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Edited Transcript of SOW.DE earnings conference call or presentation 22-Oct-19 7:30am GMT

Q3 2019 Software AG Earnings Call

Darmstadt Oct 24, 2019 (Thomson StreetEvents) -- Edited Transcript of Software AG earnings conference call or presentation Tuesday, October 22, 2019 at 7:30:00am GMT

TEXT version of Transcript

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Corporate Participants

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* Arnd Zinnhardt

Software Aktiengesellschaft - CFO & Member of the Management Board

* John Schweitzer

Software Aktiengesellschaft - Chief Revenue Officer & Member of the Management Board

* Otmar F. Winzig

Software Aktiengesellschaft - Senior VP & Head of IR

* Sanjay Brahmawar

Software Aktiengesellschaft - Chairman of the Management Board & CEO

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Conference Call Participants

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* Alastair P. Nolan

Morgan Stanley, Research Division - Research Associate

* Charles Brennan

Crédit Suisse AG, Research Division - Research Analyst

* Gautam Pillai

Goldman Sachs Group Inc., Research Division - Equity Analyst

* Knut Woller

Baader-Helvea Equity Research - Analyst

* Michael Briest

UBS Investment Bank, Research Division - MD of Global Technology Research Group & Head of the European Technology Research

* Stacy Elizabeth Pollard

JP Morgan Chase & Co, Research Division - Head of Software and IT Equity Research

* Sven Denis Merkt

Barclays Bank PLC, Research Division - Equity Research Analyst

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Presentation

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Otmar F. Winzig, Software Aktiengesellschaft - Senior VP & Head of IR [1]

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Thank you, Haley. Good morning, ladies and gentlemen. Welcome to Software AG's telephone conference and webcast on preliminary third quarter and first 9 months results 2019.

This morning, we have published a full set of numbers as well as the presentation slides used in this call on our website. Today's agenda, we'll start with CEO, Sanjay Brahmawar, giving you an update on the strategic progress; followed by CFO, Arnd Zinnhardt, with financials and insights into our preparation for subscription 2020; and our Chief Revenue Officer, John Schweitzer, with news on sales in North America. The presentations will be followed by a Q&A session.

It is also my pleasure to announce that our new Chief HR Officer, Elke Frank; and our Chief Product Officer, Stefan Sigg are also on this call to answer your questions later. So the entire Executive Board of Software AG is at your disposal. Nevertheless, we will try to keep this call in the regular 1 hour time frame and cover as many of your questions as possible.

Before we start, there are some housekeeping remarks. This telephone conference will also be broadcast via web. Access to our webcast is via our Investor Relations website. The webcast will be display the PowerPoint presentation charts related to this call. The same charts are on our website for download. After presentations, you may ask questions. Please use only the dial-in phone number for posing questions. The dial-in numbers are also published on our website. For technical reasons, we cannot take any questions via e-mail during conference call. Call and the webcast will be recorded and available for replay later today.

With respect to capital market regulations, I would like to make the following safe harbor statement. Statements and presentations made in the course of this conference call and webcast include forward-looking statements based on the beliefs of Software AG management. Such statements reflect current views of Software AG with respect to future events and results and are subject to risks and uncertainties. Actual results may vary materially from those projected here due to factors including: Changes in general economic and business conditions; changes in currency exchange; the introduction of competing products; lack of market acceptance of new products, services or technologies; and changes in business strategy.

Software AG does not intend to assume any obligation to update these forward-looking statements. Statements and presentations of this call and webcast constitute neither an offer nor a recommendation to subscribe or buy in any other way securities of Software AG and any of the companies that are members of the group at present or in future, nor does it form a part of such an offer and it should not be understood as such. Statements and presentations of this webcast do not constitute an offer of sale of securities in the United States of America and securities may not be offered or sold in the United States of America without registration or exemption for registration in accordance with U.S. Securities Act of 1933 in its current fully valid form.

Now thank you for your patience and let us start. I hand over to Sanjay Brahmawar, the CEO of Software AG. Sanjay?

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Sanjay Brahmawar, Software Aktiengesellschaft - Chairman of the Management Board & CEO [2]

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Thank you, Otmar, and hello, everyone. We are now 8 months into Helix, our multiyear program to return Software AG to sustainable, profitable growth. 8 months of tough decisions, disciplined focus and sharper execution is starting to make an impact and deliver early results. Transformations like Helix take time and energy. The true value in them only starts to show through when commitments made become commitments delivered.

In Q3, we have started to deliver against our initial Helix commitments and the early benefits to that delivery is showing through. We made a commitment to improve the quality of our earnings over time and the dial here is beginning to turn.

Our annual recurring revenue within DBP including IoT is now EUR 334 million, which is 6% higher than in quarter 2 and 12% higher year-on-year. Our subscription and SaaS commitments now make up 63% of our DBP including IoT bookings, more than double the prior year. We also committed to enhance our product strengths and to focus only on R&D in areas that will drive growth. Our development velocity has continued to gather momentum. We have brought 2 new products to market in recent weeks, webMethods.io B2B and ARIS Cloud, and our journey to the cloud has accelerated. We are working at pace now where we are delivering innovation every quarter to our customers.

Alongside these areas, you have also heard me make several key commitments around improving our sales and marketing execution. Consistent execution here in recent months has seen us secure 83 new logos in Q3, and our pipeline is steadily building. Sharp execution allows me to say that the issues we identified in North America have also begun to be addressed. Some strong decisive work by John and our North America team in Q3 has steadied our business there and given us the right platform to build from.

A significant element of our transformation efforts is being invested in evolving and deepening our partner ecosystem. There's no better way to prove our delivery here with the strategic OEM relationship we have announced today with Adobe Company, Marketo. This is a significant extension of the bonds we have built with Adobe. Of course, investing in our own team is of paramount importance, and that work is picking up now that our new CHRO Elke Frank is in place, driving further evolutions in our culture and development opportunities for our teams.

Make no mistake, this is a multiyear journey and there remains much more to do. But an energy is building now among our global team, and the Software AG I see today is changing. This energy emboldens me as we move towards the next phase in our transformation, the rollout of our subscription sales model.

