ServiceNow’s upcoming earnings report is of high interest to us. There are many key metrics to highlight, including the company’s ability to re-accelerate subscription revenues to 27% YoY in the previous quarter, up from 22% a year ago. RPO also accelerated nicely to 29% YoY growth up from 22% in the year ago quarter. Net New ACV (NNACV) was up 33% YoY compared to 30% in the year ago quarter with the number of transactions over $1M in NNACV more than doubling QoQ from 83 to 168 transactions.
The CFO stated that the company’s generative AI product, Now Assist, contributed to the recent raise for FY2024 guidance of $165 million. However, gen AI’s contribution is very new and not too impactful yet, per management.
ServiceNow is the rare cloud company that is GAAP profitable and has a strong free cash flow margin of 30% for FY2023.
This report dives deeper into the elements that underpin ServiceNow’s optimism, including an examination of its financial health, strategic initiatives, and the anticipated impact of its AI-driven products on the market.
Key Points:
- Q4 2023 Revenue Performance: ServiceNow reported a 25.62% increase in Q4 revenue, reaching $2.44 billion. QoQ growth improved by 6.6%, with expected Q1 revenue of $2.59 billion, marking a 23.5% year-over-year increase.
- Robust Subscription Growth: ServiceNow's subscription revenues reached $2.37 billion, growing 27% YoY and exceeding revenue guidance of $2.32 billion and growth of 24.75% at the mid-point and $2.32 billion, while professional services declined by 10% YoY in Q4 and 18% for the year.
- Expansion and Strategic Alliances: ServiceNow enhanced its OT management capabilities with acquisitions of 4Industry and Smart Daily Management, collaborated with Hugging Face and NVIDIA on the StarCoder2 LLM, expanded its partnership with NVIDIA for telco-specific AI solutions, deepened its alliance with EY for AI compliance, and launched new payment and AI-powered solutions through strategic alliances with Visa and AWS.
- Mixed Margin Performance: ServiceNow experienced mixed margins year-over-year, with improvements in operating and net margins, while gross and subscription margins saw slight declines.
- Operational Efficiency and Investment Strategy: The company is raising its full-year operating margin target from 28% to 29% due to continued operational efficiencies. Investments are focused on innovation in AI, particularly Gen AI, with significant hiring in R&D to drive these initiatives.
- Strong Growth Outlook with GenAI Focus: According to management, the newly launched Gen AI product, Now Assist is contributing to the company’s largest net new ACV. This segment saw 168 deals greater than $1 million, up 33% YoY.
- Strategic Gains Across Segments: Despite challenges in the market environment, ServiceNow closed numerous large deals globally, including a record number of new $1 million+ deals and major wins in the public sector such as with the US Army and Australian Department of Defense.
Revenue and Earnings:
ServiceNow reported fiscal Q4 revenue of $2.44 billion for an increase of 25.62% YoY. This is a 6.6% improvement QoQ from $2.29 billion in revenue. The growth rate was 24.96% in the September quarter, and thus, December marked a slight acceleration. In terms of being seasonal or not, this did not occur last year, rather the December 2022 quarter decelerated by 90 basis points in growth rate.
ServiceNow is expected to see slightly slower growth next quarter at 23.5% for revenue of $2.59 billion. For the full year, analysts are expecting growth of 21.4% for revenue of $10.89 billion.
The performance in Q4 was packed with milestones for ServiceNow, spanning the full breadth of their portfolio. Each of their workflow businesses, technology, customer, and creator, are over $1 billion in annual contract value (ACV). And the company has 11 individual product lines with north of $250 million in ACV.
ServiceNow ended Q4 with 1,897 customers paying over $1 million in ACV adding 108 customers compared to the prior quarter. This is the addition in $1M customers in the past five quarters.
The company closed 168 deals greater than $1 million in net new ACV (NNACV) in the quarter, a 33% increase year-over-year, that includes five deals over $10 million. Interestingly, this was over 100% growth QoQ.
For the full year 2023, ServiceNow saw an approximate 30% increase in deals greater than $1 million in net new ACV.
Despite this, total ACV only increased 15% in Q4 2023 compared to the prior year period. This is down from 17% growth in the previous quarter and down from 22% in the year ago quarter.
Remaining Performance Obligations (RPO) and current Remaining Performance Obligations (cRPO) are two popular metrics to track for ServiceNow.
RPO ended the quarter at approximately $18 billion representing an acceleration to 29% YoY. This compares to growth of 26% in the previous quarter and compared to growth of 22% in the year ago quarter.
cRPO was $8.6 billion, representing 24% YoY which was down from 27% in the previous quarter although was up from 22% in the year ago quarter.
Gen AI products, via Now Assist, drove the largest net new ACV contribution for the first full quarter of any of ServiceNow’s new product family releases ever, including the original Pro SKU.
