One of the lesser-known enterprise technology companies benefiting from artificial intelligence (AI) is ServiceNow (NOW +6.25%). The company specializes in business process automation across a variety of IT services.
Bill McDermott became CEO of ServiceNow back in October 2019 after a long, successful run at SAP. Since then, the stock is up over 160%. A good reason investors have enjoyed such robust returns is that ServiceNow has become on of the prominent players in digital transformation. Utilizing data to make more informed, impactful decisions is becoming increasingly important for businesses of all sizes. While there are a number of dashboarding tools and data analytics providers, ServiceNow has surfaced as one of the leading platforms due to its ever-evolving library of product offerings.
While the stock has been generous to investors for several years now, I think it could just be getting started. In fact, ServiceNow made The Fool's list of most undervalued growth stocks for 2023.
AI is a massive catalyst for the company, and its current financial and operating performance demonstrates that. While it may not be as well known as Microsoft, Alphabet, or Amazon, there is plenty of reason to believe that AI is helping ServiceNow evolve into an even more integral platform for businesses of all sizes. Let's assess if the stock deserves a spot in your portfolio.
Strong financials fueled by AI
As with its big tech counterparts, ServiceNow's management has been touting the prospects of AI for the last several months. The company derives revenue from two primary sources: subscriptions and professional services. Subscriptions represent high-margin recurring revenue streams, so investors tend to scrutinize trends in this metric.
For the quarter that ended Sept. 30, ServiceNow reported $2.2 billion in subscription revenue and 27% growth year over year. Even better is that the gross margin for subscription services clocked in at 81%. This high level of profitability has helped ServiceNow generate consistent positive free cash flow, which the company can use for share buybacks or to reinvest into new products and services.
During ServiceNow's Q3 earnings call, McDermott discussed why he thinks AI will help fuel continuous growth. Specifically, he referenced a study by IT research firm Gartner that estimates $3 trillion will be spent on AI-powered solutions between 2023 and 2027. Furthermore, McDermott proclaimed that AI "isn't a hype cycle; it is a generational movement."
Image source: Getty Images.
Is it all just hype?
Software companies often spend a long time testing and demoing their products. Although this often makes the sales cycle and vendor procurement process long and arduous, it is paramount that devices and systems work together seamlessly. The various software platforms that companies rely on is called a tech stack. In a way, the tech stack represents the nuts and bolts that hold everything together. If important data is stored across multiple systems but cannot easily be stitched together, the tech stack probably isn't as well-managed as it could be. Despite this challenging process, ServiceNow is answering the call.
According to its Q3 earnings report, the company has released over 5,000 add-ons and new capabilities for its various modules in 2023 alone, many of which are rooted in generative AI. Moreover, investors learned that 18 of the company's top 20 net new annual contract value deals during Q3 involved eight products or more. This level of cross-selling is precisely why ServiceNow is generating high-double-digit top-line growth at a high margin.
This is an important dynamic because it shows how end-users of ServiceNow are outlaying a lot of capital up front. It's not uncommon for a software company to make a sale, and then try to cross-sell additional services after the initial deal (perhaps upon renewal of the contract). However, in ServiceNow's case, the company is doing a great job of penetrating customers more deeply during the early stages of customer acquisition. By capturing this level of customer value so early, ServiceNow is active beyond just one layer of the tech stack and evolving into what McDermott describes as a full-spectrum "intelligent super platform."
Should you invest in ServiceNow?
NYSE: NOW
Key Data Points
The chart below illustrates the price-to-free-cash-flow multiple for SeviceNow versus that of peers Salesforce.com, Workday, Atlassian, and Snowflake.
NOW Price to Free Cash Flow data by YCharts
Interestingly, ServiceNow's price-to-free-cash-flow multiple of 52 puts it in the middle of its peer set. Salesforce.com trades at a meaningful discount by this measure, but I'd argue that is because the company is more mature and less of a growth stock.
Given the overall haziness of the macroeconomy, I'd say ServiceNow is performing extremely well. I believe the stock has much more room to run due to the heightened interest in AI and its various use cases. As of now, companies are still spending quite a bit of time figuring out exactly how new breakthroughs in generative AI can best serve the business. For this reason, it's appropriate to think that ServiceNow's place in IT budgets and its role in the AI journey is just beginning.
Long-term investors should be excited about the company's ability to thrive in a market primarily dominated by big tech. I think that now is a terrific opportunity to initiate a position in ServiceNow, given its inroads into AI, strong financial position, and attractive valuation relative to its peers.
