ServiceNow, Inc. — Q2 2017 Form 10-Q
Reporting period: Three and six months ended June 30, 2017. ServiceNow provides enterprise cloud software, primarily through subscriptions. Unless stated otherwise, amounts below are in U.S. dollars.
Financial results and key metrics
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Total revenue | $471.7 million (+38%) | $341.3 million | $888.5 million (+37%) | $647.2 million |
| Subscription revenue | $411.0 million (+41%) | $290.7 million | $787.1 million (+41%) | $558.1 million |
| Gross margin | 74% | 71% | 73% | 70% |
| Operating loss | $38.7 million | $48.3 million | $81.2 million | $372.4 million |
| Net loss | $56.5 million | $49.6 million | $97.1 million | $383.0 million |
| Net loss per share, diluted | $0.33 | $0.30 | $0.57 | $2.35 |
- Subscription revenue was 87% of Q2 revenue, up from 85% a year earlier. IT Operations Management subscription revenue grew 82% in Q2; Service Management grew 37%.
- Q2 subscription gross margin rose to 82% from 81%, which management attributed to better data-center utilization and scale. Professional services and other gross margin was 24%, helped by the annual Knowledge conference; excluding that event, the underlying comparison is less favorable.
- Operating cash flow was $316.1 million for the first half, versus cash used of $69.5 million a year earlier. Free cash flow, a non-GAAP measure, was $247.0 million versus negative $122.4 million. The prior-year comparison included a $267.5 million cash payment for legal settlements.
- Cash and cash equivalents were $1.173 billion; short-term investments were $518.7 million and long-term investments $319.8 million. Total cash and short-term investments were approximately $1.692 billion. Current liabilities were $1.217 billion.
- Convertible notes had a $1.140 billion net carrying value at June 30. Principal outstanding was $575 million on 0% notes due November 2018 and $782.5 million on 0% notes due June 2022. The 2018 notes became convertible at holders’ option in Q3 2017; ServiceNow said it intended to settle principal in cash. Note hedges are intended to offset conversion dilution, while related warrants could dilute shares above their strike prices.
- Stock-based compensation was $98.1 million in Q2 and $188.0 million for the first half, respectively 21% of revenue in both periods.
Changes versus prior periods
- Q2 revenue growth was led by subscriptions; total revenue increased 38% year over year. Management cited upsells and customer growth as drivers.
- Q2 operating loss narrowed by $9.5 million, but net loss widened by $6.8 million, primarily due to higher foreign-exchange losses and interest expense on the newly issued 2022 notes.
- First-half net loss improved substantially year over year mainly because the 2016 period included $270 million of legal settlement expense. The 2017 first-half period still recorded an operating loss.
- First-half billings, a non-GAAP measure, increased 38% to $1.034 billion. Q2 billings rose 35% to $504.9 million. Currency movements reduced billings by $18.3 million for the first half; billings duration had a favorable $17.9 million impact.
- Employee headcount increased to 5,571 from 4,241 a year earlier. Customers with annual contract value above $1 million rose to 403 from 279; Global 2000 customers increased to 790 from 683.
Outlook, commentary, and risks
- Management expected subscription revenue to grow in absolute dollars and as a share of revenue in 2017, and expected a slight improvement in annual subscription gross margin. It expected a GAAP loss for 2017. The filing provides no quantified full-year revenue or earnings guidance.
- Management also stated that revenue growth had been declining and was expected to continue declining into the foreseeable future. It expected operating costs to rise as it invested in sales, product development, data centers, and headcount.
- Management expects professional services and other revenue to grow more slowly than subscriptions, excluding Knowledge, and its gross margin to decline for full-year 2017 as it invests in the services organization. Sales and marketing, R&D, and G&A expenses were expected to rise in dollars but decline slightly as a percentage of revenue.
- Foreign exchange was a notable headwind: Q2 included an $11.2 million foreign-exchange loss, and first-half losses were $6.2 million. The company had no currency hedging program in place, though it was evaluating one.
- Liquidity was expected to cover needs for at least 12 months. ServiceNow planned to use approximately $575 million of the 2022 notes’ proceeds to repay the 2018 notes. Operating lease commitments totaled $364.2 million; total listed leases, purchase obligations, and other commitments were $419.5 million. Separate event-related cancellation penalties would have been approximately $16.2 million.
- Revenue standard Topic 606 adoption was planned for January 1, 2018 using the full retrospective method. Management did not expect a material timing impact for cloud subscriptions, but anticipated changes to on-premises revenue timing and commission accounting. It estimated 2016 revenue would have been $14–$19 million higher and sales and marketing expense $20–$25 million lower under the new standard.
- Key risks include competition and pressure on growth, execution in newer product markets, cybersecurity and service disruptions, international and foreign-exchange exposure, privacy regulation, litigation and intellectual-property claims, and potential cash needs or dilution related to convertible notes. Management reported no pending legal proceedings expected to have a material adverse effect; the HPE and BMC settlements were resolved in 2016.
- CEO John Donahoe succeeded Frank Slootman in 2017. Management reported disclosure controls were effective and no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether subscription growth, renewals, customer expansion, and billings remain strong, accounting for seasonality, future contract start dates, duration, and foreign exchange.
- The cash requirements and settlement choices for the 2018 notes during their Q3 2017 conversion window, and the potential effect of the warrants on dilution.
- Whether rising stock compensation, hiring, and infrastructure costs are consistent with management’s margin and loss outlook.
- The eventual effects and implementation risks of Topic 606, especially for on-premises contracts and commission deferrals.
- Exposure to foreign-exchange movements, cybersecurity or service incidents, and any developments in litigation, tax examinations, or contractual commitments.