ServiceNow Inc (NOW) — Q2 2023 Earnings Call Transcript

Thank you. Good afternoon. And thank you for joining ServiceNow’s second 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’ll review our second quarter 2023 results and discuss our guidance for the third 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 the 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 RPOs, current RPOs 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, Darren, and thank you, everyone, for joining us today. Once again, ServiceNow's Q2 results beat expectations for all key performance metrics. Subscription revenue grew 25% in constant currency, 1% above the high-end of our guidance. CRPO grew 24% in constant currency, 1.5% above our guidance, and operating margin was 25%, 2 points above our guidance. We had 70 deals greater than $1 million in net new ACV, which was up from 54 a year ago, representing a 30% increase. As the market consolidates, customers are moving to ServiceNow as the intelligent platform for end-to-end digital transformation. We have now more than 1 trillion workflows running through ServiceNow each year, and that metric is already growing at 40% annually. ServiceNow's long-term trajectory is being supercharged by Generative AI. ServiceNow is the most differentiated asset in enterprise software, an AI first mover, organic innovation-led, fast top line growth, best-in-class profitability, with a 99% renewal rate, and we are in the early stages of cross-sell expansion around our IT model. We have said consistently that ServiceNow will be the defining enterprise software company of the 21st Century. This Q2 beat and raise is another step forward on that journey. Looking at our solutions portfolio, large deals were evenly spread in Q2, illustrating the broad appeal of this platform. ITSM was in 16 of the top 20 deals with seven deals over $1 million. ITOM was in 13 of the top 20, also with seven deals over $1 million. Together, security and risk combined for 17 of the top 20 with eight deals over $1 million. Customer workflows had a sensational quarter, its best net new ACV growth in three years. Customer was in 16 of the top 20 deals with eight deals over $1 million. Employee Workflows were in 14 of the top 20 with seven deals over $1 million, and Creator Workflows were in 18 of the top 20, with eight deals over $1 million. Great organizations are transforming with ServiceNow, including Barclays, BT, Honda, HP, Petrobras, CSB Bank in India, and Yokohama City in Japan, to name a few. We see a sustained demand environment and pipeline for all of our product businesses, geographic regions and industry verticals. We're set up very well for a strong second half. As you'll hear from Gina, we are raising our full-year guidance for subscription revenue and operating margin. This is an unprecedented market environment for enterprise software. Our good friend, NVIDIA Co-Founder, and CEO, Jensen Huang, joined us at Knowledge ‘23 earlier this year. Jensen stated that the expanded NVIDIA-ServiceNow partnership is really important. Their partnership is the choice for enterprise IT. He thinks it's an exciting growth opportunity for both companies, and we agree. We're in the midst of a dramatic expansion of the software economy. In 2023 alone, IDC says Platform-as-a-Service spending will grow 30%, and Software-as-a-Service applications will grow 17%. When you correlate that to ServiceNow's platform and our workflow leadership, it's clear we live in a great neighborhood on a super nice street, and maybe we're in the best house. With regard to artificial intelligence, especially large language models, ServiceNow's strategy has been laser-focused for years. We accelerated that focus with our Element AI acquisition in 2020. Today, by some estimates, Generative AI could boost global GDP by almost $7 trillion. We see unprecedented parallel adoption across consumer and enterprise. Our platform experts, who have worked for the greatest brands and technology, believe this moment is as transformative, if not even more so than the Internet or even the iPhone. But they're careful to remind me, it's all about delivering enterprise-grade, domain-specific large language models, which is the core of ServiceNow's AI strategy. These models will improve the accuracy of results, leveraging a customer's enterprise data in alignment with their business rules, while maintaining the highest ethical standards for data privacy. As you saw at our Financial Analyst Day, ServiceNow is infusing Generative AI into all of our workflow offerings. We have since announced Now Assist for virtual agents, maximizing productivity by eliminating time spent searching for information. Another example is the