Business context and reporting period
ServiceNow, Inc. filed this Form 10-Q for the quarter and nine months ended September 30, 2014. The company sells cloud-based software for automating and managing enterprise IT services, primarily through subscriptions, with additional professional services and other revenue.
Management reported rapid expansion: customers increased 32% year over year to 2,514, and employee headcount rose to 2,611 from 1,654. Subscription contracts are generally billed annually in advance and revenue is recognized over the contract term.
Financial results and liquidity
Amounts below are in millions of dollars except per-share data and percentages.
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Subscription revenue | $150.4 | $93.0 | $400.5 | $244.9 |
| Professional services and other revenue | $28.3 | $18.3 | $84.1 | $54.5 |
| Total revenue | $178.7 | $111.3 | $484.6 | $299.4 |
| Gross profit / gross margin | $112.6 / 63% | $69.7 / 63% | $306.4 / 63% | $189.5 / 63% |
| Operating loss | $(34.5) | $(14.7) | $(115.2) | $(46.9) |
| Net loss | $(41.1) | $(14.7) | $(134.7) | $(49.5) |
| Basic and diluted loss per share | $(0.28) | $(0.11) | $(0.93) | $(0.37) |
Subscription revenue was 84% of Q3 revenue and 83% for the nine-month period. Q3 subscription gross margin was 75%; professional services and other gross margin was 1%. For the first nine months, those margins were 74% and 10%, respectively.
For the nine months ended September 30, 2014, operating cash flow was $91.3 million, versus $45.5 million a year earlier. Investing activities used $273.7 million, including $99.8 million for acquisitions and $45.5 million in property and equipment purchases. Financing activities provided $55.1 million. Cash and cash equivalents declined $131.2 million to $235.1 million.
At September 30, 2014, cash and cash equivalents plus short-term investments totaled $646.1 million, with a further $238.1 million in long-term investments. Deferred revenue was $350.8 million. Convertible senior notes had $575 million principal outstanding and a $436.3 million net carrying value; the notes bear no coupon and mature in November 2018. The company reported $417.4 million of stockholders’ equity.
Material changes versus the prior comparable period
- Q3 revenue increased 61% year over year; subscription revenue grew 62%. Nine-month revenue increased 62%, led by subscription growth of 64%.
- Despite higher revenue, operating and net losses widened as operating expenses increased substantially. Q3 sales and marketing rose 77%, research and development 91%, and general and administrative 45%. Stock-based compensation totaled $108.3 million for the first nine months, versus $44.7 million in 2013.
- Q3 gross margin remained 63%. Nine-month subscription gross margin declined one percentage point, partly reflecting amortization of Neebula acquired technology; professional services and other margin fell two points, partly due to higher stock-based compensation.
- In July 2014, ServiceNow acquired Neebula Systems for approximately $100.5 million in cash. The preliminary allocation included $56.2 million of developed technology and $54.0 million of goodwill, partly offset by deferred tax liabilities. Acquisition-related costs were approximately $1.2 million.
- Interest and other expense increased, principally due to $21.6 million of noncash debt-discount and issuance-cost amortization on the convertible notes in the first nine months of 2014.
Outlook, management commentary, risks and contingencies
- The filing gives no specific revenue or earnings guidance. Management expected subscription gross margin to remain relatively flat for the rest of 2014, professional services and other gross margin to improve in Q4 due in part to customer forums, and sales and marketing, research and development, and general and administrative expenses to rise in absolute dollars. Management expected research and development and general and administrative expenses to remain relatively flat as a percentage of revenue.
- Management stated that cash, investments and operating cash generation were expected to fund liquidity needs for at least the next 12 months. Longer-term adequacy depends on growth, operating results, acquisitions and capital spending.
- Management cited upsell rates of 35% for Q3 and 34% for the first nine months; renewal rates were 98% for both periods. The filing attributes subscription growth to upsells, renewals and customer additions. Management expects professional services revenue to grow more slowly than subscription revenue as it develops its partner network.
- International revenue represented 33% of Q3 revenue. Management warned that further U.S. dollar strengthening could negatively affect reported revenue; the company had not yet hedged foreign-currency transactions.
- HP sued in February 2014 alleging infringement of eight patents; BMC sued in September 2014 alleging willful infringement of seven patents. Both seek unspecified damages and injunctions. ServiceNow intends to defend the cases and said it could not reasonably estimate a potential loss; an unfavorable outcome could be material.
- Other key risks include service outages and security breaches, scaling infrastructure and operations, intense competition, reliance on renewals and enterprise sales, international and currency exposure, and the possibility that growth investments will not produce sufficient revenue or profitability. The company warned that it expects revenue growth to decline and may not achieve or sustain profitability or positive operating cash flow.
- The IRS was examining tax years ending June 2011 and the six months ended December 2011. Management said it had reserved for potential adjustments but could not estimate the full range of possible tax exposures. Management reported disclosure controls were effective at the reasonable-assurance level and no material quarter change in internal control over financial reporting was identified.
Important facts for investors to verify
- Whether subscription growth, upsell activity and high renewal rates persist, and how deferred revenue and customer additions develop.
- Whether expense growth—particularly sales and marketing, R&D and stock-based compensation—can moderate relative to revenue and improve operating losses.
- Cash generation and investment needs, including acquisition spending, infrastructure capital expenditure and the company’s ability to maintain liquidity beyond the stated 12-month outlook.
- Integration and expected benefits of the Neebula acquisition, including retention of key employees and realization of technology and market synergies.
- Developments in the HP and BMC patent lawsuits, potential exposure and any resulting effect on products, costs or customer relationships.
- Potential dilution and cash-settlement demands related to the convertible notes, employee equity awards and warrants; also monitor currency effects and tax examinations.