ServiceNow: Growing Strongly, But Is Now Time To Back Up The Truck? (NYSE:NOW)

Company overview

What is ServiceNow

ServiceNow Inc (NYSE:NOW) describes itself as an Application Platform as a Service (PAAS) that provides infrastructure, platform, and workflows apps (Figure 1) for enterprises and government. This sounds awfully technical, so I like to think of it simplistically as an outsourced cloud-based IT department for packaged operations support and back-office software that streamline and automate business workflow, unlock productivity, and improve end-user experiences.

Figure 1 ServiceNow’s Application Platform as a Service

ServiceNow’s software does not drive the core competencies of its clients (e.g., proprietary trading algorithms), which is best left to in-house developers. Instead, it strives to become the strategic center of gravity for customers by providing best-in-class software in relatively mundane but crucial functions to improve the experience and productivity of employees, drive efficiency of workflows, and enable its clients’ businesses to function as smoothly as possible.

ServiceNow’s products handle a wide variety of functions from booking conference rooms to tracking customer support tickets, on-boarding new employees to tracking assets, and managing workflows from legal documents to supply chains (Figure 2). The company’s new software release incorporates artificial intelligence algorithms to prioritize and debottleneck workflows, and to provide early warning to operational issues before they become major problems.

Figure 2 A sample of ServiceNow’s offerings

ServiceNow’s specialized developers are able to provide better products at a lower cost to clients compared to inhouse developers because of scale, and its broad range of integrated networked products provide more functionality and require less maintenance compared to single point solutions.

The ServiceNow platform also hosts an app store that offers apps from approved independent software vendors. In addition, the Creator Workflow’s low code app engine democratizes application development, enabling “citizen developers” with business process familiarity and tech curiosity to build their own apps.

Who are its customers?

ServiceNow’s customers are primarily large enterprises. As of December 31, 2021, the company had approximately 7,400 enterprise customers, including 80% of the Fortune 500. It serves a wide variety of industries, including financial services, healthcare/life sciences, manufacturing, IT services, technology/media/telecom, oil & gas, education, consumer products, as well as government. The largest geographical markets are the US, Canada, United Kingdom, Germany, Japan, Australia, and New Zealand.

Its roster of customers includes blue chip names such as Microsoft (MSFT) (which uses NOW for IT self-service), General Motors (GM) (Supply Chain) Adobe (ADBE), Experian (OTCQX:EXPGF) [EXPN.L], Deutsche Telekom (OTCQX:DTEGY) [DTE.DE], JPMorgan Chase (JPM), PepsiCo (PEP), and many others.

To extend its reach, the company also partners with eight of the top ten global advisory and systems integrators, including Accenture (ACN), Deloitte, Ernst & Young, IBM (IBM), KPMG, which have committed to plans to generate over $1 billion.

Why do customers buy from ServiceNow?

Productivity enhancement and cost reduction: ServiceNow’s software streamlines business processes, reduces operational costs, enhances employee productivity, and improves both customer and employee experiences across a variety of functional areas. Its applications are well-integrated to work better together than individual point solutions, which require user coordination and create more IT administrative burden and costs.

In addition, they are quick to implement with relatively little configuration due to its application PaaS nature (often taking just weeks or months instead of quarters) and designed to play well with clients’ existing legacy assets.

In its investor day presentation in May 2022, JPMorgan Chase gave ServiceNow a shoutout, highlighting that its software, which replaced 24 legacy applications, was a major contributor of improved productivity that resulted in nearly $50 million in savings between 2019 and 2022 (Figure 3).

Figure 3 JP Morgan investor presentation slide

As ServiceNow’s products become more ubiquitous, the number of users and administrators trained by its RiseUp education program, citizen developers trained to build apps using its low-code app engine, and base of third-party app vendors will grow, widening its moat against competitors and new entrants.

Competition

ServiceNow competes against the numerous players, including:

• Inhouse developers and legacy apps
• SaaS (software as a service providers) such as Atlassian (TEAM), Salesforce (CRM), Workday (WDAY), and low-code automation platforms such as Appian (APPN)
• Large enterprise software firms such as Oracle (ORCL) and SAP (SAP)

However, it has distinguished itself by winning a place in Gartner’s Magic Quadrant in ITSM (IT service management) for the ninth year (Figure 4) and being rated a leader in Forrester’s value stream management category (Figure 5).

Figure 4 Gartner ITSM Magic Quadrant

Figure 5 Forrester Value Stream Management Wave

Trends and macro environment

ServiceNow benefits from several powerful long-term secular trends but faces short-term economic headwinds.

