Why SAP Is Down

In this episode of MarketFoolery, Chris Hill chats with Motley Fool analyst Jim Gillies about the latest headlines and earnings reports from Wall Street. They go through the revenue guidance numbers of SAP (SAP 5.52%) and look at some other stocks in the software space. They've got news on an acquisition deal in the offing in the restaurant space, they discuss why a multinational toy conglomerate stock is down despite beating market estimates, and much more.

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This video was recorded on October 26, 2020.

Chris Hill: It's Monday, October 26th. Welcome to MarketFoolery. I'm Chris Hill, with me today, Mr. Jim Gillies. Good to see you.

Jim Gillies: Good to be seen.

Hill: We've got a big coffee deal in the works. We've got some earnings, but we're going to start with news out of Germany.

SAP, the enterprise software group based in Germany, is having its worst day in more than a decade, shares of SAP are down more than 20% after the company cut revenue and profit guidance for the year. Jim, they're saying that coronavirus lockdowns would affect demand well into 2021. What do you make of this, because I'm sort of struggling with two competing ideas, and one is that SAP is right in terms of overall demand, and if they're right then that probably bodes ill for a number of cloud-based stocks out there, the other idea is that this is an SAP thing, this is just confined to them.

Gillies: Yeah. And I think you're right to have that, kind of, two minds response. Unfortunately, I don't have a definitive answer. Of course, if I did have a definitive answer, I probably wouldn't be here with you today, I'd be on a beach earning, you know, whatever. Yeah, look, as anyone who's ever been part of an SAP implementation, I think you're probably taken a little schadenfreude today. I know I am, as my prior career, I got to be part of one and out of those experiences. And SAP implementation tends to take at least twice as long as they originally tell you and cost a lot more. And so, I'll just leave it at that. I also used to, you know, if I heard a company was implementing SAP, I would generally throw them out of my research queue for at least a year, because I've seen that movie. But, yeah, these earnings were not well received, it's about +$40 billion this morning off the market cap.

They did try the old lipstick on the pig routine. You know, they did talk about strong double-digit growth and earnings per share. They talked about growth in cash flow, they talked about their operating cash being up 54% year-over-year, free cash flow up 79% year-to-date. But the problem is, you know, and it is reminiscent of IBM a number of years ago, where IBM would talk about having these goals in a certain year, there's 2015 goals and 2020 goals, years before. SAP has had what they call their 2023 ambitions. And they reaffirmed these 2023 ambitions last quarter, which would be the quarter where coronavirus and COVID-19 really got traction. And without so much as a buy or leave this morning, they have thrown out the 2023 goals, replaced them with 2025 goals. The 2023 revenue expectation and the previous goals, or sorry, ambitions, was $35 billion; now, two years out, for 2025, that ambition is for $36 billion. Okay. That looks like a slowdown to me, SAP certainly. They have reduced a bunch of their components of their guidance, perhaps they shouldn't have been giving guidance during a pandemic, that might just be a little suggestion, some things I've seen. You know, the stock wasn't horrifically priced before this, I believe it was at about 18X EBITDA, enterprise value-to-EBITDA, it was about 5X, 5.5X, 6X sales.

There are certainly richer companies out there, but when you have this kind of growth slowdown and it comes, kind of, out of nowhere, I can see why the market is, kind of, puking it out. I've seen some suggestion that the former CEO, Bill McDermott, who I think has an exquisite sense of timing, he left about a year ago to go to ServiceNow. There is some suggestion that he had this big long acquisition string under his belt, then he left and these acquisitions are just, kind of, all in their own little personal fiefdoms within SAP. They're not well-integrated, so he kind of handed these ambitions and this integration work to the next guy. You know, so I think there's a lot of work to be done here, but really, there are serious reaction here, certainly has to be that, oh, yeah, reduced guidance, changed ambitions, like, you've just thrown out a multiyear plan, and just kind of replaced it with another one, and you're hoping no one is going to notice all they noticed, whether it has implications beyond SAP. I mean, if I was a Salesforce or an Oracle shareholder this morning, I might be a little nervous.

Now, look, that said, we know that the cloud-based transition, which we've seen other companies do very successfully, Autodesk and Adobe being, I think, exhibits 1A and 1B, where you shift from selling the -- you get the big revenue and earnings hit upfront, because you sell the license for X number of years and then you do your service revenue, but going over to this cloud where you get, you know, subscription fee every month and it's supposed to be more predictable results, we know it works when done well. As I mentioned, Adobe and Autodesk, it seems that it's not working quite as well with SAP, and we'd like to see I think, you need a few more quarters with SAP, but if I was a cloud -- I'm not really a cloud guy, I find it interesting, but I'm not remotely equipped to understand most of it, so, you know, I'd be a little worried going forward the rest of this earnings season, to be honest.

