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SAP's Sudden Price Drop

Reports of slow sales in Europe have dropped SAP's stock price 25% below its recent trading range. Have SAP's long-term prospects changed?

The Questions

Analysts in Europe have expressed doubt about SAP's ability to meet its earnings targets this quarter, and the stock price has consequently dropped much faster than the sector has.

In this Short Take, we ask three, interrelated questions about the price drop. First, are SAP sales actually slow, relative to the sector? Second, if sales are slow, is this the effect of war jitters, or is there something wrong at SAP? And third, what are SAP's long-term prospects? All readers of Short Takes care about this question, but it is particularly salient for the analysts. For you, the question translates to, "Is this a much-needed correction for a company that is incapable of justifying its premium valuation, or is this a buying opportunity?"

Let's have no surprises. We think it's a buying opportunity. Our basic answers to these questions are as follows: First, we see no indications in the Americas that sales are particularly slow for SAP this quarter; our European Correspondent sees roughly the same thing in Europe. Second, we think the entire sector may have been hurt by war jitters, but we think SAP will be hurt less than most. Third, we don't think anything in SAP's business model or long-term prospects have changed. Much as I love to criticize SAP, it is the best company with the best product suite and the best prospects. There are many long-term issues, and the way they are managed will ultimately determine what valuation is justified. But all the issues are manageable.

Are SAP's Sales Slow?

We have spent the last few days talking to customers, partners, and competitors of SAP about the current sales climate. In the Americas, we have not found any indication of particularly slow sales for SAP (though no one thinks the climate is great). The deals are there, small and large. Not all will close, but some will. There is no sign of unusual malaise or depression in the SAP sales force.

Europe seems much the same. According to our European Correspondent, "The economic climate in Europe is what it was. No changes in sight. It is unlikely that sales problems in Europe warrant such a dramatic impact [a 25% price drop -- Ed.]. Europe is fragmented and Germany is pretty resilient. With Germany, Switzerland and Austria still having a revenue share of similar size to the US, minor hiccups can occur, but landslides are not to be expected. The rest of Europe is more volatile - but the impact is smaller."

Given our policies (we don't ask people to violate laws or risk getting fired; we don't violate confidences; we don't publish insider information), we have reasonable confidence in this picture.

That said, we also want to empahsize how very unreliable our snapshot (or any snapshot) is. Year on year comparisons are always difficult, but Q1 y/y's are particularly difficult. Q1 always looks bad after Q4, and nobody remembers with any clarity whether this year's bad is worse than last year's bad.

And this year, comparisons are more difficult than ever. We've been told that in the Americas, the salesforce compensation system has changed in two fundamental ways. First, salespeople now take responsibility for all revenue coming in. License revenue is still primary, but revenue from consulting and training also count more heavily. So, while pure license activity may be down, the total may not be. Second, salespeople now have quarterly quotas, so they're under more pressure than they would have been a year ago.

These changes make it very difficult for us to generalize accurately from our small sample of contacts. But they are equally a problem for anybody else's sample. None of us who comment on these matters with legal information really have a big enough sample size. Of course, my conclusion could be based on an anomalous local willingness to invest in applications. Somebody else's could equally well be contaminated by local unwillingness to invest in these applications.

Frankly, even if you did have access to all available information, I'm not sure how much visibility you'd really get. SAP does keep track of its pipeline, but any rollup they would do at the highest level simply must have a good deal of uncertainty to it. The underlying data is simply too doubtful. They can make a guess, based on past experience, knowledge of economic trends, etc., but even if the guess is a good one, events that occur in the next two weeks could invalidate it. If the German army deal or the Microsoft deal (just to name two deals in the news about which I have zero special knowledge) go the wrong way, that guess will be so much waste paper.

Economic Jitters and the War

How much will the prospects of war affect applications sales overall? It seems to me that when war is looming, people's willingness to invest in applications is probably on a par with their willingness to invest in stocks. So you should expect some problems. As one (non-SAP) salesperson said, "My best deal just got delayed because the company's business went down 10% during the Gulf War. So they're playing it defensive, assuming that the business will go down again."

