at Merrill. Among internal emails at Merrill relating to Goto.com, a stock they had a “buy” rating on, Spitzer found one where an investor emailed Merrill about the company:”What’s so interesting about GOTO except banking fees????” A Merrill research analyst replied: “nothin.” Or from one Merrill analyst to another: “I don’t want to be a whore for f-ing management. We are losing people money and I don’t like it. john and mary smith are losing their retirement because we don’t want [the CEO of Goto.com] to be mad at us.” In another example, former Merrill analyst Henry Blodget referred to a stock he had a buy rating on as a “piece of shit” in an internal e-mail.
Despite all the talk of a wall between investment research and banking fees, it’s clear where Wall Street’s bread is buttered. Which brings us back to ServiceNow, as NOW has been a most prodigious creator of banking fees itself. A cynical person might suspect that ServiceNow’s propensity to unceasingly emit new stock and debt, and in the process offer lucrative fees to investment bankers, is in some way tempting analysts to look for the bright side of ServiceNow’s rather cloudy forward business prospects.
Hypothetically, one great way for analysts to juice up their analysis and be able to have their models spit out more optimistic price targets would be to undercount, inadvertently or intentionally, the number of outstanding shares. For ServiceNow, by ignoring the existence of 27 million fully diluted shares, analysts have an extra $1.55bn of breathing room to use when constructing their valuation estimates.
For a look at this in action, consider Janney’s valuation model from its October 7th Initiating Coverage report for ServiceNow:
Janney employs a discounted cash flow analysis model. Their model assumes optimistic growth rates of free cash flow, rising from $8 million this year to $74 million by 2015, $339 million in 2017, and all the way up to more than $1.6 billion by 2022. Obviously, it seems a little ridiculous to forecast a 132% compound growth rate of cash generation over the next five years when in fact ServiceNow’s free cash flow generation has been virtually nil over the past several years and has shown little sign of turning the corner in recent quarters.
But even granting this most optimistic of forecasts, Janney’s model still only deduces a net present value of $53.11 per share ($6.8bn of net present value plus cash). This doesn’t seem bad (or particularly good) given that the stock is trading at $58. But, when you realize that Janney only accounted for 134 million shares, when in fact there are 165.4 million fully diluted shares of ServiceNow, you have to re-run the math. Dividing that $6.8bn of net present value plus the cash balance of $347m by 165.4 million fully diluted shares, you see that Janney’s real price target is near $43! Even if ServiceNow manages to meet Janney’s lofty operating growth targets, the stock is still overvalued by 25% at present levels!
And Janney is far from the most optimistic of analysts on the street. Other more bullish firms have much more outlandish price targets. For ServiceNow, which generates almost no cash and loses money on a net income basis despite having conquered close to a quarter of the market share in its rather limited addressable market (particularly since peak penetration is likely only around 50% given security concerns around using a cloud-based service for sensitive data), it’s hard to fathom what sort of upside analysts are fantasizing about.
How It’s All Going To End
ServiceNow has a reasonably good ITSM product, and it will likely continue gaining share in that market. From its current 30% market share (Gartnerestimates market size near $1.5bn), NOW could, with good operating performance, get to maybe 50% market share as more clients move from BMC’s legacy solutions to ServiceNow’s cloud offering.
The touted great upside of the IT operations and PaaS is simply unlikely to occur. Analysts are hyper-focused on the platform area because ServiceNow’s current operations cannot come close to justifying the company’s daunting $9.6bn market cap. We don’t believe the platform business is sufficiently promising to justify the sky-high valuation multiples.
