The third quarter again underscored ServiceNow Inc. (NYSE: NOW)’s resilience in the face of economic turmoil and COVID-19 effects, with deal flow continuing even in industries directly affected by COVID-19. The company’s focus on the powerful secular trend of enterprise digital transformation, i.e., making IT work better to improve customer and employee experiences, may be a key to ServiceNow’s resilience.
The company uses a land-and-expand model to both sign new customers and upsell the installed base, increasing its client IT wallet share. The company expects to not only expand the use of its core IT service management applications, but also to enter new and adjacent product categories by releasing one or two new products per year.
On April 2, 2020 we have listed NOW among the best stocks to invest in, since then NOW has registered a 107.99% increase in price.
Along with the 3Q results, ServiceNow raised its 2020 subscription revenue guidance range for the second time, to $4.251-4.256 billion from $4.185-4.2 billion, implying 31% growth at the guidance midpoint. The new guidance now exceeds the company’s original 2020 guidance of $4.22-4.24 billion. NOW shares fell about 6% on October 29.
Positive currency movements added $15 million or two percentage points to growth. Subscription revenue rose 29% in constant currency and accounted for 95% of total revenue. The company had 41 deals worth more than $1 million in 3Q20, right on pace with recent quarters. Non-GAAP billings (i.e., revenue plus the change in deferred revenue) rose 23% in constant currency to $1.13 billion. The non-GAAP gross margin expanded by 90 basis points to 82%. Margins have been rising steadily over the last four years.
The company posted GAAP diluted EPS of $0.06, down from $0.21. Stock-based compensation accounts for most of the difference between GAAP and non-GAAP results. Stock-based compensation rose 35% year-over-year in 3Q20 to $220 million or $1.10 per share.
EARNINGS & GROWTH ANALYSIS
ServiceNow’s focus is to make enterprise software work more efficiently. Management has transparently called out the 20% of the company’s business that is in industries directly affected by COVID-19, including transportation, hospitality, retail, and energy. However, deal flow continued in 3Q20 even in these heavily affected industries. ServiceNow closed six new deals over $1 million from customers in COVID-affected industries in 3Q. As we have heard from other enterprise technology firms, notably Microsoft and Salesforce, clients across industries continue to value digital transformation as a key pillar of company resilience. This is exactly the focus of ServiceNow.
ServiceNow uses a software-as-a-service subscription model. It began by delivering scalable IT management services to its mostly enterprise-level client base. It has developed into a technology platform as it has expanded into adjacencies in employee workflow management and has begun to further expand into customer service management. The company launches two global platform refreshes per year, in March and September. The last release, dubbed ‘Paris,’ became generally available in September 2020. Clients seeking quicker individualized upgrades can go to the ServiceNow online store.
The company is following the traditional tech strategic plan of ‘land and expand’ as it looks to grow both by acquiring customers and by upselling additional services to existing clients. Some 80% of ServiceNow’s new business comes from existing customers. The company’s go-to-market strategy rests on its ability to become a strategic partner for its customers, not just another IT vendor. NOW is also developing its partner ecosystem with systems integrators such as Accenture and Computer Sciences, and working with Microsoft to offload implementation tasks and extend its sales reach. About 62% of the company’s annual contract value is ‘influenced’ by its third-party implementation partners. International expansion is another avenue for growth. The company sees its total addressable market expanding at an 8% compound annual rate to $165 billion in 2023 from $110 billion in 2018.
The company is also expanding into industry verticals with industry-specific workflows in industries including finance and telecom, and in its federal, state, and local governments practice. FedRAMP certification enables federal agencies to accelerate contracting with the company. ServiceNow is only the third SaaS vendor to receive FedRAMP certification. FedRAMP may have been related to the company’s new IT asset management (ITAM) deal with the U.S. Department of Veterans Affairs, its largest ITAM deal ever.
Another favorite management metric, ‘remaining performance obligation,’ rose 30% year-over-year in 3Q20, in line with recent quarters and underscoring the company’s robust sales pipeline.
At the company’s May 2019 Investor Day, management outlined its strategic and investment priorities. We expect that many of these priorities will remain the same, despite the change in management with John Donahoe’s resignation as CEO and Bill McDermott’s hiring. In fact, Mr. McDermott has stressed continuity, praising the company’s engineering-driven culture. He is not looking to transform the company through M&A or undisciplined salesforce expansion or reorganization. Product investment priorities are to innovate the NOW platform and increase the speed of product development. Management has reiterated its long-term goal of reaching $10 billion in revenue, or 2.2-times expected 2020 revenue. The company’s current R&D investment capital allocation is as follows: 60% to the NOW platform and current products (0-12 month ROI), 30% to new and emerging products (12-36 month ROI), and 10% to ‘future bets,’ i.e., nascent product ideas (36-60 month ROI). Management stresses that the NOW service platform is technology-agnostic and that it integrates seamlessly with other IT vendors.
FINANCIAL STRENGTH & DIVIDEND
The company floated $1.5 billion in long-term senior unsecured notes in August 2020. Total debt is $1.706 billion. The credit agencies gave ServiceNow the highest B investment-grade ratings with stable outlooks in August in conjunction with the new debt issuance.
MANAGEMENT & RISKS
As an enterprise software company, we think that ServiceNow has relatively smaller direct risk from COVID-19 effects. Even though about 20% of its customer base is in heavily affected industry verticals, including transportation, hospitality, retail and energy, there was little sign of a pullback in 3Q20. However, the company could be hurt by a more general economic downturn and a follow-on decline in technology spending. One countervailing factor is that the company’s technology is squarely aimed at making clients’ own IT systems more efficient and lowering total cost of ownership, a value proposition that has even greater salience in tough economic times.
ServiceNow already has a fairly long 6-9 month sales cycle, and economic disruption or concerns over technology spending could further lengthen this cycle and negatively impact its results.
Competitors Hewlett-Packard and BMC Software have sued ServiceNow for patent infringement. ServiceNow settled the HP suit in March 2016 with a payment of $270 million to HP.
ServiceNow was founded in 2004 by Frederic B. Luddy. Mr. Luddy served as president and CEO from 2004 until 2011, when he assumed the role of chief product officer. Mr. Luddy has been the company’s chairman since April 2018. Board member Jeffrey Miller is the lead independent director.
ServiceNow provides cloud-based software-as-a-service management applications to automate and track workflows across the enterprise, including IT, human resources, facilities, and field service, among others. About 84% of revenue comes from subscription software sales, with the remainder from professional services and ‘other.’ ServiceNow went public on June 29, 2012 at $18 per share.