In 2017, The Economist magazine published an article comparing the rising demand for data to that of oil. Thus was born the expression "data is the new oil."
It's amazing to think that in the last six years, big tech has managed to become more ingrained in our daily lives. Whether it's artificial intelligence, machine learning algorithms, social media, or cybersecurity, technology surrounds us.
A number of companies are catching up to the giants of big tech, and one is ServiceNow (NOW 2.63%), which is helping to lead the charge in digital transformation. The company develops cloud-based software that helps automate workflows for IT departments. Moreover, ServiceNow can easily integrate with a number of other applications, making its software easy to scale across an organization.
ServiceNow reports earnings in late April. Let's dig into the company's historical performance and determine if now is an optimal time to scoop up some shares.
Financial profile at a glance
ServiceNow is considered a software-as-a-service (SaaS) business. On its GAAP (generally accepted accounting principles) income statement, investors will see line items such as revenue, gross margin, and net income. However, SaaS businesses tend to highlight a number of non-GAAP figures such as annual recurring revenue (ARR), customer expansions, and remaining performance obligation (RPO).
In general, SaaS businesses deliver recurring revenue from software and nonrecurring revenue from professional services. Wall Street tends to keep a keen eye on their software revenue growth as this tends to carry higher margins than professional services.
Additionally, RPO is important because SaaS businesses tend to sign their clients to large, multiyear contracts that have built-in price increases. This means that the revenue investors see today rarely accounts for the entirety of the firm's book of business. RPO illustrates how much revenue a company like ServiceNow has already booked, but has not yet recognized on the financial statements.
In 2022, ServiceNow reported $6.9 billion in subscription revenue, which represented 24% annual growth. Moreover, the company ended the year with $14 billion in RPO, an increase of 22% year over year. Perhaps most impressive was the company's expansion profile. As of Dec. 31, ServiceNow had more than 1,600 customers paying it at least $1 million annually. However, according to the company's investor presentation, the average contract value from this particular cohort was $4.1 million. During Q4 2021, that cohort's average contract value was $3.8 million across 1,346 customers.
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The company has an amazing CEO
Those financial results are impressive, to say the least. For several months, major tech players like Microsoft, Alphabet, and Salesforce.com have explicitly stated that longer sales cycles are materially impacting their ability to sell services to their current customers and acquire new ones. They have attributed their slowdowns in growth to tighter corporate budgets, courtesy of lingering inflation and fears of recession.
Yet ServiceNow has managed to grow its sales to its established customers and gain new ones. While ServiceNow's executive suite boasts several industry veterans, I'd like to particularly call out its CEO, Bill McDermott. He previously served as CEO of SAP, and was tapped to take over ServiceNow in 2019 after then-CEO John Donahoe took the top job at Nike.
2020 was McDermott's first full year as ServiceNow's chief executive. That year, it reported subscription revenue of $4.3 billion and RPO of $8.9 billion. The next year, the company grew subscription revenue by another 30% to $5.6 billion, and RPO rose to $11.5 billion.
While its subscription revenue growth is beginning to slow, it's hard to discount what ServiceNow has been able to do in this uncertain economic climate. During the Q4 earnings call, Mark Murphy, an analyst at JP Morgan asked McDermott about his views on the macro environment. He answered by saying:
I did call it out. I think maybe we were the first ones to call it out that there were some clouds on the horizon back then with the macro, and we all know the forces that were blowing between Ukraine, inflation, tightening monetary policies and supply chain dislocation ... I think what happened back then is most businesses were not ready for that market.
Whether one is speaking of geopolitical headwinds or the Federal Reserve's interest rate hikes, McDermott is essentially pointing out that there are a lot of variables impacting ServiceNow's business at the moment that are out of his control. Nonetheless, he has managed his team to navigate these challenges and still deliver growth.
What does valuation imply?
When it comes to ServiceNow's valuation, I'm focused on two metrics in particular: the price-to-earnings (P/E) ratio and the price/earnings-to-growth (PEG) ratio.
The PEG ratio is related to P/E because it accounts for expected future growth in earnings. As of the time of this article, ServiceNow's five-year PEG ratio is 1.9. By the contrary, the company's 12-month PEG is around 6.2. In general, investors agree that a stock with a PEG ratio of less than 1 may be trading below its intrinsic value. Given that ServiceNow's PEG is well-above 1 for both a long-term and short-term estimate, the stock would appear pretty pricey. On the bright side, though, analysts are clearly forecasting that the company hits long-term sustainable profit margins, hence the PEG ratio estimates normalize over time. Given that ServiceNow is very much a growth stock, a five-year PEG target of 1.9 could be fairly reasonable regarding long-term valuation.
Let's talk about P/E. For reference, the long-term average of the S&P 500 is between 15 and 16 times P/E. ServiceNow's P/E is 294 times. It's important not to get carried away here. Clearly, the capital markets are applying a premium to ServiceNow, . But with that said, the company's revenue growth is slowing down, and there are a number of macroeconomic factors that could significantly impact its business.
It's safe to say that now is not an ideal time to lower your cost-basis on this stock, but the company could very much be worth keeping on your radar. The most prudent course of action for investors would likely be to wait until they can assess the company's next earnings report, which is due out later this month.
