ServiceNow: Too Risky for Such Small Upside

ServiceNow, the software-as-a-service business, guides for declining revenue growth rates yet still remains too richly valued. Avoid this name.
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ServiceNow  (NOW) - Get Report continues to see its shares rapidly appreciate. Nonetheless, the disconnect between its valuation and underlying operations has never been wider.

Shareholders clamoring for this stock are being primed for disappointment. Investors would do well to avoid this name. Here’s why:

Growth Prospects Are Slowing Down

ServiceNow is a workflow and IT service management company that positions itself as a sticky software-as-a-service business.

ServiceNow CEO Bill McDermott has taken the reigns of the company at a critical juncture in its journey. What's more, McDermott has dangled a carrot in front of investors declaring that ServiceNow is capable of growing into a $10 billion revenue platform, compared with the $3.5 billion of revenue it recorded in 2019. 

Meanwhile, ServiceNow’s total revenue growth rates, which were previously rising at a compounded annual growth rate of 35% over the past three years, have been guided to finish 2020 with a revenue growth rate of just 30%. 

To put it another way, there has been a consistent and predictable decline to its revenue growth rates, rates not aligned with the narrative of a sticky SaaS platform. Why is this so?

The most realistic reason for the decline is the impact of similarly positioned competitors. One noteworthy peer with a similar offering is Atlassian’s  (TEAM) - Get Report Jira Service Desk, which is arguably taking market share through its lower-priced service. Further reasons include a natural difficulty in growing revenue as the law of large numbers takes a toll.

Cash Flow Prospects Remain Unimpressive

As we enter the final stages of this long and complacent bull market, too many investors are readily accepting management add-backs as a way of bolstering their company’s illusion of profitability. 

Specifically, we can see that for 2019 ServiceNow pointed investors to its strong free cash flows as representative of the company’s strong cash conversion prospects. What’s more, ServiceNow declared that its free cash flow margin in 2020 should reach 29%.

However, we should consider that ServiceNow made $970 million of free cash flow in 2019, yet its stock-based compensation equaled $662 million during this period. This  brings back the question: Exactly how profitable is this SaaS player?

Moreover, this figure gets further obfuscated once we factor in ServiceNow’s capitalization of intangibles, which approximated $73 million in 2019.

Valuation - No Margin of Safety

In actuality, ServiceNow guided its non-GAAP income from operations before stock-based compensation and amortization of intangibles to reach approximately $1 billion in 2020.

Thus, the question for investors is whether a company that is guiding for approximately 30% growth rates with income from operations of $1 billion presents investors with a bargain opportunity when its market cap is already at more than $60 billion.

Further complicating the thesis is the reason why ServiceNow is so richly valued. Of course, this is because as a SaaS playe  most of its revenue is recurring, which lends itself to meaningful visibility and highly predictable revenue. 

However, ServiceNow's declining revenue growth rates are at odds with this, thus requiring investors to adopt prudence and demand a larger margin of safety in this investment. 

The Bottom Line

Investors are pricing a lot of good news into the stock and even perhaps pricing in expectations that ServiceNow is guiding for 2020 to be low enough to leave some room for adjustments.

Having said that and given that the stock already is priced for perfection, with growth rates steadily declining, investors would do well to reconsider this opportunity.