ServiceNow Inc (NOW) — Q1 2023 Earnings Call Transcript

Good afternoon, and thank you for joining ServiceNow's First Quarter 2023 Earnings Conference Call. Joining me are Bill McDermott, our Chairman and Chief Executive Officer; Gina Mastantuono, our Chief Financial Officer; and CJ Desai, our President and Chief Operating Officer. During today's call, we will review our first quarter 2023 results and discuss our guidance for the second quarter and full year 2023. Before we get started, we want to emphasize that the information discussed on this call, including our guidance, is based on information as of today and contains forward-looking statements that involve risks, uncertainties and assumptions. We undertake no duty or obligation to update such statements as a result of new information or future events. Please refer to today's earnings press release and our SEC filings, including our most recent 10-Q and 2022 10-K, for factors that may cause actual results to differ materially from our forward-looking statements. We'd also like to point out that we present non-GAAP measures in addition to and not as a substitute for financial measures calculated in accordance with GAAP. Unless otherwise noted, all financial measures and related growth rates we discuss today are non-GAAP, except for revenue, remaining performance obligations or RPO, current RPO and cash and investments. To see the reconciliation between these non-GAAP and GAAP measures, please refer to today's earnings press release and investor presentation, which are both posted on our website at investors.servicenow.com. A replay of today's call will also be posted on our website. With that, I'll turn the call over to Bill.