Long-term tailwinds:

1. IT spending, excluding devices, is projected to increase and estimated 9% annual from 2022-2025 (source: IDC).

2. Clients and their Chief Information Officers are under pressure to both lower costs of and boost their ROI (return on investment) on IT spending (see Figure 3 above for example from JPMorgan).3. 64% of C-suite officers believe they need to accelerate their transformations to digital business models and the cloud by 2023 (IDC study, as cited in ServiceNow’s 2022 analyst day).

4. Consolidation of multiple point solutions into a few integrated vendors:

The simplicity of an outsourced integrated infrastructure platform has advantages over multiple point solutions. An integrated solution provider enables its clients to purchase and fewer implement software solutions that support multiple processes, ensures that data is stored consistently and in a single instance, supports automatic connections between processes, and facilitates reporting across these processes.

In contrast, Point Solutions, while “best-in-class”, only solve one business problem. As a result, multiple vendors are required, and common data needs to be shared between these solutions, creating complexity, potential inconsistency, risk, and finger-pointing when things go wrong. Consolidating a large number of separate or legacy processes into a modern workflow experience declutters and drives cost efficiencies.

5. The need to speed up and improve customer and employee experiences to minimize frustration and prevent attrition.

6. The need for more new applications. IDC expects over 750M new apps built by 2025 – this can be done only with the help of citizen developers creating low code solutions.

Short-term headwinds:

The war in Ukraine, rising interest rates, and pessimism around a slowing economy has led to increasing employee layoffs and deferred corporate spending. For example, Salesforce’s growth has decelerated, Microsoft disclosed that some customers have put new cloud workloads on pause, and Oracle and SAP both noted deferred back-office activity.

While this points to potentially slower near-term growth for Service now, I believe companies are forced to spend on workflow software do more with fewer employees, and to keep up with rivals who are spending to leapfrog or pull further ahead of competitors.

Investment thesis

ServiceNow is an interesting investing due to its competent management, attractive SaaS economics, differentiated offering, and effective growth strategy.

1. Proven management and high approval ratings

William McDermott, ServiceNow’s Chairman, CEO, and President is a highly experienced and proven software executive who was credited with growing the market cap of SAP (OTCPK:SAPGF) [SAP.SE] from $39 billion to $156 billion under his watch. Even though I watch and listen to many interviews of top CEOs, I found Mr. McDermott particularly impressive in both his industry knowledge and leadership style (the latter is difficult to define, but as Justice Potter Stewart puts it, “I know it when I see it”).

According to 2876 employee surveys on glassdoor.com, 97% employees approve of their CEO (which is unusually high) and 91% would recommend a friend work there.

I was intrigued with ServiceNow’s sales compensation practice to foster linearity, or steady selling throughout the year, which enables company to manage workload to prevent spikes, level out resource utilization, maximize revenue, and make financial results more predictable

2. Attractive SaaS economics

• Strong operating leverage due to the low incremental cost and additional overhead required to sell additional units of the same software to more customers.
• Stickiness: As the process of switching out incumbent mission critical software can be disruptive, costly, risky, and require new training for users, customers generally do not switch for small pricing differences or incremental features. This is particularly true if the incumbent vendor multiple products that cover a broad range of the customer’s operations. (Even though this also applies to ServiceNow’s ability to dislodge a potential customer’s existing vendors, product reviews indicate that ServiceNow’s products bring enough additional functionality and benefits to justify switching over).
• Network effects can cause competitive moats can widen as the company scales up, due to a larger base of trained users, system administrators, third-party technical support, as well as third-party developers providing add-on products. In addition, for vendors that use anonymized clients’ data to train their artificial intelligence/machine learning models (e.g., Salesforce), having more clients and thus more client data will lead to better predictions.

3. Differentiated product offering

Many of the characteristics that differentiate ServiceNow’s products have been discussed above under the heading “Why customers buy from ServiceNow?”

In addition, the company has demonstrated the ability to roll out new products very quickly-examples include its COVID-19 emergency response workflow apps (made available at no charge) and an app developed with the State of Florida Hurricane Ian to manage requests from people searching for their loved ones, which done in a few hours.

I expect ServiceNow and its App Engine clients to continue churning out more productivity enhancing products that continue to lower costs, increase efficiency, and return on investment for clients, and widen the company’s competitive moat.

4. Viable growth strategy

ServiceNow’s pricing depends on, among other factors, the packages selected. It has adopted a “land and expand” strategy where it typically (but not always) begins with IT workflow apps, then expands into selling additional products and higher value “Pro” upgrades.

