers have been trending in the mid-20-percent range and have slowed to approximately 10-12%. By contrast, SAP’s growth rates have been mired in the low single digits, have now risen to 9% in Q1 FY23, and are forecasted to hit double digits this year. SAP’s new CFO, Dominik Asam, was not shying away from the challenge and stated on the earnings call, “Saying what we do and doing what we say will continue to be of great importance to us.”
I’ve already been hearing analysts boldly proclaiming that SAP will not be able to hold the line in terms of the 2027 end of ECC support date …?which is interesting, as Info-Tech Research Group was the only analyst firm that publicly stated SAP would not hold to the 2025 date – and we were right!
As we stated back in Q4 of 2019:
Fast-forward just over three years and ask, “Why do I disagree with the early voices of some analysts questioning SAP’s resolve in 2023?” Well, once net new customers are taken out of the equation, the adoption rates of S/4HANA are equally woeful as they were three years ago, so logic dictates SAP would run into the same brick wall, right? Not quite. Let’s start with the obvious, which is the quote (see above) SAP’s new CFO reaffirmed on the recent earnings call, which was followed up later with?CEO Christian Klein’s commentary stating, “…And then, second, what we now already communicated that there is the end of standup maintenance for all ERP releases lower than S/4HANA by the end of 2027. And I really would like to also say this today very clearly, there will be no extension of this timeline.”
That’s unequivocal. SAP must direct their full R&D resources to the new platform, so you can expect those license fees to keep declining at a 30-40% level (down from 13% in Q1) in coming quarters as SAP force-migrates customers to the cloud. Additionally, SAP has accelerated the acquisition of net new customers to the tune of over 50% of all new S/4HANA deals. The sustained influx of new customers, plus the steady slow drip of legacy customer migrations to S/4HANA and RISE, has likely calmed the waters in Walldorf and emboldened SAP to double down on their efforts to force-migrate customers to their cloud solutions. Finally, the next few years will have the cloud migrations from larger customers ramping up, consuming far more cloud resources, and driving these revenues higher just as the 2027 date arrives – a perfect storm for SAP.
Sure, things could change, and SAP could pivot backward on the legacy support issue, but not without taking a major hit to its credibility on Wall Street. S/4HANA, BTP, RISE and GROW with SAP – these are the buzzwords of a new day at SAP, and they are here to stay. Stay tuned for new targets for 2025 financials coming out of Sapphire, along with new product announcements including, of course, their generative AI efforts.
SAP Earnings Details
Key Notes and Stats from SAP’ Q1 2023:
This Deutsche Bank chart speaks volumes about how the technology landscape has changed dramatically in the past year. SAP’s cloud growth is easily outpacing that of its core competitors. To be fair to the competition, SAP had a slow start with S/4HANA Cloud and has only recently optimized its offerings with RISE/GROW with SAP. Most surprising is that SAP may be taking market share, as SAP’s growth is strengthening overall while Microsoft is in a flat-out decline, with Oracle running flat.
SAP’s cloud ERP growth is off the charts in percentage terms and not too shabby in terms of revenue, with overall cloud revenues clocking in at 3.2 billion euros in the quarter.
S/4HANA cloud revenue of 716 million euros for Q1 and an increase in the backlog to 3.4 billion euros at a rate of 79%. It is clear that SAP is building a revenue stream that will grow as new S/4HANA accounts slowly ramp up their migration/adoption of the solution in the cloud over the next few years.
SAP is bullish about these numbers and does not see a slowdown in the current challenging macroeconomic environment. The 79% growth in cloud backlog was particularly impressive as year-over-year comps are getting tougher. BTP now goes hand-in-hand with S/4HANA and continues to grow quickly while Ariba and Concur transactional volumes are back to pre-pandemic levels. The?SAP Cloud Extension policy?allows customers to retire on-premises support as long as that spend is replaced with subscription/cloud spend for eligible products, an expanded investment, and a five-year subscription term … but you get out of the shelfware! SAP is seeing this program yield a more than 2x multiplier on spend, meaning every dollar in terminated support is replaced by two dollars in cloud spend. While license revenues are declining (13% Q1, 30-40% normally) as new products are sold into the cloud, SAP’s support revenue only declined 1% to 2.91 billion euros in the quarter. We should see this number start to materially decline in the coming quarters as more customers migrate to the cloud.
SAP Current Cloud Backlog (CCB) grew 25% to 11.15 billion euros, with S/4HANA up 79% to 3.42 billion euros. Deals larger than 5 million euros stayed strong at 45% of deal volume compared to 50% in Q4 FY22 – showing that SAP is landing whales with S/4HANA. A total of 200 million euros of backlog was added to S/4HANA; expect growth to remain strong at mid-twenties percentage levels. Again, 50% of deals signed are net new customers, and SAP is gaining overall enterprise market share.
All regions globally had strong growth, led by the Americas at 19% cloud growth. Still, even EMEA grew 25% in the cloud (with lower overall growth than the Americas) despite their current recessionary environment. APAC+J clocked in with 27% cloud growth.
SAP Announcements
SAP had a lot of news events this quarter as they launched SAP Datasphere and GROW with SAP.
