Organic Growth And Expanding TAM Make ServiceNow A Buy (NYSE:NOW)


Overview And Recent Updates

ServiceNow (NOW) provides software solutions to organize and automate business processes through a SaaS delivery model. The company mainly focuses on IT functions of enterprise customers even though, more recently, it expanded into other areas such as HR service delivery, customer service and security operations.

Data by YCharts

In Q2-20, subscription revenue came in at $1.016 billion, 30% growth YoY. Total revenue of $1.071 billion grew 28% YoY, $17 million ahead of analysts’ estimate. In Q2-20, the company had 40 deals in excess of $1m and 2 deals over $10m. Positive momentum was seen in both customer service and human resources divisions, with ServiceNow now having 964 clients generating more than $1m in annual contract value (ACV). Non-GAAP subscription billings grew 26% YoY.

Remaining Performance Obligations (RPO) grew 30% YoY reaching $7.0 billion, of which $3.5 billion current RPO due within a year and $3.5 billion non-current RPO.

Opportunity Summary

Key catalysts include:

  • Business expansion in other areas of ITOM after the great success and exceptional renewal rate in the ITSM market
  • Strong organic growth coming from different channels, including HR service delivery or customer service
  • Business model is extremely sticky, with a 97% renewal rate over the past few quarters and 95% of revenue coming from subscription-based services

Key risks include:

  • As the company expands into other areas outside the core IT function, it will encounter high competition in the HR/customer service space, and some of its competitors will be better equipped to battle for market share
  • Execution risk linked to a possible increase in M&A activity as a proven track record of successful acquisitions is missing
  • Both CEO and CFO left in 2019

Investment Thesis

ServiceNow has been successful in conducting a typical land and expand strategy. The company started as a provider of SaaS solutions for IT Service Management (ITSM) and its success has come thanks to a flexible platform, a familiar interface and by becoming a single system of record for the IT function within an enterprise.

Having established itself as a leader in the ITSM space, with a rapid rise to around 40% of ITSM market share, ServiceNow is expanding into the much larger market of IT Operations Management (ITOM) by incorporating new features into its original platform. Moreover, the company successfully expanded its process automation approach to other areas beyond the IT function such as HR functions and customer service.

The company’s success has been rapid and, for the most part, organic. ServiceNow boasts an impressive 97% customer retention rate, reached by focusing on the 2,000 largest enterprises in the world (G2K); these companies continue to renew their contracts, with the average annual contract value doubling in the last three years. Moreover, renewal rate has been extremely constant over the past few quarters, reaching 97% in Q4-19, Q1-20 and Q2-20.

Interestingly, ServiceNow has no exposure to small businesses, which are generally less sticky than enterprise customers. The company not only maintains an impressive retention rate, but it is able to sell multiple products to one single customer, as 75% of its clients are multi-product buyers.

Source: Q2-20 Investor Presentation

The majority of new ACV is still coming from IT Workflows (63%), followed by Customer & Employee Workflows (24%) and Now Platform App Engine & Others (13%).

As demonstrated by the positive renewal rate, ServiceNow’s business model is extremely sticky, with 95% of GAAP Revenues coming from subscription-based services (compared with 94% for FY19 and 93% for FY18).

Management

William McDermott serves as president, CEO and Director of ServiceNow since November 2019. He previously served as a member of the executive board at SAP SE from October 2019 to November 15, 2019. He served as CEO of SAP SE since May 21, 2014 until October 10, 2019. McDermott received its B.S. degree in Business Administration from Dowling College, and he holds an M.B.A. from the Kellogg Graduate School of Management. He also completed the Executive Development Program at the University of Pennsylvania’s Wharton Graduate School of Management.

Gina Mastantuono serves as CFO and joined the company at the end of 2019. She previously held a position as CFO of Ingram Micro Inc. from December 2016 to December 2019. She began her career at Ernst & Young LLP in 1992 where she was a manager in the entrepreneurial services group. She is a CPA and holds a B.S. in Accounting & Business Administration from the State University of New York.

Chris Bedi serves as Chief Information Officer since 2015. Prior to joining ServiceNow, he served as CIO of JDSU from August 2011 to March 2015, where he was responsible for IT, Facilities and Indirect Procurement. He started his career at KPMG from June 1996 to April 2002. He holds a B.S. in Computer Science from the University of Michigan.

