Having surprised the market earlier this month when it pre-announced lower than expected software license sales, precipitating an immediate 10% drop in its share price at that point in time, the news of the lower operating margin forecast gave watchers and investors a further jolt.
There was further unease when the company announced that it was cutting its Q3 license revenue by 30m euros ($39m) as a result of a decision to help out a customer undergoing major restructuring, by amending the sales contract.
After that, the actual Q4 and full-year figures were almost sidelined as interest focused on the forecast and increased spending plans rather than past performance. Total revenue for Q4 was up 7%, or 12% at constant currency rates, to 3bn euro ($3.9bn). Software revenue also increased 7%, or 12% constant currency, to 1.3bn euros ($1.7bn). Net income was up a healthy 29% to 799m euros ($1,035m).
The reason 2007 operating margin is expected to drop to an expected 26% to 27% (compared to 23.3% in 2006) is because SAP intends spending 300m euros ($389m) to 400m euros ($518m) over the next eight quarters developing its mid-market business, bringing on a completely new application suite known as A1S, and a new business model which will include SaaS, a volume sales model based on telesales as well as internet-based sales, delivery and support.
This is the second time in a matter of years that SAP has sacrificed profitability and operating income in order to accelerate product development, having previously invested heavily in R&D to speed up development of its enterprise SOA platform. One assumption is that it is facing increased competition in the market in general, causing it to accelerate its plans.
The plans for a new mid-market product could be construed as SAP admitting that its current SMB portfolio, which consists of Business One and All-in-One, has failed to meet market requirements. However, CEO Henning Kagermann believes that the mid-market harbors massive untapped potential and the A1S product will target a $15bn market which is currently under served by existing business applications.
SAP is changing the way it deals with its customers, adding subscription-based payment models to its traditional perpetual license sales, for both large enterprises and SMBs. The transition to a new mix of pricing models could either be contributing to the shortfall in licensing sales or masking a sales slowdown and this unanswered question was also causing concern among financial analysts during the web conference.
Certainly subscription based models have an impact on license sales and revenue recognition and SAP is gradually expanding the scale of its subscriptions model. It signed up four new customers to its global enterprise agreements scheme during 2006.
These types of agreements are based on subscription payments spread over a three to five-year period and combine license and maintenance, rather than revenue being recognized up front and allocated separately to license and maintenance revenue lines.
If the revenue has been recognized in the traditional way it would have added 400m euros ($518m) to software revenue, said Ernie Gunst, president of the EMEA region. SAP also offers CRM as a subscriptions-based on demand service and in the SMB market plans to offer subscriptions to A1S as well as a perpetual license option.
The move to mixed models is also prompting SAP to change the way its reports from Q1 2007. It will no longer provide an outlook for license sales but will give guidance for software and software-related revenue, which will include licenses, maintenance and subscription revenue.
CFO Werner Brandt said the move was intended to increase transparency, although the initial response from analysts was concern over whether it suggested software license sales on their own were set to fall short of expectations. Goldman Sachs inferred that growth in software license revenue would be in-line at best, with market expectations of 12% to 14%. As far as SAP is concerned, it expects software and software-related revenue to grow by 12% to 14% in 2007 (based on constant exchange rates), compared to 12% in 2006.
The negative response to SAP’s announcements resolves down to one issue – that the additional investment and business model and reporting changes makes it difficult to deduce whether SAP is suffering more than it is indicating in terms of license sale slowdown, while also making it difficult to forecast future performance at this point in time. Despite these concerns, there do not appear to be any fundamental weaknesses in SAP or its go to market strategy, it is more likely that the competitive lead it had built up is been eroded to a degree.
