The biggest problem is there are too few problems!
That isn't entirely true. A couple of quarters ago, ServiceNow (NYSE:NOW) did indeed have some issues. For a company like this, missing bookings targets for two quarters in a row is not something to be ignored. Much of this article is going to be concerned with what has changed in the last several months and to what extent the share price appreciation since the February nadir has left any potential positive alpha going forward. I wrote about the potential inflection point for this company being hard to call a month later. Self-evidently, my article, in terms of the specifics was premature and the shares have, to a greater or lesser extent, reflected that reality. Inflection points are hard to call and March 15th was the time to be calling that for ServiceNow. And while there are some straws in the wind, just how strong these straws may be is still in question. I am inclined to believe, for reasons laid out later in this article, that Q3 forecasts by the company reflect some unique elements of conservatism that are likely to produce either upsides to various metrics or at least in line results. I am less certain that will be the case in Q4, but in any event, the company is forecasting a slowing of some significant growth metrics in Q4, and if it comes out that way, I think the expectations for 2017 are going to have to be reset lower. In the nature of things, forecasting a surprise in anything is well… a difficult undertaking because it is a surprise. But I still think it is coming and more likely coming in 2017, and I lay out some of the reasons for that projection in the balance of this article.
One thing of note is that given this company's size and its valuation, there would seemingly be no denouement that includes its acquisition by anyone. The company has a negligible free cash flow such that it will never make a P/E screen. I simply do not see the revenue synergies that would ever justify this company as a target of a strategic acquirer.
It has to be noted, that despite the quarter that was printed, which was a beat on most financial metrics, the shares sold off in the immediate wake of the announcement. And while the quarter was hardly unsuccessful, neither was it a singularly impressive success-based on the results necessary to sustain the valuation. Hyper-valuation needs hyper-growth, and as will be seen, the hyper-growth for NOW is not quite what might seem to be the case just looking at a few headlines. At the moment, the EV/S based on the consensus for the current year is 9.1X while the free cash yield for this year, based on the management projection of a 12% free cash flow margin for the 2016 is 1.36%. There are more highly valued names no doubt, but NOW is pushing the upper bound of what might be considered "normal." for hyper-growth companies.
The goal of the articles is to find those names that will either generate or fall below the goal of generating positive alpha. If I were evaluating NOW in the abstract and didn't concern myself regarding share price performance, I would almost certainly come to different conclusions regarding how it was doing and its outlook, but to readers the goal isn't to evaluate companies but to evaluate stocks. Beauty really will be in the eyes of different beholders.
In the week or so since the earnings were released, the shares have contracted marginally while the IGV software index rose 1%. Taking a bit longer perspective back to my first published report, the shares are up 23% compared to the appreciation of the IGV of about 15%. The shares needed two exceptional quarters to earn 800 bps of positive alpha. Over the past 12 months, the shares are actually flat and the IGV has appreciated by 9%.
For most of that time and certainly in the past several months, the average consensus analyst rating has been a relatively strong 1.8 which is between buy and strong buy and the current consensus price target represents an appreciation expectation for the next 12 months of 13.5%. Overall, analysts are estimating that the growth rates for most metrics are going to decelerate to 32% by the end of the year and to 30% for all of next year. The issue for the shares is one of valuation. The shares now have a P/E of more than 115X non-GAAP earnings and are selling for 74X the consensus EPS for 2017. The EV/S projected for this year is 8.8X and the metric is at 6.8X based on the 2016 consensus revenue forecast. With those kinds of valuation metrics, it has proven to be difficult to put together a story that has been credible for many prospective investors that has successfully resonated in terms of higher share prices.
From the perspective of this writer, trying to look forward evaluate the strategy of the company in its attempt to diversify its portfolio is also going to be a theme of the article. But for the moment, I want to take a look at the latest earnings report and the one before and see how it is "On the Sunny Side of the Street."
The Sunny Side of the Street
The song dates to 1930 and was composed by Dorothy Fields, one of the greatest but now sadly unknown composers of her day. It is a jazz standard that leapt into my imagination when I wanted to update the article I had initially published on NOW back in March. The relevant lyrics of the song talk about leaving worries on your doorstep and how sweet life is on the sunny side of the street, with gold dust at my feet. It was perhaps not the best of times to write such a song or perhaps it was, but it became a runaway success in a nation that would be wracked with years more of a vicious and soul deadening depression. For those of you who have never heard it, it is a very upbeat melody and must have been even more so when entering the distressed homes of the 1930s. And for the most part, results for NOW this past quarter and the one before have represented a journey to the sunny side of the street.
