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Thesis on Investment
ServiceNow, Inc. (NYSE: NOW) is one of the leading workflow management platforms. Despite its stable FCF margins, NOW stock has also come under intense pressure recently, in line with its SaaS peers. The company uses digitization corporate IT spending trend. Furthermore, it has consistently posted 30+% topline growth while delivering FCF profitability over the past few years.
However, we think the competitive environment is likely to become more difficult over time, as it operates in a market with “relatively low barriers to entry,” as highlighted in its 10-K.
In addition, high -growth SaaS stocks with high -profit bulk may continue to be under considerable pressure as investors seek safety in more defensive games.
Due to its intense competitive landscape and the current macro environment, we rate the NOW stock as Hold.
NOW Stock is Not Cheap
NOW stock NTM normalized PE vs. peers (TIKR) NOW stock NTM FCF yield vs. peers (TIKR)
As seen above, despite recent value compression on SaaS stocks, NOW is still trading at a premium against its SaaS enterprise partners. For example, NOW stock was last traded at an NTM normalized P/E of 71.5x, which is earlier than 28.3x the stock of King of SaaS, Microsoft (MSFT). It’s also higher than the software industry’s median P/E of 34.5x. In addition, it is also ahead of its peers [Oracle (ORCL), SAP (SAP), Workday (WDAY), Salesforce (CRM)] listed above.
Moreover, management has often praised its profitability in FCF. However, we also think that a marked growth premium is priced on its stock. NOW stock last traded at an NTM FCF yield of 2.2%, in line with WDAY stock’s 2.2%. However, it lacks its other peers. Thus, ServiceNow investors must continue to have a firm belief in the implementation of the company’s growth. In addition, NOW investors should be prepared for significant value compression if the company is lacking in a more risk-averse environment.
Why Is ServiceNow Possible to Perform Low?
Given the high expectations embedded in the stock price, investors need to be wary of potential circumstances that could affect its valuation. Notably, the company added a new risk factor to the recent 10-K that could provide some insight into the penetration challenges of its business. Added ServiceNow (edited):
As we target more of our sales efforts to larger enterprise customers, we may face higher costs, longer sales cycles, greater competition, and less predictability on completing some of our sales.
Such sales require considerable time for the customer to review and test our platform before making a purchase decision, which requires us to provide a higher level of education about the use and benefits of our services.
These sales opportunities may require us to allocate greater sales support and professional service resources to individual customers, increasing the costs and time required to complete sales and shifting our own resources of sales and professional services to smaller numbers of larger transactions. (ServiceNow’s FY21 10-K)
Therefore, we think the company can face marked competition as it deepens into the larger business space. Therefore, the company needs to highlight these risks for investors to carefully consider in its strategic roadmap. In addition, we highlighted earlier that the company operates in a market with relatively low barriers to entry. Therefore, investors cannot underestimate the potential impact on its profitability, due to its growth premium and its relatively low EBIT margins.
ServiceNow SBC margins % GAAP EBIT margins % (S&P Capital IQ) ServiceNow LTM FCF % margins (S&P Capital IQ)
Management prefers to use the adjusted operating profitability guide because it eliminates the focus on its stock-based compensation (SBC) margins. However, we think it is critical for investors to consider the company’s GAAP EBIT margins, given its growth premium and intense competitive environment.
As a result, investors will notice that ServiceNow GAAP EBIT margins are very low, as the adjustment from its SBC is “hidden” in its relatively weak operating profile. However, we need to highlight that such observations are not limited to ServiceNow. Many high -growth SaaS players use SBC to increase FCF margins and reduce money burning. Therefore, it is critical that investors invest only in the best breed high-growth companies that can carve out their niche and competitive moat over time. These are necessary factors to justify their embedded premium and growth momentum.
ServiceNow cRPO (Company filing) metrics ServiceNow revenue share by region % (Company filings)
Furthermore, ServiceNow’s current outstanding purchase obligations ((cRPO)) metrics have begun to show some growth digestion. For example, NOW’s cRPO YoY growth dropped to less than 30% in FQ4, reinforcing its moderation trend. As a result, investors should continue to pay attention to this metric in the upcoming FQ1 earnings card.
Of course, the law of large numbers suggests natural moderation of growth. But, NOW is still trading at a marked premium against its peers. Thus, it is necessary for management to maintain the rhythm of its growth. Moreover, the company also has significant exposure in the EMEA region (26.6% of revenue in FQ4). Therefore, investors need to monitor the impact of headwinds coming from potentially weaker EU spending going forward.
Is the Stock NOW a Buy, Sell, or Hold?
ServiceNow is set to release its FQ1 earnings card on April 27. Thus, all eyes are focused on its cRPO growth and whether there will be a measurable impact on revenue in its EMEA region.
While we think the NOW stock valuation looks fair in relation to its historical metrics, we are concerned about its operating environment. Furthermore, we also find it difficult to justify its growth premium against its peers.
Therefore, we will require a steeper discount on its current price before it is considered. A drop back to $ 400 (20% downside) would be more attractive to consider advancing.
Consequently, we are NOW rating the Hold stock.