ServiceNow Stock Just Got Slammed. Why I'm Still Not Buying the Dip.

Shares of enterprise workflow software specialist ServiceNow (NYSE: NOW) dropped nearly 17% on Thursday, following the tech company's earnings report.

That is a disappointing move for a company that just beat the high end of its guidance and raised its full-year subscription revenue outlook. Even more, the company continued to highlight strong demand for its artificial intelligence (AI)-powered offerings.

But I'm still not buying the dip.

Image source: Getty Images.

Strong business momentum

There's a lot to like in ServiceNow's first-quarter results.

Subscription revenue in Q1 alone rose 22% year over year to $3.67 billion, while total revenue climbed 22% to $3.77 billion.

And the software-as-a-service company's current remaining performance obligations (cRPO), which represent contract revenue expected to be recognized over the next 12 months, rose 22.5% to $12.64 billion.

The company also closed 16 deals worth more than $5 million in net new annual contract value.

Addressing one concern about how AI could disrupt software companies like ServiceNow, CEO Bill McDermott said that 50% of net new business now comes from a non-seat-based pricing model. This includes things like "tokens and other assets, such as infrastructure, hardware, and connectors."

"Our hybrid pricing model gives customers the best of both worlds, predictable, foundational seat licenses combined with usage-based scalability," McDermott added. "It's the freedom to scale AI adoption without a friction that the customers love."

One of the market's biggest fears right now is that old seat-based software pricing models could prove vulnerable in an AI-driven world. ServiceNow, at least, seems to be adapting.

Further, some of the issues that hurt the quarter look temporary.

The company said it delayed closings of several large on-premise deals in the Middle East, creating a 75-basis-point headwind to Q1 subscription revenue growth. But chief financial officer Gina Mastantuono said a couple of those deals had already closed in Q2.

Why I'm cautious

Where investors may be getting hung up is the company's outlook.

Yes, ServiceNow raised its full-year subscription revenue guidance to $15.735 billion to $15.775 billion. But that new outlook includes about a 125-basis-point contribution from its massive recent acquisition of cybersecurity firm Armis.

And the acquisition is expected to pressure profitability.

The deal is projected to create a 25-basis-point headwind to 2026 subscription gross margin and a 75-basis-point drag on operating margin. It is also expected to be a 200-basis-point headwind to ServiceNow's free cash flow margin.

Management also projected second-quarter cRPO growth of 19.5% on a constant-currency basis. That is a noticeable step down from Q1's 21% constant-currency pace.

And the broader market context isn't helping. With AI disruption concerns hitting software stocks across the board, the sector is under intense scrutiny.

Still, management emphasized that the company's organic business momentum remains strong.

"We feel very good and strong that we continue to have strong organic growth on top of these great acquisitions that we've added," Mastanuono said during the company's first-quarter earnings call.

Why I'm still not buying the dip

Even after the sell-off, I don't think the stock looks cheap enough to justify the risks.

The stock still trades at a price-to-earnings ratio of around 50 -- a multiple that prices in exceptional top- and bottom-line growth not just for the next few years, but for the long term.

If AI continues to raise questions about pricing models and product differentiation in the era of AI, the market could start demanding even lower valuation multiples from software stocks.

Overall, ServiceNow's business update was good. But the stock's valuation still leaves too little margin of safety -- especially in a market that seems increasingly willing to punish software stocks amid lingering AI disruption fears.

Daniel Sparks has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends ServiceNow. The Motley Fool has a disclosure policy.