Hill: It's definitely going to be something there to watch, although the companies you just namechecked, Adobe, Autodesk, Salesforce, Oracle, those stocks are down anywhere from 3% to 5% today, on a day when the market overall is down. So, at the moment, Wall Street is not reacting like this is a cloud thing, it's reacting like this is an SAP thing.

Gillies: Yes. And I think it may very well be an SAP thing. I'm a little worried when a bellwether reports a great slowdown. I have a long memory and I truly believe the most dangerous words are "this time is different." So, I do very much remember the 2000 breaking of the Nasdaq bubble, where you saw a lot of the former high-flyers of the day -- Nortel Networks would be one, Cisco would be another one, where they came out with an early 2000, March 2000, and into the Summer of 2000, they started reporting some chinks in the armor. And I'm hopeful that this is not what this is for the cloud-based businesses, but I think you want to watch the competing companies closely going through the rest of this earnings season and indeed the rest of this year.

Hill: Shares of Dunkin' Brands (DNKN) up more than 15% this morning on a New York Times report that Inspire Brands is going to buy Dunkin'. Inspire Brands is the corporate parent of Buffalo Wild Wings, Arby's, Jimmy John's, Sonic. This is, if it goes through, an $8.8 billion deal that would have a 20% premium to where Dunkin' closed on Friday. And I say this not as a shareholder, but as a huge fan of the product, I'm surprised by that premium, in part because Inspire Brands, backed by Roark Capital, when they were building out this portfolio, they weren't paying huge premiums, they weren't paying a huge premium for Buffalo Wild Wings. In some cases, some of the acquisitions they made were at a point where the restaurant chain in question was either the stock was down a bit or the business was struggling in some way, so it's interesting to see this type of premium to a stock that had been doing well.

Gillies: Yeah, if you're a Dunkin' shareholder today, you're like, thank you, we'll take that. And I agree with you, some of the deals they made in the past have been at much lesser multiples. I mean, they took a Foolish favorite, Buffalo Wild Wings, from us, after driving out the people that made it the success that it was. That's another story. Look, I love this deal, if I'm a shareholder of Dunkin' Brands, because what it looks like to me, Inspire is building another Restaurant Brands International, if you will, and I'll hold up my Tim Hortons cup here. QSR, which is Restaurant Brands ticker symbol. They, of course, are the parent of Burger King, Tim Hortons, and Popeyes, and so it looks like what's going on here is that they're building another stable of brands, and it wouldn't shock me if in three, four, five years, you get another chance to own a piece of Dunkin', Chris, when this reIPOs after Inspire Brands streamline the food purchasing and all the back office stuff for all of these brands they are putting together.

But as you mentioned, the deal values Dunkin's equity at about $8.8 billion. If you throw in the debt, it's over $11 billion. It's buying the company at about 23X EBITDA, which, now, this is a 100% franchised model. Okay. They own Dunkin' Donuts are Dunkin' Brands, and Baskin-Robbins. There's over 21,000 point-of-sales between Dunkin' and Baskin. You would expect for a franchise business like this a premium valuation, because these are what I like to call check cashing companies, all the operational risk is on the franchisees. Dunkin' as the franchisor, basically sells you a concept and, you know, you're going to give us back 6% of your gross sales every month, and, oh, by the way, we're going to have another 2% or 3% for advertising. We're going to handle all the things. You get the system from us and we just take back your money and cash or check every month. You know, these can be really great businesses. I mean, if you look at the aforementioned Restaurant Brands, heck, Domino's Pizza would be the one that I would point to and, boy! That's been an investing success story for the last decade-and-a-half.

But these make a lot of cash, Dunkin' has averaged about $250 million of free cash flow in the last five years, these steadily rising dividends have only been not even 50% of that cash flow. So, there's a lot of room here for Inspire to take that money and put it into paying off the leverage that I'm sure they're going to use to acquire this. And then from there, like I said, streamline among the various brands. By far, the biggest bite they've taken, you know, it's a great deal for Dunkin' shareholders in my opinion. And like I said, I think you probably will see, down the line you'll see this come back on the public market, so.

Hill: And between now and then, it'll be interesting to see the extent to which Inspire makes changes at Dunkin', including, and I have to believe this would be very high up the list, it would be an expansion in the Western half of the United States.

Gillies: Expansion beyond the United States. I mean, yes, I'm not sure how well they'll do in Canada, but I think we have some points here. You know, just as Tim Hortons just tried to come into the U.S., and hasn't done spectacularly well, but what I'm interested in seeing is, are they going to take a page from the Restaurant Brands playbook, which is, they've expanded, like, look, there's like 18,000 or 19,000 Burger Kings around the world -- a fact that shocks me every time I hear it -- but there's less than 5,000 Tim Hortons outlets in the world versus about 13,000 points-of-sale for Dunkin', not the Baskin-Robbins, it's the Dunkin' Donuts, Dunkin' Coffee.

