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Wednesday, November 13, 2019 9:06pm

ServiceNow Earnings: Strong Backlog Growth Outshines Slow Billings – ServiceNow, Inc. (NYSE:NOW)

In the midst of a bloodshed in the SaaS space, ServiceNow (NOW) was in the spotlight because of a change in leadership and the release of its Q3 2019 financial results.

Source: Finviz

In fact, these days have been a roller coaster for NOW’s shareholders. When the price appeared to be breaking out of a trading range, Workday disappoints analysts on its presentation, because of growth concerns on its HR core product, and SaaS stocks sold off on the aftermath.

But it was not enough for NOW. A few days later, the company announced a leadership change that took its shares down, close to the $200 level in after-hours trading activity. Finally, NOW reported its quarterly results, and the market was contented with what it saw.

So, let’s take a look for ourselves!

Quarterly Details & Analysis

Source: Q3 2019 Fact Sheet

Author’s note: All figures here are non-GAAP, except otherwise stated. Check this out for GAAP reconciliation.

Revenue for the quarter was $899 million, representing a strong growth Y/Y of 34% (only 100 bps less than in the prior quarter), and 5.5% Q/Q. The sequential growth is worrying on an annual basis (24%), and at this pace, it wouldn’t take long for growth to decelerate below the 30% levels. Also, this is the second quarter in a row with sequential growth of ~5%. NOW needs to sequentially grow revenues at a pace more like that of Q1’19 (12% per quarter), for some quarters if it wants to keep investors’ favor.

Getting into details, revenue by geography was the same Y/Y, but the EMEA region, which was gaining traction on prior quarters, suffered a negative growth of 2.6% on a sequential basis. The chart below doesn’t include this information, but it is helpful on computing it:

Source: Q3 2019 Investor Presentation

Revenue by product class continues to diversify away from IT products, with emerging products and add-ons now representing 45% of net new annual contract value (NYSE:ACV) from only 39% a year ago:

(Q3 2019 Investor Presentation)

Subscription revenue was $848 million (35% growth), total billings were $921 million (28% growth), and subscription billings were $869 million (29% growth):

Source: Q3 2019 Investor Presentation

Deferred revenue was $1.8 billion, growing at an annualized rate of 29.4%, in line with billings growth. Backlog (RPO) was $5.6 billion, growing at an impressive 36% rate Y/Y, with current RPO being $2.8 billion, growing at the same rate. It is important to keep this figure in mind, the gap between billings growth and RPO growth is ~7%, indicating that the former could strengthen in the next quarters, driving a higher revenue growth.

Source: Q3 2019 Investor Presentation

Gross margin was 81%, 100 bps up Y/Y as subscription revenue gains share of total revenue. Subscription gross margin was 86%, flat Y/Y.

Source: Q3 2019 Investor Presentation

NOW realized significant operating leverage during the quarter, as S&M and G&A expenses were down 550 bps, offsetting an increase of 150 bps in R&D expenses. This change pushed the net profit margin 250 bps higher to 21.7%.

On a dollar basis, net income was $193 million, up 49.6% Y/Y, while EPS was $0.99, with a growth of 45.6% Y/Y.

Source: Q3 2019 Investor Presentation

Operating cash flow was $234 million, representing a 26% margin and a 45% growth Y/Y. Free cash flow was $126 million (14% margin and 10% growth Y/Y).

Source: Q3 2019 Investor Presentation

NOW continues to expand the amount of customer with more than $1 million of ACV, with 809. The number is growing at 32% Y/Y, but the rate of growth has been decelerating as of late (check out the second chart below). Still, it is a significant amount of growth for a company with such a size, and especially considering that NOW is the platform of preference for the top 10 firms in most industries:

Source: 2019 Analyst Day

Source: Q3 2019 Investor Presentation

Also, 18 out of the top 20 deals of the quarter, included three or more products, the same amount Y/Y and one more Q/Q. The ability of NOW to cross-sell its products has been astonishing in the past, and the run continues. Notice the success of the HR product. It is gaining strength, and having a strong momentum.

