ServiceNow Unleashes AI, Innovation To Strengthen Competitive Advantage

ServiceNow (NYSE:NOW) has positioned itself as a competitive player in the tech industry, leveraging product development, customer engagement, and post-sale support as key differentiators. Our investment thesis centers around ServiceNow's consistent growth, innovative approach, and robust customer-centric strategy. As we delve deeper into their competitive advantage, we'll also explore significant recent events like their Analyst Day, AI collaborations, and the company's financial performance.

Competitive Advantage

Our examination of ServiceNow reveals several factors that have positioned the company as a strong contender in the competitive technology market. From their fast and comprehensive move into cloud-based solutions to their customer engagement strategy and post-sale support, the company shows impressive innovation and dedication.

The cornerstone of ServiceNow's growth has been its meticulous product development strategy. They made an early entrance into the cloud space, creating a versatile low-code platform engine that became the foundation of their diverse offerings. This platform supports IT Service Management (ITSM), IT Operations Management (ITOM), and IT Business Management (ITBM) solutions. Beyond these, ServiceNow has expanded into integrated risk management and security operations, showing a keen eye for the demands of today's complex business environments. Recently, they have pivoted towards industry-specific solutions, broadening their market appeal and demonstrating their adaptability.

In addition to a strong product line, ServiceNow's customer engagement approach sets it apart. Their strategy of engaging directly with C-level executives and key decision-makers ensures that they understand and meet the specific needs of businesses. This high-level engagement enables the company to assist businesses in optimizing operations, proving especially valuable in today's dispersed work environments. For instance, during the COVID-19 pandemic, ServiceNow's solutions remained pertinent, solving significant issues for customers and ensuring operational continuity.

ServiceNow's go-to-market strategy is another key strength. They effectively communicate their value proposition, starting with the top executives and extending down to all operational and tactical levels. This comprehensive approach resulted in a robust and compelling message that has effectively demonstrated ServiceNow's relevance and resilience to its potential customers.

The final, and perhaps most critical factor of ServiceNow's success is their dedication to post-sale customer service. Recognizing that their solutions involve multimillion-dollar investments, they work closely with customers post-sale to ensure their product is adopted, consumed, and valuable. They provide clear guidelines and timelines for implementation, and handhold customers through the process. This level of commitment to customer satisfaction is a significant differentiator for ServiceNow in the tech market.

ServiceNow's innovative product development, strategic customer engagement, effective go-to-market strategy, and exemplary post-sale support make it an attractive proposition for potential investors. These are the qualities that have helped ServiceNow not only survive but thrive in the highly competitive cloud-based tech landscape.

Takeaway From Analyst Day

ServiceNow's Analyst Day, which we attended, showcased a company in vigorous pursuit of innovation and growth, underlined by compelling new solutions, impressive artificial intelligence models, and a commitment to shareholder value via a $1.5 billion stock buyback program. A close study of these elements reveals a robust competitive advantage that maintains our optimism for this technology firm.

Central to the appeal of ServiceNow is its product innovation. The firm unveiled several groundbreaking solutions that blur the lines between the company's platform and an enterprise resource planning package, such as Finance and Supply Chain Workflows and ServiceNow Cloud Observability. These offerings represent a blend of creativity and practicality, geared toward monitoring and managing cloud-native infrastructure.

Perhaps the most significant announcement revolved around the company's foray into Artificial Intelligence. ServiceNow demonstrated its AI prowess through the introduction of Now Assist, proprietary generative AI capabilities, and a strategic integration with OpenAI. These solutions, some of which are immediately available, promise to enhance productivity and reduce costs for users. The firm's intention to monetize AI usage adds another layer to its revenue diversification strategy, highlighting its adaptability and forward-thinking approach.

ServiceNow's platform approach has facilitated this rapid pace of innovation. With a single code base enabling efficient product introduction, the company has achieved growth beyond core IT areas. Revenues from customer workflows, employee workflows, and creator workflows have all seen significant growth, contributing to a robust and diversified income stream.

However, ServiceNow has also made some prudent revisions to its financial targets. Adjustments to its 2026 subscription revenue target and other objectives account for unexpected currency headwinds experienced in 2022. While this may seem negative at first glance, our analysis finds it a reflection of sensible financial stewardship and doesn't affect our fair value estimate of $600 per share.

