ServiceNow Stock: A Promising Growth Stock With Strong Fundamentals, Buy (NOW) (2024)

Investment Thesis

ServiceNow (NYSE:NOW) is a leader in IT automation software, and it has caught my attention. While the stock price dipped recently, I see it as a candidate for a stock growing at a reasonable price. In this article, I will look into various factors including the company’s financial strength, management, and corporate strategy to see if it aligns with my strategy.

Seeking Alpha shows analysts are bullish on ServiceNow earnings, predicting a stellar year-over-year increase of 25.25% and 20.42% for the current and next fiscal year. However, recent estimates have been slightly revised, suggesting no immediate surprise on the earnings front.

Revenue paints a more dynamic picture. ServiceNow is expected to maintain consistent growth, with a projected 21.56% and 20.54% growth for both the current and next fiscal years. These figures indicate a healthy customer base expansion and strong product demand.

ServiceNow recent performance has been a mixed bag. While they surpassed earnings expectations by 5.95%, in their last earnings report on April 24th, their revenue forecast for the current quarter fell short, leading to a 4% stock price drop. As you will read later, I find the stock fairly valued, which means any negative surprises or guidance could trigger a significant price decline. Guidance for Q2 guidance was lower due to a hedge on FX but the incremental strengthening of the USD still resulted in headwinds, according to the CFO during the earnings call:

Moving to our guidance. In Q1, we initiated a program to hedge a portion of our foreign currency denominated revenues. The initiative is expected to lessen the impact of recent movements in the euro and pound, but the incremental strengthening of the US dollar has still resulted in FX headwinds compared to our previous guidance.

I find that a key strength for ServiceNow is its robust economic moat. Their software become deeply integrated into customer operations, making switching to competitors extremely expensive and time-consuming, keeping the renewable rate for their product at above 90%. This translates to significant pricing power and helps ensure long -term profitability.

The main hurdle I find is, that I find the stock is perfectly valued and any execution missteps or slowdown in the software industry, in the economy or in the company’s projected growth rates could cause a significant price drop. In fact, the company has already experienced a negative -20.5% decline in the stock price from its highest point and which is very much in line with other software companies like Salesforce (CRM), Intuit (INTU), and Adobe (ADBE) with all in negative territory YTD.

Despite these hurdles, I believe NOW is a proven leader with a history of impressive growth. According to their latest presentation, their expansion into their existing workflow in areas like automation in customer service, technology, and creator products delivery fuels future growth potential. Therefore, I find NOW a promising addition to my growth at a reasonable price portfolio and starting coverage with a Buy due to its long-term prospects, particularly its strong financial health and wide economic moat.

Management Evaluation

Bill McDermott has been ServiceNow's CEO since late 2019. According to his profile on the company's website, his focus on customer relationships aligns with ServiceNow’s goals of becoming the defining enterprise software company of the 21^st century. I find this focus even more impactful considering a significant portion of his compensation comes in the form of company stock awards and stock options. His financial success is directly tied to ServiceNow’s success, creating a powerful incentive for him to drive the company forward, and therefore I consider this to be a “high alignment ratio” with the company success.

I also find that McDermott has an impressive prior experience. During his tenure as CEO of SAP (SAP), the largest European software company, he oversaw a staggering increase in market value from $39 billion to $163 billion. I believe, this track record of driving growth through customer-centric approaches bodes well for NOW.

Furthermore, both Bill and ServiceNow enjoy exceptional reputations. They both have Glassdoor ratings exceeding 90% above industry ratings. Usually, I find that a strong leadership and a positive work environment are factors tied to the future success of a company.

Gina Mastantuono, ServiceNow CFO for nearly 4 years, plays a crucial role in financing the company’s impressive growth. I believe her focus on building a strong balance sheet has paid off. One key metric highlighting her work is the company’s ROE, which has grown over 200%. This significant increase demonstrates her ability to finance projects organically while maintaining low debt levels. Before joining NOW in early 2020, she held executive roles at Ingram Micro and Revlon.

Overall, I believe the ServiceNow team demonstrates a strong commitment to the company’s long-term success. McDermott leadership and high alignment ratio has been noticeable on their Glassdoor review scores. I believe the management is well positioned to navigate the current slowdown in the software industry. Given all these factors, I’m rating the NOW team with a “Meets Expectations”.

