ServiceNow: Profitability Is Added To The Growth Story

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About: ServiceNow (NOW), Includes: TEAM, WDAY
by: Compass Equity Research
Summary

The recent profitability of ServiceNow has become an additional argument to its growth story, making it a better option now.

As margins expand in the long term, ServiceNow’s price will show a more reasonable value for GARP investors.

Although ServiceNow continues to be a company trading at a high premium, it has slight advantages over its Workday and Atlassian peers.

After reporting the fourth quarter of 2018, ServiceNow Inc. (NYSE: NOW) saw a rapid appreciation in its market value after showing better results than expected. Despite being a company with a high valuation within the application software industry, an analyst in Goldman Sachs (paywalled) initiated its coverage with a buy rating and a price target of $260.

Like other companies that offer software and applications in the cloud, ServiceNow has generated high expectations of growth coming from the digital transformation of IT systems. On the other hand, after a comparative analysis, we see that the company's business model offers slight advantages over peer companies that make it a little more attractive, especially in the medium and long term.

ServiceNow Knowledge17 presentation

Expansion Of Existing Customer Relationship Is Leading Growth

The strong momentum from its digital transformation products continues to keep revenues in a strong growth spurt. For its last quarter of 2018, ServiceNow reported that its subscription revenues increased 33% compared to last year, surpassing analysts' expectations, and positioning it at $666 million. For its part, revenue for the quarter was $715.44 million, growing 27% thanks to the expansion in services offered to customers.

Chart Data by YCharts

We see that its offer based on the cloud has a solid competitive advantage given the nature of ServiceNow’s IT services, which have allowed the cross-selling and expansion of services in its customer base. Its strategy of creating long-term relationships with organizations, which have allowed unlocking opportunities in IT services, has kept ServiceNow in a strong secular trend. Executives remarked that by the end of 2018 their renewal rate was 98%, placing the company as a leader in customer retention within the industry.

We consider services such as IT Service Management (ITSM) and IT Operations Management (ITOM) as having strong competitive advantages given the high switch cost of these services from other companies, which gives greater long-term strength to the revenues. In addition to this, we believe that diversification towards emerging opportunities such as customer service, human resources, and security will allow the company to unlock new sources of growth over time.

At the moment, it seems that revenues will continue their current streak despite fears of a slowdown by some analysts. For fiscal year 2019, subscription revenues are expected to reach $3.2 billion, which would represent 34% growth compared to 2018.

ServiceNow Growth Rates VS peers

Source: Data provided by Ycharts.

Comparing the growth of ServiceNow with that of the industry, we see that the company's revenues have increased at a rate similar to that of its peers Workday Inc. (NYSE: WDAY) and Atlassian Corp. (NASDAQ: TEAM), making them more suitable for a comparative analysis.

We see that these companies have been characterized by a lack of positive net profit as they invest large amounts of money in sales and marketing strategies, as well as innovation and development, to maintain their current growth. Despite this operating leverage, we see that the management of ServiceNow and Atlassian have managed to grow the free cash flow steadily, making them a little more attractive compared to Workday.

Chart Data by YCharts

In relative terms, although ServiceNow has seen a slowdown in its revenue growth in recent years, the company still ranks among the fastest growing in the application software industry. We believe that this slowdown is common in this type of company, especially as the company approaches $1 billion in quarterly revenue.

Profitability And Free Cash Flow

Another quality that makes ServiceNow a bit more attractive compared to its peers, comes from the recent operating profits that the company has presented over the last couple of quarters. This profitability is largely due to the expense discipline that management has implemented, and to higher contracts value, resulting in an expansion of margins.

Sales and marketing expenses continue to represent the largest cash outflow of the company, which is directly associated with the large number of personnel in this department. By the end of 2018, the company reported that this area had 3,061 employees, representing 37.5% of all its headcount. Expenses such as salaries, benefits, and share-based compensation for the entire year totaled $1.2 billion, or 46% of total revenues.

Another factor that weighs on ServiceNow's operating leverage comes from research and development expenses; although comparatively speaking, these expenses are lower than that of its peers. For the last quarter of the year, the company destined 21% of its revenues to R&D compared to 42% for Workday and 44% for Atlassian. The management innovation strategy has been executed through organic innovation and small acquisitions such as Digital Telepathy, SkyGiraffe, VendorHawk, and Parlo, which have all strengthened both ServiceNow’s IT products and emerging products.

Chart Data by YCharts

We see that ServiceNow's cost discipline comes mostly from controlling its most important cash outflow. In the last five quarters, management has maintained similar cash outflows in S&M despite the increase in revenues. We attribute this to their strategy of expanding and extending its services within their current clients, which not only provides growth on the top line, but also offers better margins as they reach economy of scale.

In addition to this, the expansion of its gross margin has allowed the company to gradually report operating profits. This has allowed net profit to enter positive territory in the last couple of quarters after years of losses.

ServiceNow Margins and FCF VS peers industry

Source: Data provided by Ycharts.

On the balance sheet side, we see that both ServiceNow and Workday have lower leverage levels than Atlassian. This is a quality that we consider attractive, especially in the face of a scenario of increased interest rates or the possibility of a contraction in liquidity.

In the case of ServiceNow, we see that most of the long-term debt comes from convertible notes due in 2022. In comparison, the company holds $704 million in cash and cash equivalents, plus $922 million in short-term investments, so we do not see a solvency problem in the future.

ServiceNow Returns and Leverage VS peers industry

Source: Data provided by Ycharts.

Quick Valuations

Although the three companies present a convincing growth argument, we believe that both ServiceNow and Atlassian hold a slight edge over Workday, from a fundamental point of view. On the other hand, we believe that this discreet advantage for these two companies has been reflected in a slightly higher premium compared to the entire industry.

In the case of ServiceNow, the price to book ratio suggests that the company's shares are positioned at the highest end of the entire industry, which leaves little margin for error, even for investors with little risk aversion.

ServiceNow Valuations VS peers industry

Source: Data provided by Ycharts.

Looking back, we see that ServiceNow has been characterized by having high multiples compared to the rest of the industry. This high premium could be justified as the company has become the largest provider of ITSM in the market, despite competing with more established companies. With this in mind, we believe that ServiceNow's business model is quite solid, which will allow revenues to grow in the 25% range in the long term.

We hope that as the company becomes more profitable in the short term, the price of the shares will be more attractive compared to their peers, as their forward ratios suggest. We believe that this will attract new investors looking for a more reasonable entry point and a better price compared to its fundamentals.

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.