Is ServiceNow the Best Cloud Investment Option?

ServiceNow is part of the lucrative and ever-exciting enterprise cloud software space, joined by the likes of Workday, Salesforce.com, and Aspen Technology. Given its strong quarterly performance, investors are asking if the stock will continue to soar.

Jan 31, 2014 at 6:00PM

ServiceNow (NYSE:NOW) has produced stock gains of 130% over the last year, which is surprisingly better than peers Salesforce.com (NYSE:CRM), Workday (NYSE:WDAY), and Aspen Technology (NASDAQ:AZPN). Currently, the stock is trading higher by 15% following a phenomenal earnings report, but is it fairly priced, possibly still presenting value, or is there a better opportunity in this space?

Outperforming expectations
ServiceNow is a provider of cloud-based services, working to maximize the efficiency of IT operations. Essentially, it is the work of companies like ServiceNow that is weighing heavily in the on-premise IT space, companies like IBM.

By using the cloud, ServiceNow can save customers money by rolling several IT-related services into one platform, something on-premise IT companies can not accomplish. Thus, there have been a lot of eyes on ServiceNow in recent months, and following IBM's earnings report, many analysts thought that businesses were switching to enterprise IT at a quicker rate.

Turns out these analysts were correct, as ServiceNow added 160 new accounts in its last quarter, with 40 being global 2,000 customers. As a result, ServiceNow's revenue grew 66.6% to $125.2 million, easily beating expectations. Also, its deferred revenue and backlog balance rose 59% to $875.1 million, which is a reflection of future revenue and implies sustained growth .

Right in the middle
Essentially, ServiceNow is delivering in all of the areas that are most watched by Wall Street. Yet, for new investors, there are two concerns: margins and valuation. ServiceNow is not profitable, having operating margins of negative 14%, and it's a bit pricey, trading at 20 times last year's sales.

However, when investing in enterprise cloud software companies, it seems that concerns regarding valuations and profitability are a universal problem. Salesforce.com is the largest cloud company that focuses solely in this industry. Workday, a provider of payroll and HR-related cloud services, is one of the most watched and discussed companies in this space.

 

Operating Margin

Price/Sales

2014 Growth Expectations

Salesforce.com

(5.4%)

9.3

28.4%

Workday

(33.3%)

36.9

51.5%

From the chart above, a wide disconnect between the margins and sales multiple between these two particular companies is evident.

Salesforce.com isn't expected to grow as fast this year, but is about 7.5 times larger than Workday. Therefore, it is understandable that Salesforce.com wouldn't grow as fast. Also, due to being a larger company, it also makes sense that Salesforce.com's margins are better, as Workday is still in a growth phase. Workday's sales premium, although obscene, can be explained by investors betting on future growth, rather than current fundamentals.

So, considering the wide gap between how Salesforce.com and Workday are priced, ServiceNow is almost exactly in the middle. ServiceNow is expected to grow 36.3% this year, which is mid-way between its peers, as is its operating margin and price-to-sales ratio.

Is there a good investment?
Examining these three companies, it's possible to identify positives and negatives. Salesforce.com is growing rather fast for a company that has $3.76 billion in annual revenue, but despite being so large it is still not profitable. This is concerning. 

Workday is the fastest grower, but shares are expensive. Investors have to wonder if Workday will ever grow to support its valuation.

Then, there's ServiceNow, stuck right in the middle of Workday and Salesforce.com, it appears to be valued perfectly relative to its peers, which isn't exactly good.

Finally, there is an industrywide problem that should alarm investors, which is the lack of proven profits. This raises the question of whether growth is possible while operating efficiently, producing consistent earnings.

Investors might want to explore an under-the-radar company called Aspen Technology, as its services make training, presenting, and software integration easier in complicated industries such as energy, chemicals, and engineering.

Aspen is expected to grow 17% this year, which is, by far, the least impressive. Yet, is one of the only companies in this space that is profitable. In fact, with a 21.8% operating margin, it's very profitable, and at 11.5 times sales, it trades at a deep discount to its peers.

Final thoughts
While the enterprise cloud software space is clearly valued according to growth, Aspen Technology is a rare name that creates profits, and in an industry lacking, such profits must warrant a premium multiple.

ServiceNow might have deserved its large gains on Thursday. It beat expectations and raised guidance in an industry where investors want growth. Yet, it's priced accordingly with its peers, and sooner or later the question of profitability will have to be answered.

Therefore, investors might find a better opportunity in a company that's spending less money to achieve impressive growth, such as Aspen. This is a company that, long-term, might be the better performer than Workday.

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Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends Salesforce.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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