In our first two reports, we argued that ServiceNow, Inc. (NOW or the "Company") is extremely overvalued. We offered a wide range of data points that helped us arrive at that conclusion, including revenue growth deceleration, market size limitations, and accelerated insider selling, amongst others. In this article, we'll provide additional granularity on the wave of headwinds faced by the stock, including unrealistically high Q4 expectations, a tripling of the float in February, and valuation errors made by parts of the sell-side analyst community. Additionally, we've included quotations from the ITSM peer review website (helpdeskreport.com) and third-party independent experts that show that ServiceNow has its fair share of dissatisfied customers. Once these customers begin to voice their frustrations, this discontent could reverberate through the industry, making new account wins become increasingly challenging.
We believe that ServiceNow's current valuation is reflective of a temporary frenzy rather than fundamental risk-adjusted, discounted cash flow analysis. Regardless of NOW's technology profile, the stock trades at a price that makes it an exceedingly risky investment. We believe that a combination of overlooked option dilution, unrealistically high earnings expectations, and lockup expirations could cause the investment community to reconsider the medley of risks inherent in this momentum stock.
Many Wall Street Analysts Neglect Option Dilution in their Share Price Targets
As we first mentioned in our November 15th report, financial databases such as Capital IQ and Bloomberg have neglected to include NOW's highly dilutive option pool in their market capitalization figures. This has led some investors to mistakenly source incorrect valuation figures when defending NOW's stock price. According to NOW's November 15th prospectus, the Company has a 37.3m share option pool with a weighted-average exercise price of $4.48 (page 7 of the prospectus). These options must be considered in addition to 1.1m restricted stock units. At NOW's current price of $26.20 per share, the Treasury Stock Method allows us to calculate a 30.9m share dilutive effect from the option and restricted stock pools. These issuable shares must be counted alongside NOW's 125.3m (includes 0.2475m greenshoe) common shares, leading to a true share count of 157.3m and a current market capitalization of $4.1bn.
While we weren't completely surprised that some financial databases overlooked the option pool, we're astounded to learn that numerous bulge bracket equity research analysts appear to have made the same mistake. One of the most heavily cited figures in the typical analyst report is the price target. In order to properly calculate a price target, the analyst must first determine the proper diluted share count. After reading through the sell-side reports on NOW, we noticed that about half of the analysts calculated their price targets using only the common shares. As should be expected, this mistake has a material impact on the price target. We've found that analysts using an incorrect share count have an average price target of ~$40 while those that utilize a fully diluted share count have an average price target of about $32.
Below is a summary of the seven bulge bracket equity research analysts, broken down into the banks who included and excluded the significantly dilutive impact of options.
It is shocking that the analysts from Wells Fargo, Deutsche Bank and Citigroup do not appear to include the 30m+ additional shares from dilutive options in their market capitalization calculations. Their share count calculations are off by nearly 25%. This is inexcusable.
We have set up a website at www.facts-about-servicenows-total-share-count.com to express our dismay. The current site is sparse, but we have high hopes for it. Inspired by Bill Ackman, we hope to launch an activist campaign to get the equity research community to properly calculate ServiceNow's total share count.
Considering that the 30.9m share effect from the options increases the market capitalization by about 25% (30.9/125.3), it's logical that the difference in average share price between the groups ($40 and $32) works out to about the same amount. As management continues to dole out even more stock-based compensation to attract talent, the option pool should only get larger. The Company has reserved an additional 11.6m shares for future issuance under the 2012 Equity Incentive Plan and 5m shares under the 2012 Employee Stock Purchase Plan (page F-26 of the Nov 15th prospectus). In the real world, as opposed to ServiceNow equity research fantasyland, these additional options will further dilute common shareholders.
Highly-Priced SaaS Names have Unrealistically High Expectations
During each quarterly earnings season, Wall Street and cloud software management teams typically undergo a well-rehearsed dance routine. In the first act, management sets financial expectations unduly low. Then, to everyone's apparent surprise, the company serendipitously beats those original estimates. This carefully orchestrated performance is meant to trigger a rowdy applause from the investor audience, presumably so that the show's front row viewers, the venture capital firms, can quietly sneak out the door to escape the long queues for the exits when the tragicomedy is over.
