SAP SE

Moat: 3/5

Understandability: 3/5

Balance Sheet Health: 4/5

SAP SE is a global software company, renowned for its enterprise applications, but it’s now actively undergoing a transition to cloud computing and AI and is seeking to solidify its place as a platform provider.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

SAP is at a critical juncture, transitioning from on-premises software to the cloud and integrating AI, making its current financial performance less indicative of its future. While it has shown a strong commitment to this transformation, the market has reacted with cautious optimism.

Business Overview:

SAP operates in the enterprise application software market, a space that offers a range of services for managing business operations, supply chains, customer relationships, and financial systems.

  1. Revenue Distribution:
    • Cloud Revenue: SAP’s primary focus for growth is in its cloud business, which has shown consistently strong growth, increasing 24% in 2023, and now comprising ~35% of the company’s total revenue.

SAP has recently accelerated its efforts in the cloud segment, reflecting the company’s future strategy, by emphasizing its cloud platform “RISE with SAP”, and it’s seeing traction in the form of an increasing number of customers choosing to move to its cloud service.

  • Software Licenses and Support: This legacy portion of the business is characterized by higher initial prices from perpetual software licensing, but slower growth and declining revenues. It accounted for roughly half of the total revenue in 2022. * Services Revenue: Service revenues, which are comprised of software support and consulting, represent the remaining part of the revenue, and their growth has been somewhat less impressive compared to cloud.

A key point in understanding SAP’s revenue is the shift from perpetual software licenses to a cloud-based model. Cloud is now the most important part of SAP’s revenues. While legacy licenses are still an important, declining, part of its business.

  1. Industry Trends:
    • The demand for integrated cloud computing solutions is growing rapidly, as companies seek to streamline business operations. The cloud-based segment within SAP is the main growth driver.
    • Artificial intelligence is transforming industries and is creating new opportunities for companies to leverage data-driven insights. SAP has announced significant investments to improve AI capabilities and is integrating AI into its platform and software offerings.
    • Regulations, including the EU’s Carbon Border Adjustment Mechanism (CBAM), are placing new demands on the reporting and management of environmental data for industries worldwide.
  2. Margins and Competitiveness:
    • SAP’s margins tend to be quite healthy, with gross profit margins generally exceeding 70 percent. The cloud business segment, however, has typically lower margins, but this is expected to improve as the segment scales and the company reduces its reliance on its legacy product.

As the cloud segment matures, management is targeting a gross margin of 80% or greater.

  • SAP’s main competitors are Microsoft, Oracle, and a wide range of upstart software companies. Despite all these players, the switching costs offered by SAP make the landscape somewhat difficult to compete with.
  • SAP differentiates itself by providing integrated solutions for complex business processes and focusing on providing data-driven insights using AI, as well as offering a strong brand name and a large customer base that has allowed it to gain wide-moat.
    1. Recent Issues, Controversies and Management’s Thoughts:
      • The company has faced some pressure from the market given its transition to the cloud. The market is waiting to see whether SAP can complete the shift without negatively impacting its financials. SAP’s management has reiterated its plans and confidence in the transformation, emphasizing its investments in cloud and AI technology.
    SAP has recently announced further restructuring with the aim of focusing on the core business, improving its operational efficiency, and improving customer centricity. This action, while somewhat controversial for its short-term impact on revenue and profit guidance, should allow SAP to focus its efforts on growth for the longer term.
*   The company has reported that its margins in its cloud business have been lower than expected because, since its a subscription service, large costs were front-loaded with clients before significant revenue increases started to materialize.

Financial Analysis

SAP’s financial performance is currently in a transitional period, which means that past financial figures don’t reliably reflect future earning capacity. With this disclaimer, here is a look at its financials:

  1. Profitability:
    • Revenue Growth: Revenue is growing, as more and more clients prefer the subscription model. Revenue growth was 6% for the 2022 fiscal year.

SAP’s revenue composition is undergoing a change, as cloud revenue now constitutes over a third of the total revenue. The management also expects cloud revenues to grow by 23% in 2023, therefore, that the cloud business will become the biggest revenue generator in a few years.

  • Profitability: Over a ten-year period, SAP’s EBITDA margin has been generally quite stable at around 30%. Margins have taken a hit in recent times due to the shift to the cloud and restructuring.

Margins are expected to improve along with the cloud portion of revenues over the next few years. * Return on Equity (ROE): SAP’s has an average ROE of 20% for the past ten years.

  1. Balance Sheet Health:
    • Liquidity: SAP has a high quick ratio, typically above 1.25, indicating good ability to meet short-term obligations.
    • Debt: Total debt is generally below 2 times equity.

SAP has a strong balance sheet with a high quick ratio, relatively low debt, and an ability to create a lot of free cashflow.

  • Cash Flow: SAP generates good amounts of cash from its operations.

The company also does a good job in converting its income into free cash flow, and has made significant improvements to that metric in the last year.

Moat Assessment:

SAP’s moat rating is 3 / 5.

  • Intangible Assets: SAP benefits from a very strong brand reputation in enterprise software. In addition, companies that use SAP products often have extensive business and customer data stored in the software, so the switching costs can be significant.
    • Switching Costs: SAP’s enterprise software is an integrated, essential part of a company’s infrastructure, so switching to a competitor would mean a costly and risky undertaking. In addition, data must be converted to work with the new system which will entail more financial expenses and productivity downtime.
  • Network Effect: SAP, although not a direct consumer-facing product, still benefits from the network effect as new companies start to rely on SAP products to meet their business needs because other companies already use and integrate with their software.
*  **Cost Advantages:** SAP's large operation allows it to scale its operations more efficiently than a smaller competitor, so they have a small advantage on cost that contributes to the economic moat.  * **Risks to the Moat:**   *  The greatest risk to SAP is that another company comes up with more innovative software solutions that better match customer’s needs, or that new software emerges as a competitor to SAP in its space.   *  While SAP has done great strides in entering the cloud, there is a risk that a new company might be more successful at creating a cloud platform or that companies might prefer solutions that bypass the need for cloud.

Technological change is a particular threat to SAP’s moat. Therefore, the company must constantly stay on the cutting edge of new and developing technologies.

Understandability:

The understandability is 3/5. While the basic concept of enterprise software is quite easy to comprehend, the nuances of SAP’s offerings, the changes in the sector, the regulatory environment, the specific nuances of the business model, and the details of the company’s financials can make it a somewhat complex operation to grasp.

Understanding the current situation is more difficult due to the fact that the company is at a transition point, moving from a perpetual license software model into the cloud. Also the company has made considerable investments into its AI capabilities. This means that the company is more focused on growth and change rather than staying at its stable state.

Balance Sheet Health:

The balance sheet health is 4/5. The company has a high degree of financial flexibility, and seems capable of surviving for prolonged downturns. Their assets are generally liquid, and the debt is at a comfortable level.

Final Comments

SAP is a complex company, but it is transitioning to better business models and improving its financials. The key driver of value creation for SAP will likely be its cloud business, however the company must make sure to not jeopardize its main sources of profitability, and make a successful transition.