ServiceNow: High Price For High Quality, But Not A Great Investment In An Expensive Market (Rating Upgrade)

seekingalpha11-23 16:30

I'm upgrading ServiceNow to a neutral rating on strong Q3 results, but remain wary of the stock's valuation.The company delivered 23% subscription revenue growth in Q3, with growth not decelerating at...

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JHVEPhoto  With the S&P 500 clinging persistently near its all-time highs, many investors, including myself, have become incredibly nervous about valuations. Primarily owing to historically high valuations today, Goldman Sachs (GS) has issued a note saying that it expects the S&P 500 to average only a 3% return over the next 10 years. The implication here is that we're likely to see one (or several) corrections in the near-term timeframe, and richly valued stocks are more likely to suffer than those that are trading at decent value. ServiceNow (NYSE:NOW), in my view, is one of those stocks. The IT service management and customer service software company has long been a Wall Street darling, and it has extended its run this year with a 50%+ YTD gain. ServiceNow's rally continued well after its Q3 earnings print, which featured better-than-expected growth and its usual beat-and-raise. The question for investors now is: can ServiceNow keep its rally going? Data by YCharts I last wrote a bearish note on ServiceNow in September, when the stock was still trading near $900 per share. I'll acknowledge here that I missed out on ServiceNow's incredible bull run, and I wasn't expecting the company to deliver such strong Q3 growth rates (especially in the wake of many other software companies reporting IT budget compression as the reason for slowing growth rates). I will concede that ServiceNow is truly a very high-quality company that has delivered very consistent execution, which investors appreciate greatly when even big titans like Snowflake (SNOW) and Adobe (ADBE) have seen rockier trends this year. As a result of this, I'm increasing my rating on ServiceNow back up to neutral.  At its current share prices, I see more of a balanced bull-and-bear case for ServiceNow. The truth is that I don't see much of a rally continuing here as ServiceNow is already capped by extremely high valuations - but I also don't see tremendous downside in the stock, especially as ServiceNow continues to deliver excellent results. On the positive side for this company:   Rule of 50 company. Many software companies struggle just to hit the \"Rule of 40\", which is when revenue growth plus pro forma operating margins exceed 40%. And yet ServiceNow continues to see 20%+ revenue growth on top of 30%+ operating margins, comfortably positioning it in the Rule of 50 - which does justify some valuation premium for the company.  Best in breed in large software categories. ServiceNow is often considered the leader in IT service and customer service software categories. And despite its scale, it continues to grow at a 20%+ clip, which indicates the largesse of its addressable market.  At the same time, however, there are a number of risks that stand in the company's way:   Aggressive headcount expansion is limiting the company's operating margin expansion. While competitors like Salesforce have touted their new belt-tightening measures, ServiceNow keeps hiring like it's 2021, growing headcount at nearly the same pace as revenue growth. As a result, its operating margin expansion has been limited. In a bull market, investors may choose to prioritize growth over profits, but in a more conservative market, ServiceNow's lack of faster margin expansion may hurt.  Blue chip competitors. There's no doubt that ServiceNow screams legitimacy and category leadership in its space. But that's not to say that the company's software doesn't compete with other heavy-pocketed, blue-chip companies. Its service management products, in particular, face competition from Atlassian's Jira (TEAM), while also competing against the likes of Salesforce and Zendesk.  All in all, I don't see a clear rationale to invest in ServiceNow at current share prices. I advocate for staying on the sidelines here until a better price for this stock avails itself. Q3 download Let's now go through ServiceNow's latest quarterly results in greater detail. The Q3 earnings summary is shown below: ServiceNow Q3 results (ServiceNow Q3 earnings deck) ServiceNow's revenue grew 22% y/y to $2.80 billion, ahead of Wall Street's expectations of $2.75 billion (+20% y/y) - as usual, the company has issued conservative guidance and brought Wall Street estimates down with it, but delivered well above expectations. Importantly, ServiceNow isn't seeing any signs of decelerating growth. Subscription revenue grew at 23% y/y in Q3, at exactly the same pace in Q2 (though one point weaker on a constant-currency basis). ServiceNow revenue trends (ServiceNow Q3 earnings deck) In the current macro environment, many software companies have reported softening growth as customers pulled back on IT spending and delayed complex projects to future dates, with deal cycles lengthening as approval processes became more stringent. Evidently, ServiceNow isn't seeing any of this pain. Per CFO Gina Mastantuono's remarks on the Q3 earnings call detailing the company's sales momentum by vertical:  From an industry perspective, technology, media and telecom was very strong, growing net new ACV over 100% year-over-year. Retail and Hospitality also had a fantastic quarter, growing over 80% year-over-year. Health care and life sciences and manufacturing also saw strength. Year-to-date, U.S. Federal has demonstrated outstanding execution, further growing net new ACV on top of a phenomenal 2023. In Q3, we landed five deals over $5 million and two over $20 million. Overall, we once again achieved a robust renewal rate in the quarter reflecting the value ServiceNow consistently provides to customers. The importance of the Now platform has driven the number of customers paying us over $1 million in ACV to 2020. What's more, the number of customers paying us $20 million or more grew nearly 40% year-over-year, powered by large deal momentum.\"  Management noted as well that more and more customers are migrating the company's higher end Plus SKUs, which are helping to improve dollar-based net retention rates. Where ServiceNow has consistently fallen short, however, is on margin expansion. Pro forma operating margins expanded only one point y/y to 31%. ServiceNow operating margins (ServiceNow Q3 earnings deck) The company grew total headcount to 25.7k (+16% y/y) at the end of Q3, adding 1.3k net-new employees in Q3 alone (mostly in R&D and sales). Pro forma EPS of $3.72 still came in ahead of Wall Street's $3.45 expectations with ~8% upside, but in a more conservative market environment, investors may require the company to deliver more traction on the bottom line. Valuation and key takeaways The biggest reason not to invest in ServiceNow is its rich multiples. At current share prices near $1,060, ServiceNow trades at a market cap of $218.48 billion. After we net off the $9.12 billion of cash and $1.49 billion of debt on the company's latest balance sheet, ServiceNow's resulting enterprise value is $210.85 billion. Meanwhile, for next fiscal year FY25, Wall Street analysts are expecting ServiceNow to generate $13.24 billion in revenue (+21% y/y) and $16.60 in pro forma EPS (+20% y/y). This puts ServiceNow's valuation multiples at:  15.9x EV/FY25 revenue 64x FY25 P/E  To be sure, there are software stocks like Palantir (PLTR) that are commanding even more outlandish valuations than ServiceNow. But compared against other large-cap peers, ServiceNow stands out on top: Data by YCharts  In my view, we've reached a high point for software valuations, and we're overdue for a correction in the near term. As such, it's best to remain on the sidelines for ServiceNow and exercise extreme caution.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.2","shortVersion":"4.29.2","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2485793272"}