SAP SE (NYSE:SAP) Q3 2023 Earnings Call Transcript

SAP SE (NYSE:SAP) Q3 2023 Earnings Call Transcript October 18, 2023

SAP SE beats earnings expectations. Reported EPS is $1.45, expectations were $1.41.

Operator: Ladies and gentlemen, thank you for standing by. Welcome and thank you for joining the SAP Q3 2023 Earnings Conference Call. Throughout today’s recorded presentation, all participants will be in the listen-only mode. The presentation will be followed by a question-and-answer session. [Operator Instructions] I would now like to turn the conference over to Anthony Coletta, Chief Investor Relations Officer. Please go ahead.

Anthony Coletta: Good evening, everyone, and thank you for joining us to discuss our third quarter results for 2023. With me on this call are CEO, Christian Klein; CFO, Dominik Asam; and Scott Russell, who leads Customer Success. You can find the deck supplementing this call, as well as our quarterly statement on our Investor Relations website. During this call, we’ll make forward-looking statements which are predictions, projections, or other statements about future events. These statements are based on current expectations 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 Annual Report on Form 20-F for 2022.

Unless otherwise stated, all numbers on this call are non-IFRS and growth rates and percentage point changes are non-IFRS year-over-year at constant currencies. The non-IFRS financial measures we provide should not be considered as a substitute for or superior to the measures of financial performance prepared in accordance with IFRS. Before turning over the call over to Christian, I would like to take a moment to recognize a significant milestone for SAP. This quarter marked the 25-year anniversary of its listing on the New York Stock Exchange. Reflecting on this journey, SAP began with a primary listing in Frankfurt 35 years ago to now be standing as the number one company on the DAX. This dual listing is a testament to an amazing growth story.

It signifies our dedication to providing our investors with prime access across the major capital markets. As we celebrate this milestone, note that the focus on sustainable growth remains unwavering and that the company is poised to keep innovating and creating shareholder value. And with that, I’d like to turn the call over to Christian.

Christian Klein: Yeah. Thank you, Anthony, and thanks, everyone, for joining us for our Q3 earnings call today. First of all, I want to express my shock and sadness at the heartbreaking events that have unfolded over the last few weeks. SAP condemns in the strongest possible terms all acts of terror, and we are deeply concerned by the escalating conflict. We offer our deepest sympathies to all those impacted and are committed to supporting our colleagues, customers and partners during this most difficult time. I’m sure I speak for everyone here at SAP when I say that we hope for a swift resolution to this tragic situation. Let me now turn to more positive news and SAP’s earnings. Our results clearly reflect the strong foundation we’ve built over the last three years for the next phase of SAP’s transformation.

In Q3, we once again achieved strong cloud growth and double-digit operating profit growth, up 16% for Q3 and 19% for the first nine months, confirming what we have said all along. 2023 is the year of double-digit profit growth, and underlining the fact that we have reached the second phase of our transformation, the phase of acceleration. The numbers tell the story best. Current cloud backlog is up 25% again, driven by strong order entry across the portfolio and backed by significantly lower churn. Cloud revenue growth is 23%. Within that, SaaS and PaaS is up 26%. The foundation of SAP’s success story is the business technology platform which underpins both our RISE and GROW offerings. BTP is also the foundation for SAP’s business AI to ensure high-quality data and data privacy standards.

Over 22,000 BTP live customers contribute to almost 50% cloud revenue growth in our PaaS business. This business has a run rate of well over EUR2 billion. We achieved the overall cloud gross despite pressure on transactional revenue which was flat year-over-year to due to the macroeconomic situation. Our total order entry combining on-premise and cloud grew at the fastest rate in almost two years. Behind the strong numbers are many new and existing customers who turned to us to future-proof their businesses. In the third quarter with our key customer wins like Adobe and [ALDI SOUTH] (ph) across our solution portfolio. We also saw a number of important go-lives including BMW Group, Ducati, and SCOTT Sports. This quarter, we have once again seen significant momentum in our RISE customer number, reaching well over 4,300 RISE customers.

Key customer wins include Puma, Siemens Healthineers, and LG with its Energy Solution and Electronics units. There are multiple factors that drive the value of RISE with SAP for our customers. With the migration to the cloud, responsibility for IT operation shifts over to SAP and the hyperscaler. The combination of cloud ERP and SAP’s process expertise is key for business model transformation. Let’s take LG Energy Solutions, for example. They chose SAP to help meet the growing demand for electric vehicle batteries. Process standardization and embedded AI increased the productivity of customers in manufacturing, supply chain, HR and finance. And by always being on the latest release, our customers also gain greater agility through continuous innovation.

