Despite continued expansion in the face of a global economic slowdown, ServiceNow (NOW 2.63%) has seen its stock get beaten down hard by the bear market of 2022. Shares are down 38% with just days left until 2023, losing badly to both the S&P 500 and the tech-heavy Nasdaq Composite.
Could things get better in 2023? Perhaps. Research company Gartner predicts that cloud revenue will grow roughly 21% in 2023 to nearly $592 billion -- recession or not. That bodes well for ServiceNow and its category-leading platform for IT service management. But before buying this steep dip in the stock, here are a few points to consider.
ServiceNow: Slowing growth and little in unadjusted profit
Much like other cloud stocks, ServiceNow has all the makings of a great long-term investment. It has, in fact, done right by shareholders so far -- up until this past year, anyway. Over the last decade, the stock is up over 1,000%.
So what has been eating at its share performance lately? Slowing growth and meager profits.
As to the first point, ServiceNow's slowing growth isn't its own fault. As has been the case all year, the dollar's value has been on a record-setting pace versus the value of other foreign currencies. For a multinational organization like ServiceNow, that means the value of an international sale is lowered when converted back into dollars. This effect is the result of the U.S. Federal Reserve's interest-rate hikes.
In the third quarter, ServiceNow reported revenue of $1.83 billion. That was a 21% year-over-year increase, or a 27.5% when adjusted for constant currency.
But the second reason ServiceNow is being tossed aside is its small profit margins. Granted, on a free-cash-flow (FCF) basis, ServiceNow is highly profitable. Through the first nine months of 2022, FCF was $1.16 billion, a FCF profit margin of 22%. However, unadjusted net income was just $175 million, lowered by noncash expenses like depreciation and amortization of assets and employee stock-based compensation.
Higher interest rates have been a plague here as well. Higher rates lower the present value of stocks, especially those that turn little in the way of profit.
When will relief come?
The good news is that ServiceNow is indeed profitable by some metrics, even though the average investor is ignoring things like FCF right at the moment. And although the economy is slowing, the cloud is still in high-growth mode. Cloud computing software like ServiceNow's has the ability to save organizations money, so it remains a high priority even amid economic uncertainty.
In fact, earlier this year, CEO Bill McDermott increased the company's previous guidance for revenue and expects $11 billion in sales in 2024. For comparison, the company's full-year 2022 subscription revenue guidance calls for sales just shy of $6.9 billion, so the 2024 target implies a roughly 60% increase in two years.
The company could certainly pull it off given its rapid expansion this year. If the Fed stops raising interest rates sometime in 2023, the dollar's run could slow, which would be a tailwind for ServiceNow's revenue. Improving economic conditions could also cause revenue growth to reaccelerate.
ServiceNow also has a stellar balance sheet with $3.96 billion in cash and short-term investments, offset by debt of just $1.49 billion. Paired with its healthy FCF generation, ServiceNow could easily decide to start repurchasing stock in the next couple of years, which would be welcome news for a market weary of high-growth software stocks that dole out lots of new shares to employees as a paycheck.
However, for now, all eyes are unfortunately on the Federal Reserve and its fight against inflation using interest rate hikes. Until the Fed signals it's finished, ServiceNow stock may continue to struggle. Shares still aren't exactly a value, trading at 42 times trailing-12-month FCF. However, the Fed's actions aside, ServiceNow is a great company, and it's one that could be poised for another decade of market-beating gains. If you plan to hold for the long term, now looks like a great opportunity to start dollar-cost averaging into this top cloud software stock.
