ServiceNow, Inc. (NOW) Earnings Call Transcript & Summary

Okay. Great. Well, thank you, everybody joining us for Day 2 of the UBS Tech Conference. We've got a great mid-day lineup with ServiceNow, Databricks, Salesforce on the docket. So we're going to kick off the afternoon session with Gina Mastantuono at ServiceNow. Thank you very much for joining us, Gina.

Hi, Karl. Thank you so much for having me.

Yes, you got it. So Gina, maybe what we'll do is start with a few higher-level questions, and we'll leave the financial zingers to the end. So maybe, Gina, you could describe how the environment feels these days and sort of the arc of the recovery in new bookings coming out of COVID. And specifically, what I'd love to get your take on is when I'm doing calls with some large enterprises, including some of your customers, it does feel like we're at that point now where there might be a greater focus on automating a lot of the internal workflows and processes, whereas the last 18 months might have been very front office focused. And I'm wondering whether you and your account execs and Bill see that same phenomenon.

Yes, it's a great question. What I'll start by saying, Karl, is that we are absolutely seeing a strong and healthy demand environment continues. So we feel really good about that, really top to bottom. We absolutely see COVID accelerating digital transformation spend, not only in the front office, but absolutely for the mid and back office investments as well. And I think what's happening really is business leaders are recognizing the need to digitize really across the enterprise, especially to address the new realities of distributed work and that those that make these investments now are going to emerge stronger from this health crisis. And so from a value proposition perspective, we talk often about being a platform company, first and foremost. And the benefit of that really does allow us to have end-to-end functionality across IT, employee and customer, so front, mid and back office. And there's no one competitor that can really provide that end-to-end cross enterprise functionality. On the customer side, we're differentiated in our ability really to manage that end-to-end process of creating a ticket for the customer service agent and then carrying it through to resolution all in one system. And so if you think about systems being able really set up to answer questions, but not resolve the problems. ServiceNow is really differentiated, in that we're able to answer questions and solve the problems, right? And it's not just about having a great engagement layer now, enterprises, the customers that we see are really focused on providing complete experiences for their customers. And that means driving tickets to resolution in a really seamless and efficient manner. And if you think about being able to do that for the front office, in this distributed work environment, it's more important than ever to be able to do that in mid and back office as well. And so the Now Platform is able to really drive this frictionless and great employee experience as well as customer experience across the entire enterprise, whether it's customer service, HR, IT, legal, finance or any of the mid- and back-office functions. So we're absolutely seeing a trend across the board here.

Yes. So I guess that's the merit of having a balanced portfolio, right, Gina. If, in fact, there is a little bit of a tapering of the frenzy around front office, you've got a long tail of "mid and back office applications" that can make up the slack. So I know you don't -- just to stay on the subject, I know you don't guide by application portfolio within the broader suite. But I'm wondering whether the front office piece, what you call your CSM business, does it feel like it benefited, Gina, in the last 12 months by sort of unusual demand surge that might make for tougher comps over the next 12 months or not really seeing any sign of that yet.

Not any sign of that yet. We've had a really strong performance across the board, across the product portfolio, including CSM, but we continue to see demand strong across the board.

Okay. Good stuff. Another one of the broader macro trends that we talked about a little bit, and the media certainly does, is just around the labor shortages that not just tech firms in the Bay Area are suffering from, but your clients actually. So I'm wondering how that affects ServiceNow. I can think of a couple of ways, good and bad. It would -- I guess on the challenge front, it would make hiring talent a little bit tougher. So I'd love to -- perhaps you to give an update on how you've been able to hire the requisite talent despite those shortages. But then the positive is more interesting, and that is, I wonder if your clients, your customers are suffering from labor shortages. There might actually be an even greater impetus to invest in technology that automates a lot of internal tasks to remove the need for labor or to make them more productive. So curious what you're seeing on that front.

