SAP SE (SAP) Earnings Call Transcript & Summary

Hello, everyone. I'm Amit Harchandani, Head of Citi's European tech research team and your host for this virtual keynote session on SAP as a part of Citi's 2021 Global Technology Conference. Thanks for joining us, and I do hope you and your loved ones are safe and healthy. Before I move on to introducing our main speaker, I would like to highlight that we are keen to take questions from investors joining us on this chart. Please do send those over either via the option on your screen or directly to me, [email protected], and I should ask them on your behalf. As a next step, it's my pleasure to introduce our keynote speaker, SAP's CFO, Luka Mucic. Luka. It is a pleasure to have you with us, and thanks for supporting our conference every year.

Thank you, Amit. Great to be with you this year again.

Right. And there's just one last thing I need to do before we go into the Q&A with Luka, which is to read a short safe harbor statement. So here comes my best imitation of Mr. Gruber. Please note that except for certain information, matters discussed during today's presentation may contain forward-looking statements, which are subject to various risks and uncertainties that could cause actual results to differ materially from expectations. The factors that could affect SAP's future financial results are discussed more fully in SAP's most recent filings with the Securities and Exchange Commission. All right. So with that, out of the way, let us begin, Luka. And like last year, I want to start first with what you call as SAP's green line, given you also, of course, oversee SAP's sustainability efforts. So at SAPPHIRE, SAP talked about expanding its total addressable market by more than $150 billion in 2025, with one of the new markets being sustainability. Can you quantify this opportunity?

Yes, happy to do so. And indeed, it's a topic that is very close to my heart. Look, sustainability, I think, undoubtedly, is the mega challenge of this century for companies, businesses and societies of all kind. We have a climate crisis to handle. We have the growing challenge of preserving nature's resources. We have the topics around social unrest around inequality, hunger and businesses have to be part of the solution. They are held to account for that. That's why it's a top broad room topic these days and a challenge that will not be surmounted without companies of all sizes and geographies being really contributing to it as part of their license to operate and all of our license to survive at the end of the day. And therefore, very adamant about the fact that SAP needs to be part of the solution of this generational challenge. And indeed, we have been a front-runner for many years and first mover in defining SAP as both an exemplar of sustainability efforts, but also an enabler, which is, I think, the role where we can have an even bigger impact. In terms of the enabler role, we are convinced that we have through the hard work of our engineering teams that we have spent already over a number of years now, a unique ability to help customers holistically fund their journey to true sustainable operations. Let me give you a few examples. We have worked to make sure that the carbon footprint is actually a data attribute in the data model of S/4HANA, which means with our products around SAP product carbon footprint management, we can help companies track the footprint contributions of different steps in their product processes and production processes to pinpoint areas for optimization. Similarly, when it comes to the circular economy, we have solutions in our digital supply chain and digital manufacturing portfolio that help companies to really route out waste and optimize the use of recycled materials, for example, in their product design and production processes, which is a critical component to serving the equation, but also not to forget the social components in SuccessFactors, we have worked to put in distinct capabilities to drive diversity and inclusion optimization and the growing importance of topics like, for example, tracking and monitoring and influencing the human right status of your extended supply chain, which is a very hot topic here in Germany and in Europe these days is actually facilitated by capabilities that we have built in our procurement solutions around Ariba. So I think this set of capabilities is a perfect embodiment of what we mean as an intelligent enterprise vision that our solutions are meant to support. And on the analytical layer, we have built a sustainability control tower that allows companies and their management to bring all of those aspects together in one analytical dashboard view to drive proactive steering and optimization. We believe that this is a unique capability, and we believe that the opportunity connected with this is not only and not primarily driven by the sale of individual sustainability components and products that we also have, but that it really augments and amplifies the power and the attractiveness of our entire end-to-end intelligent enterprise solution portfolio. That's why it's a critical component of our high confidence to reach our EUR 22 billion plus cloud revenue targets for 2025. And certainly, it will be a subject that will drive our growth for many years, even beyond 2025.

All right. And we certainly would be -- we certainly would be talking about some of those targets as we go through this session. And secondly, very quickly, before we leave sustainability, Christian has talked about making profitability sustainable and sustainability profitable. You've talked about the opportunity, but how can you actually track that sustainabilities becoming profitable for SAP?

