Urupong
Thesis
ServiceNow (NYSE:NOW) is likely to benefit significantly from the increasing demand for workflow automation, which is a crucial component of digital transformation. This could help the company maintain its position as a leader in organic-sales growth compared to most other large cloud software peers. In addition, expanding into new product categories, maintaining a high renewal rate, achieving a net-expansion pace of over 125%, and forming partnerships with system integrators could be major drivers of growth over the next three to five years. ServiceNow’s strong growth guidance for current remaining-performance obligation (cRPO) growth in the first quarter suggests that demand for its products remains robust, despite challenging economic conditions. I keep a Buy rating on NOW stock with an end-of-year December 2023 price target of $532 derived from a forward EV/Sales multiple of 10x applied to the consensus revenue estimate of $10.8 for 2024.
NOW stock price movement (Seeking Alpha)
Management provided positive guidance for 2023
The management stated that the company is entering the next year with stronger sales coverage and a 20% increase in sales representatives who have been trained and are ready to work. As per the company, they have taken a prudent approach to provide guidance and in my view may have understated its net new ACV and cRPO assumptions. Despite this, the company’s guidance exceeded expectations. For the first quarter, the company guided subscription revenue of $1.99 billion to $2 billion, and cRPO growth of 21% year-over-year and 24% on a constant currency basis. For the full year, the company expects subscription revenue of $8.44 billion to $8.5 billion. The management also expects non-GAAP OMs of 26% and a FCF margin of around 30% for the full year, which is consistent with the consensus estimates.
ServiceNow Leads Peers in Revenue Growth and Margin Improvement
ServiceNow’s sales growth has averaged 32% over the past five years, with almost no significant acquisition contribution — evidence of its strength vs. Adobe, Workday and Salesforce. About 88% of net new business booked each year is from existing customers, underscoring the importance of its products for end-users. A 98% renewal and 125%-plus net expansion rate, also demonstrate the high return on investment offered.
ServiceNow’s margins have steadily expanded over the past five years, and I expect this to continue in the future. Non-GAAP operating margin increased to 26% in 2022 vs. 16% in 2016, averaging annual growth of 167 bps. ServiceNow’s operating margin in 2022 increased by 50 bps as the company’s cost management drove improvement in profitability despite a difficult macro environment.
I believe steady expansion among existing clients, low customer attrition, and the continuous addition of new accounts can help ServiceNow sustain its lead vs. large-cap peers in organic sales growth and predictable margin expansion. New products that focus on human resources and customer service are also key drivers as clients look beyond the company’s core IT offering.
NOW rev growth vs. Peers (YCharts)
ServiceNow’s Product Portfolio Can Fuel High Double-Digit Near-Term Growth
Sales of ServiceNow’s core IT-service management software may rise more than 20% in the next 3-5 years, driven by a steady shift to the cloud from on-premise that boosts spending by its base. Despite controlling about 37% of the market, ServiceNow is expanding market share and expanding at around 2x the pace of the overall market, which may be $6.8 billion by 2026.
ServiceNow’s extensive range of cloud products catering to large end markets can drive a subscription growth of about 25% annually for the next two to three years, in my view as companies upgrade their internal IT systems. I expect a majority of this growth to come from existing clients who purchase additional products, which is a significant advantage for ServiceNow over its competitors. The company’s expansion may be aided by system integrators, along with new products that allow corporations to write low-code applications. Moreover, ServiceNow plans to reduce marketing and hiring expenses, which may contribute to a modest increase in adjusted operating margin over the next year.
Valuation
NOW trades at a premium to the average multiple of the comp set of SaaS Application Companies with revenue of $1B+ and 20%+ unlevered free cash flow margins: Salesforce, Inc. (CRM), Adobe Inc. (ADBE), Intuit Inc., (INTU) which trade at 5-8x EV/Sales, which I believe is appropriate given NOW’s superior revenue growth and FCF at scale. Moreover, NOW is currently trading at a significant discount to its historical multiple which gives a good entry in my view to long-term investors. My December 2023 price target of $532 implies a forward EV/Sales multiple of 10x applied to the consensus revenue estimate of $10.8 for 2024. My year-end price target implies an upside of 27% from current levels.
NOW valuation multiple vs. Peers (YCharts)
Final Thoughts
ServiceNow is a trailblazer and leader in cloud-based IT workflow management and is in the early stages of expanding into a multi-product company with offerings in Employee, Customer, and Creator Workflows. The company’s remarkable growth, strong free cash flow generation, and large total addressable market (TAM) of $200B make it a rare and valuable asset in the software industry. ServiceNow’s focus on organic growth and the user-friendly nature of its products gives it a competitive edge. The development of additional IT solutions and non-IT workflow offerings will be crucial drivers of future growth as ServiceNow aims to reach $11B in subscription revenue. I keep a Buy rating on the stock with an end-of-year price target of $532 implies a forward EV/Sales multiple of 10x applied to a consensus revenue estimate of $10.8 for 2024.
