SAP SE (SAP) Earnings Call Transcript & Summary

Right. Perfect. Let me open things up for this next session. My name is Adam Wood. I look after European software research at Morgan Stanley. It's a great pleasure to have Dominik Asam with us, Dominik, CFO of SAP. Thank you very much.

Well, thanks for having me.

So just to get the regulatory stuff out the way, to start off with. So during this presentation, this is on the SAP side, SAP will make forward-looking statements, which are predictions, projections or other statements about future events. These statements are based on current expectations, forecasts and assumptions that are subject to risks and uncertainties that could cause actual results and outcomes to materially differ. Additional information regarding these risks and uncertainties may be found in our filings with the Securities and Exchange Commission, including but not limited to the Risk Factors section of SAP's 2023 annual report on Form 20-F. And from the Morgan Stanley side, please, for important Morgan Stanley conflict disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/research/disclosures. I can slow down now and go...

Well, it's all right.

Okay. So to kick off with, I think it's very interesting that you've been in the CFO seat just over a year. You're coming up for a year at SAP. You came in, you went from SAP, you went from a software background. So I guess that gives you quite a different perspective in what's possible, what could be achieved. Could you maybe just talk about, over the last year, the main 2 or 3 important things that you've seen, you've thought we can do things differently, we can improve on things that may be that outsider perspective gave you the opportunity that wouldn't have come from internal?

I think I was lucky that basically, the investment hypothesis, so to speak, I've made for myself by joining SAP turned out to be quite solid. The company, as you all know, has been in a very challenging transition from on-prem business on ERP to a cloud model with a special part of it that ERP, for many large enterprises, is still a kind of a private cloud model. And I think we've made extremely good progress on that front. So I'd say that is not something I can take credit for because I've only joined a year ago, but the fact that we really see now the top line inflecting because of that transition being successful was even more powerful than what I thought. Now in terms of margins and costs, it's not a surprise that in times where you go through this transformation, you push revenues to the right because of the switch from on-prem upfront licenses to regular subscription, recurring subscriptions and the investment in our platform. These are very difficult times, but it's also very comforting to see that we are now really starting to harvest the fruit from that investment. So we can be now really looking at how can we bring the margin level to a more competitive level and also make the company better in terms of scalability. In that time where we had to go through this transition, we've been basically growing the cost base faster than the revenues, which is, of course, not sustainable. And we want to do 2 things with our restructuring program, which we've recently announced, which is bringing, in one big step through 2025, the margin to a higher level and then also decoupling the cost base more. And I think this is where there's opportunity. And the last thing, if I may, I want to mention is the focus on cash. Because the company was so much focused on delivering these milestones that were already communicated in 2020, which were predominantly around turning the corner on growth and turning on the corner on double-digit non-IFRS operating profit growth, there was not so much focus on free cash flow. And I think there's a lot we can do over next years to bring the cash conversion up.

So maybe going through those in order, you talked about the acceleration of the top line. The real engine of that has been the S/4HANA migration that's really accelerating, and you're putting some incredible growth numbers up at scale there. Could you just talk a little bit about it from a customer perspective? What is it that's changed in that product? What are the benefits that customers are getting that's driving that adoption and that growth in S/4?

