kontekbrothers
When attempting to look further out into ServiceNow’s (NYSE:NOW) 2023 outlook, the most recent quarter offers a glimpse into what the next year could look like.
Investment thesis
For investors looking to invest in long-term secular trends, I think that ServiceNow is a company that is relatively defensive in the current challenging macroeconomic environment that also offers a long-term organic growth opportunity.
The company looks poised to grow its core IT service management and operations business, while leveraging on the strong customer base it has built to expand into new cross-selling and upselling opportunities in the newer employee workflow, customer workflow and creator workflow segments.
At the same time, ServiceNow looks well positioned for strong growth in profitability as the company benefits from a cost structure that improves with increasing economies of scale and sales efficiency. The management continues to expect that their 2026 subscription revenue target of $16 billion plus can be met, this implies a substantial revenue growth opportunity until 2026.
Over time, I am of the view that ServiceNow’s operating margins will expand and approach to the levels of the best-in-class software companies. With both revenue growth and improving profitability, the company is poised to become a best-in-class software company.
I have written an earlier article on ServiceNow about the company’s defensiveness and long-term organic growth potential.
Execution and guidance give confidence for 2023
In general, what we saw in the recent third quarter results gave me increased confidence in the company’s execution and that things are actually not as bad as the market thinks it to be.
The cRPO for 3Q22 achieved a 150 basis points beat with the 25% year on year growth that it came in at, compared to the guidance of 23.5%.
The beat of 150 basis points warrants further analysis as they mainly came from Federal, and a slight pull forward of the 4Q22 renewal cohort. For reference, this was the best quarter ever for Federal as there was a $20 million deal and a few $10 million new ACV deals. In addition, the pull forward of the 4Q22 cohort to the third quarter was an intentional move and contributed to 50 basis points of the beat.
This showed me that management is able to execute well even as the company faces tough macro challenges. The macro environment remains challenging as management continued to point towards deal spillage continuing and some new businesses being pushed to 2023. I expect that the guidance for 4Q22 already incorporates the weakness in the macro environment and the expectation that management expects further deal spillage and new businesses being pushed to the next year, and furthermore, 2023 guidance will also incorporate some form of weakness as a result of the macro environment. In addition, I like that the deal execution in the 3Q22 quarter was quite encouraging, with the Manufacturing industry seeing strong growth as a result of a large 8-digit deal, while Retail and Hospitality saw 50% year on year growth. In addition, EMEA did really well in the 3Q22 quarter as well, giving further assurance that the deal environment in Europe remains resilient despite the macroeconomic environment.
While I acknowledged that the macro environment remains challenging, I think that the combination of a better managed guidance and idiosyncratic opportunities driven by strong management execution does provide further confidence in the company’s abilities to navigate 2023.
Guidance bodes well for 2023
With 50 basis points of pull forward from 4Q22 to 3Q22, I would have expected the guidance to remain reiterated. However, management guided that cRPO growth for 4Q22 to accelerate by 100 basis points to 26% growth year on year. This was a 50-basis point beat to the 4Q22 guidance for cRPO growth.
In particular, I thought it helped improve investor sentiment especially for 2023 as management said in the 3Q22 earnings call that their confidence in the fourth quarter extends to the next year. Furthermore, management stated that the current sales capacity and pipeline coverage are actually better and higher today than at any point in the year of 2022. This does give me increasing confidence in the deal environment and demand landscape for ServiceNow despite the fears of deals slippages and poor market environment.
4Q22 will be a large renewal cohort for ServiceNow and the management’s pull forward of some of those helped to de-risk the numbers for the next quarter. For 4Q22, management still expects to continue to momentum of 98% renewal rate in the quarter, which should be at a similar pace to 3Q22.
In addition, I liked that subscription revenue guidance on a constant currency basis was raised by 50 basis points and is expected to grow by 26% to 27% year on year, which is back to 1Q22 levels. Furthermore, management reiterated full-year operating margins although they experienced 100 basis points of incremental FX pressure. That said, free cash flow margins fell on FX headwinds as well as some additional payment timing impacts.
Macro impact in 2023
I am of the view that 3Q22 results and the earnings call commentary sounded more positive than the prior quarter, when the management actually lowered outlook and mentioned deal delays.
This quarter in 3Q22, they focused more on deals getting pulled forward from 4Q22, while Europe was surprisingly strong and comments that the management sees outlook improving.
That said, management reiterates that the demand backdrop is unchanged, with continued expectations of deal delays in 4Q22. However, the company has better visibility on the business now and the guidance has been reset and takes into account the deal delays and current renewal rates we are seeing. With guidance being reset higher, this also implies that the beat that we might see in 4Q22 might be smaller than in 3Q22.
In addition, with an incremental FX headwind of 100 basis points on operating profit margins and free cash flow margin in 2022, I expect that we can expect free cash flow margin to improve 100 basis points in 2023.
Valuation
Based on both DCF method and EV/FCF multiple method, I equal weight both methods to derive my value for ServiceNow. My assumptions for 2023 include an EV/FCF multiple of 30x for 2023 and a 10% discount rate. As management has mentioned about deal delays and difficult macro in 4Q22 and 2023, I incorporated the conservatism into 2023 to de-risk my forecasts to take into account the challenging macro backdrop.
My 1-year target price for ServiceNow is $531, implying 28% upside from current levels. As ServiceNow has a stronger growth profile and a strong track record of achieving this, as well as its best-in-class renewal rates, I think that the company should trade at premium multiples over peers.
Risks
Competitive pressures
Competition is fierce in the industry in which ServiceNow operates in. Even as a leader in its core ITSM offering, the company faces threats from new entrants into the industry, as well as deep pocket competitors in the industry that wants to expand and grow. These competitors may grow meaningfully and compete with ServiceNow’s offerings. This could be detrimental for ServiceNow as its core segment serves as its anchor and differentiating factor that has enabled the company to up-sell and cross-sell over the years. There are other well capitalized competitors like Microsoft (MSFT) and Atlassian (TEAM) that compete with ServiceNow in the ITSM market, with the potential to increase competitive pressures in the industry.
Furthermore, ServiceNow is looking to expand into other workflows, and to be able to gain market share in these segments, it needs to compete with the current incumbents there, who all have their own differentiating factors.
Macro backdrop
With ServiceNow’s core ITSM segment seen as a relatively defensive software segment as IT department budgets remain resilient. If the macro backdrop were to show further signs of worsening, this will definitely impact ServiceNow. This may show itself through a slowdown deal flow and slow growth rate for the company.
Execution risk
I highlighted earlier in the article that ServiceNow has shown strong execution, but the company needs to continue that or risk losing its premium multiple attached to it. Management needs to continue to show that they are able to execute well, deliver growth even in difficult macro conditions.
Conclusion
For 2023, while the global macro backdrop remains uncertain, I think that the outlook for ServiceNow looks good. Management is showing strong execution that helps to offset the weak macro backdrop. At the same time, guidance has been de-risked as management has taken into account potential deal slippages and delays into the forward guidance. The fundamentals are also improving as the deal environment continues to look resilient while the pipeline coverage has improved to the best it has been all year. If 2023 turns out better than expected in terms of the macro backdrop, ServiceNow is well positioned to capitalize that. If not, the company remains committed to execute well amidst difficult markets to continue to perform well in the long-term. My 1-year target price for ServiceNow is $531, implying 28% upside from current levels.
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