Part 5 of 6 part series
In this five part series I provide an overview of my favorite investing theme currently - the cloud platform providers powering digital transformation and analyze what I think are four really good cloud platform stocks in this area. I will post my evaluation of each one, culminating in my selection of the best of the bunch. Follow me on Twitter @OwlWealthy to read my analysis when it's fresh off the press.
ServiceNow (NYSE: NOW) rode the Software-as-a-Service (SaaS) trend to dominance in the IT Services Management (ITSM) software sector. They have since expanded beyond ITSM and are now riding the digital transformation secular trend. Their CEO, former SAP CEO, Bill McDermott often describes digital transformation as the opportunity of a generation. I've written extensively on the topic of digital transformation, including this post about the impact of digital transformation on investing. There is no doubt digital transformation is real and it will continue to drive incremental and growing IT spend. Worldwide spending on the technologies enabling digital transformation is forecasted to reach $2.3 trillion in 2023, according to the International Data Corporation (IDC)Worldwide Semiannual Digital Transformation Spending Guide. Covid 19 has accelerated the transformation that was already underway.
ServiceNow is helping organizations apply digital transformation to themselves with their workflow platform, streamlining previously manual and inefficient processes. Rather than enabling amazing digital consumer experiences like many of today's cloud high fliers, ServiceNow is focused on enabling amazing digital employee experiences. In today’s digital world, the ease of use that WhatsApp and Starbucks provide while chatting with a friend or ordering a coffee is the kind of delightful experiences ServiceNow wants to offer employees inside large enterprises.
Long ignored by large organizations, engaging employees with great digital experiences has significant payoff for organizations. Companies that rank amongst the top with the highest engagement rate have an average three-year revenue growth of 20.1%, compared to the industry average of 8.9% (source: CEB). Building an engaged workforce is rather elusive. One study by Gallup found that only 15% of the global workforce felt engaged at work. With remote work as the default today, employee engagement is particularly important. ServiceNow wants to help its customers drive employee engagement by building great digital experiences for employees to get their work done more easily.
The next wave of growth that ServiceNow is well positioned to capture, the citizen developer trend, is the missing ingredient for truly scaling digital employee experiences. Citizen developers are end users (e.g., business analysts, admins, operational analysts, etc.) from outside the IT department who create new business applications on platforms sanctioned by IT. And they are necessary because there simply aren't enough developers available to meet the demand. In most organizations, the IT department tends to be overworked and understaffed.
So how do you enable more people in an organization (i.e., non-developers) to build apps? You lower the complexity in how apps get built so practically anyone can build them.
Hiding all of the complexity of software development is no easy feat. But a whole new category of platform providers has emerged to support citizen developers - low code and/or no code app development platforms. These are platforms that are reducing or outright removing the dependency on coding skill to build valuable apps. All of the technical complexity is getting pushed behind the curtain, so the citizen developer can do what they do best - solve the business problem.
Armed with tools that allows any non-IT user to build apps, organizations can unlock the full potential of digital transformation. Citizen developers are becoming equipped to lead small digital transformations of their own making. As more citizen developers in an organization get unlocked you start to see massive innovation happening in totality across the enterprise.
This wave of citizen developer and low code/no code platforms is real. Gartner estimates that by 2024 75% of large enterprises will be using at least four low-code development tools for both IT application development and citizen development initiatives.
Much like another recent stock idea of mine Alteryx is expanding the pool of data scientists in an organization by making data science easier, ServiceNow is expanding the pool of developers in an organization.
It is the combination of digital transformation acceleration and the rise of the citizen developer that make ServiceNow and interesting investment idea worth exploring. Let's dig in.
ServiceNow is enabling its customers to digitize the inner workings of their organizations. Whether it's building a new employee onboarding application to help new hires accelerate time to productivity, a work order management app to process and track employee requests for equipment, or a rebate fulfillment application to track and fulfill customer rebate requests, with the ServiceNow platform citizen developers and experienced coders are able to quickly build and deploy apps.
ServiceNow wasn't always a platform provider. They began as a Software-as-a-Service (SaaS) vendor serving the IT Services Management (ITSM) sector. They now have an emerging Platform-as-a-Service business. Platform-as-a-Service, or PaaS, as defined by Wikipedia is a category of cloud computing services that provides a platform allowing customers to develop, run, and manage web applications without the complexity of building and maintaining the infrastructure typically associated with developing and launching an app. ServiceNow is in unique company now that they are evolving from a Software-as-a-Service (SaaS) pure play vendor into also a PaaS provider. The only other company that went through a similar evolution at significant scale, SalesForce, wrote the playbook for growing up from SaaS to PaaS. And, they've done alright.
The PaaS market is made up of several sub categories, offering an array of services for advanced developers and citizen developers (and everyone in between) to be able to more quickly and easily builds apps. ServiceNow has not yet established itself as a leader in the overall PaaS market. They are noticeably absent from the customer rated Trust Radius ranking of Top Platform-as-a-Service solutions. AWS, Azure and SalesForce are the leaders.