ServiceNow Generative AI controller. It allows organizations to connect ServiceNow instances to Bolt, Microsoft Azure OpenAI service, and OpenAI API large language models. We're going even further by expanding our Generative AI capabilities with case summarization and text-to-code, text-to-flow, and text-to-new-application-development. Our customers are so excited for greater ROI and customer service, better employee self-service experiences, and a substantial boost in developer productivity. They are ready to invest to drive these outcomes. Based on the immense value our customers will realize from our Generative AI innovation, we have a clear strategy for monetization. First, our existing Pro offerings had a record quarter in Q2 based on the hyperautomation technologies we already engineered into those products. For all new Generative AI capabilities, beginning with our Vancouver release, we will introduce a new set of premium plus SKU offerings across ITSM, CSM, and HR SV. We have also introduced a new ServiceNow AI Lighthouse customer program, alongside NVIDIA and Accenture, all in lockstep to accelerate value realization at the cutting edge of Generative AI. Specifically, this involves our engineers locking arms with NVIDIA to co-develop new use cases for the enterprise. We already have the most significant pharmaceutical, financial services, manufacturing, and healthcare companies engaging with us. Additional customers will become design partners for new AI capabilities in their specific industries. We're currently evaluating a range of customers who are candidates for this program, and the interest is continuing to surge. These engagements share one sentiment perfectly in common: The propensity to buy is there. Even as our underlying growth is already strong, as our Q2 results indicate, AI represents a market-making tailwind for ServiceNow. Intelligence is only relevant when it is delivered where work actually gets done. It's why our single architecture, single data model workflow platform has never been more relevant than it is right now. As AI goes to work, humans will be the real machines because in most cases, AI augments people; it doesn't replace them. At a moment when employers face a 17-year high in unfilled job openings, Generative AI will lift human productivity so we can chase even bigger dreams for the global economy and for the world. With our integrated suite of automation technologies, including AI, RPA, and process mining, ServiceNow is uniquely positioned to lead the intelligence revolution, and we will. Looking broadly at the state of our business, we have the momentum with our upcoming Vancouver release in September. Our products and engineering team will deliver even more AI innovation. Our partner ecosystem has never been more invested than they are right now. We announced an expanded strategic partnership with Cognizant to accelerate the adoption of AI-driven automation. We expanded our partnership with KPMG to co-develop joint offerings through our finance and supply chain workflows. We launched a collaboration with Guidewire to improve insurance experiences. We're also seeing extensive third-party recognition of our products. ServiceNow has been recognized for AIOps, app engine, and cloud observability by prominent industry analysts. From customer service to risk to employee experience and ERP simplification, we can go on and on. This has fueled our rise into the Fortune 500 for the first time, and this is another tribute to Fred Luddy's founding vision for a hungry and humble market-leading company, and we're only getting started. In closing, this is a dynamic period for the IT industry. Think about it this way: Every leader in every department, in every business, in every industry is writing a new playbook for the AI world. CEOs are sponsoring them. The C-suite across all functions is funding them. And for the few true platforms, the opportunity is bigger than ever. ServiceNow injects speed into the business architecture. Our platform has become the de facto standard for intelligent automation. We are a growth company. We are profitable and durable. And thanks to the relentless execution, the results speak for themselves. We believe in our people, our culture, our platform, and our partners. The world is changing. Imagination is the only limit. ServiceNow is on the move. A CEO I spoke to this summer summed things up perfectly. She said, "Everywhere I go, people are talking about ServiceNow. Whatever you all are doing, it's working." That's one of the many reasons we proudly say now as ever, the world works with ServiceNow. Thank you all very much. I look forward to your questions. But first, let me turn it over to our great CFO, Gina.

