A different kind of unicorn
The common definition of unicorn in the tech world these days is a private company that is worth in excess of a billion dollars. ServiceNow (NYSE:NOW) is, of course, not a unicorn using that definition. But unicorns have been around for thousands of years at least in literature, and in popular folklore, and recently some Italian researchers found a deer with a single antler that has grown in the middle of its head that looked much like pictures folk artists had drawn of the animal.
I used to think of a unicorn as something unique or rare and possibly just a chimera. That is a pretty good metaphor for ServiceNow as a company although it is hardly a chimera. On the other hand, despite the strengths of the company, and its strong record of operational performance, I simply am not able to conjure a good rationale for rating NOW's shares as a desirable investment at this valuation.
I confess that sometimes when I review NOW's numbers, I am staggered by the progress the company has made. Partly this has to do with the growth record of the space in which the company operates. IT Service Management has been around for quite some time with different definitions and different competitors some of whom have been acquired over the years. While segments of the space have seen bursts of growth, viewed at holistically, ITSM has been a moderate growth segment over the years. Before NOW became a public company in 2012, the major competitors in the space were BMC Software (now private) and Hewlett Packard Enterprise (NYSE:HPE). Both the record of HPE and BMC are a testament to the lack of growth they have been able to generate in the ITSM space
And part of my wonderment is the very aggressive guidance that the CEO of NOW continues to articulate. At this point, aggressive or not, an observer has to give some of the projections of CEO Frank Slootman the benefit of the doubt. But the question remains as to whether the shares are worth the price. I confess that I am not in the camp that is willing to ignore valuation despite my desire to seek growth far more avidly than income. NOW's shares have been great performers and are well loved by many investors and analysts. But there are few trees that grow straight to heaven, and I doubt that NOW will prove much different in that regard. I will discuss some of the rationale for the company's success and how much the shares might be worth in the balance of the article.
The Wages of NOW
ServiceNow has been one of the best hyper-growth names to own over the past year, and the shares are trading at all-time highs just above $90/share. And so far as that goes, it has been one of the better names of its cohort of public companies for investors to own over a considerable time period. The shares went public in 2012 at a price of $18/share and first traded at around $24. That is a pretty healthy return.
Since the company has been public, its shares have traded on growth and particularly growth in orders expressed in terms of Annual Contract Value. The company has almost inevitably managed to exceed growth projections by greater or lesser amounts since it has been public. This past year it initially projected revenue growth at about 35%, and wound up producing 39% revenue growth with subscription revenues, the most highly watched metric rising 45%. Subscription billings rose 44% adjusted for currency and contract duration (one particularly large order came in with a five-year contract duration).
Like many hyper-growth companies, NOW has been able to improve non-GAAP earnings - it actually has those - but it has had GAAP operating losses that have trended higher over the years and reached $2.75/share in 2016. Self-evidently, investors have yet to concern themselves with that issue. Stock-based comp expense has been an issue to some regarding this name and to a whole host of hyper-growth companies. While of course stock-based comp is an expense, if investors accept it as a nullity in their valuations, I really can't do other.
The trend in GAAP earnings really hasn't shown much improvement with sales and marketing expense rising faster than revenue - 41% vs. 35% (some of that was because of commission accelerators that peak in Q4s). The research and development expense ratio improved last quarter rising only 26% for the period and down noticeably from the 31% for the year as a whole. The issue of research and development spend and its declining trend is one to consider carefully.
Stock-based comp is simply enormous at 21.5% of revenue as compared to 23.7% in the prior year. For the year as a hole, stock-based comp was 23% of revenues compared to 26% in 2015. Stock-based comp rose by 22% last quarter, which was a small step in the right direction in terms of ratios.
Overall, GAAP operating expense rose by 35% last quarter, in line with revenues, and because of higher gross margins, the GAAP operating loss actually declined a bit. It is interesting that the company doesn't even project GAAP financial performance metrics. I simply do not know if management tries to manage toward any set of GAAP objectives.
In terms of non-GAAP expectations, the company projected 12% operating margins at the start of 2016. The actual result was 13%. So far investors have chosen to focus on rising non-GAAP margins and have not focused on a lack of improvement in many GAAP operating expense ratios. That is going to remain a risk for future valuation as there is some level, not really known, at which investors seem to balk in terms of rewarding the company's higher valuations based on improving non-GAAP operating margins.
A stake in the ground
ServiceNow reported the results of its fiscal Q4 and 2016 year last week. The results were a beat, although almost everyone involved with this name expects beats or they wouldn't be owning the shares. I will discuss the specific numbers in the earnings release shortly.
