May 28 2020 - ServiceNow: Potential To Outperform Is Strong

Summary

ServiceNow enjoys favorable demand-side tailwinds that will uphold its growth narrative.

It is moving faster than most competitors as it extends the breadth of its capabilities.

ServiceNow has the potential to keep outperforming due to its attractive valuation factors.

No let-up in the pace of change at ServiceNow - an update from ...

Source: Sitsi

ServiceNow (NOW) has proven the ability to gain market share beyond its core capabilities in the IT workflow space. It is also investing in technologies to add more value to its customers. Besides its growth factor, its margins trend and cash flow growth are also attractive. Its billings guide leaves little room to worry about liquidity. If it outperforms its growth guidance, the current valuation will offer more gains.

Demand (Rating: Bullish)

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Market Opportunity

ServiceNow estimates its total addressable market at ~0B. It offers cloud-based IT operations management and digital workflow solutions for large enterprises (80% of Fortune 500 companies and 8600+ global enterprise customers) across the globe. It is the highest-ranked player in the ITSM (IT service management) space.

There is no doubt ServiceNow has attained the escape velocity in which CFOs and CTOs will have no choice but to switch to its platform and increase usage given ServiceNow's deep penetration amongst large enterprises.

Potential

ServiceNow is capitalizing on the rapid adoption of digital transformation initiatives across large enterprises. Its large enterprise focus has spared it from the COVID-19 induced carnage, which mostly impacts SMBs, though 20% of its business comprises customers in the sharing economy.

Regardless, the ease of deploying its solutions means ServiceNow sees little downside impact implementing new projects. Service fulfillment partners will equally face limited disruption deploying ServiceNow's offerings.

Management remains confident in delivering double-digit growth this year. ServiceNow's growth guidance is a combination of a solid ARR (annual recurring revenue) base, expanding ACV (annual contract value) amongst large enterprises, and greenfield wins. Examining some of the numbers from the last earnings call, ServiceNow reported 37 deals greater than m (+48%y/y) in the previous quarter. 18 of the top 20 deals include three or more products.

These positive demand-side trends and catalysts drive my bullish conviction on ServiceNow's growth factor.

Business/Financials (Rating: Bullish)

Products

IT Workflow: includes capabilities in incident management, service management, operations management, and change release management. ServiceNow is following the general trend of SaaS companies enhancing the availability, efficiency, and user experience of customers using its solutions. This includes the release of new products like the Now mobile app, and a virtual chatbot.

Previously, it would take two to three minutes for managers to approve a simple request, but now it's a matter of seconds. Likewise, agents would battle through an incident form to log a ticket. With ServiceNow this effort has been reduced by over 50% in many situations. - Experian

Features like predictive intelligence, omnichannel capture, social tools are creative ways to drive user engagement and retention. ServiceNow is on the right path with its product strategy in this space.

Employee Workflow: this extends the use cases of its workflow technology into verticals like Finance and HR. Use cases in HR include knowledge management, document management, and employee onboarding.

With ServiceNow, our new hires get the information and support they need, when they need it. And, we're saving 0,000 and 18,000 hours a year in onboarding costs

In finance, ServiceNow provides finance close automation tools to help accounting teams. ServiceNow's solutions are meant to complement and integrate into existing ERP (enterprise resource planning) solutions.

Customer Workflow: ServiceNow has also found use cases in the customer service space. Capabilities in collaboration, knowledge management, and performance analytics offer convincing adoption of its offerings.

New digital workflows that integrate with the knowledge base have resulted in an overall 24% reduction in the volume of cases as customers adopt self-service, freeing up consultants' time to better manage spikes or progress from first to second level of support. - Basware

This also extends into capabilities in AIOps, asset management, and improvement management. ServiceNow has more than 50 CSM customers spending greater than m.

Now platform: ServiceNow also has an app engine and an app store to empower developers. This makes it easy to understand its huge success amongst large enterprises. Providing actionable insights and intelligence at scale using AI (artificial intelligence) and ML (machine learning) is an underexplored market in several IT verticals. ServiceNow has identified this opportunity, and it has invested a lot in the field of artificial intelligence and machine learning.

Financials

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ServiceNow's growth factor is attractive relative to the strength of its nearest competitor in the ITSM (IT service management) space. Having 933 enterprises paying more than m in ACV is not an easy feat. When a platform or solution attains such a level of market penetration, the case for continual adoption is even more compelling. Its success means it can build upon its years of experience to solve complex business problems for its clients. That's the power of the network effect at play. Throw in its expanding capabilities into adjacent verticals and its rapid pace of innovation, and we have an unstoppable player that is bound to keep winning in the near term.

The implication of these translates to improving margins as average revenue per customer grows. While acquisitions and R&D spend might mask its true earnings potential, with time, ServiceNow's margins will expand to reflect the maximum strength of its platform. ServiceNow has an attractive FCF (free cash flow) margin at 30%+. Going forward, maintaining a 30%+ FCF margin won't be tough as earnings become a bigger contribution to operating cash flow. FCF will also benefit from growing deferred revenue, and the potential release of its valuation allowance.

To the extent sufficient positive evidence becomes available, we may release all or a portion of our valuation allowance in one or more future periods. A release of the valuation allowance, if any, would result in the recognition of certain deferred tax assets and a material income tax benefit for the period in which such release is recorded.

