Valued At A €105 Billion - Why SAP Is Improving As It Moves To The Cloud

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SAP System Software Automation concept on virtual screen data center. Business, modern technology, internet and networking concept

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SAP SE (NYSE:SAP) is a proven and reliable enterprise resource planning (ERP) tech company, solving complex problems for medium and large businesses while advancing as a cloud solution.

We are rating SAP a buy with an investment horizon between two and 11 months. Our intrinsic value for the company is €91 per share, or €105b in total, with a one-year price target at €97.3 per share. We estimate the value at maturity for the company at €117 per share, after which investors may expect an annual 6.7% return on investment in the form of capital appreciation and possibly dividends.

In the chart below, we can see our value line estimate compared to the historical market cap for SAP (note that all values in this article are in billions of EUR unless specified, and all data used is sourced from the FMP vendor).

Historical Market Capitalization and the Current Value Line

Chart 1. SAP Historical Market Capitalization and the Current Value Line (Image created by author using data from FMP)

If you want to see how we did all the calculations in our analysis, you can make a copy of our model here - and even change the values to suit your vision of SAP. Alternatively, you can open the sheet in a view-only mode here.

We believe that SAP will retain its ERP leadership position, and value for investors will start increasing after its acceleration to the cloud. In the future, SAP will leverage its existing software infrastructure to create additional services for companies (such as BI analytics) that will increase the return on capital while being highly effective at improving the internal workflows for clients. We believe that the opportunities outweigh the risks, and SAP will continue providing moderate 6.7% returns to investors.

You can view the full reasoning behind our valuation in the sections below, including a presentation of the business, peers and industry evaluation, a fundamental analysis, intrinsic valuation and a section on risks and opportunities.

The Business

SAP is one of the oldest companies in the world that develops enterprise software for managing business operations, customer relations and is Europe's biggest tech firm, based in Germany.

The portfolio of applications developed by SAP is enormous and covers all aspects of business activities: Human Capital Management, eCommerce, Spend Management, Business Intelligence, Analytics, etc. However, SAP's most important solution area is ERP, particularly financial management.

SAP On-Premise vs. Cloud Deployment

Historically, SAP was an "on-premise" software vendor. This traditional SAP solution deployment approach requires computers to be installed and run on the premises of the organization utilizing the software. SAP "on-premise" deployment is based on a traditional/perpetual licensing model, which means a one-time purchase of the software, followed by an annual recurring fee for maintenance and support. The license fee enables the company to own the ERP software. However, the cost of the upgrade for this kind of deployment is much more expensive. All of the legacy SAP ERP systems, the R2, R3, and SAP ECC, were created as "on-premise" solutions, but the introduction of S/4HANA (high performance analytics appliance) changed all of this.

In response to changes in technology and consumer preferences in the software market, the company has transformed itself into a cloud-based ERP supplier, offering services in both public and private clouds. SAP S/4HANA is available in on-premise, cloud, and hybrid deployments, giving customers the ability to tailor the system to their needs.

SAP cloud solutions are billed through a so-called subscription license model. In a subscription model, the customer does not have perpetual use rights to the software but instead pays an annual subscription fee as part of a term contract, which means that a single monthly payment covers everything from infrastructure to system upgrades.

High-Speed In-Memory Database

The other notable difference between the latest S/4HANA and the legacy SAP ERP applications, besides the cloud deployment option, is the database they use. While legacy SAP ERP applications run on third-party database systems such as Oracle's database, S/4HANA is dependent on the SAP in-memory database (i.e., SAP HANA). The HANA database, which was introduced in 2010, is an in-memory database designed to drastically accelerate SAP applications and the business processes they support. Practically, instead of a traditional hard-disk stored database, HANA stores data in the memory (RAM) of a computer making data retrieval much faster.

SAP's on-premise solutions remained unrivaled in terms of flexibility and customization options, while the cloud version enabled a significant increase in users, primarily among companies that do not require extensive customization.

Shifting the ERP to the Cloud

From SAP's latest report, we see that the overall number of S/4HANA customers has surpassed 20,000, representing more than a 15% increase YoY. More than 14,500 S/4HANA customers are live, with more than 60% being net new clients. SAP does not detail exactly how many customers are using S/4HANA Cloud vs. on-premise or hybrid cloud installations. But the CEO of the company indicated that there are now around 6,000 S/4HANA customers "in the cloud." A reasonable assumption here is that the simpler businesses went to the cloud first, as migrating to the cloud for a large enterprise can be a multi year process. This also implies that it will take some years before SAP can reap the benefits of the cloud shift as the traditional clients are still on premise.

