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ServiceNow: Solid Fundamentals with Support from Wall Street
Stock Analysis & Ideas

ServiceNow: Solid Fundamentals with Support from Wall Street

ServiceNow (NYSE: NOW) provides cloud computing solutions that structure and automate services for businesses.

It offers workflow automation, artificial intelligence, and performance analytics. We are neutral on the stock.

Competitive Advantage

There are a couple of ways to quantify a company’s competitive advantage using only its income statement. The first method involves calculating the earnings power value (EPV).

Earnings power value is measured as adjusted EBIT after tax, divided by the weighted average cost of capital, and reproduction value can be measured using total asset value. If earnings power value is higher than reproduction value, then a company is considered to have a competitive advantage.

The calculation is as follows:

EPV = EPV adjusted earnings / WACC
$9.2 billion = $715 million / 0.078

Since ServiceNow has a total asset value of $9.5 billion, we can say that it does not have a competitive advantage. In other words, assuming no growth for ServiceNow, it would require $9.5 billion of assets to generate $9.2 billion in value over time.

The second method is by looking at a company’s gross margins, because it represents the premium that consumers are willing to pay over the cost of a product or service. An expanding gross margin indicates that a sustainable competitive advantage is present.

If an existing company has no edge, then new entrants would gradually take away market share, leading to decreasing gross margins as pricing wars ensue to remain competitive.

Image created by the author

Taking a look at ServiceNow, we can see that gross margins have expanded in the past several years. As a result, its gross margins indicate that a competitive advantage is present in this regard.

Profitability

Most investors appear to be obsessed with earnings. This is especially true for institutional investors who tend to overreact to the slightest earnings miss. However, these paper profits have the potential to be very misleading, which is why we prefer to focus on free cash flow.

In the last 12 months, ServiceNow has recorded $1.6 billion in free cash flow, making it profitable by our definition. This indicates that the company doesn’t have to rely on equity raises to continue funding its growth.

More importantly, its free cash flow has been trending up in recent years. To us, this means that the company’s free cash flows are reasonably predictable.

Image created by the author

Risks

To measure ServiceNow’s risk, we will first check to see if financial leverage is an issue. We do this by comparing its debt-to-free cash flow. Currently, this number stands at 1.0. In addition, when looking at historical trends, we can see that the debt-to-free cash flow ratio has been trending down.

Overall, we don’t believe that debt is currently a material risk for the company because its interest coverage ratio is 56.0 (calculated as free cash flow divided by interest expenses).

However, there are other risks associated with ServiceNow. According to Tipranks’ Risk Analysis, the company disclosed 32 risks in its most recent earnings report.

The highest amount of risk came from the Finance & Corporate category. The total number of risks has increased over time, as shown in the picture below.

Wall Street’s Take

Turning to Wall Street, ServiceNow has a Strong Buy consensus rating, based on 25 Buys, two Holds, and zero Sells assigned in the past three months. The average ServiceNow price target of $748.81 implies 31% upside potential.

Conclusion

ServiceNow is a company with a solid underlying business. Although it doesn’t have a theoretical competitive advantage when using the earnings power value, its expanding gross margin indicates that a competitive advantage may actually be present in reality. This is also demonstrated by its growing free cash flow.

Nonetheless, we remain neutral on the stock due to the overall uncertainty in the market caused by rising interest rates.

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