But, alas, the market isn't that naive. Increasingly, overhyped cloud IPOs are suffering dramatic price declines even when earnings releases beat analyst estimates. NOW's most recent quarterly report was a perfect example. NOW beat the consensus Q3 2012 earnings estimates by almost 4%, yet the stock fell over 10% the day after the October 24th release. The clearest explanation for this is that NOW's 16x 2012E revenue multiple comes with a price: incredibly high expectations. Not only must NOW beat its guidance, it must do so very convincingly. NOW reports its Q4 earnings on January 30th, 2013 and the consensus revenue estimate is $70.6m (CapIQ). Failure to surpass these expectations by a double-digit percentage could lead to another sharp price correction.
Deeper examination of this trend reveals a widespread disaffection for high-multiple SaaS companies that only modestly beat Wall Street's revenue targets. Splunk (SPLK), a 'Big Data' SaaS software provider with a $3.4bn fully diluted market capitalization (10-Q Q3 2012) and a 16x 2012 revenue multiple (Jan 31 year-end), beat its third quarter revenue guidance by over 11%. That still wasn't enough for most investors; the stock fell 6% over the two-day period after the earnings release.
Palo Alto Networks (PANW) is network security firm that also utilizes a subscription-based revenue model. PANW boasts a $3.8bn market capitalization (10-Q, Oct 17th prospectus) and a similarly rich valuation of 11x 2012E revenue (Jan 31st period end). PANW's Q1 revenue results exceeded the consensus target, yet the stock still fell 5%.
A final example, though we've found more, is Bazaarvoice (BV), a SaaS business that provides an online analytics tool to examine online reviews, ratings, and social commentary about a customer's brand. Before the earnings results, BV's share price had already taken a beating as lock-up expirations, mounting earnings losses, and overpriced acquisitions quickly led to a re-rating of BV's valuation multiples. But even after a more than 50% price correction between October and late November, BV shares fell an additional 5% after it reported in-line revenue results. After this 55%+ correction, BV now trades at a more realistic revenue multiple of about 3.5x 2012E revenue (10-Q, Jul 17th prospectus, CapIQ).
Sources: Capital IQ, November 5th Press Release
Momentum investors should take heed of these case studies and the unrealistically high expectations embedded in NOW's current valuation. Combine this with a nearly unprecedented near-term share lockup waterfall and even the most optimistic NOW bulls could begin to have reservations.
An Avalanche of Share Lock-up Expirations could Nearly Triple the Public Float in February
As if unrealistically high growth expectations aren't enough to warrant caution, NOW will also experience headwinds from outsized lock-up expirations that begin just two days after the January 30th earnings announcement. According to the schedule in the November 15th prospectus, 42.7m shares will be released just two days after the Q4 earnings release (January 30th). This would more than double the public float. Just two weeks thereafter, the lockup on another 47.5m shares expires. Even in the most bullish scenario in which these shares are sold rationally over time, insider sales could create a long-term headwind for the stock. In a more bearish scenario, any sign of panic can cause a stampede for the exits as venture capital insiders rush to crystallize their already astronomical gains, or as the market anticipates them to do so.
After the post-Christmas lockup expiration on December 26th, over 3.4m NOW shares traded hands in a single day. Compare that figure to NOW's typical daily volume of 850k and one can see how active lock-up days are for a stock. The selling pressure clearly had an impact on the stock as NOW shares fell 5.4% on December 26th.
As we discussed in our previous reports, the venture capital firms Sequoia and JMI Equity are the principal shareholders of the 90m shares set to free up in February. Instead of selling shares directly and returning cash to the LPs, these VC firms could choose to instead distribute their shares directly to the LPs. This was the tact taken by many of Facebook's VC investors. However, a distribution could lead to rushed share sales as the LPs unload the stock. This article from Fortune states the problem plainly, "Remember, many LPs don't have in-house equity trading desks. That means that they are effectively forced to liquidate shares immediately via a third-party broker." Such immediate selling could have a much more negative impact on the stock than if JMI or Sequoia sold the shares directly over an extended period.
The Market is Overlooking a Growing Collection of Customer Complaints
Beyond the financial headwinds and the potential mass exodus that may be triggered by the lockup expirations, our diligence continues to confirm that ServiceNow's core Help Desk product isn't as infallible as many long investors believe. The most bullish Wall Street analysts would have investors believe that ServiceNow is head and shoulders above the competition. But in reality, the NOW product has its difficulties just like the other ITSM providers on the market.