Let's look now at our headline business numbers. At the top line, Q3 revenue and Q3 group product revenue both grew by 5% year-on-year. Our DBP core delivered a recovery in Q3, achieving EUR 108.7 million in revenue, which is 1 percentage growth year-on-year at constant currency. IoT continues to show some quarter-on-quarter license volatility with some deals edging into Q4, but the direction of travel remains positive with continued growth in maintenance and SaaS revenue.

Adabas & Natural continued its recent run of strong performance, supported by good momentum in North America, notably in the public sector. This brings us to a group EBIT for the third quarter, up 8% year-on-year, stated to EUR 59 million. It also gives us a non-IFRS EBIT margin that is consistent with the prior year at 30.5%. All of this translates into a solid first 9 months of the year, even while we have been undertaking a major transformation. 9-month group revenue and group product revenue were up 4% and five percentage, respectively. 9-month EBIT was broadly flat at EUR 148.9 million and 9-month non-IFRS EBIT margin stood at 27.7 percentage, just 1.7 percentage points lower than prior year.

So solid progress, more work to do, but some good outcomes achieved. And here I really do have to thank our Software AG people who have worked tirelessly to deliver these outcomes. Their energy and these results underpin our current view of the year overall. And for the avoidance of any doubt, we make no change today to any of our existing guidance ranges for full year 2019.

So I opened the call by speaking about progress and energy. All of that energy is centered on our 3 strategic pillars: Focus, execution and team. Q3 has seen significant activity in each of them, and I'd like to take you through some of the success now.

Let me start with focus. Focus is all about maintaining our reputation for the best products in the market. You remember in Q2, I spoke about how we had reallocated our R&D priorities, mapping them to markets where we have a real right to win. This led to a 37% increase in our development velocity. And this pace at which Stefan and our product teams are now operating, is delivering real returns.

Before Helix began, our cloud footprint was limited and our product road map off beam. Today, we now have a cloud offering available for each of our major products for growth markets. And this is because our product road map starts from customer need first, not from the technology type or form. Our newest product, webMethods.io B2B, makes this cloud offering a reality, speeding integration across B2B partners while reducing infrastructure costs. webMethods.io B2B is a symbol of Software AG's ambition.

It is unique, the only independent and coherent solution for a hybrid enterprise integration, API management and B2B all on one platform with one user interface. This is an incredibly powerful solution for enterprises struggling to drag data out of silos and transform it to a actionable insight. And it's great to be able to say that our offering is second to none in a hybrid integration market that Gartner expects to be worth $18 billion by 2022.

The industry continues to recognize our product vision and strength. In Q3, we were recognized as a leader in the Forrester Wave: Streaming Analytics evaluation. In fact, the Forrester team went so far as to say that Software AG sets the vision for real-time industrial IoT.

Elsewhere in IoT, Gartner placed Cumulocity in the top spot of its industrial IoT magic quadrant this quarter. I really believe that we can now claim to be the only vendor in the market that can offer IoT capabilities, integration and integration flow technologies, all woven together as one. And as new products emerge, we are also investing in maintaining our reputation for reliability and quality.

Our overall product Net Promoter Score has improved quarter-on-quarter through 2019. And in Q3, it reached a record high. And an important way to maintain this positive engagement with customers is to keep things simple. Our rollout of innovation will not stop, but our product portfolio is getting simpler, reduced from 900 product lines to just 40. So credit to our product and R&D teams.

After focus comes execution. Better execution in how we sell, how we market to and engage with our customers is key to driving our growth. Here, we have made real progress in 3 areas. First, we have steadied our business in North America. John will elaborate on that shortly. But the team has worked hard in Q3 to bring clarity to the pipeline, discipline to sales execution and greater sophistication to our go-to market.

Second, we've continued to make progress with our subscription model rollout. Subscription is what our customers want. It is how the software world works today, and it is how we are going to work going forward. As we evolve to subscription, we are scaling our organization to implement it. We are investing in our customer success function, which will support customers selecting and transitioning to this model. The team is already 10-strong. Through next year, we aim to grow it to 30. And in some regions, the subscription journey is already underway. Our teams in Japan, for example, now offer 3-year subscription proposals for all initial customer offers.

Third, we are also boosting the reach, relevance and revenue we see from our marketing. At the top of the funnel, we saw a 40% year-on-year improvement in the number of marketing qualified leads come through. Now these efforts are translating into some fantastic wins. In integration, we continue to bring exciting new use cases to life. In Q3, we began helping the Dubai Smart City government to deliver integration and API exchange between government entities, semi-government entities and enterprises in its landmark, smart government program. We are going to help them create a 100% paperless and digitized government by 2021, a move that will save 1 million trees. In doing so we won against strong competition including Oracle, IBM, Red Hat, Apigee and TIBCO.

In IoT, we continue to scale our customer base. During the period, STW, a leading provider of automation technology to manufacturers of mobile and agricultural machines, selected Cumulocity IoT to deliver its machine.cloud solution to its customers. With the state of the art connectivity between its working equipment and the ability to harness the data it creates, STW is truly able to make industry 4.0 a reality in the construction sector.

We have also seen the addition of 3 more well-known companies to our joint venture, ADAMOS, bringing that powerful grouping to over 15 partners, and the launch of 8 new applications to drive the platform. In Adabas & Natural, our customers are responding to our A&N 2050+ program. Our new zIIP and rehosting technologies continue to resonate, evidenced by wins such as the University of Texas, Austin. We're also working with Microsoft and AWS to help move A&N applications to the cloud, therefore reducing total cost of ownership for their customers.

And in business transformation, we continue to grow with Abu Dhabi Customs in EMEA. They selected Software AG for their digital process transformation to transform into a modern customs organization and help it achieve its strategic objectives.

That brings me to our team pillar. During Q3, we have continued to invest in our people and their skills. They have embraced it. Compared with the same period last year, our people are spending, on average, 30% more time upskilling through our digital corporate university platform. It's also worth remembering that our people have done a fair share of celebrating in Q3 as well, as we marked our 50th birthday celebration across all of our offices worldwide.

