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Investment Thesis

ServiceNow (NYSE:NOW) insiders have now sold over $400 million of stock even after its IPO, disregarding bullish calls from research firms (who happen to also be its bankers). On February 1st - the first day of the February lockup expiration - the CEO and the company founder began selling large amounts of stock at below $28.00. In the past 8 weeks, a wide range of insiders have now sold over $80 million of stock with no sensitivity to price.

In November, ServiceNow broke its lockup period early and made use of a JOBS Act exemption to further eliminate subsequent selling restrictions. ServiceNow offered 16.1 million shares at $28.00. The exemption was designed to provide small cap "emerging growth companies" with greater access to financing. There are two problems with this. First, $5 billion ServiceNow is not a small-cap company. Second, 88% of the proceeds went to selling insiders and did not provide money to ServiceNow.

Such provisions under the JOBS Act have been controversial. A Bloomberg article entitled "Job-Creation Bill Seen Eviscerating U.S. Shareholder Protections" quoted the former chief accountant from the SEC as saying:

It won't create jobs, but it will simplify fraud... This would be better known as the bucket-shop and penny-stock fraud reauthorization act of 2012.

By applying for "emerging growth company" status, ServiceNow can opt to disclose fewer years of financial statements. It is exempt from certain disclosures regarding executive compensation. Investment banks love the provision that allows them to publish research prior to their IPOs - a practice which was banned following the dot.com boom and bust.

Perhaps of greatest concern is that these "emerging growth companies" do not need to have an auditor attest to their internal controls as required by post-Enron Sarbanes-Oxley.

For ServiceNow, the recent 10-K discloses that in the 6-month period before the IPO, the auditor found "material weaknesses" in internal controls.

For the period after the IPO, it also discloses that:

This report does not include a report of management's assessment regarding internal control over financial reporting or an attestation report of our registered public accounting firm due to a transition period established by rules of the Securities and Exchange Commission for newly public companies.

So before ServiceNow was a public company, we learned from its auditor that internal controls were ineffective. Now that it is a publicly traded company, the company gets to claim an exemption such that no auditor report on internal controls is necessary.

Clearly this is what was meant by "eviscerating" shareholder protections.

Despite the bullish upgrades from analysts, those who know the company best are selling the most and at every opportunity. At a minimum, these large ongoing insider sales will certainly cap the share price. And with roughly 90 million more shares now sellable, there is significant potential for substantial price declines in ServiceNow.

In the past, ServiceNow directors and management including founder Frederic Luddy and directors John Moores and Charles Noell, were big early sellers of the their previous venture Peregrine Systems.

They pulled in over half a billion dollars from sales of stock - even though these sales had occurred during restricted periods designed to prevent selling by insiders.

Selling as early as possible was very fortuitous for these insiders because when Peregrine collapsed due to findings of massive fraud, there wasn't much left for those who hadn't sold early.

ServiceNow CFO Michael Scarpelli was less fortunate. When his HPL Technologies collapsed due to fraud, he hadn't sold and the company ended up at 8 cents on the pink sheets. But now it is 2013, and in the past few weeks alone he has sold nearly $5 million of ServiceNow stock.

Analysts say BUY while insiders say SELL

Shares of ServiceNow have rallied by more than 40% since their January lows of $26.00. On January 30th, the company announced a small beat on revenues by $4 million but the net loss was still running at $10 million. Clearly this was not what drove the rally in the share price.

Instead the stock has been propelled by a wave of analyst upgrades to prices in the $40-43 range. Coverage is currently provided by banks including Morgan Stanley, Barclays, Deutsche Bank, Credit Suisse, UBS, Citi and Wells Fargo. Most investors will be aware that these are the banks involved in ServiceNow's recent IPO and equity offering.

Clearly, insiders are unwilling to wait for the stock to rise the extra 14% to its "full value." In fact, on the first day of the February lockup expiration, CEO Frank Slootman sold $558,000 of stock, while "Chief Product Officer" and founder Frederic Luddy sold a much larger $12.4 million in stock.

