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After much research in the SaaS ITSM (IT Service Management) industry, I have made a shocking discovery. ServiceNow (NYSE:NOW), one of the most highly valued cloud companies (its Price/Sales is around 20), is not only having a hard time attaining new customers, but also uses an outdated technology which is falling behind its competitors.

I agree with UBS which put out a research report on 12/19, rating NOW as a Sell and stating that it is the least preferred stock in the software space for 2013. UBS cited its steep valuation, declining growth, aggressive competition, and lock-up risk. But I believe things can potentially be worse for ServiceNow than even UBS says it is.

ServiceNow is the leading SaaS (Software as a Service) ITSM (IT Service Management) company in the industry today. It was started in 2004 with the following vision: to steal the unhappy customers from the big four ITSM legacy vendors: BMC (NASDAQ:BMC), Hewlett Packard (NYSE:HPQ), IBM, and CA Technologies (NASDAQ:CA).

Now, eight years later, ServiceNow has successfully accomplished its goal. However, where is it going to get its growth now? All the very unhappy clients of the big four have already left and gone to ServiceNow. The ones that are still with those firms are mostly content and very reluctant to leave.

A colleague who is researching ServiceNow spoke with a relatively new salesperson in the company. This guy joined ServiceNow about a year and a half ago, and it took him over a year to get his very first sale. He left another software company to work with ServiceNow, because he thought it was "the next big thing". He thought that there would be plenty of easy prospects in his territory, the mid-Atlantic region. However, he learned the hard way that the low hanging fruit had already been picked, and the ServiceNow software is actually a very tough sell.

ServiceNow Can Only Sell To Big Enterprises

ServiceNow only works directly with companies and enterprises that have 7000 or more employees. A smaller company that is intereted in ServiceNow's SaaS is referred to ServiceNow's partners. ServiceNow specifically targets the largest legacy vendor customers, because that's how the company was built.

From NOW's Q312 earnings call, Frank Slootman, NOW's CEO said:

"We are moving into larger customers, we have a focus on global 2000 Enterprises, we explicitly target them."

Darroll Buytenhuys, President of SAManage, another SaaS ITSM company, said: "From an organizational standpoint, it's easier to scale up than scale down. With scaling up you want to get bigger and are dealing with big companies. But it's hard to then deal with smaller companies"

SAManage is a SaaS ITSM vendor that only targets companies with under 10,000 employees. There are also many other SaaS ITSM vendors that dominate the small to middle market companies and ServiceNow can't compete with them.

"We are not a competitor to ServiceNow," said Mr. Buytenhuys. "ServiceNow is a one of a kind SaaS ITSM vendor in that it has the capacity to target big companies. Its only competitors are those large legacy firms that are looking to hold on to their customers."

The fact that ServiceNow can only sell to big firms is one of the reasons why it is a tough sell. ServiceNow salesmen have to talk to numerous executives and committees of the prospective enterprise customer before a sale is made. Then the company has to consult analysts to see if switching to ServiceNow is a wise choice, and the whole sales process can take months.

Big companies are reluctant to change their service help desk because of the costs and inconvenience. They would need to retrain all their technicians and reprogram their computers. It's much easier to stay with who they have been using for many years, unless they are very annoyed with the old system.

Listening to NOW's 3Q12 earnings call, Mr. Slootman says that ServiceNow's accelerated growth is over. Some things he said were:

"We are where we think we need to be at the current time, and we think we will continue to do that going forward. The growth won't accelerate because the numbers are getting bigger every quarter."

"We've hit our headcount hiring target in our marketing/sales. In terms of productivity, we've hired so many new reps that it is taking longer in terms of getting people ramped up, but we are pleased with the quarter overall."

"We see the legacy vendors fighting hard with price and looking to slow down the attrition."

ServiceNow Discounted Cash Flow Valuation

To figure out NOW's value today, it's useful to predict its future cashflows and discount them back today. For this valuation, I used a discount rate of 10%. I came to 10%, because for a company that has fairly predictable cash flows and low risk, like Walmart, a 6% rate is appropriate. For a company that has future cash flows that aren't certain, like ServiceNow, and therefore has more risk, an increased discount rate is necessary. 10% seems about right.

The following models are using ServiceNow's long-term financial targets as stated in its Q212 earnings call. In the call, Michael Scarpelli, ServiceNow's CFO, said:

"We ultimately aim to reach a non-GAAP gross margin between 68% and 70%, sales and marketing of 29% and 31% as a percent of revenues, research and development of 11% to 13% as a percent of revenues, general and administrative of 4% to 6% as a percentage of revenues, and an operating margin of approximately 20%."

(click to enlarge)

The above model calculates an enterprise value of $13.59 per share for NOW. Add the roughly $300 million in net cash the company currently has, and its net present value is $2.447 billion, or about $15.50 per share. This model generously assumes that ServiceNow will average 10% quarter on quarter revenue growth for 2013 and 2014, for a total annual growth of 46.4%. 10% revenue growth is the company's guidance for Q412. It only had 12.2% revenue growth in Q312 from 21.2% in Q212. So to assume that it's growth will continue at 10% even though it declined in Q312 and is expected to decline in Q412 is a little bit optimistic, but it is OK for this model and realistic in my opinion.