Of more interest to me was the company guidance both for this current year and for 2020. The forecast and the goals that the company has put forth really do constitute a stake in the ground. On a constant-currency basis, management has forecast that its subscription billings will grow by 37% this year, really a number that would be a major achievement. Perhaps even more extraordinary is the company's goal of achieving $4 billion in revenue by 2020. The company's revenue forecast for 2017 is $1.835 billion based on current currency values. To reach $4 billion in revenues by 2020 will require a CAGR of 30% for the following three years. That is a bold aspiration for almost any company in any industry at this scale. The question before the house is can that happen and what might margins and cash flow do over that period?
The company expects to reach its goal both by generating new Global 2000 (G2K) customers, but of even more importance from generating increases in annual contract value throughout all of its annual cohorts of current customers at rates comparable to those experienced in the past. It also expects to achieve progress at the lower end of the market, but those numbers are not likely to be particularly large in terms of a company looking to achieve $4 billion of annual revenues, mainly from subscriptions.
The company is growing its G2K customer base at a reasonable rate. The ACV increases of its cohorts have been extraordinary. Last quarter, upsells within its major customer base showed a 9% sequential quarter increase. From a forecasting perspective, that has been and is likely to remain the company's "secret sauce." At this stage, ServiceNow has been more successful than any of its peers in the hyper-growth IT world in weaning itself off of dependence on its initial application, and today, 46% of its ACV is coming from non-legacy product. This is very much a sales-driven company with an uncanny ability to execute.
The company has long presented a matrix regarding the trade-off between revenue growth and growth in margins and in free cash flow. It is clearly still in growth mode and obviously plans to remain in growth mode for a couple of years into the future, and the way it operates, that means that margin growth is going to be modest. The company has already come close to achieving its gross margin goals. From here on out, the heavy lifting must come from significant improvements in operating expense ratios. It has forecast non-GAAP margins of 16% this year, up from the 13% achieved in 2016 and its aspiration is to improve operating margins to almost 30% by 2020. That number (30% operating margins) is essentially consistent with its margin growth matrix. I just wonder if that matrix will prove to be a reasonable expectation over the next four years.
NOW, as previously commented, is still some ways from achieving GAAP profitability, although results at the end of the year showed some progress in some expense segments in operating expense discipline, and of course, the legal settlement with BMC and HPE is no longer a drain on either resources or time. But with sales and marketing expense at 49% of revenues on a GAAP basis, and continuing to grow faster than overall revenues, it strikes me that it will be impossible for the company to reach GAAP profitability any time in the foreseeable future. The company needs the sales and marketing spend to grow revenues as fast as it has, and it is a significant component in its success in beating the competition. Just as a comparison, when BMC was a public company, it typically spent less than 30% of its revenues on sales and marketing, and I doubt that it has increased that ratio significantly since it was taken over by private equity.
Overall, the basic reason investors have bid the shares to current valuations is likely to a belief that NOW will beat the consensus and raise its guidance most quarters. But in addition to counting on short-term performance, investors are also counting on the company achieving its aspirational forecast for 2020 earnings and revenues. That forecast, adjusted for the dilution coming from stock-based comp, and using the 33% tax rate which is that currently accrued, computes to an EPS of about $4 and to free cash flow of $1.25 billion. The company currently has an enterprise value of just greater than $15 billion. I don't propose to discuss whether the current enterprise value is supported by expectations of 2020 performance. The fact is, that at best is a close run thing, I believe although there are surely those with a different viewpoint.
So there are a few questions on which to focus in the balance of the article. Can the company achieve its aspirational goals for 2020? What specifically needs to happen to sustain 30% growth at the scale the company will reach at that point. What are some specific risks to consider in terms of the aspirations for 2020? And what should the shares be worth now if the company remains on track to achieve its 2020 aspirations?
As mentioned, investors may differ substantially as to the last query. And we have no idea what the terminal growth rate might be or really the direction of operating margins at that point (2020). I am not convinced either that the company can achieve its aspirational margin goals or that the terminal growth rate will be high enough to support ever escalating valuations.
How does NOW do it?
The idea that a company focused on solutions that essentially relate to what NOW calls a forms-based workflow and on IT Service automation can grow at fantastic rates year after year is a credit to the management and the sales execution of this team. The space in which ServiceNow was founded and which is still the cornerstone of the company's product offerings is called IT Service Management. The IT Service Management market is not insubstantial, but it has a moderate projected growth rate of about 6.5-8% overall. Even the cloud-based IT Service Management space only has an estimated CAGR of 16%.