Wonderful. Great question, Karl. While the labor market certainly has become more competitive, given the momentum and runway ServiceNow has in front of us, we've really been able to hire some extremely great talent, and we're confident in our ability to continue to do so. We actually grew headcount 26% year-over-year in both Q2 and Q3. So we've proven not only that we can hire well and great talent, but we've also been able to effectively onboard all of these new employees in the COVID environment. So we have no plans to change course during the remainder of '21. And actually, we continue to see a really healthy trajectory in our hiring into Q4 as we're actually pulling forward some R&D headcount from 2020. Regarding our partners in the ecosystem, right, we haven't seen any bottlenecks in deployments due to labor shortages. But I would note that we've actually been working with our partners to sponsor and engage with some local diversity profits and nonprofits to target diverse populations for this next-gen skill development, which I think is really going to help alleviate future labor shortages. And as you think about bringing talent into the tech market, I think this is an incredible opportunity that we have to really help drive that. But you're 100% correct. Enterprise software talent is in really high demand. So competitive environment has been strong and has been on the rise for some time now. But despite these headwinds, we're committed to our margins, even if we do see some wage inflation. With respect to the second part of your question on opportunities if our customers are having issues with demand, I think, in general, this distributed workforce, the labor shortages that we're seeing continue to be a tailwind for increasing employee engagement, employee productivity. We've got to make sure that those employees are productive when at work, and that they're really highly engaged, so they're not looking for that next job. And the ServiceNow platform is really well positioned to help our customers in all those areas.

Yes. That makes sense to me. I'm certainly starting to hear that from your customers. So that's a good tailwind for everybody involved broadly in the workflow automation space. So Gina, maybe we'll talk a little bit about some of the bigger parts of the ServiceNow portfolio. And that core IT workflow automation remains your largest one. So let's hit on that for a second. One of the persistent fears to be candid since you guys went public, isn't that ITSM space going to run out of gas, like there's only so much BMC, HP software out there that can be standardized on ServiceNow, yet you keep chugging along with good ITSM numbers. So how would you address that concern about penetration and runway?

Yes. I've heard about this concern since I joined the company and the fact that it has been there since we IPO-ed, right? But at the end of the day, there's still plenty of opportunity in the ITSM market. The TAM continues to grow. When we IPO-ed, Gartner estimated the TAM was about $1 billion. It's now closer to $5 billion, right? It's now closer to $5 billion and growing. We're constantly adding new products and functionality that really expand the offering and just increases the market opportunity. If you think about things like virtual chatbots, a decade ago, we're not part of the addressable market. Our investments in AI and machine learning have really added capabilities to the platform that are able to be monetized in our Pro SKU, which, as you know, generates a 25% uplift. In addition, we're not anywhere close to being fully penetrated within existing accounts and then the massive opportunity to capture more new enterprise logos. We [ serve ] about 7,000 today, but there's tens of thousands out there. So it actually suggests that TAM for ITSM is even much larger than what they're saying today. And so we're still only 25% penetrated in ITSM Pro [indiscernible] enterprise is brand new. So there's a real -- there's great [Technical Difficulty] still in front of us and really great market opportunities still low, even within our [Technical Difficulty].

But in the last quarter or so it reaccelerated. Can you help maybe everybody listening and me understand the kind of arc of the growth in ITOM, Gina?

Yes. I think ITOM was probably the product that was most impacted when COVID hit. It's longer-term project work, right? And when COVID hit, people were uncertain and really focused on short-term stuff, right, and making sure that employees were able to do their work, do it well, they would just focus elsewhere. It's a longer sales cycle. It's a longer implementation cycle. So COVID was probably most impactful for ITOM. But back in Q4 of 2020, we really saw a reacceleration of it. As we think about true digital transformation for IT, ITOM is a huge part of it. If you think about our CSM product and the better together story about really driving resolution from ticket to end, the ITOM and CSM story better together is just a clear differentiator. So ever -- I think it was -- the first few quarters of COVID, we definitely saw a little bit of a slowdown, but it was more of a pause, and then it's reaccelerated really from Q4 of last year. So we feel really [Audio Gap] the trajectory of ITOM.

Yes. Good to see actually. So maybe while we're still on the ITSM or broadly IT workflow...

Business as well.

Okay. Good stuff. And maybe while we're still on the ITSM side, Gina. Maybe you touched a little bit on enterprise being a relatively new SKU. I know it's only been in the market for 6 months. But any update on the progress you've seen to date?

