Business context and reporting period
ServiceNow, Inc. filed this Form 10-K for the fiscal year ended December 31, 2018. The company sells enterprise cloud subscriptions for IT, employee, customer, security and other digital workflows, principally to large enterprises. It reported approximately 5,400 enterprise customers at year-end. The filing also provides unaudited fourth-quarter results; this is an annual filing, not a standalone quarterly report.
Financial performance and position
| Metric | FY 2018 | FY 2017 |
|---|---|---|
| Total revenue | $2.609 billion | $1.918 billion |
| Subscription revenue | $2.421 billion | $1.740 billion |
| Gross profit / margin | $1.986 billion / 76% | $1.419 billion / 74% |
| Operating loss | $42.4 million | $64.4 million |
| Net loss | $26.7 million | $116.8 million |
| Cash from operations | $811.1 million | $642.9 million |
| Free cash flow (non-GAAP) | $586.6 million | $492.4 million |
Revenue grew 36% year over year; subscription revenue rose 39%, while professional services and other revenue increased 5%. IT operations management subscription revenue grew 74%. Subscription gross margin improved to 83% from 82%; professional services and other gross margin was negative 9%, versus negative 3%. Operating expenses rose 37% to $2.029 billion. Stock-based compensation was $544.0 million, or 21% of revenue.
For Q4 2018, revenue was $715.4 million versus $549.1 million in Q4 2017. Net income was $7.0 million ($0.04 diluted EPS), compared with a net loss of $17.3 million ($0.10 diluted loss per share). Q4 operating income was $0.3 million.
At year-end, cash and cash equivalents were $566.2 million, short-term investments $931.7 million and long-term investments $581.9 million, totaling approximately $2.080 billion. Working capital was $332.1 million. Convertible senior notes had $782.5 million principal outstanding, with a $661.7 million net carrying amount, due June 2022. The company said available liquidity and operating cash flows should cover anticipated needs for at least 12 months.
Changes, outlook and notable items
- Total backlog was $5.1 billion, including $3.4 billion of unbilled backlog; management expected approximately 50% to be recognized as revenue in the 12 months after year-end. Backlog is an operational measure, not a GAAP revenue forecast.
- Renewal rate was 98%, up from 97% in 2017. Customers with ACV above $1 million increased to 678 from 508.
- Operating cash flow increased by $168.1 million. Free cash flow includes a $145.3 million operating cash-flow outflow associated with the repayment of convertible-note debt discount; investing cash use fell substantially, partly due to lower net investment purchases.
- Management expected 2019 subscription revenue to rise in absolute dollars and remain relatively flat as a share of revenue. It expected subscription gross margin to improve slightly; operating expenses were expected to increase in dollars, with sales and marketing declining as a share of revenue and R&D remaining relatively flat as a share.
- ServiceNow adopted Topic 606 using full retrospective application, restating prior periods. The standard changed, among other matters, timing of revenue recognition for self-hosted software, commission-cost deferral and conference-related presentation. Comparisons should use the adjusted figures shown in the filing.
- The 2018 Notes were fully settled at maturity; the remaining $782.5 million of 2022 Notes were not convertible at holders’ option for Q1 2019. The company intended to settle their principal in cash. It estimated approximately 4.0 million shares could be issued in 2019 from automatic exercise of 2018 warrants, based on the February 1, 2019 share-price measure.
- Contractual obligations included $898.9 million of operating lease payments and $140.4 million of purchase obligations. The company expected lease-accounting adoption in 2019 to add approximately $330 million of right-of-use assets and $360 million of lease liabilities, with no material income-statement or cash-flow effect anticipated.
Risks and contingencies
Key disclosed risks include intensifying competition and pricing pressure; a slowing revenue growth rate; cyberattacks, service outages and data-protection regulation; implementation and partner-delivery challenges; foreign-exchange and macroeconomic exposure; and the possibility that investment and hiring costs outpace growth. The company also highlighted tax-rate uncertainty and a full valuation allowance on U.S. and certain foreign deferred tax assets. A 10% U.S. dollar strengthening was estimated to increase operating loss by approximately $23.4 million.
The company reported no pending legal matter believed likely to have a material adverse effect. It had paid $270 million in aggregate settlements with HPE and BMC in 2016, with no remaining financial obligations under those settlements. The independent auditor issued an unqualified opinion on the financial statements and internal control; management and the auditor concluded internal control over financial reporting was effective at December 31, 2018.
Investor verification points
- Confirm FY and Q4 comparisons use Topic 606-adjusted historical figures, and distinguish the $586.6 million non-GAAP free cash flow measure from GAAP operating cash flow.
- Assess whether subscription growth, renewal performance and backlog conversion support the company’s growth assumptions, while recognizing backlog is not guaranteed revenue.
- Review the scale and quality of earnings adjustments, particularly $544.0 million of stock-based compensation and the $23.1 million Topic 606-related tax benefit recorded in Q1 2018.
- Verify the 2022 Notes cash-settlement exposure and actual dilution from the 2018 warrants; the disclosed 4.0 million-share estimate was based on a specified market-price observation.
- Monitor operating-lease commitments, expected balance-sheet effects of lease accounting, foreign-exchange exposure, and the realization of deferred tax assets.