2022 was a brutal year for tech investors, and ServiceNow (NOW 2.63%) stock didn't escape the carnage. While the company has recovered somewhat in 2023, it is still down roughly 22% over the last 12 months, making now a great time to consider buying the dip. Let's discuss two compelling reasons why it could be a long-term winner.
Headwinds look transitory
Starting in 2022, the U.S. Federal Reserve began raising its benchmark interest rates at the fastest pace in history to control inflation in the wake of the coronavirus crisis. Higher rates can hurt growth stocks because they lower the future value of their cash flows and change investors' risk/reward calculations. Furthermore, higher rates can make it more expensive for companies to raise capital needed to fund their operations.
But ServiceNow also faces industry-specific challenges. Its core business involves selling subscriptions for enterprise-level cloud platforms designed to help companies manage and automate processes, including IT, HR, and customer service. Demand might be somewhat cyclical because it depends on how confident these clients are in the economy. When the future is uncertain, businesses will be less likely to migrate their workflows to ServiceNow's platform, while existing clients will be more likely to switch to lower-priced service tiers to save cash.
ServiceNow's fourth-quarter revenue grew by 25.5% year over year to $1.94 billion, which is a modest deacceleration from the 29% growth rate reported in the corresponding period of 2021. But the good news is that the macroeconomic and industry-specific headwinds are temporary challenges that don't change the company's long-term thesis.
A massive total addressable market
The megatrends of workplace digitization and cloud adoption aren't going anywhere because they allow enterprises to unlock economic efficiencies by automating processes and outsourcing data storage and other tasks unrelated to their core operations. This transition can help businesses improve their margins and profitability, which leads to impressive stickiness and organic growth for companies like ServiceNow.
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According to its fourth-quarter presentation, clients renew their subscriptions at a whopping rate of 98%, which suggests they are getting substantial value from their ServiceNow subscriptions. Furthermore, the scale of customer relationships is also growing, with the number of annual contracts worth over $1 million jumping by roughly 22% year over year to 1,637 in the fourth quarter. ServiceNow can expand by attracting new clients and growing its existing relationships.
How does the valuation stack up?
ServiceNow's fourth-quarter net income jumped 41% to $325 million, which is a pretty impressive growth rate. But that doesn't even take into account the company's operating cash flow, which stood at a whopping $2.7 billion in the period. To be fair, this metric adds back $1.4 billion in stock-based compensation, which can cause equity dilution. But it may provide a clearer picture of how much cash the business generates.
With a price-to-earnings multiple of 50, ServiceNow's shares are more expensive than the S&P 500's average multiple of 22. But the premium makes sense when considering its massive cash flow, respectable growth rate, and strong moat -- as evidenced by its extremely high renewal rates and steady growth in client business volume. ServiceNow shares look like a buy.