Independent directors are generally qualified and come from a variety of high-profile leadership backgrounds. Board member compensation consists of a typical fee of $22,000 to $70,000 annually plus $325,000 in restricted stock unit awards, which is comparable to peers. Executive compensation consists of a base salary, cash bonus and RSU awards. The variable component of cash bonus and RSU is based on new net ACV. Compensation seems appropriate and in line with other software companies and looks skewed towards equity compensation as a way to align management with shareholders.

Financial Overview And Valuation

The company is in a safe financial position, with rapidly growing top-line and improving margins. Revenue grew from $1.0 billion in 2015 to $3.5 billion in 2019, with EBITDA turning positive in 2017 ($49.5m) and Operating Income turning positive in 2019 ($42.1m). ServiceNow has been generating positive FCF for the past few years, with LTM FCF of $1.1 billion, or 27.5% total revenue.

As of June-20, the company has $2.3 billion in cash & equivalents (includes $1.5 billion in short-term investments), offset by $1.2 billion in interest bearing debt which includes $502m in capitalized operating leases, resulting in a net cash position of $1.1 billion. In terms of capital deployment, the company is not paying dividends (and will likely continue to do so in the foreseeable future) or repurchasing shares on a consistent basis and only makes small acquisitions, as growth has mainly been organic. Since 2012, the company has only spent an aggregate $240m on acquisitions.

Analysts are expecting ServiceNow to continue growing its top-line at a healthy rate, reaching $6.9 billion total revenue by FY2022; EBITDA margins are also expected to improve, normalizing around 31%-33% EBITDA margin. In a base-case DCF, top-line growth is expected to stay at or above 20% until FY2025, with total revenue reaching $19.4 billion by FY2029 (representing a 18.0% CAGR between 2020-2029). Revenue growth is driven by two main factors: (1) a high and stable renewal rate and (2) increasingly larger deals.

Unlevered FCF is modeled to reach $4.0 billion in FY2029, with UFCF/EBITDA normalizing around 64%-65% (or 20%-21% of total revenue).

Enterprise Value is adjusted to factor in (1) value of options outstanding: as of June-20 there are 651k options outstanding at a weighted average exercise price of $92.87, 4.6y maturity, with total estimated value of $181m (34.6% volatility, 2.5% risk-free rate and current price of $453.09 per share). Note that all options outstanding, and not just vested ones, are considered (2) non-operating assets of $777m in long-term investments & financial assets (3) debt value of capitalized operating leases of $502m, 8.9y maturity, 3.5% discount rate (note: the 3.5% rate used by the company to capitalize leases is also used as a proxy for pre-tax cost of debt in the below DCF).

Below is the summary of a high-level DCF:

Source: S&P Capital IQ, Duff & Phelps for normalized risk-free rate and ERP estimates (source), NYU Stern, proprietary research. 2020-2022 Revenue and EBITDA from CapIQ estimates. Please note: the above DCF only offers a rough fair value estimate. Highlighted in dark grey are author’s estimates for top-line growth and EBITDA margins

Even though shares are up more than 70% the past year, the stock appears to be fairly valued on a DCF basis. Assuming an exit EV/Revenue of 6.5x (equivalent to a 20.3x EV/EBITDA exit), fair value comes in at $417.63 a share (7.8% downside to current price of $453.09 as of September 18th, 2020 close).

ChartData by YCharts

In the above model, a current price per share of $453.09 implies a 7.2x exit EV/Revenue in Year 10 (22.5x EV/EBITDA) which, again, seems plausible considering the high multiples at which the company is trading on an LTM basis and not too far off the 6.5x target exit. Moreover, a 7.2x exit is in line with the 7.1x median EV/Revenue of selected public comps:

Source: S&P Capital IQ

However, the company is still priced higher than most of its competitors (possibly rightly so given the strong competitive position and higher growth prospects) and any execution misstep could have an amplified impact of the company’s shares.

Key Risks

As noted above, valuation still looks high compared with peers, even though a DCF model seems to justify the premium given higher growth prospects.

ServiceNow has successfully gained market share by displacing legacy vendors with its SaaS offering but, as the company continues to expand in new areas of the enterprise, it is likely to encounter increased competition. For instance, moving into the customer experience segment will mean increased direct competition with salesforce.com (CRM).

Even though growth has been for the most part organic (the company only spent an aggregate $240m since its IPO), as the company matures, the likelihood of M&A activity increases. For now, the company has mainly engaged in acquiring feature-driven companies and, as there is no clear and proven M&A track record, investors could be exposed to execution risk if M&A activity increases.

Finally, as both CEO and CFO joined the company in the fourth quarter of 2019, they have limited experience with the team but, given their backgrounds, they will likely perform well in the years ahead.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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