Everything-as-a-Service Pays Off for ServiceNow

The company has begun to expand that approach, marrying IT operations management, or ITOM, applications to their companions in ITSM, while expanding its workflow automation expertise to other areas of the enterprise, including human resources, customer service, finance, and marketing.

Along the way, ServiceNow has racked up some of the most impressive retention rates in software today, frequently reporting quarterly figures of 97%-plus, all while it continues to aggressively push its way into new software verticals. Roughly 70% of ServiceNow’s customers now use more than one of the firm’s products, a rate that has doubled in just two years.

We believe these factors yield material increasing switching costs, ultimately resulting in our upgrade of ServiceNow’s economic moat rating to narrow from none. Further, we think the market is discounting ServiceNow’s still-large growth opportunities in ITSM, ITOM, and enterprise service management, or ESM. We think the current market valuation implies that ServiceNow will have only limited success in expanding beyond ITSM, but the natural relationships among ITSM, ITOM, and ESM will create a clear path to heightened growth over the next several years.

We believe ServiceNow will deliver on the bulk of management’s expectations in the near to medium term, while we think its high retention rates will yield continued margin expansion over the long term, ultimately affording the company GAAP operating margins approaching 30% by the end of our 10-year explicit forecast period.

The Path to a Narrow Moat ITSM includes several tools for business users and IT staffers to manage and dispatch inbound requests to the IT department to fulfill requests, troubleshoot issues, and solve problems. Founded in 2003 under the Glidesoft moniker, ServiceNow targeted a relatively small addressable market to wedge its ITSM products into large enterprises. This market, while modest, had long been controlled by Remedy and BMC, which later acquired Remedy and ultimately raced out to ITSM market share approaching 40%. Yet over the past several years, ServiceNow has gained substantial share, largely because of its cloud-first approach and a customer base that helped it create a virtuous feedback loop that allowed for faster innovation and delivery of feature enhancements.

ServiceNow has expanded into ITOM and ESM. ITOM tools are centered on identifying, monitoring, tracking, and managing IT assets and systems to ensure the IT infrastructure is operating smoothly, allowing for manipulation when necessary. We believe ITOM is a natural extension of ServiceNow’s business, as ITSM and ITOM tools frequently work hand in hand to manage and solve problems in IT infrastructure. We believe ESM is a greenfield opportunity for ServiceNow. The company has taken its expertise in managing and automating workflows in IT and expanded it to other areas of the enterprise, such as human resources. These applications can help automate tasks such as employee onboarding, in which the HR service management tool can create changes in the employee system of record, send a request to IT to deliver the new employee a laptop, and other requisite tasks.

We believe ServiceNow’s business has evolved to the point where there is a material level of customer switching costs, connoting a narrow economic moat rating. We think three factors insulate ServiceNow from usurpation: cloud migration, application interoperability, and renewal rates.

Cloud Migration We generally view the migration to the cloud as a one-time land grab for most software vendors, as we believe switching costs will be at least as strong, if not stronger, with the as-a-service model. For application software companies, the software-as-a-service model allows vendors to consistently deliver the latest version of its software while collaborating with customers to actively deliver new features in real time, eliminating the natural switching catalyst that was common in upgrade cycles with the license/maintenance model. We believe this gives ServiceNow the upper hand in terms of being on the right side of the most powerful secular tailwind in software. More important, the company has acquired a vast swath of large enterprise customers, including 35% of the Global 2000 (as defined by Fortune), yielding a sizable customer base that provides consistent feedback for ServiceNow to layer in new features and customizations to maintain superior customer retention. Further, ServiceNow has leveraged its expertise to create greenfield opportunities in ESM, yielding compelling tools for specific business users, such as HR and finance; we believe these tools represent roughly 5% of subscription revenue today but are growing at roughly 3 times the consolidated top line.

Application Interoperability ITOM applications frequently work hand in hand with ITSM as they both engage with the configuration management database system, a repository that manages key information about IT assets including hardware, software, and facilities, as well as employees that rely on them. ITOM applications are increasingly counted on to give enterprises insights into the performance of these assets, a shift that we expect to continue accelerating toward public cloud over the next several years. It is imperative that ITSM and ITOM applications work seamlessly together, as change requests that originate via ITSM tools are frequently executed via ITOM functions and captured in the configuration management database system, such as new hardware issues, software installations, upgrades, and permissions. We think ServiceNow's ITSM customers will naturally migrate toward the firm's ITOM products that have been built from scratch to manage hybrid environments, and we are beginning to see this play out. Nearly 10% of subscription revenue came from ITOM in 2016, at $113 million; this business is growing at more than twice the rate of the consolidated top line.

Superior Renewal Rates Despite the presence of legacy mainstays such as BMC and HP HPQ and an aggressive push into new verticals, ServiceNow's annual contract value retention rates have hovered between 97% and 99% over the past three years, a metric that is exclusive of customer upsells. We believe this level of retention is a top-flight indicator of customer switching costs that support a narrow economic moat rating.

ServiceNow’s moat rating may still have its skeptics, particularly given the circumstances of the firm’s rise to prominence. On the face of it, it is reasonable to suggest that ServiceNow’s meteoric ascent in ITSM could mean that another company might come along and erode ServiceNow’s competitive positioning relatively quickly. However, we believe the largely one-time nature of cloud migrations, ServiceNow’s broadening portfolio, and the firm’s strong renewal rates will ultimately prevent the share losses that have been experienced by legacy vendors such as BMC, a company that was slow to adopt cloud-based technologies and has struggled to migrate customers as a result.