That was on the first day alone, and these transactions both occurred at prices of $27-28. These were the beginning, not the end, of the most recent wave of insider selling that is still going on.

Over the past 8 weeks alone, insiders have now sold over $80 million of stock in a steady stream from week to week.

The list of selling insiders is not short, and includes the president and CEO, the CFO, the founder and "chief product officer," the chief technology officer, the SVP of Engineering, the SVP of Worldwide Sales and Service and three different directors - who happen to represent the largest institutions that own the stock.

Their sales across various transactions since February 1st can be summarized from Form 4s as follows:

Insider

Role

Shares

Avg price

Proceeds

Luddy Frederic

Founder / CPO

465,000

$27.40

$12.7m

Slootman Frank

President / CEO

135,000

$31.59

$4.3m

Scarpelli Michael

CFO

140,000

$33.92

$4.7m

Josefsberg Arne

CTO

200,000

$31.29

$6.3m

Mcgee Daniel

SVP Engin.

405,000

$28.99

$11.7m

Schneider David

SVP Sales/Srvc

227,410

$32.96

$7.5m

Barber Paul V

Director

205,795

$31.29

$6.4m

Moores John J

Director

564,397

$36.42

$20.6m

Noell Charles

Director

285,100

$32.08

$9.1m

Totals

2,627,702

$31.74

$83,392,041

Hopefully several things are readily apparent from the table above.

- The transactions involve basically every senior member of management along with directors.

- In each case, the individuals are selling large amounts of stock, netting well into seven figures each.

- The average sale price is just $31.74.

- The largest block was sold by ServiceNow founder Frederic Luddy at a price of just $27.40 - 25% below the current share price and 33% below analyst targets.

- There have been no insider buys in 2013.

Clearly, given the large size of the transactions involved, these selling members of management could pull in further gains of millions of dollars each if they were willing to simply hold their shares until they hit analysts' targets of $41.00.

Yet clearly the ones who know the company best are the ones selling the most, regardless of what the price does.

In actuality, this current wave of insider selling is not the first wave. Back in November, ServiceNow made the following announcement:

ServiceNow Announces Partial Release of Lock-up Agreement with a Director in Connection with Proposed Follow-on Offering and Waiver of Lock-up Extension Provision in Lock-up Agreements

When ServiceNow became public in July, its IPO prospectus contained the standard 180-day lockup provision which prevents insiders from selling for 6 months. This provision is added to IPOs in order to spur market confidence so that people will buy into the offering without fear of a wave of insider selling.

Yet in this case, the company and its underwriters agreed to break the lockup. ServiceNow made use of a provision in the newly enacted JOBS Act which can be taken by "emerging growth companies" to get around the lockup and sell early. Clearly, such a provision defeats the entire purpose of having a lockup in the first place.

In addition, with a market cap of $4-5 billion it is hard to consider ServiceNow an "emerging growth company." ServiceNow itself notes that the cutoff level to continue being an "emerging growth company" is just $700 million. From the most recent 10-K notes:

if the market value of our common stock that is held by non-affiliates exceeds $700 million as of June 30 of any year starting with June 30, 2013, we could cease to be an "emerging growth company" as of the following December 31.

Shortly after successfully breaking the lockup agreement, ServiceNow completed an equity offering of 16.1 million shares at $28.00 per share.

The investment banks involved were familiar, as expected: Morgan Stanley, Citi, Deutsche Bank, Credit Suisse, Barclays, UBS and Wells Fargo. Also as expected, these are the banks which continue to cover the stock with bullish research.

The primary purpose of this transaction was not to provide new money for ServiceNow. As noted,

Of the 16,100,000 shares of ServiceNow's common stock sold in the follow-on public offering, 1,897,500 shares were sold by ServiceNow and 14,202,500 shares were sold by selling stockholders.

So in this case, the urge for insiders to sell was so urgent that the then $4 billion company took an exemption for "emerging growth companies" so that insiders could sell 14.2 million shares at $28.00. The selling insider was the JMI Funds and El Caminio Advisors. ServiceNow board members Charles Noell and Paul Barber serve as managing directors at these funds, so the insider selling is about as "inside" as one can get.

