Successfully Serving Enterprise IT Has Made ServiceNow A Huge Winner

ServiceNow has been a huge performer for investors over the last five years, returning over 35% annualized in this time.

The company’s core focus on IT services management has resulted in a sticky service with considerable growth.

Expansion into customer service and HR management has greatly grown the company’s addressable market.

Current valuations are high, but this is a name that should be bought on any pullback.

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Serving enterprise IT is not necessarily the most glamorous or highly visible segment of the enterprise software market, but for ServiceNow (NYSE:NOW) and its investors, it has been an extremely profitable one. ServiceNow was founded in 2004. The business is focused on IT asset management and IT operations management.

ServiceNow developed a SaaS (Software as a Service) platform to allow simpler ticketing and helpdesk visibility for IT departments. Put simply, the organization’s core mission is workflow automation for IT. The business serves almost 900 of the Fortune 2000 enterprises and has a market capitalization of nearly $60B and is on track to do almost $3.5B in revenue in 2019. ServiceNow has delivered annualized returns of over 35% per annum over the last five years.

It is a core holding for the Sustainable Growth portfolios where it was added to in October 2019 and has returned almost 30%.

Investment thesis
Improving IT workflow automation

ServiceNow has a critical role in the bowels of IT management. The business works to improve IT workflow and functionality across IT departments globally. IT departments face a variety of issues in performing service delivery to internal customers within an enterprise. These include such tasks as IT asset management, new device ordering, provisioning, IT trouble ticket management, and employee onboarding. Such processes create a variety of tickets and escalations which need to be acted upon. Successful completion requires employee input, ticket handling and escalation, and ultimate resolution all within required service-level agreements that IT departments have with the lines of business.

ServiceNow has been able to help IT departments improve their productivity in executing all these various tasks via a common interface accessible to IT employees, helping to provide visibility into IT task execution and serving as a record of the status of various IT requests. Further, the company has streamlined the process by which employees in an enterprise interact with their IT department, providing an intuitive software portal that serves to manage interactions as an alternative to e-mail and phone. This is a critical service delivery function that enables the IT departments to meet service delivery obligations on time and on budget.

ServiceNow has progressively extended its IT Service Management toolset to Field Service Management and Facilities Service Management. Along with the core IT Service Management product, this represents a market of almost $20B for the company, growing at 10% annually.

Sticky service which makes IT departments look good

IT task management is a core function central to the operations of IT departments. Once ServiceNow establishes a beachhead within an IT department, they become very difficult to dislodge, particularly if ServiceNow is able to add significant productivity to the functioning of these departments. Deploying an alternate IT management system adds considerable costs to re-training existing internal IT employees on the use of that new system, with potential productivity gaps as users ramp up on a new system, not to mention potential confusion in task priority, handling, and resolution.

While competitors in ServiceNow’s markets do exist, such as IBM (NYSE:IBM), HP (NYSE:HPQ) and BMC, these vendors have generally tried to enter the market via acquisitions, which has given rise to complex integration where work is required to implement and make systems talk to each other rather than ServiceNow’s organic approach.

In addition, by working hand in glove with IT organizations, ServiceNow becomes a friend of IT departments and aids the agenda of IT departments to centralize and coordinate other systems and technology workflow management across other business units within an enterprise. In doing this, ServiceNow not only assists the IT departments’ agenda of expanding internal influence, but also makes IT departments an ally in helping ServiceNow expand influence into other areas within an enterprise.

Automation of workflow beyond IT expands value to an enterprise

Customer service, employee onboarding and systems management have similar workflow to the type of tasks that ServiceNow performs for IT departments. By being hand in glove with IT, ServiceNow is able to use IT as an advocate to help competently prove its credentials to be able to handle some of these other functional areas, with these business units often seeking the input of IT or consulting with them in the implementation and delivery of such workflows. Thus ServiceNow is able to progressively expand the scope of services and revenue that it extracts over time from a given customer.

ServiceNow has had considerable success here and has implemented a Customer Service Management module, helping employees manage customer service tasks, as well as a Human Resource Management module which helps with employee onboarding and employee recruitment. These newer modules account for 40% of new contract value today, a number which has been rapidly increasing recently. Further, successfully adding new modules and functionality has helped ServiceNow increase its addressable market to an estimated $165B by 2023.

Source: ServiceNow Investor Presentation

Expanding its tentacles across an enterprise from one department to another enables NOW to create such a lock on a given customer, which becomes difficult to unseat, with widespread loss of productivity across multiple functions within an enterprise if ServiceNow is displaced. This interesting aspect of the ServiceNow business model shows up in the extremely high retention rates that it experiences which have been steadily improving and are close to 99%.

Source: ServiceNow Earnings Presentation

Furthermore, greater than 75% of ServiceNow customers typically deploy multiple modules, which speaks to the success that the company has in being able to branch out beyond just the IT function.

Financials and Valuation
ServiceNow has grown revenue at a rate of 43% annualized over the last five years, and in its most recently reported results, the company grew revenue at 33%. It has been able to increase new customers at a double-digit rate, as well as successfully retain existing customers and sell them more over time. Gross margins have improved steadily over the last four years, from 67% in 2016 to almost 77% today. ServiceNow also does an excellent job with revenue to cash flow conversion, with almost 20% of cash flow being retained net from revenues generated.

Unfortunately, all of this comes at a high price for new investors today. A general sell-off in SaaS businesses and investor consternation over a CEO change took ServiceNow’s share price as low as $220 in October. Since then, it has strongly rebounded, rising more than 40% to currently trade at $312 per share, putting the business on almost 19x sales, well up from 13x sales that it recently changed hands at and well above its average price to sales ratio over the last five years of 13x sales.

Incidentally, ServiceNow’s CEO change is a development that investors should welcome, with John Donahue’s exit to Nike (NYSE:NKE), allowing Bill McDermott, former CEO of SAP Europe, to take the top post. McDermott comes well credentialed and is a veteran of the enterprise software space through his tenure at SAP.

ServiceNow has built a very lucrative niche in the workflow automation space with IT being its core customer. It plays in a fairly large market which is very sticky and has large barriers to entry. The business is extremely financially disciplined with very robust rates of growth currently that should also continue well into the future. While current valuations leave little room for any margin of error, this is a name that investors should put on their list to add with any pullback in valuation.

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