ServiceNow

ServiceNow's second-quarter revenue grew by 22.5% year over year in constant currency to $3.99 billion, driven by broad-based demand. Non-GAAP operating margin was 29.5% for the quarter.

Why it matters: Results are meaningfully better than both the company’s outlook for the quarter and our expectations. Some of the revenue upside was from US Federal revenue being pulled from the third quarter to the second, while the remainder was driven by strong overall demand. Subscription revenue grew 24.5% year over year, topping guidance by about 200 basis points. We see good performance across geographies and workflows. We also see rarely mentioned industries, like education, as among the highest growth industries in the quarter, which is bullish, in our view. We continue to believe ServiceNow is a key software beneficiary of artificial intelligence. The firm now has more than $1 billion in annual contract value, or ACV, which saw acceleration to 40% sequential growth. Deals including five or more AI products grew 5.5 times year over year.

The bottom line: We maintain our fair value estimate for narrow-moat ServiceNow at $165 per share, and we view the stock as attractive. ServiceNow offers one of the best blends of growth and margins in enterprise software, and results continue to show AI is not hurting the firm’s fundamentals. Management is excited about the pipeline, which shows solid forward-looking metrics. Current remaining performance obligations grew 21.5% year over year in constant currency to $13.2 billion, which was nicely better than guidance. We see cybersecurity as contributing materially to the pipeline, with strength in both Veza and Armis.

Coming up: The firm raised its full-year revenue outlook by $15 million to account for net new ACV while holding non-GAAP operating margin guidance flat at 31.5%. Third-quarter guidance was slightly lower than we expected, but based on demand pull-in for the second quarter, we are not concerned.

Our fair value estimate for ServiceNow is $165 per share, which implies a 2026 enterprise value/sales (EV/S) multiple of 11 times and an adjusted P/E multiple of 40 times.

We model a five-year CAGR for revenue of 17%. We see subscription revenue as driving almost all growth. In our view, top-line growth will be driven by continued new logo wins, and rapid upsell into those clients once landed, with upsell coming from new seats, new features within a given solution, vertical specific solutions, generative AI solutions, and ultimately additional products. Customer service, HR delivery, security operations, and platform should contribute meaningfully to growth over the next five years. We believe the market is large and growing, and can support ServiceNow’s expansion in the coming years. We see non-GAAP operating margin expanding from 31% in 2025 (actual) to the mid-30% area over the next five years driven by improving scale and expanding sales of premium SKUs. Assuming AI scales meaningfully, we think modest gross margin pressure will be offset by operational efficiencies.

We assign a narrow economic moat to ServiceNow derived from high customer switching costs. The company officially reports only two segments, subscriptions and services. While we view the subscription business as having a narrow moat, we do not think the company’s services segment, which is a small portion of revenue, warrants a moat. We believe ServiceNow’s moat will probably allow the company to earn returns in excess of its cost of capital over the next 10 years. Given the unknowns surrounding the impact AI will have on many software companies, we think it is inappropriate to assign a “near certainty” level of confidence to the return profile.

Switching costs for software are often driven by several factors, in our view. The more critical the function and the more touch points across an organization a software vendor has, the higher the switching costs. There is also the direct time and expense of implementing a new software package for the customer while maintaining the existing platform and re-training employees on a new system. Additionally, there is operational risk of changing software vendors, including business process re-engineering, loss of data during the changeover, and overall project execution. A major implementation is likely to involve a system integrator and can take in excess of a year in bad cases. Lastly, lost productivity is likely to be an issue as customers move up a learning curve on the new system along with the distraction of users involved in the function where the change is occurring.

Retention metrics typically help inform investors on both the presence and the durability of a moat. These come in two flavors: gross, which describes what percentage of the customer base remains customers after a given period, and net, which highlights what percentage of the customer spending is retained by the software provider after a given period. ServiceNow’s customer retention has been consistently excellent at 98% to 99%, with net retention well in excess of 100%, which places the company among the elite software firms. Software firms regularly see higher retention rates for enterprise customers relative to smaller customers, and ServiceNow tends to serve the largest companies in the world, so strong retention is not unexpected.

We believe the ServiceNow’s software business enjoys a wide moat based on switching costs. Subscriptions represent approximately 97% of revenue. The company provides some additional detail on the composition of software revenue. Specifically, IT workflows account for 55% to 60% of net new annual contract value, or ACV, customer and employee workflows account for 25% to 30% of net new ACV, and creator and other workflows account for 15% to 20% of net new ACV. IT workflows have slowly been trending down as a percentage of net new ACV, but we think it accounts for a slightly larger share of revenue given this is the area where the company directed its earliest solutions.

We believe customers value each of ServiceNow’s myriad of solutions on a stand-alone basis, but the product portfolio is highly complementary and is tightly integrated, making the platform more compelling than a point solution. In our opinion, the platform approach coupled with deep and wide add-on offerings is critical as customers are usually looking to consolidate vendors. These factors combine to reinforce our moat rating. As ServiceNow offers a wider set of related and best-in-class solutions, we believe it becomes more deeply entrenched in its customers as they adopt multiple products.

