German software giant SAP told investors that it plans to move all of its tools and customers into the cloud as it was forced to pull medium-term profitability targets as it continues to struggle with the effects of the coronavirus pandemic.

Europe’s largest technology company reported disappointed earnings, with revenue falling by 4% to €6.54 billion, while operating profit also fell 12%, based on international financial reporting standards. After adjustments and at constant currencies, profit rose 4%.

VALUATION SMASHED

The decline was offset by a 10% increase in cloud computing revenue but downgraded guidance for revenue and earnings saw the stock plunge nearly 20% to €100.86.

SAP cut its guidance for 2020, saying that fresh lockdowns around the world had hurt the business, while hard-hit industries would now take longer than expected to recover.

For decades SAP has provided critical applications for businesses of all shapes and sizes, although about 80% are small and medium-sized (SME) operations.

It specialises in key enterprise resource planning (ERP) tools without which businesses simply could not run, such as supply chain management, human resources, customer experience management and analysis, spend intelligence, machine learning-based analytics, and more.

COMPLEX CLOUD SHIFT

For several years SAP has adopted a ‘cloud-first’ strategy, encouraging new clients and existing ones to embrace the cost, distribution and efficiency benefits, but going cloud-only brings forward some of the growth and profitability uncertainty of the switchover.

Traditionally selling term licences to use its tools means getting paid up front with high margin servicing and maintenance fees added to top. Cloud revenues are typically bought on a subscriptions basis, with customers paying as they go for what they use, depressing SAP income in the short-term.

The pay-off down the line should be more sticky subscription revenues from a cheaper, more flexible platform for users, plus lower cost of distributing updates, among other things. Finding the right balance is important.

The latest shift means effectively means that profit margins will languish over the next three years. Headwinds will only turn to tailwinds after that, chief financial officer Luka Mucic told reporters on a conference call.

LONGER-RUN BENEFITS

Cloud subscription revenue from services hosted at remote data centres is now expected to triple to €22 billion by 2025. That will eclipse traditional licence sales that have for decades been SAP’s cash cow.

Total adjusted revenue in 2025 is now forecast at €36 billion and adjusted operating profit at €11.5 billion, implying operating profit margins of nearly 32%.

According to data from FinLABO Research, SAP’s adjusted operating margins over the last three years have declined from 27% to 23% despite revenues increased at an average growth rate of 8%.

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Issue Date: 26 Oct 2020