ServiceNow topped analyst estimates on both the top line and bottom line. Analysts were expecting GAAP EPS of $1.43, non-GAAP EPS at $2.78 and revenue of $2.4B, while the company reported GAAP EPS at $1.46, non-GAAP EPS at $3.11and revenue at $2.44B. Even though the company’s earnings growth is expected to slow in 2024, management is still anticipating solid double-digit growth for the year.
Revenue Segments:
In Q4, subscription revenues were $2.37 billion, growing 27% YoY, exceeding the high end of the company’s guidance. ServiceNow closed out 2023 with $8.68 billion in subscription revenues, also representing 27% growth compared to fiscal 2022 subscription revenues. The CFO Gina Mastantuono had this to add on subscription revenues, “All organic at a scale that hasn't been accomplished by any other enterprise software company.”
Professional services and other revenues were $72 million for Q4, a (-10%) decrease YoY. For the full year of fiscal 2023, professional services and other revenues amounted to $291 million, representing an (-18%) decline YoY.
With regards to ServiceNow’s total addressable market (TAM), the CFO commented on a major milestone: “For the first time in a decade, IT services will become bigger than communication services in 2024. Gartner estimates that by 2027, nearly all of the growth in worldwide IT spending will come from software and IT services. And when you drill deeper into the Gartner forecast between 2023 and 2027, $3 trillion will be spent on AI.” This speaks to size and growth of the total addressable market for ServiceNow.
Margins:
Margins were mixed YoY as the company's focus on low-margin AI products is evident in its financial outcomes. Operating margin and net margin improved, while gross margin and subscription margin declined slightly YoY.
Non-GAAP subscription gross margin dipped to 84% in Q4 2023, flat QoQ but a decrease from 86% in Q4 2022. The company expects this margin to improve slightly to 84.5% in 2024, reflecting investments in data centers and emerging growth opportunities, partially offset by a change in useful life in data center equipment from four to five years. ServiceNow is also raising its full year non-GAAP operating margin target from 28% to 29% driven by continued operational expenses efficiencies.
Margins were a topic in the conference call with one analyst congratulating the company on the performance in 2023, with the CFO adding the expectation those margins will continue to expand in 2024.
Cash Flow:
Operating cash flow of $1.61 billion in fiscal Q4 represented a margin of 66%. Free cash flow of $1.34 billion represented a FCF margin of 55%.
There is $8.1 billion in cash and investments on the balance sheet and $1.49 billion in debt. Debt has remained constant since Q4 2022 with no amounts due in the next twelve months.
ServiceNow announced that the company repurchased 400,000 shares of its common stock for $256 million as part of its share repurchase program.
Earnings Call:
ServiceNow is expecting strong growth yet again in 2024 with GenAI being a central part of the bullish view for the stock. Analysts had a lot of questions on the topic.
GenAI
ServiceNow’s new Gen AI product, Now Assist, was stated to have “drove the largest net new ACV contribution for our first full quarter of any of our new product family releases ever.” Therefore, it’s not surprising to see it as a key topic during the Q&A.
And despite the very strong performance in Q4 and fiscal year 2023, it brought out a few interesting takes from management, specifically on the environment they face as we head into 2024.
Here is what the CEO stated when asked about the Gen AI product driving the largest net new ACV contribution:
“What's really happening and I can say this after 186 CEO meetings in the last six months, the CEOs are now getting very involved with the Gen AI revolution. They realize there has to be architectural adjustments to their environment and the manner in which they manage their data and the platforms they're beholden to actually take advantage of Gen AI.
And if you think about the half a century mess that exists out there with legacy systems, in many cases, multiples of the same system, we have one unifying force in these conversations, which is the Now platform because we cooperate with the complexity of this landscape without putting people in a position to rip and replace […]
As I said, that SKU has outsold any other new introduction we put into the marketplace. So, there's a real appetite to invest in Gen AI, and there's no price sensitivity around it because the business cases are so unbelievable. I mean if you're improving productivity, 40%, 50%, it just sells itself.”
Overall, this is an encouraging note on the sales environment along with the potential of the Gen AI segment for ServiceNow. It’s not a huge revenue driver at the moment, but the trajectory means it could become a key driver of growth in 2024 and beyond.
Here’s what Gina had to add about Gen AI during the call.
I get the question often, do we see the adoption curve to be steeper for our Pro Plus than our Pro. Certainly, in the first full quarter of launch, it absolutely has shown that.
That being said, it's very early days. And so from a revenue contribution perspective, it's not going to be huge, but it's certainly helped when I thought about my guide for 2024 and that increase of $165 million at the midpoint, right? So Gen AI, early days, but the adoption curve so far is steeper than the original Pro. We will keep an eye on it.but it's certainly helped when I thought about my guide for 2024 and that increase of $165 million at the midpoint, right? So Gen AI, early days, but the adoption curve so far is steeper than the original Pro. We will keep an eye on it.
Net New ACV
ServiceNow’s new logo count continued to accelerate in Q4, with a record 10 new customers signing deals over $1 million in NNACV, including a $10 million win with a very large global financial services firm, which is their largest new customer logo in history.