Yes. I mean the enterprise SKU continues to -- I mean it's new. And as you know, it's early days. So we don't really have updates on adopting our price realization for the public yet. But we're absolutely seeing good traction. Enterprise includes everything that we have in the Pro SKU, but also adds process optimization and workforce optimization. And as a reminder, we talked about at Financial Analyst Day that the enterprise SKUs, we believe, can penetrate upwards of 20% of our existing ITSM customer base. And we think and expect that the pricing uplift will be roughly the same magnitude of the standard-to-pro uplift, which is about 25%. So early days, but good traction, and we feel good about what we're seeing so far.

And probably in terms of having an impact on the P&L, Gina, more of a 2024 phenomenon? Is that how you would phrase it or perhaps even a little bit sooner.

Potentially '23.

Okay. Okay, good. You mentioned that the enterprise SKU comes with process optimization features. So maybe that's a nice segue to the partnership that ServiceNow recently entered into with Celonis. So it seems like ServiceNow is offering your own process optimization, but you've just partnered with maybe the best-known process optimization software firm. So thread that needle for us, Gina. Maybe you can help us understand.

Absolutely. Absolutely. So ServiceNow's process mining capability that's available in our enterprise SKUs is the recommended solution when customers want to analog within the ServiceNow platform and don't want that data to leave the ServiceNow environment. We're going to continue to invest in our internal [Technical Difficulty] in the enterprise SKUs. But we've also looked at and we've always been focused on solving the problems of our customers, not only in the ServiceNow platform. But if you think about the other systems of record, Celonis is so well embedded and does that so well. And so if you think about combining Celonis' best-in-class with the third-party data and then our process optimization and combining that together, that's the partnership where we can really help our customers, really create this seamless product experience that will make it easy and simple for them to get their insights across multiple systems, whether it's ServiceNow or all the other systems, and they can do that with Celonis' EMS, but then they're able to convert those insights into action, automation and remediation with the ServiceNow platform. And so if you think about bringing it all together, the process mining, automation, machine learning and low-code app development into a seamless product experience, it's really about enabling customers to quickly and continuously improve the flow of work, regardless of what system it's working in. Does that make sense?

Yes, it does. So it sounds like the strategy that you and Bill have is to utilize this process mining or optimization technology for the existing ServiceNow Platform, your swim lane, so to speak, but it doesn't sound like you've got internal aspirations to break too far beyond that. For that, you'll rely on the Celonis partnership.

Absolutely, absolutely. And we're very conscious of the different buying centers that purchase process mining technology. Decision-makers that buy Celonis will be in the office of the CFO, where we don't do a lot of selling. So it's a really complementary partnership that both Bill and I as well as the Celonis team are so excited about.

Yes. And Gina, is this discussion we've just had on process mining and optimization, does it carry over into the RPA space, where perhaps your ambitions are similar where you want to deploy RPA technology or bot technology to further automate the products you have, but that you don't have aspirations to go right up against the broader pure plays, like UiPath or Automation Anywhere. Would you apply a similar analogy? Or might your ambitions be a little bit broader on RPA?

No, I think it's very similar, Karl, right? I think that ServiceNow has spent years building the leading workflow automation platform, right? And so we are absolutely using our internal RPA capabilities on our platform to really help drive that automation. But what we're seeing with RPA is many of our customers are really talking a little bit like they're feeling like RPA has left them with -- and Bill calls that these islands of automation, right? It's getting harder for them to scale and to manage it as they scale. So how can we really help them in a single platform where workflow is the core engine that drives the process and they have a choice of whatever automation technology they want, right? We have the integrations for all of the players that you talked about, right? So our focus is really on delivering that world-class automation platform, but really enabling the customers to choose whatever RPA solution works well for them. And whatever they've already invested in. And so RPA is an important addition to our platform, but it will be a similar type of approach as Celonis.

Got it. Okay. Gina, let's talk about some of the -- no longer new modules because they're now $300 million, $400 million in revenues. But applications like CSM and HR has probably been one of the most pleasant, surprising aspects of the whole ServiceNow story over the last 5 years, how they've scaled up to be really big businesses in their own right. When you look at and are starting to do your preliminary planning for calendar '22, are there 1 or 2 of those non-ITSM products that you're looking at to drive a larger portion of the growth? What's inflecting that's giving you confidence in your '22 outlook that you'll share with us, I guess, in due course?

