November 22, 2019 - 10:21am EST by
2019 2020
Price: 279.00 EPS 0 0
Shares Out. (in M): 195 P/E 0 0
Market Cap (in $M): 54,429 P/FCF 0 0
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0 0

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  • SaaS


Summary / The Opportunity
Unfortunately the stock started running on S&P index inclusion as I started this writeup, but I think ServiceNow (NOW) is a double within the next 3-4 years. I have owned it for a few years but think the risk/reward is still attractive on a multiyear basis. Like many TMT investors, I made a good amount of money the last 2 years being long SMID SaaS names, but I believe the market is now pricing the scaled cloud platforms (NOW, CRM, WDAY) as the more compelling play. Of these, NOW has the most interesting long-term organic growth opportunity ahead. I view NOW as a high-quality compounder that can drive 25-30%+ subscription revenue growth for the next 3 years, after which it can still do 20%+ while FCF margins go to 30%+. A business producing these economics at scale should command a premium EV/FCF multiple. Absent a severe recession where large enterprises shut down divisions or go bankrupt, I think the downside is ~25% from today's levels.
This isn't that controversial an idea, but shares are flat over the last 6 months. Aside from the recent volatility in growth stocks and cautious macro messaging from WDAY, there are some concerns on NOW's management change. In May, NOW announced that longtime CFO Mike Scarpelli (who was excellent at talking to the Street) would be leaving after the Q2 print to rejoin former CEO Frank Slootman at Snowflake. Scarpelli's replacement, ex-Ingram Micro CFO Gina Mastantuono, was just announced this week. The day prior to reporting Q3, NOW preannounced results and said SAP's former CEO Bill McDermott would be replacing John Donahoe, who joined the company as CEO less than 3 years ago upon Slootman's departure. Bears are cautious on McDermott taking the reins as his track record at SAP implies he may squander NOW's FCF on big acquisitions and tarnish the organic growth story. There are also some worries on the implied Q4 subscription billings reacceleration needed to hit FY numbers. This is really the function of deepening Q4 seasonality and the quarter being driven much more by contracted backlog and renewals than new customers lands. Overall, I believe this is all near-term noise, which is creating an attractive entry point. And since this is the VIC crowd, I'd point out this idea may be more actionable/palatable since NOW will have positive full-year GAAP earnings for the first time when it reports Q4/FY19.
NOW is a workflow automation software company that has become the de facto system of record for enterprise IT departments. Subscription revenue is ~95% of the total. The business addresses 3 major buckets of service management workflows: 1) IT; 2) HR; and 3) Customer. The company's beachhead has historically been IT Service Management (ITSM), although non-IT products have recently been contributing more to the mix. The business is managed to net new ACV, and as of Q3'19 the mix was: 55% IT, 30% Emerging Products (CSM, HR, SecOps, Finance, etc.), and 15% Platform Add-Ons & Other. At the end of FY18, NOW had 5,400 enterprise customers and covered ~75% of the Fortune 500. When it last reported its Global 2000 customer count in Q4'18, NOW had 883 of these customers who were paying an average ACV of $1.7mm per year. Management states it is still significantly less than 50% penetrated in IT across its current customer base, implying there is ample headroom for organic top-line growth even in the core product areas. The average customer land is $200-300k with a sales cycle of 9.5 months, although G2Ks can take 2-3 years. Customers expand to $1mm in ACV usually by year 4-5.
NOW's moat comes from 1) a large enterprise-focused land/expand sales motion that requires distribution scale; 2) relentless product innovation / TAM expansion efforts; and 3) an efficient financial model that follows from (and feeds into) the first 2 points, driving sticky customer relationships with higher ACV and profitability per customer over time. With the exception of CSM, the current-gen competitive landscape is benign, which has allowed NOW to differentiate its products and take market share at a rapid clip. Competitors within IT are clunky on-prem holdovers BMC Remedy and HP, driving customers to rip-and-replace with ServiceNow for several years now as part of digital transformation budgets. HR service delivery offers significant white space as a greenfield market with the closest peers serving much smaller organizations. CSM is where NOW often competes with Salesforce, but NOW tends to win with B2B companies that are managing large assets and more complex customer workflows as it approaches the problem with an operational "root cause analysis" solution set. Adding up the opportunities across the 3 markets, management sizes the TAM at $110bn in 2018 going to $165bn in 2023 (8% CAGR).