I'm also delighted that Elke Frank has joined us as our CHRO. Elke is inspiring. She brings a wealth of experience to our firm through a 20-year career spanning Daimler, Microsoft and Deutsche Telekom. She is already proving to be a great steward of our Software AG culture, leading our first all-employee survey for 7 years. Through it, we want to capture as many viewpoints as we can to shape our investments in talent going forward.

The shape of our team continues to evolve to match our opportunities for growth. We're on track to have more than 100 IoT experts within our consulting team by the end of this year, more than double the number we had on January 1. This reflects our readiness to support customers as they make their IoT journeys.

And when we talk about team at Software AG, we also mean our partner ecosystem. Beyond the fantastic news with Marketo today, we have taken important steps in Q3 to maximize the value of the ecosystem we have started to build. We're opening new routes to market, such as marketplaces with ARIS Cloud Advanced, now available via the AWS marketplace. We continue to see good momentum with A&N customers with the rehosting use cases. And of course, we're working closely with Microsoft to begin to take commercial advantage of our partnership there.

Our progress with Deutsche Telekom and other telco partners continues. Edge to core to cloud, this is the trend, and we want to go beyond that. Software AG has the potential to be relevant here, and we're making this trend a key part of our road map.

We recognize that partnership is a 2-way street, and we continue to invest in programs to help our partners engage meaningfully with us as a route to driving partner revenue. Part of that is enablement. In Q3, we launched 3 new enablement courses for Cumulocity and webMethods. It's encouraging to see that year-to-date, we have seen a 15% year-on-year increase in the number of courses undertaken by our partner base, an increasing number of which we are now releasing to the partner base for free.

So a busy quarter, a good quarter and the beginnings of real positive returns from the hard work undertaken through Helix.

Arnd, I'll now hand over to you to take everyone through the detail of our Q3 financial performance, our key business line dynamics and some further detail on our subscription model preparations.

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Arnd Zinnhardt, Software Aktiengesellschaft - CFO & Member of the Management Board [3]

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Thank you, Sanjay. Good morning, ladies and gentlemen, and a warm welcome to our conference call also from my side. Today I will cover 2 topics in the next 10 minutes. I will give an overview on the Q3 financial figures before I provide you with some insight on the progress made in our transition to subscription.

I would like to start the discussion with our FX analysis. As expected and predicted 3 months ago, we saw continued tailwind in Q3 due to a slight Euro weakening against the U.S. dollar. The U.S. dollar contributed with 80% to this tailwind, whereas all other currencies just had a tiny effect on the stated numbers.

The DBP license business recorded a number on last year's level. Whereas EMEA region continued to show strong, healthy double-digit license growth, North America showed some positive development in the last 3 months. John will spend some time on this aspect. Maintenance improved by year-to-date 3%, in line with the performance of the first 6 months of 2019. This is a development we observed around the globe. The revenue development in the last 3 months confirmed our revised outlook given in summer. Year-to-date digital, excluding IoT cloud, shows a modest decline of 2%, well in line with our current guidance.

Regarding ARR, our trend of double-digit growth continued. On the last 3 months, we were able to push the number to EUR 334 million, which is an increase of 12% year-on-year. With that, we are continuing our journey to a business model that is driven by a high portion of recurring revenue.

In line with our third G project Helix, we continued seeing sales and marketing on a high level. Consequently, the respective costs increased by 6% to EUR 46 million. R&D expenses were up as well for the quarter and increased by almost EUR 2 million in Q3 due to further investments into IoT and cloud R&D teams.

Now on to cloud IoT. Cloud IoT showed a weak performance against high comps in Q3 2018. While we acquired many new logos, the size of the respective transactions remained low. Having said this, I would like to highlight that we see several very sizable transactions in front of us. These opportunities are scheduled for the remainder of this year and should boost the Q4 numbers. Under this assumption, we will stick to our guidance for the full year.

Adabas & Natural had a great quarter and continued to generate stable total revenue. After an extraordinary H1, the segment continued with a strong revenue development, which is not unexpected a result as already mentioned in our last call.

Q3 was a very solid quarter with another strong growth in license revenue, supported by an early multiyear commitment by one of the world's largest global financial institutions. Costs are well under control for the quarter and for the first 9 months of the year. All those elements led to a segment result of 70% for the third quarter and the first 9 months. Due to this performance and a visible calendar of renewals, we do see chances to finish the full year 2019 rather at the upper end of the adjusted guidance.

The professional service business confirmed the expected development over the last -- last first month of the year. The focus of this segment stays on the supporting our strategic license project and simultaneously closely monitoring profitability, thus the revenue was in line with our expectation. With the Q3 segment margin of 10%, I can present again a pleasing result.

Despite our ongoing transformation, all revenue lines show a growth resulting in a total revenue of plus 5%. Year-to-date, the revenue increased by 4%, resulting mainly from the license and maintenance line. Our increased investments into sales and marketing, predominantly in North America and central marketing, led to higher expenses of $5 million or 7% for the quarter and $20 million or 10% for the first 3 quarters compared to the respective last year's period. In addition, R&D expenses were up by 2% for the quarter and $8 million year-to-date, mainly driven by an increase of R&D workforce of 122 full-time equivalents. Despite the higher cost level, and thanks to our strong Adabas-Natural business line, we were able to achieve an EBIT on an attractive level. The overall margin development is in line with our expectation shared with you at the beginning of the year.

The comments regarding the operating margin can be short and crisp. Based on the underlying set of numbers, we observed in general a normal pattern. The delta between IFRS EBIT and operating EBITA again amounts to $9 million. The reduction in expenses for share-based payments result from a general development of the short -- stock price as well as a shorter residual period of the management incentive plan 2019 due to the grant dates later in the year. All in all, this leads to a margin which is in line with last year.

The operating cash flow in Q3 developed as expected due to investments in conjunction with Helix. The operating cash flow remains lower than in 2018 but continuously staying on a high level.

On balance sheet, it is just as solid as always. In the interest of time, I will not give any comments, but I'm happy to answer any questions if necessary.

I want to move now the focus on our progress with Helix. When we introduced Helix at our Capital Markets Day in February, one of our core points I presented was on our switch to a subscription-based licensing model. We are on track with our timetable for making the switch. Today, I want to tell you about the milestones achieved so far due to our intensive work in recent months and the steps we are taking to be ready to hit the ground running with our new model from January 1, 2020.

