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Morningstar | ServiceNow: Differentiated Software Drives Share Consolidation and Expanding TAM; $290 FVE

We assign ServiceNow a wide moat and positive moat trend rating, while raising our fair value estimate to $290 per share, as we view shares as undervalued today. ServiceNow has been successful in executing a classic land and expand strategy. First, it built a best of breed SaaS solution for IT Service Management (ITSM) based on being flexible, having a superior familiar user interface, offering a way to automate a wide variety of workflow processes, and becoming a platform to serve as a single system of record for the IT function of an enterprise. Having established itself with a rapid rise to 40% market share in ITSM, ServiceNow then expanded into the much larger IT operations management (ITOM) market by incorporating more features onto the platform and by offering add-on solutions. The same set of product design technologies has allowed ServiceNow to bring its process automation approach to areas of the enterprise beyond the IT function, notably, HR service delivery and customer service.

ServiceNow’s success has been rapid and impressive. It already offers high-end solutions and boasts elite level customer retention of 98%. ServiceNow counts 883 of the largest 2,000 (G2K) enterprises in the world as its customers continue to renew for larger contracts, with the average annual contract value doubling in just the last three years. Further, customers are renewing for more than one solution, as more than 75% of customers buy multiple products.

ServiceNow is able to leverage the IT users to act as advocates for software purchasing decisions in other functional areas of the enterprise. The company will continue to use its position to land new IT-driven customers and upsell ITOM features on the platform, but we believe it will increasingly cross-sell emerging products in HR and customer service, and the platform as a service (PaaS) solution. In our view, product strength, market presence, and a strong sales push into areas outside of IT will drive robust growth.

Although ServiceNow officially reports two segments, Subscriptions and Professional Services, it provides a variety of metrics that enable a better understanding of the company. While management has executed a handful of technology-driven acquisitions since the IPO, growth has been entirely organic. Visibility is tremendous, with new customers typically signing three-year contracts and renewals usually for two years. Current deferred revenue is $1.7 billion, or more than half of our 2019 subscription revenue forecast of $3.2 billion, while unbilled backlog is $3.4 billion. Current remaining performance obligation (RPO) is $2.5 billion, while total RPO is $4.9 billion. Rapid new customer adds, elite retention, and strong upsells make for truly unique investment case within software, and one of the best long-term growth stories in all of software.

Subscription revenue was $2.4 billion (93% of total) in 2018 and grew 39%. IT-related solutions drove 61% of net new annual contract value (ACV) in 2018, while emerging products was 28%, and platform add-ons and other was 11%. The company previously provided another slice of information, which indicated that ITSM was 48% of net new ACV, while ITOM was 16%, and Other was 38%. Service Management products accounted for 85% of subscription revenue, while ITOM products account for 15% of revenue. Regardless, the data clearly show the company diversifying away from ITSM, which we expect to continue over the next several years. In our opinion, ServiceNow is well positioned and has caught the ITSM incumbents, namely BMC, HP/Micro Focus, CA, and IBM, flat footed much in the same way Salesforce.com caught CRM providers off guard years ago. This should result in continued ITSM share gains and additional expansion within ITOM in our view. We model revenue growth for subscriptions of 34% in 2019 and 30% in 2020.

We estimate the company’s IT related solutions enjoy a TAM of approximately $45 billion, which includes (approximately) $30 billion for ITOM and $15 billion for PaaS. The larger debate in our view is on just how big the opportunity is for porting the company’s process automation solutions to non-IT functions. The broad HR software market is $15 billion, while the customer experience market is $50 billion. These markets are generally growing in the 8% to 13% range annually. While we do not think simply summing these to conclude on one overall TAM is the best approach, we are also certain that we are not incorporating all the addressable areas that could benefit from process automation. Our conclusion is that the company is staring at a massive and rapidly growing opportunity.

Professional Services makes up just 7% of revenue and has grown in the mid- to high-single-digit area in each of the last several years. Gross margin for this segment has varied between negative 9% and +10% since the IPO. We understand the strategic importance of professional services, especially since ServiceNow tends to serve larger enterprise customers, but a negative gross margin is not a model we would favor in the long term. The company has been investing in its partner system, so we view the company’s negative 9% services gross margin as transitory, and we expect a return to the low-single-digit area. We model 5% services revenue growth in each of the next couple years.

Like most SaaS companies, ServiceNow has consistently chosen growth over margins—a strategy we support given the life time economics of a customer. We believe the company is poised to deliver its first full year of GAAP profitability in 2019, while non-GAAP operating margins were 18% in 2017 and 20% in 2018. We expect operating margin to continue to increase by at least 100 basis points annually. We do not expect much improvement from already strong subscription gross margin of 83% in 2018. As previously noted, we view the march from a negative 9% gross margin in services to better than break even as a long tailwind for margin improvement. While we are impressed by the company’s non-GAAP operating margin and free cash flow margin, we believe there is tremendous room for margin improvement. We see GAAP operating margin expanding from negative 1.6% in 2018 to near 20% over the next decade. Overall operating leverage should be very powerful, and we do expect sales and marketing expenses, which were 46% of revenue on a GAAP basis in 2018, to yield the most positive impact on margin expansion.