Source: Q3 2019 Investor Presentation

Customer retention is once again excellent, even for a SaaS company. The renewal rate (or gross retention rate) jumped back to 99% during the quarter. Once again NOW proves the stickiness of its platform.

Source: Q3 2019 Investor Presentation

CEO Exchange

On the day before the earnings release, NOW announced the departure of its CEO John Donahoe, and the arrival of Bill McDermott, former CEO of SAP (SAP), to take the seat.

SA contributor David H. Lerner has some favorable commentary on McDermott and the outlook of NOW under his leadership.

The media is praising the return achieved by McDermott as CEO of SAP. SAP was worth $39 billion in February 2010, when he took the helm, and now is worth more than $160 billion, but what about the S&P 500 (SPY), or the DAX 30. During McDermott’s tenure, SAP generated a 15.6% compounded annual return on its stock price, and a dividend yield of ~1%, so the total return was around 16.6%. During the same time, the S&P 500 and the DAX 30 returned 12.7% and 12%, respectively, in capital gains and dividends.

My conclusions?

From a shareholder’s point of view, McDermott outperformed both indices by at least 400 bps on an annual basis. Then, the question is, will he repeat his winning formula with NOW? There is an important factor to consider: his record started with the beginning of a new economic cycle (after the 2007-2009 recession), and he will take the lead in a time when most experts are forecasting a recession for 2020 (his first year). That is a tough headwind!

Off course, McDermott has a lot to bring to NOW. He worked 17 years at Xerox (XRX), was President of Gartner (IT), was a sales executive at Siebel Systems (it was acquired by Oracle (ORCL) in 2005). In 2002, he was hired by SAP to be the CEO of SAP America, and then in 2010, was promoted to co-CEO of the whole company.

In 2016, McDermott was the best paid executive the DAX index, with more than 11 million EUR as direct compensation (Source: Wikipedia). In conclusion, McDermott brings more than 35 years of IT experience to NOW.

Valuation Update

Depending on the valuation methodology used, NOW may be expensive, fair, or even cheap, when compared to similar SaaS peers.

Source: Y-Charts

Using a forward revenue multiple (more traditional for growth stocks), it appears overvalued. From the peer group that I have chosen, Shopify (SHOP) is the only one that surpass it, but it is an outlier. Maybe, if NOW were growing faster than the other three, its valuation would have been justified, but no, it is not the case:

Source: Y-Charts

Of course, this chart doesn’t take into account adjustments to revenue, such as foreign currency matters, which make for a couple of growth points in some of these companies. So, still it is slightly overvalued given its forward revenues.

Source: Y-Charts

Going on with the valuation, a forward earnings multiple, gives a fair/cheap valuation. See that NOW only exceeds Splunk (SPLK) with this method, but not by much, and it is also close to Square (SQ) and Workday (WDAY). Again SHOP is the outlier. This valuation makes more sense, considering revenue growth, so it seems fairly valued, according to its 12-month forward earnings.

Source: Y-Charts

Finally, on a Price/Cash Flow from Operations basis, NOW looks clearly undervalued. Its closest peer is WDAY, and is 30% more expensive than NOW.

My conclusion from these three methods is that NOW is undervalued against its closest peers on the SaaS space. I could say that it is overvalued, given its revenue multiple and the relevance that revenue growth has on these stocks. But the eyes of the market are turning to profitability instead of revenue growth. Investors are flying away from high-growth loss-making stocks, and I think that this is the focus of most participants at this time.

Quarterly Takeaway

The market saw these results with good eyes, and so do I. A soft growth in billings is less relevant with RPO growing (and accelerating) at such a pace. If NOW is to decelerate going forward, RPO will be the leading indicator. So I’m not particularly worried about NOW’s growth prospects. With McDermott as CEO since January 2020, the company seems well guided on its way to maturity. At this valuation, the stock appears to be a good buy opportunity.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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