AGB 2022.11 - ServiceNow (NOW)
Automating Workflows Across the Enterprise
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ServiceNow
ServiceNow is the leading provider of cloud based software for digital workflow automation. The company started with its core IT Service Management (ITSM) offering and then expanded to other areas of IT such as Operations Management, Planning, Risk, etc. ServiceNow has over 7.4k enterprise customers from around the world (and 80% of the Fortune 500), of which over 1.4k generate more than $1M in annual contract value (ACV). After gaining meaningful market share from incumbent players in the ITSM market, the company expanded horizontally into other markets like HR Service Delivery and Customer Service Management (CSM).
ServiceNow was founded by Fred Luddy in 2004 after his previous company, Peregrine Systems, had imploded from an accounting scandal. He was the CTO. After his equity in Peregrine was left worthless, Fred started his next venture. He built a cloud based application that could help simplify employee workflows within the enterprise, but the initial response was lukewarm. After the company pivoted to IT specific workflow applications, ServiceNow started to gain traction. Forbes has a nice article on the history of ServiceNow from 2018.
The core ITSM product allows the IT departments of enterprises keep a record of and meet their employees’ IT related needs in an automated fashion. The software facilitates meeting of requests, remediation of problems, automating routine tasks and recording incidents of issues. The secret sauce was the ease and simplicity of the software and the short time to implementation. The company has stated that implementation times are measured in weeks rather than months. Looking at services as a percent of total revenues, ServiceNow has similar percentage to Salesforce.com, close to 6.5%, whereas Workday’s service revenues are close to 23%.
ServiceNow’s ITSM revenues have increased ahead of many industry analysts’ initial estimates, taking share from legacy competitors like BMC, CA, HP and IBM. The company estimates that ITSM penetration rates for enterprise customers is still 20%-30%, even though subscription revenues have increased at a CAGR of +44% since the IPO in 2012. ServiceNow introduced a Pro version of ITSM in late 2018, which allowed for more automation and machine-learning capabilities. The Pro version reached 10% penetration within the company’s customer base by 2019, 20% by 2020 and 30% by 2022. In 2021, over 60% of new customer contracts came from Pro. ServiceNow benefits from an effective 25% increase in price with the Pro version.
ServiceNow has successfully executed its land and expand sales strategy over the past decade. The average customer increases the amount spent on ServiceNow software by 6x in 3 years. The company typically leads with ITSM (and other IT related products) and then upsells to vertical specific software, which have higher ASPs and increase the scope of the average deal. Within Telco, as an example, the average deal size that include Telco industry solutions are 2.5x in size.
After the success of ITSM, ServiceNow began to offer adjacent workflow automation software like HR Service Delivery and Customer Service Management. Both software modules complement existing Human Capital Management and Service Management software from other vendors. Customer case studies have pointed to a reduction of HR caseloads through the automation of answering HR questions and new employee onboarding. CSM case studies have pointed to a reduction of case volume and cost savings related to customer service requests.
Both of these new workflow products have grown faster than core IT in recent years. At the end of 2019, each product was generating $200M in annual revenues and that quickly grew to $600M for CSM and $500M for HR by the middle of 2022. There were additional products released within each segment, like Procurement and Asset Management within HR. ServiceNow believes that each of these product categories can achieve $1B in revenues in the near future.
The company has also expanded into Creator workflows, which customers can utilize to build their own custom applications. Included in the segment is the Now Platform that customers can easily use to deliver workflows across different silos within an organization within a low-code environment. The platform also allows for integration of workflows to third-party software and to public cloud environments.
The industry verticals that make-up most of ServiceNow’s customers are financial services, TMT, healthcare and manufacturing. Most of these customers utilize the company’s hosted cloud software. However, with Federal and other government agencies, ServiceNow elected to partner with Microsoft Azure since they had IL4 and FedRamp High certification. ServiceNow received FedRamp High certification in 2019 and IL5 certification in early 2022 and still continues to partner with the public cloud providers for certain customers. Federal was 10% of the business in 2019 and the company expects it to increase to 20% over time.
At the analyst day in May of 2022, ServiceNow updated its near-term financial targets. The company expects subscription revenues of $11B by 2024 and $16B by 2026 vs. prior targets of $10B and $15B (vs. 5.6B of revenues in 2021). Operating margins are expected to reach 27% and FCF margins of 33% by 2024. Morgan Stanley estimates that operating margins for ServiceNow will reach ~44% in steady state.
Why is it a good business?
Similar to other SaaS providers, ServiceNow benefits from its customers’ increasing switching costs. As we’ve discussed in our previous write-ups on Tyler Technologies, Workday, Atlassian, Veeva Systems and Salesforce.com, switching costs are typically manifested in two main ways. First is the increased knowledge base and familiarity of the software with its customers. Second is the data repository that’s created over time as customers use the software. With an existing dataset (this is more pronounced with database software), the risk of any loss of material data during a potential change in software platforms is sometimes large enough to warrant staying with an inferior software provider. There’s also a risk of business disruption during any switch.
