ServiceNow: Basics Stable, But Stock Worth Too Much (NYSE: NOW)

Thesis

Service Today (NYSE: NOW) is a SaaS company offering enterprise software suite with a broad portfolio of services around IT Management and Workflow automation and optimization. The company had a massive run over recent years but has recently been corrected in accordance with the general market and especially with tech stocks. I consider ServiceNow as a hold here, because it still trades at a high cost.

Throughout the article, I will also refer to ServiceNow as NOW.

Macro Tailwinds

ServiceNow claims to be a beneficiary of some secular tailwind. These tailwinds include a general shift in business models: Everything is moving digitally and companies that won’t make the move are left behind. The pandemic especially accelerated the use of technology and thus helped ServiceNow.

Low-Code is another tailwind for NOW. Many NOW software applications are low-code enabled and allow users to customize their workflows easily and seamlessly. This is underlined by ServiceNow being ranked as the Leader in the latest Gartner Magic Quadrant for Enterprise Low-Code applications.

ServiceNow recently raised its expected TAM to $ 200 billion, according to their expectations driven by newly added products and services to the portfolio. The macro looks nice and favorable for ServiceNow.

Running NOW on My SaaS Checklist

I have a checklist of factors to look at for SaaS companies, so let’s take a look at the final earnings report and see how ServiceNow is performing with regards to:

• Retention rates
• Customers of multiple products/number of modules
• Number of customers with revenue> 10 mil/100 mil
• Gartner magic quadrant positioning
• Margins
• Rule 40

Maintenance Rates

ServiceNow reports many useful metrics for us to review. The company reported 98% renewal rates in the last quarter with renewal rates remaining in the 97-99% range for the last 5 quarters. This indicates a churn rate between 1% and 3%, a good value. NOW services seem to be deeply ingrained in customers ’workflows, leaving very little reason to switch to another provider.

In 2021 NOW manages a 125% net expansion rate, so on average, an existing customer will spend 25% more than in the previous period. Sadly they don’t report it annually, but compared to 2020 it remained flat at 125%. They also published that 2/3 of their current customer base spends incremental dollars NOW, up from just 60% in 2020. This shows that more customers have decided to spend more on incremental services, but they also spend less on average. It’s important to watch this trend in the future: Is net expansion driven by more customers spending incremental dollars or by customers spending higher incremental dollars.

If retention is summed up, the renewal (or gross retention rate) is very good at 98% and the net expansion rate of 125% is also very healthy.

Customers of Multiple Products and Number of Modules

ServiceNow continues to offer new products to keep customers spending more incremental dollars each year. The pipeline is stacked and they expect three new products to be launched in the second half of the year on top of the seven product launches they already made in the first half. Expanding the ecosystem of services is one of the most important aspects of a SaaS company: New products serve two purposes, it keeps existing customers spending more and it gets more new customers then can also be sold along with other products.

Sadly NOW did not disclose how many products its customers used on average in 2021, but they did disclose it in 2020. We see that from 2016 to 2020 bigger deals took a big part. Deals on a product will be virtually non-existent in 2020 and will likely drop to approximately 3% by 2021. 5+ product deals now make up the majority of the share, a good sign of the stickiness and breadth of the offer. NOW.

Number of Large Customers

NOW has done a great job of raising incremental dollars for its large customers. I compiled the data from 2016 to 2021, with 2019 being an exception where I couldn’t find data. We see that all categories of customers are growing rapidly. The number of $ 1- $ 5 million customers grew 3 times over the period, $ 5- $ 10 million grew 8 times, $ 10- $ 20 million grew more than 4 times and $ 20 million customers grew 7.5 times.

Gartner Magic Quadrant Positioning

Gartner is a great resource to get an overview of a competitive landscape. I’ve already referenced the low code magic quadrant, where ServiceNow shares the leader position with companies like Salesforce (CRM) and Microsoft (MSFT). In the magic quadrant for IT Service Management Tools though ServiceNow is the undisputed number one according to Gartner. Especially in the fast -moving enterprise software landscape, companies need to constantly push boundaries and constantly change. Putting NOW here is a good indicator that they continue to do that.

Margins

Over the past decade, ServiceNow has been able to continue to grow its margins. Gross margins rose from the mid -50s to the high 70s, reflecting the company’s rising moat through the ability to take advantage of its competitive position and operate with higher cost efficiencies, as seen in rising profitability.

Rule 40

The rule of 40 is a metric to see if a SaaS company is growing healthily. The rule is calculated by adding the growth rate to the profit margin. There are different versions of the 40 rule, depending on the type of profit margin used. ServiceNow uses the Free Cash Flow margin and they are talking about the 60 rule. I prefer to use the Free Cash Flow margin as well, but I also want to talk about stock-based compensation. It’s pretty common for technology and especially in SaaS companies to give employees excessive stock-based compensation.

As we can see in the graphic above, stock-based compensation is almost as high as the amount of earnings and almost as high as free cash flow. I believe it is not fair to completely exclude these non-cash costs. While it may not hurt the company’s money reserves, it directly dilutes all existing shareholders and thus is a cost to shareholders.

The company calculates its rule of 60 with 30% revenue growth + 32% FCF margin, leaving them with 60 points. If we now exclude stock-based payments, we have a 12% free cash flow margin. The 30% growth + 12% margin leaves us at 42 in my calculation, still beating the classical rule of 40. Great.

ServiceNow is Still Appreciated

ServiceNow is a high quality company, but it also trades at high value. The company has not seen a drawdown to the extent of many of its peers in recent months. Many SaaS companies have dropped 70% and more, while NOW has fallen just 32%.

I would like to compare ServiceNow to another SaaS company that I consider to have the same high quality: Veeva Systems (VEEV). If you want to read more about the company, I wrote about Veeva in this article. ServiceNow is expected to grow a bit, while Veeva Systems is more profitable and still led by the founder. We can see that ServiceNow is trading in significantly higher multiples compared to Veeva Systems if we look at EV/EBITDA, PE, and FCF yield. On the basis of price alone in sales, they are equally priced (but we can’t forget Veeva’s higher margin).

Conclusion

ServiceNow is a high quality company with a good market position and predictable, low churn profits. I believe there are even better deals on the market today like Veeva Systems (which I personally own in my portfolio). If ServiceNow continues to fall and multiply contracts to approximately 40 forward PE, I would consider opening a position.

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