Business context and reporting period
ServiceNow, Inc. provides enterprise cloud software, principally through subscriptions. This Form 10-Q covers the quarter and nine months ended September 30, 2018. Comparative 2017 figures are adjusted for the company’s full retrospective adoption of Topic 606; that standard changed the timing of some self-hosted revenue recognition and the capitalization of sales commissions.
Financial and operating highlights
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Total revenue | $673.1 million (+37%) | $492.4 million | $1,893.4 million (+38%) | $1,369.4 million |
| Subscription revenue | $626.6 million (+39%) | $449.5 million | $1,755.2 million (+42%) | $1,239.8 million |
| Gross margin | 77% | 74% | 76% | 73% |
| Operating income (loss) | $9.6 million | $(3.9) million | $(42.7) million | $(63.5) million |
| Net income (loss) | $8.4 million | $(22.2) million | $(33.7) million | $(99.5) million |
| Operating cash flow | Not presented for quarter | Not presented for quarter | $521.5 million | $458.2 million |
| Free cash flow (non-GAAP) | Not presented for quarter | Not presented for quarter | $385.1 million | $342.3 million |
Q3 subscription gross margin was 83%, versus 82%; professional services and other gross margin was negative 10%, versus negative 6%. Stock-based compensation was $144.4 million in Q3 and $401.3 million for the nine months.
Liquidity, debt and other metrics
- At September 30, cash and cash equivalents were $703.6 million, short-term investments $922.4 million and long-term investments $457.6 million. Cash plus short-term investments totaled approximately $1.63 billion.
- Convertible senior notes had a net carrying amount of $814.6 million: $161.0 million current and $653.6 million long-term. The remaining $161.8 million principal of the 2018 Notes was repaid in cash on November 1, 2018; $782.5 million principal of 2022 Notes remained due June 2022.
- Nine-month capital expenditures were $136.3 million. The company reported $4.4 billion of total backlog, including $3.0 billion unbilled; approximately 51% was expected to be recognized as revenue in the following 12 months.
- Customers with annual contract value above $1 million increased to 614 from 447. Renewal rate was 97% for Q3 and 98% for the nine-month period, compared with 97% for each 2017 comparable period.
Material changes versus the prior comparable period
- Revenue growth was led by subscription sales to existing customers and customer additions. IT operations management subscription revenue rose 70% in Q3 and 83% for the nine months; service management revenue rose 35% and 36%, respectively.
- Gross margin improved, including through better data-center utilization and economies of scale. Professional-services margins deteriorated as staffing and compensation costs grew faster than services revenue.
- Operating expenses increased substantially in dollars, reflecting headcount growth, compensation, sales commissions, marketing and product development. Headcount was 7,661, up from 5,895 a year earlier.
- Nine-month net loss narrowed by $65.8 million. Management attributed the improvement partly to a $23.1 million one-time Topic 606-related tax benefit and a $19.3 million gain on marketable equity securities sold in 2018.
- Operating cash flow rose 14%; free cash flow rose 13%. Investing cash use fell to $100.3 million from $365.7 million, primarily due to lower net purchases of investments. Financing cash flow shifted to a $433.1 million outflow, including repayments of 2018 Notes and employee-award tax withholding.
Outlook, commentary, risks and unusual items
- The filing gives no specific numerical revenue or earnings guidance. Management expected subscription revenue to grow in dollars and as a share of revenue in 2018, subscription gross margin to improve, and professional-services revenue to grow in dollars but decline as a share of total revenue. It expected a GAAP loss for full-year 2018 and said revenue growth rates were expected to continue declining over the foreseeable future.
- Management stated existing cash, investments and operating cash generation should cover liquidity needs for at least 12 months, including debt repayment, data-center expansion, leases and growth investment.
- Operating lease commitments totaled $810.6 million undiscounted. The company anticipated that adoption of the lease accounting standard in 2019 would materially increase balance-sheet assets and liabilities, while not materially affecting earnings or cash flows.
- The 2022 Notes were convertible at holders’ option through December 31, 2018; no conversion requests had been received through the filing date. The company expected the 2018 Warrants to result in approximately 3.5 million shares based on the September 30 share price, subject to market price during the settlement period.
- Key disclosed risks include intensifying competition, cybersecurity incidents and service interruptions, execution of product and customer implementations, foreign-exchange exposure, privacy and regulatory compliance, and the possibility that investment and costs outpace revenue growth. Currency forwards hedge part, but not all, of certain exposures.
- Two acquisitions were completed during the nine months for approximately $25.1 million; two additional talent and asset transactions for approximately $12.5 million occurred in October. The filing reported no pending legal proceedings expected to have a material adverse effect.
Important facts for investors to verify
- Assess the sustainability and quality of subscription growth, including the effects of self-hosted revenue recognized upfront under Topic 606 and foreign-exchange movements.
- Track operating leverage and margin trends against rising operating expenses and stock-based compensation, which was 21% of revenue for the nine-month period.
- Reconcile reported free cash flow with its definition: the company’s nine-month figure includes a $101.6 million operating-cash-flow adjustment relating to convertible-note debt discount repayments.
- Confirm the post-quarter cash settlement of the 2018 Notes, the remaining 2022 Notes exposure, and potential dilution from outstanding warrants and equity awards.
- Monitor backlog conversion, renewals, lease obligations and the eventual impact of the lease standard; backlog is not the same as recognized revenue and may fluctuate.