As per the original Underwriting Agreement, ServiceNow's lockup should have been extended for 34 days past the original February date due to earnings / material news being announced in January. But as early as November, the company was eager to use the provision to have this waived, so the insiders could begin selling as soon as possible. As should be expected, they have begun making good use of their freedom to sell.

So why do analysts keep saying BUY?

If insiders keep selling as early as they can, then why do sell side analysts keep telling us to buy the stock?

Hopefully it did not escape the attention of readers that in the November equity offering, 88% of the $450 million in proceeds raised went to the selling shareholders who wanted to violate the 180-day lockup. Only 12% of the proceeds went to ServiceNow.

ServiceNow is currently a $5 billion company with a cash balance of $313 million, which is by no means an excessive cash balance. In addition, the company continues to operate at a loss and its current ramp up and hiring spree will no doubt prove to be expensive.

Given that the company realized minimal proceeds from the November offering, it is certainly likely that the $5 billion company makes a very good candidate for an equity or convertible (equity-linked) financing.

In any event, anyone who has ever worked on Wall Street can be certain that the pitch books from Morgan Stanley, Barclays, Credit Suisse and UBS are all flying furiously across the desks of ServiceNow management, encouraging the company to "take advantage of current strong market conditions" by selling equity soon.

Given that all members of management have demonstrated their eagerness to sell large volumes of stock at current prices (and well below), it also stands to reason that they would be eager for ServiceNow, the company, to raise equity financing at current prices.

In the November equity offering (i.e., the large insider sale) the offering price was just $28.00. On the first day of the lockup expiration, both Mr. Luddy and Mr. Slootman sold at below $28.00.

As a result, we now have a pretty good idea of where management feels the stock needs to be in order to hit the sell button.

But are the analysts wrong about the price targets?

Yes, the analysts are wrong about the targets and this can be demonstrated by looking at their own reports which contain a number of false assumptions and numerical errors.

The specific flaws are consistent across many of the analyst reports. Analysts have justified their upgraded target prices for ServiceNow simply due to the recent rise in comps such as WorkDay (NYSE:WDAY) and Salesforce.com (NYSE:CRM).

They have also chosen to dismiss the impact of the expiring lockup even as insider sales accelerate.

In addition, despite the near unanimity of share price targets, there has been a fairly wide divergence in the share count used for calculating it. ServiceNow addressed this confusion on its last conference call, clarifying that it has 164 million diluted shares outstanding. Some analysts have been wrong by as much as 30% on this number.

The contents of the recent research reports by Credit Suisse, Morgan Stanley, UBS, Barclays and others have been highly consistent in their findings and share price targets. But the recent UBS report provides the clearest example due to the fact that the firm switched from a SELL to a BUY within just a few weeks, and right as the lockup shares became free.

On December 19th, UBS placed ServiceNow on its "Least Preferred" list giving it a $30.00 price target with a $24.00 downside target. The report contained the following justifications:

Thesis:

There is no disputing NOW's strong growth rates, disruptive technology and customer base. However, we think the stock is overvalued as the 2nd most expensive name in our group at 12.5x FY13 EV/sales and growth is set to decelerate meaningfully in FY13… as a recent IPO, there are multiple share lockup expirations coming in Q1 with 92M shares becoming eligible for sale (vs. 700k ADTV)

Yet within 8 weeks, UBS had flipped from a SELL to a BUY recommendation, giving the stock a $36.00 target. The new justifications cited for the upgrade are as follows:

Our new Buy rating reflects 3 changes, 1) multiple compression played out, NOW trades inline to comps on 2014 ests despite 49% faster growth, 2) in recent weeks NOW finally priced its platform separately which we expect to be accretive to deal value, 3) 2/14 lockup expiration last of the major share unlocks.

Hopefully most readers will see the two largest problems immediately. The "multiple compression" which UBS refers to simply means that other stocks such as Workday, Splunk (NASDAQ:SPLK), SolarWinds (NYSE:SWI) and Salesforce.com have rallied even more than ServiceNow. The $36.00 target is therefore justified by the fact that other money-losing, high P/S multiple stocks are now just as overvalued. Obviously this type of valuation methodology does nothing to tell us whether or not ServiceNow is overvalued relative to its own fundamentals and prospects.

