ServiceNow, Inc. (NYSE:NOW) Barclays 2022 Global Technology, Media and Telecommunications Conference December 8, 2022 6:40 PM ET
Company Participants
Gina Mastantuono – Chief Financial Officer
Conference Call Participants
Raimo Lenschow – Barclays
Raimo Lenschow
And it’s interesting like it’s the — given the macro environment.
Gina Mastantuono
No.
Raimo Lenschow
No, I know, I know. Like that’s the thing. Like I was thinking like how do I talk about the business. But then question is like I’ve got a whole to hedge fund community like you need to ask a question, it’s like I know the answer. But like maybe we do it slightly differently. So if you think about this year about Q2, Q3, like Q2 was kind of say, oh, cute. Q3 looked a lot more stable for you. Like can you talk a little bit about like linearities in the quarter, what you saw there?
Gina Mastantuono
Yes. Well, I think, first of all, I think that we came off — so starting the year, we came off of such a strong 2021 and a really strong Q1. And by the way, in Q2, we had a really good linearity through April and May. And so we really started to see a shift in our customers’ behavior starting in June. And so what we did as we entered Q3 is when we realize that these deals were getting more scrutiny. And as our deal sizes are getting bigger and bigger, the scrutiny was incremental.
And so in Q3, we really focused on understanding what that approval process was going to be and helped our customers walk through that process, right? So what do you need to get the deals over the line? How do we help you put together the value proposition in a way that might look different for a CFO versus a CIO?
And so how do we stay close to that process. And so that’s how we executed a bit differently in Q3. And I would say we pivoted pretty quickly because the macro did shift rather quickly at least with our customer conversations. And so we feel really good about the execution of the sales teams throughout all of Q3. As we talk on December — is it 8th today? Goodness, I can’t actually believe it.
Question-and-Answer Session
Q – Raimo Lenschow
Next week? Yes, you’re right.
Gina Mastantuono
What I’d say is that linearity is similar to what we expected so far, continue to stay really close with the customers. We have our top 100 deals have all deal champions at the executive level to make sure that we are really helping those customers get these deals over the line. And so there’s a lot to execute in the last 3-plus weeks to go. Obviously, month three is always the biggest in any quarter. But we remain confident in our ability to continue to execute.
What we’re seeing is pipeline is not disappearing. Pipeline remains consistent and demand remains strong. And so we are continuing to focus on just execution first and foremost and staying really laser-focused and close with our customers on a day-to-day.
Raimo Lenschow
And like as a management team, there’s obviously also the things where you can work on in terms of pipeline coverage, kind of tracking deals, et cetera. Like has that kind of — that scrutiny changed or like have you kind of changed kind of how you do things as you went through the year?
Gina Mastantuono
Yes. What I would say is we’ve always been really disciplined on pipeline hygiene. Obviously, with macro shifts that we’ve been seeing, we’ve become even more laser-focused on that. Our deal’s stalling, why are they stalling, getting involved earlier.
The great thing is that pipeline generation throughout the year has remained strong. So we talked about at the end of Q3 that our Knowledge, our big Knowledge conference, the user conference in May, generated 40% more pipeline in 2022 versus 2021. We also had active customers with large active pipeline at the event at a much broader scale than what we’ve been seeing. So pipeline generation remains strong.
As we went into Q4, we’re having our World Forum events, which are smaller Knowledge-type events in key markets internationally. So seeing really good coverage with respect to active pipeline as well as incremental pipeline gen coming out of that. So early days, we don’t have all of the insights yet, but the conversations I’m having with my teams coming out of those events over the last several weeks have been really positive as well. So a lot of focus on pipeline hygiene, a lot of focus on making sure that coverage ratios are stronger than they have been in the past. And so we feel really good about demand.
The one thing I’ll say about this macro environment, while certainly, there’s some bumpiness and some uncertainty in the short term. The ServiceNow platform delivering great and increased productivity and efficiency as well as cost savings resonates now more so than ever. And so the mid- and long-term opportunity remains greater than ever. And that’s where we’re really focused on, making sure that we are continuing to invest behind growth, continuing to invest quota-bearing sales, innovation to ensure that we remain very well positioned given what we see as just a continuing increasing opportunity for us.
Raimo Lenschow
Yes. What point that kind of probably goes with that is — and we saw it yesterday, our leadership was here from Barclays, it’s a bank on the IT side and on the COO side and they talked about like how in these tough times you want to have good partners, and they mentioned ServiceNow is one of them there.
Like from that perspective, like that relationship, like do you see that in the — that the conversation is changing as people are consolidating towards like few guys and you’re delivering more value and people want you to deliver more value to them?
