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Investment Thesis
Service Today (NYSE: NOW) has caught the attention of many investors recently because it is a company that has managed to grow rapidly in an environment where other companies are struggling to stay profitable. Additionally, ServiceNow is a profitable company with excellent cash flow generation capabilities, so it is no surprise that it has reached a market capitalization of more than $140 billion.
However, the fact that it is currently trading at a P/E of 396 poses an important question: “Is it worth the money?”
The short answer is NO. I don’t believe ServiceNow will outperform the market in the long run and I rate it a sell.
ServiceNow Business Model
ServiceNow Business Model (medium.com)
By using ServiceNow, a cloud-based workflow automation platform, enterprise firms can increase operational efficiencies by streamlining and automating common work operations.
About 95% of ServiceNow’s revenue comes from subscription fees; the exact amount a client must pay depends on the features they need and the level of customization.
The company has three (3) sources of income:
1) The Current Platform
The Now Platform is a pre-built solution with several features that can be used with both custom apps and cloud services. Web services offered by the Now Platform include edge encryption, automated testing frameworks, performance analytics, and reporting. Additionally, there are higher tiers of functionality available for customers who want better personalization.
2) The Endless Cloud
The cloud architecture that ServiceNow uses is known as the “Nonstop Cloud,” and it works continuously. Nonstop Cloud is secure, reliable, and adaptable to meet the needs of individual clients while still complying with international laws.
3) Cloud services
The five categories that make up cloud services are business software, security, customer support, HR, and IT. Each area is further divided into a number of sub-functions, including project portfolio management, rapid development, incident response, and customer and staff satisfaction. The percentage of consumers who renew contracts when their subscriptions expire is known as the renewal rate.
Renewal Rate
Renewal Rate (ServiceNow IP)
The percentage of consumers who renew contracts when their subscriptions expire is known as the renewal rate.
The fact that ServiceNow has a renewal rate of 99% indicates that the services it offers are of high quality and worth its customer’s money as they are willing to pay for it again and again.
This will help the company to limit its expenses and thereby increase its margins compared to maintaining the existing customer, acquiring new customers is five times more expensive.
Stock Basics And Prices
Although ServiceNow is a $70 billion company, it has still managed to grow its top line revenue at a tremendous rate every year since it listed on the stock market in 2012.
However, this high growth and the strong financials that characterize the company are not reflected in the stock price as it has fallen about 50% from its all-time high of $707.60.
Now that the price has reached $355, many investors may believe that this is a good time to buy the dip, but is this really the case?
ServiceNow P/S is 9.39 compared to its sector median of 2.50. The company also trades at a relatively high P/E GAAP (TTM) of 396. Investors typically only pay for this kind of valuation in the early stages of a company’s growth among the fastest-growing ones. A company will expand more slowly as it ages, and the P/E ratio will typically decrease. So, for ServiceNow’s P/E to be reasonable, the business must have a very promising future in addition to a strong moat.
According to analysts, ServiceNow checks at least the first box as the revenue forecast for the company is 20%-25% for the next 4 years. But is that enough?
At the end of the day, without profit, the increase in sales is meaningless and at this point NOW is almost unachievable, with a net profit margin of 2.79% even though it has been profitable since 2019.
ServiceNow – Balance Sheet
Looking for an Alpha Looking for an Alpha Looking for an Alpha
I would say that the balance of ServiceNow is neither good nor bad. The company’s long-term debt is more than I’d normally like to see, especially in a high-rate environment, but it’s manageable. The value of its total assets is greater than the total liabilities that the business has, which is reassuring for the company’s investors because they know that the company is unlikely to go bankrupt in the near future. However, I would like to see its current liabilities higher than its total future liabilities just to have a bigger margin of safety.
Valuation, Is It Worth the Risk?
Author’s Calculations
This time, I’ve been more aggressive with the revenue growth rate, just to prove my point, projecting a CAGR of 19% for the next 6 years. I keep the FCF margin at 31%, about the same as it is now. I believe 31% is quite reasonable as it is high enough for a SaaS business but low enough to cover the case of increased competition which will cause margin pressure. Add to that a P/FCF of 20 (which is also quite aggressive if we consider the fact that historically, the average P/E ratio of the S&P 500 has fluctuated between 13 and 15) and you get a price of future $601.26 in 2028.
By buying the stock at $355.42, even in the bull case scenario that the above numbers come true, you will have an annualized ROI of less than 8%. By investing your money in an ETF that tracks the S&P 500, you will have an average ROI of about 10% as history has shown by taking less risk as you put your money in the 500 largest companies that listed on stock exchanges in the United States rather than just one.
So is ServiceNow really worth it?
Risks
Competition
The only notable risk I see at the moment is competitive pressure. There are many other players who can create items to rival the company’s offering, which can put the company under even more competitive pressure. Furthermore, if these players adopt a more aggressive expansion plan, the many businesses active in the ITSM industry will result in increased competitive pressures. Additionally, there are specialized competitors in each industry that ServiceNow enters beyond the more established ones, which can compete with it and make operating situations more difficult for a new entrant.
Conclusion
Overall, ServiceNow is a good business with strong fundamentals and a decent balance sheet; just not the right price. Personally, I would consider buying the company’s stock below $200. At $355, it’s not worth the risk for me and I’d rather put my money into another stock that I consider a bargain.