Software AG
XETRA:SOW
Earnings Call Analysis
Q2-2023 Analysis
Software AG
Software AG has stood its ground in a tough macroeconomic climate, successfully achieving its Q2 objectives and closing the first half of the year on target, setting a positive tone for meeting its full-year guidance. The company's strategic alignment and accomplishments instill confidence in its ability to navigate through challenging economic conditions and maintain growth trajectory.
A pivotal development for Software AG is Silver Lake securing 84% of the company's shares, setting the stage for a majority ownership once regulatory approvals are in place. This partnership is more than an equity change; it's a strategic alignment with Silver Lake's formidable technology investment reputation. Software AG anticipates that this will streamline strategy execution and is a significant milestone for the company's journey, potentially leading to a delisting post-acquisition.
The digital business segment has shown impressive growth, with a 12% increase in annual recurring revenue (ARR) on a constant currency basis, and SaaS licenses growing by a remarkable 33% year-on-year. This growth underscores a strong customer shift towards cloud subscriptions, solidifying Software AG's focus on SaaS as a strategic priority and reinforcing its commitment to full-year guidance targets.
Software AG reported an operating margin of 21.9% for Q2 and 17% for the half-year, affirming the company’s financial health and operational efficiency. These numbers align with the projected seasonality, as the company foresees consistent growth and remains on track to meet all 2023 guidance targets.
Looking ahead, the company is directing its gaze towards a simplified, innovative product portfolio, emphasizing cloud-first strategies. A major product launch planned for October speaks to Software AG's commitment to integrating AI and building a top-tier enterprise integration platform. The anticipated product differentiation is set to unlock new levels of productivity for customers, propelling the company toward value creation and profitable growth.
Software AG is preparing for a back-end loaded year, as historically, the majority of digital business ARR contributions arrive in the second half. Consequently, the existing growth in digital business ARR by 12% year-on-year and the solid performance of A&N with an 11% year-on-year ARR growth, settle within expected bounds, projecting confidence in the seasonal revenue pattern.
A&N has exhibited a strong performance, with Software AG opting to maintain its conservative full-year guidance of between -2% and 2% growth. This is despite the unit outperforming expectations, thanks to substantial deals and increased subscription migrations — a decision reflecting the company's prudent management approach.
The company has witnessed a holistic ARR growth of 12% year-on-year, with total product revenue up by 17% in Q2. This growth is parallel with efforts to tighten cost control, including a significant savings program and proactive headcount management. These disciplined measures are critical for maneuvering through increased total costs, up by 18% year-on-year, and achieving software AG's profitability goals.
Software AG is experiencing temporary headwinds in cash flow, attributable to the transition to a subscription model and business model transformation. The Q2 free cash flow dipped to -€35 million, and -€14 million for the first half-year. However, these figures are skewed by one-off effects related to acquisitions and share-based payments. The company foresees these challenges as short-term and expects improvement in the future, maintaining confidence in its guidance for the year.
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Ladies and gentlemen, thank you for standing by. Welcome, and thank you for joining Software AG's Q2 2023 Results Call. [Operator Instructions]
I would now like to turn the conference over to Robert Hildebrandt, Director, Investor Relations. Please go ahead.
Thank you, Morris. Good morning, ladies and gentlemen. Welcome to Software AG's Analyst Call and Webcast on its Preliminary Q2 and Half-Year 2023 Results. This morning, Software AG published preliminary results for the reported quarter, as well as the presentation used in this call. We will start with the presentation from our CEO, Sanjay Brahmawar; followed by our CFO, Daniela Bunger, before opening the line for taking your questions.
Before we start, here are some housekeeping remarks. This conference call is also being broadcasted via web. You may access the webcast via our Investor Relations website. The webcast will display the presentation slides related to this call, and the same slides are available for download on our website. The website, including the full call with questions, answers, and the names of the questioners will be recorded and made available for replay later today. Finally, let me remind you of our disclaimer statement, which is shown at the beginning of the slide presentation and is valid for the entire call.
