ServiceNow Represents The Best Of SaaS

It is no secret that business software is a favored investment category here.

But some variations are better than others.

For one, I like *enterprise* software that is targeted at larger companies, preferably with thousands of employees doing business across the globe. These customers are more bureaucratic, slower moving, and more conservative in general. Once they decide on a particular vendor and spend the effort to integrate software into business practices, it becomes very hard to dislodge. That isn't so much the case for small-medium businesses (SMBs), where decisions can be made by a single person and changing only affects a handful of employees.

I also like software that manages a lot of *human generated* data, as opposed to automated or machine-generated. Human generated data - like sales leads, project info, employee data, etc. - is frequently more sensitive and difficult to migrate than machine-generated data like log files or operational metrics. It also tends to be more long-lived and valuable to the business. All of this makes it riskier to migrate.

Finally, look for software that *integrates into several areas of the enterprise*. If just one department - say, HR or Accounting - uses a piece of software, it is naturally easier to migrate than a shared platform used by HR *and* Accounting *and* IT *and* Customer Service!

The stock we are looking at today meets all of these criteria. It is one of the more interesting enterprise SaaS names listed on the Green Screens right now. The firm even notes their aspiration to be "the defining enterprise software company of the 21st century" on every earnings presentation!

The stock is ServiceNow (NOW). Let's take a look!

A Platform For Service.... Now!

ServiceNow started life as an IT Service Management platform, or ITSM. That may sound a bit wonky so let's go through a very simple example that ServiceNow can handle: an employee forgetting his or her password.

In prior days, there was a dedicated internal IT staff to handle these kind of things. The employee would call a Help Desk, probably wait for a while, answer a few questions from a human help agent, and finally, get their password reset.

With ServiceNow, all of this can be automated. The employee can go to ServiceNow's help portal and request a password reset for whatever tool he/she was locked out of. The platform is integrated with all kinds of IT systems (e.g. Microsoft Outlook, or Salesforce), so it can perform a password reset action automatically and quickly, with no human intervention, for any of these systems.

The employee just saved a fair bit of lost time, and the company saved money on staffing a help desk. A win-win!

Now, take this example and apply it to literally thousands of IT use cases, and you start to see the value of ServiceNow. Routine activities like permission grants, account creation, equipment requests, software installs, and a lot more complicated things can now be done quickly and with minimal human intervention. That's the core of ServiceNow's value proposition.

Over time, it became clear that this kind of workflow automation is super useful to departments all over the enterprise. Customer Service involves many similar activities as for employees, so expanding the platform to customers was a natural evolution. Human Resources requires workflows like onboarding new employees, exiting those that leave, handling job title or life changes, etc. ServiceNow can be used for all of these.

Finally, the company realized that offering its service automation platform as a "toolbox", that can be used by customers to develop their own proprietary workflows, might be valuable. Today, this "low code" offering accounts for 11% of revenues.

Growing Fast And Fully Recurring

ServiceNow is a cloud-based software-as-a-service (SaaS) platform. Customers pay recurring subscription fees for ongoing access to use it. Over 95% of sales are from these subscription fees, making the company's revenue model almost entirely recurring.

That's just what we are looking for!

The growth outlook is equally attractive. ServiceNow's 3 year compound annual growth rate (CAGR) is excellent, at over 30%. Current revenue growth is at 28% when adjusted for currency fluctuations. Performance obligations (basically backlog) are growing at 25%. All of these figures are pretty impressive considering the general pullback in enterprise IT spend going on at present.

Management has pegged the company's addressable market at an enormous $175 billion. Given the wide applicability of what ServiceNow offers, this does not seem ridiculously inflated to me. The company has openly targeted $11 billion in revenue by 2024, and $15 billion by 2027. From a current run rate of about $7 billion, that represents 20% annual growth for the next 5 years.

I think ServiceNow can achieve it. While it has largely penetrated its target customer base (over 80% of the Fortune 500 use it), the company's "land-and-expand" model allows it to grow consistently with each of these customers year-to-year. For example, a firm may start with ServiceNow to handle its IT service needs, then gradually expand its usage into Customer Service, HR, and other departments. That is very attractive because it is a cheap way to grow (little marketing expense involved), and deepens its ties with customers. Which brings us to the next point...

