Good or Bad Capital Allocation: Example SAP SE (ISIN DE0007164600)
In my previous post on capital allocation, I had mentioned SAP as a company which might have overpaid for an acquisition. A reader commented that SAP is a good capital allocator because they increased EPS over the last 10 years.
Increasing EPS itself in my opinion is not a “proof” for good capital allocation. Actually, this itself says nothing at all. If you have a stable business, just retaining earnings and doing nothing will increase EPS as long as interest rates are positive. Good capital allocation is when you create value from retained profits.
The best way to find out if value is created is to look at how returns on equity and return on capital develop over time.
Let’s take a look at SAP over the past 17 years with some per share numbers:
One doesn’t need to be a genius to see some trends:
Yes, EPS have increased over the 17 year period significantly as did FCF. On the other hand however, ROE has decreased significantly, ROIC even more as SAP has started using debt in the recent years. The one item that has constantly increased is sales. Especially the last 2 years do look very bad compared to historical numbers.
SAP did pay out dividends but retained the majority of profits (retention rate in aggregate ~68%) and used some debt.
Let’s look how they spend they spent the retained money on
This is a list of large acquisitions they made since 2010:
07/2010: Sybase 5,3 bn (EV/EBIT 30)
02/2012: Succesfactors 3,3 bn (EV/EBIT 28)
10/2012: Ariba 4,3 bn (EV/EBIT 29)
12/2014: Concur 7,2 bn (EV/EBIT 30)
Without the smaller acquisitions, those 4 acquisition represent 20,3 bn EUR Investment or 16,50 EUR per share. This compares with 14,86 EUR total earnings in the same 6 year time period and 15,3 EUR “free” cashflow.
If we look at the table above, the impact of the acquisitions so far doesn’t look that good. Yes, there was a one time jump in earnings in 2011, but since then earnings per share have actually dropped, so clearly the 3 later acquisitions did not add a lot of positive impact so far.
One could even say that SAP returned a lot of money to shareholders, however not to its own shareholders but to shareholders of other companies at “juicy” valuations.
I am pretty sure management has very good arguments (i.e. change to cloud/SaaS) to explain all this in a very positive light this but overall this doesn’t look so good from a capital allocation point of view. Why is that so ? Often a deeper look into management compansation is helpful.
Management incentives /RSUs
As I mentioned in the previous post, the two most important things are in my opinion :
What do companies actually do and how aligned is management with shareholders.
At SAP, top management owns hardly any shares. Bill McDermot owns ~ 4mn EUR in shares which is around 4 month of his 2015 salary (he got paid 10 mn EUR). Interestingly he owns almost 3 mn EUR in Under Armour shares….
SAP pays a lot of bonuses:
The Executive Board compensation package is performance based. It has three elements:A fixed annual salary elementA variable short-term incentive (STI) element to reward performance in the plan yearA variable long-term incentive (LTI) element tied to the price of SAP shares to reward performance over multiple years
So let’s look at what they disclose about those bonuses:
The variable STI element was determined under the STI 2015 plan. Under this plan, the STI compensation depends on theSAP Group’s performance against the predefined target values for three KPIs:non-IFRS constant currency cloud and software growth;non-IFRS constant currency operating margin increase; and non-IFRS constant currency new and up sell bookings.
So the short-term bonus clearly only relies on some internal metric which has nothing to do with return on capital etc. I am not even sure if this is based on organic growth or if, more likely, M&A contributes positively to those targets, independent from the price being paid.
The long-term plan grants so-called “RSU” to the board members, which are some kind of shadow-stock. This then gets automatically settled in cash when the RSU are “vesting”. Interestingly the amount of the RSUs is determined as follows:
The number of RSUs an Executive Board member actually earns in respect of a given year depends on the Company performance against the objectives for that year (a year is a“performance period” in the plan). The objectives derive from SAP’s strategy for the period to 2015. The plan objectives relate to two KPIs:non-IFRS total revenue and non-IFRS operating profit.
Again, the amount of stocks granted does not depend on what they earn on capital but on (easy to manipulate) non-IFRS numbers.
RSUs- aligning management with shareholders ?
The argument of a “compensation consultant” now would be: The fact that the RSUs gain value with the stock price, the interest of the recipients is fully aligned with shareholders.
My personal experience with RSUs however is very different. The biggest problem of RSU’s is that you never own the shares. You only receive a cash payment usually based on the stock price at one or several days within a year. You can not decide for instance to hold the RSUs for longer if you think the stock is undervalued. The RSUs also have no rights on dividends. So paying out dividends actually lower the value of a RSU.
Also, for management it is very easy to cash out, as RSUs get exercised automatically. If they would own “real” shares they would need to disclose those sales to the market
In my experience, the RSU system leads to 2 major management reactions:
First, they try to get as many RSUs as possible by beating self defined an easy to beat targets and secondly, they try to talk up the stock price shortly before the date when the final payout is determined. Both are not aligned with long-term share holders and are not really helpful in creating long-term shareholder value.
In many German companies, those RSU “Mid term” plans were often introduced “on top” of the previous salary and annual bonus, which in my opinion further weakens the link between shareholders and management.
In my subjective opinion, SAP’s management compensation is a typical “other people’s money” scheme with only very little (long-term) alignment between company and shareholders.
Does it matter for SAP ?
Some people might argue: Why should we care about ROEs etc. at SAP ? This is a software company, so other factors (usually Non-GAAP) are much more important.
In my opinion, this is wrong. We buy stocks because the companies make profits. Either the company pays out the profits or it invest it on behalf of the shareholder into value creating new projects. One can argue about adjusting certain metrics, but in any case, reinvesting profits into overpriced M&A trnasaction is definitely not value creating, even in software.
Let’s look at the long-term stock price development of SAP:
So we can see, yes, SAP over the last 15 years or so has beaten the DAX by a small margin. But if you consider that the DAX includes some very badly run companies such as the banks, E.On, RWE, this is not such an achievement.
If you compare for instance SAP with BASF, a well run company but with a much tougher, capital-intensive cyclical business, it is quite easy to see that BASF seems to have created a lot more shareholder value than SAP despite the fact that the business itself should be a lot better.
It is always hard to quantify qualitative aspects, but I do think that the relatively weak alignment between shareholders and management play a role in the rather weak performance. It is a little bit surprising as one of the co-founders of SAp, Hasso Plattner is still head of the supervisory board but maybe he is so busy sailing against Larry Elison that he forgot to better incentivize the management.
SAP is in my opinion a relatively typical example of a large, publicly owned German company. Management is not well aligned with the long-term success of shareholders but rather is incentivized to pursue growth for the sake of growth.
In SAP’s case they can build on a solid foundation of a dominant business software product, but at least looking at the last few years, they did not much to create additional value.
It looks like that the incentives favor acquisitions which add to Top line or other “non GAAP” measures, but actually making money on the M&A investment itself is not a priority. This, in my opinion, is one of the big differences to the “Outsider Companies”: A typical Outsider CEO wants to make actual some “real” money on M&A:
Within a shorter time frame, SAP could still be a good investment, but personally, I would be very carefull to invest long-term into the stock. It looks like that SAP prefers to pay out its profits to the shareholders of acquisitions targets without creating a lot of value instead of returning money to its own shareholders.
Alignment of management and shareholders is something I did already include in the past in my investment process, but I will focus on this even more in the future.
Overall it might be fun to more systematically look at this aspect. Maybe this would make a good ETF…….
Edit: For the fun of it, check this out on SAP from Quora