Sanjay, over to you.
Thank you, Robert. Good morning, everyone, and welcome to our second quarter and half year 2023 earnings call.
In Q2, we've delivered on our goals and our strategy against a challenging macroeconomic backdrop. We have closed out the first half according to our plan and remain confident to meet our full year guidance. Before I walk you over the highlights in Q2, let me update you on the latest developments of Silver Lake's voluntary public tender offer and reiterate why we think this transaction is in the best interest of all our stakeholders.
As already announced, with the closure of the additional acceptance period last week, Silver Lake has secured 84% of Software AG's total shares. This will lead to a majority shareholding once regulatory clearances have been completed successfully. The closing of the transaction is expected in the fourth quarter of this year.
After closing, Silver Lake intends to pursue a delisting of Software AG as soon as possible. The entire management and Supervisory Board are convinced that the deepening of our relationship with Silver Lake, one of the world's leading technology investors, is an important milestone for our business. With them as our new majority owner, we have just won a totally aligned strategic partner to help us drive our plan forward.
For me, there are three things Silver Lake brings to the party. First, reaffirmed multiyear commitments. Silver Lake has publicly committed to our strategy. They have made this commitment from a position of strength, based on the fullest support of Dr. Peter Schnell, CEO of the Foundation, as well as co-founder and former CEO of Software AG. Second, financial backing. They have a track record of backing up priorities, which has already started with their pipe investment back in 2021, which helped to fund the acquisition of StreamSets.
Now, as our new majority owner, they have proven once more their ongoing support for the next phase of our strategy. And third, expertise. They have gained deep knowledge in the data integration space, as well as SaaS transformations from software companies over the last few years. Taking all of this into consideration, we believe that Silver Lake's long-term support in a non-listed environment will help us to execute the next phase of our strategy even more efficiently.
With that, I would now like to turn to our Q2 results, which are the focus of today's call. During Q2, we demonstrated our ability to deliver on our operating plan amidst a continuously challenging macroeconomic environment.
However, we have seen that customers stay cautious on their IT expenditure by intensively investigating every spend, mainly driven by persisting macroeconomic uncertainty. As a result, extended sales cycles remain a challenge that we need to face. On the other hand, the demand remains robust and shows us once more the mission-critical nature of our solution.
Let me start with our headline numbers. Please be aware that all numbers disclosed this year include the contribution from StreamSets. Digital business ARR showed good year-on-year constant currency growth of 12% and 2% sequentially.
This development is in line with the market expectations and follows the expected seasonality, which is more weighted to the second half of the year. Therefore, we remain well on track to deliver our full year guidance targets. ARR coming from SaaS licenses has grown 33% year-on-year with accelerated sequential growth. This development follows the trend we've seen last year and reaffirms our decision to make SaaS and cloud offerings our strategic priority going forward.
In A&N, our ARR grew very strong, with 11% year-on-year and 3% sequentially. This performance was mainly driven by more customers migrating into subscription licenses, as well as the earlier-than-expected closure of significant deals. As a result, we also saw higher A&N revenue, which led to Group product revenue growth of 17% year-on-year in the quarter and 9% for the first half year.
Looking at profitability, supported by the unfolding success of our cost savings program and the accelerated shift to subscriptions within our A&N business, our operating margin landed at 21.9% in the second quarter and 17% in the half year. With the expected seasonality in mind, we remain confident to deliver on all of our 2023 guidance targets.
Before I hand over to Daniela for more details on the financials, I would like to touch upon our future strategy and vision. As already announced in early February, our clear view for the medium term is more balanced and less complex product portfolio, which we see as the key to create value for our stakeholders.