The company emphasizes organic growth through innovation. More recently, it developed software that reinvent how supply chains for auto manufacturers, procurement and finance for the biggest retailers, manufacturers, freight companies around the world, and introduced artificial intelligence/machine learning to help automate and prioritize workflow items as well as detect systematic problems early before they mushroom.

However, the company has also selectively acquired smaller companies for their intellectual property. For example, it purchased Lightstep for its cloud application monitoring and incident response capabilities, followed by Era Software to enable customers to monitor their applications across the cloud with a single software solution.

Operational metrics

Market penetration:

ServiceNow reported TTM (trailing twelve-month) revenue of about $7 billion and estimates a TAM (Total Addressable Market) of $150 billion.

Number of products per customer:

Management noted that new customers typically start with IT workflow applications (but 20% of new logos landed with non-tech workflows in 2021) and expanded over time. A slide in the 2022 Analyst Day presentation showed that the time for customers to purchase additional products has shortened the 4 years it previously took to increase to increase number of products by 30% has dropped to one year (Figure 6).

Even though 18 of the top 20 deals had five or more products, just 10% of customers are using products from all four of workflows, indicating that there is room for additional growth.

Figure 6 Time to make subsequent sales of additional products

Customers with ACV (annual contract value) of greater than $1 million:

The number of customers with ACV over $1 million has quadrupled since 2017 (Figure 7). This is an important metric to follow as they are likely the most profitable customers, and is expected to increase by over 60% in the next three years (Figure 8)

Figure 7 Number of customers with ACV > $1 million

Figure 8 Growth of customers with ACV > $1 million

The total revenue from customers with ACV of over $1 million has tripled since 2019 (Figure 7, blue line, left axis) and accounts for about 83% of total revenue (red dotted line, right axis).

Figure 9 Revenue and % of revenue from customers with ACV > $1 million

Additionally, the number of customers with over $10 million in revenue grew by 60% year-over-year in Q3 2022, and is expected to grow at double the rate of customers with ACV of between $1 million and $10 million (Figure 8).

Renewal rate:

ServiceNow reports a very high renewal rate, which has been in the 97-99% range since 2018 (Figure 7).

Figure 10 Historical renewal rates

According to the 2021 Form 10-K filing (page 35), the renewal rate is defined as:

100%-(ACV lost/ (ACV renewed + ACV lost))

Renewal rate. We calculate our renewal rate by subtracting our attrition rate from 100%. Our attrition rate for a period is equal to the ACV from customers lost during the period, divided by the sum of (i) the total ACV from all customers that renewed during the period, excluding changes in price or users [italicized by author], and (ii) the total ACV from all customers lost during the period. Accordingly, our renewal rate is calculated based on ACV and is not based on the number of customers that have renewed. Further, our renewal rate does not reflect increased or decreased purchases from our customers to the extent such customers are not lost customers or lapsed renewal.

The company sold 30% more products to existing customers from 2020 to 2021 (Figure 6), ie., the ACV renewed should be greater than the previous year’s ACV. As the renewal rate is less than 100%, it would indicate that the increase in sales was still not sufficient to offset the AVC lost. As a comparison, a number of high growth companies report renewal rates of greater than 100%. If I understand it correctly, while this is certainly a good result, there is more attrition than meets the eye.

Remaining performance obligation (RPO):

The company’s total billings, RPO, current RPO and revenue have grown steadily and in synch over the last five years. However, both the cRPO and RPO for the last two quarters have not shown the same upward trend from previous years and appear to be leveling out (Figure 11, green and orange dashed lines), indicating that the stock price pullback was not purely a result of the Federal Reserve’s interest rate hikes.

Figure 11 RPO, cRPO, Billings, and Revenue

Financial analysis

Super high revenue growth

Compared to fast-growing SaaS providers like Salesforce and Workday, ServiceNow has delivered very high revenue growth (Figure 12, gray, vs brown and blue dashed lines). Its per-share revenue growth is even more impressive (up over 3.5x over the last five years) (green solid line) as most of the growth was organic and the company has not issued many shares for acquisitions (Figure 13, green line).

Figure 12 Growth of revenue and per-share revenue

Figure 13 Fully diluted shares outstanding

Even though some customer segments, such as federal government, have delivered record revenues even in 2022 Q3, we are seeing bumpiness over the last two quarters as the year-over-year per-share revenue growth is trending into the low 20% range (Figure 14, brown bar).

