Tech Stock Sensei

My Best Cloud Stock to Buy and Hold

Over the past eight years, Microsoft (MSFT) transformed itself from an aging legacy software company into a high-growth cloud giant. Satya Nadella, who took the helm as Microsoft’s third CEO in early 2014, spearheaded the company’s “mobile first, cloud first” initiative which converted a large portion of its desktop software into mobile apps and cloud services.

Between fiscal 2014 and fiscal 2021, which ended last June, Microsoft’s annual cloud revenues rose from just 5% of its top line in fiscal 2014 to 41% in fiscal 2021. It also grew at a compound annual growth rate (CAGR) of 10%, as its earnings per share (EPS) increased at a CAGR of 17%.

Investors who bought shares of Microsoft on Nadella’s first day are now sitting on a total return of nearly 700%. Microsoft remains a rock-solid blue-chip bet for long-term investors, but it probably won’t replicate those massive multibagger gains over the next eight years as its cloud business matures.

Therefore, growth-oriented investors who missed out on Microsoft’s previous rally might consider buying shares of a smaller cloud company which still has plenty of room to run: ServiceNow (NOW 0.74%).

How fast is ServiceNow growing?

ServiceNow’s cloud-based services help companies manage their digital workflows. It only served 602 customers in 2010, but it ended last year with over 7,400 customers — including approximately 80% of the Fortune 500.

ServiceNow was founded in 2003, and it went public in 2012. It raised $210 million with its IPO, and subsequently acquired a long list of smaller companies to expand its portfolio of cloud-based services.

Between 2012 and 2021, the company’s annual revenue rose from $244 million to $5.9 billion, representing a CAGR of 42.5%. Like many other high-growth cloud companies, ServiceNow was initially unprofitable. But over the past three years, it turned consistently profitable on a generally accepted accounting principles (GAAP) basis while keeping its gross margins above 80%.

PeriodFY 2019FY 2020FY 2021
Revenue$3.46 billion$4.51 billion$5.90 billion
Gross margin83%83%82%
Net income$627 million$119 million$230 million

DATA SOURCE: SERVICENOW. GAAP BASIS.

In fiscal 2022, ServiceNow expects its subscription revenue, which accounts for most of its top line, to increase 26% as its non-GAAP operating margin remains unchanged at 25%. Analysts expect its revenue and non-GAAP EPS to increase 26% and 24%, respectively, for the full year.

A rosy outlook for the future

During an analyst day presentation in May, ServiceNow predicted it would generate more than $16 billion in annual revenue in 2026 — which would represent a CAGR of at least 22.1% from 2021. That also replaced its previous target for $15 billion in revenue by 2026, which it had only set last year. 

In January, CEO Bill McDermott told investors that the company’s “organic growth machine” was still in “full flight” and it didn’t need to rely on acquisitions to hit that long-term target. He also proclaimed that as “rising interest rates challenge others,” ServiceNow’s business model would continue to “flourish in any economic environment.”

McDermott believes ServiceNow’s business model is evergreen because it directly benefits from digital transformation trends across large organizations and the shift toward hybrid and remote work. Those secular trends are largely resistant to macroeconomic headwinds and often accelerate during economic downturns as companies streamline their operations.

Many of ServiceNow’s cloud-based peers share that confident long-term outlook. Salesforce (CRM 0.37%), the market leader in cloud-based customer relationship management (CRM) software, expects its revenue to rise 20% in fiscal 2023 (which ends next January) and continue growing at a CAGR of more than 16.3% between fiscal 2023 and 2026.

Could ServiceNow generate big multibagger gains?

ServiceNow currently trades at 64 times forward earnings and 12 times this year’s sales. That makes it a bit pricier than Salesforce, which trades at 35 times forward earnings and five times this year’s sales, but it’s also growing at a significantly faster rate.

If ServiceNow can generate $15 billion in annual revenue in 2026 with expanding margins and rising profits, then its stock could conceivably retain its premium valuation. If that happens…

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