First of all, we made great progress with our efforts to convert existing contracts onto our new model. As of today, we have reviewed and analyzed 100% of our active contracts and set up a detailed, target-oriented plan for converting the majority of them over time into the new subscription model. A focus point in this respect was creating incentives for customers to come with us on our new journey, another objective which we achieved.

Currently, we are working on implementing and rolling out the new model across the different regions. Sales is fully involved and driving the process. Additionally, we are advancing very well in our preparation of the new contractual framework. We already defined an optimal contract design in the first quarter, and so we have already laid the foundation for our future sales activities. Meanwhile, the models were finalized. And so starting January 1, 2020, we will roll out the contracts with an annual termination right. The annual termination rights will lead to a 12-month revenue recognition approach, so until the customer's next contractual termination right as required by IFRS 15.

Accounting-wise, we will start to see a gradual increase in our recurring revenue stream. As promised, we will gradually reduce our quarterly revenue volatility and improve our revenue predictability. Please remember that, as set out in February, we have guided to a technical interim squeeze in our revenue and margins as we transition to the entirely subscription-based business model over the next years. Therefore, we established the new KPI of bookings to help you see the true progress being made.

To incorporate this into our internal controlling, our internal planning and to ensure that we are -- that we can provide the most accurate forecasting, we have adapted our management information system in our budgeting process. Since the end of Q1, all new KPIs have been well-established in our systems and are monitored on an ongoing basis. It goes without saying that the [bunch] budget concept and our budget procedures reflects these KPIs as well.

Let me be very clear. In the past, our budgeting was based on revenue. Today and going forward, the leading parameters for us are our growth parameters, bookings and AR. To align the entire organization's behavior with this growth mindset, we have also adjusted our compensation framework around these new KPIs. The whole process is monitored, managed and controlled by a multifunctional team, including our new global compensation incentive director, our HR team and also finance. The 2020 framework will mirror our go-to-market approach, including the customer coverage model, which will lead to an increased and intensified customer penetration.

I strongly believe in the statement, you only get what you measure. Consequently, we also enhanced our management information system to also track the newly established business units as well as the new leading parameters. Over the last 7 months since Helix was launched, we have seen a massive amount of work taking place across all corners of Software AG. I'm very happy to report that we have made great progress and that our conversion to subscription is well on track, and all traffic lights are on green.

Starting into the new year, we will focus our new KPIs explaining our development of -- on penetrating the markets, which are bookings and AR. So please prepare yourself and your model for the future, and please build them around these parameters I just mentioned.

With this, I would like to hand over to John, who will give you some insights of what has achieved in the last 3 months in North America. John?

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John Schweitzer, Software Aktiengesellschaft - Chief Revenue Officer & Member of the Management Board [4]

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Thank you, Arnd, and hello, everyone. I'm certainly pleased overall with the Q3 results, as you can imagine, particularly in EMEA and North America. We continue to make progress towards our Helix goals while executing at the same time.

During the past months, I've made several key commitments around improving our sales and go-to-market execution. And I'm proud to say that we claimed some new ground in key areas of the marketplace through our direct channel with 83 new logos added in the quarter, as noted earlier. The Adobe Marketo partnership announced today will also further our net new focus. I expect this reseller arrangement will contribute starting in Q4.

We also see incredibly powerful wins. In integration, we secured a fantastic competitive win in EMEA at Michelin, which will use our webMethods' hybrid API solution to drive its digital transformation. Michelin is trusting us to provide a hybrid integration API management solution that will connect a whole host of internal and external apps for the years to come. Here, we won in an intense competitive environment against Apigee.

In IoT, we continue to scale our customer base with 17 new logos added in the period. We continue to expand our install base too, leveraging our leading position and strong relationships with key industry 4.0 players. I'm also happy to announce that we've been seeing breakthrough in new markets, including ones in South Africa where sensor manufacturer Pylot has committed to our IoT platform.

And in business transformation we continue to grow too, with Ernst & Young in EMEA. We closed an ARIS Connect contract to address their current future business requirements.

And in A&N, Q3 was another very solid quarter, supported by a pull-forward deal from one of the world's largest financial institutions, which validates, for sure, our 2050 commitment to our customers. This financial institution obviously showed their commitment to our A&N platform and its significance in their business by renewing this multiyear agreement.

In Q2, I highlighted 3 long-standing issues for North America: Historic uninvestment in marketing, in our brand and in our sales operation. That, combined with multiple disruptive changes in our sales structure, impacted our customer relationships overall.

To begin a meaningful change in North America, I explained that we had to derisk our pipeline, strengthen and structure our sales approach and bring new leadership to the region to lead the change [in] the ground. To that end, I'm happy to report that through the team's focus and hard work over the many months has delivered some early encouraging evidence that shows the tide is turning in North America.

Firstly, the work we've done on our pipeline to make it clearer and improve visibility. And as a result, the pipeline conversion rate has improved in Q3, resulting in fewer slipped deals and much better field execution. I'm also seeing a greater proportion of our account executives participate in deal-making quarter-over-quarter.

With the existing pipeline clean, we've now doubled down on our efforts to increase demand for our solutions in the market with global and regional campaigns and plays that focus our solutions and -- those offers to our customers that are most important to them, including disruptive plays around API management, B2B, hybrid cloud and IoT and analytics. While it's still early in this turnaround in North America business, it's pleasing to see these results delivered by the team displaying real energy and an appetite for success. This isn't just about 1 or 2 people. It's about a whole culture shift taking root and will give the business the foundation it needs to grow in the future.

I'm particularly pleased to result in an excellent quarter from our North American government solutions team, which delivered a fantastic performance through an approach at the heart of Helix, focused execution with all the passion, confidence and precision you'd expect from a high-class, world-class sales organization. It's true customer engagement like this that secures us wins from customers who already trust us. The team is now focused on executing its year-end goals.

While I'm conscious there's still plenty of road to run, I also know there's a massive future potential in front of us in North America if we stay on the path we started. And after all, North America is Software AG's integration home market. And as we expand and continue to prove ourselves as a leader in hybrid integration, B2B and API management, we're ready to start taking our unfair share in these markets.

