Now's the Time for ServiceNow
We've upgraded our moat rating to wide and think the shares are undervalued.
We recently took a fresh look at ServiceNow (NOW) and raised our economic moat rating to wide from narrow while maintaining a positive moat trend rating. We have greater conviction in the company’s ability to profit from customer switching costs, given its robust retention metrics. As a result of assuming excess returns over a 20-year time frame--consistent with our wide moat rating methodology--we increased our fair value estimate to $221 per share from $195. We are maintaining our medium fair value uncertainty rating. We see the shares as undervalued today and still see upside for ServiceNow’s long-term growth story around major enterprises modernizing their IT infrastructure.
ServiceNow has followed the successful software paradigm of introducing a single, mission-critical product in a market vertical and expanding from that beachhead into other niches, providing ample upselling and cross-selling opportunities. ServiceNow created a software-as-a-service IT service management product, a cloud ticketing tool designed to track internal IT issues. The company has since entered the IT operations management, IT business management, human resources, customer service management, and security verticals.
We model a 26.5% compound annual growth rate over the next five years, largely driven by the IT service management and IT operations management products. Overall, we expect the emerging offerings to prop up ServiceNow’s torrid subscription growth. We think the company is well on its way to its goal of surpassing $4 billion in revenue by fiscal 2020 and expect it will eclipse $10 billion in revenue by fiscal 2027. In terms of the market opportunity of just IT service management, management has said that even with approximately 4,400 customers and 837 Global 2000 clients, many clients may have implemented ServiceNow’s tools in only one office or in one geography. IT service management alone is estimated to be a multi-billion-dollar opportunity, but ServiceNow’s end goal of servicing all unstructured workflow as enterprise customers undergo a digital transformation is an opportunity many multiples above the core product.
ServiceNow’s IT offerings composed 66% of revenue in fiscal 2017. In the near term, we expect IT service management and IT operations management to serve as the growth engines of the business, but longer term, we anticipate the IT offerings versus emerging products (HR, customer service management, and security) and platform add-on revenue share to sit closer to a 50/50 split. As an enterprise integrates an IT service management or IT operations management tool, it becomes easier for a customer to become increasingly reliant on ServiceNow’s ecosystem. For example, if an enterprise already utilizes a ServiceNow IT operations management tool, the next logical step is to utilize a ServiceNow security product to handle a major cybersecurity breach.
Our overall thesis for our wide moat rating is anchored in ServiceNow’s industry-leading customer retention metrics and lifetime value to customer acquisition ratio, or LTV/CAC. ServiceNow has reported 97%-99% retention every quarter since the data point was first provided in 2013. We view this as indicative of a sticky product and note that many of ServiceNow’s peers obfuscate this metric by reporting revenue retention instead of customer retention, which mixes churn with cross-sells and upsells, frequently resulting in a number in excess of 100%. We think these SaaS competitors are attempting to obscure less-than-stellar retention ratios because this calculation can lead to noise, particularly as it gives us no indication of how many customers left in a given period; a large upsell of a single customer could mask the departure of numerous smaller customers. In contrast, ServiceNow’s pure customer retention metric is best in class, producing LTV/CAC ratios well above those of the vast majority of software companies we cover. We believe this is indicative of substantial switching costs commensurate with a wide moat rating.
By our estimates, ServiceNow’s LTV/CAC has averaged about 5.00 over the past eight quarters. We view this as best in class, sitting at the upper end of our departmentwide software coverage. We believe this metric is an important indicator of a software vendor’s efficiency in attracting new customers and retaining existing ones. By our math, for every $1.38 spent to acquire a customer, ServiceNow extracts a $6.85 lifetime value for the customer. Similarly, as we look at ServiceNow’s limited GAAP profitability, we use the LTV/CAC ratio to assess whether the company lacks pricing power and operating expenses are out of control, or whether the company is making wise investments in order to secure more customers and future revenue. We think the latter clearly applies to ServiceNow today.
ServiceNow sits in an elite pantheon of vendors, such as Workday (WDAY) and Guidewire Software (GWRE), with these companies producing higher LTV/CAC numbers than nearly every application software vendor. ServiceNow, along with this cohort, has mission-critical products, which lead to switching costs and high retention ratios. We believe this is compounded by an expanding slew of products for each of these businesses, which have provided cross-selling and upselling opportunities. These exemplary unit economics give us confidence in the stability of ServiceNow’s business, wide economic moat, and positive moat trend.
In 2011, ServiceNow’s market share in IT service management sat below 10%, while BMC controlled over 30% share, according to Gartner. In 2017, estimates suggest ServiceNow controlled over 40% of the market, while BMC’s share fell below 20%. While an onlooker might reason that the rapid swing in market share may be indicative of the absence of switching costs in the space, we refute this claim for several reasons.
First, the aggregate IT service management market has expanded rapidly over the past 10 years, allowing ServiceNow to win share from new customers purchasing an IT service management product for the first time. The secular increase in enterprises needing software applications to perform mission-critical roles has meant that businesses need a more efficient process to service software and hardware outages.
Second, we believe incumbents like BMC struggled to migrate their on-premises customers to the cloud. We think enterprises have migrated to cloud solutions to save costs, move away from internally developed applications, and improve business processes. Because BMC’s share decline was relatively steady, we see this as indicative of general switching costs in the overall IT service management space. Many of ServiceNow’s current Global 2000 customers implemented the company’s IT service management product in only a discretionary segment of the business or had dual IT service management products for a time before fully transitioning. However, we assert that BMC’s share declines were exacerbated by customers migrating to the cloud, which served as a tailwind to ServiceNow’s rapid growth. Our thesis on cloud migration is that it has served as a one-time land grab for software vendors. We do not foresee an analogous catalyst to allow ServiceNow’s competitors to win back lost share.
Third, we believe customers will be less likely to move away from ServiceNow’s cloud IT service management solutions, especially as they increasingly purchase additional products from the company, whether in IT operations management, security, customer service, or HR. Incumbents who lost share lacked ServiceNow’s land-and-expand strategy, which has allowed the company to increasingly embed itself in the IT ecosystem of its client base. We believe our wide moat and trend thesis is supported by ServiceNow’s 97%-plus retention and growing share of multiproduct customers, which was above 75% at the end of fiscal 2017.
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William Fitzsimmons does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.