Up 6%, NowX Could Justify ServiceNow’s 18x Forward Revenue Valuation

ServiceNow, the San Francisco-based provider of workflow process management services, has been on a roll since its IPO.

Thanks to my June 29 interview with chief product officer, C.J. Desai, I understand better why. That’s good news for ServiceNow investors and bad news for companies that think they can acquire their way out of a growth slowdown.

Should you invest? While ServiceNow’s revenue growth rate has slowed down from a torrid 59% average rate in the decade ending 2020, it anticipates growth in subscription revenues of about 28% for 2021 to around $5.4 billion, according to its Q1 2021 investor presentation.

If ServiceNow can exceed that growth rate each quarter, its shares — which are up a mere 6% in 2021 so far (while the S&P 500 has risen 16%) — could climb.

(I have no financial interest in the securities mentioned).

I admire what ServiceNow is doing to try to spur its growth through internally-developed products. That’s because research shows that the majority of acquisitions fail to generate a return on the price paid to complete them.

ServiceNow’s story of organic growth starts with its founder’s remarkable foresight in 2005 to develop a product architecture to make business processes more efficient. Sadly, it took years to figure out how to communicate that value to customers.

In 2009, ServiceNow developed an application for IT service management (ITSM) that spurred very rapid growth. With relatively modest additional cost, ServiceNow could adapt that ITSM application for other corporate processes such as customer service, human resources, legal, and procurement.

In 2018, ServiceNow institutionalized the idea of launching one or two new revenue-generating products a year through what it calls NowX. This year, ServiceNow expects to introduce two to three new products that generate about $100 million in revenue.

ServiceNow took its time winning customers. “ServiceNow founder and Chairman Fred Luddy was 5o when he started the company. He had been banged up at his previous company [Peregrine Systems some of whose other executives went to jail in the wake of a 2002 bankruptcy, according to Forbes]. In 2004, he created a platform as a service. At that time, firms were still in the early days of architecting cloud-based services. It was hard for normal people to understand the value. We visited banks, governments, and health care providers and they asked ‘What should we do with this?'” said Desai.

Finally, a demo got customers to buy the concept. As he said, “From 2005 to 2009, we struggled to convince customers. We did a demo in which an employee requested a computer or struggled to reset a password but could not reach an IT person. Fred and the team developed a platform for IT service management (ITSM). Companies loved how flexible and extensible it was. They asked ‘Will it work with other systems?’ We gave sales people an extensible ITSM platform. It gave us a much better growth trajectory.”

ITSM was able to manage IT customer service. “It worked. An employee at a large bank requests a laptop. What happens? The employee wants to add a monitor; will the manager approve the purchase? Is it allowed in our department? IT must provide the security credentials; the computer is shipped to the employee who acknowledges receipt but can’t get the computer to run,” noted Desai.

Once ServiceNow went public, investors questioned whether its market opportunity was large enough. As he told me, “We went public in 2012 with ITSM as our product. The overhanging questions were: ‘Is that a big enough market? Will it grow or is it a small TAM niche? We realized that our ITSM platform could be extended to solve other business problems using the same architecture such as customer service, legal, and procurement.”

ServiceNow was able to extend a favorable reputation into new business functions while quickly adapting its product to solve those new problems. “We had a good relationship with the chief information officer and asked the CIO to refer us to the heads of human resources and customer support. We could scale into a different buying center. The unit economics to create a new product were super-favorable. We could build a customer service platform with 24 engineers in six months,” explained Desai.

What was in the platform? As he said, “The platform provided all the core services to support operations — including user experience, the data model, and the application programming interfaces (APIs) needed to integrate with other systems. We had all the building blocks and it was 100% cloud-based. From the customer perspective, we were offering the ability to integrate with other systems without requiring them to spend millions of dollars.”

In 2018, ServiceNow launched NowX with the aim of introducing one to two new revenue-generating products every year. “Starting in 2016, we introduced a human resources and customer service service; in 2017 we added software asset management; in 2020 we added industry-specific solutions in telecommunications and banking. In 2021, we are adding healthcare and manufacturing and we will introduce one for insurance in 2022,” said Desai.

ServiceNow is proud of its ability to grow without acquiring revenue. As he told me, “We are the only one in the SaaS industry that is scaling by building products organically. We will acquire small teams with technological skills. We can create a new software as a service with 10 to 24 people in six months to a year. Our products are in four buckets with a total addressable market of $175 billion. We create products that deliver value for customers and we partner with systems integrators such as Accenture and Deloitte.”

In theory, what ServiceNow does is based on a culture and organizational mechanisms that other firms could adapt.

One of them is a culture that talks and acts — the hard part being the action — on the premise of customer focus.

As Desai described this, “Why do we win? Unlike other firms I have worked at, ServiceNow has real customer focus. Fred was focused on the customer. We have a humble and hungry culture. The company is 16 years old and has not lost that aspect. We speak with our customers and ask how we can make them successful. We have a large customer that is going live with a customer service application on July 4. On July 1, out leaders in engineering, sales, and service all working on it. We were all on call the night before until midnight. That kind of service is always received well. If our customer has a speed bump, we figure it out. We have very high renewal rates and high renewal rates. There is no finish line.”

NowX also shields its product development focus from the pressures of meeting quarterly investor expectations. As he said, “With NowX we ring-fence our investment to protect it from short-term pressure to meet quarterly forecasts. We increase R&D investment at our revenue growth rate plus 4%.”

It does not seem to me that ServiceNow is resting on its laurels. “We have a healthy paranoia to continuously innovate and scale the way we execute. 60% of our people are working on today’s products; 30% are developing products that will generate a return on investment in 12 to 36 months; and 10% are working on products further into the future. In 2019, we introduced two new products; in 202, five new products; in 2021 we will introduce to new products; in 2021, we will introduce two to three new products with $100 million in revenue,” he concluded.

Sadly for ServiceNow, it has not escaped investor notice that the company’s revenues are not growing as fast as they used to.

SeekingAlpha pointed out that after having rallied about 20% through June 22, ServiceNow stock was expensive. The argument is that with a market capitalization north of $100 billion and growth in the 20% range, ServiceNow’s valuation at about 18 times forward revenue is expensive when compared to that of Workday, Atlassian, and Snowflake.

If ServiceNow can grow faster than investors expect — about 27% or its valuation drops to about 14 times forward revenue, its shares could be a buy. “Key takeaways Trading at >18x forward revenue despite declining growth rates and rather disappointing progress on profitability, I see much more risk than reward for ServiceNow. Remain on the sidelines until this stock comes down to more buyable levels,” notes SeekingAlpha.

Not all analysts agree — Goldman sees the stock rising to $695. “In our view, ServiceNow’s scale and breadth of offerings across [IT service management, IT operations management, customer service management], HR and workflow engine uniquely position the company to grow its 2020 revenue of $4.5bn more than 3x, potentially reaching $15bn of revenue in C26, driven by multiple secular themes including Digital Transformation, Workflow Automation, and Low-code No-Code,” wrote analyst Kash Rangan.

If he’s right, ServiceNow shares have 25% upside potential.

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