Going forward, we will double down on innovation and integration and accelerate our journey to cloud first. Our vision is to build a truly differentiated, full stack, AI-enabled enterprise integration platform. This new product roadmap will give us a demonstrable differentiation to the market by enabling the customers to unlock the value from their data, more productively than before.
Our first proof point will be a major product launch in October. At the same time, our increasing focus on cloud will offer us attractive unit economics as we scale through the acceleration of customer demand. To achieve this, we will work more closely with a selected network of hyperscalers, not only to scale our cloud products more efficiently but also to optimize our support costs.
Additionally, we will continue to manage our costs tightly across the entire company while building a superior go-to-market function. All in all, these initiatives will enable us to accelerate Software AG's journey towards positive cash generation, as well as sustainable and profitable growth.
Now, I'll hand over to Daniela to run through the quarterly financials. Daniela, over to you.
Thank you, Sanjay.
Now, let's take a closer look at the quarter's preliminary numbers. Turning first to ARR. In our digital business, our ARR grew 12% year-on-year. Looking at the sequential growth, we have seen an increase of 2%. As Sanjay already mentioned, we've anticipated the back-end loaded seasonality in our full year guidance and expect the majority of digital business ARR continue -- contribution in the second half of the year.
Looking at the license mix, SaaS grew 33% year-on-year, showing an accelerated sequential growth of 4% and a 90% portion of total digital business ARR. This development demonstrates the increasing customer demand for SaaS, which is a key pillar of the next phase of our strategy. For A&N, we saw again very strong performance with ARR growth of 11% year-on-year and a sequential growth of 3% in Q2.
This has been driven not only by a few large customers who have migrated into subscription, but also by an earlier-than-expected closure of a significant deal. Therefore, we refrain from adjusting our A&N guidance upwards for now, while remaining confident to deliver on our target of minus 2% to 2% for the full year. Combining both business units, our total ARR grew 12% year-on-year and 2% sequentially to €718 million.
Moving on to product revenue, our digital business grew 4% and year-on-year to €138 million in quarter two, and 6% to €258 million for the half year. With the growing portion of SaaS licenses in our ARR mix, the temporary trend of less upfront revenue recognition from subscription licenses continues.
In the long term, we will benefit from higher revenue contributions from SaaS licenses, as well as the more symmetrical ARR and revenue growth. The product revenue coming from A&N increases by 49% year-on-year to €73 million in the quarter and 17% to €123 million in the first six months. This strong performance has been mainly driven by the upfront revenue recognition coming from increased subscription migrations. Combining both segments, our total product revenue grew 17% year-on-year to €211 million in Q2 and 9% to €381 million for the half year, in line with our expectations.
When combined with the second quarter revenue from Professional Services of €37 million, total revenue landed at €248 million in Q2, representing growth of 14% year-on-year. First half revenue was €459 million, growing 8%.
Now turning to our cost development. Total costs in the quarter were at €226 million, representing an increase of 18% year-on-year. In the first half, our total costs were €434 million, an increase of 70% year-on-year. Now let's take a closer look at the various cost lines. Our R&D costs in Q2 has mainly increased year-over-year due to the full-year impact from general investments already made in 2022. Also, StreamSets accounts for the full three months now compared to the two and a half months last year.
On top of that, we had an impact from merit increases, which has been granted already in the previous year. Sales and marketing, as well as administration cost has decreased significantly in Q2. This has been primarily driven by early impact of the cost measures taken in the context of our €30 million to €35 million savings program, which we announced earlier this year.
So far, we've made good progress with the implementation of meaningful cost-saving initiatives across various functions, like go to market, customer support, G&A and Professional Services. Our announced headcount reduction of 200 employees has been initiated and is now in an advanced stage.
Our other income and expenses in Q2 show a negative deviation of roughly €30 million, mainly due to lower FX gains, consultancy and transaction fees in the context of the takeover, as well as severance payments due to our cost optimization program.
