1 AI Stock That Is Highly Profitable

IT company ServiceNow (NYSE:NOW) followed many other technology companies on an upward trajectory in 2023. Over the last 12 months, the stock is up more than 72%. With the tech sector as a whole looking increasingly expensive, this run raises the question of whether or not ServiceNow is a good buy at today’s prices.

ServiceNow is an enterprise IT company that specializes in digital transformation, AI process assistance, data analytics and cloud migration. Though the company has been around since 2004, it has received a significant tailwind over the last year as business interest in artificial intelligence has spiked.

ServiceNow’s most potentially lucrative product is its Now Intelligence platform, which facilitates AI automation. In addition, the platform can be used to draw insights from large data pools and help managers to improve their decision-making.

Is ServiceNow Profitable?

While many AI stocks are largely speculative, ServiceNow generates respectable profits that make it attractive.

Over the last year, the company has generated earnings of $8.42 per diluted share and maintained a net profit margin of 19.3%. This sets the company apart from the likes of Datadog, a competitor that is still earning only a few cents per share.

ServiceNow’s Q4 earnings report showed impressive growth, with subscription revenue rising 27% to $2.4 billion. The company also saw a 33% jump in new transactions that would contribute $1 million or more in annualized revenue, with 168 such transactions taking place during the quarter.

Despite these impressive results, it should be noted that ServiceNow has only recently achieved anything close to its current level of profitability.

In 2022, for example, the company generated just $1.60 per share in earnings. In addition, more than half of ServiceNow’s trailing 12-month earnings can be attributed to a positive Q2. As such, the company hasn’t yet established a firm trend of regular, predictable earnings growth.

This fact, however, hasn’t stopped analysts from issuing very bullish long-term guidance for the company. Looking at the next five years, analysts project earnings to grow at a rate of about 31% annually.

ServiceNow’s management is also notably bullish about its continued growth. For Q1 of 2024, the company forecasts revenue growth continuing at about 24% year-over-year. Free cash flow is also expected to grow by 31% annually.

A final note on ServiceNow’s performance is its successful avoidance of debt. The company’s debt-to-equity ratio is 0.2, which is quite manageable for such a fast-growing business.

The combination of low debt and realized profits makes ServiceNow a refreshing story in the tech world, where companies often carry higher debt loads and trade on expectations of distant future profits.

ServiceNow’s Sky-high Valuation

Between existing profitability, strong current growth and a potentially long runway, there is a lot to like about ServiceNow.

The problem for investors, however, could be the stock’s high valuation. NOW shares trade at about 60x forward earnings, 99x cash flow and 18x sales. Even with earnings expected to increase at a very rapid rate over the coming years, it’s clear that ServiceNow is priced at a substantial premium.

To justify its current valuation, ServiceNow would have to maintain strong double-digit earnings growth well beyond a 5-year horizon. Given that the company’s current level of net income is a relatively recent development, the current valuation seems to have close to a best-case scenario priced in.

It should be noted, though, that analysts do not expect ServiceNow to stall out or correct downward this year. In fact, the stock’s average analyst price forecast implies an upside of about 6% from the most recent price of $790.39. While there is still room for growth, investors may not find enough upside in NOW shares to justify their already high price tag.

Where Are The Pitfalls?

As one might expect from a volatile, high-growth tech stock, ServiceNow carries a decent amount of risk. Aside from its possible overvaluation, NOW also operates in a highly competitive environment. While Datadog hasn’t achieved anywhere near ServiceNow’s level of profitability, it’s difficult to count the company out when it comes to its competitive position.

ServiceNow is also riding a wave of AI enthusiasm that is priced to continue in perpetuity but will likely start to be infringed upon my an ever growing list of competitors.

Skeptics have likened the gains produced by AI enthusiasm in 2023 to a bubble, potentially setting the stage for a stock market correction sometime in 2024. Though it’s clear that the technology has real value, investors must consider the possibility that AI will be subjected to more realistic views this year.

Finally, ServiceNow faces the risks of a macroeconomic slowdown that could curtail spending on digital transformation.

Analysts expect IT spending to slow down slightly this year as businesses take stock of new technologies and make calculated decisions about their needs. If a recession occurs later this year, this slowdown could be exacerbated by trimmed IT budgets and a greater fear of spending in a difficult macro environment.

Is ServiceNow a Good Stock To Buy?

According to 37 analysts, ServiceNow is a good stock to buy with 6.0% upside to fair value at $832 per share.

ServiceNow is an attractive company that is riding a technological tailwind as businesses invest more heavily in both AI and cloud computing. The company has not only managed to significantly raise its earnings but also kept its debt levels to a minimum, giving it a decent amount of financial flexibility.

ServiceNow’s problem, though, is its valuation. With high investor enthusiasm surrounding the stock, there is a good chance that NOW has already reached a point where new investors could face diminishing returns.

With enormous growth already priced in, ServiceNow must continue to perform or face a potentially sharp correction. Management has done well in this department so far but will have little room for missteps going forward.

With that said, ServiceNow may be worth a small position for growth investors who are bullish on AI and cloud spending.

ServiceNow appears to be a very good business, albeit one that’s priced close to its logical limits. Investors who are fairly risk-tolerant and looking for high-growth shares may want to invest a small amount, and wait to see whether the company can continue to produce high levels of growth before making the decision to buy more. This approach may provide room for upside while limiting downside in the event of a correction.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.