We did not have to look far to find negative opinions of the NOW Help Desk software. If one queries "ServiceNow review" on Google, the fourth result (after employee reviews and a pair of generic spec sheets) leads to the website helpdeskreport.com. Based on the below comments, selected for their high peer ratings, many NOW customers are unsatisfied. Some have even nicknamed the company Service-Impossible or Service-Later.
Selected HelpDeskReport.com Reviews
"Unfortunately I have to agree with the people complaining about performance. I know that my company is one of the so-called references of Service-Now but let me say that the opinion expressed in that document is not really shared by us who have to work with the system. It looks decent, it is certainly better than the home grown system we used to have, it has all required functionalities (though all a bit shallow and not always [too] well thought of). BUT, performance is one big disaster! We often call it Service-Impossible [emphasis added]."
Grace Beckett (helpdeskreport.com)
Feedback: 12 positive, 2 negative
"I was so hopeful about Service-Now when we brought it in, after replacing BMC's Remedy, but I now wish we would have just kept Remedy [emphasis added]. They just aren't ready to handle organizations like ours. We are a multi-hospital system and have about 200 concurrent users in the system and the latency is unbelievably slow. We've worked with their tech support for many hours over multiple weeks and [are] just not getting anywhere."
Feedback: 11 positive, 3 negative
"Service-Now was implemented in my company about a year ago. Everyone on the field agrees it has been a complete disaster.
- Performance is generally poor and sometimes very poor. Users call it Service-Later [emphasis added].
- This is probably the most user unfriendly system ever created.
- The database structure is so complex (read chaotic) that reporting is extremely difficult to manage. After a year with Service-Now, most reports still cannot be trusted.
I would summarize this review by saying that it feels like the people who created Service-Now did so after reading an ITIL manual but never actually worked in a Helpdesk environment. Otherwise, Service-Now would not be so painfully awkward."
Selected Quotations from Kerrisdale's Independent Calls
We also did our own diligence calls. These calls confirmed our belief that NOW's growth has likely been the result of an aggressive marketing machine rather than a world-beating product.
Independent ITSM Consultant 1
Intensive customization increases the costs to ServiceNow…
"Customization is not recommended because…if you start customizing, it becomes more expensive for [NOW] to maintain and they can't pass on the [typical SaaS] cost advantages…If everyone is using the same features, it's much cheaper for them."
… leading to a larger expense base over time
"The major problem that a lot of the older vendors have is that they have a big installed base… which you need to support and maintain."
Independent ITSM Consultant 2
The ServiceNOW Help Desk product is not particularly innovative
"Innovation is needed in terms of implementation strategy…and having worked at one of the vendors at a reasonable level of visibility…problem management and change management is a commodity and has been for some time"
"For ServiceNow…the actual application itself is not particularly innovative…it's not the product, it's the [SaaS] model and the way that they sell it…The downside of that is that they are hitting their toxic point…capability to deliver is struggling. They have a partner network but that has its own problems as BMC will tell you"
"Guys who sold washing machines" don't understand ITSM
"They have this policy of let's get as many Fortune 500 customers as possible... [NOW] hired this new sales force… guys who sold washing machines and don't understand IT or ITSM but are very aggressive. And at the same time they have to start to deal with a lot of problems with their existing customer base. [Customers] are coming back and saying, 'what you gave us was great but we want to take this to the next level' and [NOW] doesn't have that type of capability… and they are really at that difficult point where they are trying to grow into the next level but their existing customer base is starting to come back and give them some problems."
Independent ITSM Consultant 3
NOW product demos utilize a 'smoke and mirrors' selling approach
Upfront implementation expense could go up for end-users
"Pre-IPO… they were saying whatever you spend for a license, your professional services will cost you like 40% of that cost. What's the scope of work? Whatever the sales rep promised. Now that was easy enough to do because they didn't have any internal professional services with the costs associated with that… what they had were some partners who they could throw this out to. And the threat [to the partner] is if you're not going to do this for the customer, then we aren't going to send you any more work… we are sending you so much work that it's frustrating for you but you're making money."
"what they've done now [after] the IPO… they are building up their own professional services department, and having done that, no, they won't do [implementation] for 40% of [the license cost] not knowing what [costs they'll incur]… that's why they're moving to time-and-materials."