Yes. We definitely want to remain an absolute front-runner in our -- reporting around our sustainability performance. SAP has been one of the first companies worldwide that has actually come up with an integrated report from showcasing not only the financial but also the non-financial performance SAP. But we want to go a step further. That's why we have become a founding member of the Value Balancing Alliance, which is a group of companies, forward-looking companies across various sectors of the industry that have come together to define and pilot an impact valuation methodology, which essentially means coming up with a holistic balance sheet for the company that not only holds the financial assets and liabilities, but also the social as well as the environmental assets and liabilities, all with a view to demonstrate how we are creating actually a wider, hopefully, an aggregate positive impact to society and at the same time, positively influence our financial performance as well. We have been, again, implementing a host of sustainability reporting requirements in our external financial report already. GRI, TCO3 and a lot of other acronyms that you know from the sustainability reporting work with this holistic impact valuation that we are piloting internally already and where my ambition is that I would like to front run an implementation as part of our 2022 external financial reporting, then to be released at the beginning of 2023. We want to demonstrate the value and the power that this will have to external stakeholders as well ahead of the public exposure of -- for the Value Balancing Alliance's results that is planned for 2023.

Thank you, Luka. We'll look forward to that one in 2023 then. Right, so as we move from the green line towards the top line, I'd like to start by going back to your announcement last year in October. You announced an accelerated cloud transition and changed your midterm targets. And now you're 3 -- about 3/4 in. Can you maybe let us know where you are in your cloud transition?

Yes. I have to say that while that was a bold step in October 2020, we have been extremely pleased with the tremendous progress that we have been making. I think we have now a clear clarity across the entire company what our role is. It's the accelerated transformation of our entire business towards the cloud. We have released in January RISE with SAP, which is the holistic business transformation offering to lead, in particular, our ERP customers to a modern cloud-based ERP architecture based on S/4HANA. That has had tremendous successes already in the first half year of operations with great customer wins, an increasing number of customers selecting the offering we have had in the first half for the first time, a significantly higher number of S/4HANA Cloud customers than customers that are selecting S/4 on premise. So this is on a very positive path. The second important decision that we took was to double down on our investment in organic innovation and new innovation categories like industry cloud, business networks, business process intelligence and also the further rounding out of our sustainability portfolio that we've just talked about. But also, very importantly, we fulfilled the promise to come up with a much deeper integration across all of our key applications on the basis of the business technology platform, which now really allows us to demonstrate a common data model across all of the applications. So that has allowed us to release at SAPPHIRE our Modular Cloud ERP solution, where together with RISE in S/4HANA, we are actually packaging our procurement capabilities and human resource management capabilities in one modular, but integrated approach, which is resonating extremely well and has been driving customer net promoter score and customer satisfaction levels up to a materially higher level already in the first half of the year. And third, we clearly see that the momentum in our business as a result of those decisions is picking up that we're having very meaningful strategic conversations and that we are seeing truly groundbreaking transactions where companies are embracing the entirety of the portfolio in very large combined transactions where they are leading with RISE and S/4HANA, but where they are actually also accompanying this with the selection of SuccessFactors for HR of our Intelligent Spend solutions, of our CX solutions. And that is driving actually a far greater opportunity than just the replacement of an installed base in on-prem and ERP through cloud ERP. So I'm very happy about where we stand right now. The momentum just feels great and is further accelerating, so we couldn't be more confident about the momentum.

Thank you for setting up the stage there, Luka. I guess, if I could just dig a little bit in some of the points you have made, and of course, starting with RISE, you talked about resonating with customers. You've obviously unveiled those 5 industry solutions at SAPPHIRE as well. Help us understand what's resonating most with those customers who constitute the ECC or the R3 base? What is it that really gets them excited about RISE and what's coming up next?