For 2022, SAP expects a revenue growth between 7% and 9%, close to the growth rate from the last 12-months. This implies revenues of around €30 billion for FY 2022. In the chart below, we can see the historical revenue growth rates for the company on a rolling trailing 12-month basis.

SAP's Rolling TTM Revenue Growth

Chart 2. SAP's Rolling TTM Revenue Growth (Image created by author using data from FMP)

The tendency to transform itself into a cloud-based ERP supplier was further reinforced by the emergence of COVID-19 and consequent lockdowns. In early 2021, SAP launched "Rise with SAP" for customers who desire to move to SAP Cloud ERP. Rise with SAP is a subscription-based service that combines a number of products and services. The main component is the S/4 HANA Cloud edition, which enables customers' cloud infrastructures to run in a SAP cloud data center.

The "Rise with SAP" project is strongly incentivized by the company as management needs to present a successful shift to the cloud for clients and is offering early-adopter benefits. SAP's CEO Christian Klein attributed the increase in S/4HANA customers to continued strong adoption of "Rise with SAP." However, shifting advanced, customized end-to-end ERP processes to the cloud is far more difficult than greenfield implementation, especially when we consider that SAP software is used by 92% of Fortune 500 corporations, ranging from carmakers like BMW (OTCPK:BMWYY) to defense companies like Lockheed Martin (LMT).

Despite the early positive results for SAP, we must bear in mind that the cloud computing market is becoming more competitive and growing faster than the market for on-premise solutions, which is why we must compare SAP's solutions to some of the other key competitors in the segment.

Peer Comparison

SAP has multiple competitors offering services for the ERP and the adjacent CRM sphere. If you are bullish on this industry, but want to spread the risk among multiple stocks, here are some examples to investigate:

Enterprise Resource Planning:

Customer Relationship Management:

As we can see, the landscape is competitive and evolving as the technology becomes cheaper to develop. In the following section we will make two closer comparisons between SAP and peers.

S/4HANA vs. Oracle Cloud ERP

Oracle Cloud ERP is one of the tools that businesses most commonly compare to SAP S/4HANA. Both solutions may be scaled to suit the demands of larger, more complex, and heterogeneous organizations and companies that operate on a global scale naturally lean toward these two options.

It is noteworthy that Oracle has long been a leader in data and analytics, particularly since its acquisition of Hyperion. Both SAP and Oracle are in the process of transitioning from their well-established legacy systems to these newer flagship products, which results in a relative lack of functional maturity. But when it comes to employee adoption, Oracle ERP Cloud has the edge. In contrast, in relation to standardizing and coordinating business processes, SAP is the industry leader.

When it comes to deployment flexibility, SAP has the upper hand. While most ERP vendors, including Oracle, are attempting to push their customers into the cloud, SAP continues to offer multiple deployment models with S/4HANA, as mentioned earlier. Rather than requiring a pure cloud or on-premise delivery, SAP allows customers to choose between an on-premise, cloud, or hybrid implementation. Oracle on the other hand, hardly ever provides on-premise solutions, unless there are deficiencies in its product that can only be addressed by a legacy on-premise solution.

All in all, in the SAP S/4HANA vs. Oracle ERP Cloud debate, there is no clear "winner" nor a single right answer when selecting between these ERP systems. The main advantage of SAP is that they can better tailor to complex clients with the on-premise solution.

S/4HANA vs. Infor CloudSuite

Infor CloudSuite is a private ERP software and a more industry specific rival to SAP. SAP is the industry's largest ERP vendor, with Infor ranked fourth - following SAP, Oracle, and Microsoft.

Investors will notice two distinct characteristics in Infor's push to become a cloud-first company:

  1. The ERP vendor's commitment to multi-tenant cloud ERP on AWS infrastructure.
  2. The industry-specific ERP approach.

While S/4HANA contains certain specific advantages, CloudSuite also has some qualities to offer. For example, CloudSuite is designed to focus on the manufacturing and distribution businesses, whereas S/4HANA attempts to offer everything to everyone across a variety of industries. Infor builds industry customizations into its CloudSuite products for discrete manufacturing, distribution, food and beverage, healthcare, fashion and retail, and hospitality, rather than a monolithic product that customers must customize. In general, CloudSuite takes less time, money, resources, and risk to implement than S/4HANA. Infor specializes in supply chain management, enterprise asset management, and other areas other than basic ERP. This goes to show, that competition in the ERP space is fierce and present across both private and publicly traded companies.

Customers in the middle market and enterprises with specific business needs tend to favor Infor. As Infor offers greater flexibility for a wide range of business operations, while SAP provides more rigid standardization and scalability.