Where they are making inroads is in the PaaS sub sector Low Code Application Platform (LCAP) market. ServiceNow moved from Gartner's Magic Quadrant Challenger ranking (in 2019) to Leader as of 2020.
There is reason for optimism in ServiceNow's PaaS business:
Morningstar estimates that platform and related solutions drove 11% of ServiceNow Annual Contract Value in 2018, up from 3% in 2013
ServiceNow has grown the number of 3rd party apps in their app store. As of 2018, there were a total of 347 available apps in the ServiceNow Store as compared to the 80 apps offered when ServiceNow launched the store in 2015.
The Now platform is quickly increasing the number of third party apps, a positive sign of growing network effects. With greater end user adoption of ServiceNow, more developers are being attracted to the ServiceNow platform. This is still well behind the 3,400 3rd party apps that are available in the SalesForce AppExchange store, but there has been progress.
ServiceNow has the advantage of an extremely strong brand with IT departments in large organizations. IT is where ServiceNow built its business and because of the strong reputation they earned IT decision makers are more likely to bring the Now platform to their stakeholders outside of IT. This will work well to ServiceNow's advantage, as IT departments are always looking to offload app development to citizen developers outside of IT.
ServiceNow estimates it's total addressable market (TAM) at $110B as of 2018, expecting it to grow to $165B by 2023.
To properly assess this market opportunity, it's important to dive into what makes up the ServiceNow TAM. This is where things get interesting. Have a look at what you get when you zoom into their notes about how they define their TAM (source: ServiceNow investor day report, 2018).
No, I'm not trying to cause you to strain your eyes by reading the fine print. These are the legit markets ServiceNow competes in. The IT Service Management (ITSM) market is expected to reach $4.6 billion by 2023, compared with $4.1 billion in 2018, growing at a compound growth rate of 2.3% (Source: App Research and Buyers Insight). The IT Operations Management (ITOM) market reached $30.9 billion in size in 2019 and grew 10% from 2018. These are the core markets ServiceNow grew up in and have come to dominate - ServiceNow has 40% share in the ITSM market. This doesn't even count their more niche markets like AIOps, performance analytics, and software asset management.
If ServiceNow already dominates these maturing IT related markets, where is the growth opportunity? ServiceNow's growth lies in the broader Platform-as-a-Service (Paas) market and its sub sector application-Platform-as-a-Service (aPaaS). How do these two markets relate, and why are they so important to the next wave of ServiceNow growth? PaaS and aPaaS are conceptually similar because they enable people to focus on solving problems rather than worrying about setting up the infrastructure (PaaS) or worrying about doing the coding (aPaaS). Said another way, PaaS is for professional developers to build apps on so they can skip the boring stuff (setting up and running the underlying infrastructure) and aPaaS is for citizen developers. In a world of exploding digital transformation and an app for everything, they both matter. According to Statista, the global PaaS market is expected to compound an annual growth rate (CAGR 2020-2025) of 20.5%, resulting in a market volume of US$104.5B by 2025.This estimate includes all PaaS types (there are many variants), including aPaaS. While I was not able to find data that reflected ServiceNow share of the overall market, it's likely a small portion providing ServiceNow with a lot of greenfield to capture.
There could be some additional upside for ServiceNow if you buy into the argument that the PaaS market is underestimated, especially aPaaS which caters to citizen developers. Factors to consider:
Digital transformation will be bigger than we expect it to be
Artificial intelligence and machine learning will add more capability to PaaS offerings, driving increased demand. McKinsey estimates that AI will create $13 trillion in value by 2030. PaaS should capture a good chunk of that spend.
Apps, apps and more apps. The demand for apps in the enterprise requires more development talent, which means more citizen developers and more spend on low/no code platforms like ServiceNow.
In the core IT services related markets that make up ServiceNow's core, they have very strong products. Gartner ranks them as a Leader or Visionary across many categories.
It is in the growing and more strategic Platform-as-a-Service (PaaS) market that ServiceNow lags. Their weakness appears to be in trying to straddle the breadth of both developer personas, professional and citizen developers, and not fulfilling all of the unique requirements of each to sufficient levels. Customers in the past have shared that the ServiceNow platform requires “specialist developers” as opposed to true to citizen developers. They have also received lower-than-average scores for their application development capabilities. We already discussed how far ServiceNow trails PaaS leaders such as SalesForce in the number of 3rd party solutions available in its app store ecosystem, which can really limit the value of a platform.
Despite these challenges, their investment in improving their PaaS offering is clear with a growing streak of two major platform product releases each year and the recent leader recognition they received from Gartner. If you believe like I do that ServiceNow will come to be a major PaaS player, you can also probably see the upside I see in their stock price.
To up its game in the PaaS market ServiceNow needs to up its game with developers. While ServiceNow sponsored a Gartner study that found the introduction of ServiceNow within large organizations doubled developer satisfaction scores, we also saw how they scored below average in terms of application development capabilities.