It's a couple of points. First of all, that it's truly a holistic offer. That SAP is taking the responsibility to equip them with a powerful elastic cloud infrastructure as well as the modern ERP architecture with S/4HANA, but that we are also taking responsibility of providing them the tools and services to truly transform with a view to simplification, standardization and process excellence. So when you break this down into the components, clearly, the fact that we are bundling with S/4HANA and access to the business technology platform that with the move towards better integration with the Modular Cloud ERP offering, we are actually able to fulfill the promise of true end-to-end process transformation is resonating extremely well. We are also providing access with RISE with SAP and to our business process intelligence offerings, which we have strengthened at the beginning of the year with an acquisition of Signavio, which is really, really resonating extremely well with strong triple-digit growth in our business process intelligence portfolio, where we truly can help our customers define a continuous virtuous cycle of ongoing business process excellence and transformation with designing, documenting, rolling out processes, measuring the actual process performance against benchmarks and then also overcoming shortcomings and gets in the actual utilization of systems by the users through process mining and user behavior mining. Those are some of the key elements that really resonate extremely well and that are actually amplifying the growth beyond just S/4HANA, even though the growth in S/4HANA Cloud has been tremendous, as you could see in the accelerating current backlog, where we had already strong growth of 43% in Q1 and moved to 48% in Q2, and we'll see further acceleration in the second half year. So the strategy is coming really nicely together. But at the end of the day, it's a combination of overarching ownership by SAP for the success of a business model transformation based on our newest applications. It's fulfilling the promise on integration, and its building intelligence at the business process level into the offering.

Thank you, Luka. Again, a couple of points that came up in your response, and I want to go through them. You talked about S/4HANA Cloud, right? And you talked about the relationship with RISE, and I think 50% of the deals in Q2 were correlated with RISE. Do you think that correlation strengthens? Is that what you're telling us as things going forward, S/4HANA Cloud goes very much hand-in-hand with RISE?

Yes. RISE has certainly been a tremendous force multiplier for our success in S/4HANA. We had a great trajectory in Q1. We signed already more than 100 deals in Q2. We moved to 250. It's safe to say that we will further increase quarter-over-quarter also into the second half. But it's not only the quantity of deals. It's also the quality in Q1. We still have primarily, let's say, lower large enterprise or upper mid-sized customers who were taking advantage of the offering. In Q2, we had already the first truly large transactions with the likes of an AMD, Siemens Energy, and Coop Switzerland, and Etihad, so all quite sizable companies. And that trend continues to strengthen. And so also in terms of the order entry contribution of RISE, we certainly expect a growing trend here. So the 50% that you have cited in terms of the deal count actually has already in the first half year, translated to a slightly higher number in terms of the share of order entry. We expect this to continue to slightly trend up. There will never be a 100% contribution of RISE to S/4HANA because in particular, in the net new space, so we don't have to lift an installed base, ECC implementation to S/4, but perhaps have a competitive replacement or a net new customer. They are also continuing to be deals that are just following the traditional path. So I would say for the next couple of years, probably a share of somewhere around 70%, 75% of the order intake might come through RISE. And that's, of course, with some level of speculation before it will then start to moderate again once we have a majority of our installed base shifted to S/4HANA and are then really concentrating more on the net new territory that we also continue to believe to a win for us. I mean, we are running now at around about 4,000 as for cloud customers, and we will add certainly hundreds and hundreds on a quarterly basis, our ambitions to end the year with definitely a 4 digit number of RISE transactions closed, and with Q4 being the largest quarter, that should be a safe bet. So we are very, very positive about the momentum of RISE, but most importantly, therefore, also the uptake of S/4HANA Cloud, which is really tremendous.

Thank you, Luka, for that comprehensive explanation, but the other bit you touched upon was, of course, the current cloud backlog. You talked about it in the S/4HANA Cloud context. The year-on-year growth rate in Q2 was 20%, up from 19%. So that's for the overall current cloud backlog. To some investors whom I spoke to, it came as a bit of a disappointment. They were hoping for a greater acceleration. So if I understand your comments correctly, you expect that acceleration to come through underpinned by this momentum for S/4HANA current cloud backlog?

