ServiceNow Is a Top AI Stock, but Is It Really a Good Buy?

The cloud software company is cranking out 20%-plus growth like clockwork, but the stock has already priced in a lot of AI hype.

In May 2023, cloud and artificial intelligence (AI) software provider ServiceNow (NOW 3.01%) laid out its roadmap for scaling its subscription business from $8.5 billion a year to over $15 billion by 2026. Since then, AI has gone from early hype to a legitimate driver of business growth.

The problem is, ServiceNow stock has soared some 60% in the last 12 months, pricing in a large part of the business‘s expected growth over the next few years. Is this top AI software stock still a buy?

ServiceNow’s momentum continues to roll

In the first quarter of 2024, ServiceNow reported total subscription revenue of $2.52 billion, a 25% year-over-year increase. Management kept its full-year 2024 revenue outlook mostly unchanged, slightly upping the low-end of guidance for $10.560 billion to $10.575 billion in expected subscription revenue. That implies full-year growth of about 22%, keeping ServiceNow on track for that 2026 target.

The company provides enterprise software for IT, customer service, and other workflow management. Last spring, the big news was an agreement with Nvidia, where the AI pioneer would use ServiceNow’s offerings for its generative AI research and development (R&D) workflow. In return, the result of Nvidia’s AI R&D would get implemented into ServiceNow’s software solutions.

It takes time to get new software development like this ready for customers and for the sale of said new software to trickle down into financial results. It seems investors are still waiting for AI to provide some sort of revenue boost as ServiceNow’s full-year 2024 guidance continues to imply a slowdown from the 26% growth reported last year. Shares sold off a bit following the company’s Q1 update.

Nevertheless, there’s still reason for optimism as the company has been announcing fresh software tools like a second-gen software code generation tool called StarCoder2, co-developed with Nvidia and private AI start-up Hugging Face. Perhaps there’s still reason to believe ServiceNow’s 20%-plus pace of growth can continue through the rest of this year and beyond.

More than AI needed

As great as the AI story may be, it’s important to remember that the reason to own ServiceNow stock isn’t just for growth. The company is making a much-needed pivot toward stoking higher profit margins and higher earnings per share (EPS) from its software empire.

As it scales, the company says it expects free cash flow (FCF) margins to rise to 31% this year (up from about 30% last year). And in an appeal to value investors, the goal is to steadily lower employee stock-based compensation to generate those higher GAAP EPS figures, while share repurchases keep the total share count in check.

Progress is being made, but there’s still room for improvement in this department. ServiceNow’s stock-based compensation was $422 million in Q1 2024, partially offset by $175 million in share repurchases. The company still has lots of firepower, though, with $5.1 billion in cash and short-term investments and debt of just under $1.5 billion as of the end of March.

ServiceNow trades for 74 times trailing-12-month GAAP EPS, or a more reasonable 50 times expected 2024 GAAP EPS. On a free-cash-flow basis (which backs out the employee stock-based compensation), shares trade for 45 times trailing FCF and about 42 times expected 2024 FCF. Clearly, a lot is still riding on ServiceNow’s AI software plans, as well as its ability to juice profitability in the years ahead.

The high valuation, especially as the stock soared in the last year, is what has kept me from nibbling on ServiceNow stock. Investors who like the story can consider using a dollar-cost average (DCA) plan to build a position in this top cloud and AI software stock over time. But given the price tag, expect some bumps in the road.

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