Absolutely. I think we continue to see the new products outside of IT, including CSM, including HR and including our platform business, right, do really, really well. We've said it externally before. We expect CSM to be our next $1 billion business. But we're seeing amazing traction across the board in all areas. So we are very focused on all 3 of them as well as continuing in IT. And so I think at the end of the day, we're a platform company. And our differentiator is that where this software company at our size is one platform that is really able to sit on any of the -- on top of any of the systems of record to enable workflows across. And so as we talked about earlier, the demand from the customers in the front office as well as the mid and back office remains strong. And so as we're really driving this fierce customer loyalty and employee engagement, we're seeing CSM, HR and the platform all doing extremely well.

And Gina, on the CSM side, it's getting to a scale where we wouldn't be surprised to hear that you're bumping up against some of the larger incumbents is, in fact, that starting to happen, where you're finding yourself a little bit more in head-to-head to Salesforce? Or are you attacking a different vector within that broad customer support area, where you're, in fact, not bumping up to them as much as outside parties might think?

Yes. I mean in CSM, we absolutely compete with Salesforce on the front-end engagement, and it's definitely the most competitive market we're in. But we've differentiated in our ability, as I talked about earlier, to really manage the end-to-end process of creating a ticket and carrying it through to resolution, right? Our platform is really built to manage these complex workflows where, especially if it's a digital asset, right? And how does that come back to really driving customer satisfaction, right? It's the CSM and ITOM story, the better together. How are we able to really allow customer service agents to not only answer the question, but resolve the problem quickly for the customers. So that's where we differentiate. However, I would say, CSM [Audio Gap] even as the business grows larger, we're just really excited about the success that we've been having and the demand that we continue to see.

And Gina, as those CSM and HR application scale and are growing likely faster than obviously overall ServiceNow. Is there a margin issue that we should be cognizant of? Or is the margin structure on those non-ITSM applications, frankly, not that different than the core?

There's no margin issue that you should be worried about. I think one of the benefits of the one platform, especially on the R&D side, is that all of the innovation, right, is built upon the platform. It benefits all of the businesses and all of the workflows. And so from a margin perspective, we are -- we manage that all internally. And so that -- there's nothing that we should worry about with respect to as those businesses are growing faster, that it will have a negative impact on the margin.

Okay. Good to know. So maybe that's a good segue to spend our last 10 minutes or so hitting on some of the financial metrics. So I guess one thing that was encouraging from this last print is that your constant currency subscription revenue growth rate, Gina, has been accelerating modestly over the last several quarters and hit almost 30% in this most recent quarter. So if you could break down what's fundamentally driving that acceleration we're seeing in the sub revs growth?

Yes. I mean in Q3, subscription revenues exceeded the high end of our guidance by about $22 million. And that beat was really driven by strong execution from the sales team. It is about net new ACV upside and really good linearity within the quarter. But you're absolutely right, net new ACV growth. We talked about the demand that we continue to see.

Yes. [Technical Difficulty]. Great. Well, Gina, maybe on the -- on the revenue growth side, the acceleration that we've seen in the third quarter, super impressive. And maybe you could unpack what caused that.

Yes. In Q3, we were really happy with our results. Subscription revenues exceeded the high end of the guidance by $22 million, and that beat was really driven by strong execution from our sales team, really generating net new ACV upside and strong linearity within the quarter. And we've seen net new ACV growth accelerating throughout 2021. We talked a little bit earlier, the demand environment continues to be strong, and we believe we're well positioned to take advantage really of the digital transformation tailwinds that we continue to see in Q4 and as we head into 2021. We did see some incremental upside in on-prem revenue in Q3, but it was a very modest increase. It was really about net new ACV upside.

Got it. And then, Gina, if we think about the fourth quarter, I know the adjusted or constant currency subscription billings growth metric gets a lot of attention. You're probably -- you and Darren are going to be relieved that this is the last time you have to guide to that, I think, correct? You're going to move to cRPO starting next quarter, right?

That is correct. Absolutely. We're going to stop guiding to billings and begin focusing on our cRPO guide when we report Q4 earnings and give our guidance for '22.

Well, certainly, the fourth quarter adjusted billings guide gets a lot of attention, and it requires a modest acceleration, I think, to hit your guidance? And maybe one logical question, Gina, is that's always a tough setup for stocks, but I think you've been communicating your confidence level and a modest acceleration in that metric. Maybe you can refresh us as to what gives you that confidence?

