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Investment thesis
I think 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 software segments. As explained in my previous article in ServiceNow that can be seen here, the company has a core IT service management and operations business that is, in my view, a relatively defensive category in software as budgets for IT departments continue to grow. The company’s other segments serve as opportunities 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 deliver solid growth in a weakening global macroeconomic backdrop. While management continues to expect that their 2026 subscription revenue target of $16 billion plus can be met, this indicates significant revenue growth opportunities through 2026. With a cost structure that benefits from increasing economies of scale as well as improving sales efficiency within the organization , I expect we’ll see ServiceNow’s operating margins closer to those with the best margins like Microsoft ( MSFT ) and Adobe ( ADBE ). As a result, I’m more bullish on ServiceNow in the long term because we’re likely to see steady revenue growth along with improving and sustainable profitability as the company grows and becomes the best software company.
Well positioned for long-term organic growth
By looking at the longer term, management continues to see that they have a strong team that will be able to successfully grow the business. In addition, the emphasis is on an organic growth strategy, leveraging the strengths of the platform products to grow the business in a long-term and sustainable manner.
As a result of its focus on workflow-based technologies, it will unleash its future growth potential. CEO Bill McDermott believes we’ll see 750 million new applications built using low-code platforms in the next 2 years that will take advantage of ServiceNow’s focus on it. In fact, all of the company’s top 20 deals are low-code in nature, indicating that the company is ready for the future of application development.
I was also encouraged that Microsoft CEO Satya Nadella said he expects 75% of apps to be built using low-code technology. I think this further illustrates the point that these low-code offerings are reaching a larger and broader audience and seeing increased adoption which is where ServiceNow is well positioned.
On top of the low-code focus, ServiceNow brings a strong value proposition to its customers that will continue to drive organic growth in the coming years. This includes its platform being cloud-native, which allows it to drive real-time data across the ecosystem. In addition, by having a unified platform, ServiceNow enables customers to simplify the integration process across their organizations. As a result of the shortage of software developers worldwide, ServiceNow’s low-code development will make sense to many customers in the future.
I also liked that management emphasized 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 like it can use the strength of the platform to drive future sales. Second, it reduces the risk that management may make poor or dilutive M&A acquisitions that may not be to the benefit of investors. While management said that in the current environment they see decent discounts for solid assets, they would need to see a good opportunity for ServiceNow to consider moving from its traditional tuck-in acquisition strategy to more than large scale acquisitions.
I think ServiceNow expects that its emerging workflows like employee, customer and creator workflows will continue to see momentum as its customers look for more than one workflow. Because penetration in each of these segments is so low right now, the opportunity for ServiceNow in each of these workflows is huge.
Opportunity in a difficult macroeconomic environment
While I think the company will not be immune to a macroeconomic slowdown, there is no doubt that there are opportunities for the company as we see market volatility. As a result of difficult market conditions and a weakening macroeconomic environment, I think this bodes well for positioning ServiceNow 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 a weakening macroeconomic environment. By enabling automation and improving efficiency in various workflows such as ITSM, customer, employee workflows among others, I think potential customers can actually realize the importance of incorporating automation and business transformation in difficult times to emerge from it as a better and better one. organization.
Next quarter’s results are effectively de-risked
As we reflect on ServiceNow’s 2Q22 results, I generally think that expectations and estimates for 3Q22 have been effectively de-risked.
First, the company reported 2Q22 subscription revenue growth of 25%, and free cash flow growth of 16% year over year, both slightly soft.
On the other hand, current outstanding performance obligation (“cRPO”), grew by 27% year-over-year, in line with expectations. That said, guidance for cRPO in 3Q22 is 20%, softer than expected. Embedded in the softer guidance is the potential for further delays in large deals that the company has been experiencing since earlier in the year. Based on management’s commentary, I continue to believe that these deals that were delayed earlier in the year as well as those likely to be delayed in the current and next quarters will likely ultimately still close. As a result, since management has stated this as a delay in the deal, it is likely more of a timing issue rather than a reduction in demand or interest in their products. In fact, management explained that the deal cycle has lengthened because their customers now have to bring these large deals to the C-suite for approvals before they can be successfully closed.
If we consider the weakening macroeconomic backdrop, I think the downward guidance revision has sufficiently de-risked the 3Q22 results so that the current guidance and valuation look attractive at the levels we see today.
Appreciation
I use an equally weighted DCF and EV/FCF multiple method to value ServiceNow. I assume 2023F EV/FCF is 30x and the discount rate is 10%. I consider potential delays in deals and de-risk management guidance to account for the uncertain economic environment.
As such, my 1-year price target for ServiceNow is $520, which represents 46% upside from current levels. I continue to think ServiceNow should trade at premium multiples to peers given its best-in-class renewal rates and stronger growth profile as well as its long-term organic growth runway.
Risks
Industry competition
Although ServiceNow is currently the leader in its core ITSM offering, there is a risk that other players may enter ITSM to compete with ServiceNow or that existing players in the industry develop an ITSM offering that can compete meaningfully on ServiceNow. If that’s the case, ServiceNow’s core segment is at risk as it looks to retain market share. As a result of increased competition, this could lead to lower growth rates for the core segment as well as downward pressure on margins. With other well-capitalized companies such as Microsoft and Atlassian (TEAM) competing in the ITSM market, these companies may pursue a more aggressive growth strategy that may increase competitive pressure in the industry. As ServiceNow looks to strengthen its business in its other workflows where it is trying to gain market share, there are many other competitors within these markets who are specialists in their own rights which could increase competition among this particular market as ServiceNow tries to enter.
Macroeconomic environment
As I mentioned earlier, the core ITSM segment that makes up the majority of ServiceNow’s revenues is, in my view, quite defensive as IT department budgets continue to stretch. That said, in the event of a sharp and severe downturn in the macroeconomic environment, we could see a slowdown in deals, and result in a slower growth rate for ServiceNow, at least in the short term. As a result, there is certainly a risk that the macroeconomic environment could deteriorate so badly that even relatively more defensive software businesses could see slower growth.
Implementation risk
While I think management continues to work well on ServiceNow’s strategy, the multiple premium valuation investors are paying for ServiceNow would indicate that they expect nothing from management. As a result, if management is unable to execute, it could 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 their various product offerings, as well as strong secular tailwinds for in business as well as low penetration rates in newer workflow segments. I think the 3Q22 results are sufficiently de-risked and we may see some positive surprises in the results if management continues to perform well. With management’s continued emphasis on an organic growth strategy, it shows their confidence in growing the platform due to 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 be profitable and the nature of its core ITSM segment remains more robust than other software segments. As such, my 1-year price target for ServiceNow is $520, which represents 46% upside from current levels.