But what are they doing with Tim Hortons, they're going into the Philippines? Well, you know, I think the brand equity, historically, in the Philippines for -- I mean, Canadian-Filipino citizens going back-and-forth certainly know about it, I don't think; Filipino citizens have certainly nothing clamoring for Tim Hortons brand. So, I find that interesting, they're going into the U.K. and they're going into China, so I wonder if they're going to step up and kind of try to take the brand worldwide the way Restaurant Brands is, because they certainly have a business case for doing so.

But I think there's some serious brand equity in Dunkin', as much grief as I give you for them, and I think they'll probably do at least as well as Tims in some of these far-flung locales, if not better. So, good for Inspire for trying something different.

Hill: Third quarter profits and revenue for Hasbro (HAS 4.01%) came in higher than expected, and yet, shares of Hasbro dropped nearly 10% this morning. What is going on here? I mean, this was a good quarter, their margins are improving, did they guide in some way that is causing this reaction?

Gillies: I'm not sure; I think it was a good quarter, I'm going to push back a little bit there. I think it was a quarter where there were definitely some bright spots. So, their franchise brands, so the brands that they own or control, which is about 44% or 45% of revenue, they were up about 4% sales, but their partner brands, so Star Wars -- [laughs] look behind me -- Star Wars was up, it's owned by Disney, but they also do toys for Marvel, also owned by Disney, that's down. Frozen, also owned by Disney, was bad. And so the revenues were down 4% in the quarter, year-to-date, they're down 12%, so just stepping out a little bit from the quarter. Things aren't great. And their film division, they bought Canada's Entertainment One about a year ago, that's down close to 30% year-to-date.

Now, you can blame COVID for that, a lot of production has just been pushed out, but that acquisition, I think they probably like that acquisition, that $4 billion acquisition, I think they'd like that one back. And this is something that I've, kind of, talked a little bit about in other locales, but toys are surprisingly difficult, I like to think, toys, to my mind, are basically fashion, and fashion is notoriously fickle. And so, if you have the next hot thing, fantastic, but if you put a lot of resources into what you think will be the next hot thing, and it turns out not to be, you get hurt. So, for example, as mentioned, Hasbro does some licensing for Star Wars for the Star Wars property.

Okay, well, the flagship of Star Wars, of course, the last few years under Disney has been the Skywalker saga movies, which have not been big toy sellers. You can see in my background, you can't see if you're listening to the podcast, I have a little bit of Star Wars in my house. We're a big LEGO house, Star Wars LEGO has been a fantastic property, but Star Wars, the Skywalker saga, the movies, the toy sales have been pretty moribund. And so, if you produced a lot for that, you kind have been, meh! You know, you have a lot of discount toys, put it that way, from Rise of Skywalker or whatever. But now that The Mandalorian comes along, the TV property, and they got caught flat-footed last year, they had no offerings for that deliberately hide baby Yoda. And so, this year maybe they're going to make up for that, because there's certainly been a lot of increased toy interest there. But you, kind of, hope they don't overdo it and kind of kill the appeal of baby Yoda or the child as they call him.

But you know, as well in the fashion thing, like, if you get something hot, you do well for a while, but you have a lot of misses. And I look back at, you know, you got Hasbro, you got Mattel, you got Spin Master, which is a Canadian company, it's also in the toy space. You know, if I told you, Chris, that the last five years that the annualized return for Hasbro, I didn't include dividends here. Hasbro has done 3.3%; Mattel has done terribly, -10.4%; even Spin Master, which has had a few hot properties, it's kind of a little cool last year or so, but they've still been 6.9%. So, no one is doing anything really exciting here, meanwhile the last five years SPY, so the S&P 500 tracker, has done 10.8%.

So, there's an argument to say unless you're getting really, really cheap valuation, and I don't think any of the players here qualify as such, you're probably just better off just buying the index, where you get some exposure, at least to Hasbro and Mattel, and just not trying to play what's in fashion for the toymakers, because they're going to have some hits, they're going to have some misses, you and I have no ability to predict which is which. So, I don't like these companies as a whole, in general.

Hill: I've never heard that analogy before, and I really like it, it's just that toys are like fashion. [laughs]

Gillies: Sorry... [laughs]

Hill: No, no. You know, when you put it that way, I mean, you think about all the apparel stocks, that at any given moment, Gap, American Eagle, Abercrombie & Fitch, they've all had 6- to 12 months periods where that was a great stock to own, but over the long term it's ugly ...

Gillies: Terrible. Almost across the board they've been terrible. Yeah.

Hill: Jim Gillies, great talking to you, as always, thanks for being here.

Gillies: Thank you, Chris.

Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.

That's going to do it for this edition of MarketFoolery. The show is mixed by Dan Boyd, I'm Chris Hill, thanks for listening, we'll see you tomorrow.