That's correct. And also to put the growth here that we had in Q2 and in the first half a little bit into perspective, and it's an important metric for us because it's a leading metric for the growth in cloud revenues that will come. And we are very glad that we are actually ahead of our internal planning for the current cloud backlog for the first half year. That's due to, first of all, the very strong order entry performance that we had, but also due to the fact that renewal rates are up nicely year-over-year and are actually also ahead of our internal plan for 2021. So we are actually above and beyond the levels that we thought we would reach at this point in time. And also to put it a bit further into perspective, if you would exclude Concur, which continues to be affected obviously by the pandemic circumstances from our current cloud backlog growth in Q2 because they have next to a transactional component also a fixed component in their business model, and that is part of the CCB, actually, our growth would have been in the mid-20s, so very similar to our cloud revenue growth if you would exclude the Intelligent Spend Group from it. So we have a very strong underlying momentum in the CCB, and we continue to expect also in the second half year further acceleration. But also to make it very clear, in the first 3 quarters of the year, there is actually not such a great opportunity to have dramatically increased sequential quarter-over-quarter growth rates. That's just purely due to the fact that the up for renewal volume in those quarters, but also the net new bookings volume is not so different from each other that it can move the needle dramatically. That's different in Q4. So if you ask me about the trajectory for the second half year and what the market should expect, definitely continued acceleration of growth, but more moderate and gradual in Q3, and then more pronounced in Q4, where we are, by far, the largest up for renewal volume and net new bookings volume, where we will then really see a significant increases also in net new bookings year-over-year flowing through to the current cloud backlog growth. And as you have rightfully pointed out, of course, one major driver of this is the significant further acceleration in CCB that we expect from S/4HANA Cloud. And as this is becoming an ever-increasing piece of our overall cloud portfolio, of course, it will more materially influence the overarching growth rates.

Thank you, Luka. Thanks for that. So well, you've already been halfway through the session here. And as we start moving into the second half of the session, I want to touch upon some of the other key elements of your cloud transition. So earlier in the clean line discussion, we talked about sustainability as an opportunity. 2 of the other markets you've highlighted, of course, our business network and the industry cloud. Help us better understand the long-term opportunity in those areas?

Yes. I would say both of these areas are actually a great embodiment of some of the key tenets of our strategy as it has been revised. And that's strengthening the strengths that the company has. In business networks, we obviously have the leading procurement networks in our industry. We have cloud revenue in those areas that is 6x larger than revenues of our next largest competitor. We are trading $3.8 trillion on a per annum basis. That's not from the existence of the company, that's the ongoing run rate over those networks. So this is a clear stronghold of SAP. And we see that, of course, with the ongoing supply chain disruptions that many industries are experiencing these days, the ability to tap into agile networks of connected companies who quickly respond to a new and changed demand needs is becoming table stakes. We have expanded our work on business networks in the last couple of years into additional areas, such as supply chain networks and logistics networks. And now we are bringing this all together in one overarching, technically connected networks. So that, for example, companies have one common route, one inbox, if you will, to address all of their network connectivity needs, whether it's in logistics supply chain or in classic procurement. And we believe that with the demand in the times of the disruption that we are seeing going significantly up and also the general trading volumes in the markets returning back to normal or even to an increase, we have a great opportunity to drive very profitable and long-term sticky business through those connected business networks, again, playing from our strength across all of those areas. And in industry cloud, it's the same story with a slightly different flavor. SAP is very well-known for the fact that one of our key competitive differentiations is our deep level industry business process experience. And what we are doing now is actually we are creating in a prioritized set of industries, again, our stronghold industries, automotive, industrial machinery, utilities, consumer products and retail, industry cloud applications natively built on the business technology platform and integrated with the underlying core ERP capabilities around S/4HANA. Essentially, we are taking a lot of forward looking, best-in-class and future-oriented needs of those different industries that in the past would have been individually built by customers in terms of modifications of their underlying ERP systems and make them scalable, cloud-native applications for a wider market. We are uniquely positioned to do that. The market is still fragmented. Many of the incumbent players in many industry-specific applications come from predominantly an on-premise world. So we can really leapfrog and be a front-runner in leading those companies to the cloud for their industry-specific capabilities. And secondly, we have long-term trusted customer relationships. So in industry cloud, we are returning to our routes of customer-driven co-innovation with partners and with customers to deliver those applications. And we believe that this will be a strong growth factor, again, not only for industry cloud apps as a standalone items to sell. But again, we are back to the RISE with SAP bundle, but in order to strengthen the power and the value proposition of the underlying for core ERP and other Intelligent Enterprise applications. I think both is extremely well received in our customer base, and there is great eagerness to co-innovate with us.

