ServiceNow, Inc. — Q1 2018 Form 10-Q
Reporting period: Three months ended March 31, 2018. Amounts are in U.S. dollars; financial statement amounts are in millions unless otherwise noted. Prior-year comparisons are adjusted retrospectively for Topic 606 adoption.
Business context and operating metrics
ServiceNow provides enterprise cloud software for managing and automating services. Subscription services are generally billed annually in advance; subscription revenue is recognized over the contract term. The company reported 6,675 employees, up from 5,223 a year earlier.
- Customers with annualized contract value (ACV) above $1 million: 536, versus 374.
- Global 2000 customers: 850, versus 765; average ACV per G2K customer was approximately $1.4 million, versus $1.1 million.
- ACV-based renewal rate: 98%, versus 97%.
- Total backlog: $3.98 billion, including $2.63 billion of unbilled backlog; approximately 51% expected to be recognized as revenue in the following 12 months.
Financial results and liquidity
| Metric | Q1 2018 | Q1 2017 | Change |
|---|---|---|---|
| Subscription revenue | $543.3 million | $387.6 million | +40% |
| Professional services and other revenue | $45.9 million | $41.2 million | +11% |
| Total revenue | $589.2 million | $428.8 million | +37% |
| Gross profit / margin | $445.7 million / 76% | $312.7 million / 73% | Margin +3 percentage points |
| Operating loss | $(20.3) million | $(21.8) million | Improved |
| Net income (loss) | $10.6 million | $(21.5) million | Turned profitable |
| Operating cash flow | $250.1 million | $187.6 million | +33% |
| Free cash flow (non-GAAP) | $214.7 million | $154.4 million | +39% |
Operating expenses were $466.0 million, or 79% of revenue, broadly unchanged as a revenue share year over year. Stock-based compensation was $121.3 million, 21% of revenue, compared with $89.9 million in Q1 2017. Interest expense increased to $17.1 million from $8.7 million.
Net income was driven by non-recurring accounting effects: a $23.1 million indirect tax benefit associated with Topic 606 adoption and an $18.5 million unrealized gain on marketable equity securities following adoption of new financial-instrument accounting guidance. Management said it did not expect full-year 2018 GAAP profitability because these gains were not expected to recur.
At March 31, cash and cash equivalents were $682.9 million, short-term investments $1.203 billion, and long-term investments $451.2 million. Cash plus short-term investments totaled approximately $1.89 billion. Operating cash flow benefited from earnings adjustments and working-capital changes; investing activities used $237.2 million, mainly for net investment purchases, while financing activities used $61.8 million.
Total liabilities were $2.839 billion, including $1.155 billion net carrying value of convertible notes. The 2018 Notes had $537.7 million principal outstanding and mature November 1, 2018; the 2022 Notes had $782.5 million principal and mature June 1, 2022. The company paid cash to settle $37.3 million of 2018 Notes principal in Q1 and expected to settle another $319.5 million principal in Q2 based on conversion requests received through the filing date.
Material changes and accounting
- Revenue grew 37%, led by subscription growth from customer expansion and a higher customer count. IT operations management subscription revenue rose 84%; service management revenue rose 35%.
- Operating loss narrowed despite operating expenses rising 39%, as gross profit increased 43%. Subscription gross margin held at 82%; professional services remained loss-making, though its gross loss margin improved to 5% from 11%.
- Foreign exchange benefited reported revenue; at prior-year exchange rates, Q1 2018 revenue would have been $25.4 million lower. Foreign exchange also favorably affected billings by $29.6 million; changes in billings duration reduced billings by $2.0 million.
- Topic 606 was adopted retrospectively. It changed the timing of revenue for certain on-premises software arrangements, commission-cost deferral and classification of Knowledge forum proceeds. The adjusted Q1 2017 comparison shows revenue of $428.8 million and net loss of $21.5 million; the filing also presents previously reported figures that differ.
- Billings, a non-GAAP measure, were $689.4 million, up 33%. Definitions and accounting changes affect comparability; management identifies billings duration, renewal timing, future contract start dates and foreign exchange as factors.
Outlook, risks and contingencies
Management expected subscription revenue to grow in absolute dollars and as a share of revenue in 2018. It expected subscription costs to rise in dollars, with subscription gross margin improving slightly; sales and marketing, research and development, general and administrative, and stock-based compensation expenses were expected to rise in dollars while remaining relatively flat as percentages of revenue. The company cautioned that revenue growth was expected to continue declining and said it did not expect to be profitable for full-year 2018. No specific full-year revenue or earnings guidance figure is provided in the supplied filing text.
Management said existing cash and operating cash generation should meet liquidity needs for at least the next 12 months, including repayment of 2018 Notes, data-center expansion, leases, hiring and capital expenditures. Key risks include cybersecurity incidents and service disruptions, competition and pricing pressure, execution of product development and customer implementations, foreign-exchange exposure, privacy and regulatory changes (including GDPR), tax uncertainty, and variability in renewals, billings and results.
The company began a limited foreign-currency hedging program in Q1; contracts had $835.1 million notional value and were not designated as accounting hedges. The company reported no legal proceedings expected to have a material adverse effect, while noting ordinary-course litigation and customer intellectual-property indemnification obligations.
Commitments included $357.5 million of operating lease payments and $87.6 million of purchase obligations in the disclosed schedule. After quarter-end, ServiceNow entered into Santa Clara headquarters lease extensions and expansion arrangements, with approximately $453.7 million of incremental estimated minimum payments not included in that schedule. It also reported approximately $25 million paid after quarter-end to acquire two private companies; purchase accounting was still pending. Lease adoption guidance was expected to materially increase reported balance-sheet assets and liabilities, given operating lease commitments above $300 million at quarter-end.
Important facts for investors to verify
- How much of Q1 net income and reported growth reflects recurring operations versus the $23.1 million tax benefit, $18.5 million investment gain and Topic 606 presentation changes.
- Cash required to settle the 2018 Notes, including the reported $319.5 million expected Q2 principal conversions and any additional conversion requests.
- Whether backlog conversion, billings growth, renewal rates and large-customer expansion continue at comparable rates, accounting for seasonality and foreign exchange.
- Execution and cost implications of the headquarters lease commitments, data-center investment and rapid headcount growth.
- Potential effects of tax-law interpretation, cybersecurity, service reliability, competition, privacy regulation and foreign-currency movements on margins and cash generation.