As detailed in our previous article and full report, we believe that ServiceNow, Inc. (NOW or the "Company") is grossly overvalued. Our research indicates that growth will become incrementally more challenging, as much of the 'low-hanging fruit' (i.e. BMC's dissatisfied customers) has already been captured, the limited ITSM market size places a ceiling on the Company's revenue potential, and SaaS alternatives to NOW emerge in the ever-changing ITSM sector. Should revenue growth continue to slow, we think that investors will begin to recommit themselves to a more sober valuation, given ServiceNow's current $5bn market capitalization versus $239m of 2012E revenue.
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Our concern with NOW's stock price appears shared. Two weeks ago, ServiceNow's early investors began selling NOW shares well ahead of their original lock-up schedule. ServiceNow's June 2012 IPO Prospectus disclosed a lock-up agreement that prevented insider sales until December 26th. But on November 9th, six weeks ahead of the original lock-up expiration, ServiceNow waived these lock-up commitments and allowed insiders (primarily JMI Equity, a 50% shareholder) to sell 14.2m shares at $28.00 (Nov 15th Prospectus, Nov 20th Press Release). That equates to approximately $400 million worth of NOW shares that were dumped on the public markets by insiders.
In addition to the large insider share sale, ServiceNow itself diluted existing shareholders with the issuance of 1.9m new shares (Nov 20th Press Release). We question the intentions of this dilutive offering since the Company already had $256.5m of cash as of Q3 (10-Q), seemingly more than enough to fund organic growth. We think the capital raise was a sign that management itself believed the stock was overvalued, and wanted to raise capital at inflated prices before the stock price declined to more rational levels.
This combination of insider sales and fresh equity fundraising activity could encourage investors to shift their attention towards grounded fundamental analysis rather than the amorphous hype that currently envelops the stock.
Growth has Slowed since NOW was Priced at $10.20 in February 2012
Just nine months ago (February 21st), NOW sold 2.45m shares at $10.20/share to Greylock Partners, a venture capital firm (page 70 of Nov 15th Prospectus). Greylock's investment has appreciated from $10.20/share in February to $32/share today for an annualized return of over 200%. Yet, between February 2012 and today, NOW's revenue growth has declined materially. The Company was growing revenue at 21% sequentially when the $10.20/share investment was first made. Today, NOW is only growing revenue at 9% sequentially, based on guidance in the Q3 earnings report, yet the stock has appreciated to over $30/share.
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Sources: NOW's IPO Prospectus, Nov 15th Prospectus, Reuters, and Q3 earnings report.
This trend is not sustainable. In fact, NOW shares fell 12% after its Q3 earnings report when it announced sequential Q3 growth slowed to 13%. Should the Company continue to decelerate in 2013, we expect NOW's valuation to quickly revert to a valuation multiple more in line with its peers.
Precedent Transactions Show that a Buyout is Unrealistic at this Price Level
Some investors may disregard ServiceNow's nosebleed valuation multiples, arguing that the Company might one day be a takeover target. This thesis, while highly speculative, is probably the result of a few widely publicized SaaS deals such as SAP's $3.5bn acquisition of SuccessFactors, an HR management firm. Yet, SuccessFactors had LTM revenue of $292 million in the quarter prior to its buyout (see 10-K and 10-Q here), which infers an EV/LTM revenue multiple of 12x. This itself is extraordinarily rich acquisition price, and numerous analysts including S&P criticized SAP for overpaying, but that multiple is still nearly half of NOW's current 22x EV/LTM revenue valuation multiple. Prior to the acquisition, SuccessFactors had grown revenue by 55% over the last twelve months. Since the multiple paid should be related to growth, let's apply this relationship to NOW's growth to compute a theoretical buyout price. In the chart below, we provide valuation multiples of selected precedent transactions in the SaaS space. Other deals used in our analysis include Oracle's (ORCL) $1.9bn acquisition of Taleo, IBM's $440m acquisition of DemandTec, and Oracle's $1.6bn acquisition of RightNow.
In the final column above, we've compared LTM revenue multiples vs. growth rates over the same period. Using the average of the two highest-growth deals (these are most comparable to NOW's growth), the figure of 4.98x tells us that for every 5% of growth, a SaaS buyout can be awarded one turn of revenue. Using this logic, then a growth rate of 30% would be worth a 6x LTM revenue multiple, 40% would translate to 8x, and so on.
We can use the 5% rule-of-thumb to approximate ServiceNow's 'M&A' value under various growth scenarios. For the fourth quarter of 2012, the Company has guided to a revenue range of $69 - $71m. If we use the mid-point of that range ($70m), ServiceNow will grow by about 8.8% QoQ or 45% on an annualized basis. If we charitably assume that NOW beats this guidance and grows at 50% through 2013, this translates to an LTM revenue multiple of 10x. As shown below, this equates to a NOW 'M&A' price of only $17.50/share.
In our opinion, the M&A upside scenario does not exist for ServiceNow at its current price level.
As a final point, we do not believe that ServiceNow is an attractive acquisition target at its current share price due to the limited market size of the ITSM sector. Whereas SuccessFactors, Taleo and RightNow addressed large market opportunities, NOW's end market is more restricted in comparison.