Sanjay, back to you to close it out.

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Sanjay Brahmawar, Software Aktiengesellschaft - Chairman of the Management Board & CEO [5]

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Thanks, John.

So here we are 8 months into Helix and at a turning point in our transformation. We have not shied away from making tough decisions, and the strategy we are pursuing is starting to deliver on its potential. Of course, there's much more to do, but we're working hard as one team. Our partners are working with us, and my focus continues to rest on the big initiatives that will grow this company, on sales segmentation, on geographic focus, on our subscription rollout and on continuing to evolve our partner ecosystem. I look forward to sharing more proof points with you in Q4 around each of these initiatives.

So Otmar, let me pass the call back to you now to open the Q&A session.

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Otmar F. Winzig, Software Aktiengesellschaft - Senior VP & Head of IR [6]

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Thank you, members of the Board. Operator, please would you repeat the instructions to those questions as the Q&A round will start?

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question comes from the line of Gautam Pillai of Goldman Sachs.

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Gautam Pillai, Goldman Sachs Group Inc., Research Division - Equity Analyst [2]

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Congratulations on a good quarter. I have 3 questions. Firstly, on the DBP -- the core DBP segment, this has stabilized. The growth has stabilized in Q3, and you've mentioned that the measures taken to improve sales execution have paid off. Can you talk about the pipeline you're seeing currently? And also about the sustainability of the improved sales execution, the measures you have taken, do you think that, that's enough to kind of drive -- deliver the growth to the segment?

A second question I have is on A&N. Clearly, this segment continues to surprise to the upside. And the year-to-date growth is tracking well above the guidance for the year. And Sanjay, you have spoken about containerization of the A&N products into the cloud. Has there been any initial successes here?

And the final one, on IoT. Can you please discuss the large deal pipeline in Q4 which gives you confidence to deliver Q4, which clearly is a high bar?

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Sanjay Brahmawar, Software Aktiengesellschaft - Chairman of the Management Board & CEO [3]

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Gautam, thanks for the questions. It's Sanjay. So first of all, let me just make a comment on DBP, and I'll definitely ask John to comment a bit more on the pipeline. Look, we had taken some specific actions around DBP to be able to make sure that we understand our pipeline, we understand the deals and the opportunity with customers and how do we execute on that. And I am very confident that our ability to execute on our opportunities has definitely improved significantly. So that's one thing that gives me a lot of confidence. Second thing, John will talk about pipeline, but we can see our rolling 4-quarter pipeline also improve sustainably.

Now the part about Adabas & Natural. Well, of course, we also seem very pleased with the developments in Adabas & Natural, but there's reason behind this. First and foremost, the customers are -- they have taken off this worry off their head that Adabas & Natural will not be supported. Adabas 2050+ program really gives them assurance. Number two, we are working with our customers to be able to help them reduce the total cost of ownership, for example, the zIIP initiatives and now the rehosting and the opportunity to be able to use Microsoft and AWS cloud. This makes it very exciting for customers. To answer your question, we are in pilot mode, and we are working with customers with both AWS and Microsoft and hope to obviously share some of that news with you in the coming quarters.

And then the last part about IoT. Well, look, yes, the lumpiness is probably a question on everybody's mind. But please bear in mind, we are doing 2 things in parallel: Number one, we are of course securing significant OEM deals on IoT, which you have heard about, Deutsche Telekom, Siemens MindSphere, ADAMOS, et cetera. At the same time, we are steadily increasing our recurring revenue by landing. And you can see, as John mentioned, we scored 17 new logos in Q3. That starts improving the base. So those 2 activities are happening, and I'm very confident that Q3 -- Q4, we will land the bigger deals that we needed to make up for the year. So John, would you like to make a comment on the pipeline?

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John Schweitzer, Software Aktiengesellschaft - Chief Revenue Officer & Member of the Management Board [4]

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Yes. Thanks, Sanjay. Just on the DBP side, I would characterize it as clean and consolidate and then fill. We've seen a slight overall reduction in the pipeline because we've cleaned and consolidated down. What that does is that takes our discrete resources' focus on the right deals, increases the conversion rate and our win rates overall. But probably what I'm most pleased about, particularly in North America, is our fill rate there has improved. We've taken a sort of a campaign or sales play approach where we're launching those every 4 weeks, [various focus] on specific plays and most recently on B2B, previously on API management, and next month is IoT. So when we get everyone focused in the right place and take the full energy, we're seeing returns on that pull-through into deal volumes, pipeline and getting the team focused. So I'm pleased the fill rate is increasing.

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Gautam Pillai, Goldman Sachs Group Inc., Research Division - Equity Analyst [5]

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Great. And if I may squeeze a quick one on cash flow to Arnd. So clearly, it looks like the cash conversion has come down in the quarter. Can you please throw some color on the dynamics here? And it seems like the long-term receivables has gone up. Is it because of any IFRS 15 accounting changes?

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Arnd Zinnhardt, Software Aktiengesellschaft - CFO & Member of the Management Board [6]

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No, Gautam. So first of all, the cash flow is in line with our expectation and is developing as expected. We have signed up, as I mentioned in my discussion of the numbers, multiyear contracts, sizable multiyear contracts. So based on this, the [connectees], the cash collection is done on an annual basis over the next years, and that basically drives the pattern on the long-term receivables, as you mentioned. The creditworthiness of that organization that I'm talking about is extremely high. As I mentioned, it is one of the biggest leading financial service organization worldwide. So from a credit point of view, I have no doubt whatsoever.

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Operator [7]

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The next question is from the line of Stacy Pollard of JPMorgan.

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Stacy Elizabeth Pollard, JP Morgan Chase & Co, Research Division - Head of Software and IT Equity Research [8]

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Can you talk about and perhaps quantify what you've seen from your Adobe, Microsoft and T-Systems partnerships so far? And then secondly, what we could expect from Marketo? I know you've said revenues should flow into Q4. Maybe what is the opportunity in absolute terms in terms of what order of magnitude are you thinking of both for Marketo and then the other deals as well, partnerships?

