ServiceNow (NYSE:NOW) has been one of the stronger performers among enterprise service players as investors began to appreciate the secular tailwinds for the company. Coming out of COVID-19, we think ServiceNow will become ever more present in the corporate world as corporations shift towards remote working and further digitize infrastructure.
Essential Service
While many industries have been decimated by the ongoing pandemic, ServiceNow becomes ever more important to its clients many of whom are have shifted towards working from home for most of their employees. ServiceNow is a leading cloud service provider of enterprise software solutions and it began in the IT segment. Over the years, it has expanded beyond its reliance on IT service management to expand into customer service and HR. ServiceNow essentially allows a company to standardize and streamline its business process to drive performance and efficiency. It started its presence in IT and has been expanding to other areas as the world moves towards digitization of workflows and, amid the pandemic, working from home arrangements. These are all secular tailwinds benefiting cloud service providers such as ServiceNow.
(Source: IR Deck)
Back in 2013, IT workflows accounted for 95% of ServiceNow's revenue but that number has since come down to only 66% in Q1 2020. The company remains heavily focused on the IT segment but its push into HR and customer workflows have paid off. All three verticals are essential to corporations even under today's crisis. Under the subscription model, it is not difficult to understand why investors have piled into technology stocks due to their revenue visibility and cash flow profile. Importantly, ServiceNow's HR offerings are focused on improving workflows between HR and other departments that do not compete directly with traditional HCM vendors such as Workday (WDAY), SAP (SAP), or Salesforce (CRM).
(Source: IR Deck)
There will be an acceleration of the adoption of the digital workflow by companies in all industries. With the majority of workers now working from home, it is easy to conceive a world where companies handle most of its IT, HR, and customer service workflows on an integrated cloud platform. That is why we think ServiceNow's total addressable market just expanded significantly as a result of the current pandemic. While it is not easy to quantify the impact, directionally the positive momentum should be meaningful and long-lasting. It is also important to realize that this is not a new trend but rather a bring-forward of a secular theme that has been playing out over the last many years. The pandemic has brought about changes in workplace and business interactions which is favorable to ServiceNow.
Valuation & Financials
ServiceNow currently has a market cap of $81 billion and trades at ~15x 2021 revenue which at the high end among its SaaS software peers. The higher multiple is partly due to its superior growth profile which makes sense. For example, Oracle (ORCL) has not been growing for years and is expected to remain flat, which corresponds to the lowest trading multiple in this group. Adobe (ADBE) is one of the most successful examples of a transformation to a SaaS model and is trading at 12x 2021 sales.
(Source: Public Filings and Bloomberg)
From another perspective, we think ServiceNow has likely been overbought on a short-term basis as the stock is up 30% YTD, a significant divergence from the rest of the group. Part of the recent rally was due to a strong 2020 Q1 earnings and management provided a rosy outlook. During Q1, subscription revenue grew 36% from last year and the Remaining Performance Obligation grew 32% to $6.6 billion with a 97% renewal rate. The company reported strong margins and cash flow as less traveling benefited cost lines. Management conveyed confidence in their guidance supported by the visibility into subscription billings which are 50% driven by backlogs, 25% by renewal, and 25% by new customers. In other words, around 80% of the 2020 revenue is already accounted for by signed contracts. The strength of the SaaS model has never been clearer during the current crisis as investors appreciate the predictability and visibility into future revenue and cash flow. When you add in the mission-critical nature of the product and services, ServiceNow is in a very good spot to ride out the current storm relatively intact.
(Source: Bloomberg)
Looking Ahead
We think ServiceNow represents the best-in-class SaaS enterprise software play in the market right now, albeit at an expensive multiple. Investors have bid up ServiceNow's multiple in light of a strong Q1 and confident tone from the management. We think there are lots to like about this stock including its SaaS model, global scale, top-of-class renewal and growth, product innovation, and overall execution track record. However, we are also conscious of the recent rally relative to its peers so we would await better entry points. For existing shareholders, we think the secular shift towards digital workflow will only accelerate due to COVID-19, and ServiceNow is one of the best-positioned to capitalize on that trend.
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