NOW Insiders Sold Shares Ahead of Original Lock-up Expiration
Beyond our very genuine valuation concerns, we think that the hasty sale of 14.2m shares by insiders ahead of an originally disclosed lock-up date betrays a lack of confidence in the stock. According to ServiceNow's IPO prospectus, the vast majority of its shareholders were originally subject to a 180-day lock-up. As a group, these holders represented 106.2 million common shares, or roughly 87% of the outstanding common stock as of the IPO. A remaining 2.5m shares were subject to a lock-up until February 21, 2013. But just as investors were leaving their desks for the weekend on November 9th, ServiceNow filed an amended S-1 to push forward their first share sale by over a month.
This sudden modification of the lock-up structure does not inspire investor confidence. Investors should ask themselves: why were insiders so eager to sell $400 million of NOW shares that they could not wait another month for their lockup to expire. After all, JMI first invested in ServiceNow in 2005 - after 7 years of backing NOW, what's the big deal about waiting another 40 days? Our interpretation is that JMI and other insiders know full well that NOW is wildly overvalued and its shares are unlikely to remain at current prices much longer. As such, we believe these insiders were so eager to cash out that they could not even wait until December 26th to sell down their stakes.
NOW Continues to Dilute its Existing Shareholders
While the secondary offering that closed on November 20th was predominantly used as a conduit to allow insiders to sell their shares before the lockup expiration, the equity offering also raised new capital for ServiceNow. Specifically, NOW sold 1.9m newly issued stock at $28/share, or more precisely, $26.88 after the underwriting discount, which equates to about $49.9m in proceeds (pg 30 of Nov 15th prospectus).
We believe that this freshly dilutive equity issuance is yet more evidence that ServiceNow is highly overvalued. ServiceNow hardly needs the newly raised capital. As of its Q3 quarter-end, the Company had $256.5m of cash and equivalents on its balance sheet. Over the last nine months, the Company's cash flow from operations minus capital expenditures has been roughly breakeven (10-Q Q3 2012). Given the large cash balance and the fact that NOW is not burning cash at a material level, it seems that the cash was not raised for any near-term business purpose. Rather, we believe that management viewed NOW's stock as overvalued and wished to raise capital at an inflated valuation before the share price declined to a more realistic level. The offering suggests that management believes that NOW stock is rich even at $26.88.
A Final Way to Examine Valuation
When we compare NOW's valuation multiple to other disruptive SaaS providers, many of which we believe are highly overvalued themselves, it sticks out as an outlier. For instance, NOW's CY12E and CY13E revenue multiples are double those of RP, ET or CRM.
Yet, long holders may argue that NOW has brighter growth prospects, so as a final analysis, let's examine NOW's expected growth from now to 2015, and consider the company's valuation multiple based on those 2015 figures.
Analysts currently estimate 2014E and 2015E revenue for NOW to be $525m and $662m. We find this hard to believe given the recent revenue growth deceleration trends. In Q4 2012, the company forecasts sequential revenue growth to be 9%. If we assume 9% sequential revenue growth in 2013, 7.5% sequential growth in 2014 and 6% sequential growth in 2015, which equate to 47%, 36% and 29% overall annual sales growth rates in 2013, 2014 and 2015, respectively, we only get to $615m of 2015 revenue, not $660m.
Of course, this assumes that NOW executes on its growth targets. We believe this is a tall order, given the material revenue growth deceleration experienced in the past few quarters. Given its limited market opportunity, the high switching costs between product offerings, and the regular entry of competing products, we believe that ServiceNow's 7% - 10% sequential quarterly growth is unsustainable. Also, as we discussed in our previous report, we believe that NOW's addressable IT Help Desk market is only $1.5bn - $2bn. Going further, Gartner predicts that only 50% of IT companies will move to a SaaS model by 2015. This cuts NOW's addressable market in half. Should we accept the consensus scenario that NOW captures over half of this $1bn addressable SaaS IT Help Desk market in just two years, we believe that at that point, NOW would have significantly limited additional growth opportunities.
Yet even if NOW does achieve analyst targets, the stock still trades at 7.5x 2015E revenue. In comparison, salesforce.com is projected to grow 34% in the twelve months ending January 31, 2013, and yet it only trades at 7.5x revenue today. So if we assume NOW should trade at 7.5x revenue in 2015, which equates to the current ~$32 stock price, and discount that back by a 15% discount rate to today, we get to a stock price of only $21.
No matter how much one believes in ServiceNow's product and management's ability to execute, the stock itself appears highly overvalued by almost any metric. Revenue growth has slowed sequentially in each of the first three quarters in 2012, yet NOW's stock price has risen from $10.20 in February (Greylock transaction) to $32.63 today. This inversely proportionate relationship between growth and value is simply unsustainable. Once investors come to terms with NOW's limited growth prospects, NOW shares could quickly fall from their stratospheric 20x 2012E revenue multiple to one more in-line with their ITSM and SaaS peers. Investors seeking a buyout similar to SuccessFactors or Taleo will also most likely be disappointed. The revenue multiples of these deals suggest that NOW would be lucky to earn a 10x LTM revenue price, implying a ~50% drop from the current share price.
This value discrepancy hasn't escaped the attention of insiders. These shareholders appear to have circumvented NOW's original December 26th lock-up date by six weeks to unload 14.2m shares at a post-fee price of $26.88/share (Nov 15th prospectus). We wouldn't be surprised to see even more discounted share offerings hit the market in the coming months.
Disclosure: I am short NOW.
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