I think the first important discussion and frankly, it even changed over the -- almost a year I've been with the company now is should we go into the cloud or should we stay on-prem. And of course, the challenge with the ERP system is that it is a quite complicated product. So every customer is different. There are many processes that have been created over years. They are related to some physical infrastructure to the way that a lot of people operate, how the supply chain is built. So we were always cursed by the fact that our software was procured and then people have been spending 10x the money they spend for our software to modify it. And that meant that every upgrade was a big pain for the customer, meaning that they would need to invest a multiple of the money in just making sure that all the customizations would be upgraded in line with the SAP product. That had -- as a result that the customer could consume our innovation just 5, 10 years later than it was available by SAP. And with the move to the cloud, that is, of course, changing. Also, AI has created an awareness that we will not be able to train these models if you're not having access to all the data in the cloud and data of our customers in the cloud. And of course, they have to give us their consent. If they want to have the access to these learnings in the cloud, they give us their consent. So I think the story that we should be on the cloud is now understood by almost everyone. And now it's about really showing them the value in that transition. And here, we can leverage our process mining tools like Signavio. We can also use our enterprise architecture management tools like LeanIX to come from a move where we say, well, you have to do an upgrade, we have to go to the cloud to say, where is the real business value for you. And this is a new value-added proposition, which is resonating very well. And if you look at the S/4 success -- and I would say it's not quite right. I think our success is by now much broader than S/4 only. We have recently introduced a key metric, which we call cloud ERP suite. It's basically all the ERP products that are transactional in nature. They represented in Q4 of last year 83% of our combined SaaS and PaaS revenues, and the biggest aha moment for me at SAP was looking at the number over the last 2 years because it was 31% in the first quarters of 2022 and then it was, what, 33% plus or minus a percentage point for the 6 quarters thereafter. I've never in my life seen such a high growth number with such a stability in terms of growth rate. And this shows it's not only S/4, which is a little bit more volatile, frankly. There's also the BTP in there. There's also Signavio in there. There's LeanIX now in there. And there is, of course, also the cross-sell and the upsell in there that once we have landed on S/4, we can also expand. So the next leg of the journey is basically to transform these customers in customers that are consuming more of our products. And we have now really created that measure, which is, for me, the key metric on the revenue side quarter-by-quarter, to see how well can we sustain that super high growth rate, winning market share on the cloud ERP business because I think we can all agree that 33% is not what you have as a market growth. So I think it's the best testimony that this cloud story really works out.

I think when we speak to partners, you alluded to this integration that's happened between the core ERP and the adjacent solutions has really improved. I mean, is that the main metric we should be looking at that cloud ERP suite growth? Is there anything else you can help us with around cross-sell of these products into the base?

Yes. I think it's indeed the key metric because the -- this number will give you -- well, it's 83% of the revenues in the cloud and SaaS and PaaS. You know that Infrastructure as a Service is something we kind of deemphasize. It's a highly capital-intensive business. There are very mighty competitors in the hyperscaler space, so we don't feel it's wise for us to invest too much money there. So that kind of 83% of SaaS/PaaS revenue will represent a larger and larger share of the SaaS, PaaS, IaaS, i.e., the entire cloud revenue base, and then the software and license business and -- sorry, the maintenance revenues really becomes smaller and smaller. So I would say this is the key metric to focus on. I think, of course, there's also the forward-looking metric, which is quite interesting on the CCB. I would say that the lion's share of the CCB growth comes from that kind of bucket.

Right. And when we think about -- we know that a lot of customers are doing large multiyear deals with you, and there are step-ups in their consumption in years 2, 3, 4, and often, these are 4, 5, 6 or plus year deals. Could you just help us with the visibility you have and the confidence you can sustain those types of growth rates on cloud ERP with the comfort that you have from how customers have been signing up already?

Yes. I mean, of course, we've gone, as any company, through a comprehensive bottom-up 5-year planning cycle. So I can confirm that we have certain confidence that by virtue of still tackling the large base of customers we need to convert on the RISE journey, the RISE journey being the private cloud, large enterprises that we bring from on-prem to cloud, plus then the fast-growing emerging business, where basically before we have not really been present. I mean it was almost prohibitive for a smaller company to install an SAP software because of the high integration costs. But now with the public product, which we call the GROW initiative, we see really high growth, I have to say, from an embryonic base. But the growth numbers are kind of triple-digit percent in 2023, so over 100% growth, so more than doubling last year. So it's one of these flywheels we are starting to spin. And once that will have some size, it will also contribute to the growth going forward. And last but not least, yes, with the advent of AI, while certainly for our 2025 ambition we've earmarked we don't need any miracles on AI, frankly, for the second half of the decade, that is something that should help us sustain the high cloud ERP growth.