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John Schweitzer, Software Aktiengesellschaft - Chief Revenue Officer & Member of the Management Board [9]

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Stacy, this is John, I'll answer that or at least start it. On the Marketo -- the Marketo announcement from today, so very specifically, this is an integration between Marketo and SAP. What we're seeing in the early returns is a net new customer adoption for us. And the nice thing about this arrangement is while there's some initial license revenue that will be pulled through from the channel, it creates an opportunity for our sellers to go in and expand. So just to be really clear, Marketo will resell this solution as part of their offering.

They've struggled to compete without this integration. So they're highly motivated. And when they land, we'll take the customer information and go in and be able to expand at an enterprise level. That's the strategic value. On Q4, I expect to land several transactions. They won't be material in terms of overall license, but they'll start to build that land and expand for the partnership going forward.

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Sanjay Brahmawar, Software Aktiengesellschaft - Chairman of the Management Board & CEO [10]

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And I think -- Stacy, it's Sanjay. You mentioned your wider question, which is around when do we start seeing results from our partnerships with Microsoft and Deutsche Telekom. So our partnership with Siemens' MindSphere and ADAMOS are already driving revenue, as you know. And so that's adding to our recurring revenues. With Microsoft, we have seen some fantastic response to the Azure accelerator that we created, combine that with webMethods. A big customer that we've been working together on is Walgreen Boots Alliance, a fantastic story about transformation.

And indeed, we are working on many other customers like Walgreen Boots in our pipeline, and we would be looking forward to sharing some of that information in Q4 and, of course, in the upcoming quarters. It does take time to grow and develop these partnerships. So I think we need to remain conscious about that. This is not about just doing only upfront signing, it's about really building a very sustainable, true-growth business with Microsoft. Deutsche Telekom, T-Systems is moving in -- with pace, and we -- as you know, Deutsche Telekom consolidated all of their IoT efforts on to Cumulocity. So at the moment, we are doing some migrations for -- of their existing customers but also continuing to support them on new customer initiatives.

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Stacy Elizabeth Pollard, JP Morgan Chase & Co, Research Division - Head of Software and IT Equity Research [11]

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So would you expect many more partnerships to be announced in the future? Or do you feel like you're set as you are and focus on those?

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Sanjay Brahmawar, Software Aktiengesellschaft - Chairman of the Management Board & CEO [12]

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Yes. So you remember when I started today Stacy, I said that we don't need too many partnerships. We need meaningful partnerships. We have announced 5 meaningful partnerships. As you know, we're working on a couple more that are also for the hyperscale ones. But that's about it. And we're going to now translate these partnerships into real value for customers but also revenue for Software AG.

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Operator [13]

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The next question is from the line of Knut Woller of Baader Bank.

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Knut Woller, Baader-Helvea Equity Research - Analyst [14]

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A first one to John. John, I think we have seen now first positive signs from your efforts in North America, which it's quite encouraging. Can you please provide us an update beyond the numbers? How far we are with the restructuring of the North American sales force? Is that now behind us? Is this still lasting in the fourth quarter? When is it over? And when can you truly focus purely on the operating business?

And then a second question, a similar direction like Stacy before. In terms of the IoT partnerships, we have seen that the growth of the recurring revenues has also been driven, I think, on the back of minimal contractual payments. Can you provide us an update which of these partnerships are already in the mode of revenue burn, so where you are generating already beyond the minimum contractual obligations, payments?

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John Schweitzer, Software Aktiengesellschaft - Chief Revenue Officer & Member of the Management Board [15]

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Sure. Yes. Hi, Knut. Thanks for the questions. So on the North America restructure, it's important to note that we started this really 9-plus months ago. We've only advanced very aggressively in the past several months now. So from a status update, we're completely vetted down in the territories now. If you recall in one of my updates in previous quarters, there was too much disruption in terms of the direct field teams' relationships with customers. So we've vetted down with those now almost 9 months.

I've made several key leadership changes this quarter, including the primary leader and some other sales leadership changes. I'm very confident that we'll get the top leader resolved in this quarter, very encouraged by the pipeline and final candidates there. And then that person, along with me, will make some final, what I call fine-tuning at the first-line manager level. But overall, if you take a look at sales capacity, I'm quite happy with where we are.

We have consolidated but advanced -- consolidated, I mean we've taken out nonperformers and started to build more of a winning culture around the people that are here today. And that gives us a foundation now from -- to continue to build on in terms of sales capacity. So overall, I think the restructure is well advanced going into 2020. I expect the sales leadership will be in place. Our capacity will be ready and then able to execute, and I'm expecting continued quarters of advancement in terms of top line and field execution.

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Sanjay Brahmawar, Software Aktiengesellschaft - Chairman of the Management Board & CEO [16]

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Great. And I think, Knut, you asked a question about IoT partnerships. So maybe I'll just make a comment there. I already said these partnerships like ADAMOS, Siemens, T-Systems, the revenue from them in terms of the recurring or -- let's say, burn, consumption-based revenue has already started. So there we start seeing the flow. With Dell, we have all of the servers and solid Cumulocity now available in their distribution network. And so we will start seeing the output from the Dell partnership coming through in Q4 and early next year. And then as John mentioned, the LOB market, where he expects to see results in Q4 already. So I think this consumption-based model is starting to deliver results for us now.

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Operator [17]

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The next question comes from the line of Alastair Nolan of Morgan Stanley.

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Alastair P. Nolan, Morgan Stanley, Research Division - Research Associate [18]

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Just 2 for me. First of all, you mentioned on the IoT side that some of the deals slipped into Q4. Is any of that down to the macro or the environment changing? And maybe you could provide a comment there? And then finally, on the SaaS transition. Arnd, you mentioned before previously that, that was going to have kind of a 200 basis point negative impact on margins from 2020 onwards. Is that still the plan? And I guess how long do you think that drag may be in place for?

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John Schweitzer, Software Aktiengesellschaft - Chief Revenue Officer & Member of the Management Board [19]

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Alastair, it's John. I'll answer the first one in terms of IoT and the macro impact. I don't see any macro trend impacting our ability to build pipeline or convert it. I think what I do see and what I'm really encouraged by is the field teams' execution around the positioning, our positioning of these solutions in the market to include integration and analytics. So what I've seen very specifically is a trend [that] this combination will improve our competitiveness and overall win rates.

