NOW: Solid beat and 2021 outlook makes conviction buy

ServiceNow has seen an acceleration of its business since the pandemic started and management has consistently stated that this acceleration won’t slow down even with the end of COVID. The company reported Q4 earnings and as usual smashed their own guidance and expectations.

• $1.23bn in Q4 revenue beat expectations by $20mm
• Beat own guidance on subscription revenue and billings (see slide below)

You can find the call transcript here , earnings presentation here and financials here.

One thing that will help frame this post is that NOW has always said the want to be a $10bn revenue company. ($6.5 is the projection for 2021). If you assume 35% FCF margins, that’s $3.5bn of free cash flow, which at a 5% yield makes them a $70bn company and 2.5% yield makes them an $140bn company. As of close of trading Friday, NOW was a $106bn company. You can tell the valuation feels a bit stretched. That said, I commit in this newsletter to covering the companies I own and keeping up with the business and then the stock, in that order. If we see a big general market correction, NOW is one of the first companies I’ll look to buy.

I’ll also caveat that we could see NOW’s FCF margins go up, but I don’t think it’s likely over the next few quarters. CEO Bill McDermott suggested they could do more in M&A and invest more in the business, especially in AI. I think this is fine as a shareholder as they’re clearly growing ACV and winning huge deals. The ACV point is worth emphasizing as that was a highlight of this quarter:

We closed 89 deals greater than $1 million in ACV in the quarter, with average deal sizes up 18% year-over-year. In 2020, we added nearly 700 net new customers, ending the year with almost 6,900 enterprises. The number of customers paying us $5 million or more in ACV grew over 40% in fiscal 2020…

NOW Q4 earnings call

For the full year 2021, we expect subscription revenues between $5.48 billion and $5.5 billion, representing 28% year-over-year growth, including a 3-point FX tailwind. We expect subscription billings between $6.205 billion and $6.225 billion, representing 25% year-over-year growth. Excluding the early customer payments in 2020, our 2021 normalized subscription billings growth outlook would be 28% to 29% year-over-year growth. This growth reflects an acceleration in net new ACV in 2021

NOW Q4 earnings call

I trust management to allocate capital and they’ve delivered spectacular returns over the years. Each dollar going back into the business keeps getting more valuable as ACV and margins expand.

Some more notes from the call:

• ServiceNow’s TAM I continue to feel great about. The amount of companies moving from paper processes to digital, EMEA and other markets and new applications of NOW – specifically vaccine distribution and administration – were highlighted on the call. The vaccine piece while perhaps not material tor revenue is definitely going to drive exposure and display how powerful the NOW platform can be – North Carolina and Scotland are already using it to administer the vaccine and having great success:

This week, we just launched the first in a suite of planned vaccine administration applications to deliver out-of-the-box functionality for our customers. Our comprehensive approach enables workflow solutions to the complex challenges of vaccine distribution, administration and monitoring. As we have done with Safe Workplace, we will be delivering continuous innovation with our vaccine administration management applications. I’m excited to announce that the state of North Carolina Department of Health and Human Services is already leveraging the ServiceNow Platform to power its COVID vaccine management system to help quickly and efficiently vaccinate 10 million North Carolinians.

We’re also proud to be supporting NHS Scotland in their efforts to vaccinate 5.5 million citizens. NHS Scotland is using the Now Platform and our customer workflow to deploy a customized solution designed to meet their specific needs. Deployment took only 6 weeks, showing the agility of the Now Platform. ServiceNow is enabling a comprehensive solution for the schedule and the reporting of vaccination for Scotland’s most vulnerable citizens. Within 12 hours of rollout, NHS Scotland booked over 220,000 appointments.

• The company’s acquisition of Element AI came up a few times in the call and McDermott clearly is excited about the NOW AI offering driving growth. One of the co-founders is Dr. Yoshua Bengio, who has some papers that have come up in AI/ML Coursera classes I’ve taken. He’s a legend in academic and business circles and now also is an advisor to ServiceNow. Element also was equity funded by MSFT, NVDA and Tencent – this seems like a strong acquisition (expected to close early 2021). That said, I want to see market adoption of AI-powered chat or other offerings before I get excited here. As a general gripe, I think ML / AI comes up so often on company calls without actual explanation of how this investment is driving growth

• Is ServiceNow starting to market itself and will the company after seeing its strong FCF margins this year consider lowering marketing expense? An excerpt:

Turning to profitability. Q4 operating margin was 22%, a 100 basis point beat versus our guidance, driven by our strong top line outperformance. Year-over-year, our Q4 operating margin was consistent with last year as lower T&E expenses were offset by planned incremental R&D investments and marketing spend on pipeline generation. Our free cash flow margin was 45%, up 900 basis points year-over-year, driven by lower T&E spend and strong collection.

For full year 2020, operating margin was 25%, up 300 basis points year-over-year. And free cash flow was 32%, up 400 basis points year-over-year. Together, these results show the power of our business model and our ability to drive a balance of growth and profitability.

• The company cites many examples of existing and new customers who are asking about NOW without being specifically marketed to. The customer inbound is a hugely positive sign and I’d love to see a future where having NOW is as essential as having AWS / GCP / Azure for compute or Jira for bug tickets / work planning. At this point, my feeling is NOW is very much an enterpris-y product that sits in the Fortune 2000 and federal / state governments, but I could see a case where SMBs and other parts of the market see the CRM, HR and other offerings and adoption picks up.

• Some quick notes on financials – NOW has more than twice as much cash on the balance sheet v. FYE 2019 (~$1.7bn v. $780mm). Much of this was driven by ~$1.5bn of bonds issued last year due in 2030 at a 1.4% coupon (holy smokes on this cost of debt), company was probably one of the few where capex increased versus 2019 ($419mm v. $265mm).

• 99% retention rate, best in a few quarters. Customers don’t leave NOW – super sticky product

Overall, another great print and even with some modest valuation concerns, I feel extremely comfortable holding NOW and increasing my position on any general market weakness. Great business with management hyper focused on long-term growth.