Perfect. That's really helpful. You talked about support and that gradually declining. But actually, I think the support line has surprised investors with its resilience so far. Could you just help us a little bit with, are there any unusual factors in there that could fall off is -- how much is pricing? Are customers kind of paying premium support while they do the migration, and once they're migrated and things are running, it starts to fall off? Or is -- just help us with what's supporting that?

So in terms of the numbers we've shown in 2023, maintenance was remarkably robust and also because we have been increasing prices, we had a price cap increase 1st of January 2023 of 3.5%. We've increased that to 5% 1st of January 2024. Now there are some jurisdictions where inflation rates have been lower. So the formula is basically max 5% or CPI is lower. I think we had -- of the 3.5% last year, we had a little bit more than 2 percentage points, which ultimately ended up in our revenues. And I'd say the ratio in terms of fall-through of the mix, if you haircut for the countries like Switzerland and so forth, we didn't have that high inflation. That should give us also some significant boost. So if you strip out that inflation premium, so to speak, simply adjusting for inflation, and by the way, these are contractual rights we have. They are in our contracts for some reason, which I don't quite understand. We have not utilized that in the past, but since 2 years, we do. You see there is actually a decline in the maintenance base. And now how that will evolve, I think there will be a gradual slow increase in the decline rates, of course, because as we move more and more customers on to cloud, that will happen. But let's not forget, the lion's share of these losses on maintenance will be converted to cloud. I'm really deeply convinced about that. And the typical factor we have is between 2 and 3x. So 2.5x, we say, on average. That means that both from a revenue point of view and from a gross margin point of view, we are better off converting these customers to the cloud. And this is also why we basically have a little bit of a schizophrenic commercial policy. We are really, really robust on, on-prem, because I always say the hardest competition we have is our own -- bring your own license on hyperscaler software versus the cloud. And it means that we are really using all the leverage we have, and all the contractual rights we have, we will enforce that on maintenance. We will also become more robust on software. In terms of commercial concessions, we incentivize our sales force less on software sales. We even provide migration credits to customers to make sure that we are smoothening that journey and are not kind of having too much of a clock system in 2027 when we're running out of maintenance on ECC. And we're really trying to roll that customer base gradually into our on-prem business, and that gives us tremendous boost because we have a 2.5x conversion. The advocates -- the advocate logic would be okay. These customers, they run out of maintenance and maybe they go third-party maintenance at some point in time, but this is a pretty big risk to take because you would basically run systems that are not certified anymore, so it's basically insurance policy, which you will lose. And at some point in time, it's really a business continuity issue. You cannot play that game forever, and they will need to run on some ERP system. And because I'm deeply convinced that those companies who progressed in the most are the ones who want to least money necessary on ERP. It's getting, for them, more expensive if they change the system. So I'd say we are a natural kind of recipient of these customers, and I'm not very nervous about not being able to ultimately really convert the lion's share of the customer base to the cloud.

Perfect. That kind of brings us on to another debate. I wanted to ask about competition from 2 angles. I was sat in the presentation of a competitor, and they were kind of talking about this move of ERP in financials to cloud is a huge opportunity for them. This was more in the HR and financial space. Could you just talk a little bit about how you see that battle with competition? If customers are being forced to choose going to S/4, does that open them up to competitors? What are you seeing? What are win rates like?

Well, I'm not very nervous about that conversion. If I come back to the cloud ERP suite definition, this is really all about the transactional systems. I mean you might ask what is not in cloud ERP suite, and if you look at the businesses that we have now in the so-called Extension Suite, these are businesses -- it's basically SuccessFactors, excluding the transactional part, which is the core HR and the payroll; and it's the CRM, excluding the transactional part, which is the e-commerce and the customer data system, so basically the data for the customers we need also to run e-commerce platforms. So what is outside is actually what I would call more content business. And the way I would summarize it that we are super strong on winning market share on everything that's transactional. And I'm not intimidated by any of our competitors with my 33% cloud ERP suite on that front. And I would always challenge them if they say they eat into our lunch. I'd say, yes, we have lower growth on the Extension Suite, which is more content business. So what do we have in terms of sales and marketing services in there? We have on HR learning in there, which are sizable revenue buckets, as I mentioned, well, 17%, the rest versus 83% of our SaaS/PaaS offering. And there, frankly, we had not much growth in 2023 because we divested Litmos, which was part of that. We will have a little bit of a snapback in growth, but this is growing much more slowly. So I'd say where our competitive strength lies is really on the transactional part of these systems. I think we are now starting to occupy some space, which was previously not tackled by us, which is the mid-market. And I'd say as long as we can continue to run at that kind of a growth rate, I wouldn't be too nervous about losing market share because I know the market overall is maybe growing by 20% or so.