Thank you, Luka. Very comprehensive. So right, picking up pace now. In terms of -- well, now I need to go to one of your famous T-shirt slides from SAPPHIRE in which you talked about the fact that your largest solution within the SaaS/PaaS category is, of course, human experience management. You've been market leader historically. But frankly, Workday is closing in if you look at data from industry research firms like Gartner and IDC. Help us understand what's happening there and how can you get back to market leading growth.

Yes. So first of all, I have never felt stronger about the competitive position of SuccessFactors at this present time. I think if you take a look at some of the externally published market data in terms of growth of others in the market or even the fact that some others have recently not disclosed growth in this specific market any longer, part of that fact that those growth rates have been coming down, I think, is our strength. And I will tell you why I believe we have a very strong position. First of all, we have unique capabilities that extend beyond core human experience management to areas that really matter to companies. We have the combination of SuccessFactors with Qualtrics for employee sentiment measurement and fast reactions. Others are partially trying to catch up with niche acquisitions, or some organic developments we have with Qualtrics are very clear market leader in this space. We can offer our SuccessFactors and Fieldglass total workforce management in a unique fashion. We have a leading business technology platform, which means that we can beyond a pure focus on HR alone help our customers to embed an HR-driven transformation in a total holistic digital transformation of the company. This platform capability is a true differentiator. And last but not least, we have Business Process Intelligence capabilities that are also highly relevant in HR to identify and pinpoint areas to further leverage process improvement opportunities in the area of HR and then extending it down the chain, for example, into ERPs. Let me give you a customer example. We had, in this quarter, one of our largest cloud transactions that we already signed now was with a carve-out from one of our major customers, a long-term SAP ERP customer that carved out a major business area to set it up as a stand-alone company. This company opted obviously for S/4HANA for the core ERP workloads. They opted for SuccessFactors for HR, even though the incumbent mother company had selected a couple of years ago for one of these competitors that they selected for SAP customer experience management, even though the incumbent mother company had selected for Salesforce in this area. They selected, obviously, our procurement solutions. They selected our analytics and business technology platform solutions. This was really a sale that was purely driven around the power of the Intelligent Enterprise and all of these pieces coming together in an integrated fashion. And that's the capability that nobody in the market can match and has been driving also growth rates in SuccessFactors. So as far as new order entry is concerned to a significantly higher level, actually, SuccessFactors was a very positive contributor to the order entry growth that we have seen in the first half year. And I can't wait to then lay out this example and a few other great ones when we are finally able to announce earnings. And this is going to be a great showcase of how all of the work that we have been putting into seeing those categories, not only a stand-alone siloed applications, but as part of a wider proposition that branches out into experience management, total workforce management, digital transformation and amplifies the value proposition not only in the single siloes, but also across the portfolio.

Got it, Luka. In the interest of time, maybe if you start pivoting towards margins right now, a critical topic, of course, has been gross margins for the SaaS/Pass category. You've executed very well over the past 2 years. You've raised it by 10 percentage points, but there is more heavy lifting to be done now. You're planning to make some investments, for example, to support the harmonized cloud delivery. Help us understand how we should think about the gross margins in 2021 and '22 from a SaaS/PaaS perspective?

Happy to do that. But just before I have to explain perhaps what we are doing in our next-generation cloud delivery program. We are essentially pulling forward a long-term lifting that we always had in our planning into a shorter time period. Why are we doing this? Because we are expecting far greater growth in our cloud business. And so we want to make sure that our infrastructure is ready in order to drive far greater efficiency in a shorter time frame. And that's why we are pushing forward the investments to do this. We had already worked quite a few years ago to make all of our applications available on the combination of hyperscaler infrastructure and our converged cloud infrastructure. We have deployed new customers into -- on this, but we still have legacy data centers with installed base customers that are running on the old infrastructure. And frankly, we are accelerating the move and the migration of them to the new one. This will mean that in 2021 and 2022, we only expect a slight improvement in the cloud margins. As you have seen it in the first half year, they have continued to trend up, but obviously, not at a significant level due to the dampening impact of those investments, which sum up to a mid- triple-digit million euro amount split across 2021 and 2022. But once these investments have been made and we have finalized the migrations, you will see a very significant step-up of the cloud margins already starting in 2023 and then leading up to around about 80% on cloud margin target for 2025; very similar to the effect that you have seen once we were completing the migration of the databases of our underlying cloud applications to HANA. Actually, it should be an even more pronounced effect that you are going to see when we finalize the harmonized cloud delivery infrastructure. And this is not only a source of margin increases, but quite frankly also competitive differentiation. Some others in the markets have had a very ambiguous and often changing strategy around hyperscalers, for example, or have completely refrained from working with them. I think the choice that we are able to drive with our openness between an own infrastructure and hyperscalers has allowed us to really have a very broad global footprint, which is important in a time where data residency requirements are becoming more pronounced in a number of jurisdictions. So it helps us also to grow fast, while at the same time, now with the accelerated harmonization, we will see significant step-ups in gross margins starting as of 2023. And in the meantime, it should give us a lot of trust that actually we can make this very meaningful investments in '21 and '22 and still drive for continuous further improvements at a point in time, where our business networks, business from a transactional revenue perspective, which is very high margin, is actually suffering from the pandemic. So just imagine once this revenue comes back to normalized growth rates what kind of an additional positive impact this will have on the overarching margin performance.

