SAP Stock: A Good Time To Sell-Down Some Exposure (NYSE:SAP)

Thesis

SAP SE (NYSE:SAP) delivered a somewhat worse than expected Q4 performance, missing analyst consensus estimates with regard to both revenue and EPS. While management commentary implies that the company is likely going to respond with cost-cutting, like other tech giants, I believe it is unlikely that the company will achieve material EPS expansion as long as the demand environment for enterprise software remains depressed.

Personally, I continue to value SAP stock with a residual earnings model. And given EPS downgrades through 2025, I now calculate a fair implied share price of $97.26. Accordingly, as a function of valuation, I lower my recommendation for SAP from ‘Buy’ to Hold’. Note also that my previous target price of $110.18 has been met. So, even assuming no EPS downgrades, SAP would now offer little upside from a valuation perspective.

For reference, SAP stock is down approximately 7% for the past twelve months, more or less in line with the S&P 500 (SPY). However, since September 2022, SAP has appreciated at a much faster rate than the S&P, closing the previous performance gap.

A Softer Than Expected Q4

During the period from September to the end of December, SAP recorded total revenues of €8.44 billion, as compared to €7.98 billion for the same period one year earlier. Although total group sales expanded by about 6% year over year, the result fell short of analyst expectations, which had estimated revenues to fall somewhere around €8.7 billion.

With regard to profitability, SAP’s operating profit increased by about 17% year over year, to €1.71 billion for Q4 2022, as compared to €1.46 billion for the same period in 2021. Net profit after taxes, however, which includes restructuring and other non-recurring costs, contracted to only €332 million, versus €1.44 billion one year earlier (a 77% plunge!). On a per-share bases, Q4 earnings came in at €0.47, which is approximately 50% below the respective median analyst expectation.

For the FY 2022, SAP’s revenues expanded by 11% year over year, to about €30.9 billion, and IFRS operating profit remained approximately flat — recorded at €4.67 billion.

Cautious Going Into 2023

Although SAP’s cloud business continues to see good momentum, being up 30% yoy in Q4 2022, the company is clearly pressured by the deteriorating demand environment for enterprise software — similar to other software/ tech giants such as Microsoft (MSFT) and Salesforce (CRM). And accordingly, I would advise investors to approach a potential investment somewhat cautiously. I understand that my advice conflicts with SAP’s CEO Christian Klein comments, saying that:

[h]eading into 2023, this gives us great confidence in delivering on our promise of accelerating topline and double-digit non-IFRS operating profit growth

But reflecting on the macro environment and commentary from Microsoft, Salesforce, and others, I fear Mr. Klein’s positivity might create excessively optimistic expectations (even though my assumption might be wrong).

With that frame of reference, investors might also consider if SAP’s cost cutting program is a sign of a slowing demand environment, or a simple restructuring exercise. Together with Q4 results, SAP announced that the company is planning to cut approximately 3,000 jobs, or about 2.5% of the company’s total headcount in relative terms. The company also voiced willingness ‘to explore a sale of its stake in Qualtrics’. In sum, the cost saving program will cost SAP an estimated one-off €250 million to €300 million, but could materialize €300 million to €350 million in annual cost savings as early as starting in 2024.

Valuation Update: Lower TP to $97.26

On the backdrop of a softer than expected profitability outlook, I lower my EPS expectations for SAP in 2023. I estimate that SAP’s EPS in 2023 will likely contract to somewhere between $5.6 and $5.8, as compared to $6.01 estimates prior. Moreover, I also lower my EPS expectations for 2024 and 2025, to $6.10 and $6.40, respectively.

I continue to anchor on a 2.5% terminal growth rate, as I see no material reason to change this. However, reflecting on a higher cost of capital requirement for tech firms (higher risk premia), I raise my required return assumption by 75 basis points, to 8.75%.

Given the EPS updates as highlighted below, I now calculate a fair implied share price for SAP of $97.26 as compared to $110.18 before.

Below is also the updated sensitivity table.

Conclusion

SAP stock has appreciated by about 32% since I initiated coverage with a ‘Buy’ recommendation and a $110.18/ share target price. Given that my target price has been met, and reflecting on a softer than expected Q4 performance, I believe this is a good time to sell-down some exposure.

As a function of EPS downgrades, I now calculate a fair implied share price of $97.26; and I lower my recommendation for SAP from ‘Buy’ to Hold’.