A Sticky Situation

ServiceNow considers their target customer base as the largest 2,000 firms in the world. When these large firms spend the time building out their business processes on top of ServiceNow's platform, those processes become relevant to thousands of employees and/or customers. It is not a stretch to say that the platform going down, or going away, is immensely disruptive to ongoing business activity.

Now, if you are an IT manager, are you going to cavalierly decide to switch out these systems with a competitor, and risk time, money, and failure implementing and re-training employees and customers? Particularly when you are replacing a platform that is considered the gold standard in the industry?

Of course not!

This simple anecdote shows the power of ServiceNow's SWITCHING COSTS moat. It is a platform that runs some of the most key business functions for large organizations. As more business units adopt it, and it becomes intertwined all across the enterprise, it becomes even MORE difficult to dislodge! There is just too much risk and expense involved with replacing it.

This factor keeps customers captive, as long as ServiceNow continues to provide a good solution. The firm has a customer retention rate of over 98%. That's remarkable! That implies that each customer ServiceNow adds stays with the company for well over 20 years.

Not only that, but the power of this switching moat also allows ServiceNow to push through modest price increases without a lot of customer push-back. The value it provides to the enterprise, once embedded, is immense.

Switching costs are a factor in nearly all business software offerings, but here more than most. ServiceNow's focus on large companies, combined with its importance within those companies, and the effort it takes to develop workflows with it, all add to one of the higher switching cost moats I've seen. This is certainly a "wide moat" company.

A Management-Proof Business?

Let's just put it out there right away - ServiceNow is no longer founder-run!

Fred Luddy founded the company back in 2004, and ran it as CEO until 2011. He then brought in Frank Slootman to guide the firm through its IPO.

That proved to be a great call - Slootman presided over an explosion in the firm's sales from $100 million to almost $2 billion! He handed over the reigns to successful former eBay CEO John Donahoe in 2017 (Slootman is now CEO at another Green Screen stock, Snowflake (SNOW)).

Donahoe delivered 2 years of excellent results before being poached for the head job at Nike (NKE) in 2019. That led to the current CEO appointment, Bill McDermott, whose long business resume includes a stint as CEO of enterprise software juggernaut SAP.

In the 3 years since McDermott took over, ServiceNow has continued its trajectory of rapid growth, strong free cash generation (30% FCF margin), and impressive returns on capital (over 45%).

Warren Buffett once famously said "I always invest in companies an idiot could run, because one day one will.". Now, this roster of CEOs are certainly not that - Slootman, Donahoe, and McDermott are all proven leaders. But the point is, ServiceNow is such a fantastic business that it would take some remarkably bad decisions to bring it down.

What encourages me is the company's culture of growing organically. From Luddy forward, ServiceNow has eschewed large, "transformative" acquisitions, preferring to grow from within. That's exactly what we want to see! A big red flag to this investment would be a major acquisition, because it goes against everything the firm has done in the past.

Risks

From a wider perspective of all stocks, I would consider ServiceNow a lower-risk option. Its recurring revenue model and high level of switching costs are going to protect it from many economic downturns that would crush stocks in the automotive, airline, or travel industries, for example.

The main risk I see is buying the stock at too high of a valuation. At 12 times sales, the market still expects substantial growth going forward. A prolonged pull-back in IT spend, or an inability of the company to continue driving increased growth from existing customers could mute potential investor returns in the stock.

We definitely do not want to see large, "transformative" acquisitions here, either. Time and again, we've seen these fail to work out and instead ruin the investment case for promising enterprise software firms (see: Twilio, or Okta).

Conclusion

ServiceNow is a great Green Screen option. It easily clears the bar on recurring revenue, growth potential, economic moat, and strong leadership. It gets added to the Watch List today, and we will look for a buying point in the near future. Check out the NOW stock page for thoughts on valuation and a good price to buy (for members, join today!).