The other challenge for developers with the ServiceNow platform is that their centralized IT department needs to make the procurement decision to adopt it before they can start using it for building production ready apps. This means long sales cycles and dealing with salespeople, something developers are generally allergic to. Pure play PaaS providers like AWS and Microsoft Azure offer pay as you go models making it super easy for developers to transact and get going. This limitation the ServiceNow model places on developers is similar to what the pioneer SaaS to PaaS player SalesForce forces upon its customers. Vendors like SalesForce and ServiceNow want their customers to first adopt their flagship SaaS offering before expanding the account into a paying PaaS customer. I'm not critiquing the strategy per se, but it does make it harder for developers to just get started building useful production apps that will solve immediate business problems.
The Platform-as-a-Service (PaaS) market represents the greatest growth upside for ServiceNow. To put the potential in perspective, platform revenue currently only represents 11% of ServiceNow total revenue (as of 2019). The closest comparable would be the more mature SalesForce platform business, which as of Fiscal Year 2020 accounted for 28% of SalesForce total revenue. This after SalesForce deeply discounted their take rate (the amount that the 3rd party software vendor has to pay Salesforce whenever their solution is sold via the SalesForce platform) from 25% to 15% 2017.
I believe the improvements to their PaaS offering and their trusted reputation with IT decision makers puts ServiceNow in a good position to grow their platform business into a more dominant revenue stream. For comparison, SalesForce's strongest support in an account comes from the Sales organization. And, the apps built on the SalesForce platform leverage the sales data stored in their Customer Relationship Management (CRM) SaaS offering.
ServiceNow is supported by the IT department who have the authority and motivation to standardize on a platform like Now, and to enable their colleagues across the business to become citizen developers.
ServiceNow is also working on building industry-focused solutions, opening up new monetization opportunities thru greater specialization. It has plans to build solutions for the finance and telecommunications industries, among others. This is a natural move for a large software vendor like ServiceNow, and the new CEO Bill McDermott has a successful track record verticalizing SAP's offerings. I see this move as more of an incremental one, optimizing revenue from an existing category rather than the next big idea that propels ServiceNow to a whole new stratosphere.
ServiceNow, like a lot of other cloud players, is also investing significantly in Artificial Intelligence (AI). ServiceNow made six acquisitions in the machine learning/AI arena in the last four years, which is now starting to pay off with the release of new products. This includes its new predictive intelligence workbench, which makes it easier for process owners to detect issues, while also suggesting relevant tasks and prioritizing incoming requests automatically. While their growing AI capabilities could lead to some new products, I mainly see it strengthening existing offerings.
For sustained innovation that could open up new markets, ServiceNow has a growing team focused on incubating new product ideas called NowX. The first new product out of this incubation team is a Finance Operations Management solution, with others on the way.
ServiceNow is a $98 billion company (as of October 14th). As a large company, the stock's best growth days may be behind it. However, I do see meaningful value upside if they grow their share in the PaaS market. Is it a future 10 bagger? Unlikely. But, can I see it doubling in size over the next five years if they continue to execute? Yes.
ServiceNow is led by Tech veteran Bill McDermott. Prior to taking over as CEO of ServiceNow, Mr. McDermott was CEO of German software giant SAP.
Since taking over as CEO in 2019, McDermott has developed a stellar reputation with ServiceNow employees. I believe employees are the best judge of a CEO and in the case of Mr. McDermott they have given him an employee approval score of 98% on Glassdoor.
McDermott is a seasoned and proven tech CEO. I have no doubts about his leadership and likelihood to continue ServiceNow's growth as they enter a new phase as a company.
Key Metrics
ServiceNow excels in some key performance areas. Existing customers are spending more with them each year (net expansion rate) and they have great margins. Their growth rate is reasonable for a company of their size. They are not cheap at a 25 Price to Sales ratio, but not out of line given the overall frothiness of the tech sector, especially cloud stocks.
My Bottom Line
ServiceNow is a great enterprise software company, with proven leadership that is executing on all fronts. This is not a surprise to anyone and it is the reason for their current high valuation. Where I see some potential upside is they are in the process of transforming from a Software-as-a-Service (SaaS) business into the powerful combination of SaaS plus Platform-as-a-Service (PaaS). SalesForce has shown what can happen to a stock when this transition is successful. ServiceNow is still in the early innings of this transformation and I believe they are better positioned for PaaS dominance then SalesForce ever was or is because of the support they receive from IT decision makers. They could also be doing this under the nose of Wall Street who doesn't appear to be talking much about this important growth driver.
I have a small, starter position in ServiceNow but I'm NOT ready to issue a recommendation. I will provide a formal recommendation (or not) in a few weeks when I publish the results of my analysis of four cloud platform providers powering digital transformation, including Fastly, Alteryx, PagerDuty and now ServiceNow.
Stay tuned.
Follow me on Twitter @OwlWealthy to read my analysis when it's fresh off the press.
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