ServiceNow's strategic focus on growth vectors deserves a closer look. The company's organic growth strategy - pricing uplift from premium tiers and industry-specific vertical versions of its solutions, seat expansion and cross-selling within existing customers, geographic and portfolio expansion - promises to drive it toward its $15 billion revenue target. It's especially notable that about 85% of ServiceNow's revenue comes from existing customers, attesting to its success in retaining and growing its client base.

Another intriguing growth prospect is the company's plan to concentrate on its top 200 marquee accounts, which already generate more than $3 billion in annual contract value. There is a clear potential for expansion here, aligning with ServiceNow's target of less than 5% penetration into key industry-specific solutions.

ServiceNow's Analyst Day was a testament to the company's dynamic and strategic growth pursuits. Coupled with a commitment to shareholder value, significant product innovations, an evolving growth strategy, and a keen eye on financial stewardship, ServiceNow maintains a solid competitive advantage. We continue to rate NOW stock as one of our top picks, driven by these compelling dynamics.

Generative AI Opportunity

ServiceNow's partnership with Nvidia (NVDA), announced on May 17, 2023, is poised to bolster the company's offerings in the area of enterprise-grade artificial intelligence (AI), particularly in the realm of workflow automation. This collaboration stands as a testament to ServiceNow's forward-thinking approach and underscores its commitment to delivering industry-leading AI capabilities that have the potential to transform business processes.

ServiceNow and Nvidia are pooling their resources to develop custom Large Language Models (LLMs) specifically designed for the ServiceNow platform. This initiative will significantly enhance the AI functionality of ServiceNow, driving efficiency and productivity gains for customers and fortifying the company's competitive standing in the tech industry.

ServiceNow's Generative AI (GenAI) strategy demonstrates the company's ambition and innovative thinking. They have indicated that all of their workforce will employ GenAI, which is capable of data summarization. Their recently launched connector to OpenAI amplifies this effort, broadening the scope of their GenAI offerings.

ServiceNow is also exploring partnerships with key players like Microsoft and potentially Google Cloud, while simultaneously developing domain-specific LLMs using their ties with Nvidia and Hugging Face. This multi-pronged approach strengthens the company's AI offerings and positions it for sustained growth and competitiveness.

GenAI presents several key advantages to ServiceNow, including Average Selling Price (ASP) uplift, Total Addressable Market (TAM) expansion, and competitive differentiation. Through the deployment of domain-specific LLMs, ServiceNow aims to provide greater value to its customers, which could translate to increased pricing or product quantity sold. This focus on delivering high-value services also presents opportunities for ServiceNow to monetize API calls.

The partnership with Nvidia fits well with GenAI’s key capabilities – intent understanding, knowledge synthesis (including summarization), and language generation. These functions provide a nuanced understanding of users' needs and a means to communicate empathetically, offering customers a more human-like interaction with AI.

ServiceNow’s roadmap for implementing GenAI further reinforces the company’s commitment to AI. The recent Utah release, followed by the Vancouver solution scheduled for September 2023, and the Washington DC solution in 2024, show a deliberate and phased approach to AI implementation. The Washington DC release, specifically, will extend GenAI capabilities to admins and builders, showing ServiceNow's holistic approach to AI adoption.

ServiceNow's partnership with Nvidia, coupled with its ongoing GenAI strategy, points to a future defined by powerful, AI-driven solutions that can transform business processes. It is this commitment to innovation and collaboration that continues to cement ServiceNow's competitive advantage in the tech industry.

Financial, Valuation and Caution

Note: All historical data in this section comes from the company’s 10-K filings, and all consensus numbers come from FactSet.

The robust FY Q1 earnings report for NOW that was released on 04/27/2023, reveals the company's strong growth trajectory. Revenue surged by 21.7% y/y to $2,096 million, meeting consensus estimates, and EPS spiked by 37% y/y to $2.37, exceeding consensus by a solid 16%. Such impressive performance is indicative of the company's excellent financial health and compelling growth prospects.

Analyzing the financial trends, NOW's revenue grew by an impressive CAGR of 27.9% over the past three fiscal years. Furthermore, the sell-side consensus predicts a revenue growth of 22.0% this fiscal year, culminating in an estimated $8.8 billion, and an expected growth of 21.8% in the following fiscal year, reaching $10.8 billion. Notably, NOW's EBIT margin also increased by 4.3% points over the past three fiscal years, from 21.4% to 25.7%, signifying a healthy profit margin expansion.

