SAP Q3 earnings

Strong cloud earnings and a new mid-market strategy keep SAP up with expectations

Q3 2024 Results

Numbers

Revenue: EUR 8.47bn (+10% yoy, inline with consensus)

Cloud Revenue: EUR 4.35bn (+27% yoy, inline with consensus)

Cloud Backlog: EUR 15.37bn (25% yoy,)

Cloud Gross Profit: EUR 3.2bn (27% yoy, 73.7% margin +81bps yoy)

Operating Profit: EUR 2.24bn (22% yoy, +10% versus consensus)

EPS: EUR 1.23 (+6% yoy, +5% versus consensus)

FCF: EUR 1.25bn (+44% yoy, versus consensus @ -157m)

Highlights

The headline cloud revenue performance continues to be extremely healthy for SAP. We have now seen another sequential increase in cloud revenues at 26% vs 24% in Q2. An acceleration again fuelled by SAP's core Cloud ERP suite (36%), though with Extension Suite only increasing 5%. What is notable about these revenue dynamics is the consistency against a softer enterprise software backdrop. Continuing to produce and accelerate >20% is in my opinion built on two very long-term foundations, SAP's continued sales execution of its new cloud platform and the significant revenue uplift SAP's cloud proposition is attracting.

SAP's outperformance is also broad-based. 60% of deals are above $5m, driven by existing customers, while the acceleration this quarter was driven by net new customer wins. SAP's CEO Christian gave a clear explanation as to why this might be the case:

"When you are in a transformation, no matter if it's in the chemical industry or in the auto industry, actually we see no slowdown. They [customers] really see our cloud ERP suite as the only way to restructure their portfolio, to transform to new business models, and of course, also to drive productivity."

Digital transformation lives! While there is some evidence that AI spending is cannibalizing enterprise software spending, there is still clearly demand for the underlying productivity gains from upgrading enterprise software. What has differentiated SAP in my view has been their ability to execute; programs like RISE and GROW are clearly convincing customers to keep ERP transformation high on the agenda despite the temptations of AI.

What is interesting is management is also becoming more ambitious about the future. SAP announced a major go-to-market reorganization. Christian Klein again went into some detail on the plans during the earnings call:

"We will structure our go-to-market setup even more strongly around our land and expand strategy with a strong focus on adoption and consumption. First, we are making our operating model clearer and more streamlined, reducing the number of the different job profiles with the goal to improve productivity and our sales ratio. Second, we will empower our partner ecosystem to go big in the mid-market. By that, we are expanding this highly profitable sales channel and pushing our future growth. Third, to get even more steam behind our land and expand strategy, we are overhauling our commercials, including how we package our solutions."

This bodes extremely well for SAP's growth potential. For the last two years, the main driver for SAP's cloud growth has been the 2-3x spending uplift the company has seen when customers transition to the cloud. The company is now leaning into new vectors of growth, net customer wins and mid-market customers. Until now, both have been considered a limited opportunity for the company. Perhaps convinced by the success they have had with new and smaller customers without a specific go-to-market, SAP is now investing in an area previously thought unachievable.

I believe there should be some valid excitement about what SAP can achieve given the clarity of the strategy. Again, CEO Christian Klein gave a very succinct view: "Let them capture the mid-market by enabling our resellers' growth, bring our partner teams together, enable them to sell the suite, to sell business processes." SAP is almost acting like an actual SaaS company now.

The positive takeaways also continue into margins. Cloud gross margins have now reached parity with overall group gross margins, and the company is increasingly confident of reaching 75% cloud gross margins in 2025. Higher cloud margins have been delivered through centralization of SAP's cloud infrastructure and increasing adoption of multi-tenant architecture by customers. Cloud gross margins are clearly tracking well ahead of investors' expectations. Most sell-side commentary had guided to cloud gross margins in the low 70s. A cloud business that is now enhancing the overall group gross margin, I believe, could require many to update their earnings growth expectations for SAP going forward.

Operating margins are also seeing some positive trends with further operational leverage at the company. Despite the revenue growth acceleration, operating costs only increased 5% yoy, leading to 26% operating margins. The company is keeping its guidance conservative given a coming ramp in hiring and lack of visibility on high-margin software licenses. However, SAP continues to convert higher value cloud business into higher profitability for the overall group. In my view, should this cost discipline continue, there is very little to undermine SAP's higher margin trajectory going forward.

The final standout from the results was the inflection in SAP's free cash flow generation. Free cash flow in Q3 increased by 44% to €1.25 billion. This is despite around €0.3 billion in cash restructuring costs during the quarter. This has been the 3rd straight quarter of >EUR1.2bn FCF for SAP. Q4 will see outflows due to working capital movements and the remaining cash restructuring payments. However, between revenue growth, better cost efficiency, and better working capital, I believe SAP has all the ingredients for a very strong FCF trajectory going forward.

Impact on the investment case

In some ways, the investment case in SAP is running ahead of itself. The significant re-rating from 20x P/E to c.30x this year has driven most of the share price performance (+60% ytd). However, the Q3 demonstrated the strength of the underlying drivers within SAP's business and an emerging strategy to drive even more growth from the business. Fundamentally, between accelerating revenue growth and now cloud revenues driving margins higher, I have even more confidence in SAP producing mid-teens or higher earnings growth going forward. While the valuation leaves limited room for further re-rating going forward, the investment case is more dependent on this earnings growth being delivered; Q3 suggests SAP is not just doing that, it's going on the offensive and trying to deliver even more.