This model predicts a 46.4% annual growth in 2013 and 2014, 26.2% annual growth from 2015-2017, 12.5% growth from 2018 to 2022, 5% growth from 2023 to 2025 and a perpetual 3% annual growth rate thereafter. If the company slips on growth in the next couple years, then a more appropriate share value would be between $8-$15 per share. The worst case scenario for ServiceNow would be if one of the big four legacy vendors comes out with a multi-tenant ITSM solution in the next 2-3 years that appeals to big enterprises and steals customers back from ServiceNow. Then NOW shares should have a value today of under $8.

Next, lets look at a discounted cash flow model that represents how much the market expects ServiceNow to grow based on its current enterprise value of about $29 per share. Adding the $300 million cash balance, the net present value comes to $4.872 billion, or $30.8 per share, which is roughly where the stock is trading now.

(click to enlarge)

As shown in the above model, for NOW to be worth $30.80 per share, it would have to average 12% quarter on quarter revenue growth for 2013, to total 57% annual growth. Then, it must average 10% quarterly revenue growth for years 2014, 2015, and 2016, to total 46.4% annual growth for each of those years. Unless ServiceNow has an ace in the hole, I believe investors are overly optimistic to think that the company will now average 12% qoq growth in 2012, and continue with a 10% qoq growth for the following three years. Remember, this isn't just getting 10% growth for one quarter, but the company has to reach it or average it every single quarter for the next four years. This model also requires that ServiceNow will have annual revenue growth of 31% in the years 2017, 2018, and 2019, 12.5% growth from 2020 to 2022, 5% in 2023 to 2025, and have a perpetual annual growth rate of 3% each year thereafter, which will enable it to grow to over $5 billion in revenues by 2030. These are big expectations for a company which I believe already has outdated technology.

ServiceNow Uses An Outdated, Labor Intensive, Single Tenant Solution

"The key element of SaaS is its subscription base. So the big argument is: is single tenant SaaS truly SaaS?" asks Mr. Buytenhuys.

While more nimble and easier to use SaaS ITSM software from companies like Cherwell, SAManage, and EasyVista use a multi-tenant solution, ServiceNow still uses a single tenant solution. This requires ServiceNow to have a lengthy implementation period which, per a report from Kerrisdale Capital, can take 6-8 months and tens of thousands of dollars in implementation costs to get the system up and running. Necessary periodic upgrades required by ServiceNow are also inconvenient for the customer and can take a long time. This usually requires a programmer to go on premise and manually update the company's computers.

Compare ServiceNow's single-tenant implementation period with SAManage's multi-tenant solution. With SAManage, clients use it first, and then customize it later. "Customers that use our two week free trial are often fully customized before they even become a paying customer," said Mr. Buytenhuys. SAManage updates its software every Sunday, and this only requires a few minutes of downtime at the most.

Mr. Buytenhuys states in a blogpost on ServiceNow: "the "multi-instance" model and the fact that ServiceNow has some on-premise customers (the architecture allowed them to do this), has lead to ServiceNow having all of the challenges that the replaced vendors have struggled with. The basic fact that ServiceNow has hundreds of instances makes them look and act more like an older legacy vendor than a modern SaaS vendor."

If you, as an investor, want to invest in a high price/revenue valued SaaS company that enables an enterprise to work more efficiently, then I would take a look at Workday (NYSE:WDAY). Unlike ServiceNow, Workday embraces the multi-tenancy concept, and is the true SaaS leader and innovator. Here, Workday describes the importance of multi-tenant software and the difference from traditional software companies.

ServiceNow's Service Is Not "Now"

EasyVista is another example of a SaaS ITSM vendor that is very easy and intuitive to customize. It is codeless, which means a non-programmer can easily learn to customize it to the firm. Although EasyVista is a publicly traded French company and most of its clients are in France, it is aggressively moving to the United States.

"We recently replaced an unhappy ServiceNow customer," said an EasyVista product specialist who asked to remain nameless. "The customer was unhappy with ServiceNow's lack of commitment with an installation, and wasn't thorough with its program work. I've heard that a few times before, that ServiceNow isn't committed to the client after getting the sale," she said.

A couple days ago I experienced a demo of SAManage's ITSM and ITAM (IT Asset Management) software programs. I was amazed at the width of things that SAManage's programs cover. Its service desk product covers all forms of employee communication and monitoring, including incidences, risks, requests, and support tools.

I was amazed at how easy it is for anyone to customize the controls. For example, in the requests section, you can add more modules (for example if an employee wants a new phone), you can configure the screen to add more requirements (like the color of the phone), you can make it a free text or dropdown menu, and you can change the order of requirements in the menu. All this by simply dragging and dropping or clicking the plus and minus signs. It's very intuitive and easy to figure out.

I asked the SAManage demo specialist if a ServiceNow user could do any of this on his own? "Nope", he said. "With ServiceNow, even the simplest of modifications would require a programmer to change the code."

This surprised me. I asked him: "Why would a large company want to deal with all the complexity of ServiceNow's single-tenant model and spend more money too, when it could just simplify things and do 95% of what is needed with a multi-tenant, intuitively simple,self-customizable model like yours?"

"You're preaching to a converter", he said.

Source: ServiceNow's Technology Is Not 'Now' Anymore