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Investment thesis
I think that ServiceNow (NYSE:NOW) is well positioned in the current macroeconomic environment as we are likely to see the benefits of its relatively defensive business compared to other parts of software. As elaborated in my earlier article on ServiceNow that can be found here, the company has a core IT service management and operations business that is, in my view, a rather defensive category in software as the budgets for IT departments continue to grow. The other segments of the company serve as opportunity for cross-sell and upsell as ServiceNow looks to gain share in their employee workflow, customer workflow and creator workflow segments respectively.
The next step for ServiceNow is to scale profitability while continuing to provide solid growth in a waning global macroeconomic backdrop. As 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. With a cost structure that benefits from the increasing economies of scale as well as improving sales efficiency within the organisation, I expect that we will see ServiceNow’s operating margins move closer to those with best-in-class margins like Microsoft (MSFT) and Adobe (ADBE). As a result, I am rather constructive on ServiceNow in the long-term as we will likely see solid revenue growths coupled with improving and sustainable profitability as the company scales up and becomes a best-in-class software company.
Well positioned for long-term organic growth
By looking longer-term, management continues to see that they have a solid team that will be able to scale the business successfully. In addition, the emphasis is on an organic growth strategy, leveraging on the strengths of the products on the platform to grow the business in a long-term and sustainable manner.
As a result of its focus on workflow-based technologies, this will bring forth its organic growth potential in the future. CEO Bill McDermott believes that we will see 750 million net new applications that are built using low-code platforms in the next 2 years that will play to ServiceNow’s advantages given its focus on this. In fact, all of the company’s top 20 deals were low-code in nature, implying that the company is ready for the future of application development.
I was also encouraged that Microsoft CEO Satya Nadella said that he expects 75% of apps will be built using low-code technology. I think that this further illustrates the point that these low-code offerings are reaching a larger and wider group of audience and seeing increasing adoption that ServiceNow is well positioned for.
On top of the low-code focus, ServiceNow brings strong value proposition to its customers that will continue to drive organic growth in the years to come. This includes its platform being cloud-native, enabling it to be able to drive real-time data across the entire ecosystem. In addition, by having one unified platform, ServiceNow enables customers to simplify the process of integration in their organisations. As a result of a lack of software developers globally, ServiceNow’s low-code development will make sense to many customers in the future.
I also liked that management emphasised that it does not need M&A for its strategy going forward. This has two implications. First, that the company sees a long runway in terms of organic growth as it looks to leverage on the strength of the platform to drive future sales. Second, this reduces the risk that management may make poor or dilutive M&A acquisitions that may not be for the benefit of investors. While management did say that in the current environment they are seeing decent discounts for solid assets, they will need to see an excellent opportunity for ServiceNow to think go shifting from its traditional tuck-in acquisition strategy to more of large scale acquisitions.
I think that ServiceNow expects that its emerging workflows like the employee, customer and creator workflows will continue to see momentum as its customers look to take up more than one workflow. Given that penetration in each of these segments are small at the moment, the opportunity for ServiceNow in each of these workflows is huge.
Opportunity in tough macroeconomic environment
While I think that the company will not be immune to a macroeconomic slowdown, there is no doubt that there are opportunities for the company as we see volatility in the market. As a result of tough market conditions and weakening macroeconomic environment, I think that this is good for ServiceNow’s positioning to enable automation and business transformation. With the ability to do more with less, ServiceNow’s value proposition becomes even more convincing to customers in times of weakening macroeconomic environment. By enabling automation and efficiency improvement across different workflows like ITSM, customer, employee workflows amongst others, I think that potential customers may actually realise the importance of incorporating automation and transforming the business in difficult times to come out of it as a better and more efficient organisation.
Next quarter results effectively de-risked
As we reflect on ServiceNow’s 2Q22 results, I generally think that the expectations and estimates for 3Q22 have been effectively de-risked.
First, the company reported 2Q22 subscription revenue growth at 25%, and free cash flow growth of 16% year on year, both of which were slightly soft.
On the other hand, the current remaining performance obligation (“cRPO”), grew 27% year on year, in-line with expectations. That said, the guide for cRPO in 3Q22 was 20%, coming in softer than expected. Embedded in the softer guide is the potential for further delays in large deals that the company has been experiencing since earlier in the year. Based on management commentary, I continue to take the view that these deals that were delayed earlier in the year as well as those that are likely to be delayed in the current and next quarter will likely still ultimately be closed. As a result, as the management phrased it as a deal delay, this is likely still more of a timing issue rather than a reduction in demand or interest in their products. In fact, management did explain that the deal cycle has lengthened because their customers now need to bring these large deals to the C-suite for approvals before they can be closed successfully.
When we take into account the weakening macroeconomic backdrop, I think that the downward guidance revision has sufficiently de-risked 3Q22 results such that the current guide and valuation looks attractive at the levels we are seeing today.
Valuation
I use an equal weight DCF method and EV/FCF multiple method to value ServiceNow. I assume 2023F EV/FCF of 30x and discount rate of 10%. I take into account potential delays in deals and de-risk management’s guidance further to take into account the uncertain economic environment.
As such, my 1-year target price for ServiceNow is $520, representing 46% upside from current levels. I continue to think that ServiceNow should trade at premium multiples over peers given the best-in-class renewal rates and stronger growth profile as well as its long-term organic growth runway.
Risks
Competition in the industry
Although ServiceNow is currently a leader in its core ITSM offering, there is the risk that other players may enter the ITSM to compete with ServiceNow or that current players in the industry develop an ITSM offering that can compete meaningfully with that of ServiceNow. If that is the case, ServiceNow’s main segment would be in jeopardy as it looks to maintain market share. As a result of increased competition, this may then lead to lower growth rates for the core segment as well as downward pressure on margins. With other companies that are well capitalised like Microsoft and Atlassian (TEAM) competing in the ITSM market, these companies may pursue a more aggressive growth strategy that can then ramp up competitive pressures in the industry. As ServiceNow looks to ramp up its business in its other workflows where it is trying to gain market share, there are many other competitors within these markets that are specialists in their own rights that might increase competition in these specific markets as ServiceNow tries to enter.
Macroeconomic environment
As I have alluded to earlier, the core ITSM segment that makes up the bulk of ServiceNow’s revenues, in my view, are rather defensive given that IT department budgets continue to be resilient. That said, in the event of a drastic and severe weakening of the macroeconomic environment, we may see a slowdown in the deals, and result in a slower growth rate for ServiceNow, at least in the short-term. As a result, there is definitely a risk that the macroeconomic environment may deteriorate so bad that even relatively more defensive software businesses may see slower growth.
Execution risk
While I think that the management continues to execute well on ServiceNow’s strategy, the premium valuation multiple that investors pay for ServiceNow would imply that they expect nothing less from management. As a result, if management were to slip on execution, this may result in a change in the multiples that investors are willing to pay for ServiceNow.
Conclusion
I continue to like ServiceNow for their best-in-class renewal rates, ability to cross-sell and upsell to their different product offerings, as well as strong secular tailwinds for the business as well as a low penetration rate in the newer workflow segments. I think that 3Q22 results are sufficiently de-risked and that we could see some positive surprises in the results if management continues to execute well. With management’s continued emphasis on an organic growth strategy, this shows their confidence in growing the platform given the low penetration of its new and emerging workflows. ServiceNow looks set to remain defensive in a volatile and uncertain macroeconomic environment as its business continues to scale profitably and the nature of its core ITSM segment remains more resilient than other parts of software. As such, my 1-year target price for ServiceNow is $520, representing 46% upside from current levels.
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