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Morningstar | Now for Wide-Moat ServiceNow; We Are Maintaining our $221 FVE and Continue to Foresee Upside. See Updated Analyst Note from 24 Oct 2018

ServiceNow reported its third quarter of 2018, outperforming both our revenue and EPS expectations and surprisingly posting a quarter of GAAP profitability. We are thus maintaining our $221 per share fair value estimate and wide-moat positive trend rating. We had previously added ServiceNow to our Best Ideas list for the month of August, but removed it due to outperformance. With shares once again trading at a significant discount to our fair value estimate, we think the shares look attractive at this price.

The firm continues to post excellent metrics, with 860 customers in the Forbes Global 2000 (43% penetration) and customer retention of 97%. In terms of the quarter, the firm reported $637 million in sales, growing the topline at 36.7% year over year. We think the firm is well on its way to achieving its $4 billion by 2020 target.

ServiceNow is a leader in SaaS IT Service Management space, or ITSM, with a flagship product designed to track internal IT issues. As enterprises enact digital transformation, or DX, initiatives to improve internal inefficiencies, customers are buying ServiceNow’s products to streamline previously unstructured workflow. In the past, we believe evidence suggests that customers selected a vendor based on cost and without a regard for the user experience, or UX, design. We think DX initiatives have changed that paradigm, where customers want a best-in-class solution. Furthermore, ServiceNow and a couple of its competitors have prioritized the UX, as more end users interact with ITSM tools, not just those in the IT department.

We have witnessed ServiceNow expand into other verticals (ITOM, IBTM, Customer Service, HR, Security, and Platform), which we believe are equally sticky. We believe each is a natural extension of ITSM, providing ServiceNow with a growing total addressable market, or TAM.

ServiceNow reported revenue of $1.9 billion for fiscal 2017 and is targeting $4 billion for fiscal 2020, effectively doubling the top line in three years. While ServiceNow modestly raised guidance for the full year, once again, the guidance raise was perhaps a little more tepid than previous upward revisions. However, the guidance still gives us confidence in our long-term projections. We continue to forecast the firm producing a GAAP operating profit in fiscal 2020 and track modestly ahead of the $4 billion total revenue by 2020 expectation. The firm’s success is primarily coming from selling into its current install base, as it benefits from an enterprise focus. Longer term, management is already targeting $10 billion in revenue and we model the firm achieving that target by fiscal 2027.

Financially, ServiceNow posted a quarter of positive GAAP EPS. While the firm already reported positive GAAP EPS in the first quarter of 2018, that was largely due to a one-time adjustment. Typically, SaaS businesses reinvest in their offerings to grow share and lack GAAP profitability for a years before quickly expanding margins as the business matures, revenue growth slows, and the headcount stagnates. We ServiceNow has been fairly expense disciplined thus far, as the firm is not acquisitive, and margins have continued to expand. While we sometimes see SaaS businesses expand spending as they are about to achieve GAAP profitability, ServiceNow indicated to us that it largely sees operating margin expansion going forward.

Looking at the firm qualitatively, ServiceNow was already named Forbes' Number 1 most innovative company, outpacing other cloud leaders like Salesforce and Workday, but it was also recently identified as Number 3 on Fortune’s Future 50 list. Why is this important though? The Fortune 50 looks at companies with the “best prospects for long-term growth.” We have already identified that ServiceNow is buoyed by a number of salient trends, namely DX and workflow efficiencies. The Forbes and Fortune rankings further substantiates our view that ServiceNow’s products are best in class, lauded for their user interface, and helps underscore our Wide-moat positive trend rating.

Lastly, we continue to like ServiceNow’s lifetime value to cost of customer acquisition, or LTV to CAC ratios, for every enterprise company in our software coverage list. Basically, we look at the dollar cost to acquire a customer versus the total value that customer will provide. ServiceNow’s average LTV:CAC is about 5, which is best in class, sitting at the upper end of our TMT coverage as a whole, with the only peers being perhaps Adobe, Workday, and Guidewire. The U.S. Federal government accounted for a fifth of ServiceNow’s total net new annual contract value, or ACV, with the State Department becoming ServiceNow’s largest PaaS customer. The federal government deal excites us, because once ServiceNow lands a contract with a major customer, it has historically excelled at selling into its customer base. ServiceNow’s ACV per G2K customer has increased to $1.5 million in third-quarter 2018, from about $1 million in third-quarter 2016, and 11 customers are doing more than $10 million in sales. Thus, deals with the federal government provide opportunities for expansion in our opinion.

For investors seeking to better understand the unit economics for Software-as-a-Service businesses, we would urge them to read out October 2018 ad-hoc, “Salesforce One: Clear Skies for Salesforce in CRM and Beyond,” as we explain why we believe wide-moat ServiceNow and Salesforce remain attractive.