Thank you very much, Darren, and thank you, everyone, for joining us today. ServiceNow had an outstanding first quarter. Subscription revenue grew 27% in constant currency, which was 150 basis points above the high end of our guidance. The RPO grew 25% in constant currency, 100 basis points above our guidance. Operating margin was 26%, 2 full points above our guidance. We have 66 deals greater than $1 million in net new ACV. We saw strong, sustained demand for ServiceNow's platform. In January, we committed the company to performing beyond expectations. We said it, we did it. Our Q2 guidance reflects our strong conviction in the fundamentals of this business. We remain laser-focused on net new innovation, new business growth, and profitability. ServiceNow is a growth company that consistently executes in any environment, and we will continue to do exactly that, execute. Looking at the big picture, there's no question this remains a complicated macro environment. C-level leaders are managing an endless array of headlines and mixed signals. When you filter all that noise, it comes down to one simple reality. There is an app for everything, but nobody wants every app. This consolidation is a tailwind for ServiceNow as the intelligent platform for end-to-end digital transformation. We are now seeing conversations up-level to business transformation. This is bringing CEOs directly into the process as principal executive sponsors. Nearly 40% of CEOs think their company will no longer be economically viable in a decade if they continue on their current path. They aren't interested in turf battles between departments; rather, they want one enterprise-level investment to drive business impact. This isn't merely an inspection of what historically has been a significant cost center. This is CEOs engaging on a strategic level, insisting on a clear roster of technology partners to drive very specific business outcomes. For example, in the age of generative AI, it's a build-buy-operate conversation. They're looking for a single platform that can orchestrate the entire technology value chain. ServiceNow does just that. Businesses are also working hard to transform their customer experience. The AI opportunity here lies in integrating the front, middle, and back offices to better serve customers, which is a core competency of ServiceNow. On the internal side, it's about reducing the number of touchpoints for employees to get work done. People can't maximize their potential by juggling multiple systems with different user experiences. Our customers use ServiceNow as the one-stop digital hub to create a consumer-grade experience at work. Whether it's efficiency, productivity, cost reduction, or business model innovation, ServiceNow has never been more relevant. This is the message I hear directly from CEOs who know they need to shake things up, and they want our help to do it. Once again, these secular trends are fueling ServiceNow. About 70% of global tech equity value comes from firms that rely on network effects, and we see growing platform adoption across all of our businesses. ITSM was present in 18 of our top 20 deals with 3 deals over $1 million. ITOM was in 14 of the top 20 with 5 deals over $1 million. With increased focus on cost reduction, ITAM had a very strong quarter in 14 of our top 20 with 3 deals over $1 million. Security and risk were in 12 of the top 20 with 3 deals over $1 million. Customer workflows were hot in Q1, appearing in 18 of the top 20 with 9 deals over $1 million. This is worth emphasizing because ServiceNow is more relevant than ever as businesses invest in a differentiated experience for their end consumers, which is very exciting indeed. Employee workflows appeared in 10 of the top 20 with 4 deals over $1 million. Creative workflows were in 18 of the top 20 with 3 deals over $1 million. Major global brands continue to accelerate their own transformation by partnering with ServiceNow, including Marriott, Group Bimbo, Navy Federal Credit Union, Travelers, the U.S. Air Force, and Schneider Electric, to name a few. For example, in banking, PNC is modernizing the way it manages disputes, reducing losses and improving case closures by working with ServiceNow. We also saw significant co-innovation milestones in the quarter. For example, ServiceNow and AT&T have created a global telecom product to help communication service providers manage 5G and fiber networks. Q1 was also the latest step forward for our organic innovation machine with the ServiceNow Utah release, engineered to drive faster business outcomes for our customers. This release includes AI-powered process mining, robotic process automation capabilities, additional search enhancements, expanded workforce optimization, and health and safety incident management, all designed to help increase automation, simplify experiences, and offer greater organizational agility. It bears repeating that while customers are aware of market excitement for individual technologies like generative AI, they expect a platform strategy to integrate the various tools. ServiceNow has AI, process mining, RPA, low-code, and many other technologies built natively into a single workflow automation platform. Of course, we will have much more to say about all of this at our Knowledge event in Las Vegas on May 16. I hope you can join us. I'd also like to extend a warm welcome to Deborah Black, Vice President, Engineering at Netflix, who is the newest member of ServiceNow's Board of Directors. We're so proud to have Debbie's leadership on our journey to be the defining enterprise software company of the 21st century. In closing, I'll simply reiterate things we've said consistently. First, businesses need ServiceNow. Enterprise software is mission-critical. The demand environment is robust. Second, ServiceNow is a unique company performing at a very high level. We are delivering strong growth, aggressively managing costs, and creating immense shareholder value. The company has momentum everywhere. We're performing very well across the best places to work scorecards, including Glassdoor. Our brand recognition is increasing as we rise on lists like Fortune's Most Admired Companies. Our market opportunity is expanding, and this is the early days of a truly generational growth story. Finally, we know that trust is the ultimate human currency. What we have here is a platform, a culture, and a company built entirely on trust. The results tell that story. We just eclipsed the $2 billion threshold in a single quarter, and we were the fastest ever to achieve that on an organic basis. This is about a fast-growth, durable, predictable cloud business model. This will be the central theme at our Financial Analyst Day in a few weeks. We look forward to seeing you all there. Businesses work with ServiceNow. People work with ServiceNow. The world works with ServiceNow, and we're only getting started. I'd like to thank you very much for your time today. I'm looking forward to your questions. And for now, I'll hand things over to Gina.