Finally, we are removing the data silos with RISE with SAP and build one strong data layer to allow to steer the business 360 with real-time data. RISE and GROW are also very exciting opportunities for SAP. The two offerings result in net new customers and an installed base maintenance conversion of more than 2x. At the heart of RISE and GROW, we have the Business Technology Platform. It is the B2B platform for customers, partners, hyperscalers, and of course, our own developers because it is the platform for the development of mission-critical business applications to extend our core. And this is why it represents such a massive business opportunity also in the years to come. More than 80% of our RISE and GROW customers use BTP to integrate and extend their cloud ERP portfolio with differentiating capabilities.

And we are already seeing strong cross-sell potential with customers replacing legacy ERP with public cloud ERP components such as SAP success factors, Ariba and Concur. That trend continues to grow. S/4HANA Cloud customers are four times more likely to have four or more of our Cloud LoB products with the BTP as the equation extension layer for cloud ERP. And finally, we are able to deliver innovation to customers much faster, meaning we can focus our R&D spend on innovation and not on maintenance and localization. It’s a win-win for our customers and SAP even under difficult macroeconomic conditions. Last week, we took RISE to the next level. We have launched a new premium plus package for RISE, including differentiating AI, sustainability and advanced finance capabilities such as cash flow optimization.

It also simplifies how our customers consume AI with a new consumption-oriented license model. Furthermore, we have introduced a new conversion program for RISE with SAP. This program offers further commercial incentives to support our customers on their transformation journeys and accelerate their move to SAP’s cloud ERP. Likewise, GROW with SAP had also a great start with strong adoption among startups and companies new to SAP. GROW with SAP is our cloud-native ERP suite offering for rapidly growing mid-market companies. After only three quarters, more than 440 customers in over 80 countries have selected GROW with SAP’s cloud ERP to accelerate their business, innovate and grow around the world. Business transformation is much more than the pure technical migration of ERP legacy landscapes to the cloud.

It’s key to connect end-to-end processes and the entire data and system landscape to drive tool transformation. In 2021, we acquired Signavio, covering the process perspective, and in Q3, we announced our intent to acquire LeanIX to cover the overall enterprise architecture perspective, making sure processes, systems and data are yielding the wide outcome for every SAP customer. Together, LeanIX, Signavio and SAP Cloud Application Lifecycle Management create a unique business transformation suite. Earlier this year, we also introduced our business AI strategy to the market, bringing together our existing AI capabilities with the new potential of generative AI to transform how businesses run. We have already made a lot of progress over the last few months.

We have consent from thousands of customers to use their anonymized data to develop and train our AI use cases and foundational data model. The launch of our digital co-pilot tool was a huge success and we are starting to roll it out across our portfolio this fall. And just last week, we announced our new RISE premium plus commercial offering, as I mentioned already. SAP business AI is reliable. We are making promising progress on building foundational models to enable generative and predictive capabilities from structured business data. SAP Datasphere combines structured SAP data with data from other sources to produce highly accurate results, which is so essential in the B2B world. And our new co-pilot tool will be able to work together with many LLM models to ensure we can offer this technology across the globe.

And, as a result, SAP business AI is also more relevant. Our co-pilot speaks more than CRM. It can manage finance, HR, procurement, sales, marketing, industries and ESG data, providing answers and recommendations to even the most complex questions, and automating many activities currently performed manually by millions of SAP end users. Recent announcements by key partners such as Accenture and Deloitte further underscore the central role played by SAP. Let’s be clear, this is just the beginning. Over time, business AI will have a revolutionary impact on the entire business landscape and SAP will be at the center of that. So stay tuned for more exciting announcement at CX LIVE and TechEd next month. In closing, let me quickly summarize. We have had a strong Q3 and I’m excited by the results.

First, SAP continues to deliver on our commitments to the market, and we are now well into the second phase of our transformation. Second, SAP’s unique position at the nexus between business and technology allows us to continue to translate innovations into business outcomes for our customers. Meaning thirdly, despite ongoing macroeconomic headwinds, our cloud momentum remains strong and growth continues to accelerate, all in all, putting us well on track to achieve our 2025 ambition. This is just the beginning of the next phase. We will further accelerate innovation, drive focus in our portfolio and realize greater efficiencies with our increasing scale. So with that, Dominik, over to you.

