Service Now Is A Long-Term Conviction Buy, Here's Why


Last week, Service Now issued its fully updated guidance for FY2020 and said it sees minimal impact from the Covid19 outbreak. The SaaS (Software as a Service) company did cut its growth expectations for the year, but still expects 27% subscription growth. There are five reasons why Service Now is a great long-term buy and hold opportunity, especially in conjunction with portfolio overwriting (out-of-the-money covered calls). Today's price action presents an attractive breakout setup.

1) Long Runway For Growth: In The Past, Present and Future

In the very beginning, Service Now had to aggressively double down on marketing expenses to drive revenue growth and create scalability. With over 1.1 billion USD in expected free cash flow in 2020, that picture has changed as the company's revenue growth rate will fall to 30%. The good news is that free cash flow margins have improved noticeably from 6.6% in 2014 to 25% this year. With a targeted annual FCF margin improvement of 100 basis points, slowing revenue growth should not be seen as an insurmountable issue.

(Source: Option Generator)

Despite the fact that revenue growth rates have come down in absolute terms, the exponential picture is still intact with free cash flows doubling every three years. In terms of revenues, it's highly realistic to assume that Service Now can reach the 10 billion USD threshold by 2024, thereby propelling the free cash flow number to 3 billion USD.

(Source: Option Generator)

2) Digitalization And Wide Moat

Although the coronavirus crisis may create short-term pain, the long-term gain will be substantial. More enterprises opting for Service Now's digital workflow solutions, a highly consistent retention rate of 97% in the last quarter and increasing margins will continue to sustain 25+ % growth in FCFs. The fact that the company is expanding its long-term partnerships with ACVs in excess of $1M growing at a YoY growth rate of 48% underpins the favorable business outlook. The high retention rate can be explained by the elevated switching costs if clients decide to replace Service Now with one of its competitors.

(Source: Service Now Presentation)

When it comes to NOW's moat, the initial strategy of focusing solely on acquiring market share as fast as possible has borne fruit. Today, the company controls close to 40% of IT Services Management and has recently stepped up efforts to repeat that success story in the IT Operations Management area. By offering complementary products, 75% of NOW's customers are subscribing to more-than-one service, while expanding beyond non-IT areas will deepen its pipeline and further improve cash flow visibility.

3) Excellent Management Execution

Back in May of 2018, the company held an analyst meeting during which the following graph was shown. In order to estimate the capacities of a management team, it's worthwhile checking out the promises made regarding long-term revenue targets.

(Source: Service Now Presentation)

Based on what we've seen so far, I believe Service Now's management team ranks among the best in the entire technology industry, which justifies a valuation premium (see later). They've kept their promise and are actually on track to beat their ambitious goals.

4) Industry-Leading Shareholder Returns

The coronavirus stock market crash separated the wheat from chaff. Great business benefiting from secular growth trends are now the new safe havens. The fact that NOW shares are trading at all-time highs should be seen as a positive. The stock currently makes it to the best 6% of the S&P-500 in terms of momentum and belongs to the 3% best when it comes to earnings consistency and cash flow growth. Moreover, it has done so with a great portion of consistency, which is quite remarkable given the volatile nature of high-growth companies.

(Source: Service Now Annual Report)

5) Long-Term Investors Don't Need To Worry About NOW's Valuation If They Apply Covered-Call Writing

While Service Now shares are far from inexpensive, a projected FCF of 3 billion USD by 2024 and a net cash pile of 10 billion USD (assuming no M&A) would lead to a forward EV/FCF yield of 5.4%. Without a doubt, that's a lot more affordable than its current 1.8% EV/FCF return. Although there's always a present risk of a sudden re-rating to 2%-2.5%, lowering your cost-basis by selling covered calls can provide a solution to cushion future corrections.

By selling monthly out-of-the-money covered calls, one can generate a cash premium of 3% while enjoying 4%-5% upside potential (under normal circumstances). If the option is in-the-money at expiration, you can roll out and up for either a small debit or still sizable credit.

The June 19th covered call options generate the following returns:

(Source: Option Generator Spreadsheet)

Technically speaking, the directional movement remains bullish (green bars) with the MACD bouncing back up from the signal line, well above 0. The last time Service Now generated a buying or accumulating signal was in 2016 at $75-$85. The stock has since more than quadrupled, with new buying signals presenting themselves at the lower end of the channel.

(Source: Pro Real Time)

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