Another aspect that stands out in NOW's performance is its EPS growth. Given the revenue, margin, and share dynamics, EPS grew at a remarkable CAGR of 31.7% over the past three fiscal years, eclipsing its revenue growth. The consensus forecast anticipates the EPS to increase by 25.5% to $9.53 this fiscal year, and by 24.6% to $11.87 the following fiscal year. The trend of these numbers reinforces our confidence in NOW's steady growth and financial performance.

The company's Free Cash Flow (FCF) generation is commendable as well. Consensus estimates project FCF for this fiscal year to reach $2,666 million, indicating a robust 30.2% FCF margin. The company generated an average FCF margin of 32.5% over the past four fiscal years, reflecting its efficient cash flow management. However, its business exhibit relatively high capital intensity with capex as a % of revenue averaging 8.9%.

Regarding the stock performance, NOW has outperformed the S&P 500 over the past year by 10 percentage points, providing a 19.6% absolute return. This speaks volumes about the company's robust market standing. However, we must be cautious as the company does not pay dividends, unlike the S&P 500 which has a dividend yield of 1.5%.

Valuation-wise, NOW is trading at a premium relative to the S&P 500. It trades at an EV/Sales multiple of 9.3, an EV/EBIT multiple of 33.6, a P/E multiple of 43.0, and a FCF multiple of 31.0. These premiums could be indicative of the market's high growth expectations for NOW. That being said, NOW's FY2 PEG ratio is currently 1.2, offering a discount of 23.7% compared to the S&P 500's PEG ratio, signaling potentially undervalued future growth, or skepticism about the sustainability of these growths.

Historically, the stock's valuation relative to its 5-year range appears to be in the medium zone, with a current rolling forward 12-month P/E of 49.0 compared to a 5-year mean of 70.4, and a 2-standard deviation range of 37.5 to 103.3.

Relative to its peers, NOW's forward 12-month P/E ratio seems moderate. While NOW is trading at a higher P/E ratio than CRM and ADBE, which are at 27.4 and 22.6 respectively, it is notably lower than SNOW's staggering 240.1. This comparison places NOW in an intermediate position within its peer group in terms of valuation, neither too overvalued like SNOW nor undervalued like CRM and ADBE.

As we consider the valuation metrics in combination with its financial performance, it's clear that NOW's stock currently trades at a higher premium than the S&P 500 and some peers, likely because of its demonstrated ability to deliver consistent, impressive revenue and EPS growth, as well as its ability to generate strong cash flows.

While our overall outlook on NOW is positive, there are certain cautionary points we would like to emphasize. In particular, we note the high levels of share-based compensation (SBC) which accounted for 19.3% of its revenue over the past three fiscal years. This is not a trivial figure and it certainly impacts the company's profitability. SBC can be a useful tool for attracting and retaining talent, particularly in the competitive tech industry, but it also represents a real cost to the company and its shareholders, through earnings dilution. The 6.4% increase in diluted outstanding common shares over the past three years evidences this fact.

Moreover, the company's strong margins and earnings are adjusted numbers, which don't account for this high SBC. The impressive gross margin of 82.8% and operating margin of 25.6%, as well as the 37% y/y growth in EPS, all look somewhat different if one takes into account the substantial SBC. These high adjusted margins and EPS figures may thus paint a somewhat rosier picture of NOW's profitability than is accurate.

Investors should keep these factors in mind when evaluating the company's financial health and performance. While NOW's growth story and robust financials are commendable, the high SBC and the impact it has on the company's true earnings represent a potential risk factor. Consequently, it is crucial to assess these elements in light of one's investment objectives and risk tolerance.

Conclusion

ServiceNow's competitive advantage, underscored by its focus on innovation and customer-centricity, positions it as a compelling proposition for potential investors. Its strategic collaborations, like the partnership with Nvidia, and an ambitious AI roadmap demonstrate its forward-thinking ethos, signaling strong prospects for future growth. The company's robust financials, driven by consistent revenue and EPS growth and strong cash flows, further enhance its investment appeal.

However, it's important to consider potential risk factors, including the impact of significant share-based compensation and the use of adjusted margins. Such factors need careful evaluation in light of individual investment objectives and risk tolerance. While ServiceNow is an appealing player in the tech industry, a balanced understanding of its strengths and challenges is crucial for making informed investment decisions. As we keep a keen eye on ServiceNow's journey, we remain optimistic about its ability to navigate the competitive tech landscape and deliver value for its stakeholders.