Quantifying ServiceNow's Rise and Competitive Position Although we have long held ServiceNow's ITSM portfolio in high regard, we had refrained from awarding the company a narrow moat rating, largely because it remained unclear whether it would be able to successfully branch out from the relatively small ITSM market. However, as the company has broadened its portfolio and continued to innovate via the cloud and iterative feature development, adoption of its products beyond ITSM has followed, and we believe the path is clear for ServiceNow to tackle a much larger addressable market with a high degree of success.

ITSM remains the most prominent driver of ServiceNow’s subscription revenue, but the company continues to take share at an accelerated pace. We believe these share gains are largely attributable to ServiceNow’s embrace of the cloud. While legacy vendors such as BMC and HP struggle to migrate on-premises customers to the cloud, ServiceNow has snapped up customers left and right while continuously innovating its ITSM offering.

We think BMC’s initially slow decline is evidence of some level of switching costs in ITSM, as customers do not merely rip out applications on a whim. We believe enterprises are migrating to the cloud for three reasons: (1) Companies are moving away from clunky, internally developed applications; (2) software is a way to improve business processes; and (3) software is a way to save costs via the cloud.

We believe ServiceNow’s rise is tied to all three of these waves, most notably the second and third points, as the firm’s applications are closely tied to process and workflow automation, while SaaS vendors can save customers roughly 30% on IT costs by migrating applications to the cloud. Despite ServiceNow’s aggressive share gains between 2009 and 2012, BMC’s market share was relatively well insulated. However, as cloud adoption has accelerated over the past few years, we believe BMC’s customers have recognized the multiple benefits of the SaaS model, including a significant reduction in IT maintenance costs, greater visibility into software budgeting, and increased operational efficiency by continuously operating on the latest version of the vendor’s software. We believe this bodes well for ServiceNow, as we think customers will be even less likely to migrate away from its ITSM platform once they become fully immersed, a level of switching costs that should only increase as more applications are layered into an individual customer’s ecosystem. Further, BMC has had cloud-ready ITSM products on the market for some time now, but it has not been able to stem the tide of share losses, which we believe supports our argument that cloud migrations are likely to represent one-time land grabs for many software vendors. Switching costs are often quite high in a shift from one on-premises software platform to another, and we foresee them being just as high in a switch from one cloud vendor to another, but the three main benefits of the shift to a SaaS model have emboldened enterprises to move from on-premises software to the cloud.

As ServiceNow becomes more aggressive in ITOM, it faces an uphill battle in dethroning many of the same rivals it faced in the ITSM arena. However, many leading ITOM leaders of the past have a significant portion of their businesses tied up in on-premises data centers, creating a proving ground for companies with an eye toward hybrid cloud IT infrastructure. We think this dynamic creates an opportunity for ServiceNow, similar to the opportunity it capitalized on in ITSM. In fact, if we look at ITOM spending data exclusive of ITSM spending (which is included in the ITOM analysis conducted by Gartner each year), we can see the erosion of revenue and share for legacy vendors beyond the ITSM product set, with much of the new spending directed toward other vendors (including ServiceNow). In fact, the only legacy vendor we see generating any material growth over the past several years is Microsoft MSFT, which we believe has the clearest cloud strategy of any major legacy software vendor.

Market Underappreciates ServiceNow's Potential We believe ServiceNow will remain in its growth phase in fiscal 2017, as we currently model roughly 30% top-line growth and roughly 350 basis points of non-GAAP operating margin expansion to 17%. In the longer term, management has outlined several aspirational goals to achieve by 2020, including $4 billion in revenue, 28%-30% non-GAAP operating margin, and 30%-32% free cash flow margin. Although we remain conservative in our revenue expectations for the firm over this time frame given the number of incumbents it faces in ITOM, we believe management will be able to pull the natural levers that will bring its profitability and cash flow goals into striking distance by fiscal 2020, while we foresee even more robust operating leverage for the company beyond 2020.

Although we are more conservative regarding top-line growth through 2020, we believe this reflects the still-unpredictable nature of how quickly IT infrastructure will tilt toward cloud. However, we do expect this transition to play out largely over the next 10 years, and ServiceNow will be a key beneficiary, which is reflected in our longer-term targets. Over the long term, we expect this trade-off between revenue growth and profitability to continue tilting more heavily toward margins, predicated on ServiceNow continuing to generate a high level of customer switching costs. Cash outlays to sales resources will naturally fade as customers roll into renewals (which generally carry far lower commissions than new business in the SaaS model), yielding significant operating leverage.

We believe ServiceNow’s current market valuation is making a number of inaccurate assumptions about the business model--primarily the natural relationship among top-line growth, renewal rates, and operating margin. We believe the current stock price implies only limited top-line growth opportunities beyond ITSM and, as a result, risk to the firm’s retention rates and margins. However, ServiceNow has boasted high 90s renewal rates while primarily operating as an ITSM vendor to this point, and we believe the ongoing migration to the cloud will only create more demand for standardization on ServiceNow’s platform, rather than using several solutions from disparate vendors. Thus, we find it highly unlikely that customers would become more willing to rip out applications if they are using services across the firm’s ITSM, ITOM, and ESM portfolios. We believe spending patterns among individual customers align with this view, supporting our expectations of a low 30s subscription compound annual growth rate through 2020, compared with a market valuation that implies just a low 20s rate over the same period and subsequently lower margins. We think this growth rate implies a meaningful increase in customer churn, a story arc that we do not believe will play out for this narrow-moat firm.