Stock ServiceNow: Won’t drive the next bull market, but that’s okay

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Investment thesis

ServiceNow (NYSE:NYSE:NYSE: NOW) is an IT service management and workflow productivity company. It is a company that almost always reveals 98% to 99% customer renewal rates.

ServiceNow is a company that generates a strong cash flow well positioned to withstand a recession, this is the thesis I jotted down in mine previous one Bullish article on ServiceNow. And since then, over the past 2 months, the stock appears to have underperformed.

Evaluation of the shares

The author’s work

Typically, I wouldn’t call it underperformance. However, as the “most toxic” tech stocks have soared over the past 2 months, I think it’s best to be ahead of the curve.

However, I argue that the bullish case here lies in its free cash flow line. That said, I moderate my upside as the macro environment weighed on ServiceNow’s near-term outlook.

So, weighing all the different sides, I remain tepidly bullish on this name.

ServiceNow’s revenue growth rates are trending downward

NOW revenue growth rates

NOW revenue growth rates

In recent years, being a global company has had tremendous benefits. Companies have reached size and may continue to seek growth at all costs. As we’ll discuss soon, ServiceNow didn’t fit in that bucket.

After all, ServiceNow has consistently reported solid non-GAAP profitability. But I go ahead of myself, as we will soon be discussing its profitability.

The theme for large multinational tech companies was to seek exposure far and wide. Today multinationals are fighting on two fronts. One temporary and one more lasting.

The temporary impact that the market is watching over are the headwinds of the currency. This is plaguing companies’ revenue growth rates of around 300-600 basis points, and ServiceNow is no exception.

The second head wind, more serious and uncertain, concerns Europe. Companies like ServiceNow see Europe as an obstacle to their business.

In this sense, this is what ServiceNow CFO Gina Mastantuono said during the recent ServiceNow earnings call,

[…] we expect the extended cycles of agreements we experienced in the last two weeks of June to persist for the rest of the year.

So, these comments were picked up in a conference in early September,

[…] what we have seen is that deals get a higher level of scrutiny and more approvals which just stretched the sales cycle.

However, in both cases, Mastantuono moved quickly to reassure the investment community that it is “confident” that ServiceNow will fulfill its lead.

ServiceNow short-term prospects

ServiceNow believes that as more and more companies are forced to be thrifty with their budgets, as there has been a proliferation of workflow platforms for many companies, the industry is now looking for a consolation platform.

The goal is not only to increase efficiency throughout the workplace, but also to reduce overall business expenses.

For their part, ServiceNow says that even if the sales cycle has lengthened, it will have no difficulty in meeting its revenue targets.

However, the main focus of the investing community is that ServiceNow’s current remaining performance bonds (cRPOs) are down to 21% y / y, down from 29% y / y in the first quarter of 2022.

In practical terms, ServiceNow’s cRPO is an important indicator of the trajectory that its revenue growth rates will be recognized over time.

Ideally, investors want to see software companies’ cRPO figures above their revenue growth rates, or at least match revenue growth rates. What investors don’t like to see is a decline between cRPO data and revenue growth rates.

Of course, management argues that investors shouldn’t be short-sighted and overly focused on quarterly results.

On the other hand, keep in mind that any investor who has invested in this stock in the past 2 years is unlikely to keep their earnings. So, these dynamics have been plaguing his stock price for some time, this isn’t just a quarter’s performance.

Next, we will turn our attention to discussing its profitability profile.

Profitability profile in the foreground

The following are ServiceNow’s GAAP operating margins:

  • 2nd quarter 2021: 4%
  • 3rd quarter 2021: 5%
  • 4th quarter 2021: 2%
  • 1st quarter 2022: 5%
  • 2nd quarter 2022: 1%

What you see is a company that is barely reporting GAAP profitability. And for a while, investors haven’t worried that many software companies have overcompensation based on shares, but in recent months, investors have increasingly wondered if some of these businesses aren’t as profitable as we previously thought.

Ultimately, the whole point of paying for these highly recurring business models is that they should see significant “clean” free cash flows back to shareholders.

In addition, the full-year free cash flow guide at the end of Q1 2022 foresaw a free cash flow margin of 31%, while recent headwinds have dampened these outlook so that ServiceNow only drives for one flow. free cash of 30% for the year as a total.

However, given that Q1 2022 posted free cash flow margins of 45%, while Q2 reported only 16%, investors are now skeptical that ServiceNow’s free cash flow margins in 2023 they may not rise, but they may actually fall below 30%.

Given that the company has over 60% of its free cash flow for the first half of 2022 consisting of share-based compensation, investors rightly ask “what do I have left?”

NOW Stock Valuation – 11 times next year’s revenues

In 2020, a business that could be relied upon to grow at a 20% CAGR, investors would easily be willing to 10x forward sales. The problem for ServiceNow is that we are not in 2020. In fact, we are approaching 2023.

And 2023 will not only be a more challenging context for companies with exposure to Europe, which risks being in the throes of a significant recession, not to mention that the comparison with the first half of 2022 will be nothing short of onerous.

So, to further complicate the investment thesis, investors are not asked to pay 10 times this year’s revenues, but 11 times. revenues next year.

When many software companies are priced very close to ServiceNow, but can be expected to grow at a faster rate, it’s hard to get too excited about ServiceNow.

Or perhaps investors may be willing to pay a slightly higher multiple, but are looking for cybersecurity companies that are not only likely to be played even more defensible, but should also steadily grow at a faster rate than ServiceNow.

The bottom line

The tide is slowly turning. Previous bull market winners are rarely the next bull market winners.

There is a lot to like about ServiceNow, for example, that it is a blue chip company with significant global reach.

The problem here is that the multiple has not fallen sufficiently to offer new investors in the stock a large margin of safety.

On the other hand, the company is clearly reporting strong free cash flows. Even if there is a temporary drop in its free cash flow profile, investors can feel reassured that ServiceNow is very well set up to have lasting free cash flows.

As a result, when all the positives and negatives are evaluated, I remain slightly bullish on this name.

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