Is ServiceNow Inc. (NOW) A Smart Long-Term Buy?

Palm Capital, an investment management firm, published its first quarter 2021 investor letter – a copy of which can be downloaded here. Over the three months ending 31 March 2021 the portfolio increased by 3.1% after management fees & trading expenses. Over the same period our benchmark, the MSCI World Index, increased by 4.5%. You can view the fund’s top 5 holdings to have a peek at their top bets for 2021.

Palm Capital, in their Q1 2021 investor letter, mentioned ServiceNow, Inc. (NYSE: NOW), and shared their insights on the company. ServiceNow, Inc. is a Santa Clara, California-based software company that currently has a $94.6 billion market capitalization. Since the beginning of the year, NOW delivered a -12.96% return, while its 12-month gains are up by 29.27%. As of May 03, 2021, the stock closed at $490.32 per share.

Here is what Palm Capital has to say about ServiceNow, Inc. in their Q1 2021 investor letter:

“ServiceNow provides software solutions to structure and automate various task and processes for large businesses. The company began in 2004 with a solution to help businesses manage the IT services they offer employees and customers. Unlike the existing solutions in the market, ServiceNow’s offering was built using modern architecture that was flexible, modular, and user-friendly. And it left the incumbents – large companies such as BMC, IBM and MicroFocus – playing catch up.

As the company grew to dominate this market, it saw the opportunity to expand its offering to include the broader task of IT Operations Management – or the monitoring and control of an entire business’s IT infrastructure. And over time its success in
improving productivity and user experience in IT resulted in customers asking the company to expand its offering into other business
workflows including HR Management and Customer Services – which it has since done.

All ServiceNow’s applications (including those built by customers and third parties) are built on its ‘Now’ platform. This allows the company and its customers to innovate and deploy new solutions quickly. And it helps ServiceNow gather a large amount of data to gain insights into and use machine learning to build solutions to meet customer needs in other areas. Crucially, this platform can interface with other SaaS and legacy software services used by its customers. Not only does this allow an IT department to manage all the myriad software services used by a business from a single point of control, it also reduces the operational disruption risk for those transitioning from legacy software systems to the cloud.

Aside from the ease of use of ServiceNow’s offerings, the other factor driving its growth is that its ‘land and expand’ strategy starts in the IT department of customers – the very department whose task it is to recommend other software solutions for businesses. It is therefore no surprise that more than 75% of ServiceNow’s customers use more than one of its products and 80% of its new business is from existing clients.

The company now serves almost 400 of The Fortune 500 companies and counts 6,900 of the largest enterprises globally as customers. Since listing in 2012, its sales have grown 18-fold from $0.2b to $4.5b – yet another illustration of the pace with which the internet enables businesses to grow and the pace at which digitization is occurring.

Importantly, ServiceNow has a strong switching cost advantage. IT Operations Management is mission critical as businesses cannot afford to risk the failure of IT equipment or software given the growing dependence on digital systems. Furthermore, these services tend to have long lifecycles as change involves an investment of time and money as well as operational disruption. And this lock-in is strengthened as customers build more and more solutions on the Now platform. As evidence of the switching cost advantages, ServiceNow’s retention rates – the percentage of existing customers who are still customers a year later – have never fallen below 97% since listing.

ServiceNow has a long runway of growth ahead. Not only are its existing markets growing in the high single digits as businesses digitize, it is disrupting its existing markets and entering new markets as it develops new products. Furthermore, its customers are also upgrading to premium versions of products. Management estimate that its total addressable market is in the hundreds of billions. Our conservative estimates point to a number comfortably north of $100b. This is significant relative to its current revenue and given the superiority of its products and entrenchment with its customers’ businesses.

What is remarkable about ServiceNow is that it is able to sustain such strong growth while still generating high free cashflow margins – currently above 20%. And these margins will only expand over time as its operating expenses of product development, distribution and marketing decline as a percentage of sales. For example, its marketing spend is currently 40% of sales but according to our calculations, this is yielding returns well above 300%.

ServiceNow is run by a highly rated management team. Its founder is still Chairman. And while its CEO and CFO have recently
changed, the new CEO, Bill McDermott left enterprise software titan, SAP, to join the company. Furthermore, the company has substantial management depth.

The company has a net cash position of $1.5b on its balance sheet and generated $1b of free cashflow in 2020 that we expect to grow above 20% per annum over the next five years. Based on the price we paid for the business, we expect to earn more than 8% per annum in US$ from our investment and it is the type of business we would like to own for a long time.”

Our calculations show that ServiceNow, Inc. (NYSE: NOW) ranks 25th in our list of the 30 Most Popular Stocks Among Hedge Funds. As of the end of the fourth quarter of 2020, ServiceNow, Inc. was in 96 hedge fund portfolios, compared to 82 funds in the third quarter. NOW delivered a -17.99% return in the past 3 months.

The top 10 stocks among hedge funds returned 231.2% between 2015 and 2020, and outperformed the S&P 500 Index ETFs by more than 126 percentage points. We know it sounds unbelievable. You have been dismissing our articles about top hedge fund stocks mostly because you were fed biased information by other media outlets about hedge funds’ poor performance. You could have doubled the size of your nest egg by investing in the top hedge fund stocks instead of dumb S&P 500 ETFs. Here you can watch our video about the top 5 hedge fund stocks right now. All of these stocks had positive returns in 2020.

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Disclosure: None. This article is originally published at Insider Monkey.