ServiceNow, Inc. — Q3 2017 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2017; comparisons are with the same 2016 periods. Amounts below are in U.S. dollars.
Business context and reporting period
ServiceNow provides enterprise cloud software for automating and managing services, primarily through subscriptions. Subscription services accounted for 91% of Q3 revenue. The company reported 5,895 employees, up from 4,501 a year earlier, and continued investing in product development, infrastructure, and sales capacity.
Financial and operating performance
| Metric | Q3 2017 | Q3 2016 | Nine months 2017 | Nine months 2016 |
|---|---|---|---|---|
| Subscription revenue | $455.4 million | $318.9 million | $1,242.6 million | $877.0 million |
| Professional services and other revenue | $42.7 million | $38.7 million | $144.1 million | $127.8 million |
| Total revenue | $498.2 million | $357.7 million | $1,386.7 million | $1,004.8 million |
| Gross profit / margin | $370.9 million / 74% | $254.8 million / 71% | $1,021.2 million / 74% | $711.1 million / 71% |
| Operating loss | $(7.1) million | $(26.8) million | $(88.3) million | $(399.2) million |
| Net loss | $(24.2) million | $(36.3) million | $(121.3) million | $(419.2) million |
| Net loss per share | $(0.14) | $(0.22) | $(0.71) | $(2.56) |
- Q3 total revenue increased 39% year over year; subscription revenue grew 43%. For the first nine months, total revenue increased 38% and subscription revenue grew 42%. IT Operations Management subscription revenue grew 92% in Q3 and 87% for the nine-month period.
- Q3 subscription gross margin was 82%, versus 81% a year earlier. Professional services and other had a 6% gross loss margin in Q3; its nine-month gross margin was 5%. Management attributed subscription margin improvement to data-center utilization and economies of scale.
- Operating expenses were $377.9 million in Q3, including $100.4 million of stock-based compensation. For the first nine months, stock-based compensation was $288.5 million, or 21% of revenue.
- Operating cash flow was $458.0 million for the first nine months, versus $27.2 million in 2016. Free cash flow, a company-defined non-GAAP measure, was $342.2 million, compared with negative $56.9 million. The company cited lower net loss, noncash adjustments, and changes in operating assets and liabilities; deferred revenue increased $193.6 million.
- Cash and cash equivalents were $1.105 billion at September 30; short-term investments were $567.0 million and long-term investments were $424.9 million. Current assets were $2.127 billion and current liabilities $1.281 billion. Management said available cash and operating cash generation should cover liquidity needs for at least 12 months.
- Convertible notes had $1.358 billion aggregate principal outstanding: $575.0 million of 0% notes due November 2018 and $782.5 million of 0% notes due June 2022. Their combined net carrying amount was $1.157 billion. Management intended to settle principal in cash and use approximately $575 million of the 2022-note proceeds to repay the 2018 notes. The 2018 notes were convertible at holders’ option; conversion requests for $4,000 principal were received in Q3 and elected for cash settlement.
Material changes versus the prior comparable period
- The nine-month net loss narrowed by $297.9 million, primarily because 2016 included a $270.0 million charge for settlements with HPE and BMC. The settlements resolved those lawsuits and the filing states no financial obligations remain under them.
- Cash and cash equivalents rose from $401.2 million at December 31, 2016 to $1.105 billion at September 30, 2017, reflecting operating cash generation and financing from the 2022 notes, among other items.
- Interest expense rose 97% in Q3 and 48% for the first nine months, mainly from amortization of debt discount and issuance costs on the convertible notes.
- Deferred revenue, including current and long-term amounts, increased from $895.1 million at December 31, 2016 to $1.125 billion at September 30, 2017.
- Customers with annual contract value above $1 million rose to 436 from 308; Global 2000 customers increased to 815 from 707. Renewal rate was 97% in both Q3 and the first nine months, versus 99% and 98%, respectively, in 2016.
Outlook, commentary, risks, and unusual items
- The filing provides no specific quarterly or full-year revenue or earnings guidance figures. Management expected subscription revenue to grow in absolute dollars and as a share of revenue in 2017, while also expecting a GAAP loss for the year. It expected professional-services revenue to rise more slowly than subscription revenue and subscription gross margin to improve slightly.
- Management identified fourth-quarter seasonality: the company typically signs more new and renewal agreements late in the year, but future-start contracts and ratable subscription revenue recognition can delay the effect on billings and reported revenue. Management also warned that revenue growth rates were expected to continue declining.
- Billings, a non-GAAP measure, were $546.1 million in Q3, up 35%, and $1.580 billion for the first nine months, up 37%. Free cash flow and billings are company-defined measures and may not be comparable with similarly named measures from other companies.
- Revenue recognition standard Topic 606 was scheduled for adoption beginning January 1, 2018; the company expected full retrospective adoption. It did not expect a material timing impact on cloud subscriptions, but expected changes for certain on-premises contracts and commission accounting. Management estimated 2016 revenue would have been $10–$15 million higher and sales and marketing expense $20–$25 million lower under the new standard, on a pro forma basis.
- Operating lease commitments totaled $352.0 million; purchase obligations were $78.2 million. Certain conference commitments carried approximately $22.9 million in cancellation penalties. A subsequent acquisition of SkyGiraffe for approximately $32 million closed October 31, 2017.
- Key risks include slowing revenue growth and continued GAAP losses; competition and execution in newer product markets; cybersecurity incidents or service disruptions; foreign-exchange exposure (the company did not then hedge transactional exposures); privacy and regulatory changes; and the cash, dilution, and counterparty risks associated with convertible notes, note hedges, and warrants. The company also noted that it lacked insurance sufficient to cover potentially significant losses from security breaches or service claims.
- Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter. It said pending ordinary-course legal matters were not expected to have a material adverse effect.
Most important facts for investors to verify
- Whether subscription growth, customer expansion, and the 97% renewal rate persist, particularly as growth rates are expected to decelerate.
- How operating cash flow and free cash flow develop, including the contribution from deferred revenue, stock-based compensation, and working-capital timing.
- Cash requirements and settlement plans for the $575 million 2018 notes, and potential conversion or repurchase obligations under both note issues.
- The realized effects of Topic 606 adoption on revenue timing, deferred commissions, expenses, and comparability of reported periods.
- Whether improving subscription margins can offset continued growth in sales, research, infrastructure, and stock-based compensation costs.
- Integration and financial effects of recent acquisitions, including SkyGiraffe, and exposure to cybersecurity, service-continuity, foreign-exchange, and legal risks.