Is ServiceNow Stock a Buy After Earnings and Its Investor Day?

ServiceNow NOW released its first-quarter earnings report on April 24 and held its investor day presentation on May 6. Here’s Morningstar’s take on ServiceNow’s earnings and the outlook for its stock.

Key Morningstar Metrics for ServiceNow

• Fair Value Estimate: $790.00
• Morningstar Rating: 4 stars
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: Medium

What We Thought of ServiceNow’s Q1 Earnings and Investor Day

• Results reinforce our thesis that ServiceNow is leading the charge to automate and simplify processes for enterprise customers. We are impressed with both its resilient near-term performance and long-term organic-driven growth. We think the company is well-positioned as it leverages its strength in workflow automation to drive success for its clients in other areas, like customer service and human resource service delivery. We believe ServiceNow’s introduction and proliferation of specialized industry niches, premium pricing tiers, and expanding portfolio will lead to continued growth and enhance the company’s moat. Adding generative artificial intelligence to the platform in September 2023 should further cement its leadership position.
• Trends from the last quarter continued into 2024, as strong AI adoption was once again the key story, with the Pro Plus version seeing strong uptake. Pro Plus remains ServiceNow’s fastest-growing product ever. We see good traction in both vertical solutions and premium offerings, which help top-line growth and margins, as these solutions enjoy a material pricing uplift. Pro Plus with generative AI capabilities carries a price premium of 60% from the existing ITSM Pro version.
• The demand environment is good, and revenue is ahead of consensus. Large deals are still strong, consistent with last quarter and other enterprise vendors. Vertical solutions and AI have premium pricing and help drive revenue growth. The public sector and telecom, media, and technology verticals were strong. All geographies were at least solid.
• Fading hopes for interest rate cuts this year are likely letting the steam out of software stocks. We’re starting to see some value for high-quality names like ServiceNow, and we see its stock as undervalued.

Fair Value Estimate for ServiceNow Stock

With its 4-star rating, we believe ServiceNow’s stock is undervalued compared with our long-term fair value estimate of $790 per share, which implies a 2024 enterprise value/sales multiple of 14 times and an adjusted P/E multiple of 58 times.

Read more about ServiceNow’s fair value estimate.

Economic Moat Rating

We assign ServiceNow a wide moat, derived from high customer switching costs. The company officially reports only two segments, subscriptions and services. We view the subscription business as having a wide moat but do not think the services segment, which is a small portion of revenue, warrants a moat. We believe ServiceNow’s moat will allow the company to earn returns over its cost of capital for the next 20 years.

The more critical the function and the more touch points across an organization a software vendor has, the higher the switching costs. There is also the direct time and expense of implementing a new software package for the customer while maintaining the existing platform and retraining employees. Additionally, there is the operational risk of changing software vendors, including business process reengineering, loss of data during the changeover, and overall project execution. A major implementation likely involves a system integrator and can take over a year in bad cases. Lastly, lost productivity is likely to be an issue, as customers move up a learning curve on the new system along with the distraction of users involved in the function where the change occurs.

Read more about ServiceNow’s economic moat.

Financial Strength

We believe ServiceNow is financially sound. Revenue is growing rapidly, while non-GAAP margins are robust and expanding. We believe continued traction in Information Technology Service Management and Information Technology Operations Management, along with the adoption of new use cases in customer service and HR service delivery, will continue to drive strong revenue growth for at least the next five years.

ServiceNow does not pay a dividend, but it has begun repurchasing shares to help offset dilution from stock-based compensation. The firm also makes occasional relatively small acquisitions. Over the last several years, the company has made various tuck-in acquisitions for undisclosed amounts. We expect small feature-driven acquisitions to continue but have not explicitly modeled any such deals. We do not expect the company to initiate a dividend in the foreseeable future.

Read more about ServiceNow’s financial strength.

Risk and Uncertainty

We assign ServiceNow an Uncertainty Rating of Medium. While valuation is high relative to peers—we would argue deservedly so, given its strong market position and superior growth prospects—any execution misstep or issue during quarterly earnings updates will likely have a magnified impact on the shares.

We believe the most important metric for ServiceNow investors is revenue growth. Therefore, continued deceleration in subscriptions, or growth that does not materialize as expected in PaaS or emerging products, would likely harm the stock. We have sometimes seen software companies struggle to manage rapid growth.

Read more about ServiceNow’s risk and uncertainty.

NOW Bulls Say

• ServiceNow’s superior product has led to rapid share gains and exceptional retention in the ITSM market. Now the company is using this strength to expand into other areas of ITOM.
• The company has added additional growth drivers, including customer service and human resource service delivery, which should help propel robust growth over the next five years.
• Operating margin was breakeven for the first time in 2019, and we see a decadelong runway for expansion.

NOW Bears Say

• As ServiceNow expands deeper into areas outside the core Information Technology function, it will encounter an expanding set of competitors. Some of these will be better equipped to battle.
• The company’s market opportunity is difficult to define.
• Rapid growth, especially given the company’s scale, will inevitably slow.

This article was compiled by Sokhoeun Noeut.