Thank you, Bill. Q2 was another exceptionally strong quarter for ServiceNow. We exceeded the high-end of our guidance range for all of our key performance metrics, delivering robust subscription revenue and CRPO growth while continuing to drive operating margin expansion and very healthy free cash flow. In Q2, subscription revenues were $2.08 billion, growing 25% year-over-year in constant currency, exceeding the high-end of our guidance range by 100 basis points. RPO ended the quarter at approximately $14.2 billion, representing 22.5% year-over-year constant currency growth. Current RPO was approximately $7.2 billion, representing 24% year-over-year constant currency growth, a 150 basis point beat versus our guidance. From an industry perspective, transportation and logistics led the way with over 80% growth in Q2, followed by a very strong growth in education, business and consumer services, energy, utilities, and government. In fact, U.S. Federal had its best Q2 ever, continuing the trend of strong growth over the past several quarters. Our best-in-class renewal rate was 99% in Q2, demonstrating the resilience of our business, as the Now Platform remains a mission-critical part of our customers' operations. With that foundation from which to grow, top line strength in the quarter was further driven by a healthy expansion of our existing customers. We ended the quarter with 1,724 customers paying us over $1 million in ACV, including 45 paying us over $20 million, a 55% increase year-over-year. The Better Together story is continuing to resonate with C-suites, driving larger multiproduct deals, as enterprises are looking to consolidate purchasing with our strategic platforms like ServiceNow. In Q2, 19 of our top 20 deals contained five or more products, with nine of them containing ten or more products. In addition to our cross sales, our upsell motion also remained very strong. ITSM Pro had its strongest growth quarter since 2020, driven by both upsells from the standard SKU and seed expansions from existing customers. Overall, we closed 70 deals greater than $1 million in net new ACV in the quarter, up from 54 a year ago, representing 30% year-over-year growth. What's more, 12 of those deals were over $5 million, of which three were over $10 million. We also saw a strong performance from our industry SKUs, with our telco and technology SKUs closing six deals over $1 million in net new ACV, and our newly launched public sector SKU gaining further momentum, landing another seven-figure deal in the quarter. Turning to profitability, the non-GAAP operating margin was 25%, 200 basis points above our guidance, driven by continued disciplined spend management. Our free cash flow margin was 21%. I would also note that given our path to sustained profitability, in Q2, we recorded a large GAAP income tax benefit, reflecting a $965 million valuation allowance release related to our deferred tax assets in the U.S. We ended the quarter with a robust balance sheet, including $7.5 billion in cash and investments. Given the current macro environment and our strong cash position in May, the Board of Directors authorized the company's first-ever share repurchase program. The new program authorizes the purchase of up to $1.5 billion of common stock. The program's primary objective is managing the impact of dilution. Together, these results continue to demonstrate our ability to drive a strong balance of world-class growth, profitability, and shareholder value. Moving to our outlook. While we continue to prudently factor the evolving macro crosswind into our guidance, our first half outperformance has driven strong momentum as we head into the back half of the year. As a result, we are raising our top line and operating margin guidance. For 2023, we are raising our subscription revenue outlook by $95 million at the midpoint to a range of $8.58 billion to $8.6 billion, representing 24.5% to 25% year-over-year growth or 24% on a constant currency basis. We are raising our full-year operating margin target from 26% to 26.5%. And we continue to expect subscription gross margin of 84%, a free cash flow margin of 30%, and GAAP diluted weighted average outstanding shares of 206 million. For Q3, we expect subscription revenues between $2.185 billion and $2.195 billion, representing 25.5% to 26% year-over-year growth, or 23% to 23.5% on a constant currency basis. We expect CRPO growth of 25.5% or 21.5% on a constant currency basis. We expect an operating margin of 27%, and we expect 206 million GAAP diluted weighted average outstanding shares for the quarter. In conclusion, Q2 was another tremendous quarter of outstanding execution, and we are well positioned for the remainder of the year. Our pipeline remains strong as we've already seen $0.5 billion of pipeline generation from our Knowledge 2023 event in May. The week-long event of keynote, panels, and customer discussions showcase the power and the endless possibilities achievable through ServiceNow workflows, along with the incremental opportunities unlocked with our Gen AI roadmap. Over $3 billion in pipeline attended with an over 50% increase in executive program attendees. The response has been overwhelming. Our intelligent platform for end-to-end digital transformation uniquely positions us to seize the opportunities in front of us as we continue to deliver durable top line growth and margin expansion on our journey to becoming the defining enterprise software company in the 21st Century. Bill and I would also like to extend a heartfelt thank you to our employees around the globe for their continued hard work and dedication. It's their commitment to excellence that has propelled ServiceNow into the Fortune 500, and we couldn't be prouder. This distinction is a testament to our win as a team of core values and a culmination of the outstanding results we passionately delivered together in service to our customers, partners, and investors. With that, I'll open it up for Q&A.