Subscription Revenue Growth Runway
NOW reports the total number of customers paying more than $1mm in ACV. In Q3, it had 809 of these customers and has added 40+ in each quarter YTD, a greater absolute number of net adds than any other prior year. This is not only because of larger initial lands happening with more frequency today (often with multiple products), but also a critical mass of customers who started with smaller levels of spend in prior years breaking through the $1mm ACV threshold over the last year. This has caused a "compounding effect" on billings, which unfortunately creates the headache of consistently tough comps but also indicates strong ongoing business momentum. The deal metrics given in earnings releases continue to be impressive (example from Q3'19: 46 transactions with net new ACV >$1mm, growing 84% y/y and representing a third straight quarter of acceleration). All this speaks to the big dynamic at play here, which is that NOW's growth algorithm is driven far more by going deeper in existing large enterprise accounts vs landing new customers. 81% of net new ACV in 2018 came from the installed base, and management estimates this will go to the mid-high 80s one day. Dollar-based net expansion, a metric not regularly reported, was given at the Analyst Day in May as slightly north of 130% (including both renewals and upsells). This is for a business doing almost $4bn of subscription billings this year; keep in mind SMID companies are lauded for the same absolute DBNER on much smaller top-line scale. Clearly something is making customers buy more ServiceNow products over time while also effectively monetizing at higher rates for existing products. I think this continues for longer than the market believes through multiple growth vectors that are impossible to model with precision, but should provide directional conviction that subscription billings/revenue can compound at 25%+ for the next several years:
  • CSM/HR products: both doing >$100mm of revenue with paths to $1bn over time; more multimillion deals highlighted for each on earnings calls
  • NowX internal innovation lab to incubate more new products with $1bn revenue potential: financial close management (GA in Q3) is next up and will land with a CFO buyer
  • US federal government opportunity (more below)
  • Further verticalizing the sales force around key industries: healthcare, telecom, and financials are all regulated industries where ServiceNow solutions can go deeper
  • EMEA/APAC: 2/3 of revenues are still North America; Germany and Japan have been called out as two key investment areas where there is already noticeable strength
  • Select investments in commercial segment (20% of business): management thinks it can strengthen some offerings (like CSM) for fast-growing companies with 1k-5k employees that will one day be enterprise customers
Federal Opportunity / Microsoft Partnership
One of the more interesting near-term opportunities is in the public sector, specifically the US federal government. 20% of new ACV in some recent quarters has come from federal, up from the teens in 2017. Although modernization of the IT stack in government agencies has taken eons, it's finally here. This is exciting because the government's contracts can obviously get large very quickly, as evidenced by NOW's reported deal metrics. 4 of the top 10 customers are already federal agencies, where management believes there are still multiples of upside in ACV per customer ahead given most of these deals are still just ITSM. There are early signs of traction in CSM, SecOps, and other emerging products with the government in the last few quarters. Q3 has typically been the big federal quarter, but management notes that the buying pattern is now mirroring enterprise as it's more continuous throughout the year vs history. Due to the sensitive data that federal customers have, many require that ServiceNow be deployed on-premise, and the company breaks out self-hosted revenue every quarter so investors can size the contribution. The on-prem requirement and data sensitivity issues have resulted in frequently taking much longer than the company average 9.5 months to land new federal agencies. However, I believe this will change in 2020 because of the partnership announced with MSFT in July, which has positive implications for sustained federal strength in future years. MSFT has the highest level of government security clearance, which even for NOW's size is expensive to obtain. NOW only has IL4 clearance. The partnership allows NOW to piggyback off of MSFT's clearance and set up ServiceNow instances inside Azure's cloud for government customers. I think this potentially makes both the land and expand motions easier with large agencies and accelerates the path to realizing higher ACV per customer. My primary research and discussions with IR have supported that this partnership hasn't contributed to Q3 results but is positively impacting the pipeline for 2020 and beyond.
Management Change
First a disclaimer that I'm personally a fan of Bill McDermott; he is definitely one of the most likable CEOs I've ever interacted with. More practically though, I view the CEO change as a natural progression over time and don't share the concerns held by some investors. Frank Slootman was pivotal to strong execution when the company was putting up eye-popping growth numbers every quarter; it's clear he is an early stage growth CEO. John Donahoe never quite made total sense to me, but I acknowledge his commitments to investing in product design and continued innovation. The company is now in the "replication" stage of its life cycle (which will still be very long), and I think McDermott is a sensible choice for leading the company through optimizing R&D/S&M capital allocation from here. He has said he would honor the company's commitment to organic growth on its path to $10bn of revenue and margin expansion of 100bps per year. He has also said that any substantial M&A would be thoughtful and cloud-native. This part of the thesis boils down to whether you believe McDermott or not. I think the guy is a winner with a track record of success throughout his life. I'm sure most people know his story but would encourage those who don't to read up on him. He is promotional like most software CEOs and can come across as a little too slick at times, but I believe he's honest and would be shocked if he did something that derailed the long-term growth algo.
