ServiceNow: Temporary Headwinds Give Long-Term Opportunities

ServiceNow office building in Silicon Valley

Miscellaneous Photography

Investment Thesis

Service Today (NYSE: NOW) is a platform-as-a-service business that helps global businesses across all industries digitize their workflows, defining the individual tasks that need to be performed to complete a specific job . In other words, ServiceNow it powers the core Now Platform that businesses can use to help maximize workforce productivity and efficiency, by ensuring employees are making the most of the software tools available to them.

ServiceNow platform

ServiceNow Q3’22 Investor Presentation

One of the most exciting aspects of ServiceNow as an investment is the company’s ability to launch new products and services, while expanding into new areas of technology such as robotic process automation and process mining. Then they have an existing base of customers to whom they can easily upsell – a solid land-and-expand strategy.

ServiceNow continues to release new product innovations

ServiceNow 2022 Analyst Day

Combine this with renewal rates consistently over 98%, gross margins over 85%, and a positive net income, then it’s no wonder this company has been a big winner for shareholders in the past decade.

Total ServiceNow Returns
YCharts data

But 2022 has been a tough year for ServiceNow, as it’s not immune to the macroeconomic turmoil seen across all industries. The company has seen shares drop more than 40% so far this year, and it has continued to cut its full-year revenue guidance.

The company just released its Q3 results, and investors are hoping for some good news to stop the share price from falling – so, did they get their wish? Let’s see.

ServiceNow Q3 Earnings Overview

Starting at the top, ServiceNow saw its revenue grow 22% to $1,831m, although it fell slightly short of analysts’ expectations of $1.85B.

ServiceNow quarterly earnings performance compared to analysts' expectations

Looking for Alpha / Author’s Work

In terms of outlook, ServiceNow provided fourth quarter guidance of $1,834-$1,839m for subscription revenue, representing 20-21% YoY growth. It is worth highlighting that ServiceNow only provides guidance on subscription revenue, but there is also a small portion of total revenue that falls into the ‘professional services and other revenue’ category.

The difficulty we have is that analysts’ expectations are based on total revenue, so one way we can compare guidance to expectations is by using growth rates. Analysts were expecting Q4 revenue of $1.98B, representing YoY growth of ~22.8%. Since subscription revenue often exceeds the growth rate of ‘professional services and other’ revenue, I expect to see ServiceNow’s total revenue in Q4 see YoY growth of 19-20% based on its guidance – meaning it currently falls short of analysts’ expectations.

In fact, looking at the changes in ServiceNow’s full-year guidance for subscription revenue, it’s clear to see where these revenue numbers are headed.

ServiceNow year-round revenue evolution guide

ServiceNow / Author’s Work

Management lowered its full-year revenue guidance for the second quarter in a row. This is not a good sign to shareholders, but it is quite understandable, and we will get to its drivers later.

Moving to the bottom line, and ServiceNow posted EPS of $1.96, which was above analysts’ estimates of $1.85 for the third quarter in a row.

ServiceNow quarterly earnings performance vs analysts expectations

Looking for Alpha / Author’s Work

This is at least a positive sign; even if revenue growth is hampered by poor macroeconomic conditions, at least ServiceNow still manages to deliver profitability ahead of expectations.

But what is dragging this company down? Well, there is one obvious place to point the finger…

Currency Headwinds Plague Service Today

A recurring theme seen among companies reporting in US dollars is the currency headwinds they all face. Over the past 12 months, the dollar’s strength against most major currencies has resulted in weaker results from US businesses that operate around the world – and because revenues outside North America cost more at 35% of ServiceNow’s total revenue, this company is not immune. .

USD exchange rate
YCharts data

Management is incredibly keen to highlight the impact of this unbridled wind, and I honestly don’t blame them. The extract below from ServiceNow’s Q3 investor presentation clearly shows the impact of foreign exchange rates on YoY growth – the blue column represents previous years’ growth, the light green column represents the growth of this year, and the dark green column represents this years’ growth on a constant currency basis (ie, if the value of the US dollar has remained constant over the past 12 months).

ServiceNow year-over-year subscription revenue growth trend

ServiceNow Q3’22 Investor Presentation

The big takeaway is the fact that the blue and dark green columns are almost identical, and on an FX-neutral basis, growth has slowed slightly for ServiceNow — and I expect growth to slow even further, as 2022 is a more difficult macroeconomic environment than the boom we saw in 2020 and 2021.

This currency headwind affects all areas of ServiceNow’s business, including RPO (residual performance obligations). It’s a key metric that helps investors understand how much contracted revenue there is currently unrecognized, making it a key indicator for future revenue growth.

ServiceNow outstanding performance obligations RPO trends

ServiceNow Q3’22 Investor Presentation

As we can see, RPO growth has slowed down over the past five quarters, and it grew by just 18% YoY in Q3’22. But, again, it was negatively affected by the strong US dollar – and the constant currency growth was 25%; still a big slowdown, but given the risk of a looming recession, it’s understandable to see businesses being more cautious about spending.

In reality, ServiceNow’s underlying business remains strong – currency headwinds and macroeconomic uncertainty were the biggest drivers of its weaker financial performance, but these should be temporary headwinds, perhaps providing a good buying opportunity to investors who with a multi-year time horizon.

NOW Stock Valuation

As with all high-growth, disruptive companies, valuation is difficult. I believe my approach will give me an idea about whether ServiceNow is overvalued or undervalued, but valuation is the last thing I look at – the quality of the business itself is more important in the long run.

ServiceNow (<a src=

ServiceNow / Author’s Work

In my base case scenario, I assume that management’s recent long-term revenue guidance through 2026 of at least $16B is achieved, and that comes with slight improvements in impressive free cash flow margins. I also assume that shares outstanding during this period will increase by about 14% in total, as ServiceNow wants some stock-based compensation.

ServiceNow's long-term revenue guidance

ServiceNow 2022 Analyst Day

My bull case scenario assumes that the slowdown in 2022 is short-lived, and that ServiceNow experiences an increase in its top line in 2023 as the economy adjusts itself. The company continues to release new products, and my bull case scenario assumes that they are used as growth levers to help the company achieve a revenue CAGR of 30% over time. I also assume that with this additional revenue growth comes additional scale and efficiency, with free cash flow margins reaching 35% by 2026.

My situation in the bear case effectively assumes the complete opposite; that ServiceNow continues to be hit hard through 2023 due to the macroeconomic climate, and the business itself has failed to regain its previously high growth rate.

Put all that together, and I see ServiceNow shares achieving CAGRs through 2026 of 3%, 14%, and 30% in my respective bear, base, and bull case scenarios.

Bottom Line

Looking at this quarter, ServiceNow seems to me to be a high-quality business that is currently experiencing temporary, macro-induced headwinds. For short-term investors, this could make ServiceNow too risky, but I believe the current share price could offer long-term investors a good opportunity to buy shares in a brilliant business at a reasonable price.

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