Excellent. Thank you guys for taking the question. And really nice quarter. And while we're still not in a super solid spending environment, it definitely looks like ServiceNow is outperforming in that environment. I'm sure the focal point for a lot of investors though is going to be on Gen AI. You guys continue to innovate there and roll out new solutions. I'm not sure if this is for Bill or Gina, but could you help us understand how we should be thinking about the time frame of the upcoming releases in September and the adoption by customers, and maybe for Gina, when should we start to see revenue contributions coming from these Gen AI solutions in the ServiceNow model?

Well, thank you, Keith, for all of those comments. I appreciate that. Vancouver launch is at the end of September. So think about it from a timing perspective. We won't see it in the market until Q4. I'll let CJ talk a little bit more about our very exciting Lighthouse program. But as we think about longer-term guidance, right, our scale is such that it will take a little while for us to see real impact on the top line. Rest assured, we are very bullish on the opportunities in front of us as we think about the value we're creating for our customers with Gen AI.

Thank you, Gina. Thank you, Keith, for the question. The way I would answer it in terms of the demand we are seeing from some of the largest companies, some of those mentioned earlier from the industry perspective, is very real. They believe that Generative AI, in the context of ServiceNow, will deliver higher productivity. We will monetize, only when we get higher value delivered for our customer and take a fraction of that value. So if a customer gets 100 points of value, ServiceNow keeps 10%, the customer gets 90% of the value. Our premium SKUs that Bill outlined will be Pro Plus, on top of ITSM Pro, CSM Pro, HRSV Pro, with an exciting new offering for ServiceNow developers featuring text-to-code and text-to-workflow. These products are being released in September. We know how our adoption curve was for ITSM Pro and CSM Pro back in 2019, so we have some models. But customers want to try it first, see the value, and then we will share how things are going at the next earnings call.

Outstanding. Nice job, guys.

Thank you, Keith.

Thanks, Keith.

Great. Thanks for taking my question, and congrats on a strong quarter. I wanted to ask a follow-up question. Gina, you mentioned Vancouver is coming out at the end of September. Is it changing how customers are thinking about renewal timing? I want to tie that to the CRPO guidance that you just gave for the third quarter. How should we interpret the release of new products and what that means for your short-term guidance?

Yes, it's a great question, Samad. At the end of the day, what you've seen quarter-after-quarter from ServiceNow is solid execution. The demand environment is very durable. That being said, we continue to be prudent with our guidance. We believe that Generative AI could potentially bring renewals forward, but I'm not incorporating that into the guide right now as we just don't know what that would look like. I can share that, when thinking about the Q3 guide versus last year, we have a full-year of slower macro demand. Q3 of last year had an incredible Q4 of '21 and Q1 of '22 in that CRPO guide. Our CRPO guide for Q3 is strong, reflecting a lower level of early renewals.

Great, thanks for that. Congrats again.

Thank you, Samad.

Great. I'll offer my congrats again, guys, on the strong quarter. Hearing seed expansion within ITSM Pro is great, especially with some investor questions about fewer IT developers in the Gen AI world. Could you provide more context on what drove that and given the history, Bill, what are the long-term trends for developers in this Gen AI world?

First of all, thanks, Matt. ITSM Pro and CSM Pro had amazing growth in Q2. While I look at the percentage of total, I feel very good about the trajectory we have been on in this market for the past few years, driven by automation and other features. Regarding seat expansion, this is the result of the world becoming more digitized, leading to increasing incident volumes. Even with the number of incidents constant, digitization drives the rate of increase. Generative AI will enable higher productivity, and we will monetize that effectively.

What I would build on from CJ's commentary is that this is all about transforming businesses. Generative AI and large language models put CEOs in a position requiring a new playbook. Companies in sectors like telco, media, technology, public sector, and healthcare are seeking transformative business processes. ServiceNow is now part of these discussions, becoming the intelligent enterprise for digital transformation, lifting people from mundane work with a 21st Century platform.

Thank you.

Thanks, Matt.

Yes, thank you. Bill, you generated real pipeline after the conference last month. Can you comment on the trend in business confidence and willingness to invest? Is the exit velocity coming out of June and July turning a corner compared to how it felt coming out of April and March? And is there more consistency across the U.S., Europe, and Asia at the moment?

Thank you for the question, Mark. When speaking to the C-level, it's all about innovation. There is no lack of interest in digital transformation across all functions. That said, each geographic area is growing well despite individual challenges. The Americas and Europe are seeing strong growth while Asia, particularly Japan, is showing promise. There remains a strong engagement due to our platform's broad capabilities, leading to multi-product deals.

Thank you very much.

Thank you, Mark.

Thanks, Mark.

Thanks for taking my question. Hi, Gina. You mentioned the U.S. Fed had its best quarter ever. Can you provide more color on that? Were you referring to new ACV, and can you share any rough gauge of that?

Yes, John, what I said was that it had its best Q2 ever. While Q3 is typically a strong quarter for Federal, this year was notable as it had strong growth, with several $10 million deals including one over $8 million. Our message around digitally transforming the citizen experience is resonating, and we see strong opportunities ahead.

I want to build on Gina's commentary. We're seeing amazing opportunities in U.S. federal, state, and local sectors, with the potential for expansion onward to international markets. The foundational leadership of Kevin Haverty is helping drive this growth.

Thanks, Bill. Thanks, Gina. Nice job.

Yes, thank you.

Thanks, John.

Thank you for taking my question. A lot of discussions have centered around pipeline and enthusiasm toward the second half. Can you provide perspective on the economic landscape, specifically the willingness to invest from customers? Is there an all-clear signal, or are we still facing challenges?

