Miscellaneous Photography
It has not been a good year for software company investors. 2020 and early 2021 saw unprecedented stock price gains for cloud software companies as significant growth was pulled forward due to the pandemic. Since then, these companies were crushed. Check out these values below, graph courtesy of Jamin Ball’s Clouded Judgment Substack:
Clouded Judgment Substack
Note the gray line in the middle as the long-term pre-covid average valuation for the software-as-a-service cloud company. The average company is now trading back below the average value before all the madness started.
The company I want to highlight today is among the stalwarts of the cloud space, ServiceNow (NYSE:NYSE: NOW). This company isn’t necessarily as well known as many others, but is in the same league as Salesforce (NYSE:CRM), Adobe (NYSE:ADBE) and other similar big cap software names in my opinion.
The Business
NOW surprised many old-line companies when it was founded in 2004, such as IBM (NYSE:IBM). It’s a similar story with other cloud companies that have done the same or better job for an enterprise with little or no on-site infrastructure and thus cost less. In addition, cloud companies are able to onboard faster, in general, and depending on the customer still provide similar product personalization.
Cloud software is built on a land-and-expand model, where a product gets their foot in the door, and once the customer is well integrated, they subscribe to more and more. over time. See the graph below, which shows where NOW gets its revenue.
NOW Investor Presentation
Note customers from 2010 continue to grow their footprint in the company’s revenue breakdown. I will discuss what ACV is later in the article.
NOW started as a tech help desk function, automating employee IT needs and getting tickets to the right person in the IT department. From there, the company ballooned its offerings across the enterprise. In IT, the company offers automation of workflows in both IT Services and Operations by providing visibility and reducing time on administrative tasks for its customers. Additionally, the company grew through HR onboarding automation for new employees, customer automation of front-end customer requests like password resets, etc., and created an app store allowing customers to build their own low-code solutions within the NOW platform.
These solutions are very sticky, and NOW’s target audience of the world’s largest companies gives the company significant stability over the long term because those companies are less likely to fail or want to change when something works. NOW boasts 99% customer retention in the most recent quarter, and has a history of maintaining 97-99% figures for long periods of time.
More than 75% of customers buy more than one product, and 85% of new business for the company comes from existing customers. In addition to that, the average contract value has doubled in the last three years. These metrics show why SaaS companies used to command the bulk they do, considering that revenues are predictable and grow quickly.
Tech buzzwords and industry-specific performance metrics
One thing you may notice as you start looking at these SaaS companies is the love of industry-specific metrics and buzzwords. It drives me crazy sometimes, and not all companies define metrics the same way. I’ll just reference a few below from sources around the internet to help you look at some of the data below.
ACV – Annual Contract Value – average annual contract value of your account subscription agreements. For companies that also charge a one-time fee along with recurring fees, the first-year ACV may be higher than subsequent years’ ACV in a multi-year contract.
ARR – Annual Recurring Revenue – the amount of recurring revenue of business subscription terms normalized to a calendar year.
RPO (C in front stands for current) – Outstanding Performance Obligations – represents the total future performance obligations arising from contractual relationships. More specifically, RPO is the sum of the invoiced amount and the future amounts that have not yet been invoiced for a contract with a customer.
I think that’s all I want to cover here, but trust that there’s more, and it’s important to look at as many disclosures as possible to understand what exactly the company is trying to show you.
Recent Company Performance
NOW Investor Presentation
NOW’s most recent quarter showed few signs of slowing down for the company. Subscription revenue growth accelerated 3% to 29.5% on a constant currency basis. RPO grew 27% constant-currency, and customer numbers were solid with 22% growth in customers over $1M ACV and 50% growth over $10M.
