ServiceNow - Long Way To Go Before It Can Start Generating Profits

| About: ServiceNow (NOW)
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The public cloud services market segment, as estimated by Gartner, is expected to grow at a CAGR of 17.7 percent over the next few years. Within the public cloud market, cloud system infrastructure services (IaaS) is expected to be the main driver of growth in the market. Cloud application services (SAAS), the segment in which the company I am going to review today is operating, is expected to achieve a growth rate of 19.5 percent over the next few years.

North America is expected to remain by far the largest market in terms of cloud spending, while western Europe is expected to be the second-largest market. North America is expected to put forth a total of $250 billion in cloud spending and would achieve a CAGR in spending of 20.3 percent. For a growth-oriented company, such as ServiceNow (NYSE:NOW), large growth in the market would provide significant opportunities to enhance its financial position.

ServiceNow Historic Performance

The company has seen a gradual growth in its total revenues by an average growth of around 17 percent. Subscription revenues, which are charged for the access to its application suites, are the most significant area of growth for the company. These revenues saw a growth rate of around 16 percent over the past few years.

The company's gross profit margin has been somewhat stable over the periods, around the 60 percent mark, with the highest percentage achieved in the second quarter of 2011. This suggests that the company's cost of services has been increasing proportionally with sales.

After the first few quarters of positive margins, the company's operating margin has declined sharply. After the decline, the operating margin has persisted at around the -15 percentage mark. This is suggestive of the fact that the company's operating cost has been highly volatile over the period and increasing substantially throughout the periods.

The largest costs for the company are its sales and marketing costs. Because the company is generally involved in direct selling, this portion is bound to be high. Another cause of high percentage of costs for sales and marketing, as stated by the management, is that the company has continued to expand its operations in existing markets as well as in new markets. Thus, the company has substantially increased its headcount in sales and marketing personnel in order to grasp a higher market share. Although it seems imprudent, it is vital for a growing company to invest highly in sales and marketing in order to establish itself in the market, especially in a market where big-name players such as International Business Machines (NYSE:IBM) and Hewlett-Packard (NYSE:HPQ) already exist. The second-largest cost for the company is the cost associated with R&D. These expenditures are also vital for the company in order to enhance and improve its services so as to capture new customers and retain already existing customers. General and administrative costs have remained low throughout the periods, coming in at an average of 15 percent of total revenues.

The net margin has also followed the trends in the operating margins, as the company has significantly low interest expense and other incomes. This means that controlling operating costs is very important for the company to return to profitability.

DuPont Analysis

Due to negative shareholders' equity prior to Q3 2012, it was not possible to conduct a DuPont analysis for prior periods. As can be seen from the table above, the company has been generating negative returns for its shareholders. This is due to the fact that company margins have been negative for several periods. Although the company has improved its performance, the primary reason for this improvement is the decline in its financial leverage. The leverage has declined significantly, but this is because the company has seen its shareholders' equity move from a negative figure to a positive one. This resulted in a low shareholders' equity in the early periods, which gradually increased to lower the financial leverage for the company. The reason for the increase in shareholders' equity is that the company has been issuing new stocks in order to finance the growth of the company. Another reason for the company's negative ROE is the gradual reduction in the company's utilization of its assets. The asset turnover of the company declined to 0.17 from 0.22 in Q3 of 2012.

Major Segments

Despite the fact that the company has enhanced its operations in the international market, it is still heavily dependent on the US market. This is also because of the fact that the US cloud market is the largest and is also expected to be the highest-growing in the future. However, the US market is also the most competitive of all the regions. The second most significant geographic area for the company is Europe, which is also the second-largest cloud market in the world.

Competition and Future Outlook

The public cloud is expected to grow exponentially in the coming years, reaching up to $144.7 billion by 2016 from the 2012 figure of $84.1 billion. The new cloud has generated extensive interest from various regions of the world. The largest market for the industry is still North America, and it is also expected to remain the largest for the foreseeable future. The market has seen a huge influx of vendors in the market, creating intense competition despite high growth. Although there are several small and new players in the industry, it continues to be dominated by large players such as IBM, Amazon (NASDAQ:AMZN), Oracle (NYSE:ORCL), and SAP (NYSE:SAP).

The ERP segment of the cloud market in which NOW operates has also seen a large amount of competition. The industry is highly fragmented with numerous companies holding less than 5 percent share. As can be seen from the chart below, the largest company is SAP, which holds approximately one-fourth of the industry's share. The graph clearly indicates the high level of competition in the market, and it is also evident that NOW holds a very small proportion of the market.

The company has significantly underperformed its competitors in terms of all the indicators. The company is expected to continue to perform at the given rate because of the fact that it would have to heavily invest in marketing and sales as well as R&D in order to increase its market share, which is going to be extremely difficult.

Conclusion

This new company has a long way to go before it can start generating profits. The high level of competition in the core market of the company indicates that it would have to find new regions in order to increase its sales rapidly; however, such a step would put additional strain on the company's margins. The control of large companies with better financial positions is another problem for the company, as it would be extremely difficult for the company to cut the market share of its competitors. All these reasons indicate a negative future outlook for NOW; thus I would give a sell recommendation for the company.

Disclosure: I 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.