SAP Trims Profit Outlook Through 2017 on Shift to Cloud Software

Shares of the German business software giant SAP fell in the U.S. and Germany by more than four percent after it cut its profit outlook through its 2017 fiscal year.

SAP said it expected its 2017 operating profit to come in between 6.3 billion euros (about $7.3 billion) and 7 billion euros on sales of 21 to 22 billion euros. Operating margin, a closely watched metric indicating profitability, is expected to be less than 31 percent, lower than the 35 percent previously promised.

But ask CEO Bill McDermott, and he’ll tell you that it’s all part of the plan.

In an phone interview with Re/code, McDermott said SAP’s old goal of a 35 percent operating margin is “no longer realistic” in a marketplace where software is increasingly delivered in the cloud.

“I can deliver that old operating margin, but I can’t do it and grow the cloud business in the right way at the same time,” he said. “If I did, we’d be dead as a company.”

SAP, based in Walldorf, Germany, is the world’s biggest creator of software used by large companies to track day-to-day operations in manufacturing, finance, sales, human resources and other parts of their businesses. But it has been challenged by the onset of software delivered in the cloud by companies like Salesforce, Workday and NetSuite, which sell their applications as a service delivered via a Web browser.

Today, McDermott sounded a bit like rival Marc Benioff, Salesforce’s CEO and founder, describing the cloud as “still in its land-rush phase” and arguing that now is the time to spend big and acquire customers. It’s part of a five-year plan he first articulated in an interview last year.

“You have to land and expand and grow the cloud business for market share now, and get the business to a large scale,” he said. “Eventually it will generate a lot of profit.”

It sounded a lot like the business models at Salesforce, Workday and NetSuite, none of which are profitable on a GAAP basis. SAP at least has the profits from his traditional software business — what McDermott called “core SAP” — to sustain the company while it shifts to the cloud. For the quarter just ended, SAP posted a profit of 1.6 billion euros on revenue of 5.5 billion euros, which works out to 1.31 euro per share, up three percent year-on-year.

Still, judging by today’s movement in the stock price, the transition will be painful at first. Cloud software is sold as a subscription, and revenue is booked month-by-month, quarter-by-quarter through the life of a contract. Traditional software is sold once, and revenue is booked all at once. As more customers embrace the cloud, revenue stabilizes and becomes more predictable. “The cloud story only gets better over time,” McDermott said.

For SAP, the shift to the cloud has been one marked by acquisitions. It has spent some $20 billion on cloud-software companies over the last five years, among them Concur Technologies, SuccessFactors and Ariba. The company’s biggest critics have said that SAP initially failed to anticipate the coming of the cloud era.

And that criticism isn’t without merit: Even after all that M&A spending, its cloud operation is still much smaller than its core software business. For the 2014 fiscal year reported today, SAP posted revenue of 17.6 billion euros up four percent. Of that, cloud revenue amounted to only 1.1 billion euros, up 45 percent, but still not big enough to move the needle much.

But framed another way, it does not seem so far behind: SAP now has 50 million people using its cloud offerings and the second highest revenue of any cloud software provider after Salesforce ($4 billion, fiscal 2014 sales).

The acquisitions are done, McDermott said, with no more significant deals in the foreseeable future. “Now,” he said, “is the time to execute.”

This article originally appeared on Recode.net.

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