In 1972, five former IBM employees founded a company named SAP (SystemAnalyse und Programmentwicklung) (NYSE:SAP). 43 years later, SAP serves more than 263.000 customers in over 190 countries worldwide. Headquartered in Germany, SAP touches US$16 trillion of retail purchases around the world. SAP is the world market leader for enterprise applications, analytics and mobile solutions with a 25% global market share. In addition, SAP is the second-largest enterprise cloud company with more than 35 million users and is the fastest growing database provider in the world.

Current business situation
In the first three quarters, worldwide IT business growth again outpaced growth in the overall world economy, according to US market research firm IDC. Software continued to lead IT spending, with companies investing primarily in the cloud, in Big Data, social, and mobile. At the moment, IDC expects the global software market to grow slightly over 4% this year and keep growing faster than the global GDP in the future. IT markets in the emerging economies have developed at different rates since the beginning of the year. The market for IT in the EMEA region has been largely stable but has failed to keep pace with the expansion of the IT market globally. IT market growth, and particularly software and services segment growth, was much stronger in the AJP region than in the world as a whole. The resurgent U.S. market drove growth in the Americas region. Emerging markets will continue to be a growth driver, with high double-digit growth in software and cloud revenues expected through 2017. In addition to SAP’s investments in China, Russia and the Middle East, the company is expanding in Africa as well.

During this year, SAP’s revenue has increased by only 3% compared to last year. Owner earnings and the balance sheet remain pretty much unchanged except the fact that goodwill has increased because of acquisitions and will grow in Q4 because of Concur by several billions of Euros. The main driver for revenue growth was the cloud business which grew by 51%. Over half of the revenue growth can be explained with that segment. The drive in the cloud business is now extremely strong and SAP has had to raise its outlook for the segment a few times this year. A negative fact has been that the margins decreased in the cloud business by 7.6% points to 65%. This decrease was primarily due to increasing expenses related to the ramp-up of the cloud business, with related investments, as well as additional personnel expenses. So, all in all the problem was not in the market.

Currencies had a negative effect on revenue growth. Margins decreased slightly as profits did not rise together with revenue. During this year 47% of revenues were generated in Europe, 38% in Americas and the rest in Asia. For the cloud business, Americas is by far the biggest geographical customer. In Europe, Germany is the biggest customer which accounts for 15% of total revenues. US generates 28% from total revenues. IBM (NYSE:IBM), Oracle (NYSE:ORCL) and HP (NYSE:HPQ) are finding growth harder to come by as customers move from traditional software contracts and computer purchases to programs delivered from remote data centers online. SAP already has a good head start with cloud compared to its peers.

In the case of SAP which has equity worth of €18 billion and a market capitalization of €70 billion, it is quite clear that most of the value of the company is not visible in the balance sheet. This is quite common with software companies where the value lies in intangible software and know-how. This year Interbrand evaluated SAP’s brand worth of $17 billion. In general, SAP’s business and balance sheet are in good order as Moody’s and Standard & Poor’s have both assigned it a credit rating of “A2” and outlook “Stable”. Below you can see the recent liquidity statement for the group which is pretty much a perfect example of cash flow of a wonderful business.

SAP HANA’s customer count has gone up to 1,450 as compared to 450 a year ago. It has been, alongside the cloud business, the main contributor for revenue growth. With total license revenue of €1.2 billion in less than three years, SAP HANA is the most successful product in SAP’s history. This technology is the basis of all SAP applications in the future. Hence, the strategy change towards SAP HANA made in 2010 has proved to be correct so far.

Three major technology trends – in-memory computing, enterprise mobility and the cloud – have triggered change in the world of IT. Those trends are changing not only the way enterprises adopt and deploy business technology, but also fundamentally the way how work is done. Cloud computing has now become mainstream and is a widely accepted delivery model in the United States, and increasingly in Asia and Europe. According to SAP, organizations around the world are now entering a new era of business model innovation, made possible by the convergence of cloud, mobile, social, and in-memory technologies. The company tries to serve this market need by simplifying its customer’s IT infrastructure. SAP can achieve this by offering all of its products through cloud-based SAP HANA. Today, cloud, mobile, and Big Data are the dominant themes in the IT industry and SAP HANA tries to answer all these demands.

At the moment the company is in the middle of a transition in its business model from traditional software sales to cloud computing and this will take some time before it starts to show on the bottom line. However, the disproportionate growth of cloud business leads to short-term margin pressure: upfront cloud sales and delivery costs increase as customers sign more cloud deals but revenue and profits are generated much later. Consequently, SAP has adjusted its outlook for operating profit for the full year 2014 a few times. However, the cloud business can be expected to increase its profitability in the longer term, as economies of scale start to kick in with revenue growth. The good part with cloud is that SAP will now see a consistent stream of revenue from its customers as compared to one-time payments.This will also allow those enterprises who cannot afford to pay high fees upfront, but are capable of paying small installments, to buy SAP’s services. This move will effectively increase the company’s customer base. Below you can see SAP’s current revenue base where the majority of the revenues are already recurring.