I've personally been involved in several of these strategic transactions this quarter. So I haven't heard anything from our customers or prospects that suggests a pullback of their interest or their investments in this area. And -- but just to add, I would say our competitiveness and how we position these in the market has changed slightly. And I think it's probably going to advance deal cycles and grow deal cycles overall as an outcome.

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Arnd Zinnhardt, Software Aktiengesellschaft - CFO & Member of the Management Board [20]

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Alastair, and I'll take your second question on the subscription topic. So first of all, as Sanjay and I mentioned in our initial speech, the adoption on subscription has been very positive this year. So that's the first remark. And coming back to the cash flow question earlier in this call, that, of course, has also an impact on the cash flow as the payments are recognized on an annual basis. So good adoption in 2019, first statement.

Secondly, the pace of adoption in 2020 will determine what the impact on the margin and the revenue squeeze will look like. So the faster we and the customers are willing to go to a subscription, the higher will be the impact. So therefore, a higher impact on revenue and margin does -- is not a negative sign, but it's rather a positive sign as the adoption is higher. So based on the good adoption that we have seen this year, I would currently think of the margin squeeze between 300 and 200 basis points for next year. But again, this will be determined throughout the year. And again, if the adoption gets higher and we shift faster towards subscription, it could be higher. If we are not that successful, it's lower.

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Alastair P. Nolan, Morgan Stanley, Research Division - Research Associate [21]

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And is that 200 to 300 basis points, is that -- where is that reference from? Is that from FY '18? Or will that be from -- will that be a further kind of downward trend from where we finish this year?

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Arnd Zinnhardt, Software Aktiengesellschaft - CFO & Member of the Management Board [22]

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That is against 2019.

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Operator [23]

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The next question comes from the line of Charlie Brennan of Crédit Suisse.

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Charles Brennan, Crédit Suisse AG, Research Division - Research Analyst [24]

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This is just to follow up on the subscription question actually. It seems to be a topic that's at the front of investors' minds. If I think about the results today, there are 2 aspects that seem to go against the trend to subscription. Firstly, you've got the -- what you're describing as a pull-forward of a multiyear deal in A&N that seems to go against a smoother revenue recognition profile. And then if we think about the implied Q4 guidance for IoT, I guess the only way you get there is by booking significant license in Q4. Is there a way of thinking about the revenue that you've pulled forward from the future to help support 2019? And is that one of the reasons that you've now changed your expectation for the margin impact next year from 200 basis points to now 300 to 200 basis points?

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Arnd Zinnhardt, Software Aktiengesellschaft - CFO & Member of the Management Board [25]

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So first of all, Charles, looking to a single transaction is not making a trend, yes? So we give the customer the option to choose the -- either the deployment model, on-premise or cloud, or the way they want to set up a license contract. And with this customer, especially on the Adabas Natural side, we have a relationship for more than 20 or 30 years, so it's a very long-standing relationship. And I think the positive aspect, we should not underestimate what this is, that this customer, as I said, global financial institution, is giving their commitment to Adabas Natural for the next years. So I think that is a very strong statement in itself, yes.

Sanjay made some comments on IoT regarding landing and expanding and made comments about our OEM partnerships. So the OEM partnerships are going to be recurring revenue, either usage-based or subscription, yes? On the other side, we also see customers who want simply to make a perpetual license. So we do not, in all cases, have the trend towards OpEx, so from CapEx to OpEx. Some industries, some customers rather like to have our CapEx. So therefore, we give them the option and the flexibility to either go perpetual or subscription. So therefore, we are not forcing customers into a specific license model but give the customers the options and the flexibility to pick and choose.

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Sanjay Brahmawar, Software Aktiengesellschaft - Chairman of the Management Board & CEO [26]

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Yes. And I think if you take away Adabas & Natural, then you look at the growth rates of subscription on our DBP portfolio, as I mentioned, we are now 63% of our total bookings is subscription and SaaS. So that's really giving us a lot of confidence, Charlie, in terms of the adoption of subscription, what the customer really wants in that area. And then yes, the OEM partnerships will substantiate some of the major license deals next year.

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Charles Brennan, Crédit Suisse AG, Research Division - Research Analyst [27]

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And just as a general point, as we look into next year in A&N, I know it's early to be talking about 2020. But this has clearly been an above-trend year for you in A&N. Should we naturally think of 2020 as being a below-trend year as we're against tough comps? Or is it too early to make that statement for 2020?

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Sanjay Brahmawar, Software Aktiengesellschaft - Chairman of the Management Board & CEO [28]

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Yes. I would agree, it's too early to make that statement. We are in our budgeting process. So clearly, we are trying to fully understand exactly our pipeline and, of course, our commitments from customers. One thing we can say for sure is that the trend of Adabas & Natural 2050+ program, the zIIP activities, the rehosting and the efforts that we're doing with AWS and Microsoft, these are all going to pay results 2020. So I am not in a position to be able to tell you exactly where Adabas & Natural forecast is going to be, but we will do that in January.

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Operator [29]

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The next question is from Michael Briest of UBS.

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Michael Briest, UBS Investment Bank, Research Division - MD of Global Technology Research Group & Head of the European Technology Research [30]

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A couple from me as well. Firstly, Sanjay, just going back to the IoT topic. Obviously, the guidance range is quite wide for the year. I think you said Adabas & Natural is going to be at the top end. Do you think it's possible that IoT could indeed achieve the high end for the year? Or is the low end of the range more likely? And then I've got a question on subscription for Arnd.

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Sanjay Brahmawar, Software Aktiengesellschaft - Chairman of the Management Board & CEO [31]

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Okay. Well, look, I mean I think we are healthily growing our business in IoT. Even after 9 months, we are at -- had a strong growth of almost 49% or 50%. So I feel very confident that we will hit the range that we have committed. Now as we said, we have some significant deals in Q4, and it will be very dependent on some of these deals where -- whether we are able to land all the deals or we're able to land a few of those deals in Q4. So that will determine where we land in that range. But as I said, confident about meeting the range and being able to deliver on that, yes.