ERP Market Brief Overview

The ERP market size is estimated at $54.77 billion in 2021, and gaining traction because of the increase in big data and the growing advantages of cloud technology. Additionally, this market is anticipated to expand rapidly due to advantages including quick implementation and affordable installation. The market for ERP software is anticipated to grow over $123 billion by 2030 at a CAGR of 9.4%.

SAP is the current overall leader in the ERP market, but Oracle is leading in the ERP cloud market. This reflects the belief that while SAP outperforms Oracle for on-premise solutions, Oracle outperforms SAP in cloud, this may change if SAP is successful in onboarding their clients to the cloud.

Fundamental Analysis

In order to discover the value of SAP for investors, we must establish the key fundamentals and build a model reflecting the most likely future cash flows which the company is able to produce.

While SAP is a large enterprise, their move to the cloud will have the effect of making their service available to different types of clients via the cloud and can unlock additional growth in the future. For this reason, we see it possible for the company to continue on its growth trajectory and reach €50b to €55b in 10 years. Growth may also be charged by inflation in the next two years, which is why we caution investors to keep in mind the profitability and returns in relation to revenue.

In the chart below, we can see the trailing 12 months revenue, EBIT and free cash flows to the firm up to Q2 2022, with an annual projection spanning 10 years into the future as the basis for our valuation.

SAP Historical Fundamentals and 10-Year Estimates

Chart 3. SAP Historical Fundamentals and 10-Year Estimates (Image created by author using data from FMP)

While it took the company some 10 years to grow revenue from €15.16b to €29.4b in the last 12 months, we believe it is reasonable to assume that the company will trail the mentioned industry growth projection and have estimated an 8.5% CAGR for the next five years, with a decay function converging to the German 10-year bond of 0,973% as the risk-free rate. Note that the model values the company as of today, and if you want to reassess the valuation in the future, you should copy the spreadsheet and update the numbers.

In the last 12 months, SAP made €29,418b in revenue, €21b in gross profit - a 71,4% margin, €4,433b EBIT - a 15,1% margin, and €1.331b in FCFF. In the chart below, we can see how the profitability margins look for SAP.

SAP's Profit Margins on a TTM Basis

Chart 4. SAP's Profit Margins on a TTM Basis (Image created by author using data from FMP)

We see that margins have been beaten down on the back of the European crisis, but have a chance to improve once the cloud vertical integration is complete, which is why we estimate EBIT margins converging to 26% at the end of the 10-year forecast period. This implies that SAP successfully pivots to the cloud as a main revenue source, and embarks on a cost cutting campaign in order to improve profitability. We also place SAP as a market leader, despite competitive pressures on account that their solution is among the most complex systems and will be hard for competitors to catch up before SAP captures large key clients.

Next, we will focus on analyzing the cash flows attributable to all investors.

SAP's Cash Flows on a TTM Basis

Chart 5. SAP's Cash Flows on a TTM Basis (Image created by author using data from FMP)

The FCFF is adjusted for stock based compensation upon granting, which we think is a fair subtraction. If you want to go with the simpler FCFF calculation i.e., CFO - capex, then the company made €4.356b, however this calculation does not take into account working capital, acquisitions and SBC, so be cautious when using the bigger number. Considering the fluctuations in FCFF, a three-year normalization gives us €3.45b, which could be considered a more appropriate representation.

The projected cash flows in our 10-year model amount to €67.3b, 30% of which are attributable to servicing debt (we will adjust for this in the final valuation) and the rest to equity investors. The present value of the 10-year cash flows is €43.9b.

Next we need to analyze returns and see if growth matters for SAP. In the chart below, we can see the returns on equity, capital, as well as the sales/capital ratio for SAP.

SAP's Fundamental Returns on a TTM Basis

Chart 6. SAP's Fundamental Returns on a TTM Basis (Image created by author using data from FMP)

Our general assumption is that returns are declining but slated to improve once the cloud project is over. We notice a significant issue with returns as they are currently around the cost of capital. This means that even as the company grows, it is not creating any excess value, partly because inflation is eating away any value gains from revenue growth, and that the growth of costs does not allow free cash flows to increase. This means that the company has two active headwinds pressing down shareholder value: inflation and decreasing margins from implementing the cloud project. If SAP manages to grow margins, then the company will unlock additional value, else the stock will only grow at the risk to return rate as measured by the 7.45% cost of capital.

Finally, let's put all of this together in the value of SAP as of today.

Valuation

Using our FCFF discounted cash flow valuation, we can see that SAP is trading close to its intrinsic value, estimated at €105.1 billion. As the company returns capital to investors, we estimate that it will converge to the 1-year price target of €97.9 per share.

