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ServiceNow: mission-critical, with no competition

03092020_ServiceNow

ServiceNow: mission-critical, with no competition

The digital transformation of the enterprise is a long-term trend which is now accelerating as a direct consequence of the COVID-19 pandemic. Privileged business models operating with the benefit of this structural tailwind, therefore, should be considered carefully for an investment opportunity. ServiceNow is rare in that it operates a privileged ecosystem business model, built in software – which carries superior economics, delivering mission-critical building blocks required by the enterprise and has no meaningful competition today.

ServiceNow owns enterprise services

Thinking abstractly, the operations of any enterprise is simply a large collection of services. A service typically takes the form of human employees interacting with multiple software applications in a pre-defined manner (called a workflow).

In most large enterprises, these workflows are defined and delivered by ServiceNow.  The services that are delivered are measured, evaluated and optimised by ServiceNow. Unlike most software applications, ServiceNow is not trying to disrupt other enterprise application. ServiceNow is aiming to become the “operating system” of the enterprise – enabling employees to more efficiently deliver services across all functions, as illustrated below.

Importantly, all of ServiceNow’s applications (as well as those developed by third parties) are built on its Now Platform – a single platform, with a single data model on a technology stack owned by ServiceNow from the application layer all the way down to its datacentre infrastructure, located all over the world. It is one of the few technology businesses not reliant on the hyperscale cloud providers today.

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ServiceNow serves more than 6,000 of the world’s largest enterprises today, including Goldman Sachs, JP Morgan, Disney and even the US State Department. It consistently delivers a best-in-class 97 per cent retention rate. And interestingly, 80 per cent of its new business which drives its 30 per cent p.a. top line growth stems from existing customers – as they leverage the Now Platform more fully throughout the internal enterprise operations.

ServiceNow generates cash flows of the highest quality

There are three key reasons why ServiceNow’s cash flows are of the highest quality: (i) ServiceNow’s core workflow offering is mission-critical in the enterprise; (ii) ServiceNow operates with no meaningful competition; and (iii) ServiceNow extracts far less value than it adds.

To demonstrate the latter point, ServiceNow’s largest customers spend around $20 million per annum, far higher than the average ~$1 million per annum across all of its customers. But for these large customers, the $20 million annual payment to ServiceNow is in the context of an IT budget greater than $8 billion!

We believe ServiceNow extracts far less value than it adds. And the company believes this too, pointing out that for every $1 spent by a customer, roughly $5 of productivity gains are created. And in the context of an estimated $165 billion total addressable market (versus company annual revenues of just $4 billion today), one can see a very long runway ahead for growth.

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ServiceNow’s cash flows are of the highest quality because they are resilient, predictable and growing. And through this lens, there is genuine question to be asked about the appropriate discount rate that should be applied to the valuation of such cash flows – especially in the context of an interest rate environment that will very likely remain near zero for the foreseeable future.

ServiceNow’s advantage will extend with its data

Given ServiceNow’s complete ownership of its Now Platform across the entire technology stack, it owns a particularly privileged data set on the world’s largest enterprises from which it can (and does already) develop predicted AI-based tools to further enhance the value proposition of its applications for its enterprise customers.

For example, ServiceNow has only recently rolled out its AI-enabled virtual agents, predictive intelligence and performance analytics tools in its core IT service management product – and already 80 per cent of new customers are opting for this higher-value offering. But the existing customer base remain only 15 per cent penetrated today – a penetration level that ServiceNow confidently believes will evolve to 100 per cent over the coming years.

We seek to own the long-term winners in attractive markets. And we believe there is a very high probability that ServiceNow will remain a winner in enterprise services and workflows for decades to come.

We recently launched the ASX-quoted Montaka Global Extension Fund (ASX: MKAX). Investors gain access to Montaka’s method of picking long-term winners in attractive markets and expertise in differentiated short selling. To learn more, please join our webinar on Thursday 17 September 2020 at 6pm, Sydney-time. You can register here: MKAX: Compound your wealth with convenience

The Montgomery Global Funds and Montaka own shares in ServiceNow. This article was prepared 03 September with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade ServiceNow you should seek financial advice.

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Andrew Macken is the Chief Investment Officer of the Montaka funds and the Montgomery Global funds. He established MGIM in 2015 in partnership with Montgomery.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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2 Comments

  1. Hi Andrew,

    Thanks for the summary analysis on ServiceNow. I agree that this is a very unique business, has a considerable ‘moat’ with no specific competitors and a long runway ahead given the acceleration of digital transformation in business.

    What is contentious or challenging about investing in these types of companies (NOW, CRM, OKTA) is the current multiples applied to the stock prices. These companies are the ‘hot stocks’ right now and certainly have bright prospects. But based on the closing price Friday 4/9, the PE ratio for NOW stands at 127 with a price/sales ratio of 27. So based on the current price, it will take 27 years of (current) revenue to get your initial investment back. This assumes they have no employee costs, overheads, R&D, depreciation, provisions, taxes on profits etc.

    Whilst there is no arguing where the future of business is heading, the challenge is arriving at a meaningful and evidence based, or factually coherent valuation. Not one based on shallow assumptions and forecasts of revenue and earnings growth. I can’t get my head around the multiples being paid to own some of these businesses.

    So, how do you arrive at the ‘meaningful valuation’ to enable an investor to confidently invest given the stock price and taking into consideration weighting in a portfolio. Hoping you will release part 2 of the whitepaper on digital transformation soon!

    Thanks in advance,
    Pascal

    • Thanks Pascal, excellent points.
      We will address this in Part II of our whitepaper, coming out over the next couple of weeks.
      One thing we’ve come to realise over the last five years is that equity markets tend to structurally underestimate the value of the abilities of the world’s greatest businesses to create new lines of revenues and earnings that don’t exist today. This is one of the reasons why the usual valuation ratios (P/S, P/E, etc) can be misleading. (Another is the interest rate environment we find ourselves in today).
      All the best,
      -AM

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