Figure 14 Quarterly year-over-year per-share revenue percent change

Management attributes a large part of the weakness in Q3 of 2022 to the negative impact of foreign currency exchange rates, which resulted in 650bps of headwind on subscription revenues and more on cRPO and RPO (Figure 14), without which subscription revenues would have grown at 28.5%.

Figure 15 Effects of currency headwinds

As ServiceNow’s workflow platforms deliver productivity, efficiency, and cost savings, I believe its mid- to long-term growth opportunity remains strong regardless of near-term volatility.

Gross margin very high

ServiceNow’s TTM gross margin has been climbing since prior to 2016 as it benefited from scale (Figure 16, green line). It is now highest amongst some of its peers, and likely to expand further as its revenue continues to expand.

Figure 16 Gross margin

EBITDA margin

More significantly, ServiceNow’s EBITDA margin crossed into positive in 2018 as it reached sufficient scale (Figure 17, green line), but has trended down in the last two years as the company stepped up R&D spending and due to foreign currency headwinds (Figure 18, green line-note that expenses are negative).

I note that the Q3 2022 TTM share-based compensation of $1.3 billion represents almost 2 times the TTM EBITDA, without which the “adjusted” EBITDA would be three times higher and the non-GAAP, adjusted operating margin would be 26% (as opposed to 3.4%) (the other “adjustments” are relatively minor)

Figure 17 EBITDA margin

Figure 18 R&D as percentage of revenue

Free cash flow

Free cash flow margin is very high compared to its peers and is up by 10% since 2019, and TTM Q3 2022 free cash flow has almost double since 2019.

Figure 19 Free cash flow margins

However, its Q3 free cash flow was down to 2018 levels. I will be watching Q4 2022 free cash flow very closely for signs of further deterioration.

Figure 20 ServiceNow’s per-share free cash flow

ServiceNow notes that it is one of the relatively few growth companies that meets the Rule of 60 (defined as the sum of revenue growth and free cash flow margin (both in percent)), which is a yardstick that some tech analysts use to determine if a company is growing healthily. However, I note that the number has ticked down towards 50 in the last quarter.

Figure 21 Rule of 60

Return on tangible capital

The company’s free cash flow return on tangible is very high, particularly for company that just turned cash flow positive in 2017 (Figure 22). This is particularly for a company that emphasizes organic over acquisition growth.

Figure 22 Return on tangible capital

Valuation

ServiceNow stock was up 10-fold from 2015 through 2022 but has declined by over 40% from its peak (Figure 23).

Figure 23 Stock price, indexed to 2015

The company’s free cash flow yield has risen to over 2% – levels not seen since 2016 (Figure 24, blue line).

Figure 24 Valuation

However, it remains the most highly valued compared to many of its peers (Figure 25) due to its higher growth rate (Figure 12).

Figure 25 Valuation vs comparables

Concerns

1. Growth decelerating?

ServiceNow’s still-lofty valuation can only be justified by its high growth rate. The leveling of RPO and cRPO (Figure 11) may be potential warning signs of a deceleration in growth, but they too are likely affected by the foreign exchange headwinds depicted in Figure 15. This is something to keep a close watch on.

2. Very high stock-based compensation expenses

ServiceNow’s stock-based compensation expense (SBC) (Figure 26) is about 20% of revenue and two-thirds of pre-SBC EBITDA (i.e., EBITDA + SBC) (Figure 27). SBC is a non-cash expense determined using some form of option pricing model, but it represents valuable consideration that is transferred from shareholder to employees in the form of dilution.

Figure 26 ServiceNow stock-based compensation expense

Figure 27 ServiceNow stock-based compensation as % of key financial metrics

3. Higher customer churn than meets the eye

(Discussed in and following Figure 10)

In summary…

• ServiceNow is a global outsourced provider of best-in-class applications that streamline workflow, unlock productivity, and improve end-user experiences for enterprises and government. Its customers include 80% of the Fortune 500 across multiple industries.
• The company has a strong management team and benefits from several powerful long-term secular trends and attractive economic characteristics of software providers but may be facing near-term headwinds from a slowing economy and a strong US dollar.
• Revenue growth is driven by a large total addressable market, growing number of large customers that purchase more products over time, a high customer renewal rate, and margins should expand due to inherent operating leverage.
• The stock price is down by over 40% from its peak but remains more richly valued than peers due to its higher growth.
• I rate ServiceNow stock a long term hold, but will be closely watching its growth-related metrics for signs of deceleration in the company’s growth.