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Investment Thesis
Service Today (NYSE:NYSE: NOW) is an IT service management and workflow productivity company. This is a business that almost always reveals 98% to 99% customer renewal rates.
ServiceNow is a strong cash flow generating business already well positioned to withstand a recession, that’s the thesis I noted in my before bullish article on ServiceNow. And since then, over the past 2 months, the stock appears to have been an underperformer.
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Usually, I wouldn’t call it underperformance. However, since the “junkier” tech stocks have risen over the past 2 months, I believe it is better to be upfront with this dynamic.
However, I would argue that the bull case here is found in its free cash flow line. That said, I’m feeling bullish because the macro backdrop has weighed on ServiceNow’s near-term prospects.
Therefore, weighing all the different sides, I remain calm on this name.
The Trend of Income Growth Rates is Declining
NOW’s income growth rates
Over the past few years, being a global company has had a big advantage. Companies have achieved scale and can continue to seek growth at any cost. As we’ll discuss shortly, ServiceNow doesn’t fit into that bucket.
After all, ServiceNow has consistently reported solid non-GAAP profitability. But I’m getting ahead of myself, because we’re about to discuss its profitability.
The theme for large multinational technology companies is to seek exposure far and wide. Today, multinationals are struggling on two fronts. One is temporary and the other is permanent.
The temporary effect that the market is looking at is currency headwinds. This holds back companies’ revenue growth rates by about 300 to 600 basis points, and ServiceNow is no exception.
A second headwind that is both more serious and uncertain concerns Europe. Companies like ServiceNow see Europe creating barriers to their businesses.
Along these lines, ServiceNow CFO Gina Mastantuono had this to say on ServiceNow’s recent earnings call,
[…] we expect the extended deal cycles we experienced in the last two weeks of June to continue for the rest of the year.
Then, these comments were repeated at a conference in September,
[…] what we’ve seen is, deals that get a higher level of scrutiny and more approvals just lengthen that sales cycle.
However, in both cases, Mastantuono moved quickly to reassure the investment community that he was “confident” ServiceNow would meet its guidance.
ServiceNow Close Prospects
ServiceNow believes that as more companies are forced to be frugal with their budgets, as many businesses have seen the proliferation of workflow platforms, the industry is now looking for platform comfort.
The drive is not only to drive efficiencies across the workplace but also to reduce companies’ overall costs.
For their part, ServiceNow is making the case that even if the sales cycle is lengthened, it won’t struggle to meet its revenue targets.
However, the big focus here from the investment community is that ServiceNow’s current remaining performance obligations (cRPO) is down to 21% y/y, down from 29% y/y in Q1 2022.
In practical terms, ServiceNow’s cRPO is a leading indicator of the trajectory that its revenue growth rates will recognize over time.
Ideally, investors like to see software companies’ cRPO numbers that are higher than their revenue growth rates, or at least match those revenue growth rates. What investors don’t want to see is the decline between cRPO numbers and revenue growth rates.
Obviously, management will make the argument that investors shouldn’t be so short-sighted and overly focused on a quarter’s results.
On the other hand, keep in mind that any investor who has invested in this stock for the past 2 years is unlikely to hold on to the gains. Therefore, these dynamics hurt its share price for a while, it is not just the performance of a quarter.
Next, we turn our attention to discussing its profitability profile.
Focused Profitability Profile
The following are ServiceNow’s GAAP operating margins:
- Q2 2021: 4%
- Q3 2021: 5%
- Q4 2021: 2%
- Q1 2022: 5%
- Q2 2022: 1%
What you see is a business that barely reports GAAP profitability. And for a while investors didn’t realize that many software companies had excessive stock-based compensation, but over the past few months, investors have increasingly questioned whether some of these businesses aren’t as profitable as we once thought. regards
Ultimately, the whole point of paying for these recurring business models is that they should see significant “clean” free cash flows coming back to shareholders.
Furthermore, full-year free cash flow guidance at the end of Q1 2022 is for a 31% free cash flow margin, while recent headwinds have dampened these prospects so ServiceNow is only guiding for a 30% free cash flow for the year as a whole.
However, since Q1 2022 reported a 45% free cash flow margin, while Q2 reported only 16%, investors are now skeptical that in 2023 the free cash flow margins of ServiceNow may not jump back higher, but may actually drop below 30%.
Since the business has more than 60% of free cash flow for H1 2022 made up of stock-based compensation, investors are rightly asking “what’s left for me?”
NOW Stock Valuation — 11x Next Year’s Earnings
By 2020, a business that can reliably grow at 20% CAGR investors will easily be poised to 10x forward sales. The problem for ServiceNow is that we are not in 2020 yet. In fact, we are close to 2023.
And 2023 will not only be a more challenging environment for companies with exposure to Europe, which is likely to be in the majority of a significant recession, not to mention that the comparison with H1 2022 will be heavy, to say the least .
Then, to further complicate the investment thesis, investors are not being asked to pay 10x this year’s earnings, but 11x next year’s earnings.
When many software companies are priced at roughly the same price as ServiceNow but can be expected to grow at a faster rate, it’s hard to get too excited about ServiceNow.
Or perhaps investors might be willing to pay a slightly higher multiple, but look for cybersecurity companies that are not only likely to be more defensive plays, but also expected to continue to grow at a faster rate than ServiceNow. .
The Bottom Line
Gradually the water circulates. The winners of the previous bull market are rarely the winners of the next bull market.
There’s a lot to like about ServiceNow, for example, the fact that it’s a blue chip enterprise, with significant global reach.
The problem here is that the multiple hasn’t come down enough to give new investors in the stock much of a margin of safety.
On the other hand, the business clearly reports strong free cash flow. Even if there is a temporary dip in its free cash flow profile, investors can feel reassured that ServiceNow is very well set up to have long-term free cash flow.
Consequently, when all the positives and negatives are weighed, I remain slightly bullish on this name.