Bill McDermott - talking a good game

As we previously noted, SAP closed out 2014 pretty much where it had said it would at the Q3 earnings call (see Q4 statement - PDF.)

That should not surprise since SAP is good at managing expectations but by the nature of enterprise software sales, the company knows a good way in advance what it is likely to close out.

In addition, SAP benefits from the transition to subscription revenue. That is because as deals get smaller a the revenue recognition level, the numbers become - as CFO Luka Mucic has said - more predictable. In short, sweating on a $100 million deal doesn't become a priority. Instead, the priorities change to signing three year deals with a booking value of $100 million.

The flip side is that subscription revenue is front loaded with the cost of deal acquisition which in turn means the margin is impacted. We have seen this time and again among SaaS vendors so none of that should be a surprise and in part explains why the company is providing guidance out to 2017 that many will see as 'soft.'

In SAP's case, it represents something of a culture shock for a company used to regular champagne suppers at Bollinger prices. They might have to downgrade the brand of champagne for a while. Let's get to the detail.

Shuffling the numbers

Prior to the earnings call, the company fielded a short webinar on changes it is making to the way it reports it numbers. This is usually a red flag. We have seem many occasions where vendors have operated a shell game as a way of disguising impending or overseen bad news. That is not the case here. Instead, Mucic has done a couple things that I welcome. See image below:

First up, he has simplified the naming conventions used when describing revenue sources. This is a huge relief for those of us who occasionally struggle with apparently contradictory and clumsy terms. So 'software and software-related service revenue' becomes 'cloud and software' while 'professional services and other service revenue' simply becomes 'services.'

Next, he has re-bucketed part of the services revenue. The cloud subscription revenue reflects both the pure subscription revenue and basic associated support. That's in line with what other vendors do and is readily understandable. 'Services' is really about allowing SAP to go into market with customizations and one off projects in a single line item. From the blurbs:

In its services business, SAP has started to radically simplify the way it engages with customers and delivers services to its customers: Under the new ONE Service approach, rather than offering different services separately with a mix of local and global delivery, SAP now provides services in one service portfolio, out of one global organization and under one contract.

SAP has said that it will implement these changes with effect from Q1 2015 with comparative numbers going back into past years for ease of comparison. That will no doubt give the financial analysts something to angst over. What's next?

2017 outlook

I remember when SAP announced the SuccessFactors acquistion, then co-CEO Jim Snabe was exuberant at the prospect of acquiring a business that would be (pretty much) immediately accretive. He was also convinced that SAP would be able to do what no other SaaS vendor has achieved so far: get its cloud business profitable. By August of 2012, I was concerned:

In my preliminary analysis of SAP's Q2 2012 results , I had trouble figuring out how the cloud related figures work. My initial conclusion was that they were going backwards rather than forwards, a point I made to co-CEO Jim Snabe. I suggested this was possibly as a result of an accounting difference that had yet to wash through. He said "You are right" adding that SAP knows it has to do a better job of providing transparency into cloud earnings.

Over the next couple of years, SAP weaved its way towards offering a more complete cloud HCM offering with Employee Central. That seems to be going reasonably well with CEO Bill McDermott declaring:

And with Employee Central, it’s actually up 90% year-over-year, we now have 560 customers that are running core HR in the cloud. That’s up from under 300 a year ago and many wins against the competition.

I wouldn't class that as outstanding but it is certainly credible and, as Mucic pointed out, the company has grown organic cloud revenue by 30% in the last year.

Senior executives inside SAP tell me they are making good progress with net-new wins and that the speed at which customers are going live is ramping quickly. However, my sense is that SAP under-estimated the cost of customer acquisition largely due to three factors:

SAP quickly lost many of the lead people picked up in the SuccessFactors deal so wasn't able to acquire all the knowledge needed to fully appreciate SaaS economics and sales methods.

The implementation difference between SaaS and on-premise delivery is huge. It's like night and day. Consultants that have made that transition say they have to be much more aware of current development activity and possess a much broader skill set than is needed for an on-premises implementation.

Workday and now Oracle represent significant competition in a market where SAP was unquestionably the HR leader from a packaged apps viewpoint. Both those competitors boast of taking customers from SAP which in turn places pressure on SAP to maintain prices.

My belief is that having learned from the past, SAP is now more realistic about the impact of a different business model, hence the relative softness in the 2017 outlook but also the need for rapid data center expansion. During the earnings call, SAP announced it now has 40 data centers around the world, supplanted by those operated by partners.

It should be no surprise then that hearing all this, the markets were less than pleased and hammered the stock. But there is one more fly in this particular pot of ointment that should be a concern and that is Simple Finance or SFIN for short.

Simple Finance - where is it?

When I met with the company last fall, it was clear to me that SFin has a long way to go before it is truly ready as a replacement for SAP's core accounting or FI/CO. This is the rock upon which SAP's business has been built and as far as I am aware, SFin is not ready for prime time. Put another way, I can find no customer examples that point to success. Back in June, Frank Scavo said:

As I see it, Simple Finance will be a major new release of SAP financial applications (starting with FI and CO) as the first SAP Business Suite products to undergo radical code optimization to take advantage of HANA, SAP’s in-memory database technology.

Today, the company talks about "immense momentum" around SFin but I still have a lot of questions about the reality among customers.

My take

For the first time in a number of quarters, SAP talked up HANA, which is the cornerstone for everything SAP wants to do in the coming years. The fact it got a mention at all was something of a surprise but my sense it was to remind the market that SAP is able to generate revenue on all its big bets.

Although the 2017 outlook is soft, SAP gave guidance all the way through to 2020, saying that cloud revenues will exceed on-premise by 2018 and that by 2020, the company will have an €8 billion cloud subscriptions business. Five years in software is a very long way ahead. SAP has the benefit of knowing what its long term contract position looks like and is steadily gaining experience in moving customers to the subscription model. Hence the company's bold predictions. But as we've seen in the past, you can make long term predictions all you want but they rarely work out. Anyone remember McDermott's Exocet to be launched against NetSuite via Business ByDesign? Never happened.

Getting SFin into the hands of hundreds of customers while continuing the Employee Central push will be critical in the next 18 months. The competition won't hang around to wait for SAP to catch up.

SAP will earn lot of credibility if it improves services like Concur's Tripit/Pro and learn from the Concur folk what a great and simple application can do for users. The fact Steve Singh is due on stage at the company's upcoming investor roadshow/webcast on February 3rd is a very promising sign.

SAP, Oracle, NetSuite, Workday and Salesforce are premier partners at time of writing.