For the record, total revenues grew by 38% for the quarter just ended and were up 41% for the first 6 months of the year. Subscription revenues grew 45% last quarter and grew by 47% for the first 6 months of the year. That is a slight deceleration, but the operative word is slight and the fact is that most companies will never see 45% product revenue growth and at the scale that NOW has achieved.
Most intriguing, at least to this writer, is that 40% of the company's increase in net new annual contract value (ACV) came from outside service management. This is one of those cases of the glass being either half full or half empty. And no one can really know at this point which it is! This compares to 24% in the year earlier quarter. IT Operations Management (ITOM) was the second largest set of products contributing 13% to ACV this just reported quarter up from 10% in the prior year.
For reasons not specifically known to this writer, the company does not provide a specific ACV metric in its press release. CEO Frank Slootman was asked about that metric and its split between the company's foundation which is the IT Service Management space (ITSM) and said on the call that he would not be prepared to make more disclosure, "I am not going to talk about growth in terms of ACV with Service Management." This writer interpreted the comment to imply that the net ACV for Service Management was significantly less than might have been previously guessed. There are observers and readers who will doubtless reach different conclusions.
If the overall math is right, then it would appear that ITSM showed an ACV growth of only 10% or so, probably the lowest it has been since the company went public. On the other hand, the ACV growth for everything else was above 100%. The growth rate in ITSM is far more sustainable given at 10% or less; on the other hand, the growth rate of everything else at the elevated levels that were recorded in Q2 is most likely not sustainable.
One thing to note, however, is that 24 out of 26 large deals still had an ITSM component and this company leads conversations with ITSM. If the ITSM wheelhouse continues to weaken as the above numbers may well suggest (that statement is likely to be one that would be challenged by many, but I cannot think of what else one would call the significant and highly visible drop in growth rate but a weakening), will the other solutions be enough to pick up the slack?
This company has a dominant position in ITSM and it has a strong position in the ancillary fields of security. It doesn't sell firewalls; its security offering is part of spotting anomalies in the overall workflow of service management and is hence easy to sell. But beyond service management and security of service management are the new frontiers for this company. Still very small these days and to a greater or lesser extent nascent - but the areas that have to succeed as the core of the company's business begins to show so some signs of ageing. The growth of the non-ITSM categories is likely to be dispositive with regards to the future for the growth rate of the company and the future performance of the shares
Overall, the company's guidance on its conference call was consistent with the revenue trends of the most recent quarter. It should be noted that as the company gets larger, more and more of subscription bookings are going to come from renewals, and as the average installed life of the product continues to increase, it is more than likely that users are going to attempt to negotiate renewal discounts. Every user is well aware that there are few costs other than sales commissions related to renewals and they will be threatening to the final minute to find alternative solutions for workloads. This proved to be one of the more contentious points of the Q2 conference call - or at least as contentious as these conference calls get to be.
The company is planning to accelerate its spend on both research and development and on sales and marketing. Perhaps overlooked by some in the current after-glow euphoria is that the company reported it had some issues of deals at the end of the quarter that perhaps related to subscription bookings growth decelerating in this past quarter. The company CFO Michael Scarpelli put it his way, "Once again, these were renewals that were supposed to have renewed right at the end of the quarter, and it was delays in procurement organizations who tried to renegotiate deals many times, (but the slipped deals) they've been signed already." Further in his answer, Mr. Scarpelli said that, "There's deals that get pushed and pulled every quarter on the renewal side. I would say this quarter they tended to be more that got pushed." Is that an issue? Could it be that the lower level of bookings growth in the last half of 2015 had to with that (never discussed at the time) and that the significant upswing in bookings growth in both the March quarter and the quarter just ended had to do with strong renewals. Again, the transparency isn't there for outside observers to really know. It is those kinds of issues which might be troubling to some including this writer.
It should be noted that because this company generates all of its product revenues from subscriptions, it doesn't matter significantly when a deal is signed; acquisition arrangements are charged on a daily basis. The issue only shows up in billings and bookings and it may be that the forecast of a progressive decline in the percentage growth of those numbers, particularly in Q4, is a consequence of issues in getting renewals contracted for at prices sought by the company.
If I were a suspicious individual or one who looked for the darned old cockroach under every rock, some of the above might be troubling. Why might it be, that if there were deals scheduled for Q2 that pushed and pulled down bookings growth, and those deals have now been signed in Q3, where they were not supposed to be, that the company might not expect an acceleration in bookings? At the mid-point that is not the forecast of the company. Mr. Scarpelli danced effectively on a question that was essentially on that point. As I mentioned earlier in this article, this is one of the factors that leads me to believe that an inflection point, particularly in terms of revenue metrics, is unlikely to be seen in Q3 results.
