3alexd
Summary
Following my coverage of SAP (NYSE:SAP) in January 2024, for which I recommended a buy rating as I believed the SAP business model was really attractive and defensive and that it would continue to see growth momentum in the cloud, this post is to provide an update on my thoughts on the business and stock. I reiterate my buy rating for SAP as the business continues to show a very strong trend in its cloud business (evident from the CCB growth trend). The growing adoption of AI should continue to support this trend, and the relative strength in growth should support SAP’s current premium valuation vs. its own history.
Investment thesis
On April 22, 2024, SAP released its 1Q24 earnings, which saw revenue of EUR8 billion, representing 9% constant currency [CC] y/y growth, in line with consensus estimates of 9.25%. Within it, cloud revenue saw EUR3.9 billion, with the current cloud backlog [CCB] accelerating again to 28% y/y growth CC from the 27% growth seen in 4Q23. The Cloud ERP Suite saw 32% y/y CC growth, while the Extension Suite saw 8% y/y CC growth. Elsewhere, maintenance revenue saw EUR2.8 billion, and license revenue saw EUR200 million. One key highlight was the strong FCF generated, coming in at EUR2.5 billion, beating consensus estimates by 50%.
With the 1Q24 results out, my confidence in SAP’s ability to continue driving strong cloud growth has increased. Hence, I am reiterating my buy rating. I think the 1Q24 results really showed that demand momentum is strong for SAP, specifically the CCB growth metric, which accelerated by 100 bps sequentially to 28%-the second consecutive quarter of acceleration (1-3Q23 saw 25% and 4Q23 saw 27% growth). I believe the S/4HANA migration cycle is now starting to ramp significantly (management noted S/4 HANA growth remained robust, growing in line with 4Q23) and driving accelerating growth metrics at scale: SAP added EUR750 million of cloud subscription revenue in 1Q24, the largest first quarter revenue add it has ever done so over the past 5 years. Using EUR750 million as a baseline for the rest of FY24 and beyond, I believe this supports a path for cloud revenue growth to grow at least above 20% for the near-to-medium term and possibly the high end of the 20% range looking at the current CCB growth trend (27%). Cloud subscription revenue is now 40% of total revenue; this easily translates to 8-10% growth ahead on a consolidated basis (above the consensus estimate for FY24-25 growth).
As I see it, the increasing use of AI will keep the industry-wide cloud computing adoption momentum going, which means more migration opportunities for SAP. For those that SAP managed to convert, this is great news for SAP because it means they have more chances to upsell and cross-sell AI features (since SAP is already doing the migration, it is very likely clients would just adopt SAP AI modules since integration would not be an issue). We know that SAP is making progress in this area because management acknowledged on the call that AI affected the 1Q24 backlog. On the point of up/cross-selling, I was encouraged to know that SAP is putting in a lot of efforts to increase the number of products available. In particular for AI, it was noted that SAP is already progressing very well, in that it has already released >30 new AI use cases to over 27,000 customers. The current pipeline expectation is for >100 new cases for the rest of FY24; as such, I am very optimistic that SAP can take advantage of this trend to continue driving growth. A key event catalyst that would drive more confidence in SAP’s ability to capture this growth would be the upcoming SAPPHIRE event in June, which should provide the market with more information about the roadmap and upcoming products.
This is the fastest growth on record and demonstrates the strong momentum across our portfolio with Business AI as an enabling factor with a strong impact already on our Q1 backlog. Cloud revenue increased 25% and reached EUR3.9 billion. 1Q24 earnings results call
In addition, AI does not only help SAP drive growth; it also comes with very attractive margin expansion opportunities. While the exact amount was not disclosed by management, it was mentioned that SAP could potentially reap mid-triple-digit million-dollar savings by integrating AI into their entire portfolio. Readers can make their guess on what “mid-triple-digit million” means, but if it is EUR500 million, it equates to ~1.6% of margin expansion (based on FY23 revenue) or ~9% EBIT growth from FY23 stated EBIT.
Valuation
Own calculation
My target price for SAP based on my model has been adjusted up to EUR253 from EUR190.81 previously. My model assumptions are that SAP will continue to see strong cloud momentum (evident in the 1Q24 results), thereby easily driving =>10% top line growth over the near term. Down the P&L, I increased FY24 by 250bps (previous model assumed 19%) and FY25 earnings margins by 150 bps (previous model assumed 23%) to reflect the strong cloud momentum and the potential margin expansion noted by management. One big adjustment I made to the model is that I now expect SAP to trade at 33x forward PE. While on a historical basis this is high, I think relative to how peers’ are doing, the market is likely to continue supporting SAP premium valuation. Specifically, unlike SAP, which is seeing a very strong acceleration in growth, other enterprise software peers are showing slower growth. For instance, Oracle (ORCL) saw a slight deceleration in core ERP and strategic back office apps, with Fusion ERP decelerating 100bps to 18% y/y CC growth; Salesforce (CRM) 4Q24 quarter revenue growth was only 9% (a lot less than the cloud revenue SAP saw in 1Q24); and Workday (WDAY) guided for 1Q25 12 month subscription backlog growth of ~18% at the midpoint (a deceleration from the 20% seen in 4Q24).
Risk
SAP is trading at a very high valuation relative to its own history, and while I am positive that its strong growth profile can support this valuation, a weak macro situation could be a headwind to growth. My worry is that even though there is a strong migration trend, businesses could end up holding off this migration if a recession occurs in the coming months. This will impact SAP growth, which will impact its valuation premium against peers. A downward reversion of valuation from 33x to its average of 22x over the past 3 years is a 33% negative return.
Conclusion
In conclusion, my rating for SAP is a buy rating. SAP’s cloud business continues to impress, with strong growth and a significant backlog. I expect the adoption of AI to further drive this momentum. SAP’s margins are also poised to benefit from AI integration. While the company trades at a premium valuation, its strong growth profile relative to peers justifies this. The biggest risk is a potential economic downturn that could delay cloud migration plans.
