SERVICENOW INC NOW S
August 14, 2012 - 11:51am EST by
heffer504
2012 2013
Price: 33.75 EPS $0.00 $0.00
Shares Out. (in M): 170 P/E nm nm
Market Cap (in $M): 5,750 P/FCF nm nm
Net Debt (in $M): -200 EBIT 0 0
TEV ($): 5,550 TEV/EBIT nm nm
Borrow Cost: NA

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Description

Servicenow is the most egregiously price stock I have ever seen in my life.  At $5.8b of market cap, with $200m of run-rate subscription revenues, the company is valued at an eye-popping 39x trailing revenues.  CRM has never traded above 18x P/Sales in its history, for comparison.  BMC software, which is a direct competitor (but has 400 software products, not just a few), has the same enterprise value but generates $800 million of free cashflow a year (versus burning cash).
 
Servicenow has a SAAS platform that allows companies to manage aspects of their IT process-- help desk requests, tracking of assets (servers, laptops) and their configurations, etc.  It is a nice niche that is currently dominated by BMC's Remedy product, though CA, HP, and IBM also have applications here.  Currently the company is focused on the help desk market.  The total size of the help desk market is around $4b according to Gartner, though since NOW charges less for their product the total addressable market for NOW would probably be around $2b.  BMC's ESM division, which includes Remedy along with a lot of other products, has $1.1b of revenues and most sources say they have a 40% share of the total market.  Thus, I believe that a $4b market estimate may be aggressive, and have heard other estimates of as low as $1 billion.  Since NOW is focused on mid to large accounts, but since there are a lot of long-term Remedy users that will not be displaced, I believe the addressable market for them is around $1b.  It is important to note that while their product is currently the easiest to use and the cheapest, SAAS models are inherently prone to substitution over time, so it is not clear how durable this position will be.  We have heard of dozens of competitors from our diligence calls
 
The real upside for this company is that the SAAS platform will be used to develop "custom apps", or company-specific software.  In other words, if a company wants to write some code so that its customers can check something online, or so an employee can submit an expense report, it can use this platform to do so.  However, there are many applications to do this (.net, sharepoint, lotus notes, force.com, etc) and developers are comfortable with those platforms.  More importantly, the very nature of a SAAS platform means that CIO's will be reluctant to develop too much on the platform, since they do not own the code.  One CIO told me that if he put anything aside from IT functions on this platform, he should be fired, because when the time came to trade out the NOW software for a new offering from BMC (for example), they couldn't do so without disrupting other IT verticals within the enterprise.  If an enterprise is going to spend the time and money developing custom applications, then it has to be sure that it will own them at the end of the day!  For this reason, I think that the custom development will be a small, and well-segregated, part of the business.
 
So, I believe the near-term revenue opportunity is limited, and that the long-term "blue sky" promise is bogus.  There are also some short-term dynamics which can help this short.
 
 
1) The share count is materially misstated.  Specifically, there are 122m basic shares, 1m RSU's, 39m options struck at $3, and at least as many RSU's that will be granted around 7m a year (according to the CFO).  I am using a share count of 170m as the year-end share count.  Many sell-side analysts are using the incorrect number of shares since the options are "anti-dilutive" as long as the company loses money.
 
2) The largest shareholder is JMI, which invested around $15 million for their stake which is now worth $1.9b.  This appears to be held in a fund that invested around $500 million, so the importance of distributing this stake cannot be underestimated.  Management, generously, valued the company at $4.65 a share in December of 2011. 
 
3) The company has a significantly negative gross margin on its services business.  I have never seen this before, and it implies that they are grossly undercharging for the training/installation of the software so that they can make it up on the recurring piece.  Specifically:  negative gross profit percentages from professional services of (220)%, (202)% and (21)% for fiscal 2009, 2010 and 2011, respectively, (43)% and (51)% for the six months ended December 31, 2010 and 2011, respectively, and (19)% and (30)% for the three months ended March 31, 2011 and 2012, respectively
 
4) The company makes the following disclosure regarding SarbOx compliance:  The material weaknesses our independent registered public accounting firm identified related to the design and operation of policies and procedures for accounting and reporting control processes, performance of account review and analysis, the development and review of complex judgments and estimates, the preparation of the provision for income taxes and the identification, communication and accounting of significant contracts and agreements. These material weaknesses, which contributed to multiple audit adjustments, primarily resulted from our failure to maintain a sufficient number of personnel with an appropriate level of knowledge, experience and training in the application of U.S. generally accepted accounting principles, or GAAP
 
5) $3 million of the revenues last quarter (services revenues) are non-recurring, since $2 million are fees for a user conference (which will cost a lot more than that) and $1 million is from deferred service revenues under a contract accounting method which they no longer use.
 
6) renewal rate has dropped from 97% in fiscal 2011, to 96% last year, to 95% last quarter.  small changes to be sure...
 
So, to put it all together, I believe that if this company executes incredibly well over many years and reaches $1 billion of revenues, it may be valued at that time at the ridiculous 6x sales that CRM currently enjoys, in which case the stock price would be the same five years from now.  However, I think the most likely scenario is that his company is worth 3x revs of $400 million, or roughly $8 a share.
 

Catalyst

JMI sells
analysts get the share count correct
gravity
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