ServiceNow (NYSE:NOW) is a SaaS company that offers an enterprise software suite with a broad portfolio of services around IT Management and Workflow automation & optimization. The company has had a tremendous run over the past years but recently corrected in line with the general market and especially tech stocks. I consider ServiceNow to be a hold here, as it still trades at an elevated valuation.
Throughout the article, I will also refer to ServiceNow as NOW.
ServiceNow claims to be a beneficiary of several secular tailwinds. These tailwinds include the general transformation of business models: Everything is moving digital and the companies that won't make the transition are left behind. The pandemic especially accelerated the adoption of technology and thus helped ServiceNow.
Low-Code is another tailwind for NOW. A lot of NOW's software applications are low-code enabled and allow users to customize their workflows easily and seamlessly. This is underlined by ServiceNow being ranked as a Leader in the latest Gartner Magic Quadrant for Enterprise Low-Code applications.
ServiceNow recently increased its expected TAM to $200 billion, according to their expectations driven by newly added products and services into the portfolio. The macro looks good and favorable for ServiceNow.
I have a checklist of factors to look at for SaaS companies, so let's take a look at the last earnings report and see how ServiceNow is performing regarding:
ServiceNow reports a lot of useful metrics for us to analyze. The company reported 98% renewal rates in the last quarter with renewal rates staying in the 97-99% range for the last 5 quarters. This implies a churn rate between 1% and 3%, an excellent value. NOW's services seem to be deeply ingrained into the customers' workflow, leaving very little reason to switch to another provider.
In 2021 NOW managed a 125% net expansion rate, so on average, an existing customer spent 25% more than in the previous period. They sadly don't report this every year, but compared to 2020 it stayed flat at 125%. They also published that 2/3 of their existing customer base spent incremental dollars with NOW, up from just 60% in 2020. This shows that more customers decide to spend more on incremental services, but also that they spend less on average. It will be important to watch this trend going forward: Is net expansion driven by more customers spending incremental dollars or by customers spending higher incremental dollars.
To sum retention up, the renewal (or gross retention rate) is splendid at 98% and the net expansion rate of 125% is also very healthy.
ServiceNow continues to offer new products to keep customers spending more incremental dollars every year. The pipeline is stacked and they expect three new products to launch in the second half of the year on top of the seven product launches they already made in the first half. Expanding the ecosystem of services is one of the most crucial aspects of a SaaS company: New products serve two purposes, it keeps existing customers spending more and it draws in more new customers which then can be up-sold with other products as well.
Sadly NOW hasn't disclosed how many products its customers use on average in 2021, but they did disclose it in 2020. We can see that from 2016 to 2020 bigger deals took a lot of the share. Single product deals were almost nonexistent in 2020 and probably declined to around 3% in 2021. 5+ product deals now make up the majority of the share, a good sign of the stickiness and breadth of NOWs offering.
NOW has done a great job at growing incremental dollars for its big customers. I aggregated the data from 2016 until 2021, with 2019 being an exception where I couldn't find data. We can see that all categories of customers grew rapidly. The number of $1-$5 million customers grew 3 times in the period, $5-$10 million grew a staggering 8 times, $10-$20 million grew over 4 times and $20 million customers grew 7.5 times.
Gartner is a great resource to get an overview of a competitive landscape. I already referenced the low code magic quadrant, where ServiceNow shared the leader position with companies like Salesforce (CRM) and Microsoft (MSFT). In the magic quadrant for IT Service Management Tools though ServiceNow is the undisputed number one according to Gartner. Especially in the fast-moving enterprise software landscape, companies need to keep pushing the boundaries and keep innovating. NOW's placement here is a good indicator that they continue to do that.
Over the last decade, ServiceNow managed to continuously grow its margins. Gross margins increased from the mid-50s to the high 70s, showing the increasing moat of the company by being able to leverage its competitive position and operate with higher cost efficiency, as can be seen in rising profitability.
The rule of 40 is a metric to see if a SaaS company is growing healthily. The rule is calculated by adding the growth rate to the profit margin. There are different versions of the rule of 40, depending on the type of profit margin used. ServiceNow uses the Free Cash Flow margin and they talk about the rule of 60. I prefer to use the Free Cash Flow margin as well, but I also want to talk about the stock-based compensation. It is pretty common for technology and especially SaaS companies to award employees with excessive stock-based compensation.
As we can see in the graphic above, stock-based compensation is about as high as the cost of revenues and almost as high as the free cash flow. I believe that it is not fair to completely exclude these non-cash expenses. Even though it might not hurt the cash reserves of the company, it directly dilutes all existing shareholders and thus is a cost to shareholders.
The company calculates its rule of 60 with 30% revenue growth + 32% FCF margin, which leaves them with 60 points. If we now exclude stock-based compensation we are left with a 12% free cash flow margin. 30% growth + 12% margin leaves us at a 42 with my calculation, still beating the classical rule of 40. Great.
ServiceNow is a high-quality company, but it also trades at a high valuation. The company hasn't seen a drawdown to the extent many of its peers have in the last months. Many SaaS companies are down 70% and more, while NOW only fell 32%.
I want to compare ServiceNow to another SaaS company I consider to be of equally high quality: Veeva Systems (VEEV). If you want to read more about the company, I wrote about Veeva in this article. ServiceNow is expected to grow a little faster, while Veeva Systems is more profitable and still is founder-led. We can see that ServiceNow trades at significantly higher multiples compared to Veeva Systems if we look at EV/EBITDA, PE, and FCF yield. Only on a price to sales basis are they priced equally (but we can't forget Veeva's higher margins).
ServiceNow is a high-quality company with a great market position and predictable, low churn revenue. I do believe though that there are better deals in the market right now like Veeva Systems (which I personally own in my portfolio). If ServiceNow continues to fall and multiples contracts to around a 40 forward PE, I would consider opening a position.
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Disclosure: I/we have a beneficial long position in the shares of VEEV either through stock ownership, options, or other derivatives. 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.
Additional disclosure: This is not financial advice.