I would not say we're giving an all-clear signal on the economy. We continue to execute extremely well, but macro conditions remain static, save for Gen AI's impact. There is much excitement surrounding productivity gains and solutions offered through Generative AI, and while it's early to tell how things will unfold, we have a strong pipeline heading into Q3.

A factor to consider is customer loyalty. We've taken a strong position with our employees, ensuring loyalty during market fluctuations. We currently have a 99% retention rate with customers, which underscores the net present value of our loyalty to them.

Thanks for the insights.

Thanks, Rob.

Thank you very much. One for you, Bill, and one for CJ. Bill, regarding the challenging economy, you outperformed and gained market share. As the cycle turns, what does ServiceNow's pricing power look like, and how do you aim to extract value from Generative AI? CJ, you mentioned the value share model for customers. Can you elaborate on why not more than 10% of that value goes to ServiceNow, and how does the customer achieve the remaining value?

The pricing power of a technology company derives from its innovation. We're experiencing significant growth in our Pro offerings. We believe the business cases for customers are extremely compelling.

We always consider pricing based on the value our customers receive. For Pro Plus, we'd like to see at least a 60% uplift on top of Pro. Customers are testing our large language models and their values. Hence our adoption strategies focus on value delivery to our customers, and we anticipate increased pricing as more value is provided.

Very lucid. Thank you.

Thanks, Kash.

Thank you, Kash.

Hi, it's Keith Bachman. Just a clarification: In the past, you've had ITSM Pro and Enterprise. Will there still be an Enterprise offering, or does Pro Plus subsume that in some way? At the analyst event, we discussed Gen AI rolling out and its impact on seat count. Have you received any feedback from customers regarding their plans for seat counts with Gen AI solutions?

ITSM Pro is complemented with Enterprise Plus. Enterprise's features are unrelated to AI and Pro Plus. Revenue growth with Generative AI retains optimism for seat expansion, aided by strong customer sentiment focusing on productivity enhancements.

We're gaining new logos, and with every new client comes new seats. Our multi-product sales approach is effective; 19 of our top 20 deals had five or more products, creating significant seat count growth. We also see a notable increase in $20 million-plus contract deals, reaching a 50% growth year-on-year.

Many thanks.

Thank you.

Thanks, Keith.

Hey, guys. Thanks for taking my question. Considering the pricing commentary on Pro Plus, can you clarify if the uplift comes from a fee increase or consumption dynamics? What's the percentage of adoption among your client base expected? Additionally, is there a significant CapEx cycle required for implementation?

From a CapEx perspective, we are not concerned as our margin guide for 2023 reflects any incremental demand.

We do not require large language models. The domain-specific use cases we develop need not be massive to run effectively and securely. Therefore, we are comfortable with a 60% uplift on Pro pricing given the high value delivered.

Overall, our focus on new logos and expanding the platform across companies positions us for success. New logos equal new seats, positioning ServiceNow for significant, sustainable growth.

Sounds like a pretty good recipe for success, congrats.

Thank you, Alex.

Thanks, Alex.

Thank you. Gina, can you update us on the financial services vertical? Last quarter, you noted some wobbliness. How has that segment performed now?

We continue to see strength in financial services, and we had good growth there, notably with deals like Barclays.

Environmental progress in the banking sector led to measurable progress across portfolios in various regions, with significant expansions occurring, including a notable bank around a $100 million TCV level.

Thank you.

Thanks, Karl.

Thank you. Can you provide an update on your channel strategy and its significance to growth? Are you seeing revenue generation from that channel increase?

We have established strong partnerships with companies like Cognizant, KPMG, and Accenture, accelerating AI-driven automation through collaboration. Increasing engagement with technology partners enhances our service and drive revenue growth.

I wanted to ask about Customer Workflows and the strengths observed in net new ACV this quarter. What applications or use cases should we attribute that strength to?

CSM had its best quarter, and initiatives tying front office to mid office and back office have contributed. Our differentiator is enabling strong relationships with major brands globally across industries, resonating particularly well in the public sector.

Great to hear, thanks, CJ.

You bet.

Hey, thanks for squeezing me in. Given the inflation concerns, how do you gauge corporate AI adoption? How is management adapting their budgeting to accommodate significant shifts?

There's significant interest in AI at the C-suite levels. Tools such as Generative AI are essential for enhancing margin efficiency and customer engagement. While IT budgets play a crucial role, innovative platforms like ServiceNow that span budgets across departments will benefit the most from these changes. We are hopeful for a stellar 2024 ahead.

Excellent, thank you. Congrats.

Thank you very much, Raimo.