Business context and reporting period
ServiceNow, Inc. filed this Form 10-Q for the quarter ended June 30, 2014. It provides cloud-based software to automate and manage enterprise IT services, primarily through subscriptions. Subscription revenue is recognized over contract terms; customers are generally billed annually in advance. The filing reports Q2 and year-to-date results against 2013.
Key financial metrics
| Metric | Q2 2014 | Q2 2013 | Six months 2014 | Six months 2013 |
|---|---|---|---|---|
| Revenue | $166.8M | $102.2M | $305.8M | $188.2M |
| Subscription revenue | $132.7M | $80.4M | $250.1M | $151.9M |
| Gross profit / margin | $107.8M / 65% | $66.2M / 65% | $193.8M / 63% | $119.9M / 64% |
| Operating loss | $(44.5)M | $(19.3)M | $(80.7)M | $(32.3)M |
| Net loss | $(50.4)M | $(21.4)M | $(93.7)M | $(34.8)M |
| Net loss per share | $(0.35) | $(0.16) | $(0.65) | $(0.26) |
Q2 subscription gross margin was 75%; professional services and other gross margin was 24%. Q2 operating expenses were $152.3M, up from $85.6M. Stock-based compensation totaled $66.8M for the first half, compared with $26.9M a year earlier.
For the six months, operating cash flow was $66.3M, versus $24.8M. Investing activities used $132.7M, including capital expenditures of $27.4M; financing activities provided $29.4M. Cash and cash equivalents were $329.3M at June 30. Short-term investments were $348.2M and long-term investments $279.6M. Current assets were $844.7M and current liabilities $403.0M.
Convertible senior notes had $575.0M principal outstanding and a $429.0M net carrying amount. The notes bear no coupon, mature in November 2018, and are intended to have principal settled in cash upon conversion. The company also had $12.6M of property and equipment included in accounts payable and accrued expenses.
Material changes versus the prior comparable period
- Q2 revenue rose 63% year over year; subscription revenue grew 65%. Management attributed subscription growth to upsells, renewals, and customer additions. Customer count increased 33%, to 2,364.
- Q2 net loss more than doubled, while operating expenses rose 78%. Sales and marketing increased 76%, research and development 97%, and general and administrative 63%.
- Operating cash flow improved, supported partly by higher deferred revenue and other operating changes. Cash and cash equivalents declined $37.0M during the first half, while investment holdings increased.
- First-half total gross margin decreased to 63% from 64%; subscription gross margin was 74% versus 75%, and professional services and other gross margin was 15% versus 18%.
- Upsell rate was 33% for Q2 and 34% for the first half; renewal rate was 98% and 97%, respectively. Employee headcount reached 2,328, up from 1,443 a year earlier.
Outlook, management commentary, risks and unusual items
- Management expected subscription gross margin of 74%–75% for the remainder of 2014, with additional technology amortization following the Neebula acquisition. It expected professional services margins to decline, and operating expenses to increase in absolute dollars in several functions. No specific revenue or earnings guidance is provided in the filing.
- Management said existing cash, investments, and operating cash generation should fund expected needs for at least 12 months. It expected approximately $100M of cash use for the Neebula acquisition and approximately $11.5M of related cash tax payment in the next quarter.
- On July 11, 2014, after quarter-end, ServiceNow acquired Neebula Systems for approximately $100M in cash. The preliminary purchase-price allocation was $100.5M, including $54.6M goodwill and $56.2M developed technology. Valuations remained provisional.
- The annual Knowledge conference was an unusual quarterly factor: Q2 revenue was $8.2M, up from $5.0M, while related sales and marketing expense was $15.3M, up from $8.3M. Both conference revenue and costs are recognized in the event quarter.
- HP sued ServiceNow in February 2014, alleging infringement of eight patents and seeking unspecified damages and an injunction. The company said it could not reasonably estimate any loss; an unfavorable result could be material.
- Key stated risks include slower revenue growth, continued losses and rising costs, service reliability and security incidents, competition, international and foreign-exchange exposure, customer renewal and sales-cycle variability, acquisition integration, and potential dilution. The company had not hedged foreign-currency transactions. It also disclosed that ASC 606 would take effect for it in 2017 and that it was evaluating the impact.
- Management reported effective disclosure controls and no material quarterly change in internal control over financial reporting.
Important facts for investors to verify
- Whether subscription growth, customer additions, upsells, and renewal rates persist, and how deferred revenue translates into future recognized revenue.
- Whether operating expenses and stock-based compensation growth can be absorbed without further deterioration in operating losses and margins.
- Cash conversion quality, including the contribution of deferred revenue and other working-capital movements, and liquidity after the Neebula cash and tax payments.
- Neebula integration progress, realized benefits, final purchase accounting, and the expected amortization and operating costs.
- Developments and potential financial exposure in the HP patent litigation, for which the filing provides no clear loss estimate.
- Terms, conversion exposure, and potential cash requirements of the convertible notes, including the note hedge and warrants.