The table below shows our valuation result.

Valuation Output for SAP

Chart 7. Valuation Output for SAP (Image created by author using data from FMP)

At maturity, we estimate a value of $117 per share with a 25.7% upside - this means that as the company reaches the end of the forecast period (10 years) and growth converges to a sustainable (low) rate, the company will gain 25% more value from today.

Here are the valuation details:

  • Initial cost of capital 7.45%, terminal cost of capital 6.7%
  • Terminal value €147.2b, present value of TV €73.3b
  • Present value of cash flows €43.9b
  • Sum of present value €117.2b
  • Value of equity: €105.12b
  • Intrinsic value per share: €90.8
  • Overvalued by 2%

Risks and Opportunities

When thinking about investments, we must do our best to factor in the risks and opportunities of a company. Here is a short list of what may impact SAP's future value

Risks

For SAP, there are a number of peer-, industry-, and profitability-related risks that need to be understood before moving forward with an investment strategy.

Competition could drain the excess value. As a company matures it can provide additional services that are easy to produce but need the core service first in order to function i.e. the ERP system. Competitors can come in and offer these extra services cheaper than SAP, draining the company of higher returns on capital. For example, SAP may prepare an analytics add-on to the core ERP. But clients may opt for using a third-party analytics service because they don't want to pay SAP the extra fees.

The company may have to absorb a large portion of the current inflationary shock and may not be able to raise prices as much as it would like. The ECB is also reacting slowly to curb inflationary pressures and may prolong the inflation in Europe, leading to further margin decreases in the region where SAP gets some 43% of revenues.

Europe has been a difficult destination for equity investors, and companies such as SAP are shifting to stakeholder capitalism which, coupled with Germany's high 30%+ tax rates, may leave little for equity investors. Conversely, companies in Europe orient towards debt investors as they mature, which means that the future cash flows may be absorbed by banks.

Implementing the ERP systems within the cloud is a complex project which can take longer, and countries may enact security legislation which geographically limits where companies can store data - this will increase costs of doing business as SAP will have to lease or build international data warehouses.

Technology is becoming drastically cheaper, and smaller teams of developers can now create complex solutions at a fraction of the price. Large key competitors may encircle SAP's services and push clients into their own ecosystem even if their offered service is not at par with SAP's. Microsoft, for example, may push clients to use MS Dynamics because it is better integrated with the office suite.

All of the above mentioned factors, give SAP's competition more opportunities to move into the ERP market and take market share away from the company. Management will have to compensate for these factors and employ disciplinary measures, innovation and growth via acquisitions.

Opportunities

On the other side, we should note the most significant opportunities that make SAP a viable investment.

SAP is an established, recognized and efficiently managed organization. The brand is differentiated as representing a quality product for large enterprises. The company's services are complex with a large amount of capex and R&D already invested, making them hard to reach and copy by competitors.

SAP is the flagship tech company of Germany, which may step in should the company need leniency in the future. The core software may allow SAP to create small additional services which can boost the company's return on capital, and SAP's in-memory database approach makes the software much faster than peers. As RAM prices decline, SAP databases may become cheaper for clients.

The available customization options make SAP a very flexible solution that can accommodate tax, compliance, financial and other needs of international enterprises. While highly customized configurations for SAP void their warranty, this feature drives large efficacy and cost savings for corporations.

Conclusion and Investment Approach

We feel that the market is not wrong on the current value of SAP, as our valuation shows that the company is trading around intrinsic value. That said, we see SAP continuing the push to the cloud, which should improve the profitability of the company, as well as allow them to continue developing services that will increase the returns on capital. The company may also improve its vertical integration by optimizing the cost structure of their cloud database storage and ease the onboarding process for clients to the cloud.

All of the mentioned factors are priced in to our valuation for which the value at maturity for SAP is estimated at €117 per share, after which investors may expect a 6.7% annual return. This places SAP close to the mature company category with the last major developments along with cash flow optimization expected to happen within this decade.

We feel that SAP is the type of company that can provide moderate returns to a portfolio, but the key benefit for investors is the portfolio stabilization aspect and geographic diversification. Alternatively, investors may bundle up some of the previously mentioned ERP peers in their portfolio if they are bullish on the development of enterprise technology, but are unsure who will win the ERP race.

This article was written by

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Stock Valuation Research with an emphasis on Intrinsic Value.We conduct in-depth, forward looking analyses of companies. We estimate the value of a business, what differentiates it from the rest of the market, how they manage risk and where will future value come from.

Disclosure: I/we have a beneficial long position in the shares of SAP either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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