Noted. Noted, Luka. I guess the natural extension to margins is, of course, cash flow generation. You had a very solid free cash flow performance in 2020. This year, your outlook is for more than EUR 4.5 billion. You talked about some of these investments. So I guess, help us understand how we should think about cash flow generation across [ 21 ] to the EUR 8 billion that is potentially anticipated for 2025. Is there a bit of dampening and then a pickup after '23? How should investors think about cash flow profile?

Broadly speaking, I think the progression on the cash flow front will follow the profitability and the operating profit profile of the company. As we have said in 2021 and 2022, we expect a flat to slight decline in operating profit. That's actually what we are tracking toward as well in terms of our guidance, updated guidance for 2021. And that means that we are not expecting an increase in free cash flow during those 2 years. Actually, the drop in -- from 2020 to 2021, where we are now guiding for more than EUR 4.5 billion is not skewed to any operational weakening, so to say, of cash collections. They're actually continuing to come in at very, very healthy rates. It's mainly a factor of higher cash taxes and also adverse currency movements, which we are suffering from -- in 2021. For the next couple of years, our capital expenditures will not be a drag on free cash flow because we are utilizing hyperscalers, and we have a plan that has us at around about flat CapEx spend over the course of the next year also in 2022 and beyond. So the main factor here is really the increase in profitability that we expect as of 2023. And that will be followed through also on the cash flow front. So our expectations for the roughly EUR 8 billion in free cash flow remain intact, and the lion's share of this improvement will then come starting in 2023 with significant step-ups once we have finalized the next-generation cloud delivery program, have reached the scale in our cloud business to lift the margins and profitability levels up again and then the free cash flow will follow.

Thank you, Luka. And as we're probably coming towards the end of this session, would you say you're still confident of achieving all of your targets without embarking on further material M&A?

I'm absolutely confident because the momentum is right. Our strategy is resonating with customers, the organic innovation that we have been working on, which has led also to an increase in our R&D ratio is paying off. Now that does not mean though that we would rule out acquisitions, a company of our size, as we have seen it with the smart acquisitions around Signavio and Emarsys last year, we'll always have to look at the 3 options of buying, building or partnering to further round out its portfolio. I think SAP has proven in the past that we have a great model with our global sales force to take smart solutions that are complementary and not presenting an overlap with what we have and amplifying their growth due to our global presence, and we will continue to look at opportunities to do that, which obviously, given current valuation levels, if it makes sense, could even also be larger than EUR 1 billion in size. However, we will remain very disciplined in considering any of those opportunities, our primary focus is on the continued organic innovation. And if we did something more significant, then obviously, it would have to come on top of the targets that we have laid out, and we would adjust those so in terms of the targets that are out there. Our current portfolio and the new organic innovations that we are building out are going to carry us there. And I'm more confident than ever. Actually, way more confident at first at the outset of our strategy outlined in October that this is not only possible, but actually also more than achievable.

All right. On that very confident note, I must say we are out of time. On behalf of Citi and its clients, thanks for joining us, Luka. Best wishes to you and the rest of the SAP team. Ladies and gentlemen, this concludes the keynote session on SAP. Thank you.