Chipotle, Air France, TIAA, NTT, Data Group Corporation, and Busch are some of the brands that are utilizing ServiceNow to enhance their operations.
Additionally, in Q4 ServiceNow built on a record Q3 with the public sector, with key wins including in the United States Army, US Postal Service, and Australian Department of Defense Digital Delivery Group.
During the call, one analyst wanted more details on the drivers of the momentum in ACV.
Bill McDermott:
Just a couple of statistics on the customer workflows, 18 of our top 20 deals, what we're seeing is there's a tremendous opportunity to really take ServiceNow and squarely place it on the Customer Relationship Management category.
When you think about front, mid and back office and the fact that we can align all three of those things, and nobody has to lose for us to win. We could fill in all the blanks for what the current participants don't do, especially with their integration problems. It's just a fantastic opportunity for our customers.
And I think it's important to note, when I gave the Field Service Management example, our net new ACV in Field Service Management, specifically was up over 50% and year-over-year.
So, I think it's important to recognize that we have a whole list of new logos in this space. And employee workflows, nine of our top 20 deals and was kind of interesting. Every single CEO now is looking to make the people packed far more productive than it is and with natural language to have your employees seek the data and the information they want and have it reported back to them in just a very nice paragraph of content and data so they can do their jobs better, is kind of like in the no-brainer category.
RPO and cRPO
RPO and cRPO are key indicators of growth and future projections for ServiceNow. Analysts were zeroing in on what the upside is for the current quarter, Q1 2024, and how much is due to Gen AI adoption.
Gina Mastantuono:
So, we beat our Q4 cRPO growth guidance by 200 basis points as you know. And I would say it's driven probably half and half by net new ACV outperformance and certainly, Gen AI is in there, but it's not all Gen AI.
So, our core business is also doing well. And then we also did see higher early renewals than we had assumed in our guidance. And I would say it's about half and half of the total beat.
Government:
The government is a very strong potential growth area for ServiceNow. A few analysts wanted more details.
They asked about cyclical spending at the public sector and what their AI adoption cadence is going to look like.
Here’s Bill’s take:
Our federal business is really outstanding. And for the benefit of our shareholders, I think that there's a tremendous opportunity to replicate what we're doing in the United States federal and many other governments around the world. That is clearly an ambition that we have, and we have many use cases and many references to back that up.
Recent AI Announcements:
On March 18, 2024, ServiceNow announced it has signed an agreement to acquire 4Industry, a Netherlands‑based partner whose manufacturing technology application is built on the Now Platform, and has completed the acquisition of Smart Daily Management, a connected digital worker application from EY. Together, the deals augment ServiceNow’s existing operational technology (OT) management capabilities, adding Connected Worker solutions and enhancing expertise across key industrial markets such as manufacturing, energy and transport & logistics.
On February 28, 2024, ServiceNow, Hugging Face, and NVIDIA, announced the release of StarCoder2, a family of open‑access large language models (LLMs) for code generation that sets new standards for performance, transparency, and cost‑effectiveness.
On February 26, 2024, ServiceNow and NVIDIA announced that they are broadening their relationship with the introduction of telco‑specific generative AI solutions to elevate service experiences.
On January 24, 2024, ServiceNow announced a broader strategic alliance with EY to empower responsible AI use for enterprise customers, deliver unified solutions for AI compliance and governance, and bring AI‑enhanced experiences to EY employees and clients with ServiceNow Now Assist.
Additionally, ServiceNow and Visa announced a five‑year strategic alliance to transform payment services experiences. The initial phase includes the launch of ServiceNow Disputes Management, Built with Visa–– a single, connected solution for disputes resolution.
ServiceNow also announced a five‑year Strategic Collaboration Agreement with Amazon Web Services (AWS) to offer the ServiceNow Platform and full suite of solutions in the AWS Marketplace. The two companies will also co‑develop and launch industry‑specific, AI powered applications.
Conclusion:
The key metrics on ServiceNow help to create a picture that something special is going on at this company compared to many cloud peers. As with nearly every stock in the market right now, investors must contend with valuations. This is one thing if you’ve owned a stock for some time and are sitting on gains, but is a bigger risk if you’re wanting to enter now for the initial entry. We’d like to keep ServiceNow in our pipeline to buy at lower levels, while also keeping an eye on the upcoming earnings report to see if any new information changes that decision. As always, each investor must determine their own unique risk profile for themselves. For our purposes, we view ServiceNow as fairly valued at 17 PS ratio compared to a 17 PS ratio 5-year median and 15.5 PS ratio 3-year median. The bottom line is only recently GAAP profitable and trades at a 88.6 PE Ratio compared to 5-year median of 1826 (noisy signal). Price to free cash flow is at 56 compared to a 5-year median of 52.6. Therefore, for our purposes, it makes sense to try and get the stock lower since the probability it can stretch higher (and sustain a higher valuation) is low.
Chad Shoop, Equity Analyst for the I/O Fund, contributed to this analysis
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