25% Below Its High, ServiceNow Inc. Stock Is 26% Undervalued

Investors lack the information they need to decide what stocks to buy. To be sure, there are rules that drive changes in a company’s stock price.

One of my favorites — “beat and raise” says that if a company reports quarterly revenue and earnings growth and boosts its forecasts above what investors expect, the stock price will rise. Otherwise it will go down.

Investors can’t know until it is too late whether a company will beat and raise each quarter until it’s too late. But if they analyze a company’s track record of doing so and assess whether the company is making good investments in future growth, investors can make reasonable long-term bets.

Sadly for investors, that rule is periodically over-ruled by another one — institutional opacity (IO). IO refers to abrupt decisions by institutional investors — or the computers they run — to make high volume bets to buy or sell entire categories of stocks.

IO is particularly difficult for individual investors because unlike publicly traded companies — which must disclose detailed information about their performance and prospects — institutions do not have to disclose ahead of time the rationale for their trading decisions.

One such institutional trade is a sectoral rotation — the decision to shift capital from high-growth technology companies to so-called cyclical stocks driven by expectations that higher interest rates will boost the latter’s value.

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This comes to mind in considering the 25% decline in the stock of ServiceNow — operator of a business cloud computing service — since it peaked last November. The drop coincides with a 7% decline in the tech heavy NASDAQ NDAQ .

Yet analysts peg ServiceNow’s stock 26% above where it trades now. If ServiceNow beats and raises when it reports fourth quarter earnings on January 26, its stock could rise rapidly.

Given its sustained rapid growth, ServiceNow shares are likely to rise.

(I have no financial interest in the securities mentioned in this post).

Sectoral Rotation Out Of Growth Stocks

IO is not just for individual investors — it also hurts hedge funds. How so? As the Wall Street Journal reported, hedge funds that had enjoyed profitable runs — due to their ownership of stock in fast-growing technology companies — suffered their worst performance in years in 2021.

2021 was not a good year for hedge funds. They returned an average of 11.9% in 2021 — well-short of the S&P 500’s 28.7% return and the Nasdaq’s 22.2% gain. The Journal attributes much of the hedge fund pain to losses late in 2021 for “growth- and technology-oriented strategies account for one of the largest pots of money in the more than $4 trillion hedge-fund industry.”

The losses were triggered by sectoral rotation out of growth and into financial stocks due to expectations of higher interest rates. The Journal wrote that growth stocks “become vulnerable as investors shift into such sectors as financials, which have traditionally benefited from higher rates.”

I find it interesting that investors told the Journal that the November renomination of of Jerome Powell as Fed Chair triggered the selloff. Is that really the cause? We have no way of knowing which investors sold off their tech stocks, how many shares they dumped and what triggered their decisions.

If Powell’s nomination caused the drop in tech stocks, how did those hedge funds get caught so flat-footed that they did not take their profits when rumors of the renomination were afoot?

With expectations of higher interest rates already widely known, is there further upside to investing in cyclicals — which judging by the BKW Nasdaq Bank Index (up a mere 0.5% since early November) have not done so well — or would investors be better off betting on growth companies with high odds of beating and raising?

ServiceNow’s Performance and Prospects

When ServiceNow last reported earnings — it beat expectations and raised guidance for its third quarter. Yet its stock fell.

How so? According to MarketWatch, ServiceNow’s third quarter revenue rose about 31% to $1.51 billion — $30 million above expectations — as its adjusted earnings per share of $1.55 were 16 cents above analysts’ estimates.

ServiceNow’s revenue guidance for the fourth quarter was slightly above expectations. Specifically, ServiceNow’s fourth-quarter subscription revenue guidance was $1.52 billion — $10 million more than the analyst average while the company’s forecast for billions — $2.31 billion — equaled expectations.

ServiceNow said that its service lets companies build more applications with fewer engineers. As CEO Bill McDermott told MarketWatch, “Some 500 million new applications will need to be built by enterprises in the next two and a half years. There are not enough engineers in the world to do that; ServiceNow offers a hyper-automation layer” to achieve it.

When ServiceNow reports fourth quarter results on January 26, investors are expecting $1.6 billion in revenue — 28% above the year before, according to MarketBeat.

In order to beat expectations, the company will need to forecast growth that exceeds 25% for the current year. How so? for 2022, investors expect ServiceNow to grow revenues by 25% from $5.88 billion to $7.37 billion, according to analysts polled by Zacks.

ServiceNow’s Growth Processes

Unlike hedge funds and other institutional investors, individuals who buy stocks are not judged on annual performance. Such individual investors can judge their success over longer time frames.

On that basis, ServiceNow has been a winner. Specifically, I have been researching 36 publicly-traded technology companies. In the decade from 2010 to 2020, ServiceNow’s revenues top the list — having grown at a 59.2% average annual rate while its stock rose at 44% a year.

ServiceNow performs four processes that contribute to its long-term growth. As I wrote in June 2021, these include:

  • It creates compelling value for customers. For example, it helped Lloyds Banking Group’s payment operations unit to increase customer satisfaction by resolving problems 70% faster, slashing errors and eliminating mundane tasks for agents. Such value creation helps ServiceNow to win new customers, keep them from bolting to rivals, and buying more services over time.
  • It grows organically — rather than by acquisition. ServiceNow has grown by adapting its core service to new corporate departments. Specifically, it extended its skill at managing workflows from IT service management to IT operations management and business management. If ServiceNow can sell more to its current customers as it adds new ones, it should sustain rapid growth.
  • Its culture attracts and inspires great talent. Innovation depends on hiring and motivating talented people and ServiceNow says it is doing this well. Last June McDermott told investors that the company hire 3,000 new people. He also said, “Our employee engagement scores are soaring. Our people are really happy and…fired up to be the fastest growing SaaS company at scale in the world.”
  • It empowers people and holds them accountable. ServiceNow has a process for turning these skills into results. As CFO Gina Mastantuono told me, “Each employee’s work ties to the strategy and priorities needed to get to $10 billion and $15 billion in revenue. Every single person has three to five goals relating what they do to corporate priorities.”

What does all this mean for investors? If Wall Street analysts are worth their salt, ServiceNow’s stock trades at a 25% discount to its target price. If that means anything, you should be able to buy shares now and enjoy a 36% return on your investment when the shares rise to that target price, according to WallStreetZen.

If ServiceNow can beat growth expectations and raise guidance above 25%, its stock could pop. But a Fed announcement for even higher interest rates could drive down ServiceNow’s stock even further.

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