ServiceNow (NYSE:NOW) announced fourth quarter 2012 results yesterday and we'll readily admit that the headline numbers appeared strong. NOW grew quarterly revenues by 17% sequentially and the company guided to revenue of $81.5m - $82.5m for Q1 2013 and gave full year revenue guidance of $387m - $389m. Billings, a measure indicative of sales momentum, grew to $97.6m from $81.2m in Q3 2012. We congratulate the NOW team on a good quarter (Q4 press release, 2012 Q3).
But even at these growth rates, NOW's stock is absurdly overvalued. Beating revenues by $4m doesn't justify the company's 19x revenue multiple. The 60% YoY growth implied in 2013 is much lower than the 90% that NOW grew in 2012. And while NOW's Help Desk product appears to be selling well, investors still have little insight on how much revenue is generated from the Discovery and Runbook Automation tools. Since the market size of the Help Desk is only $1.5bn, according to Gartner, NOW must prove to investors that it can generate real revenue in other product segments. ServiceNow's Platform product, which many analysts think could provide the largest eventual end-market, is just now launching as a separately priced product. While this Platform product will be for sale for the vast majority of this year, NOW doesn't expect Platform sales to be consequential until 2014 onwards.
Without meaningful revenue from Discovery, Runbook Automation, Platform, or other non-Help Desk products, NOW could quickly saturate its share of the 50% of the $1.5bn Help Desk market that Gartner expects to convert to SaaS. Future year-over-year revenue growth will be especially difficult since, due to legacy contracts and the enormous cost of switching vendors, only a small percentage of the market opportunity can be captured in any single year. At its current exorbitant price of 12x 2013E revenue, NOW investors are placing too much trust in unproven revenue streams and too little scrutiny in the challenge of future growth.
NOW's market capitalization currently approaches $5bn, an absurdly high figure relative to the $400m of revenue that NOW hopes to collect in 2014. Besides, profitability continues to be nil. To hit its revenue figures, NOW may have to aggressively expand its headcount, adding costs to an already unprofitable business. On its fourth quarter call, NOW remarked that it doesn't expect to be profitable in the first half of 2013 and that it might reach profitability in the second half of 2013 on a non-GAAP basis (non-GAAP excludes stock-based compensation expense). While stock-based compensation isn't a cash expense, it does have an immediately dilutive effect on NOW's current shareholders. We applaud NOW's CFO, Michael Scarpelli, for taking time during the call to address the misunderstanding around ServiceNow's share count. Mr. Scarpelli stated that, "At December 31st, we had approximately 164 million diluted shares outstanding, consisting of approximately 126.4 shares outstanding, 13.1m vested and 23.0 unvested options outstanding, and 1.5m RSUs" (NOW Q4 2012 Call). Using the treasury method to net out the proceeds from future option exercises, this implies a diluted share count of 158.3 at NOW's current share price. As we've previously pointed out, numerous financial databases and many Wall Street analysts continue to overlook NOW's highly dilutive option pool for valuation purposes.
Moving back to NOW's quarterly results, sequential Billings and Revenue growth increased to 20% and 17%, respectively, for the quarter. While we expect NOW to utilize an under-promise/over-deliver guidance cadence, the Q1 2013 revenue guidance of only $82m/9% sequential growth should be uninspiring to most.
Looking more closely at NOW's financials, we noticed that Professional Services revenue increased by 35% in Q4 versus only 14% sequential growth in Subscription Revenue. ServiceNow expects 2013 revenue of $387m - $392m composed of $327m - $329m in Subscription revenue and $60m - $63m in Professional Services. Last year's Professional Services revenue was only $39.2m, implying 57% YoY growth from the midpoint of guidance. Since Professional Services revenue is relatively one-time in nature, it deserves a lower valuation multiple than the recurring Subscription revenue. As the Professional Services segment becomes a larger percentage of the overall revenue pie, we'd expect analysts to begin to notice and adjust their valuation techniques accordingly.
NOW's largest competitor in the Help Desk vertical, BMC (NASDAQ:BMC), reported its own set of financial results on Monday, January 28th. Though BMC printed weak numbers overall, management commentary indicated that BMC sees increasing strength in its Remedy (On-premise) and RemedyForce (SAAS) products. BMC's SaaS customer base grew from 475 on September 31st to 550 at year-end (BMC FQ3 2012 Call). BMC's 16% sequential SaaS growth in the fourth quarter was higher than the 12% growth in NOW's customer base over the same period.
Beyond these fundamental headwinds, lock-up expirations unfold over the next few weeks. This Friday (tomorrow), 42.7m shares will be available for sale by NOW's founders and venture capital investors. According to Bloomberg, NOW's current float (the shares traded on the public markets) is only 36.3m, meaning that the float could more than double as these shares are sold on the public markets. This lock-up expiration will be compounded by another one on February 13th. On that date, 47.5m shares will be available for sale, which cumulatively adds 90.2m shares into the potential float.
ServiceNow is a stock where expectations have gotten ahead of reality. In order for any discounted cash flow or takeover analysis to justify NOW's current share price, NOW needs to continue its 2012 growth rate even as it saturates the Help Desk market. We just don't see this happening. Once sequential growth in NOW's Help Desk market begins to slow, which it invariably must given a limited market size and BMC's increased efforts, scrutiny of NOW's ancillary product lines will quickly take center stage. We remain confident that our short thesis will play out over time.
Disclosure: The author is short NOW. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Read our full disclaimer at kerrisdalecap.com/legal-disclaimer-3. This is not a recommendation to buy or sell any investment. We may transact in the securities of NOW subsequent to publication.