Even if the quarter started well (and I think it did), the emotional climate of late February and early March have to mean that some projects were delayed, enough to make it doubtful that the sector will make its numbers. But remember, not all is black. Certain kinds of projects will not be affected all that much by war jitters. Small projects and projects recently budgeted should still go forward. So should projects in industries that are helped by the war or in companies that feel the projects are strategic. Speculative applications deals are less likely, of course, but how many of those were there anyway?

If this logic is right, then overall, SAP should slightly out-perform the sector, and so should PeopleSoft. Siebel should be hurting a little more, and the smaller companies should really hurt. The core SAP customer base is fundamentally in extension and upgrade mode. These are the kinds of projects that are most likely to keep their momentum. They are budgeted for already. They have clear goals. They are deferrable, as all infrastructure projects are, but deferring a project that you are in the middle of is significantly harder than deferring a new project whose value was doubtful in the first place.

Long-Term Issues

I look on SAP as a great big, multi-currency money machine which the Germans, in the German way, have chosen to operate at well less than capacity.

The issues at SAP, in other words, are quite real, but they simply impede the flow of profit; they don't prevent the stream from flowing.

In no particular order, here are some of these issues:

We all know that the current leadership is gradually letting go (Hasso went sailing during the last Sapphire!!). We know, too, that in all empires, the wars of succession are rarely pretty. SAP politics are complex and by all accounts terribly consuming for the participants.
One additional worry I have is that the layers two levels down from the current leaders are not terribly strong. As the new leadership emerges and the losers leave the company, this layer will be asked to do more, and in my experience, that will be problematic. This was a big problem for i2, as less than competent people were promoted during the growth spurt based on length of service with the company, and they (i2) are still suffering the consequences.

New Products
SAP has a tremendous array of new products that ought to be ready for the marketplace and bringing in new revenue. There's SRM. There are the x-apps. There is the integration framework. And there are even more products that have reached some level of maturity, but have not become accepted standard parts of the product. There's the portal, the supply chain management suite (only 60 reference customers in the States), and the CRM suite. These products should all be bringing value to customers and revenue to SAP faster than they are.

Long-Term Revenue Accession
SAP has become the default infrastructure for an enormous number of very large companies. The challenge for any infrastructure company is threefold. One, keep the switching cost high. (SAP does this well.) Two, provide more value-added services. (See previous note.) And three, while keeping TCO reasonable, take control of as much revenue as possible.
Here, I've been arguing for some time, SAP has been remiss. In the end game, SAP ought to be trying to get control over every revenue stream that's related to their product--services, training, even hardware, as well as license revenue and extension revenue. They clearly are doing this some--the web application server, for instance, grabs at hardware revenue. But they could do more. One advisory board member, for instance, recently told me that R/3 Enterprise requires a mirror version for the upgrade, a windfall for hardware manufacturers, a windfall that SAP created but does not share in.

The Shelf
It is also the case that SAP sold a lot of seats that are unused, and there is a lot of depreciation out there for projects that were too expensive. I'm not necessarily talking about the ridiculous stuff, the $300 million spent without a line of code going into production, but just the day-to-day impediments that the past keeps on throwing into SAP's path. I think, for instance, of the SAP shop that went outside for its CRM recently, because the original SD implementation was inflexible, and no one in the organization wanted to try the upgrade.

Our European Correspondent and other members of the advisory board can add others, all of which are serious. But of course, at any company, there are always big differences between "is" and "ought."

For SAP, these differences don't show up in any single, dramatic way. There is no single line item in the income statement that is clearly suspect. Instead, they show up as ASP's that are a little smaller than they should be, as wages paid to developers who don't produce the product they should, as a cost of sales that seems excessive given the current sales processes, etc., etc.

In the long run, it is the weakness in these kinds of numbers and not whether we go to war with Iraq that will determine SAP's valuation. If the company remains as it is, that money machine will still operate at well less than capacity. Fix the issues, and a market cap of $25 billion will look puny.

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