Here is another company that seems to be firing out of all cylinders, IT services management platform provider ServiceNow (NOW). It’s another SaaS business software provider that has strong tailwinds that don’t look to be abating anytime soon:
The company started out as a ITSM (IT service management) platform, helping clients to digitalize and streamline their IT service management process and bringing it into the cloud.
But as so often, having a cloud platform enables the company to add features and modules into an award winning platform. Some of these modules are succinctly listed by Wiki:
Asset and Configuration: identify and monitor IT service assets and their relationships.
Planning and Policy: define IT strategies and manage projects.
IT Services: deliver IT services and support to business users.
IT Operations Management: track and manage IT resources and systems.
Non-IT Services: automate business processes outside of IT.
You can click on these links for a quick overview of what they’re offering, or go to the company website for another product overview.
Growth
The market for cloud based IT Service Management is still projected to grow at a CAGR of 15%. The company makes 90% via subscriptions, the rest they earn in services (which carry a much lower margin).
While the company already has 800 or 40% of the biggest global 2000 companies under contract, it doesn’t look like the explosive growth the company has been experiencing is slowing down significantly anytime soon.
For instance, the company is not only getting these big corporate clients but they tend to start small, which leaves a lot of up-sell opportunities. The company is also increasingly servicing government agencies, some of these are among the biggest customers they have.
For instance, they just closed their biggest ever deal with an average customer value of $7M with a federal agency.
There are still plenty of growth opportunities, even in their basic modules like ITSM, which was included in 17 of their top 20 deals in Q3. ITSM is what “gets them in the door with their Global 2000 companies”, according to CFO Michael Scarpelli on the Q3 CC.
Adding features
The company is constantly adding functions and features, developed in-house but also acquired. This year they acquired a host of companies, like DxContinuum, Qlue, Telepathy and SkyGiraffe.
One reason is simply to increase cross-selling opportunities, and there is plenty of that:
But when asked during the Q3 CC, management actually said that most of the acquisitions are simply platform economics. That is, the improved functionality improves the whole platform, which makes it both more sticky for existing customers and more attractive for prospective ones. But it also improves pricing, here is CEO John Donahue on the Q3 CC:
I will say that as we are selling today, our latest versions to new customers, those products or those applications have a lot more features and functionality than it did two years ago so we are able to extract more on a per user basis and show customers real value. So yes, over time I do expect our pricing with what were extracting out of customers to increase
Some of the additions that the company has made are IT security features that collaborate with known security platforms like Palo Alto (PANW) and others that allows companies to respond faster to threats and security breaches.
Another whole new growth opportunity is AI (artificial intelligence). The company is rolling out machine learning capabilities especially for customer service management in their upcoming Kingston release.
The company has acquired a couple of interesting AI plays this year to help develop these capabilities, like DxContinuum and Qlue. On the former, from ZdNet:
ServiceNow wants to use DxContinuum to make inroads in the area of Internet of Things automation, so things like device service requests, which are typically handled manually, can be automatically categorized and routed for each ServiceNow customer. ServiceNow says it’s well positioned to provide this type of tailored approach to machine learning because its predictive models are already specific to each customer and their own cloud instance.
They are guinea pigging the DxContinuum algorithms on their own customer support center before it’s rolled out to customers with the upcoming Kingston release.
Qlue develops virtual agents for better communication with customers. SA contributor Donovan Jones has a more extended take on this.
Another acquisition has been SkyGiraffe, a company that enables them to produce easier mobile applications. SA contributor Donovan Jones has a more extensive take on that.
Service
In order to be more ‘sticky’ yet, it helps if the company basically solves problems for their client, instead of just selling it services. The idea is perhaps best put into words by analyst Alex Zukin from Piper Jaffray on the Q3 CC when he argued that (our emphasis):
As you get further down this path and becoming kind of strategic digital transformation partner for your customers
One way they do this is through their Inspire Team:
The ServiceNow Inspire program works with leaders ready for significant business transformation. We help Global 2000 CXOs reimagine their service management strategy and roadmap from first insight to final implementation. Our team of industry strategists, former customers, architects, and designers have improved corporate results, brand, and valuation for some of the worlds largest companies.
But service is a much lower margin activity, and in order to keep margins up, they’re also outsourcing part of this to partners (like Accenture and DXC), although these are complementary to their own sales teams and work in conjunction with them.
Margins
Here are the GAAP margins:
While gross margins have trended nicely upwards, this is much less the case with operating and EBITDA margins, but there is nevertheless real improvement also here:
That is, it looks like operational leverage is finally starting to kick in. Another indication of that is the following:
A 25% free cash flow margin sounds pretty impressive but is hugely inflated by the rather liberal use of stock-based compensation (roughly 23% of revenues), so we wouldn’t get too jubilant about this.
What’s next?
As SA contributor Gary Alexander already pointed out, while revenue growth was still topping expectations, billings (revenue + change in deferred revenues) came in as expected and this might signal a limited capability of the company to keep exceeding expectations.
Q4 is seasonally their strongest quarter, but they’re also going to increase hiring, so we have to wait and see how that plays out. Revenues are still guided to grow 38%-39% in Q4, although billings will grow by 30%-31%, which opens up just a tad of concern that growth is slowing down.
Valuation
Twelve times sales isn’t exactly cheap, and mind you, the company has a substantial amount of debt outstanding, the result of a considerable amount of acquisitions.
One should also be aware of a substantial gap between GAAP and non-GAAP figures. Despite a considerable improvement, the adjusted EPS of $0.38 in Q3 turns into a GAAP loss of $0.14.
The biggest part of that is stock-based compensation. For instance, for the first nine months of the year, stock-based compensation totaled $288M, a good 23% of revenues ($1.24B). That, and the acquisitions lead to the following:
That count is going to 181M in Q4.
The company has $1.67B in cash and $1.15B in long-term debt on its books. This year the company is expected to produce an EPS of $1.2 (non-GAAP), rising to $1.8 in 2018, the latter gives it a forward multiple of 71.
Verdict
Given the amount of share-based compensation and the rich valuation, we cannot but see the shares as fully valued. That doesn’t mean there is no upside.
The market is very likely to keep on growing at substantial rates (some 15% as a market research has it). The company is likely to do substantially better than that, but whether they can remain at their current 40% pace remains very much to be seen.
However, the company’s platform has a strong and established position. We haven’t found anything about churn rates, but we would be surprised this would be anywhere near significant.
The company will continue to up-sell and cross-sell, and it will continue to develop new functionalities and modules and acquire these, creating a more sticky and attractive platform with more opportunities to up-sell.
Also, operational leverage has started to kick in so the company basically has three tailwinds, revenue growth, up-selling opportunities and operational leverage.
However, it also has something of a headwind, the liberal use of stock-based compensation and acquiring quite a few companies is pushing debt and the share count upwards, blunting part of the leverage.
A good scenario would be where the company can roughly maintain their growth whilst cutting those headwinds (operational leverage would allow them at least in part). In that case, the shares would still be interesting.
A bad scenario where growth diminishes and not much is done about the share and debt issuing is equally possible in our view, and in that case, it’s much harder to see significant upside for the shares.
These SaaS platforms are the darlings of Wall Street at the moment, and rightly so, as these platforms are sticky and offer numerous ways to add additional revenue streams, but the valuations are really quite stretched.
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.
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