SAP currently estimates that they will increasingly be subject to intellectual property infringement claims as the number of products in its industry segment grows, as it acquires more companies and expands into new industry segments. Even at the moment, SAP is subject to multiple lawsuits. The biggest one is with Oracle which started already in 2007 legal proceedings in the United States against TomorrowNow which was slightly earlier acquired by SAP. In the worst case, Oracle is seeking $1.3 billion relief from SAP because of lost revenues.

Concur acquisition
On September 18 this year, SAP announced it will buy the global market travel and expense management software manufacturer Concur with a whopping price of $8.3 billion. The initial market reaction was a 4% drop in share price. SAP has unused credit facilities worth of €7 billion for the purchase and will issue bonds if needed to fund the acquisition. There has been a lot of discussion whether the purchase price was overly absurd considering that in the last fiscal year, Concur had revenue of $700 million and generated owner earnings of $25 million. This would make the P/S ratio 12 and P/OE ratio 332. It still has to be noted that during the last 5 years Concur has grown more than 20% annually and that it is quite difficult for a regular investor to assess the synergies generated from this acquisition. E.g. When Concur is combined with the Ariba and Fieldglass business networks, SAP will be positioned to power transactions that drive more than US$10 trillion of addressable global spend annually. The main idea with the Concur purchase is to add it to SAP HANA so that customers could glance through a single report all company-related costs. Concur simply completes SAP’s offering. If you imagine that SAP could double Concur’s revenue because of its larger customer base, the P/S would be only 6 as compared to SAP’s 4 which is not a lot any more, considering Concur’s strong growth rate.

Competitors
SAP’s main competitors in the applications market are IBM, Oracle, and Microsoft (NASDAQ:MSFT). Key competitors in the business analytics market include IBM, SAS Institute, Tableau (NYSE:DATA) and Oracle. The mobile market is still highly fragmented but competitors include among others Antenna. In the cloud market, SAP faces line-of-business on-demand players such as Salesforce.com (NYSE:CRM), Workday (NYSE:WDAY), and NetSuite (NYSE:N), as well as Oracle. Principal competitors for technology & database products include IBM, Microsoft, and Oracle.

SAP products
SAP offers products in 5 different segments: business applications, database & technology, analytics, cloud and mobile. Its portfolio of solutions currently covers 12 lines of business; asset management, corporate strategy and sustainability, finance, human resources, information technology, manufacturing, marketing, procurement, R&D and engineering, sales, service and supply chain management. In total, SAP now supports enterprises in 25 industries.

SAP’s goal is to offer all these products through SAP cloud-based SAP HANA. SAP is the only company in the world with a portfolio to enable its customers to manage all key resources on one cloud platform. SAP’s products can be installed on-site or offered through cloud and can be used either mobile or via other user interfaces. SAP mainly sells these products by itself or through partners. Partners can directly sell them, develop their own solutions that complement SAP’s products or provide implementation and other services for SAP software. In addition to these products, the company offers consulting, training and customer-oriented software development. Consulting generated 13% from total revenues in 2013.

For its software, SAP provides two different licensing models: software licenses and cloud subscriptions. For software licenses, the group recognizes the majority of revenue as a one time up-front license fee. The customers receive a perpetual license to SAP’s software. The list price for the perpetual license forms the basis for the support fees. Support is usually sold and invoiced on a monthly or annual basis. Support revenue is a strong recurring revenue stream for SAP, representing 52% of 2013 total revenue. Software sales accounted for 27% of total revenues in 2013. For cloud subscriptions, SAP recognizes revenue ratably over several years. Cloud offerings are typically installed in a data center of SAP or one of its partners. Cloud subscriptions include license, support, and operation costs for the data center. It is SAP’s second recurring revenue stream, strongly growing and in 2013 contributing about 4% of total revenue.

Outlook
SAP expects the combination of a stable, highly-profitable core and fast-growing cloud business to deliver continued growth and margin growth in the near future. The management has stated that the dividend payout ratio should be more than 30% of the profit after tax.

SAP’s near term financial goal is to increase its total revenue to at least €20 billion and total revenue from its cloud business to approximately €2 billion by 2015. In the medium-term it is striving to increase its revenue at least to €22 billion by the end of 2017 and increase its operating margin to 35%. To capture the growth opportunities in the cloud, the group now expects the margin target to be reached by 2017 rather than in 2015 as previously stated. This is why the share price has been performing so badly this year. SAP anticipates that the fast-growing cloud business along with growth in support revenue will drive a higher proportion of more predictable, recurring revenue in the future. SAP expects that annual cloud subscription and support revenue will be higher than annual software license revenue, latest by 2020. Hence, the cloud business will be critical for future growth and margins for SAP.

SAP plans to grow both organically and through acquisitions to reach the revenue targets. In recent years majors acquisitions include BusinessObjects (2007), Sybase (2010), SuccessFactors (2011), Syclo (2012), Ariba (2012), hybris (2013), Fieldglass, and Concur (2014). SAP does not currently have any other major acquisition plans in the cloud business as opposed to recent years. Now is the time to integrate them and let the synergies take over.

Ownership
Board members of SAP own in total ~120M shares which translates to a € 6.6 billion ownership. This is the biggest management holding compared to all my other holdings. An interesting thing to note is that almost everyone in the global managing board have joined SAP over a decade ago so they should have a deep understanding about the company and industry.