The Short Thesis for Cloud Computing Company, ServiceNow Inc

We believe that ServiceNow Inc (NYSE:NOW) (“NOW” or the “Company”) is highly overvalued. We are short the stock.

ServiceNow Inc (NYSE:NOW) was taken public earlier this year at $18/share and has since ridden the cloud computing wave to a price of $30/share, implying an eye-popping 18.3x 2012E revenue multiple. Even if ServiceNow becomes the market leader and grows its share of the $1.5bn IT Help Desk market from the current 10%-15% to 30%, we believe the stock is still worth less than half of its current trading price.

We have spoken to numerous industry professionals about ServiceNow and the IT Service Management (“ITSM”) sector, and our research indicates that ServiceNow Inc (NYSE:NOW) does not have a sustainable competitive advantage over its numerous public and private peers. The Company has become a victim of its own success by helping to galvanize a previously dormant industry to rapid innovation. NOW does not offer a unique technology; rather, it merely introduced the SaaS business model to a sector where slow-moving incumbents had frustrated certain segments of their customer base through cumbersome upgrades and lumpy up-front costs. Its adoption of a SaaS solution, combined with an aggressive salesforce, helped NOW gain market share at the expense of larger players.

Today, however, the competitive landscape is changing, with both incumbents and a slew of new upstarts featuring SaaS offerings similar to NOW’s products, and many at lower price points. The result has been predictable: NOW’s once enviable growth is rapidly decelerating. The first signs of this became apparent when the company reported its third quarter earnings – NOW declined 12% after reporting slowing growth in the third quarter and projecting further decelerating growth in the upcoming quarter.

We also believe that ServiceNow Inc (NYSE:NOW) is burdened with many of the same problems as legacy systems. Like hosted software, ServiceNow’s fully-customizable, programmable code can lead to long implementation times, problems during software upgrade cycles, and increased total cost of ownership (“TCO”). These problems will only be exacerbated as NOW’s customer count continues to grow and its legacy customers begin to voice concerns.

From a catalyst perspective, the market may view NOW’s Amended S-1 filing and the VCs’ rush to unload their shares into the market as sufficient reason to reduce the stock’s valuation multiple to a more reasonable level. Once the Amended S-1 offering doubles NOW’s public float and investors begin to scrutinize future lock-up expirations, institutional demand for shares could begin to wane, dragging down NOW’s share price.

Given ServiceNow’s absurd $4.7 billion market capitalization, when compared to its projected 2012 revenue of $239m, we think NOW’s share price is poised to collapse. The market is gradually digesting the company’s decelerating growth trends, and as NOW’s lockup expires, we believe the market will send the stock materially lower.

Below are key reasons why NOW’s share price should plummet:

