An American giant actually making money from AI

One of the few large software companies making a success of AI is ServiceNow (US:NOW). The difference is it hasn’t slapped an AI feature onto its product in the past year in response to the release of ChatGPT. Management has been aware of the importance of AI for a while and has been investing accordingly. In 2015, ServiceNow launched a venture arm, which has since invested in over 45 businesses. It went on to acquire Element AI in 2020 for $500mn (£380mn) “to bring expertise in applying modern AI to text and language, chat, images, search, question response, and summarisation”.

AI monetisation is now 

This investment is starting to bear fruit. In the three months to June, the group's generative AI invention 'Now Assist' became the fastest-growing product in its history, doubling its net new annual contract value quarter on quarter. Management said it signed 11 deals worth over $1mn, two of which were over $5mn. More importantly, it is selling its AI products for 30 per cent more and the deal sizes are three times larger than during previous adoption cycles.

“We think GenAI is driving large deals for ServiceNow, primarily due to the [return on investment],” said RBC Capital analyst Matthew Hedberg. He added that the dynamics could result in organic subscription growth of over 20 per cent next year. 

ServiceNow was founded in 2003 as a cloud-based software company to automate IT processes. It would issue tickets, manage workflow, and track changes. It sounds trivial but it streamlined corporate admin and, by doing it on the cloud, meant customers didn’t have to invest in on-premise servers to save all of the data. The company still makes most of its money from its IT service management platform, but now it also has HR and customer service management tools.

The benefit of the AI offering is it includes predictive analysis, as well chatbots to handle IT support and HR enquiries. For example, it can predict IT incidents before they occur and identify trends in customer service issues, with management saying response times for analytical enquiries have got significantly better. It also has ‘low-code development’ tools, which allow businesses to easily build custom applications without needing to code.

These features are starting to have a tangible impact. Last year, BT announced it planned to cut 40,000 to 55,000 of its workforce by 2030 by automating a lot of its processes. Much of this automation has come from ServiceNow’s sparkly new product Now Assist. BT said the tool helps agents write case summaries and review notes faster, cutting both times by 55 per cent. This has driven down the average time to resolve cases by a third.

Currently, ServiceNow is selling most of its generative AI products directly, but it is partnering with other businesses to speed up sales. In May, ServiceNow announced it had partnered with Microsoft (US:MSFT), which will give customers access to large language models powered by OpenAI’s ChatGPT. “We are working to onboard partners, arming them with the tools to sell Now Assist and further expand our go-to-market reach,” said chief financial officer Gina Mastantuono.

Expectations rising 

The growth of the AI product is exciting, but it is from a small base and will take a few years to move the needle on the top-line figure. However, the rest of the business is also performing well, especially compared with software rivals.

In the three months to June, subscription revenue increased 23 per cent year on year to $2.5bn, while current remaining performance obligations (CRPO) – which refer to contract revenue that will be recognised as revenue in the next 12 months – rose 22.5 per cent to $8.8bn at constant currency. This was an acceleration from the 21 per cent growth last quarter and ahead of the 20.5 per cent guidance. Next quarter, management expects CRPO growth to be similarly high.

The surprisingly strong quarter encouraged management to raise its full-year subscription revenue guidance to roughly $10.6bn, implying year-on-year growth of 22 per cent. It has also increased its operating margin forecast by 50 basis points to 29.5 per cent. This was after the non-GAAP operating margin rose to 27 per cent last quarter, nearly 250 basis points ahead of its guidance.

Part of the reason for all of this good news is that the AI rollout has been much more successful than all its previous ones. While most other companies are underperforming the exceedingly high expectations for AI, ServiceNow is overperforming. This is reflected in the FactSet consensus broker forecasts, which show analysts getting increasingly bullish. In the last year, the 2025 earnings per share forecast has risen from $15.12 to $16.55.

The latest earnings update did have one catch: the departure of chief operating officer CJ Desai. After an investigation from the board of directors, it was found he violated policy when he hired a former chief information officer of the US Army. ServiceNow has temporarily replaced Desai with an internal hire and has started the search process for a replacement.

Whenever there is a scandal, investors worry that there are deeper governance issues. However, analysts at RBC Capital markets seem unconcerned by the departure, saying “it signals the company's willingness to do the right thing around compliance”.

Expensive but worth it 

The bigger issue for investors is ServiceNow’s valuation. The share price has increased 37 per cent in the past year, meaning it is trading on a forward price/earnings multiple of 58. However, due to its predicted earnings trajectory, the 2026 PE ratio is a more reasonable 39. But this still isn’t cheap.

If we look price to free cash flow, things look slightly more affordable. The 2026 price/free cash flow is roughly 33 which, for a company with 80 per cent gross margins and revenue growth consistently above 20 per cent, doesn’t look unreasonable. 

Before the pandemic, it was expected that software companies would grow at over 20 per cent a year. However, when interest rates were increased companies started focusing more on profitability and there has been a cut back in IT spending. Last fiscal year at Workday, for example, subscription revenue grew 19 per cent versus 22.4 per cent in 2021.  

Despite generating the same amount of sales at the start of 2021, ServiceNow has pulled decisively ahead of Workday. This suggests that its products are genuinely essential. It is one thing accelerating growth when everyone else is doing well. But accelerating while others are slowing down shows true differentiation.

The other impressive thing is the expansion of the operating margin ahead of expectations, especially given the costs involved in rolling out an improved AI product. ServiceNow appears to have the enticing ability to combine growth, margin expansion and product development. 

It is a difficult moment for software investment. AI is threatening to upend traditional business models, but it is too early to tell for certain who the winners and losers are going to be. But by investing early, ServiceNow is leading the pack.