ServiceNow reported strong numbers during its trailing nine months of fiscal 2019, while its share price performance grew at an impressive clip during 2019, outperforming the S&P500 during 2019.
However, with sky-high expectations already priced in, investors are forced to ask the difficult question: is there enough upside potential left at its current valuation? I argue there is not, and that investors should take profits and sidestep this stock.
Handover at a Critical Juncture
ServiceNow finds itself at a critical time with John Donahoe stepping down from his role as CEO to be CEO of Nike , and Bill McDermott coming in to lead ServiceNow towards its long-term $10 billion revenue target.
Upon his arrival, Mcdermott laid out his vision. He believes ServiceNow has a strong runway ahead, and under his stewardship, ServiceNow will continue to invest in itself to grow and optimize its suite of products, rather than opting for inorganic growth. Specifically, Mcdermott's proclaims that there is significant room to tailor the platform to be increasingly industry-focused.
Moreover, Mcdermott posits that ServiceNow sees a large opportunity to grow within large organizations, truly aiding enterprises' digital journey towards becoming more automated and efficient, insofar as ServiceNow finds itself with no appetite to go after smaller enterprises -- deeming the economics unattractive.
Further reinforcing this vision, during fiscal Q3 2019, ServiceNow was able to boast of nearly tripling the number of contracts with federal agencies worth more than $1 million to 14 compared with the same period a year ago.
Sector With Huge Tailwinds Boosts ServiceNow
For investors, the task today is to make an objective argument for why ServiceNow will not only be a clear beneficiary of the rapidly growing cloud sector but how ServiceNow also has a truly enduring competitive advantage. Furthermore, investors need to ensure that its future prospects are not already being fully priced into its stock.
In actuality, for a considerable amount of time, the competition was slow to recognize the highly compelling cloud opportunity, as well as enterprises’ demand for cloud computing and digital workflows as a way to unlock employee productivity. Right away, ServiceNow recognized this opportunity and its first mover-advantage allowed itself (and a few other players) to outdistance themselves from the rest of the pack.
Moving on, the landscape has changed so much that today, nobody doubts any longer whether or not the cloud sector has huge tailwinds at its back. Having said that, the onus for investors is on choosing the right company that has enough of a value proposition so as to have staying power as the competition starts to consolidate.
Valuation – No Margin of Safety
The table above reminds readers of just how expensive the whole sector is. Further, despite ServiceNow’s strong rhetoric, investors at some point will start question whether paying 52x trailing cash flows for a company growing its top line at 35% offers investors enough margin of safety?
Towards the back of 2019, investors’ appetite for high flying companies with no GAAP profits started to wane, as they started to demand a clear ‘’path towards profitability’’ from their companies.
One advantage ServiceNow has over many of its peers is that its retention rates are close to 100%, meaning that ServiceNow has strong visibility. That lends itself to predictable earnings, which investors crave and are happy to reward with a high multiple.
But paying already close to 18x trailing sales, in this author’s opinion. leaves very little margin of error.
With so much competition, together with a very expensive valuation, investors will struggle to find a suitable return in ServiceNow's share price.
ServiceNow will post its highly anticipated Q4 2019 results at the back end of January. Stay tuned for an update.