EUR 850.00 For Business Accounts Only

Morningstar | Upgrading ServiceNow to a Wide Moat Rating; Raising our FVE to $221; Solid 2Q; Shares Undervalued. See Updated Analyst Note from 25 Jul 2018

We have taken a fresh look at ServiceNow and raised our moat rating to wide from narrow, while maintaining a positive moat trend rating. We have greater conviction in the firm's ability to profit from customer switching costs given the firm's robust retention metrics. As a result of assuming excess returns over a 20-year time frame (consistent with our wide moat rating methodology), we are increasing our fair value estimate to $221 from $195. Given our medium uncertainty rating, we see shares as undervalued today and still see upside for ServiceNow's long-term growth story around major enterprises modernizing their IT infrastructure.

ServiceNow has followed the successful software paradigm of introducing a single, mission-critical product in a market vertical and expanding from that beachhead into other niches, providing ample upsell and cross-sell opportunities. ServiceNow created a software-as-a-service, or SaaS, IT service management, or ITSM, product, a cloud ticketing tool designed to track internal IT issues. ServiceNow has since entered IT operations management, or ITOM, IT business management, or ITBM, HR, customer service management, or CSM, and security verticals.

ServiceNow reported earnings on July 25, with the results reaffirming our long-term thesis in the business. The firm provided exemplary metrics, such as renewal rates of 98%, emerging products and platform add-ons now encompassing 37% of revenue, and 42% of the global 2000 cohort, or G2K. Higher gross margin subscription revenue continues to climb relative to services revenue, with subscription revenue of 93%. ServiceNow gave some clarity into the 20 largest deals of the quarter, with 16 of those 20 customers purchasing ITOM products, with most purchasing the ITOM suite, and 19 of the 20 purchasing platform add-ons and other products. All these metrics reported this quarter reaffirm our upgrade to a wide economic moat rating.

In terms of valuation, we model a 26.5% compound annual growth rate over the next five years, largely driven by ITSM and ITOM. Overall, we expect ServiceNow's emerging offerings to prop up the firm's torrid subscription growth. We think the firm is well on its way to its goal of surpassing $4 billion in revenue by fiscal 2020 and model the firm eclipsing $10 billion in revenue by fiscal 2027. In terms of the market opportunity of just ITSM, management iterated on the call that even with approximately 4,400 customers and 837 G2K clients, many clients may have only implemented ServiceNow's tools in one office or in one geography. ITSM alone is estimated to be a multi-billion-dollar opportunity, but ServiceNow's end goal of servicing all unstructured workflow as enterprise customers undergo a digital transformation is an opportunity many multiples above core ITSM.

ServiceNow's IT offerings composed 66% of revenue in fiscal 2017. Looking ahead, in the near term, we expect ITSM and ITOM to serve as the growth engines of the business, but longer term, we anticipate the IT offerings versus emerging products (HR, CSM, and security) and platform add-on revenue share to sit closer to a 50/50 split. As an enterprise integrates an ITSM or ITOM tool, it becomes easier for a customer to become increasingly reliant on ServiceNow's ecosystem. For example, if an enterprise already utilizes a ServiceNow ITOM tool, the next logical step is to utilize a security product to handle a major cybersecurity breach.

Our overall thesis for our wide moat rating is anchored in both ServiceNow's industry leading customer retention metrics and lifetime value to customer acquisition ratio (LTV:CAC). ServiceNow has reported 97%, at the low end, to 99% retention every quarter since the data point was first provided in 2013. We view this as indicative of a sticky product and note that many of ServiceNow's peers obfuscate this metric by reporting "revenue retention" instead of customer retention, which mixes churn, with cross-sells and upsells, frequently resulting in a number in excess of 100%. We posit that these SaaS competitors are attempting to obscure less than stellar retention ratios since this calculation can lead to noise, particularly as this metric gives us no indication of how many customers left in a given period and a large upsell of a single customer could mask the departure of numerous smaller customers. In contrast, ServiceNow's pure customer retention metric is best in class, producing LTV:CAC ratios well above the vast majority of software firms in our coverage list. We believe this is indicative of substantial switching costs commensurate with a wide moat rating.

By our estimates, ServiceNow's lifetime value to customer acquisition ratio, or LTV/CAC, is about 5.00, which we calculate as the average LTV:CAC over the last eight quarters. We view this as best in class, sitting at the upper end of our department-wide software coverage. We believe this metric is an important indicator of a software vendor's efficiency in attracting new customers and retaining existing ones. By our math, for every $1.38 spent to acquirer a customer, ServiceNow extracts a $6.85 lifetime value for the customer. Similarly, as we look at ServiceNow's limited GAAP profitability, we use the LTV/CAC ratio to assess whether the firm lacks pricing power and operating expenses are out of control, or whether the firm is making wise investments in order to secure more customers and future revenue. We think the latter clearly applies to ServiceNow today.

ServiceNow sits in an elite pantheon of vendors, such as Workday and Guidewire Software, with these firms producing higher LTV/CAC numbers than nearly every application software vendor. ServiceNow, along with this cohort, have mission-critical products, which lead to switching costs and high retention ratios. We believe this is compounded by an expanding slew of products for each of these businesses, which have provided cross-sell and upsell opportunities. These exemplary unit economics give us confidence in the stability of ServiceNow's business, wide economic moat rating, and positive trend.

In 2011, ServiceNow's market share in ITSM sat below 10% percent, while BMC controlled over 30% share according to Gartner. In 2017, estimates suggest ServiceNow controlled over 40% of the space, while BMC's market share fell below 20%. While an onlooker might reason that the rapid swing in market share may be indicative of the absence of switching costs in the space, we refute this claim for several reasons. First, the aggregate ITSM market has expanded rapidly over the last 10 years, allowing ServiceNow to win share from new customers purchasing an ITSM product for the first time. The secular increase in enterprises needing software applications to perform mission critical roles has meant that businesses need a more efficient process to service software and hardware outages. Second, we believe that incumbents like BMC struggled to migrate their on-premises customers to the cloud. We think enterprises have migrated to cloud solutions to save costs, to move away from internally developed applications, and to improve businesses processes. Since BMC's share decline was relatively steady, we see this as indicative of general switching costs in the overall ITSM space. Many of ServiceNow's current G2K customers implemented ServiceNow's ITSM in only a discretionary segment of the business or had dual ITSM products for a period of time before the enterprise decided on fully transitioning. However, we assert that BMC's share declines were exacerbated by customers migrating to the cloud, which served as a tailwind to ServiceNow's rapid growth. Our thesis around cloud migrations is that they have served as a one-time land grab for software vendors. We do not foresee an analogous catalyst to allow ServiceNow's competitors to win back lost share. Third, we believe customers will be less likely to move away from ServiceNow's cloud ITSM solutions, especially as customers increasingly purchase additional products from ServiceNow, whether in ITOM, security, customer service, or HR. Incumbents who lost share lacked ServiceNow's land-and-expand strategy which has allowed ServiceNow to increasingly embed itself in the IT ecosystem of its client base. We believe our wide moat and trend thesis is supported by ServiceNow's above-97% retention and growing share of multiproduct customers, which was above 75% at the end of fiscal 2017.