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Morningstar | SAP's Capital Markets Day Highlights a Shifting Strategic Focus Toward Qualtrics; Maintain FVE

SAP spent an outsize portion of its Capital Markets Day discussing the recently closed Qualtrics acquisition, further indicating SAP strategic shift toward optimizing customer experience. While we think CEO Bill McDermott’s conjecture that the Qualtrics deal could be as transformative as Facebook’s acquisition of Instagram would surpass even the very best bull-case scenario, we agree that Qualtrics’ strength in optimizing customer experience with SAP’s historical core competency of operational data. Furthermore, we believe that with current trends toward big data and analytics, Qualtrics takes a differentiated approach in allowing companies to operate smarter and make customers and employees happier. SAP continues to call out that it is five times more expensive to gain a new customer than to retain an existing one. In a corporate world that is increasingly focused on customer lifetime value and retention rates, Qualtrics presents an attractive market opportunity. The focus on the recent deal was warranted as only 44% of meeting attendees surveyed at the beginning of the session (using Qualtrics of course) indicated they understood the rationale for the acquisition. We are maintaining our fair value estimates of EUR 88 per share and $100 per U.S. ADR for narrow-moat SAP and continue to view shares as fairly valued.

Other takeaways from the meeting included more clarity on operating cash flow, restructuring plans, and future M&A expectations. SAP’s forecast for no growth in operating cash flow, which implies 2019 cash flow of EUR 4.3 billion, was well below our estimate of EUR 5.4 billion due to restructuring costs, tax outflows, and share-based compensation. Regarding the restructuring, we gained more comfort around management’s plans to focus their headcount behind the divisions likely to drive future top line growth. Lastly, while we do not anticipate another transformative deal, we believe management is taking an overly conservative approach to further M&A.

Management expects operating cash flow will remain flat in 2019 around EUR 4.3 billion. The company will continue to see headwinds in 2019 due to outflows from taxes and cash-settled share-based compensation. Management expects operating cash flow to reaccelerate starting in 2020, due to the disappearance of these headwinds, working capital improvements, and operating margin expansion. Looking out further, management indicated during Q&A that operating cash flow is likely to track with revenue as SAP approaches their 2023 target of EUR 35 billion. The 2023 revenue target indicates a 7% average growth rate, starting in 2019. These estimates are slightly lower than our 2023 estimated revenue of EUR 35.7 billion.

Management made a distinct effort to further explain their rationale for the restructuring effort announced during last week’s earnings call. Management thinks the market overreacted to the “fitness program” and reemphasized that the effort is focused on moving headcount from legacy businesses to those that will drive revenue and value going forward. We think this is a reasonable plan in light of the ongoing shift in enterprise computing toward the cloud. The cash flow implications due to the restructuring are expected to be between EUR 550-750 million in 2019.

Regarding M&A, SAP reinforced that their current product offering provides them with significant runway for growth and they are very unlikely to do another large deal until the debt from the Qualtrics acquisition is retired, at the earliest. Despite this, we believe the company has the balance sheet to make another acquisition with under EU 2 billion in net debt and operating cash flow projected to exceed EUR 5 billion in 2020. Nonetheless, we would expect the company will look to do strategic tuck-in acquisitions to fill in minor gaps in their product offering.