ServiceNow: Impressive Free Cash Flow Growth, Still Overpriced

ServiceNow (NOW) supplies global enterprises across industries, universities, and governments with cloud computing solutions to digitize their workflows.

The company’s technology platform, referred to as the Now Platform, allows for the connections of systems, silos, departments, and processes with digital workflows that give IT departments the ability to design, develop, and operate across the entire IT lifecycle.

ServiceNow’s financials have seen a tremendous expansion since the company’s public listing, with the past year showing no signs of a slowdown. The company has lately started to post improving records of free cash flow generation, and with the stock recently retreating from its previous highs, investors may want to revisit its investment case.

However, I still find ServiceNow shares relatively overvalued. For this reason, I am neutral on the stock.

Recent Results 

ServiceNow’s Q4 2021 came in quite strong, with revenues growing 29% year-over-year to $1.61 billion, beating Wall Street’s estimates of $1.60 billion.

While this revenue growth rate sounds strong but not amazing, it’s worth taking a look at billings. Due to the majority of ServiceNow’s revenues being sourced from a subscription model, billings provide a clearer picture of the business’s growth trajectory than revenues.

Billings reflect deals signed during the quarter and deferred revenue growth, which will be later realized as revenue in coming quarters. Total billings for the period grew 33% to $2.53 billion, shaking off any recent concerns, including the company’s growth decelerating.

ServiceNow’s profitability has also been improving along with revenues as the company scales its margins over time. For context, gross margins have expanded from close to 64% in 2014 to approximately 77% in the most recent quarters. The company posted earnings per share of $0.13 versus $0.09 in the comparable period last year.

However, due to the company reporting rather high stock-based compensation levels, it’s better to take at its free cash flow. In its most recent results, free cash flow amounted to $744 million, up 31.9% year-over-year.

More importantly, however, this implies a free cash flow margin of 46%, which is utterly impressive and, combined with ServiceNow’s SaaS model, suggests the company is gradually becoming a cash cow.

Wall Street’s Take

Turning to Wall Street, ServiceNow has a Strong Buy consensus rating based on 18 Buys and two Holds assigned in the past three months. At $684.95, the average ServiceNow price target suggests 15.9% upside potential over the next 12 months.

Valuation & Conclsuion 

ServiceNow’s growth has been undeniably very strong, and the company’s most recent billing metrics imply that this is likely to remain the case. Additionally, with every sequential quarter of higher revenues amid its SaaS business model, the company should be printing cash moving forward.

ServiceNow is expected to produce revenues close to $7.42 billion in 2022. If we attach a reasonable free-cash-flow margin of 35% (free-cash-flow margin landed at 32% in 2021) to this amount, the company could generate free cash flow close to $2.37 billion this year.

At its current price levels, the stock is trading at approximately 45 times this year’s potential FCF. I find this multiple rather rich despite the company’s quality revenues and strong growth visibility. I believe a fairer P/FCF below 40 would still reflect the stock’s growth prospects while offering investors a much more significant margin of safety.

Accordingly, I am neutral on ServiceNow.

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