And incidentally, these comparable stocks such as Workday are now seeing nearly identical concerns from critics, as shown in this recent article entitled: Workday: Overvaluation And Lock-Up Expiration Will Cause Shares To Crash.

The analysts' rationale for buying these stocks is no different than what we saw in the Great Internet Bubble which imploded in the year 2000. By upgrading a Pets.com just because a Stamps.com had traded higher, what analysts were really doing was simply pushing the whole space higher. When the stocks trade down substantially, the analysts will then tell us (after the fact) that they are downgrading the stocks due to "multiple contraction."

The second major flaw (which is shared across most of these reports) is that analysts are upgrading the stock because the lockup has now expired.

It is now the case that there are roughly 90 million shares which have become free for insiders to sell at any time or price they please. In the past 8 weeks, we have seen insiders steadily unloaded over $80 million in stock regardless of the price. The time for investors to take relief regarding the lockup will be once the overhang is removed due to completed sales by insiders, not due to the fact that these insiders are able to begin selling.

With ServiceNow, the selling is just beginning and it is beginning with a very strong start. If anything, now would be a time for analysts to maintain caution regarding the overhang.

Why do insiders sell?

By making use of a JOBS Act exemption intended for small-cap companies to raise additional operating funds, ServiceNow insiders stuck to the letter of the law but certainly bent the intentions of the act by a wide degree.

By selling $13 million of stock on the first day of the February lockup expiration, they further communicated their eagerness to get out of the stock regardless of price. As we can see, the $13 million was just the beginning.

Many of these sellers undoubtedly learned the value of "sell early, sell big" as a result of the massive gains they realized shortly before their previous company imploded due to findings of fraud. Had they not made use of similar creative maneuvers to sell early, they would have been stuck sitting on worthless shares along with the rest of the investors in those stocks.

Now that they are substantial insiders at ServiceNow, they appear to be replicating this philosophy of "sell early, sell big."

At Peregrine Systems, many of the early sales by these insiders were completed during a "no sale" blackout period imposed by the company which had already been communicated to the market. Their defense for doing so would likely be that they were not (in theory) "insiders" because they knew nothing about the company's inner workings when they unloaded over half a billion dollars worth of stock.

ServiceNow Director John Moores had previously been Chairman of Peregrine Systems and his VC firm JMI Capital held a substantial stake. He had recruited Fred Luddy to assume the eventual role of Chief Technology Officer. ServiceNow Director Charles Noell served as a Peregrine Director and as the Audit Committee Chairman.

The SEC complaint describing the fraud at Peregrine systems can be found here. Like ServiceNow, Peregrine was based in San Diego. The San Diego Union Tribune provided significant detail on the $4 billion fraud implosion, including the following:

"The indictment charges these defendants with a massive conspiracy that had at its core one corrupt goal: to hit the numbers quarter after quarter, no matter what," Attorney General John Ashcroft said in a statement.

Like ServiceNow, Peregrine had a habit of beating expectations, even as insiders continued selling into the successful results. The similarities between the two San Diego companies are noteworthy.

From its initial public stock offering in 1997 through mid-2001, Peregrine reported 17 consecutive quarters of growth that met or exceeded Wall Street analysts' expectations. … Although Peregrine was unprofitable, its ever-increasing sales suggested it was dramatically expanding its share of the market for business software. One of the company's biggest products helps large organizations keep track of desktop computers and other assets. Another big seller helps coordinate computer help-desk services.

As the fraud findings shook out, John Moores and his JMI Capital certainly received some unwanted attention due to the size of his early cash-outs which occurred in the middle of the period where the fraud was at its peak:

Moores had sold most of his ownership stake in the company by 2001, including more than $600 million worth of Peregrine shares sold during the long-running fraud.

From July 1999 to February 2001, Moores sold more than 10.9 million shares of Peregrine for nearly $402 million, the suit alleges. Nearly 5 million shares were sold during company-imposed "blackout periods" that prohibited sales by key executives and board members.

