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Morningstar | We Have Added Wide-Moat, Positive Trend ServiceNow to the Best Ideas List

On Aug. 1, 2018, we added wide-moat ServiceNow to our Best Ideas list based on the firm's growth opportunities, our conviction in its wide economic moat rating, and a best-in-class lifetime value/customer acquisition ratio. A few weeks ago, we upgraded ServiceNow's moat rating to wide from narrow on the basis of greater conviction in the firm’s ability to profit from customer switching costs given its robust retention metrics across what we see as its core seven market verticals: IT service management, or ITSM; IT operations management, or ITOM; IT business management, or ITBM; human resources; customer service management, or CSM; security; and platform add-ons. Our current fair value estimate of $221 per share places ServiceNow shares in 4-star territory, and we believe this represents an attractive entry point for a firm set to capitalize on enterprise clients undergoing a digital transformation as they upgrade 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 upselling and cross-selling opportunities. ServiceNow created a software-as-a-service, or SaaS, ITSM product, a cloud ticketing tool designed to track internal IT issues. ServiceNow has since expanded into other verticals (ITOM, ITBM, CSM, HR, and platform) that we believe to be equally sticky. Thus, we see ServiceNow’s aggregate market opportunity as the ability to service all unstructured workflow, not simply ITSM.

The firm reported earnings on July 25, with 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. With customers like Coca-Cola, McDonald's, GE, Intel, and Qualcomm, we think ServiceNow’s penetration of large, multinational corporations adds to the firm’s switching costs and revenue growth prospects.

In the quarter, higher gross margin subscription revenue continued 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. 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 multibillion-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 uses a ServiceNow ITOM tool, the next logical step is to use a security product to handle a major cybersecurity breach. For investors seeking a broader explanation of ServiceNow’s various markets and the characteristics of each, we would refer investors to the moat section of our report.

Our overall thesis for our wide moat rating is anchored in both ServiceNow's industry-leading customer retention metrics and lifetime value/customer acquisition ratio, or 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 the software firms we cover. We believe this is indicative of substantial switching costs commensurate with a wide moat rating.

By our estimates, ServiceNow's LTV/CAC is about 5, which we calculate as the average LTV/CAC over the past eight quarters. We view this as best in class, sitting at the upper end of our departmentwide 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.