Projections from the latest earnings call:
Mainly to reflect the incremental $87 million headwind we’ve seen from FX since the end of March, we now expect subscription revenues between $6.915 billion and $6.925 billion, representing 24% year-over-year growth . That’s 28% growth on a constant currency basis in line with the original outlook we gave in January. We continue to expect a gross subscription margin of 86%, up 100 basis points year over year. We continue to expect an operating margin of 25%, as we currently plan to offset the estimated one point impact from FX with operational efficiencies and disciplined cost management. We will continue to monitor FX rates over the next two quarters.
FX headwinds will continue to affect the company as the dollar maintains its strength, and there will likely be some recessionary pressure on contracts as companies potentially feel the pinch and may not choose to expand their offerings. Management stands by projections for $11B in ARR in 2024 and $16B in 2026, which are solid goals considering the $5.5B total in 2021.
Something to consider as you look out over the landscape in a bear market. NOW serves large companies across the market landscape. While they may see some slippage in growth in the broader economic pain, companies are generally reluctant to cut technology budgets. When NOW is integrated into their workflows, moving or trying to create solutions in-house can make a big difference in lost productivity. Because of this fact, many of these B2B SaaS companies are quite defensive and isolated in a period of market uncertainty.
Another thing to look for in promotion is increased competition. NOW competes with some of the heavyweights in the tech space, and as the company continues to expand its offerings, it may even end up in competitor spaces. One particular area to monitor is the customer segment, which was once dominated by CRM.
Many cloud companies caught up in the chaos have adopted some pretty poor shareholder practices, most notably significant stock-based compensation as a recurring expense cloud (no pun intended) measure of ability. profit for prospective investors. NOW’s share count has slowed its rapid rise from its early days as a public company. I’ve got the 10-Q below, and for the most recent 6 months ended June 2022, stock-based compensation was calculated at $677M, with 1.4M shares issued and 600K from the settlement of warrants. The company currently carries $5.4B in cash with $1.6B in debt on the balance sheet, and is generating enough free cash flow with an expected margin of 30% to continue to fund growth.
To put some perspective on share-based compensation, it’s not something I like to see, and it’s prevalent in the technology sector, even more so in unprofitable companies. Again from the Clouded Judgment Substack, NOW’s SBC accounts for 19% of revenues. Snowflake (NYSE:SNOW) is at 41%, Palantir (PLTR) at 38%, ADBE just 8%. NOW’s SBC levels are at a median of 22% for this growth phase.
Company Filing – 10-Q
Clouded Judgment Substack
Looking at the landscape, I’ve attached some more useful metric comparisons from Clouded Judgment. NOW sits slightly above the median valuation when comparing earnings growth to the company’s price to earnings multiple. It’s the same price as ADBE and CRM, and I think it’s likely that the company’s profitability and relative stability earns it a premium over some of its less profitable names compared to the above.
Looking at the chart below, the key metrics against some peers are listed. Note that NOW comfortably meets the Rule-of-40, and management has set their bar at the Rule-of-60, defined as a revenue growth rate added to FCF margin of more than 40%.
Clouded Judgment Substack FASTGRAPHS
Since the company is profitable, I will include the FAST graph here. Based on the company’s long-term valuation, the company is trading well. It is approaching many others in line with its actual earnings growth rate, and is currently at about 51X blended P/E. With these high-growth companies, there is a ton of uncertainty when applying a valuation. Looking at the cloud landscape, companies are trading below their long-term mean from pre-COVID. NOW is relatively in-line with peers considering its growth rates, and is a strong defensive software company, well entrenched among the largest companies in the economy. Morningstar assigns a fair value estimate of $675 per share, which puts the company at about 53% of current fair value. I think the company may face some recessionary pressure on its growth rates, but it will come out of this market stronger than it has been in my opinion. I own shares since 2018 and I keep adding to it.
Disclaimer: This article is for informational purposes only and represents the author’s own opinions. Not a formal recommendation to buy or sell any stock, as the author is not a registered investment advisor. Please do your own due diligence and/or consult a financial professional before making investment decisions. All investments involve risk, including loss of principal.