Why Now Is the Time for ServiceNow

* Let’s do a deeper dive on why we initiated ServiceNow.

Earlier today, we initiated a new position in ServiceNow NOW with a Two rating and a $840 price target that offers net upside potential of 16%-18% from current price levels. 

While we have AI exposure through Nvidia NVDA, Qualcomm QCOM, and Marvell Technology MRVL those are primarily in data center and upcoming AI-enabled devices. The addition of ServiceNow adds exposure to the enterprise as it deploys AI-enabled solutions across its enterprise workflow platform.

Background on ServiceNow

The company’s intelligent platform named the “Now Platform” is a cloud-based solution with embedded AI and machine learning (ML) capabilities that help unify and digitize workflows, driving productivity. At the heart of it, the company’s platform automates workflows across an entire enterprise by connecting disparate departments, systems, and silos in a seamless way to unlock productivity. ServiceNow counts more than 8,100 global customers, including 85% of the Fortune 500, with 97% of its revenue from subscriptions that have notched a 98% renewal rate.

While ServiceNow reports its revenue in one reportable segment, it does break its offerings into four workflows:

• Technology Workflows: asset and risk management, cloud and IT, security.

• Customer and Industry Workflows: customer service, field service, banking, insurance, telecommunications, technology, healthcare, life sciences, and manufacturing as well as global public sector.

• Employees Workflows: human resources, legal, and service delivery.

• Creator & Other Workflows: App engine, privacy and security, ERP systems.

The opportunity we’re taking advantage of with NOW is continued cloud and productivity adoption that will accelerate with AI deployments. Research firm IDC sees worldwide spending on Digital Transformation (DX) reaching almost $4 trillion in 2027. AI and generative AI are expected to fuel a compound annual growth rate of just over 16% for the 2022-2027 period. That means taking a larger share of IT budgets over the next several years. While that may sound a bit lofty, 100% of 1,200 CEOs surveyed by EY plan to invest in generative AI. It also supports the strong demand outlook for our positions in Nvidia and Marvell.

When we think about why companies are investing in AI with Microsoft MSFT, it’s for employee productivity through Copilot. For similar gains in customer service, human resources, and other areas of the enterprise, that means ServiceNow.

With the recent software release, ServiceNow has combined the power of the Now Platform with new generative AI features to provide AI-driven intelligence offered through Now Assist. This generative AI solution is currently available for certain products at an additional cost. The company also offers enterprise-ready, domain-specific large language models (LLMs) that power generative AI experiences on the Now Platform and supports third-party LLMs as well.

During ServiceNow’s March-quarter earnings call, management shared generative AI was in seven of its top 10 deals for the quarter. More recently, at ServiceNow’s early May Knowledge 2024 conference, it announced new collaborations for generative AI with Microsoft and IBM IBM that will incorporate their generative AI offerings, including Watsonx and Copilot, into its offerings. 

Appearing at the TD Cowen 52^nd Annual Technology, Media & Telecom conference last week, management shared it is seeing a 30% uplift in pricing with its AI offering, which if it holds could mean consensus revenue and EPS estimates for 2024 and potentially 2025 are conservative. That also means free cash generation expectations could also be conservative.

Why Now for ServiceNow?

NOW shares are down 15% following the company’s recent quarterly earnings report that topped consensus expectations but did not contain a surprise to the upside outlook for the current quarter. While down slightly compared to its December quarter, ServiceNow’s current remaining performance obligations came in at $8.45 billion, up 21% year over year, topping previous guidance. Exiting the March quarter, its remaining performance obligations, which we think of as “backlog” stood at $17.7 billion, up 26% year over, and 23% higher than it was exiting the September 2023 quarter.

We see a few things in that March-quarter figure. First, continued adoption of ServiceNow’s platform. Growing adoption of its AI-enabled solutions, which are helping lift pricing. Continued strength in the coming quarters should drive subscription revenue, which accounts for 97% of the company’s revenue and carries gross margins above 80%. We’d also point out that customer renewal rates over the last two quarters averaged 98%, another strong consideration, especially as ServiceNow rolls out more AI-enabled solutions across different industries.

Looking back at the results and the stock price reaction, it’s fair to say NOW shares were the victim of exuberant AI expectations and investor enthusiasm getting out over its skis. They were also impacted by the strong dollar given that one-third of the company's sales are outside the U.S. For us, the sobering last few weeks have brought an opportunity to start a NOW position, which offers ample upside over the ensuing quarters as we move into the next leg of AI adoption.

Current price targets for NOW shares range between $780-$950 with the consensus around $850, almost 30% higher than current levels. We can see why those price targets are where they are given expected top and bottom-line growth over the next few years to $13.1 billion and $16.25 per share in 2025 from $8.97 billion and $10.78 per share in 2023, respectively. Examining enterprise value-to-sales and PEG (P/E to growth) ratios leads us to see NOW shares worth $840 with a downside of $585-$600, which offers net upside potential of 16%-18% from the current levels.

That favorable trade-off led us to start a new position in NOW with a Two rating and a panic point of $585 earlier today. As NOW shares move higher, we will lift our panic point accordingly. 

Factors that could lead us to revise our price target to higher levels will be accelerating program wins, which will be reflected in ServiceNow’s current remaining performance obligations and remaining performance obligations, and greater AI-related pricing uplift. In terms of risk, enterprise spending and deal conversion cycles will be on our radar screen. 

We would revisit our Two rating if NOW shares slipped near $645 because the net upside to our price target would be above 20%. 

At the time of publication, TheStreet Pro Portfolio was long NOW.