Kerrisdale Capital:  ServiceNow Inc (NYSE:NOW): Widespread Mistakes in Analyst Share Counts Fuel Overvaluation

Kerrisdale Capital:  on ServiceNow Inc (NYSE:NOW)

It’s certainly been

a year to remember for investors, with the benchmark S&P 500 up 30%, the tech-heavy NASDAQ-100 up 37%, and many sectors, including cloud computing, rising further yet. Last year provided great opportunities to make money, as every dip in the market has been an excellent buying opportunity.

 

But we think the tech euphoria has gotten out of hand in certain sectors. In many ways, the investing community seems to be repeating its mistakes from the irrational exuberance of the late 1990s. Many investors are buying stocks not due to fundamentals, but rather due to sexy-sounding stories of future growth combined with momentum:as in that previous internet tech era, people are again buying stocks principally because the stocks are already rising and have garnered investor enthusiasm.

In the case of ServiceNow (NOW), we’ve already spent a good deal of time focusing on the very low likelihood that the company can grow into its valuation. Longs are overestimating ServiceNow’s addressable markets and software capabilities. Investors were shown another red flag last Thursdaywhen NOW’s Chief Technology Officer, Arne Josefsberg, who joined the business in October 2011 after 25 years with Microsoft, unexpectedly resignedfrom his position.

 

But enough has been said about ServiceNow’s business prospects. We’d rather focus on the more basic similarities between the current environment and 1999. One of the most jarring flashbacks has been the return of extremely sloppy and dubious sell-side research. While we have not quite hit the excesses of the tech bubble yet, we’re seeing disturbing reminders of that past mania.

 

During the 1990s tech boom, abuses within equity research led to SEC enforcement actions, industry bans and a litany of new regulations to curtail the ongoing tacit barter of stock promotion for investment banking business. Reg FD was enacted in 2000, Henry Blodget was banned from the industry and “Chinese Walls” sprang up all over the industry.

Ten years later, it appears that history is repeating itself. With the IPO and secondary offering market as hot as they’ve been in ages, it seems that banks may again be putting deal-making ahead of quality research.

 

In the specific case of ServiceNow, analysts have gotten sloppy on one of the most basic facts of equity valuation: the number of outstanding shares of common stock. Visit a basic finance website such as Yahoo Finance or Google and you’ll see 138.7 million shares of ServiceNow, leading to a market cap of about $8.05bn at the current $58 share price. You could forgive an ordinary retail investor for assuming that this information is accurate.

 

However, professional investors should always be aware of the total capital structure, rather than just the number of current outstanding shares, which is one of many inputs to determine valuation. In the case of young companies, particularly in technology, analysts can’t overlook stock option grants to employees. Since tech startups tend to be short on cash and long on blue sky potential, they forgo paying higher compensation in the short-run and defer it via options. Usually this doesn’t make too much of a difference in the long run, but if a company is particularly successful, and/or its shares perform exceedingly well, the impact of options grants given to executives and early-hire employees can be dramatic.

 

ServiceNow has more than 25 million outstanding in-the-money stock options, in addition to almost 5 million restricted stock units (“RSUs”) (2013 10-Q3). With the options having an average strike price of $8.12 and RSUs providing no future cash to ServiceNow’s treasury at all, these 30 million issued shares represent a tremendous dilutive overhang to the company’s share count. When these 30 million shares convert into common stock, the company will raise only ~$200 million in proceeds but be burdened with $1.75bn of newly traded common stock.

In reality there are 169 million shares of ServiceNow, or 165.4 million using the treasury stock method, rather than the 139 million you see reported at sites such as Yahoo or Google. And it’s excusable that these free finance sites are wrong; you get what you pay for. This is why an investor should always check a company’s filings rather than simply trusting a free website’s computer-generated financial information.

It’s less excusable when professional equity research analysts, trained at top business schools and working at prestigious investment banks, are no more reliable than Google Finance. We first noted a year ago that several bulge bracket analysts were overlooking the option pool. We figured that analysts would quickly correct what we figured was merely a simple oversight.

 

But it’s now been more than a year, and analysts are still willingly sticking with their clearly inaccurate numbers. Numerous banks continue to mislead clients with wildly inaccurate share counts and market capitalizations for ServiceNow.

 

Data to calculate the correct share count is easily found in ServiceNow’s latest 10-Q3 2013:

 

Here, we see 138.7 million shares of common stock, 4.8 million Restricted Stock Units (RSUs), and 25.5 million outstanding stock options. RSUs cost employees nothing to exercise, so those are virtually assured to turn into common stock as they vest. Now let’s check the outstanding options to see where their strike price is on average:

Given that the average exercise price for the options is $8, compared to a current share price of $58, and even the most recently granted round of options are still well in the money, it should be assumed that the vast majority of these options will turn into common stock as well. Thus, adding together the 138.7 million common shares, the 4.8 million RSUs, and 21.9 million dilutive impact from the options (using the treasury method), we arrive at 165.4 million fully diluted outstanding shares, which results in a market cap of $9.6bn. Not so difficult.

 

By comparison, below is a quick tour around various investment banks’ reports for the company. These figures were pulled from the batch of October 23-24th reports following NOW’s Q3 2013 results.

 

Wells Fargo:  

Wells Fargo claims 137.5 million shares. Did they simply lift this figure from Reuters?

 

Barclays:

 

Barclays claims 136.8 million shares. At least Barclays can blame FactSet Fundamentals for getting it wrong, perhaps?

 

 Credit Suisse:

Kerrisdale Capital Servicenow

Credit Suisse follows Barclays’ lead with a similarly erroneous 136.8 million figure.

Deutsche Bank:

Deutsche Bank diverges from the others using a share count of 147 million (still well off the

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