Software companies solidify the switching cost benefits by adding new modules around its core product. ServiceNow has done that by offering more IT centric software as well as expanding horizontally to other areas like HR Service Delivery and CSM. But even as the company has expanded its product offerings, only 20% of its customer base have three or more workflows. This will move higher as time progresses since over 30% of new deals are 2-4 product deals and over 65% are 5+ product deals.
The company also benefits from selling predominantly to enterprise customers. ServiceNow will sell to customers that have as a little as 3k-5k employees but most customers are much larger. Because of this and the value that customers receive from ServiceNow’s software, the company’s churn is one of the lowest across the peer group. Gross retention rates are between 97%-98%. As we mentioned in our previous SaaS write-ups, a low gross churn implies a good LTV/CAC. This also implies good unit economics for new deals and superior returns on sales and marketing expenses.
LTV/CAC = (Δ Subscription Gross Profit Dollars / Incremental S&M expenses) x
(1 / Churn x Discount Rate) x (New Customers / Total Customers)
As the company has grown, ServiceNow’s overall sales efficiency has increased from 2.9x in 2015, when the company first crossed $1B in revenues. As the company reached bigger revenue milestones, sales efficiency increased to 5.1x in 2021 when reaching $5B in revenues. We point out that this was admittedly helped with lower S&M expenses as a % of revenues after Covid.
ServiceNow’s net renewal rates are consistently 130%+, which is also one of the highest in the peer group, across enterprise and smaller, high growth software providers. This is the result of existing customers continuing to adopt more modules and increase the scope of when renewing contracts. ServiceNow has stated that 88% of incremental ACV each year is from existing customers. At the company’s analyst day, the company gave an example of a customer that started with a $100k contract in 2010 and is now spending $2.2M for an increase of 22x. Another customer started with a $1M contract in 2013 and expanded the scope of the contract to include App Engine, Security, Risk, ITAM, CSM, HR and upgraded to Pro for an ACV greater than $10M in 2022.
Returns on incremental capital?
Over the past 10 years, ServiceNow has spent 23% of its capital on capex, 15% on M&A and 62% on R&D. Capex and R&D have been steady but have trended in opposite directions as a percentage of revenues. Capex was 17.3% of revenues in 2012 and headed lower to 6.6% in 2021. Whereas R&D was 16.1% of revenues in 2012 and headed higher to 23.7% by 2021.
Capex spend is mostly related to server infrastructure for the company’s hosted cloud. Similar to other gen 1 enterprise SaaS providers, ServiceNow for the most part hosts software on its own servers for customers. Recently, the company has leveraged public cloud providers like Microsoft Azure for certain customers that have strict security requirements such as government agencies. R&D as a % of revenues has increased over time as ServiceNow has expanded its software offerings outside of core IT to include Employee, Customer and Creator workflows.
R&D spend is the growth engine for the company due to ServiceNow’s predominantly organic growth trajectory. Compared to the other large enterprise SaaS companies like Salesforce.com and Workday, ServiceNow has spent the least on M&A over the past 5 years. Cash spent on M&A as a percentage of revenues has averaged 4.1% for ServiceNow vs. 20.6% for Salesforce.com (this is much higher if you include stock used for the Mulesoft, Tableau, and Slack acquisitions) and 17.7% for Workday.
Even though the company hasn’t been very acquisitive, interestingly, ServiceNow’s R&D spend as a percentage of revenues is only a few points above Salesforce.com and much lower than Workday. ServiceNow’s R&D spend as a percentage of revenues for the past 5 years has averaged 21.6%, whereas Salesforce.com is at 15.8% and Workday 40.9%. It’s likely that ServiceNow’s R&D efforts are more efficient than its counterparts due to most of the software being organically built on the Now Platform. As an example, the company’s initial CSM offering was released after 18 engineers worked on the project for just a year and a half.
Here is the company’s CFO discussing potential margin differences between core IT and HR + CSM at the UBS Global TMT Conference in December of 2021:
“There's no margin issue that you should be worried about. I think one of the benefits of the One platform, especially on the R&D side, is that all of the innovation, right, is built upon the platform. It benefits all of the businesses and all of the workflows. And so, from a margin perspective, we manage that all internally. And so, there's nothing that we should worry about with respect to as those businesses are growing faster, that it will have a negative impact on the margin.” - Chief Financial Officer, Gina Mastantuono
On the M&A front, the company has made a few acquisitions, but many have been early stage acqui-hires, leading to future development of these products on the Now Platform. Over the past decade, ServiceNow’s three largest acquisitions were Neebula (2014) for $100M, Element AI (2021) for $228M and LightStep (2021) for $512M.
Neebula integrated with ServiceNow’s IT Operations Management software.
Element AI integrated with ServiceNow’s Now Platform, helping customers to develop AI based applications. ServiceNow’s recent Pro products like ITSM Pro, CSM Pro and HR Pro all leverage AI capabilities as well.