While ServiceNow positions itself as a workflow solution, it is more easily understood as a provider of software for Information Technology Service Management, or ITSM, and Information Technology Operations Management, or ITOM, which represent the first suite of products the company offered. Importantly, the workflow element of ITSM has been crucial in driving adoption for use cases outside of the IT function. The broad appeal of modernizing workflows and automating processes across the enterprise has opened up a larger array of use cases for the company’s solutions. These factors have allowed ServiceNow to initially bore deeply into the IT function as a system of record, and then to expand laterally to other non-IT functions. Both of these sales dynamics have helped the company to become entrenched in an organization across a variety of mission-critical functions. Since the software sales process across the enterprise will regularly touch the IT department, ServiceNow adopted a stance early on that it would let the internal IT function sell the platform to other areas of the customer. This process has clearly been successful.

At a basic level, if an employee’s computer has an issue, they call the help desk, which creates a ticket and endeavors to solve the problem. ITOM more broadly involved monitoring and controlling various components of the IT infrastructure. The lines between the two are blurring, as functions have been added to ITSM solutions, and the complexity of IT infrastructure has increased with the rise of bring your own device and cloud and hybrid cloud environments. ServiceNow’s ITOM tools integrate smoothly with existing monitoring and operations tools, which is a critical feature in today’s complex hybrid cloud IT environments.

We believe ServiceNow has been an agent of change for the entire industry. Most obviously, the platform was built in a modern and flexible way and was intended from its inception to be delivered as a multi-tenant SaaS solution. Beyond that, the company strove to democratize the help desk function, giving the interface an intuitive and consumer-friendly feel. ServiceNow was also early to offer a platform for no-code and low-code application development, which we view as critical in a solution geared for the IT department, but helpful for non-IT professionals for quickly establishing automated workflows. The company has continued to pack the ITSM platform with features that might have previously been considered part of a different ITOM solution. Lastly, its platform allows for ITSM functions and various ITOM tools to be incorporated within the same dashboard. At the core of it all is the workflow automation solution that streamlines operations.

In short, ServiceNow has taken the key IT function, which is a business that might have otherwise warranted only a narrow moat rating, and incorporated an extensive set of features, thus allowing it to become more heavily ingrained within IT more broadly. While switching costs may be more easily overcome for a simple help desk solution, we believe that an ITSM installation has a long sales process and historically has enjoyed a life cycle not unlike an ERP system, with 10-15 years between major changes (usually upgrades on the existing platform) contemplated. Additionally, the incorporation of a variety of other ITOM features, such as IT Asset Management, in IT Business Management has made the company’s solution broader and focused on solving business problems rather than just selling applications. Operating and maintaining the hardware and software is absolutely mission critical to the enterprise, and these customers are loath to change. The risk of IT asset failure is simply too high, especially in the exponentially more complex hybrid cloud environments of today.

Recognizing the shifting balance of power, ServiceNow has moved beyond providing the system of record for the IT function to focus on simplifying and automating enterprise workflows more broadly. In doing so, customers are increasingly finding the solution indispensable. A variety of metrics support this notion, including best-in-class retention. Meanwhile, 80% of ACV is derived from existing customers. ITSM and ITOM together have declined steadily from 95% of revenue in 2013 to around half of revenue, underscoring the company’s broadening portfolio. Most of the largest companies in the world are ServiceNow customers, with their average annual contract value approximately doubling over the last several years. Approximately 80% of customers use multiple products. Regardless of how we slice the data, the conclusion is the same, customers are adopting multiple solutions, renewing contracts, and adding more products over time. We see this as strong evidence of the moatiness of ServiceNow's solutions.

As workflow automation proliferated within the IT function, other areas of the enterprise became increasingly interested in process automation as well as a way to improve productivity and user experience. Several use cases outside of IT, namely employee and customer service, have emerged. We estimate emerging products generated 35% of ACV in 2020. Enterprise customers have seen the benefits that ServiceNow can bring to the IT function in terms of a better user experience, process automation, and self-service, and are looking to apply that internally to the HR function. We were surprised by HR interest when we first heard this from management a decade ago but quickly understood the similarities and the larger opportunity. In HR, for example, a new employee represents a service ticket that initiates a series of automated onboarding processes much in the same way a call to tech support about a PC malfunction does the same. Rather than competing with Human Capital Management, or HCM, software vendors such as Workday, ServiceNow’s solutions sit on top of those platforms. NOW interfaces with all the disparate platforms, including (for example) Workday for HCM, Oracle for finance, Salesforce for CRM, Adobe for marketing automation, and ADP for payroll, and can automate processes across all functions of an organization. This is powerful as enterprise customers contend with the reality of maintaining legacy systems while bringing modern platforms into the fold.

ServiceNow is introducing a variety of AI features and offers its own proprietary AI models, while still allowing large language models to operate on its platform. AI features require a premium seat license and then also carry consumption pricing on top of the license. At the onset of the AI era, ServiceNow has been among the most successful among enterprise software vendors at driving AI monetization.

ServiceNow’s robust portfolio has rapidly propelled the firm to the leadership position within ITSM. This dominance has enabled it to expand into the system of record for the entire IT function.

ServiceNow has organically expanded beyond ITSM into other areas outside IT, including customer service and HR service delivery, enabling a more durable growth profile for the firm.

ServiceNow delivers excellent profitability and free cash flow generation that has enabled strong growth, strengthened the platform, and allowed for acquisitions and share buybacks.

As ServiceNow expands deeper into areas outside of core IT functions, it has encountered an expanding set of competitors. Some of these peers will be well-equipped for battle.

ServiceNow has more recently turned to acquisitions, including larger deals, to expand its reach. Increased acquisition activity raises integration risks and muddies the firm’s organic growth narrative.

There is a fear that AI models can replace applications like ServiceNow’s or pressure the seat licensing model.