  • NOW’s decelerating growth rates in Q3 and Q4E are only the beginning. NOW’s market shares gains have not been driven by technology, patents or enhanced R&D; rather, they are the function of ServiceNow offering a SaaS ITSM help desk solution for customers who were disenchanted with the incumbents’ on-premise offerings due to cumbersome upgrades, unpredictable costs, and a lack of customization flexibility. While that helped NOW gain initial momentum, the marketplace is meaningfully changing, with virtually all players introducing SaaS offerings. BMC is quickly expanding its RemedyForce segment and has introduced the user-friendly MyIT offering. Hewlett-Packard Company (NYSE:HPQ) has reworked its help desk product with the release of Service Anywhere, a SaaS-based ITSM upgrade designed for what it calls “codeless configuration”. Smaller players like Cherwell Software, EasyVista, and Hornbill are offering competitive SaaS solutions that are winning business and gaining share. The increased competition should pressure NOW’s overall growth rate as well as reduce market pricing, rendering ServiceNow’s historical growth rates unsustainable. Finally, the low-hanging fruit in terms of customer wins is rapidly drying up. NOW’s prior client wins have been fueled by frustrated customers who had no qualms about switching from on-premise to SaaS; future wins will have to come from customers who may not be as aggravated with BMC’s or HP’s on-premise offerings or, for small- and mid-sized businesses, may prefer a simpler out-of-the-box solution from Cherwell, Hornbill, EasyVista, or other private competitors.
  • The overall ITSM market size is only $1.5 billion, less than one-third of NOW’s $4.7 billion market capitalization. Leading technology research firm Gartner estimates that the IT Service Management market opportunity is $1.5 billion, and is growing at a modest 7% per year. Furthermore, Gartner’s research predicts that only 50% of IT organizations will move to SaaS by 2015, implying that the total market opportunity for NOW’s ITSM business is less than $1 billion. Given emerging competition from other SaaS ITSM service providers, we believe that the company will have a difficult time exceeding 30% market share. At $207m of LTM revenue, NOW appears to already control 10% to 15% of the market. So even if NOW’s market share rises to 30%, which we don’t see happening until 2014 at the earliest, NOW’s ITSM business should be generating less than $600 million revenue with limited additional growth opportunities. The result of the limited market size and increasing competition will be flattening growth over the next few years.
  • We see limited evidence that NOW is generating meaningful business outside of its core ITSM help desk offering. In order to inflate its addressable market size, NOW management claims to have created revenue opportunities beyond the IT Help Desk with its Discovery and Runbook Automation products. These modules contain additive functionality designed for the Configuration Management and Workload Automation software markets used by IT departments. But analysis from Gartner, Inc. (NYSE:IT), Citigroup Inc. (NYSE:C), and our research all indicate that ServiceNow’s simplistic products have yet to capture more than a negligible share of either market opportunity. ServiceNow has yet to even make it into Gartner’s Magic Quadrant for Workload Automation or its categorization of Configuration Management providers, which summarize the leading vendors in each discipline.
  • ServiceNow’s PaaS is unproven and outmatched. NOW’s PaaS offering faces daunting challenges. The product’s closed platform and lack of off-the-shelf third-party applications strikes us as too flawed to succeed against entrenched platforms from the likes of Google Inc (NASDAQ:GOOG), salesforce.com, inc. (NYSE:CRM), and Microsoft Corporation (NASDAQ:MSFT). ServiceNow’s PaaS uses a largely closed, “single-tenant” system that does not easily integrate with outside software applications, complicating its ability to integrate best-of-breed tools that come from outside the ServiceNow ecosystem. For these reasons, we don’t believe that PaaS can grow into the type of revenue driver that could justify NOW’s lofty valuation. In fact, the closed nature of NOW’s PaaS offering could be a long-term shortcoming of NOW’s Help Desk product versus more open solutions like Remedyforce, which integrates with the Force.com platform.
  • ServiceNow’s Help Desk product has many of the same flaws as its legacy competitors’, including long implementation times, complexity during software upgrade cycles, and daunting upfront coding costs. After numerous calls with customers and Help Desk experts, we believe that NOW falls well short of fully addressing the industry’s pervasive problems. Should a customer require customized functionality, as many do, it can take 6-8 months and tens of thousands of dollars in implementation costs to get NOW’s system up and running. Furthermore, a ‘pure’ SaaS offering should have a multi-tenant design, meaning that the underlying code is shared by all users in the cloud. This makes regular software updates simpler and vastly reduces the time and costs required for upfront implementation. And if an enterprise-class customer needs a high degree of customization, then a non-SaaS, hosted system like BMC Remedy may be comparable. For these reasons, we think it’s a mistake to assume that the Company’s growth can remain head and shoulders above its rapidly evolving competition over the next 1-2 years.
  • Given ServiceNow’s limited market size, competitive pressures within the SaaS ITSM sector, unproven PaaS product, and uninspiring technology when one looks past its more commodity ITSM offering, the math behind NOW’s valuation simply does not add up. ServiceNow reported 13% sequential revenue growth in Q3 and has projected about 10% sequential revenue growth in Q4. Even if it beats guidance in Q4, sequential quarter-over-quarter growth will likely decline below 10% in 2013 and probably below 5% by 2014, which implies annual revenue growth of 20% to 30%. The current 18x 2012E revenue is a preposterous multiple given the slowing growth and numerous business challenges NOW will face.
  • From a technical standpoint, the Company’s looming lockup expiration on December 26th, as well as its recent S-1 which allows certain insiders to sell shares before the lockup expiration, should exert downward pressure on shares. Only 11% of NOW’s float is publicly traded (13.4m of its 123m unadjusted shares) but that should soon increase as lockups expire and as its highly dilutive option pool (37m; $4.48 strike) is exercised. ServiceNow’s non-trading shares were supposed to be locked-up until the day after Christmas, but according to a recently filed secondary S-1 (the “Amended S-1”), the Company has modified this lock-up and plans to sell 13.4m new shares at an earlier date. This will approximately double the public float. Should the underwriters exercise their greenshoe, as is typical, NOW will dilute its existing shareholders with 1.9m new shares. The remaining 11.5m shares (assuming the greenshoe is exercised) are being sold by NOW’s venture capital investors. NOW also has an enormously dilutive option pool consisting of 37m options struck at an average price of $4.48, creating a dilutive effect of 32m shares at the current share price. Certain financial databases, industry press, and even Wall Street analysts completely overlook this option number in their valuation calculations. Finally, following an initial IPO price range of only $15-$17, NOW shares have since traded up to $30 on very little news (shares moved up 5% after a Q1 2012 revenue beat). We believe this run has been partly caused by NOW’s ‘thin float’ or ‘sliver sale’ initial public offering, a practice that even Jim Cramer eviscerates as reckless. ServiceNow sold 13.4m of its 123m common shares in the June 2012 IPO. By creating a mismatch between supply and demand, these thin floats can artificially drive up demand for shares, thereby inflating share prices in the hopes that it remains at elevated levels through the lock-up period.

In our report, we address the above concerns in detail and their implications to value.

Kerrrisdale Capital and our clients are short and own options on the shares of ServiceNow. We stand to benefit in the event of a price decline in NOW shares, and will transact in the securities subsequent to this email. Please read our full disclaimer at the end of the report.

NOW Report November 2012