Sorry, I missed that. Is that -- was that Q4 billings?

Yes, Q4 adjusted billings guidance. What gives you the confidence in at least a slight acceleration?

Yes. I think that for Q4, we talked about subscription billings growth of 26% year-over-year despite a pretty tough comp from last year. Q4 2020 saw -- it was strong billings and then with strong normalized billings and then we had that $80 million of early payments, right? And so if you normalize for those $80 million in Q4 of last year and this year, our normalized Q4 subscription billings growth is actually 32% year-over-year. And so as we grow, our business just continues to get more Q4 weighted. Our pipeline remains really strong, and we see great momentum across all geographies. And so when we guided, we felt very comfortable and confident.

Got it. Okay. Good. And then if we close the discussion with a little bit of conversation about 2022, Gina, you've talked a little bit about having a relatively large renewal pool. Can you comment on what that renewal pool looks like next year?

Yes. 2022 does have a slightly larger renewal cohort. But the difference in sizing is more marginal than really substantial. And for perspective, we didn't call it out in the Q3 prepared remarks, but rather it was brought up when we were asked about other impacts on our cRPO guide aside from FX. And so if you think about it and to provide a little bit of context, we had a very large net new logo year in 2013 following our IPO. And given that the majority of our contracts are 3-year renewal cycles that slightly larger than average cohort came up for renewal in 2016, 2019 and now 2022. It's a big enough difference that you're going to see an impact on cRPO for a few quarters, given the outsized number of these partial yield contracts up for renewal in '22. But I wouldn't say the difference in cohorts year-to-year is massive, right? It's not a huge driver. And what I would say is these types of contracts and seasonality of the renewals is very consistent with the overall business.

Yes. Got it. So if perhaps we get at least a modest increase in that renewal pool and the uptick this year in net new ACV bookings layers into next year, that seems like a prospect for revenue growth to stabilize next year. Is that an unreasonable outlook, Gina?

No, we [Technical Difficulty]. It's not a news at all. We've actually commented 2021. We'll have a stabilizing effect on revenue growth in constant currency in 2022. That being said, it's a little bit early to talk in detail about 2022, given the uncertainty around COVID and the recent news about Omicron. We're going to keep an eye out on the broader macro economy to see how things play out, and we'll provide that impact for the outlook for 2022 in January. But we feel really good about the acceleration of net new in '21 and what that means for our numbers in '22 and beyond.

Got it. And maybe I'll close with a comment on margins. Gina, at the Analyst Day, you and Darren and the team guided to a 3-year out 300 basis point increase. But on the most recent call, I interpreted as you communicating that, that's not going to be a linear improvement, that, for some reasons, next year, we'll see a more modest increase or maybe even a decline. Maybe you could just comment on why calendar '22 might not see that 100 bps improvement.

Yes. We are -- we remain very focused on driving a balance of growth and profitability. And I've been pretty transparent that some of the COVID-related savings that we've seen in 2020 and 2021 are not going to be sustainable. Before the pandemic and at Analyst Day, we talked about 100 basis points of margin expansion every year. When we started '21 at our Financial Analyst Day, though, we were guiding to 23.5% operating margin versus the 25% that we're now guiding to. So that's 150 basis points differential. And that's really because we had originally assumed we will be back in the office a lot sooner in 2021, right? And so with the spread of delta variant, the in-person work expenses that we expected to return didn't come back in '21, but they will come back in '22, and we're definitely anticipating that they're coming back in '22. So if you think about that 150 basis points being very COVID-related savings, which we're going to expect that to be a headwind going into 2022. So we absolutely remain committed to 26.5% operating margin by 2024 that we provided back in May. But the path to get there, given the changes in return to office [Technical Difficulty] and COVID-related savings, it's definitely not going [Technical Difficulty]. We'll see a headwind in 2022 as we return to office, get back [Technical Difficulty].

Great. Thank you, Gina, for that. So maybe we'll end it there. We're up against time. But Gina, Darren, thanks for updating everybody listening in, all of the UBS clients on the state of affairs with ServiceNow. It sounds like the business is continuing to hum along. It's encouraging message to hear. Thank you both. And if we don't speak beforehand, happy holidays to both of you and your families.

Thank you, Karl. Happy holidays to you and your families, and thanks so much for having us. Have a great one. Bye.

Thank you.