ServiceNow, Inc. — Q3 2019 Form 10-Q
Reporting period: Three and nine months ended September 30, 2019; comparisons are with the corresponding 2018 periods unless noted. ServiceNow provides enterprise cloud software for digital workflows, primarily through annual subscriptions.
Financial performance
| Metric | Q3 2019 | Q3 2018 | Change |
|---|---|---|---|
| Total revenue | $885.8 million | $673.1 million | +32% |
| Subscription revenue | $834.9 million | $626.6 million | +33% |
| Gross profit margin | 77% | 77% | Flat |
| Operating income | $56.3 million | $9.6 million | Higher |
| Net income | $40.6 million | $8.4 million | Higher |
| Diluted earnings per share | $0.21 | $0.04 | Higher |
| Nine-month metric | 2019 | 2018 |
|---|---|---|
| Total revenue | $2,508.7 million (+32%) | $1,893.4 million |
| Gross profit margin | 77% | 76% |
| Operating income (loss) | $13.6 million | $(42.7) million |
| Net income (loss) | $28.0 million | $(33.7) million |
| Operating cash flow | $814.8 million | $521.5 million |
| Free cash flow (non-GAAP) | $628.9 million | $385.1 million |
Margins and costs: Subscription gross margin was 83% in both Q3 periods. Professional services and other generated a gross loss equal to 21% of that revenue, versus 10% a year earlier; management attributed the deterioration to investment in specialized resources and a shift toward strategic advisory services. Total operating expenses rose 24% in Q3, slower than revenue growth. Stock-based compensation was $162.9 million in Q3 and $492.1 million for the nine months.
Balance sheet, cash flow and debt
- At September 30, 2019, cash and cash equivalents were $622.9 million, short-term investments $848.1 million and long-term investments $1,001.5 million. Management described cash and short-term investments as approximately $1.5 billion, with another $1.0 billion in long-term investments.
- Total assets were $4.76 billion and total liabilities $3.33 billion. Accounts receivable were $539.4 million; deferred revenue totaled $1.80 billion.
- Operating cash flow for the first nine months was $814.8 million. Capital expenditures were $185.9 million; free cash flow, defined by the company as operating cash flow less property and equipment purchases, was $628.9 million.
- The company had $782.5 million principal amount of 0% convertible notes due June 2022, with a net carrying value of $686.5 million. The notes were conditionally convertible through December 31, 2019; ServiceNow said it intended to settle principal in cash and expected an immaterial cash settlement in Q4 2019 based on requests received.
- Adoption of lease accounting in January 2019 added operating lease right-of-use assets and liabilities. At September 30, lease liabilities were $437.8 million; a further $412.5 million of undiscounted commitments related to leases not yet commenced.
Business trends and outlook
- Subscription growth reflected increased purchases by existing customers and customer additions. Customers with annual contract value above $1 million increased to 809 from 612 year over year; renewal rates were 99% for Q3 2019 versus 97% for Q3 2018.
- Total backlog was $5.8 billion at September 30, including $4.0 billion of unbilled backlog. Remaining performance obligations were approximately $5.6 billion; the company expected to recognize about 51% of RPO over the following 12 months.
- Management expected subscription revenue to grow in absolute dollars and as a share of revenue in 2019, and expected GAAP net income for 2019. It anticipated higher R&D spending, a slight improvement in subscription gross margin, and a professional-services gross loss for the year. These are qualitative expectations, not specific revenue or earnings guidance.
- Foreign exchange was a headwind: at prior-year exchange rates, Q3 subscription revenue would have been $12.7 million higher; for the nine months, subscription revenue would have been $49.7 million higher.
Material developments, risks and unusual items
- Management said a release of the valuation allowance on the Irish subsidiary’s deferred tax assets could become supportable in the following months. At September 30 exchange rates, such a release could produce a one-time income tax benefit of approximately $550 million to $600 million; timing and realization were uncertain. The company maintained a full valuation allowance on U.S. and certain foreign deferred tax assets.
- CEO John Donahoe announced his departure, effective on or before December 31, 2019; William McDermott was named incoming CEO, effective on or before January 1, 2020. CFO Michael Scarpelli had left in August, and a successor search was underway.
- In Q3 2019, ServiceNow adopted the new lease accounting standard without restating comparative periods. It recorded approximately $334.7 million of right-of-use assets and $362.7 million of lease liabilities on adoption.
- Key disclosed risks include intense competition and pricing pressure, cybersecurity or service interruptions, macroeconomic and foreign-exchange exposure, privacy and regulatory requirements, execution of international growth, and retention of key personnel. Management said no pending legal proceeding was expected to have a material adverse effect.
- The company reported effective disclosure controls and no material change in internal control over financial reporting during the quarter. A subsequent event disclosed a planned approximately $35 million cash acquisition of intellectual property and R&D talent, expected to close in Q4 2019.
Important facts for investors to verify
- Whether revenue growth, billings growth and backlog conversion continue, given seasonality and the company’s subscription revenue-recognition model.
- Whether the potential Irish tax valuation-allowance release occurs, and how its one-time benefit would affect reported earnings and comparability.
- The timing and cash impact of any 2022 Notes conversions, alongside potential dilution from outstanding warrants and equity awards.
- Whether sales and R&D investment, professional-services losses and substantial stock-based compensation affect operating leverage and sustained profitability.
- How the CEO transition and open CFO position affect execution, financial oversight and retention of key employees.