SAP Datasphere is a successor product to the BTP-based SAP Data Warehouse. SAP Datasphere aims to provide a data fabric approach to enable data sources located anywhere to be accessed, blended, and used holistically by SAP end users. SAP made this product switch mandatory, and when it launched, it instantly replaced the legacy SAP Data Warehouse Cloud product on March 8, 2023. SAP Datasphere aims to become the foundation for managing the data needs of the business across functions and applying AI based on high-quality, contextualized business data. SAP’s GVP-Head of Solution Management for Data Management, Planning & Analysis Tom Chelednik states, “With SAP Datasphere, it can be ‘connect, not collect’ and ‘federate first rather than ingest,’” to describe the ability to query data from multiple sources without replication and the data integrity issues that come with that practice.
To accelerate the adoption of this service, SAP has forged partnerships with Collibra (data governance), Confluent (real-time data streaming), Databricks (data lakehouse), and DataRobot (machine learning) to foster integration with SAP Datasphere.
Access these SAP articles to learn more about this new service:
GROW with SAP was also launched this quarter by SAP:?SAP Products – GROW with SAP. Think of GROW with SAP as a little brother to RISE with SAP. GROW is focused on mid-market companies with revenue of $1 billion or less. It is exclusively offered as an SAP public cloud solution and contains a subset of the attach offerings, such as BTP and “preconfigured, industry-specific, best-practice processes.” Of course, GROW will also come with various acceleration and launch services to assist in the ERP adoption. SAP sees high growth in mid-market customers new to SAP, and GROW is focused on this customer segment exclusively. SAP claims new customers can “go live in weeks at a fixed price.”
SAP also announced a new partnership with UI Path to build upon the SAP Build Process Automation stack. UI Path is also committed to expanding its use of S/4HANA Cloud in its own environment.
Qualtrics has been sold to Silver Lake for $12.5 billion, which will net approximately $8 billion to SAP’s balance sheet upon the deal closing. Qualtrics results have been backed out of this quarter’s earnings, resulting in a slight uplift to SAP’s core cloud numbers as Qualtrics grew slower than SAP’s core offerings. When asked about the Qualtrics sale and how the funds would be used (e.g., stock buyback or acquisition), SAP declined to comment. I would not be surprised to see an acquisition of a firm like Icertis (CLM) or Blackline (G/L Optimization), where SAP already has deep partnerships.
And last but certainly not least, SAP repeatedly advised that they would have announcements around their use of AI and generative AI at Sapphire in May. SAP claims they are in the advanced stages of applying generative AI across the SAP portfolio as they are an early release partner with Open AI and others. I expect this offering to materialize sometime in 2024, and one can also expect similar announcements from all the major tech vendors.
SAP Forward-Looking Projections
SAP is not backing down from their 2023 forecast and are projecting cloud revenues between 14-14.4 billion euros.
SAP gross margins are strong at 72.9% (down slightly from 74.1% in Q4/22), mainly due to the lower contribution from high-margin software licenses offset by margin from Cloud. Cloud gross margins improved to 71.4% despite increased investments. The harmonization costs associated with the cloud delivery program (many of which were prepayments to hyperscalers) will dissipate toward the end of Q2, which should see margin acceleration into Q3. As costs decline and efficiencies improve, these margins should appreciate further over the next 2-3 years. Predictable revenue is targeted at ~82% (vs. 79% in FY22) coupled with a stronger FCF of 4.9 billion euros. This graphic illustrates the path forward quite well but still understates the revenue growth targets reaching double-digits later this year:
Digging into the numbers on SAP’s income statement, more encouraging shoots are emerging regarding how the company manages resources. Of particular note is that R&D spending as a percentage of revenue is rising, up from 14% in 2019 to between 18-19% as an ongoing run rate this fiscal year 2023. This clearly indicates that SAP is reinvesting in its technology stack and aims to deliver on the mega-transformational potential touted for S/4HANA, BTP, and their other cloud offerings. Net net, SAP has already taken the pain from their restructuring and pre-investments in the hyperscalers for cloud capacity, and they can expect to see their gross margins expand over the next few years. SAP’s revenue goals also look achievable.
Tripling Down on SAP RISE and S/4 Cloud
SAP promotes large deals and logos acquired/expanded on each quarterly call. Below is a summary from Q1. Please note that deals that advertise a product specifically (e.g. RISE with SAP) do not necessarily indicate the deal is of a large scale. We have seen instances where large deals were done with perpetual licenses, for example, and contain a RISE component to be advertised as all-in on RISE.
Expansions of Customer Contracts
SAP Public Cloud Adoption
Mid-market (GROW)
Cross-Sell Success
Bottom Line
SAP is clicking on all cylinders, and the numbers are showing it. Even non-core products like Concur and Ariba are seeing transaction volumes rebound back to pre-pandemic levels. However, many organizations are still wondering if they are moving to S/4HANA for the right reasons; one customer quoted by JMP Securities stated candidly, “Are we doing this because it’s really new and better or just because they’re not really going to support the old version of this anymore?”
If your organization is not prepared to go to market for a new ERP solution or to at least push SAP competitively, then prepare to be a Led Zeppelin fan as “The Song Remains the Same.” SAP is committed to moving its customer base to the cloud, and it will become ever tougher moving ahead to purchase perpetual licenses at a competitive price, even for S/4HANA.
With momentum at its tail and a bright future, SAP will likely resolve to stand firm on guiding customers down their preferred product and deployment path. I believe SAP is sincere in the need for customers to transform their business processes, to build a clean ERP core, and to leverage the cloud fully to unleash the most impactful and cutting-edge capabilities. Whether their customers agree or not is a different story.