Macro/Competitors (Rating: Bullish)

Competitors

ITSM: ServiceNow leads competitors in the IT workflow space by a significant margin. This is its bread and butter. The other player ranking as a leader in the ITSM space is BMC (recently acquired by KKR). Gartner claims NOW's ITSM revenue is more than 3x its closest competitor. An implication of its leadership position is that ServiceNow will be highly recommended by system partners and integrators. The flywheel has no choice but to spin faster as NOW gains more customers.

Low-code: a good use for ServiceNow's workflow solution is in the low code space. The low code market evolved due to a dearth of highly skilled software developers.

Low code application platforms abstract a lot of programming complexity to help enterprises develop, ship, and deploy apps faster. The leaders in this space include Microsoft (MSFT), Appian (APPN), Salesforce (NYSE:CRM), Mendix (acquired by Siemens), and OutSystems. Alongside Oracle (ORCL) and Zoho, ServiceNow is considered a challenger. While Alphabet (GOOGL) wasn't ranked, it recently made a low code acquisition in addition to App Maker. Going forward, winners in the low code space will rely on a combination of product innovation and platform adoption. ServiceNow is highly regarded for its depth of innovation. Adoption should naturally follow as users build creative projects that extend beyond incident management using its platform.

CRM CEC: ServiceNow plays in this space alongside leading CRM vendors like Salesforce and Zendesk (ZEN). This space also has ERP vendors like Oracle and SAP (NYSE:SAP). ServiceNow plays in this space because its workflow technology helps in the customer engagement process. Investors will begin to notice a pattern in which a productivity tool finds compelling use cases in adjacent verticals. Such a tool can dominate in other verticals if management is quick to innovate and master a winning sales strategy. This ensures it captures enough market share to keep expanding its average revenue per customer.

Asset management: ServiceNow's offerings also have use cases in IT asset management. This helps to monitor usage and IT license contracts to stay compliant with the latest regulations. The efficient deployment of asset management tools can also evolve into use cases that extend into the DevOps and cybersecurity segments. Leaders in this space include Flexera and Snow Software.

Before, gathering data for a single vendor audit cost us more than 0,000. With ServiceNow Software Asset Management, we can save millions on compliance fines and resource costs.

ServiceNow's strength in this space revolves around its ability to sell into its customer base. The potential to partner with DevOps and security players can help extend the visibility of ServiceNow's offerings. Like Elastic (ESTC) search extends into the APM and SIEM space, NOW's asset management solutions can disrupt the way consumers approach vulnerability management and DevOps.

Risk management: the IRM (integrated risk management) space involves the use of IT solutions to automate and aggregate workflow around risk management. Use cases include policy and compliance management, audit management, and business continuity management.

Cyberattacks, customer trust, new data protection and privacy compliance requirements, and the rapid adoption of new technology are introducing unanticipated risks.

ServiceNow is a leader in this space. Other top players in this space include IBM (IBM) and Dell (NYSE:DELL). ServiceNow's strength in this space stems from its global reach and strong partnership network.

Across most of the highlighted use cases, the ITSM space is ServiceNow's strongest niche. The low-code space is the most promising as it plays into the dearth of skilled developers across the globe. Management highlighted wins in the customer service management space, indicating its strong grasp of this space. There isn't enough evidence to doubt ServiceNow's ability to keep growing across all segments. Most organizations don't know how effective IT productivity tools are until they master their full capabilities. In most cases, mastery is accelerated when enterprises are aware that competitors are leveraging a tool to outperform. Expanding the capabilities of its offering will drive the value add to NOW's customers. This will translate into better margins and sustainable growth.

Macro

ServiceNow sells into large enterprises, most of which have built enough liquidity to weather short-term market volatility. Also, more enterprises will adopt ServiceNow in troubling times if their purchase strategy is to adopt the best ITSM vendor to match the productivity of their competitors. The major near term concern is the COVID-19 impact to 20% of its customers in the hospitality space.

Investors/Valuation (Rating: Neutral)

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Investors

The Street has been bullish on ServiceNow. NOW has recovered most of its COVID-19 induced losses. Management's guidance and conviction during the last conference call were positive. ServiceNow is now trading above analysts' average price target of 3. Analysts have an average revenue growth estimate of 26% in CY'20, and 25% in CY'21. These bullish sentiments and forecasts have lifted its valuation in recent quarters.

Valuation (Sandbox)

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ServiceNow enjoys a combination of solid growth, margins, and cash flow. These attractive valuation factors will continue to drive positive momentum. The Street is valuing ServiceNow for 25%+ revenue growth in the near term. While ServiceNow has the capabilities to deliver, it has to maintain the double-digit y/y growth to keep commanding a double digit sales multiple. There isn't enough negative headwind to prevent it from outperforming in the near term.

Risks

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Besides the impact (COVID-19 induced) to its customers in the sharing economy, ServiceNow's risk factor revolves around the oversubscription to cloud stocks. Most cloud stocks are trading at record-high valuation multiples.

Conclusion (Overall Rating: Outperform)

ServiceNow has a bright future. It is able to fight for market share outside its primary ITSM/ITOM space. Its strong ARR and renewal rate suggest customers are able to solve their business problems with its offerings. It is well-positioned in the midst of more competition as it expands beyond the IT workflow space. While it is priced for perfection, attractive valuation factors will continue to drive positive momentum. As a result, ServiceNow has strong potentials to keep outperforming in the near term.

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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