ServiceNow Stock is Crashing - What You Need to Know

Daniel examines ServiceNow's latest earnings report, highlighting the market's extreme negative reaction, which saw the stock plummet nearly 18% and dragged down the broader software sector. He asserts that this market response is a "massive overreaction" and "completely unjustified," arguing that AI disruption fears are currently "overblown" and leading to indiscriminate selling across the industry.

He notes that ServiceNow's first-quarter results were strong, with revenue growing 19% on a constant currency basis and 22% net, and current remaining performance obligations (RPO) increasing by 22.5%. The free cash flow margin remained robust at 44%, despite a slight year-over-year decline. However, the company's guidance for Q2 and the full year 2026, particularly the projected decline in operating and gross margins, became a major concern for investors. ServiceNow lowered its margin outlook for 2026 compared to the previous quarter. Daniel points out that while the company increased its 2026 revenue guidance by $200 million, this increase was primarily driven by acquisitions, suggesting a flat revenue outlook for the core business alongside expected margin compression.

Daniel acknowledges the observed deceleration in ServiceNow's revenue growth rates over the years but argues this is a natural consequence of a business scaling, not necessarily AI disruption. The market, however, is interpreting this deceleration, coupled with declining gross margins, as a sign that AI is not benefiting ServiceNow and may even be lowering its profit potential. This narrative is reinforced by the fact that ServiceNow has positioned itself as an AI winner, yet its numbers do not show an acceleration driven by AI tailwinds. On a more positive note, Daniel highlights that ServiceNow's average revenue per user continues to grow, and the number of customers spending over $5 million increased by 28% quarter-over-quarter, indicating a strong moat and pricing power. The renewal rate also remains very strong at 97%.

The core issue driving margin compression, according to Daniel, is the rising cost of goods sold (COGS), which grew 44% year-over-year. He attributes this partly to short-term margin compression from acquisitions and, more significantly, to the increasing cost of using AI, which falls under COGS. Despite this gross margin decline, Daniel emphasizes a critical counterpoint: ServiceNow's free cash flow (FCF) margin has been expanding over time and is projected to be around 35% for 2026. He explains that while AI increases COGS, it also drives operational efficiencies and employee savings, shifting costs up the income statement but protecting the bottom line. This suggests that the market's focus on gross margin decline might be "short-sighted."

Regarding valuation, Daniel calculates that after the 18% drop, ServiceNow is trading at approximately 19 times trailing 12 months free cash flow. Based on its 2026 guidance of $15.75 billion in revenue and a 35% FCF margin, the projected 2026 free cash flow of around $5.5 billion puts the stock's forward price-to-free cash flow at only 16.2. Daniel considers this valuation "pretty dang wild" for a business that is still projecting 20% top-line revenue growth and a 35% free cash flow margin, especially given that it historically traded above 30 times FCF. He concludes that while software sentiment may remain negative until tangible AI benefits are clearly demonstrated, the current selling is fear-driven and presents opportunities in "some pretty cheap stocks" that are more immune to or benefit from AI.