An ancillary market that ServiceNow participates in is called IT Operations Management. Service management is basically concerned with providing software to remediate problems as they arise and to attempt to minimize disruptions to IT operations caused by service outages. IT Operations Management is, as the name implies, the process of managing day-to-day IT infrastructure, including provisioning, capacity, performance and availability of the computing, networking and application environment. The large competitors including BMC, HPE and IBM (NYSE:IBM) usually offer solutions that span both business areas. Operations management has been far more resistant to change than service management, and it therefore probably has a greater unaddressed TAM.
All of that being said, however, ServiceNow is growing at least twice as fast as its peers within both the ITSM and ITOM markets. The superior growth rate is not particularly a function of NOW offering unique or uniquely "better" solutions. The magic quadrants that Gartner has created rank ServiceNow in the first place, but primarily because of its ability to execute. BMC is said to have a slightly greater "completeness of vision" which is Gartner speak for technology.
In addition, there are many smaller companies that offer point solutions but they are rarely involved in enterprise transactions. What does NOW do better. I think the preponderance of the company's superior performance has to do with sales execution, solution packaging and positioning. Many readers want to hear about companies that have some kind of special technology moat. There is no special sauce in terms of how NOW solutions work. That would not be easy to achieve given the requirements of the markets in which it operates (At the end of the day, IT management still revolves around resolving trouble tickers or requests for service in an automated fashion that brings the most automation possible to helpdesks). What NOW does better than anyone is figure out how to offer what larger users want to buy at a competitive price. Not to be too picky, but it is really what might be expected of a company that spends almost half of its revenues on sales and marketing and has pledged to even accelerate it sales and marketing spend.
I think the other component of success that NOW is enjoying has to do with its expansion beyond ITSM. 46% of net new ACV was outside of ACV and most large deals the company closes include other products. Over time, the ability that NOW has to gain share in the ITSM and ITOM markets is probably reaching an asymptote. I simply do not think that the company is likely to be able to grow its ITSM business, still more than half of total of total bookings, at 25%, the growth rate achieved in Q4 or to see ITOM bookings more than double year over year; that was actually the result in Q4 (It should be noted that ITOM had seen two relatively middling quarters in terms of year-on-year bookings growth and Q4 was most likely a catch-up).
A few ago, when this company went public, it had a noticeable technology lead compared to its rivals. Its rivals in the space were basically contributing share and barely knowing what was happening. Please see the link as to how users felt about the company and its technology in 2012. While there continues to be some kind of aura that emanates from this company about its technology, the gap between its ITSM and ITOM solutions and those offered by the other major companies in the space has probably narrowed. Things like that are hard to measure, but I expect that the overall market space will see declining growth through the years and that NOW's outsize market share gains will moderate. As mentioned, ITSM grew 25% last quarter and was still 54% of the company's bookings and a much greater percentage of revenues. The company forecast for this year implies that ITSM's growth will be lower this quarter and this year, and I think that the trend is such as to suggest that ITSM revenue growth for NOW will gradually decline to 10-15% over the next several years.
If not through ITSM and ITOM growth, then how does NOW achieve its very bold revenue growth projections? To do so is going to require a raft of successful new products that can be sold at decent margins. It is a difficult bet to handicap because many of the new products haven't been designed, let alone released. This company has had a great record in terms of monetizing its new releases. Most of its 2016 cohort of product releases has apparently had far shorter sales cycles than the company's historical base of solutions and it has allowed NOW to engage both current and prospective customers on a far wider range of offerings than has been the case up till this time.
Part of the success that ServiceNow has enjoyed relates to its ability to sell large deals to large customers. The company's business plan involves selling 17 new logos/quarter and increasing the contract size in each of its G2K logos from $1 million to $2 million. In addition to service management and operations management/automation, the company has several other new products. These days, most of its customers order the company's platform to take advantage of third-party products that work with ServiceNow and they also choose to add analytics solutions. The company also sells what it describes as a business management suite for Information Technology departments. Although it is a new offering, it got lots of traction last quarter. In all, of the 20 largest new deals consummated in Q4, 18 customers ordered three or more products.
Last quarter, the ACV for the newer products grew by 84% and reached $270 million. I think it would be a brave soul indeed who would think that new products currently released could sustain a CAGR high enough to offset the declining CAGR of ITSM and probably ITOM by 2020. Can the company achieve it aspirational goal of 30% CAGR after this current year? Although I have pointed out several issues that might make it more difficult to achieve NOW's goals, when it comes to revenue attainment, I wouldn't bet against it.
The future for margins and cash flow at NOW
As mentioned earlier in this article, one of the long-standing projections that the company has provided investors are its expectations for growth in operating margins at different revenue growth levels. Management has forecast that at a revenue growth of around 30%, it can increase operating margins by about 4%/ year and can increase free cash flow margins by about 2% year. What that might mean for GAAP margins is unsaid and apparently is not of material importance to the company's management.