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Michael Briest, UBS Investment Bank, Research Division - MD of Global Technology Research Group & Head of the European Technology Research [32]

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And then just on the subscription, Arnd. Can you talk a bit about the mechanics of these contracts that you're currently signing on subscription? Should we assume that the 1st of January next year, they will all be novated to the new format and drop them automatically to subscription? So I think you've said previously, it's equivalent to 3-years licenses. And then also will there be any retrospective application of the accounting? Would you restate 2019 as though the subscription had been in place from sort of 2019 or 2018 even?

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Arnd Zinnhardt, Software Aktiengesellschaft - CFO & Member of the Management Board [33]

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Yes. Michael, so the contracts that we sign this year are on average 3-years contracts. And as they don't have any kind of termination right on one or the other side, the respective license piece is recognized for that 3-years period, yes. Moving into next year, we will offer the customers a cancellation right after a 12-month period and then 24 months. And then if it's a 3-years contract, then he's got a right after 36 months anyway.

So based on this right that we offer to the customers, the revenue recognition is on a 12-month basis, which will then lead to this recurring, predictable revenue stream that we were talking about already in January and February. Given that the contracts in 2019 are excluding such a clause, there is no requirement or possibility, however you want to put it, to restate the 2019 numbers. So 2019 stays as it is. And moving forward, we will have this 12-months recognition, which will then lead into the revenue and margin squeeze.

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Michael Briest, UBS Investment Bank, Research Division - MD of Global Technology Research Group & Head of the European Technology Research [34]

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I mean just to sort of understand your assumption on the margins. I mean if, let's say, DBP does about 150 of licenses this year and roughly 2/3 of that would move to subscription, you'd lose EUR 100 million of licenses or revenue, which I understand from a long-term perspective is no issue. But this is -- you're saying that's only 200 to 300 basis points of margin into -- I'm struggling with that.

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Arnd Zinnhardt, Software Aktiengesellschaft - CFO & Member of the Management Board [35]

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So first of all, you are assume that all the number is moving to subscription. As referring to Charles' question, you see that not everybody is moving into a subscription model. We made some base assumptions on -- and the feedback that we received from the market. And based on those assumptions, we made our modeling, which then leads to this 200 to 300 basis points.

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Michael Briest, UBS Investment Bank, Research Division - MD of Global Technology Research Group & Head of the European Technology Research [36]

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Can you say what your assumption is? It is clearly not 2/3.

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Arnd Zinnhardt, Software Aktiengesellschaft - CFO & Member of the Management Board [37]

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It's certainly not 2/3. It's rather between 1/3 and 50% on -- for the next year. But again, this is something that we will see coming -- going throughout the year. And this is why I made this range and not a precise number based on the question that was raised by Alastair.

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Michael Briest, UBS Investment Bank, Research Division - MD of Global Technology Research Group & Head of the European Technology Research [38]

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Okay. And the cash flow would be annual as well under...

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Arnd Zinnhardt, Software Aktiengesellschaft - CFO & Member of the Management Board [39]

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It will be annual, and we would collect, so that is a standard term, would collect the money for the 12-months period on day 1, so in advance, so that we have certainly a smaller impact on the cash flow but not a really significant impact on the cash flow.

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Operator [40]

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The final question is from the line of Sven Merkt of Barclays.

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Sven Denis Merkt, Barclays Bank PLC, Research Division - Equity Research Analyst [41]

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Just a question. Could you please give us some comments around the competitive environment for DBP? Have you recently seen any changes in the win rates across the different subsegments? And then secondly, if possible, could you quantify the size of the slipped deals in IoT? And likewise, the size of the deals you brought forward in A&N?

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Sanjay Brahmawar, Software Aktiengesellschaft - Chairman of the Management Board & CEO [42]

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Yes. Let -- thank you very much for your questions, Sven. So first, let me answer about the win rates. And I think we shared quite a few examples, and particularly because we wanted to emphasize the fact that we are truly winning with pace in the market in actually both areas, DBP as well as in IoT. DBP example we gave you was of the Smart City Dubai, which was a very competitive battle against Oracle, IBM, Apigee, Neusoft and TIBCO, and we stood above all of them. The example on IoT, again, we are winning against several other players such as PTC in the market. So we see the innovation that we're bringing out in our product and the focus on quality and customer service helping us differentiate, and hence adding to our win rates. John, do you want to make a comment on the Q4 IoT slipped deals?

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John Schweitzer, Software Aktiengesellschaft - Chief Revenue Officer & Member of the Management Board [43]

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I won't make a comment in particular on specific deal names. I'll just reemphasize, it's already been said that we continue to make ground on recurring revenue in this product portfolio in terms of landing new customers and increasing the vault, the velocity with which they buy, the second buy and the third buy. So I'm really encouraged by that. We'll continue to need these big OEM transformational deals as well. So I sort of -- from a go-to-market planning but also a results standpoint, I see these 2 revenue streams going forward being critically important for us in IoT now and in 2020.

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Sven Denis Merkt, Barclays Bank PLC, Research Division - Equity Research Analyst [44]

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And could you quantify on the size roughly of these deals that slipped and the size of the deal that you brought forward in A&N?

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Sanjay Brahmawar, Software Aktiengesellschaft - Chairman of the Management Board & CEO [45]

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Yes. Obviously, as Arnd mentioned and John also emphasized, the size of the deal that we brought forward in A&N was a significant one. But if you look at it over the year, we already said that it will balance out, and therefore will allow us to get to the top range of the Adabas & Natural performance. So I think that I'm sure you will get in the math.

The second thing, of course, is what are the size of the slipped deals in IoT? There again, you can see we are sitting at about 50% after the 9 months. It's pretty clear that we have a couple of sizable deals sitting in Q4, which we have to close. We are very confident we'll close it. And as I said, we will land between 75% and 125%. So that's the magnitude of the big deals over and above, of course, the recurring revenue that we are getting through the year.

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Otmar F. Winzig, Software Aktiengesellschaft - Senior VP & Head of IR [46]

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Okay. Thank you, ladies and gentlemen. I'm afraid I have to close this call now due to other assignments. We have had our 30 minutes Q&A, as promised. Thank you for all your participation and interest in Software AG and the good questions. All the remaining questions, if there are any, will be handled by the IR team. So thanks for now, and goodbye.