Thank you, Bill. Q1 was a tremendous quarter with strong beats across our top line and profitability guidance metrics. We saw resilient demand as the Now Platform continues to deliver the productivity improvements our clients are seeking in the current macro environment. The quarter was yet another example of consistent execution from our team. In Q1, subscription revenues were $2.02 billion, growing 27% year-over-year in constant currency, exceeding the high end of our guidance range by 150 basis points. RPO ended the quarter at approximately $14 billion, representing 24% year-over-year constant currency growth. Current RPO was approximately $7.01 billion, representing 25% year-over-year constant currency growth, a 100 basis point beat versus our guidance. From an industry perspective, energy and utilities, government, and transportation and logistics led the way, followed by strong growth in education. Financial services net new ACV also continued to grow despite a tough compare and volatility in the banking sector. New customer ACV growth remained an area of strength, and the average deal size was up significantly year-over-year. Our renewal rate was a best-in-class 98% in Q1, continuing to demonstrate the stickiness of our business as the Now Platform remains a mission-critical part of our customers' operations. Our customer cohorts have also continued to show solid expansion. We ended the quarter with 1,682 customers paying us over $1 million in ACV, up 20% year-over-year. We're continuing to see healthy customer engagement with enterprise buying patterns demonstrating the extensibility of the Now Platform. We closed 66 deals greater than $1 million in net new ACV in the quarter, up from 52 a year ago. In Q1, 18 of our top 20 deals contained 5 or more products, showcasing how ServiceNow is providing customers with the single platform they need to orchestrate their technology value chain. Turning to profitability, non-GAAP operating margin was 26%, 200 basis points above our guidance, driven by continued disciplined spend management. Our free cash flow margin was 35%. We ended the quarter with a robust balance sheet, including $7.2 billion in cash and investments. Together, these results continue to demonstrate our ability to drive a strong balance of world-class growth and profitability. Moving to our outlook, our pipeline continues to look robust for the remainder of the year, and we're excited about what the Utah release and Knowledge 2023 can further contribute to those opportunities. While we've seen market resiliency, we continue to prudently factor in the evolving macro cost with each of our guidance. As Bill mentioned, we remain laser-focused on balancing net new innovation and new business growth with cost management and profitability. With that in mind, let's turn to our 2023 guidance. We are raising our subscription revenue outlook by $25 million at the midpoint to a range of $8.47 billion and $8.52 billion, representing 23% to 23.5% year-over-year growth on both a reported and constant currency basis. We expect subscription gross margin of 84%, an operating margin of 26%, a free cash flow margin of 30%. And we continue to expect GAAP diluted weighted average outstanding shares of $206 million. For Q2, we expect subscription revenues between $2.04 billion and $2.045 billion, representing 23.5% to 24% year-over-year growth on a constant currency basis, excluding a 50 basis point FX headwind. We expect CRPO growth of 22.5% on a constant currency basis, excluding a 50 basis point FX tailwind or 23% on a reported basis. We expect an operating margin of 23%, and we expect $205 million GAAP diluted weighted average outstanding shares for the quarter. In summary, Q1 was a very strong quarter. We're extremely proud of our team's performance, and we can't thank our employees enough for their continued hard work and dedication. It's their collective commitment to our culture that has enabled us to be named one of Fortune's 100 Best Companies to Work For, yet again in 2023. The consistency of our results exemplifies the strength of our platform and our people. We're delivering great experiences that drive powerful employee engagement, fierce customer loyalty, and significant productivity gains. ServiceNow's intelligent automation is a deflationary force that helps enterprises retool their business to get more done with less. And since we use the Now Platform ourselves extensively, we continue to see the benefit from those efficiencies, generating incremental opportunities for further operational leverage. That's why ServiceNow is so well-positioned to become the defining enterprise software company of the 21st century. You can hear more about that momentum in our new products and long-term opportunities at our upcoming Investor Day on May 16 in Las Vegas. We look forward to seeing you there. And with that, I'll open it up for Q&A.

Congratulations on another excellent quarter. So I wanted to ask CJ or Bill. You seem to be in a great position to embed AI into your Pro SKUs and try to unlock new efficiencies. Can you speak to how you see that opportunity playing out? And as chatbots become more powerful, do you see that affecting the headcount or seat count of a typical IT help desk or a contact center if you project that forward a few years down the road?

Mark, first of all, thanks for the question. Here is what I would say. When we started the ITSM Pro journey in Q4 2018, the exact question was asked because we embedded machine learning and AI into ITSM Pro, and that was a game changer both for our customers and our shareholders. When I look specifically at generative AI, we absolutely believe that besides our core machine learning and AI features that are in the platform today, there is a clear opportunity. This particular and versus an or provides more productivity not only for the employees of our customers but for the customer service agent or IT agents, as you asked. And wherever we can capture that additional value, we will monetize that further via additional SKUs that we offer on top of our current offerings. So overall, I feel very good about generative AI and what it does for our business. We have learned a lot through our ITSM Pro traction over the last 4 years, and I feel very optimistic for the next 3 to 5 years relating to its accretive effect on our top line.

