ServiceNow (NOW) reported an excellent Q412 on January 30th. It beat revenues and earnings estimates, as well as guiding higher for 2013. So in a way, I should eat crow given my previous bearish articles here and here.
However, my bearish thesis is still intact, it was just too early. In some ways, one can compare ServiceNow to Apple (AAPL). When Apple was the innovator and created new products that no one had seen before, the stock did very well and everyone was bullish. However, when other companies came out with similar products and Apple quit innovating, after a while Apple stock fell because it had lost its edge. I believe ServiceNow is going through a similar cycle. It's currently doing very well, like Apple at its peak. It created a great IT Service Management (ITSM) product in the 2000s, and then used its reliable reputation to help large companies make the transition into cloud ITSM. However, one could say that ServiceNow is now in much worse position than Apple. Not only has it stopped innovating, but its competitors are creating a model that is better than ServiceNow's older model.
In the earnings call, ServiceNow's CEO, Frank Slootman, spoke about how many enterprise companies are still using the 1990s helpdesk on-premise solutions, and they will all inevitably move to the new SaaS (Software as a Service) ITSM technology when they are ready. What he didn't say is all those firms that currently provide that old school 1990s helpdesk: IBM, HPQ, CA, and BMC, are all well aware of this fact and have finally evolved to SaaS ITSM. ServiceNow may have been able to dominate in the last several years and the latest quarter, but I predict this year, 2013, will be the year that ServiceNow falls behind as those big technology firms become direct competitors.
One could say ServiceNow is stuck in 2000s ITSM technology, which is the next generation above the 1990s helpdesk solutions. But it is behind the new, 2010s ITSM multi-tenant architecture. It's interesting that no analyst questioned ServiceNow's single-tenant architecture, even though that is a clear drawback for the company. I would've asked if ServiceNow is considering moving to multi-tenant.
Multi-tenant Is Superior To Single-tenant
A few days ago, I interviewed Kevin Smith, the VP of the Cloud Business Unit at Frontrange, another ITSM provider and one of ServiceNow's biggest competitors. Frontrange, a private company, has over 15,000 customers, compared to ServiceNow's reported 1,512. Frontrange was founded way back in 1989, when helpdesk was all anyone ever spoke about. Two years ago, Frontrange completed building a multi-tenant cloud platform. Frontrange was late to the cloud market, but finally bit the bullet and went multi-tenant.
"Multi-tenant and single-tenant is becoming a big issue," said Mr. Smith. "CIOs and CTOs weren't asking about this a couple years ago, but now they are asking about it. Single-tenant isn't authentic. SaaS and cloud were supposed to be multi-tenant. When ServiceNow was signing up a lot of customers in the beginning, Fred Luddy (the founder of ServiceNow) never intended to stay with single tenant for the long term. The problem with single tenant is it's so expensive to operate. ServiceNow is under more pressure to make money, and so they are charging their customers more, or charging for things that were free before."
Multi-tenant infrastructure is so much less expensive than single tenant. The cost per user for ServiceNow is a whopping 5x that of Frontrange! Cost pressures was apparent in ServiceNow's earnings call. ServiceNow didn't give any earnings or cash flow guidance for 2013. Frontrange, although a private company, has had positive cash flow and earnings every single quarter for the last nine years. With the cost pressures ServiceNow has and its striving for growth, it might never become profitable.
What Frontrange does is use a hybrid of both cloud and on-premise applications. That way enterprises can have the best of both worlds. With the hybrid, companies who have the utmost need for security, and have reservations to moving fully to the cloud, can keep their data on premise and at the same time they have the cloud platform for configurability and flexibility.
ServiceNow management said in the earnings call that the company is going to ramp up advertising and marketing in 2013. That is a sign that the company will need to try harder for sales, and can't just rely on its reputation anymore. I also noticed that it wasn't discussed on the call how much business ServiceNow has received in the other cloud sectors besides ITSM. Its revenue and upsell numbers weren't specific as to where exactly they came from. This tells me that the company is not successfully penetrating other markets like it needs to. Gartner predicts that the $1.5 billion ITSM market is growing at a modest 7% per year and 50% of IT organizations will move to SaaS by 2015. Even if ServiceNow secures 30% of that market, it won't be nearly enough to support its current valuation.
In conclusion, ServiceNow's valuation is priced to expect huge increases in revenues and earnings many years in the future. Because of this, investors should think about where ServiceNow is going in the future, and not just its current performance. Even bears would say that ServiceNow is a dominant force today in the IT Service Management industry. However, the questions to ask are: 1) will that last, and 2) will ServiceNow be able to grab sizeable market share anywhere else? It's clear that the answers to both questions need to be a "yes," or the stock is very overvalued.
Disclosure: I am short NOW.