I think it will be much harder for the company to achieve its aspirational 2020 goals than the stock price might suggest. Here is a quote from the CEO Frank Slootman in last week's conference call on what the company's plans are in terms of sales and marketing spend for its newer products:
"Well, we're going to continue to-I mean, these products came out of the gate very strong in 2016. We had high expectations, but they still managed to exceed that. So, they are growing into numbers now that are substantially contributing to the overall result. In 2017, our goal is to maintain that momentum. In other words, we are leaning in hard. We're investing heavily in the selling motion because it's working so well for us. So, we're really going to push it along as fast and as hard as we can."
What does that mean quantitatively? My guess is that it means that sales and marketing expense growth, at least in the GAAP presentation, will outstrip revenue growth, making it difficult for GAAP financial results to show lower losses. The company CFO, Michael Scarpelli, is forecasting that non-GAAP operating margins will increase by 300 bps this year, and based on its track record, I would bet against that. And that is consistent with the company's investor presentation matrix. But, for that to happen, it seems to me that the company will have to cut the growth of its research and development function noticeably. Research and development growth was 31% last year and was 25% last quarter and were I to present a detailed model, given management comments on sales and marketing spend, I would have to think that the growth of research and development spending would slow to only 20% or so this year.
Will that spend level be an under-investment in research and development? I could make the case, given the likely growth trajectory of the company's core ITSM business, that it probably is. The company is going to need to accelerate the number of new products in its stack in order to maintain a 30% CAGR, and while there is not a perfect correlation between development spending and new products, I think over time that it is hard to imagine that the company will get more products while tightening the growth of development spending. It rarely works that way.
I certainly don't claim to have prescience or a crystal ball. It is easier to see great execution in terms of the company's ability to launch products and achieve visible revenue growth than it is to see great productivity in the research and development function. Maybe the company can achieve rising productivity and thus curb the growth of development spending. But my guess is that a slower cadence in the growth of development spending will lead to a slower cadence in new product introductions, and the company is going to have to find "a next big thing" if it is to achieve a 30% CAGR after this current year.
I tend to look at spending comparisons year on year almost entirely on a GAAP basis unless they have some one-time elements involved. For example, I don't think it is worthwhile to discuss the company's legal settlement earlier this year - it has nothing to do with evaluating future expectations. The company doesn't forecast GAAP and perhaps the answer to my dilemma is that stock-based comp expenses will rise. I don't think that is likely - the growth ratio has been declining.
But if operating margins are going to increase by 300 bps, if gross margins are going to be more or less consistent and if marketing spend will to continue to grow faster than revenues, then development spending has to grow more slowly and that is probably a bad choice for a company trying to maintain an elevated rate of revenue growth.
Just how expensive are NOW's shares? On the CS analysis to which I have referred in the past, the shares are expensive but not incredibly so. Less highly valued than the shares of Shopify (NYSE:SHOP), and far more highly valued than Atlassian's (NASDAQ:TEAM) shares. In absolute numbers, the EV/S is just less than 8X. The company currently has a market capitalization of $15 billion, and it has an enterprise value of $14.4 billion. The consensus revenue projection for 2017 is $1.84 billion.
The P/E on current non-GAAP estimates is 83X. Estimates for 2018 show more than 50% projected growth in EPS, which is more or less consistent with the company's growth matrix presentation, but which seem unlikely nonetheless. EPS for 2018 is projected by the consensus to be $1.62. Revenue growth for the same period is forecast by the FirstCall consensus to be 28%. To reach consensus EPS number, operating margins need to rise another 300 bps to 19%.
The company is projecting a free cash flow margin of 24%. That is free cash flow of $440 million. That provides a free cash flow yield of 3%, not perhaps the lowest free cash flow yield, but a level that is certainly within the upper decile.
There are those who think that NOW is a good acquisition target, and certainly from a strategic sense, the projection of a consolidation seems to be pretty reasonable. And Cisco's (NASDAQ:CSCO) buy of AppDynamics seemingly casts a whole new and different light on EV/S ranges for acquisitions. But this company is more than 4X the size of AppDynamics, and I just can't bring myself to believe that there is a potential buyer out there willing to pay 10X for NOW.
NOW's shares, as might be anticipated, are well loved by analysts with 27 out of 31 ratings published on FirstCall at buy or strong buy and only 4 at hold. But, with all of that enthusiasm, the consensus price target is just $102, 13% above current share prices. The numbers just don't quite fit.
From many aspects, NOW is an admirable company with prodigious execution capabilities. But it also needs to be considered as a stock. I admire the company; I find the shares at levels that make it difficult to expect that it will be able to generate positive alpha going forward.
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.