ServiceNow, Inc. — Q2 2020 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2020. Amounts are in U.S. dollars; financial statement amounts below are rounded to millions unless stated otherwise.
Business context
ServiceNow sells enterprise cloud software for digital workflows, primarily through annual subscriptions. Subscription revenue represented 95% of revenue in Q2. The company noted that COVID-19 was creating significant economic uncertainty and could affect customer spending, sales cycles, contract duration, collections and future results.
Financial performance
| Metric | Q2 2020 | Q2 2019 | Six months 2020 | Six months 2019 |
|---|---|---|---|---|
| Total revenue | $1,070.8m (+28%) | $833.9m | $2,117.2m (+30%) | $1,622.8m |
| Subscription revenue | $1,015.5m (+30%) | $781.0m | $2,010.2m (+32%) | $1,521.0m |
| Professional services and other revenue | $55.3m (+5%) | $52.9m | $107.0m (+5%) | $101.9m |
| Gross profit / gross margin | $837.9m / 78% | $635.8m / 76% | $1,660.9m / 78% | $1,238.4m / 76% |
| Operating income (loss) | $62.3m | $(27.0)m | $111.6m | $(42.7)m |
| Net income (loss) | $40.8m | $(11.1)m | $89.0m | $(12.6)m |
| Diluted EPS | $0.20 | $(0.06) | $0.44 | $(0.07) |
- Subscription growth was attributed primarily to increased purchases by existing customers and a larger customer base. Digital workflow subscriptions grew 31% in Q2; ITOM subscriptions grew 22%.
- Q2 operating income improved from a year-earlier loss despite higher operating expenses. Research and development expense rose 34% in Q2; stock-based compensation was $216.8m, or 20% of revenue.
- Professional services remained loss-making at the gross profit level, though its gross loss margin improved to 10% in Q2 from 18% a year earlier.
- For the first six months, operating cash flow was $859.6m, up from $604.6m. Capital expenditures were $193.7m, producing company-defined free cash flow of $666.0m, up 31% from $507.6m.
- Six-month investing cash outflow was $628.1m, including $193.7m of property and equipment purchases and $82.9m for business combinations. Financing cash outflow was $163.2m. Cash, cash equivalents and restricted cash increased by $63.4m.
Financial position and operating indicators
- At June 30, 2020, cash and cash equivalents were $837.3m, short-term investments $1,505.4m and long-term investments $776.8m. Cash plus short-term investments totaled approximately $2.34bn.
- Convertible senior notes had $764.8m principal outstanding and a $696.1m net carrying value. The notes bear no coupon and mature June 1, 2022. The company paid $18m principal during the first half and expected to settle approximately $23m more in cash in Q3 based on conversion requests received through the filing date.
- Operating lease liabilities totaled $502.2m. The company also disclosed $359m of undiscounted commitments for leases not yet commenced.
- Deferred revenue was $2.25bn current and $31.4m long-term. Remaining performance obligations were $7.0bn, with approximately 51% expected to be recognized over the next 12 months.
- Billings, a non-GAAP measure, increased 24% to $1,079.2m in Q2 and 26% to $2,182.4m for the first half. Foreign exchange reduced billings by $13m and $26m, respectively.
- Customers with annual contract value above $1m increased to 964 from 764 a year earlier. The reported renewal rate was 97%, compared with 98% in the prior-year periods.
Changes, outlook and material items
- Compared with Q2 2019, the company moved from operating and net losses to profits; revenue and gross margin also increased. Six-month results showed the same improvement.
- Management expected 2020 subscription revenue to increase in absolute dollars, with subscription gross margin relatively flat year over year. It expected professional services revenue to rise and its gross loss margin to improve. No specific full-year revenue or earnings guidance figures are provided in the filing text.
- Management expected operating expenses to increase in absolute dollars. Sales and marketing expense was expected to decline as a percentage of revenue, partly due to fewer travel and in-person event costs; R&D was expected to increase slightly as a percentage of revenue.
- COVID-19 led to remote work, office closures, travel restrictions, a digital replacement for the Knowledge conference and postponement of Financial Analyst Day. The company said these changes had not affected, and were not expected to affect, its ability to maintain operations and financial reporting controls.
- Acquisitions included Loom Systems for $58m and Passage AI for $33m in cash during February. A further acquisition, Sweagle, closed July 1 for approximately $25m; purchase price allocation was still being evaluated.
- The company reported a $21m income tax provision for the first half and maintained a full valuation allowance on U.S. federal and state deferred tax assets. Its disclosure controls were assessed as effective, with no material change in internal control over financial reporting identified during the quarter.
Risks and contingencies
- Management emphasized uncertainty around COVID-19 and possible reduced customer spend, delayed purchasing, shorter contracts, slower collections, longer sales cycles, vendor disruption and increased cybersecurity risks.
- Other stated risks include intense competition, privacy and data-transfer regulation, cybersecurity or service interruptions, reliance on implementation and reseller partners, foreign-exchange volatility, international expansion and acquisition integration.
- The notes are conditionally convertible and the company intends to settle principal in cash; further conversions could affect liquidity. The 2022 warrants could dilute shareholders: based on the June 30 share price, the company estimated approximately 2.9m shares could be issued, though the actual amount is unknown.
- One customer represented 14% of accounts receivable at June 30; no customer individually exceeded 10% of revenue in the periods presented. Management stated it was not party to legal proceedings expected to have a material adverse effect.
Important facts for investors to verify
- Whether COVID-19 affects renewals, customer expansion, contract duration, billings, collections and the company’s full-year outlook.
- How much cash will be used to settle further 2022 Notes conversions, and the timing and effect of the notes’ 2022 maturity.
- The sustainability of GAAP profitability given rising operating expenses and substantial stock-based compensation.
- Whether reported RPO converts to revenue on the anticipated schedule, and how billings and renewal trends develop.
- Potential dilution from equity awards and the 2022 warrants, plus integration and return on investment from acquisitions.