Independent ITSM Consultant 4
Timing had a lot to do with NOW's initial success
"Everyone was talking cloud, cloud, cloud… and I think timing has had a lot to do with [why ServiceNow was successful]… the product was in the right place at the right time."
NOW's overly aggressive marketing machine
"The other thing about ServiceNow is that they were very aggressive in their marketing… by aggressive I mean that they were very positive about what their product could and [about what their competitors] couldn't do…and they really drove the argument very strongly."
Independent ITSM Consultant 5
Implementations could take longer than expected
"ServiceNow is complicated, but the perception in the marketplace is that ServiceNow is easier to implement. I'm not going to confuse that with reality… I personally think that ServiceNow is going to take some hits to their reputation since they've grown so quickly… I don't think they're capable of delivering quality because of their growth… [NOW's] reputation will take a hit when some of these implementations take longer than they should or aren't going to produce [adequate] outcomes… that is potentially an issue for them…. I believe that [ServiceNow] is living on borrowed time.
Independent IT Consultant 6
Rapidly emerging SaaS competitors could erode NOW's pricing power
"I don't believe [ServiceNow] will be able to maintain their price point over time just with what they've got in the toolset… customers are going to be coming and asking for new capabilities and as new vendors come in and offer those … I think smaller firms have the advantage (the Cherwells, the Hornbills of the world)…are more nimble… And I don't think the whole 'go build it yourself' idea… makes sense."
The opinions of these industry experts converge on a few central themes, all of which poke holes in NOW's seemingly impermeable valuation. Many customers prefer NOW since it's a fully-customizable SaaS solution. But customization leads to more cumbersome upfront implementation (both time and costs). Before the IPO, NOW would shift this cost burden onto third-party partners, who helped absorb the workload. But now, in order to fulfill Wall Street's sky-high growth expectations, NOW will increasingly bring this work in-house. As NOW takes ownership of the implementation responsibilities, the services should become more expensive for end-users, who have come to expect robust coding assistance at a low price. These issues provide room for smaller, more nimble SaaS competitors to encroach into NOW's customer accounts and intercept new contract wins.
The Technology Hype Cycle Forebodes a Waning Interest in NOW
In our opinion, ServiceNow's Help Desk software is a perfect example of a product at the peak of its hype cycle. Gartner, the well-regarded research firm, has an excellent chart depicting a typical technology hype cycle. A typical technology launch can trigger widespread publicity and investor excitement, leading to a 'peak of inflated expectations.' Next, as forward-thinking industry participants realize that the technology isn't foolproof nor are competitors wholly obtuse to change, the peak precipitously falls into a 'trough of disillusionment.' Eventually, if the technology is proven out, it will plateau at a modest level of productivity.
By proving that demand for SaaS Help Desk software exists, NOW has inadvertently encouraged BMC, HP, and CA to invest in SaaS products and incentivized capital inflows to smaller ITSM peers. Cherwell Software, a well-regarded NOW competitor, received a $25m growth equity investment from Insight Venture Partners in late November 2012. An increasingly crowded marketplace will negate NOW's first-mover advantage and lead to a lower visibility profile over time.
Google Trends provides anecdotal evidence that NOW's prominence in the marketplace peaked with its heavily promoted IPO but has since diminished.
(click to enlarge)
Source: Google Trends, keyword: "ServiceNow", January 2010 - January 2013
If we wish to impart one takeaway, it's that even good businesses can be terrible investments at the wrong price. Based on the headwinds mentioned in this report, as well as our two previous NOW articles, we continue to believe that ServiceNow's stock is dangerously mispriced at 65x 2014 EBITDA. In our mind, the clearest explanation is that Wall Street believes NOW has a near-guaranteed monopoly on the $1.5bn Help Desk market. But the diligence that we've cited leads us to believe in an alternate scenario. Disillusioned customers will continue to voice their discontent while newly energized SaaS competitors push to steal new business from NOW. These competitive headwinds combined with an avalanche of lock-up expirations, option dilution, and impractically high expectations could cause investors to question the risk profile of this richly-priced stock.
Additional disclosure: Please read our full legal disclaimer at the end of our report: kerrisdalecap.com/wp-content/uploads/201....pdf