Dominik Asam: Thank you very much, Christian, and good evening ladies and gentlemen. In light of the current macroeconomic environment, we are pleased with the results of the third quarter across the globe. And now with the added capabilities of LeanIX in June, SAP is even better positioned to develop and deliver unparalleled value to our stakeholders. In Q3, we saw continued momentum of our cloud business with current cloud backlog growing by 25% for the third consecutive quarter. Cloud revenue in the third quarter grew by 23%, maintaining the growth rate we had achieved in Q3 of last year. The trend towards larger cloud transactions continued with deals greater than EUR5 million in volume contributing approximately half of our cloud order entry.

Let me walk you through our financial performance. Current cloud backlog was EUR12.3 billion, growing by 25%, fueled by the success of RISE with SAP offerings. Our combined SaaS and the PaaS portfolio continued to grow by 26%, with the SaaS cloud revenue up 23% and PaaS cloud revenue even up 46%. This continued momentum was again fueled by the strong contribution of the Business Technology Platform, which underpins every single SAP application. Software licenses revenue saw a decrease of only 14%, demonstrating the resilience thanks to a few major transactions. Finally, total revenue was up 9%, driven by broad-based strength across all predictable revenue streams. Now, let’s take a brief look at our regional performance. In the third quarter, SAP’s cloud revenue performance was particularly strong in APJ and EMEA, and solid in the Americas region.

Brazil, India and the Netherlands had outstanding cloud revenue growth while Canada, China, France, Germany, Japan and Switzerland performed particularly strong. Now, let’s move down the income statement. Our cloud gross profit grew by 28%, driven by the effective leveraging of economies of scale and operational efficiencies as evidenced by reduced cost ratios across the board. Growth in cloud gross margin in turn improved for the third consecutive quarter, expanding roughly 2.9 percentage points to 73.7% year-over-year. In the third quarter, non-IFRS operating profit increased by 16%, supported by the resilience of our on-premise business as well as operational discipline which overcompensated the negative impact of an accelerated amortization of capitalized sales commissions.

Finally, the operating margin landed at 29.4%, which is a 1.9 percentage point improvement compared to prior year. IFRS earnings per share in the quarter increased by 45% to EUR1.09. The IFRS effective tax rate for Q3 was 27.8%, and the non-IFRS tax rate was 27.1%. On to our cash generation. Free cash flow for Q3 increased to EUR865 million driven by SAP’s profitability, improvements in working capital and lower payments for CapEx and leasing. For the first nine months, free cash flow was EUR3.4 billion, an increase by EUR761 million. Now, let’s move on to our financial outlook. As you’ve likely seen by now, we are reiterating the outlook we had updated in July. For the detailed outlook, please refer to our quarterly statement published earlier today.

Let’s now discuss our non-financial targets. We can confirm our non-financial guidance for 2023, as we are well on track to meet our targets this year. In Q3, SAP once again had net carbon emissions of zero kilotons. We continue to focus on achieving net zero emissions across our value chain by 2030. In summary, Q3 proved to be another solid quarter as evidenced by strong revenue and current cloud backlog growth. The structural move to the cloud and the interest of our customers in future-proofing their businesses remain unabated. Despite the persisting macro headwinds, SAP continues to be mission-critical in helping our customers transform their businesses. LeanIX and Joule are prime examples of our ongoing efforts to innovate around all solutions, giving customers access to a full suite of tools to fundamentally change the way they run their businesses.

In addition to the top-line, we continue to balance growth and profitability, allowing us to boost our bottom line. All of this gives us confidence in our ability to capitalize on the massive market opportunity presenting itself to SAP. Thank you. And we will now be happy to take your questions.

Anthony Coletta: All right. Then, I would like to kindly remind you to only ask one question when prompted please. So, operator, please open the line.

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Q&A Session

Operator: Ladies and gentlemen, at this time, we will begin with the question-and-answer session. [Operator Instructions] The first question comes from the line of Mark Moerdler with Sanford C. Bernstein. Go ahead, your line is open.

Mark Moerdler: Thank you very much for taking my questions. Congratulations on the strong quarter. In fact, I’d like to ask about that specifically. ERP has generally been thought of as core workloads that’s not really impacted by macro. But I was seeing some other vendors in the market that there is persistent macro concerns of slowing, slowing to the pipeline, et cetera. Can you give us some color on, are you seeing anything in terms of slowing in the pipeline build, time to transition through the pipeline? Is there any difference between existing customers migrating versus new customers adoption? How should we think about that going forward? Thank you.