In any event, the net of the dance is that overall, the company is not forecasting materially different performance in either revenues or in EPS than its outlook had been before the quarter was reported. Nonetheless, 5 analysts out of the 29 analysts who provide estimates to First Call raised their expectations. I am not quite sure how that may have happened, but despite estimate increases and an ebullient market overall, the shares were unable to gain headway.
The next set of all numbers will all be GAAP. It is not really worth analyzing cost comparisons any other way, in this writer's opinion since pretending not to be paying people by paying them with stock… well, it is what it is, particularly in trying to analyze year-on-year changes in cost ratios
Gross margins in Q2 were 71.7%, up 400 bps from 67.6% in Q2 2015. That is really a significant attainment and understates the improvement in product gross margins as service gross margins were under quite a bit of pressure. Sales and marketing expense was 54.6% and that was down was 90 bps from the year earlier. Research and development costs at 20.5% also improved by about 100 bps from the prior year level. General and administrative costs dropped by almost 200 bps to 10.6%. Overall, operating losses improved to negative 14.1% compared to 21.6% the prior year. The company has a negligible GAAP tax rate of less than 10%. Overall, with the average share count at about 164 million, up from 154 million in the prior year, the per share for the quarter loss shrunk to $.30 from $.40.
Stock-based comp represented 23% of total revenues. Stock-based comp which was up by 18% year on year growing just half as fast as total revenues. Stock-based comp increased by $3 million or just 4% sequentially. While this quarter's growth in stock-based comp was far slower than in the recent past, and while stock-based comp is down as a percentage from the year earlier period, some of the comments on the conference call in terms of accelerating hiring suggest to me that these improvements may not prove to be permanent.
The company has a reasonably healthy balance sheet, with cash and equivalents totaling $807 million, about unchanged from the start of the year. Long-term investments declined, however. The declines in cash balances were primarily due to the need to help fund an acquisition consummated in Q2 coupled with the significant legal settlements with BMC and Hewlett Packard (NYSE:HPE) during the quarter. The company has $491 million of convertible debt outstanding.
The growth in deferred revenues is at moderate levels for a company such as this and the company indicated some decline in the length of its average contract signings. Deferred revenues are at 204% of revenues last quarter and that compares to a ratio of 240% in the prior year. I believe that the reasonable expectation for a company such as this is to see the ratio rise rather than fall and this does reflect a couple of quarters of disappointing bookings in the recent past
The company's cash flow from operations was muddied by accruals relating to some legal settlements for patent infringement claims. Overall, the company paid $270 million in aggregate during the quarter to both BMC and Hewlett Packard Enterprise
The not so sunny side of the streets in the future!
To be sure, I have mentioned some causes for concern or for pause earlier in this article. But there are a few things that were perhaps a bit more telling, at least in the way I read tea leaves. Again, I would almost certainly come to a different set of perspectives if the valuation were lower - when the valuation is at the levels it is, and the margins are where they are or seem likely to be going, it really isn't the most prudent of strategies, "to leave your troubles on your doorstep and just direct your feet…"
One of the issues that I have, and I think it is a self-evident one, is that the company's future growth is predicated on selling its user base almost all of its product portfolio. At the moment, more and more of the company's revenues are coming from upselling, an issue that was discussed on the call. The CFO said the statistic would no longer be disclosed because, as the company had grown, it represented more and more of the total performance. Exactly why that meant the statistic shouldn't be disclosed unless it suggested an inability to close large new name deals, this writer does not know.
In any event, the company's growth projection is based on taking the average annual revenue of its large installed customers - the Global 2000 from $941k to $2 million between now and 2020. I am going to say that it is both a very ambitious and a very tendentious target and leaves me more than a bit of a doubting Thomas.
Here is an answer that left me more than a bit uncomfortable. Michael Scarpelli said to the call audience:
"Sure. So as you know we've been acquiring companies. For instance, we bought ITapp on the ITOM side. We just bought BrightPoint this quarter. We're making some additional investments in research and development (in) our core ITSM products. And so we're accelerating research and development hiring and also we're pulling forward, especially around some of these new products and especially sales from Q4 into Q3. So… it changes the timing of some of our salespeople as well, too, because of the opportunity we're seeing in some of these newer emerging products."
Why do I find that a worrying commentary? Well, again, pulling revenues forward ought to mean seeing an upside in something-bookings, billings reported revenues, something. But it isn't there - at least not in the company guidance. But what is there is a slowdown in growth expectations for Q4. That is what might be expected to happen if you pull forward some revenue elements from Q4 to Q3. And what is the organic level of bookings growth. I am the last person to deprecate a strategy of acquiring around a core set of competencies and all successful software company's do it and need to do it, but I wonder what that might say about the state of demand for the company's core technology?