Moores and other outside directors (including ServiceNow director Charles Noell) were found liable for $56 million in settlements, as noted:

of the directors' total $55.75 million settlement contribution, $27.5 million is to be paid in the form of a note signed and payable by John J. Moores and Rebecca Ann Mores as individuals and as trustees of the John and Rebecca Ann Moores Family Trust. The stipulation also provides that the security for the note will be provided either by a letter of credit or by a security interest in JMI Holdings LLC's economic interest in a San Diego hotel.

By the time the dust had settled, 18 members of Peregrine management had been charged with fraud and 14 were ultimately sentenced.

Frederic Luddy eventually settled for $100,000. It was his second tough break with a promising software startup. When discussing his previous failed attempt with Enterprise Software Associates, he stated:

I have advice for any entrepreneur, which is if you're starting a company and you have a partner, you should first find out if your partner is a convicted felon for fraud. I forgot to do that.

But things finally turned for Mr. Luddy and Forbes now estimates his net worth at $400 million.

ServiceNow's current CFO, Michael Scarpelli, was less fortunate. When his former software venture imploded due to fraud, he had not sold and the company ended up at just 8 cents on the pink sheets once the fraud was uncovered, down from over $14.00.

However with ServiceNow, Mr. Scarpelli has been much quicker to sell, already pulling in nearly $5 million in the past few weeks.

Scarpelli had originally been a partner at PWC in the 1990's at a time when PWC was auditing a software company called HPL Technologies. Scarpelli eventually moved from his role as auditor at PWC over to a management role with HPL Technologies, ultimately becoming CFO.

During his tenure at HPL it was uncovered that as much as 80% of revenue had been improperly recognized and that the CEO had used a subsidiary to funnel cash into his personal account. PWC and UBS were then named in a $100 million lawsuit, with the lead plaintiff attorney stating that "It's inexcusable that an audit could have been done and not detected these irregularities." The biggest issue was that the audit failed to uncover $10 million of missing cash, which should normally be very easy to detect.

Conclusion

No one, myself included, is presently accusing ServiceNow of committing fraud.

The current observation is simply that the only thing more blistering than the pace of ServiceNow revenue growth has been the blistering pace of insider selling.

ServiceNow became public in July of 2012. In the 8 months since, insiders have already cashed out over $400 million in stock. This is excluding the amounts sold in the IPO itself. And the pace of selling continues to be brisk nearly every week, regardless of the share price.

Wall Street analysts (from the very banks who run ServiceNow's financings) are telling the rest of us to buy into the shares even at prices up to $43.00. Yet the insiders have demonstrated an eagerness to sell at prices of $28.00 and below. This has been the case even when these sales required a creative interpretation of the meaning of "emerging growth company."

History has shown that insiders know their own companies far better than Wall Street analysts. History has also shown that Wall Street analysts can find many reasons to upgrade and recommend stocks, while sellers typically have only one reason to sell big and sell early.

Post script

The details of the multi-billion dollar accounting fraud at Peregrine Systems are truly fascinating for those who are interested in such things.

According to this Complaint:

To perpetuate the accounting fraud, members of Peregrine's senior management

team would communicate near the ends of quarters to determine how much additional revenue the company needed to book that quarter in order to meet or exceed analysts' expectations.

They would then devise fraudulent and misleading transactions, as described herein, and the resulting "revenue" would be recognized in that quarter in order to mislead the analysts and the investing public into believing that Peregrine's financial condition was significantly better than it actually was and to maintain Peregrine's inflated stock price.

The complaint contains multiple references to quotes by management speaking of starting a new company such as "End-of-the-Quarter.com" which would "sign sham deals for a fee to help companies meet their quarterly forecasts."

At its peak, Peregrine reached $9 billion in market cap, making it somewhat smaller than the more notorious frauds such as Enron and Worldcom. But the details revealed in the filings are every bit as egregious and equally intriguing.

Source: ServiceNow: Analysts Say Buy But Insiders Rush To Sell Big