Corporate Strategy

ServiceNow's strategy revolves around solidifying themselves as the leading enterprise software company. The company has also expanded beyond IT workflows and is now incorporating workflows in customer service, supply chain, and creator workflows. The diversification broadens their appeal and strengthens their position in the enterprise software landscape.

I find that a key competitive advantage for NOW is their extensive platform capabilities. They offer a comprehensive suite of tools encompassing ITSM, customer service management ("CSM"), and IT operations Management ("ITOM"), while providing deep integrations with other enterprise applications. This allows them to cater to complex workflows and large organizations, which some competitors may struggle with. In fact, the number of customers with more than $1 million in Annual Contract Value ("ACV") has been steadily increasing. However, ServiceNow high cost and complexity can be a deterrent for smaller businesses, making other niche players more attractive.

I have created the table below comparing NOW current strategy to some of its current competitors:

Source: From companies’ website, presentations, SeekingAlpha, Gartner Report.

ServiceNow stands out to me from other competitors like Freshservice and the management tool from Atlassian in the ITSM space due to its extensive platform capabilities. While these competitors offer user-friendly interfaces and cost-effective solutions, ServiceNow boasts a more comprehensive suite of applications. Their offering makes it a more compelling choice for large, established enterprises. These organizations, with their complex workflows and deep pockets, are better positioned to weather economic slowdowns and often prioritize features over pure cost-effectiveness.

Valuation

ServiceNow currently trades at around $655, falling around 12% since it last reported earnings in late April.

To assess its value, I employed a conservative 11% discount rate, this rate reflects the minimum return an investor expects to receive for their investments. Here, I am using a 5% risk-free rate, combined with the additional risk premium for holding stocks versus risk-free investments, I’m using 6% for this risk premium. While this could be further refined, lower or higher, I’m using it as a starting point only to get a gauge for unbiased market expectations.

Then, using a simple 10-year two staged DCF model, I reversed the formula to solve for the high-growth rate. To achieve this, I assumed a conservative terminal growth rate of 4%. In my experience, this rate reflects a slower but more sustainable growth trajectory for mature companies in the longer term. Again, this rate can be higher or lower, but from my experience, I feel comfortable using a 4% rate as a base case scenario. The formula used is:

$655 = (sum^10 FCF (1 + "X") / 1+r)) + TV (sum^10 FCF (1+g) / (1+r))

Solving for g = 24%

This suggests that the market currently prices NOW FCF to grow at 24%. According to Seeking Alpha analyst consensus, FCF is expected to grow at a 24.07%.

While economic headwinds may put pressure on growth expectations across the market, companies with an established client base, strong revenue growth, and solid financials are better positioned to navigate these challenges. They'll likely experience some slowdown, but these companies have the potential to rebound and resume strong growth once CAPEX picks up again.

This is why I'm taking a measured approach by starting my coverage with a cautious buy. I believe in their leadership team and their ability to execute their growth strategy, and while the current price reflects fair value, I'm a buyer of stock weakness to capitalize on any potential dips.

Technical Analysis

NOW has dropped over -20% from its all-time high this year of $815 in mid-February. What changed? The economic environment and company’s forecasts have been less positive, I believe due to lower CAPEX spending due to higher interest rates. This has been felt across the Top Software industry and impacting stock prices including Salesforce, Adobe, and Intuit.

The stock broke an important short-term support level of $672 recently, I believe due to the current economic scenario that it will have a hard time breaking above it. However, I believe it will float above $600 and around $700 until more information becomes available. I will revise my investment thesis as needed.

The next earnings report is estimated to be July 26.

Takeaway

ServiceNow is a good candidate for a Growth At a Reasonable Price if you believe in the long-term story. While the current economic climate and recent software industry guidance have cast a wait-and-see approach on the stock, I find NOW fundamentals remain strong. Their healthy financials, combined with a strong leadership team, positions them well to weather the storm. Additionally, NOW’s focus on large enterprises, which tend to be more resilient during economic downturns, adds to their appeal. Based on all these factors, I’m initiating coverage with a Buy.

Matteo Sada, CFA