Turning next to profits, our non-IFRS EBITDA margin was 21.9% for the quarter and 17% for the first half, which is in line with our full year guidance. Non-IFRS adjustments increased by €19 million in Q2 and €24 million in the first half, due to higher amortization from the StreamSets acquisition, higher severances and retention bonuses payments, as well as consultancy and transaction fees in the context of the takeover.
This brings me to cash flow. As in previous quarters, we have continued to see technical headwind on cash flow as insight of our business model transformation and subscription shifts. As we are currently going through the trough, we expect this to phase out in the coming quarters. Looking at the numbers, free cash flow landed at minus €35 million in Q2 and minus €14 million for the first half of the year.
This result has mainly been affected by one-off effects just coming from share-based payments triggered by the latest share price development, as well as negative cash impacts coming from the exclusion acquisition of StreamSets. Therefore, from the outside, the reported number might look like a negative development. However, taking the above into account, the underlying operational business has significantly improved.
Let me comment on the outlook before I close and move to Q&A. First, to reiterate what Sanjay has already outlined. Our guidance for the full year 2023 remains unchanged given our expected seasonality for the year. Therefore, we remain confident in delivering on the full-year guidance KPIs, as well as our medium-term ambitions.
And with that, we'll now take your questions. Robert, back to you.
Thank you, Daniela. Ladies and gentlemen, you may now ask your questions. Please only ask one question at a time. Morris, please repeat the instructions on how to proceed.
[Operator Instructions] And the first question comes from Michael Briest from UBS. Please go ahead.
Yes, good morning. Just could you talk a little bit about the regional profile of the quarter? Looking at the currency split, the U.S. dollar was 41% of revenues this quarter, it was 35% in Q1. So I'm just curious, did you see much better sales execution in the U.S. versus elsewhere, or was this -- there's large Adabas & Natural deals? And then the second one is just on the headcount in the U.S. There has been a big decline year-to-date, there's nearly 100 people. I know the anniversary of the StreamSets deal that has been done. Is that related to it? Have you struggled with retention in the U.S.? Thank you.
Hey, Michael. Good morning. It's Sanjay. And thank you for your question. So first of all, on the regional profile, good pickup on that. Yes, indeed, we have seen a strong performance in our Americas, particularly in North America. And in fact, a, we saw really good deal execution. We saw good conversion of the pipeline. We see the results -- the first good results coming through of the specialization that our CRO, Joshua Husk, has been leading and our new sales leader in North America, Rowan Scranage. So that's one thing really.
And the other thing is, of course, we also had the A&N strong results being driven by a pull-forward deal that came through and that was in the Americas. So you see overall Americas was really robust. But just put that A&N deal aside for a second, I feel really good and very bullish about the way we have started the year in North America. So that's one thing.
On the headcount decline, well, listen, two things. One is this decline in the headcount was anyway part of our plan? As you know, we have mentioned that we were going to the specialization model, which didn't effectively mean for us adding more people. It actually meant dedicating more people in specialized teams to particular areas, like integration or RS, Alphabet et cetera. But then, reducing our common layers or common kind of central pools of resources that we have. So again, here too we have seen good results of that shift.
And then honestly, of course, we've also had the same challenge that many other companies around some level of attrition. We've seen that. That continues to be a normal -- I wouldn't say it's anything out of the usual, Michael. It is the usual attrition that most companies see it in the first half of a year. So nothing that concerns us. But it is also part of that reduction.
Understood. Thank you.
Thank you.
[Operator Instructions] It seems like there are no more questions at this time. So I hand back to Robert Hildebrandt for closing comments.
Thank you. And with that last question, we would like to conclude the conference call. Ladies and gentlemen, we appreciate your participation and constructive questions. If there are further questions you would like to ask, please contact the IR team. Until next time, goodbye.
Thank you very much.
Thank you. Goodbye.
Ladies and gentlemen, the conference has now concluded, and you may disconnect your telephone. Thank you for joining and have a pleasant day. Goodbye.