Earnings and Revenue Growth Can Help ServiceNow Rally after 5-Week Decline

Since the beginning of 2021, the software sector has underperformed the overall market. Using the iShares North American Tech-Software ETF (IGV) as a barometer for the industry, the group has dropped 5.75% from the start of the year through March 18. During the same time period, the S&P is up 4.24%. Not all software firms have seen their stocks decline, but there does seem to be a disparity in performances based on whether the company is perceived as a growth stock versus a value stock.

ServiceNow (NOW) falls in to the former category with the current trailing P/E ratio at 100 and the forward P/E at 85.5. Since the beginning of 2021, ServiceNow is down 11.4%, but it was up 8% through February 11. From that date in February through the low in early March, it seems like an entirely different stock with the price dropping 18%. By comparison, Microsoft (MSFT) is up 4.5% so far in 2021. At this point Microsoft would be considered more of a value stock than a growth stock.

What changed after February 11? Did the company issue bad news? Did earnings disappoint? The answer to those two questions is “no”. The company reported back on January 27 and it beat estimates on the earnings and the revenue side. The stock jumped over 15% in the weeks that followed.

ServiceNow saw earnings grow by 22% in the fourth quarter of 2020 while revenue jumped by 31%. Over the last three years the company’s earnings have grown by 49% per year while revenue has grown by an average rate of 33%. The cloud-based software firm has seen demand for its products hold up well during a challenging time in the global economy.

Because ServiceNow’s platforms help companies operate more efficiently and be more productive, I don’t see the demand for its products falling off dramatically anytime soon. With more and more companies allowing employees to work from home, workflow software should see demand increase going forward. ServiceNow already works with “nearly 80% of the Fortune 500”, and with most companies looking to implement or expand the use of predictive analytics, we could see that percentage climb in the coming years.

Looking at the profitability measurements for ServiceNow, the profit margin is at 78.2% and that is incredibly high. Unfortunately the profit margin is one of the few measurements where the company is above average.

I mentioned how high the P/E ratios are earlier, and they aren’t the only value metrics that are extremely high. The price/sales ratio is at 19.92 and the price/book is at 32.2. Both of those figures are extremely high whether you are comparing them to the average stock or to the industry averages. There even high for the growth segment of the market.

Recent Drop has the Stock Facing Support at 50-Week Moving Average

The recent rotation out of growth stocks and in to value stocks has caused a pretty sizable drop for ServiceNow. The stock fell 22.7% from its February high to the most recent low. That low last week came right at the 50-week moving average and so far the trend line has acted as support.

Looking at the last three years we see how the stock has moved below the 50-week moving average on several occasions, but it never stayed below it for very long. In late 2018 the stock danced around the 50-week for several months before going on a nice bullish run. In October 2019, the stock dropped below the trend line again, but didn’t close any week below the 50-week. Last March, during the market meltdown, the stock spent four weeks below the trend line before it rallied over 150%.

The rapid decline did move the overbought/oversold indicators out of overbought territory and in the case of the weekly stochastic indicators they are entering oversold territory. The 13-week RSI is hovering near the 40 level and has a way to go before it would reach oversold territory.

The Strengths and Opportunities Outweigh the Weaknesses and Threats

Looking at ServiceNow in an old 90’s business analysis style, the company’s strengths and opportunities seem to outweigh its weaknesses and threats. If you aren’t familiar with SWOT Analysis, SWOT is an acronym that stands for Strengths, Weaknesses, Opportunities, and Threats. It was a popular tool taught in business schools and used by companies in the 1990s. For ServiceNow, the earnings and revenue growth are definite strengths for the company while the low return on equity (4.78%) is a weakness.

I see the opportunities and the threats applying more to the stock itself than the company, although there are definitely opportunities for the company as well. Starting with the chart, it looks like the recent pullback is providing investors with an opportunity to get in at a much lower price than they would have paid just a few months ago. The support at the 50-week moving average and the oversold status of the stochastic indicators suggest the stock is ready to bounce back.

The biggest threat I see for the stock is the extremely high valuation figures. If investors continue to shift away from growth and in to value, this could cause the stock to move even lower in the coming months. Of course if the company continues to issue strong earnings and revenue growth, it will help bring the valuations down. You have to remember that there are two ways for valuations to move lower—either the price of the stock comes down while the earnings and revenue remain constant, or the earnings and revenue increase while the price remains constant. For ServiceNow it looks more likely that the earnings and revenue will increase.

One other area that could be a threat for ServiceNow is in the overall analysts’ ratings. There are currently 33 analysts covering the stock and 30 of them have the stock rated as a “buy”. The other three analysts have the stock rated as a hold. The reason this is a possible threat is due to the probabilities of a downgrade are much greater than the probabilities of an upgrade. Whether we value analyst ratings or not, a downgrade by the right analyst or a series of downgrades can push a stock down.

Overall the outlook for ServiceNow is a bullish one and I can see the stock rallying over the next four to six months. Based on the previous instances where the stock used the 50-week moving average as support while the stochastic indicators were in oversold territory, I can see a move of over 40% off the low. A move of this magnitude would put the stock up near the $650 level.