Wonderful, and great to see a nice start to the fiscal year here. I wanted to ask a question around the non-IT mix. If you take customer and employee, plus creator combined, it's 43% of new ACV this quarter, which is the highest I can remember. The question is, what is it about Now that you're seeing success kind of taking ServiceNow outside of the IT department? Obviously, you have these great products to address more workflow automation. But is there something about the go-to-market, whether it's direct or in the channel, that you'd call out here where you're seeing real traction outside of IT?

Yes. Thank you very much for the question, Brad. And I think it underscores the importance of ServiceNow becoming the intelligent platform for end-to-end digital transformation. As I said, the C-level decision-makers now, CEO, the CFO, obviously, the head of technology, along with the head of HR and various other departments in the company, are aligning their business strategy on technology platforms that truly matter and can impact business results. They're moving away from the app of the day and platforms that don't matter. They're also taking antiquated platforms and building our innovation on top of them. So if you want to think about our unfair advantage, we actually started in IT and have extended that beautifully into HR, customer service management, and creator. Think about the importance of creator. 75% of the app development that will take place in the next 2 years will be done by the customers themselves on a low-code platform like ServiceNow. We feel we have a pole position. Customer service management; everybody is trying to align the front, mid, and back office to provide a seamless, self-service, direct-to-consumer experience via mobile. It's our core competency. And when you think about the employee experience, there's wonderful systems of record out there that perform their tasks effectively, but our expertise is truly in taking a technological view of recruiting, hiring, onboarding, and providing all services while using generative AI to suggest the employee's next best action, fundamentally changing the game on the productivity curve. All of this aligns the executive team around platform strategy, and our teammates here at ServiceNow are proud and confident in that platform. They can tell the story by industry, by persona, and they can bring countless examples to the first meeting now, and they are aligning the executives. One of the biggest requests we get is, 'Hey, can we have an off-site with our entire management team with your team so we can figure out the best next step for the relationship?' That's certainly a very different outcome than we were doing 4 years ago, where it was a more land-and-expand kind of approach.

Congratulations on a really nice start to the year. I want to dig in a little bit on the thread that Mark Murphy started pulling out in terms of the impacts of generative AI. The question I get a lot from investors is whether it necessitates that ServiceNow has to change its pricing model. And is there an ability to do that? Maybe if you could walk us through how this functionality creates more automation and drives value, is there a necessity or potential for changing the pricing model towards consumption or volume-oriented versus a seat-based model?

Yes. So Keith, this is CJ, and I'll address it. We think in multiple buckets. When we look at technology workflows, as you know, the CMDB is the core foundation. All the ITSM processes or ITOM, or our security and fast-growing products like risk and asset management are driven through our CMDB for a single end-to-end platform for transformation from a technology standpoint. So when I look at that, we have good, better, best packages. We have been pretty consistent in how we drive the go-to-market, as Bill described, overall at a platform level. It's the same for customer service management and HR as an employee workflow. When I look at creator workflow, we also have the opportunity to expand the ServiceNow ecosystem significantly, where anyone could be a ServiceNow developer by using text to code or text to workflow or, someday, text to app that they can create. So overall, these four buckets and the good, better, best mechanism we've implemented are working beautifully. The traction is great. We are getting the uplift we've shared with you and will provide more on Financial Analyst Day. Regarding additional pricing with generative AI, I told Mark that it is an 'and' proposition; as in, you can achieve higher productivity for specific use cases, whether it's incident deflection or agent productivity, and we believe we can absolutely monetize that. We're fairly early on this, and I'll share more at the Financial Analyst Day regarding what that pricing model may look like, whether it's an add-on or a bundle. We're working through the details but will only charge where we provide value for our customers, which is our first principle.