Christian Klein: Yeah, thanks. Thanks a lot, Mark, for the question. I mean, look, first of all, from the customer base perspective, I mean, we see strong momentum both in converting our installed base, as you heard, with a very healthy conversion factor to the cloud. But second, GROW with SAP has also had an exceptionally strong start and these are really representing new customers to the SAP family. And with regard to the pipeline, look, I highlighted LG Electronics, for example, and this is a very good example on many of the ERP deals we are doing. This company is also going through a massive transformation. And electric and batteries, they are producing this at mass scale. And this is a different business model to what they did in the past.

And so they not only need a new ERP, they need a new way of how they run LG Electronics. And that’s why they are deciding and approving this business case. And so this is essential to their business. And while of course the macroeconomic times are tough out there, we are extremely relevant to our customers’ transformation. And on top, you heard the announcement around SAP Business AI and of course we have to deliver that in the cloud and that’s of course another strong driver for our pipeline in the next quarter. But, Scott, over to you to give some more light on the quarter and the pipeline.

Scott Russell: Yeah, sure. Happy to. Happy to, Christian. So I think you said it well with the example of LG. If I broaden that out, what we’re seeing in the market across all geographies is companies, small, medium and large, are focusing on their core. What’s mission critical? How do they get efficiency and then set themselves up to be able to seize opportunities or protect against threats in their business. And so that’s why the ERP in the cloud is so important. It’s not just the move in the cloud, it’s the transformation of their business using our ERP cloud and extended capabilities. And so that’s why you see such resilience, because when things are uncertain or you need prudence, you make sure your core operating model of your company is fit and match fit for the future that you’re driving.

So LG, but I think about customers like Adobe, 3M, there’s so many others that are going through this journey with us to be able to make sure that they can seize and future proof their business. The one other thing that I would highlight, and Christian mentioned this in the opening comments, is that when we see our customers, which we’ve had a lot of large customers come in with RISE with SAP, they’re not just looking at the core ERP, they’re then looking at the extended capabilities to be able to resolve, whether it be in commerce, or in HR, or in procurement, or in supply chains. So the extended capability through that integration that we’ve invested so heavily over the past few years, they’re now able to seize upon that opportunity to be able to drive forward, which means the future is obviously, notwithstanding the macroeconomic conditions, we feel like we’re well placed.

Mark Moerdler: Excellent. Thank you.

Anthony Coletta: Thank you. And we’ll take the next question, please.

Operator: The next question is from the line of Toby Ogg with JPMorgan Cazenove Limited. Please go ahead.

Toby Ogg: Yes, hi, and thanks for the question. Perhaps just on the cloud revenue growth side, so the guidance implies continued acceleration into Q4. I know there’s the Litmos divestiture, which is going to annualize, but I think you exited that in December, so probably not the full benefit there. Well, I guess just with that in mind, Dominik, what are the drivers of that implied cloud revenue growth acceleration into Q4, and how confident are you in achieving that, I guess, just given the more difficult macro, and also, I guess, the potential for transactional to be a headwind there as well? Thank you.

Dominik Asam: Yeah, maybe a little bit of granularity on some things you already mentioned, like the Litmos impact. I mean, for the full year, we think that Litmos will add a good percentage point of basically headwind. So when you look at the kind of cumulative year to date, it’s already kind of pulled down by that. So the real underlying growth rate is already very close to the 24% or so we need to fulfill the lower end of the guides. Now on top of that, there is of course the discussion about the transactional business, where Q2 has already been difficult. We have been very slightly up, but marginally Q3 was actually flattish or even very slightly down. So we have not seen much relief on that front. And that’s another thing that’s of course something we will not see as such a strong headwind from our perspective for quarters to come, but might be more temporary in nature.

But when exactly that will happen is of course a little bit dependent on the macroeconomic environment. Logically, when you are in a soft environment, the first thing you do is cutting travel expenses, cutting contingent workforce. So that business has been very difficult. There are other parts in it which are growing fast, but the kind of decline for instance in contingent workforce has resulted in a flattish environment. So that’s the acceleration we need. I also want to remind you that even if you jump off the kind of low end of the range for the guidance for this year, which is EUR14 billion, toward our 2025 guidance, we need about 24%. So you see that we’re really on the cloud revenue trajectory, de-polluted for Litmos, de-polluted for that kind of temporary headwind where we think that this will be more cyclical around that trend line, very much on track for that trajectory.

Christian Klein: And you also have to consider with regard to 2025, you have to consider that, especially the large transactions, they foresee a ramp. So when we are looking at the current cloud backlog of 12 — or for now, over EUR12 billion ACV, obviously, there is a ramp included in the contracts, which are also going to help us now in the years. Now that RISE is out there for three years, the ramp will now going up. And with that, with the adoption, of course, we will also going to see further cloud revenue acceleration in the years to come.