Description

Thesis / Idea

ServiceNow (NOW) is one the best businesses in one of the best industries that is endowed with a customer base that loves the product and faces substantial switching costs, resulting in >97% customer retention rates, and a long runway for expansion with new and existing customers. Member robberbaron wrote up the business in November 2019, and we believe the thesis continues to play out. In particular, we would underline that the subsequent data (in our view) reaffirms that the company is under-earning, should ultimately achieve best-in-class margins and profitability and, through this dynamic as well as topline growth, can produce EBITDA and FCF per share CAGR of >30% over the next five years  More recently, the stock sold off on a noisy Q1 earnings report and the sector rotation away from high growth / high multiple businesses. We believe this has created a window of opportunity caused by its relative underperformance to its peer group. Ultimately, the combination of long duration growth in its core IT product suite and explosive growth in newer product suites will produce revenue growth in excess of what the market anticipates. Combined with continued margin improvement, we think owning NOW can create a mid-teens IRR from here.

Business Overview

ServiceNow is an enterprise software business that was founded in 2003 by Fred Luddy. Fred stepped aside as CEO in 2011 and stepped down as Chief Product Officer in 2016, but is still on the BoD as Chairman and owns >$200M of stock. NOW went public in June 2012 at a $3B market cap vs >$100B today.

NOW’s purpose is to “make the world of work, work better for people” and its software is designed to eliminate the burden of admin work across organizations. NOW’s ambition is to be the central nervous system for the enterprise, coordinating the flow of work, intelligently and efficiently; eliminating the use of email and paper-based forms and replacing email, homegrown systems or legacy on-prem software providers.

NOW is mission critical and has a lengthy sales cycle (6 months to >1 year) and implementation time (6-9 months)

In 2020, nearly 80% of the F500 were NOW customers, however this overstates the penetration in that in many cases this is just a division, certain geo region or particular part of the organization. Today NOW has 6.9K customers, of which 16% spend >$1M and 3% spend >$5M. ARR / customer is $686K, but the average >$1M customer spends >$3.4M.

The typical NOW contract is 2-3 years long (3 year initial / 2 year renewal) and NOW boasts the best gross retention rates in the industry (97% to 99%) with net retention of 125%, and consistently sees significant expansion after landing (the 2010-2014 cohorts have grown at a ~30% CAGR). NOW has NPS of >50, which is excellent for B2B software (average of ~30).

Revenue mix is split geographically as 65% NA / 35% Intl (25% Europe / 10% APJ), with Intl regions growing the fastest. We estimate ~75% of NOW’s ARR comes from its IT Workflow product, but NOW is seeing rapid adoption of newer products in Customer Workflows, Employee Workflows, Platform & Other.

Recent Results

NOW’s stock sold off >9% on the Q1 ’21 release given the optics of decelerating top-line growth (Q1 sub billings only up 24.6% xFX, Q2 sub billings guidance for only up 20% xFX) and full year guidance for sub revenue and sub billings was cut by -0.5% and -0.3%.

The billings metric is particularly noisy given payment shifts and the full year guidance cut was solely due to a move in FX (on our math the underlying xFX guidance was actually increased) and many of the other metrics (sub rev) are lagging indicators that reflect tougher bookings in 2020 due to covid but that is hitting the P&L today (NOW estimates 20% of their customer base was in especially sensitive verticals such as retail, energy, transport).

In addition, several metrics that we view as important were very positive:  >$1M ACV customers grew 23.0% yoy vs 22.7% in Q4 (and up 4.8% QoQ vs 4.6% QoQ in Q1 ’20), >$5M ACV customers grew 50% yoy vs 40% in Q4, cRPO xFX grew 29% vs 27% guidance and was guided to grow 27.5% xFX in Q2 ’21 and the cohort data NOW provides suggests the business continues to excel. We also have conducted many customer calls that suggest a bright future for the business.

NOW has underperformed the S&P by -15% YTD (-1% vs +14%) and by -2% over the LTM as well as underperforming the IGV (Tech SW ETF).

Financial Path

We think NOW is in a very unique position with mission critical software that is loved by its users, an excellent track record of innovation and substantial growth ahead driven by both existing and new products and existing and new customers. Once NOW acquires a new customer, the ultimate ARR is usually a multiple of the initial contract size.

A few years ago, ~90% of NOW’s revenue came from its IT Workflow solutions, but today that number is closer to ~75%, and of the net new ACV the business is generating, now ~40% to 45% comes from non-IT Workflows. Despite its perceived “maturity”, IT Workflow revenue is still growing >25% per year.

From a customer perspective, NOW has seen a nice increase in >$1M ACV customers (now 16% of customer base vs 5% in 2013) and >$5M ACV customers (now 3% of customer base vs only 2 customers in 2013) which we believe can continue. We are also seeing a sizeable increase in mega customers (37 with $10M - $20M ACV and 12 with >$20M ACV).

NOW is also significantly underpenetrated globally, only 35% of revenue coming from outside North America today. Most large, established software companies typically reach figures in the 45-60% range.

NOW has all the hallmarks of a top decile margin software business: 1) high mix of subscription revenue (>95%); 2) high gross margins (86% subscription GM and 82% Total GM); 3) very low churn (retention rates have been >=97% for 7+ years); 4) excellent unit economics (gross profit payback periods of

We believe that a combination of all of the factors above can produce revenue growth in excess of 25% over the next five years, and that we will see continuous margin expansion, which should produce EBITDA and FCF CAGRs of >30%. Assuming NOW ultimately trades at 28x FCF in five years (note that we think the business will still be growing revenue at ~19% then), we think this translates to a mid-teens IRR from here. 

Catalyst

Greater recognition of the underlying dynamic within billings  

Continued margin expansion