Gina Mastantuono
Absolutely. I think the platform consolidation that you’re seeing, quick time to value trends, all work in our favor at ServiceNow. The fact that we are the trusted platform of the IT organization as they’re looking to potentially take out point solutions to drive cost savings, to drive efficiencies, positions us well. The fact that time to implementation for the most part is weeks and months and not years and years really helps in our favor. And so I think these are trends that you’ll continue to see the opportunities for us.
And I certainly appreciate your CIO calling us out as a strategic partner because that’s absolutely been our focus across the board with our customers.
Raimo Lenschow
Yes. And then — and sorry, that’s the last one, I apologize. Linking it a little bit back to kind of the current environment. Like you also have this kind of as part of that, Q4, you mentioned like this big renewal cohort. I mean in a way that should help you to sleep at night better because like you were very strategic to your customer. They’re not going to go away like so that kind of should help you as you think about like making the numbers, et cetera.
Gina Mastantuono
Yes, I think that’s right. So with 98%, 99% renewal rates even in Q2 and Q3 of this year, clearly, we’re mission-critical to our customers. And so that large renewal cohort is expected to renew. We also saw when we reported in Q3, we did see that part of our beat in Q3 was actually early renewals of some of that cohort. So derisking the plan, helping drive those early renewals, a big piece of it.
And so certainly, that gives much more visibility into the pipe and into the closing. So what ends up at risk is kind of that net new in that expansion. And so what I’d say when I talked about at the end of Q3, while we don’t give expansion rates on a quarterly basis, we do give them on an annual basis. And at our scale last year, 2021, we saw 125% expansion rate. And what I said in Q3 is we saw continued strong expansion throughout the year, including in Q2 and Q3.
And so — and that’s because we have visibility. They are — these are longer cycles. So we understand the demand of the customers. That being said, there is some macro uncertainty out there. And so staying close to the customer and understanding where they are in their buying cycle is something that we are laser-focused on.
Raimo Lenschow
Yes, yes, yes. Okay. And then where are we — like over the — in 2021, there was a lot of kind of catch-up hiring after 2020 in terms of sales, sales capacity, you kind of make sure you kind of have the sales capacity to kind of continue to grow. Like where are you on that sales capacity, but also in terms of like how they ramped up? Like how far are they in the ramp-up?
Gina Mastantuono
Yes. So what I’d say is that we definitely saw higher attrition than we had seen in 2020 and ’21 in the beginning half of 2022. It’s not uncommon. I’m sure you’ll heard that for most. It was lower than benchmark, but still significantly higher than what we’ve seen. What we’ve done this year is even in the face of the macro headwinds, we have not stopped pace in hiring quota-bearing feet-on-the-street, go-to-market sales. We’ve not stopped hiring our key fingers on keyboards engineers driving innovation.
What that means from a ramped rep perspective as we’re entering into ’23 is that the percentage increase in ramp reps going into ’23 is significantly more than what we entered in 2022. So that positions us well as we go into the marketplace. We also are expecting lower attrition in Q1 and Q2 as a result of current market trends. So all in all, we absolutely see a pretty direct linearity in top line growth with increase in ramp rep.
So entering ’23 strong. And as we think about headcount growth in ’23, because it takes about 9 months to ramp a rep, all or most of the hiring we do in ’23 will be all about ensuring that we have good increase in ramp reps going into ’24. So it’s why we talk about the fact that even with the current macro, we’re not stopping in driving that quota-bearing rep headcount because it’s going to position us well into the future. What we do see leveraging is in more of the supporting sales, right, supporting sales and marketing, back office, G&A, and that’s where you’ll continue to see us drive leverage on the bottom line.
Raimo Lenschow
Should there not also be like an argument to really pay attention now because if you think like the VC-funded guys, whereas people would get rich overnight with kind of that sort of stuff, that’s not going to happen. And so there should be a lot more good talent on the market and you, with your strong position, et cetera, expect it. Do you notice already like the number of people coming towards you, the quality of the people coming towards you that that’s changing?
Gina Mastantuono
We absolutely have been very focused on grabbing great talent in the marketplace. And so that will always be a strategy of ours that will not change. And the talent brand that ServiceNow has today vis-a-vis a year and two years ago is pretty incredible. And so we’ve been really excited about the great talent that we’ve been able to bring in. And certainly, given what I just talked about continuing to invest for growth, you’ll continue to see us really go aggressively to get that great talent.
Raimo Lenschow
Yes. Okay. Let’s shift gears a little bit more on the product side. Like for a long time, and it’s normal in the life cycle of a software company, you were kind of selling one product. Then you started to have like a slightly more differentiation in terms of light there was the Pro SKU, the enterprise SKU. Can you talk a little bit about that evolution and kind of where are we on adoption of that one?
Gina Mastantuono
Yes. So Pro SKU gives us incremental capabilities in differentiation. Think about incremental AI and machine learning, how can we automate more allow the IT organization to deflect lower-tier issues so they can focus on harder, more important stuff. We’ve seen Pro adoption well ahead of what we had originally anticipated. And we’re currently at about 35% penetration. We’ve talked about expectations for the Pro SKU to get upwards of 55%. So there’s still some significant tailwinds there and headroom there.