I value NOW using EV/FCF and triangulate with EV/S. This should be relatively comforting to hear vs SaaS peers with little EBIT or FCF to speak of. So what do you have to believe to own this business? NOW will do well over $4bn of total revenue in FY20, with ~95% of that being subscription. They think the next milestone is $10bn of revenue. The high-level shortcut to getting there is whether you believe they can get to 2k customers paying an average of $5mm in ACV. I think that's very doable but the reality is the distribution will be much chunkier, with some customers doing $10-20mm+ and a very long tail of others contributing $1-5mm. I think they get to nearly $11bn of revenue by FY24, of which $10.6bn (97%) is subscription revenue. This implies a 28% subscription revenue CAGR since FY18. The margin structure is best-in-class as subscription gross margins are 86% today. Long-term guide is for them to be at 84-86% because NOW is currently investing more in public cloud (the Azure partnership being an example), which will weigh on near-term GMs. However, the scale efficiency of the business has resulted in them beating those lowered expectations consistently. The biggest opex leverage will come from S&M. NOW still spends 35%+ of revenue on S&M, but I think this can get to sub-30% by the time top-line growth slows to 20% per my model in FY24. Management has promised 100bps of EBIT margin expansion per year and improving FCF margins, but they will accelerate growth investments when it's prudent. If growth does slow per my model in FY24, I think they can do 33% FCF margins ($3.6bn of FCF), at which point FCF per share will still be growing 20% y/y. These economics should get a premium multiple, especially given the scale and organic growth (acquisitions to date have all been tuck-in tech/acqui-hires).
I think the business should trade at 30x EV/FCF in FY24. This implies EV/subscription revs of ~10x, which I think is very reasonable. Using 30x EV/FCF on my FY24 estimate gives me a $548 stock (96% upside). If I'm wrong, I think the stock trades at 10x consensus NTM subscription revs for a $206 stock (26% downside). Given the mission-critical nature of the product especially within IT, I see the downside case as a multiple de-rate on reporting an in-line quarter (NOW has a good history of beating the Street) rather than a share loss / permanent capital impairment scenario. Overall, I view this as a good risk/reward skew for a longer-term holding period.
Key Risks / Pushback
"They're definitely still going to acquire something."
The fear of aggressive, illogical M&A is the one risk that is discussed the most but is probably the most overblown. First, prior management said repeatedly that the path to $10bn will be organic but could always be complemented with another growth engine (in other words, additive to the $10bn). They've also said that valuations are currently expensive for the most interesting tech, and the bar is extremely high for a sizable deal. All this has been reiterated by McDermott. I think there's more discipline at the company than some would like to believe, particularly since the ACV growth levers I outlined above are all meaningful opportunities with untapped runway. The company doesn't "need" to buy growth.
Macro / EMEA weakness / IT spend concerns
Sellside CIO surveys have shown that the peak in enterprise IT spend and buyer sentiment was probably in H2'18. NOW's G2K presence is obviously large, so macro is a real risk. NOW is also making more investments abroad and noted softness in EMEA in H1'19. This sounds like it's normalizing but also seems too early to tell. I think the mitigant to this bucket of risks is just that ServiceNow has a central and dominant position as the IT backbone within the enterprise, which will prevent customer churn. Losing entire customers is the biggest source of structural business risk that any software company faces. At least in the IT product set, there is no substitute so if large companies don't want to disrupt their business processes, it's unlikely that ServiceNow instances get shut off (unless of course these customers start going BK in a recession). There will be continued stock volatility if macro worries persist, but I'm comforted by 80%+ of net new ACV coming from the installed base and FCF support.
" think this should trade at 30x FY24 FCF?? That's not a value investment."
Fair point, and I'm expecting low ratings on VIC for what is undoubtedly a growth idea. I am a growth investor but frankly I'm not finding a lot of great new long ideas. However, I can tell you NOW is one of the best businesses I have analyzed in my career. I almost didn't invest years ago because I was worried about valuation. What many folks missed was that the TAM wasn't as narrow as initially perceived (IT help desk), and management was making all the right investments to capture more share of wallet in customers with deep pockets. As time passes, it's increasingly clear to me that NOW is just a well-oiled machine. Customers love the product and note it's gotten much better over time. There are very few scaled competitors across all product lines. Management continues reinvesting to expand and capture more TAM. It's my view that if the business keeps executing, my valuation assumptions are sound.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


  • Earnings execution / Bill McDermott continues to pursue organic growth
  • 2020 Analyst Day with new management team and potential upward revision to LT target model
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