The other discussion I increasingly have with investors is people are maybe a little -- are actually a little bit less worried about that battle at the application layer and people are more interested in what's going on at the platform layer. And they're saying it's really important for SAP to sell BTP and get customers to use it.and not allow a hyperscaler like Microsoft to put its technology in underneath. Could you -- is that something that SAP thinks about? How do you see that battling?

Absolutely. You would not be surprised that SAP belongs to the -- to those who say that the analytics, wherever possible, should be embedded in the application as opposed to some enterprise analytics on a higher layer. And in the financial community, I always try to find some non-technical way of explaining that, and I have not found a better example so far than using an Excel spreadsheet as an analogy and say, look, you could argue that an ERP system is a highly sophisticated development of an Excel spreadsheet where every single time somebody is entering something into some cell, it's a new line in a general ledger, a universal ledger. The access rights are highly modified, which by the way, is already one of the things these authorizations, if you extract data somewhere in an obscure data lake, it's very difficult to preserve that integrity in terms of access rights. So you think about you modeling a company and having smart logic as to how the volume and the pricing and inflation and the cost, all that, plays together. And you've spent a lot of time creating that logic between the thing. We call it the semantics around the data. And this is something these guys don't have access to. So they would need to reinvent the wheel, basically, with their analytics to find out what is actually the embedded logic because we are not exposing these semantics to these type of higher-level layers. So -- but that's exactly, in my eye, is the right discussion. This is the big battle. I mean, the new data -- the data is really the kind of goal of the system and how do we exploit it. And of course, it's our ambition because we are so convinced that the value, the gravity of data we have and the value of the data is super high, that we also monetize that by giving easy-to-consume use cases to the customer. So I think just charging customers who are egressing some data is not really what makes the customer happy, because customers say, I paid for your software, your cloud product. It's my data. But while it's the customers' data, the semantics are all semantics, and we have the liberty to decide to whom I expose those or not. And we will also need some data from some Snowflake or some other people. So what is currently ongoing is that everybody is kind of bartering and saying, I need that from you. You need that from me. Who has the gravity of the data? And I, again, feel quite solid on that front that there's a lot of good stuff in the ERP system a lot of people want to have. And it's nice to get the data only, but it's not sufficient to run powerful analytics.

And what's the best way for investors to track whether you're succeeding there or not? Is it attach rate to BTP to customers? Is there any other thing that we should be looking at to track?

Again, for me, the best KPI is the quarterly progression on cloud ERP suite because it's kind of summarizing all of these things, and the attach rate of BTP is, of course, growing. And we are promoting that by bundling. I mean, you might have seen that our backlog is growing faster than the CCB. So the long term, the overall backlog, the TCB, is growing faster than the current cloud backlog, so that means that the customers are pushing for longer contract duration. And while that gives us some stability for customers, it's actually not easy to predict. The further they move out, the more error margin they have around their consumption forecast. And what we do more and more is we bundle all these things together and allow the customer to migrate from one product to the other if they under consume on one and overconsume on something else. I think that's a huge advantage we can play vis-à-vis narrow competitors who are just in one product because it's so d*** hard for these customers to commit. If they order too much, so to speak, they have too much capacity, they pay too much. And if they under order, we clean them on overages, which they don't want either. So I think that story of integration, which has only been activated seriously by SAP over the last years,is really playing out nicely that it's a better commercial offering, it can offer you more interesting use cases, it reduces the costs for the customer to do that integration himself or herself. So we really want to create a big domain around these transactional processes where we want to occupy a very, very high market share.