ServiceNow: Commercially Interesting, But Dangerous Pitch At 15x EV/Sales (NYSE:NOW)

ServiceNow: Revolutionizing Workflows Through Cloud-Based Solutions

ServiceNow stands at the forefront of revolutionizing digital workflows, offering cloud-based solutions that streamline and automate business processes. Founded in 2004, the company has evolved from IT service management (ITSM) roots to become a leader in digital transformation across various organizational functions, including HR service delivery, customer service, and security operations. In that context, ServiceNow operates in the broader enterprise software and cloud computing sector, catering to organizations’ increasing demand for workflow optimization.

After having discussed ServiceNow’s product offering with five actual customers of the company’s NOW platform, I understand that ServiceNow’s competitive position anchors on the company’s broad functionality surrounding workflow optimization, user-friendly interface, usage scalability, and focus on customer-centric innovation. Furthermore, and specifically relating to ServiceNow’s core market ITSM, I learned that there are few alternative vendors offering a competitive solution to the NOW platform. In fact, only Atlassian’s (TEAM) Jira solution could offer similar value; however, Jira is mostly addressing teams close to DevOps.

Market Whitespace To Support High Growth Through 2027

Anchored on NOW’s competitive standing, it is noteworthy to point out that the company is in a leading position to capture growth in the fast-growing cloud computing market for managing workflows, an opportunity that ServiceNow management estimates at $220 billion in 2025.

Pointing to ServiceNow’s TAM, management repeatedly emphasized that there is still ample room for growth in higher-tier accounts, on both new logo and in-logo penetration. Specifically, ServiceNow underscored that its existing customer base of approximately ~8,000 is significantly below the estimated ~50,000 potential customers (clients with either >$100M in revenue or 1,000 employees), with international expansion being a key growth driver. On that note, ServiceNow has doubled down on selling to the global enterprise IT market, having signed sales and collaboration deals with arguably all major system integrators and tech firms.

Moreover, I believe that ServiceNow is positioned advantageously to experience near-term tailwinds from the evolutionary cycle of generative AI. Investors should consider that ServiceNow has already launched an AI feature for the NOW platform, called NOW Assist, which resulted in a 40% PRO+ adoption and a 25% ASP uplift. On a practical perspective, AI should support the NOW platform in achieving higher deflection rates for incidents, quicker root cause analysis, and the use of natural language for post-incident summaries and analysis. Additionally, AI could support various aspects of digital workflows such as shared services automation, boosting agent productivity, and creating automated knowledge.

All that said, I am optimistic about ServiceNow’s growth outlook for the next ~5 years, and I approve analyst consensus projections of ~21% topline CAGR through 2028.

Financial Performance and Metrics

As an additional argument that speaks in ServiceNow’s favor, commercially, relates to the company’s solid financial performance and metrics. During the past decade, ServiceNow has aggressively and consistently expanded its topline, growing at a CAGR of about 100% from 2013 through 2023 TTM, bringing the company’s topline to almost $8.5 billion. Over the same period, ServiceNow has also expanded its gross profit, with gross profit margin jumping from 63% in 2013 to 79% for the TTM 2023. On that note, investors will certainly appreciate that the lion’s share of ServiceNow’s topline is composed of subscription-based revenue, or annual recurring revenue (ARR).

A downside for ServiceNow’s financials relates to the company’s sales-intensive business model, with costs for SG&A consuming close to 60% of the company’s gross profit. And with R&D expenses taking another 30% cut out of gross profit, only about 10% remains as operating income, or about $650 million in dollar numbers. That said, it will be interesting to see how ServiceNow can leverage operating jaws on higher topline.

Valuation: Set TP At $320/share

To value a company’s intrinsic worth, I am a great fan of using a residual earnings model, which anchors on the idea that a valuation should equal a business’ discounted future earnings after capital charge. As per the CFA Institute:

Conceptually, residual income is net income less a charge (deduction) for common shareholders’ opportunity cost in generating net income. It is the residual or remaining income after considering the costs of all of a company’s capital.

With regard to my ServiceNow stock valuation model, I make the following assumptions:

• To forecast EPS, I anchor on the consensus analyst forecast as available on the Bloomberg Terminal till 2026. In my opinion, any estimate beyond 2025 is too speculative to include in a valuation framework. But for 2-3 years, analyst consensus is usually quite precise.
• To estimate the capital charge, I anchor on NOW’s cost of equity at 9%, which is approximately in line with the CAPM framework.
• For the terminal growth rate after 2025, I apply a proud 4.25%, which is about 150-175 basis points above the estimated nominal global GDP growth. The growth premium should reflect the elevated potential for technology businesses in general, as well as NOW’s penetration whitespace.

Given these assumptions, I calculate a base-case target price for IBM stock of about $320/share, suggesting more than 50% downside based on fundamentals and consensus estimates!

I acknowledge that investors may hold varying assumptions regarding these rates. Therefore, I’ve included a sensitivity table to test different scenarios and assumptions. See below.

Upside Risks

I am bearish on ServiceNow stock, mostly as a function of valuation. However, there may be a few “upside risks” that may render ServiceNow’s valuation less notable. Specifically, I highlight that a strengthening global GDP outlook could stimulate increased IT spending, especially in segments like Consulting and Software, exerting upward pressure on consensus EPS estimations and bolstering NOW’s financial outlook. Moreover, market sentiment towards high-growth tech stocks, supported by pending rate cuts in 2024, could positively influence the company’s stock performance and investor perception.

Investor Takeaway

ServiceNow has seen strong growth in the past, and the company is poised for more growth upside, as the NOW platform could play a crucial role in driving digital transformation. On that note, I point out that ServiceNow has a large market whitespace and potential for growth with a total addressable market estimated at $220 billion, offering a backdrop for a 21% topline CAGR through 2028. Moreover, I believe that ServiceNow is positioned advantageously to experience near-term tailwinds from the evolutionary cycle of generative AI. That said, however, it is impossible for me to justify an investment at 15x EV/Sales. Moreover, many valuation concerns are compounded by the company’s sales-intensive business model, with costs for SG&A consuming close to 60% of the company’s gross profit. Concluding, I calculate NOW’s intrinsic value at $320/share.