LightStep was a leading next gen application monitoring and observability company.
We estimate that ServiceNow generated returns on incremental capital between 65%-80% over the past 5 years. Because most of the company’s growth has been organic, the returns on capital are higher for ServiceNow vs. the other enterprise SaaS providers. This is because acquisitions tend to be expensive (high multiple implies low returns on capital) and margin dilutive. Furthermore, ServiceNow has been able to achieve superior growth. The lack of meaningful M&A does result in a lower reinvestment rate even with the company’s recent increase in R&D spend.
Reinvestment potential?
When ServiceNow completed its IPO in 2012, industry research firms estimated the size of the ITSM market to be $1.5B. Through nine years of outsized growth (+42% CAGR for revenue) the company has shown that the ITSM market (and later the ITAM, ITOM, observability, etc.) is much larger.
At the company’s analyst day in May of 2022, ServiceNow laid out its updated TAM to incorporate all the expanded product sets from recent years. The IT workflow market is estimated to be $70B by 2024, Customer workflow is estimated to be $51B, Employee workflow is estimated to be $14B and Creator workflow is estimated to be $54B. Collectively, this is higher than the company’s previous estimates at the prior 2021 analyst day at $61B, $33B, $20B and $36B, respectively. Interestingly, the updated Employee workflow market estimate is lower than the one from 2021.
From a bottom-up perspective, there is still much more room to grow with ServiceNow’s existing product offerings. ITSM is still only 20%-30% penetrated within the Enterprise and the Pro version has only reached 30% penetration within ServiceNow’s customer base. The company expects to reach 50% penetration for the Pro version. And because 2/3 of existing customers increased their spend each year with ServiceNow and 88% of all net new ACV is coming from existing customers, there is much more room to grow.
From a customer cohort perspective, there is also lots of room for continued subscription revenue growth. Looking at one of the oldest cohorts from 2010, the annual growth rate from the original ACV has increased +183% or an increase of almost 23x. This is a function of lower starting ACVs in the early years when the company offered fewer products and ServiceNow was less well known. While the following years’ cohorts’ revenue CAGRs are lower, the annual growth rates are still very impressive, with even the 2016 cohort growing at an annual rate of +98%.
Looking at the customer cohorts broken down by ACV, the customers paying $20M+ and $10M-$20M annually are actually growing faster than the smaller customers, indicating that the larger customers are adopting multiple modules and increasing ServiceNow’s penetration rate within those enterprise customers. The two largest cohorts are growing over +30% annually while the smaller cohorts of $5M-$10M and $1M-$5M are growing in the mid teens % annually.
The company’s Now Platform is also an interesting opportunity over the next few years as customers will want to customize and build their own workflow applications. IDC is forecasting 750M new applications to be created from 2023 and 2025. Furthermore, Gartner estimates that 70% of new applications developed will be in low-code or no-code environments. This will be beneficial to ServiceNow, especially since the company’s software is known to establish clean workflows between disparate software solutions from different providers.
With a reinvestment rate between 25%-35% and a return on incremental capital between 65%-80%, we estimate that ServiceNow has increased its intrinsic value between 20%-23% annually over the past 5 years. Because most of the company’s growth has been organic, the reinvestment rate is steady year to year and it’s likely very sustainable at these levels going forward.
What else is important?
Covid beneficiary?
Many enterprise software stocks performed really well from the start of Covid until the beginning of 2022, because digital transformation was pulled forward for many large customers. For ServiceNow, there were certainly benefits to demand and it shows in the sustained high growth levels relative to its peers. While Salesforce.com saw it’s revenue growth rates stay steady near +25% y/y for 2020 and 2021, we have to remember that the company made acquisitions of Tableau in 2019 and Slack in 2020. Workday saw it’s growth rates decelerate to +19% for 2020 and 2021 from +28.5% in 2019. ServiceNow sustained its growth rates in the 30%+ range for the same time period.
Covid did shine some light into the benefits of using ServiceNow’s workflow automation software for certain verticals like Government and other companies that needed employee workflow automation software. As an example, Lowe’s put together an employee workflow application for emergency paid leave requests in just 96 hours by leveraging ServiceNow’s platform.
ServiceNow also experienced a cost savings benefit during the lockdown period with Zoom meetings being more cost efficient that traveling. But the company is expecting some of that to reverse as business travel returns.
Optionality
Large M&A is unlikely at ServiceNow given the culture of building software organically. The company’s smaller M&A deals have all been re-platformed after the acquisitions closed.
The most likely source of optionality is from the company entering more adjacent areas for workflow automation like ServiceNow did for HR Service Delivery and Customer Service Management. The company will also benefit from customer developed applications on the Now Platform over the next few years.
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Nicely explained! I have worked on developing ServiceNow at my workplace and can only imagine companies using it more going forward. It has become such an integral part of our IT systems.