The company articulated that its ITOM business was one of its major opportunities and it has made some significant investments into the space both through acquisition and through accelerated internal development. But the fact is that IT Operations management, which is all about automating help desks, is not either something new or something particularly unique in the service world. For much of its life, NOW has been the beneficiary of its competitors and in particular BMC Software and its Remedy suite of products. BMC has been one of the more generous of share donors on the planet and NOW has been its favored recipient-particularly in this space.
So now, a lawsuit that alleged that NOW misappropriated BMC's code in this particular space has been settled, NOW is accelerating its development spend in this area and this area is that which has to support much of the company's future growth. Is that worrisome - even a little? The same scenario is true with regards to Hewlett's Service Manager offering. Somnolence on the part of competitors is a consummation devoutly to be wished, but for investors to rely on it as a basis for valuing an investment strikes this writer as a bit in the same category of going skydiving without a parachute, although I saw a photo of such an accomplishment recently.
But in addition to competitors BMC and HPE, there is Computer Associates and there is VMware (NYSE:VMW) Service Manager and then there are a huge cohort of other vendors who are active in this space with offerings that are quite comparable or perhaps even better depending on some particular feature/function mix.
My issue is that this is a crowded space, it is somewhat mature and there is nothing hugely better (or to be fair worse) about what NOW is offering. And it has awoken two very large and dangerous competitors who can readily roam the neighborhood if they are sufficiently energized.
These days, NOW offers a significant suite of what it describes as Business Management tools. The word "Manage" is one of the most overused terms amongst IT marketers and there are those who readily adopt to the lexicon. But what is being talked about is the ability to use the data that is generated by trouble tickets and service desk logs and use it to prioritize which issues and which applications are given the focus of resources. If that sounds as though it might have been done in the past, the reason is because it has. Again, Remedy pioneered many of these solutions 15 years ago.
One question on the call suggested that some of the new NOW - which are confusedly labeled as CRM offerings - compete against those of Salesforce (NYSE:CRM) and thus suggest a dramatic expansion in the TAM for this company. Without a lengthy discussion to which some readers may take exception, this company isn't trying to accomplish the same set of functions that Salesforce sells. This company sells software that looks at IT processes on a holistic basis and helps users prioritize and automate the resolution of performance issues. That is an interesting market and one that is very important to IT managers and leaders. This company doesn't try to go after selling solutions that address the business processes themselves. The TAM for what it sells is large, but in the nature of things, far less sizeable than the TAM for application software.
What seems to have happened is that as NOW has matched its established competitors in capability it has and continues to be able to sell these capabilities, primarily to its installed base and to increase its revenue per customer significantly. The issue isn't whether or not this is a good strategy-it surely is and it is surely the only strategy with even a chance of success. The issue for me isn't whether the strategy is wise but how far the strategy can carry NOW and its growth rate.
I clearly erred back in March in my belief that NOW had reached an inflection point visible to the naked eye. That hasn't happened. But there are some issues below the headlines that lead me to believe that the inflection point is a lot closer at hand than is indicated by the valuation. Inflection points are hard to call, but I still see the denouement for ServiceNow as the same as I forecast in March - just delayed.
- ServiceNow reported Q2 earnings on July 27 that were considered generally in line with the consensus of prior expectations.
- Some analysts were hoping for a more robust set of expectations for the balance of 2016, but the company essentially retained its prior outlook.
- The extrapolation of some of the numbers presented during the course of the call suggested that the company's core product in the ITSM space has seen a dramatic growth slowdown that may be worrisome.
- The company made substantial progress in terms of improving operating efficiencies in Q2.
- Guidance, however, suggests that some of these improvements are likely to prove to be ephemeral.
- The company's competitive offerings in the ITOM space, while in some ways a reprise of its strategy in ITSM, are going to come against more aware and less complacent legacy vendors - and yet the importance of ITOM in the company's forward growth is hard to underestimate.
- The company has a strategy to maintain its growth by more than doubling the annual revenue contribution from its current installed base of the Global 2000 by 2020 which seems to be one of those expectations that is best characterized as "a bridge too far."
- The company's deliberate lack of transparency in some areas of particular interest to analyst and to serious investors is certainly not a factor lending credibility to estimates of future growth.
One must, in terms of evaluating NOW, acknowledge the fantastic job it has done in dislodging BMC from its long held position of primacy in the ITSM space. Few would have forecast that denouement back in 2009 and this team and in particular the company founder, Frank Luddy, who has announced his retirement, have to be credited with knocking off the home team against high odds. But at the least, the team on the field has to compete against far too many other teams to sustain a growth rate necessary to achieve positive alpha.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.