Back in March, I wrote that ServiceNow (NYSE:NOW) was a great company, that I thought at a 10x 2023 P/S multiple the stock looked fairly valued. Since then, the market has agreed that NOW is a great company, but it didn’t agree that the stock was fairly valued, sending it up about 38% since my write-up, easily surpassing the 16% return of the S&P 500. Let’s catch up on the name, which is set to report its Q2 results next week.
As a refresher, NOW uses a single platform to connect siloed systems and bring them together to manage workflows across systems. It started out in the IT Service Management (ITSM) space, where its solution allowed IT departments to better manage their networks, optimize costs, and quickly identify and fix any security vulnerabilities. It has since expanded to offer a number of solutions in this space as well as solutions aimed at other departments.
For example, its Customer & Industry Workflows solutions helps customer service reps deliver a better customer experience by not having them search for answers across multiple systems. Meanwhile, its Employee Workforce platform helps companies manage their HR solutions, including things such as onboarding and offboarding. In addition, its Creator Workforce platform helps in the areas of low-code, automation, and procurement.
Its subscriptions are mainly through a direct salesforce. It had approximately 7,700 customers at the end of 2022.
NOW reported a solid earnings report after my initial article, although the stock only moved up a modest 2.7% on the session following its report. The stock’s big move didn’t really begin until a few weeks later in May, which seemed in anticipation of its Analyst Day.
NOW’s Q1 results were good, with the company beating on the top and bottom lines. It reported a 24% increase in subscription revenues to $2.02 billion, while total sales were $2.09 billion. Meanwhile, adjusted EPS of $2.37 easily surpassed the analyst consensus of $2.04.
But it was its Analyst Day that appeared to really excite investors. At the event the company announced a $1.5 billion repurchase program, but it was its discussion on AI that appears to have gotten investors the most excited.
Discussing AI at the event, COO Chirantan Desai said:
I 100% believe that Gen AI is a catalyst for our platform. It’s an augmentation of our platform. You can deliver better workflow results using Gen AI. … So what is our strategy? Our strategy is two-pronged. Number one, currently, we just launched today our connector integration hub to open AI. You can sign up, you can go to store.servicenow.com. We’ll approve it if we feel that, okay, you’re trying to do the right thing. And that’s available today. And we will learn with you, customers. We are working with Microsoft (MSFT) and others to make sure that this general purpose AI can be used if a customer wants to try out for a few use case on better intent understanding or summarization and so on. We are exploring others. However, the value for our customers is domain-specific LLMs. What does that mean? For our workflows and for our use cases, if we can train the models, that we can take open source model like from hugging phase that we announced last week. You will hear more about NVIDIA tomorrow morning. NVIDIA (NVDA) shared that we cannot release it today because we are working with them. But you’ll hear from Jensen tomorrow morning on what we are doing with them. But that’s a domain-specific LLM for ITSM use case or a CSM use case, customer service use case or a procurement use case, where customers’ data plus that LLM equals goodness while following trustworthy AI guidelines and governance to make sure that our customers get the value and trust with domain-specific LLM that ServiceNow uses.”
AI is a hot investor topic, especially generative AI. NOW execs talked a lot about the subject at their investor day, and having collaborations with MSFT and NVDA only added fuel to the fire for NOW to start transforming itself into an AI story.
Q2 Earnings Preview
When looking at earnings, it is worth noting that for EPS that NOW has beaten the consensus each quarter over the past two years. The past few quarter, it has blown by the EPS quite handily. The revenue line has been a different story, with the company missing results three of the past quarters, albeit by small amounts.
NOW’s stock has generally reacted positively to earnings, with its stock rising the next session 11 of the past 12 quarters. During that stretch, the stock has made a move over 10% or more only 3 times, rising 10.4% in Q3 2022 and 10.5% in Q1 2022, while falling -10.2% in Q1 2021. Market reactions for Q2 results have tended to be pretty muted, ranging from -0.8% to +3.2% over the past three years.
Analyst expectations for EPS and revenue are down slightly versus 12 months ago, although have risen slightly off their lows.
Meanwhile, Stifel was out with a note earlier this month saying channel checks were strong. It said demand was “robust” in Europe and that the U.S. public sector was “very healthy” while adding that government demand was “solid.”
In his note analyst Brad Reback wrote: “Looking forward, customer engagement remains high post a successful Knowledge 2023 event, and pipelines appear solid heading into [the second half of 2023].”
For the quarter, I’d pay attention to RPO (deferred revenue + backlog) growth, to see if that is starting to accelerate. An acceleration there could be bullish for the stock, as it could be a sign of accelerating revenue growth in the coming quarters.
SaaS companies are generally valued based on a sales multiple given their high gross margins and the companies wanting to pump money back into sales and marketing to grow.
In this regard, NOW is valued at a P/S ratio of about 13.7x based on the 2003 consensus for revenue of $8.84 billion. Based on the 2024 revenue consensus of $10.76 billion, it trades at a P/S multiple of 11.2x.
In the past, the company has often traded at over 13x LTM sales sometimes over 20x. However, growth is slowing from over 30% to low 20%.
Given the stock’s huge jump and current valuation, the company will likely have to deliver some pretty extraordinary results for the stock to get a big lift following its earnings report. History and channel checks point to the company likely topping estimates, but that alone won’t be enough to see the stock skyrocket higher following its report. I think it will need a pretty big RPO growth number to really excite investors.
I continue to think that NOW is a great company, but I still think valuations matter, and an over 10x multiple on 2024 revenue is just too rich for my blood for a company expected to grow in the low to mid 20%. At the same time, I wouldn’t bet against a company like NOW. As such, I remain neutral on the stock.