From an Enterprise SKU perspective, again, expectations we’ve told that we expect about 20% penetration, but we are in very early days. We haven’t even given that number. So as you think about continuing to drive significant increases in value for our customers, some real headway still in front of us even within our core ITSM.
Raimo Lenschow
Yes, okay. And then the — is the — how do you see this for — going forward more from a product evolution? Is like Pro and Enterprise and you’re done? Or like I mean, if I look at other vendors, arguably, they are kind of much bigger than you by now already. Like there’s a lot more like differentiation coming in, there’s like industry, there’s kind of like analytics coming in differently. Like how do you see that evolving for you?
Gina Mastantuono
Yes, I mean, I think the innovation that ServiceNow has been able to continue to drive has been pretty incredible. I talked about at the end of Q3, the fact that we have now 11 products that are greater than $200 million in ARR; pretty incredible, all organically grown. And those 11 products are not 11 at $200 million. We have a couple over $1 billion, we have several over $500 million. And so the innovation that we continue to drive has been pretty remarkable from the product perspective.
And then as we continue to add capabilities to the platform, one of the reasons why we have such a great unit economics is that all of the innovation that we put in the platform goes across every product. And so you’ll continue to see us differentiate with capabilities in the platform as well as industry solutions as well as continued evolution of new products like our ERP workflows, for example.
Raimo Lenschow
Yes, yes. And the — talk a little bit about the — I remember when I did the IPO, it was like ITSM, then ITOM came, then HR, and then customer, the Platform, now ERP. Like where are we on that maturity curve for these kind of product segments? And how do you see the different sizes when they are kind of fully scaled out for these ones?
Gina Mastantuono
Yes, I mean if you think about where we are outside of ITSM, there’s a lot of runway ahead, like penetration levels are early days still. If you think about the opportunity for customer workflows that will probably be our next billion-dollar workflow, Creator workflows. We talked about back in May at it being over $600 million. There’s a lot of opportunity.
And I got the question earlier today in some of my meetings, the need for application development outside of IT organizations just is getting greater and greater. And so the traction for creator is pretty remarkable. We talked about it at Analyst Day, the fact that by 2024, we expect as a percentage of net new ACV Creator Workflows to be at 20%, customer and employee together at 35%, right, and core IT at 45%. It doesn’t mean that core IT is not growing very well. It’s just that the growth in those other more early stage are growing faster.
And so there’s a ton of upside. And we’ve talked about also historically the fact that even with our current product portfolio, and our current customer base, if you think about the total addressable market within those customers based on our current product portfolio, it’s 5 times where we are today. So there’s a lot of wide space penetration still to come, a lot of opportunity ahead.
Raimo Lenschow
And I’m warning you, I’m like trying to sneak into the current environment. Like on those newer products, is there a differentiation in terms of the way you think like because like some products work better in certain times of the cycle. Like so if you look like customer — I’m looking at the Salesforce number at the moment, and they’re maybe not quite as good as some of the other players like how do you see that playing out for you and the focus that you’re putting on them?
Gina Mastantuono
Yes. I think that we’re seeing pretty strong resiliency across the board in our portfolio. And if you think about why, even with respect to customer where we play really well is where we’re able to orchestrate complex workflows across the enterprise. How do we tie a customer service ticket to the resolution? And it’s a system of action, and it’s making the customer service reps much more productive and efficient. That is something that resonates really well in a recessionary environment when many customers are focused on taking costs out, driving greater productivity and greater efficiency.
If you think about employee workflows. Well, while we’re in an uncertain macro environment, we’re also in an environment where workers are more dispersed than ever, distributed than ever. So driving employee productivity and efficiency as well as employee experience for those employees that remain really important and still top of mind. And then you see our core, of course, again, driving more resiliency.
If you think about ITOM continues to do extremely well, risk security while smaller growing really well in this environment. So really good resiliency across the board, but obviously, we’re staying super close.
Raimo Lenschow
Yes, yes, okay. And then the — so all of those kind of products kind of in a way, come out of the core ServiceNow platform that Fred Luddy worked on. Over the years, we always had a discussion about like adjacent kind of platforms. So there then we have like at the moment, all the work that you do were on observability. Like can you talk a little bit about like how that will — how that’s playing out for you?
Gina Mastantuono
Yes. So super excited about the Lightstep acquisition. Early days, but we’re in the process of integrating that into ITOM. And if you think about observability combined with AI ops and workflow, it’s a fulsome solution for the customers. So that’s fantastic.
And then we announced a smaller acquisition of Era Software which adds logging to the metrics and tracing. So we have unified telemetry across the board that we’re very excited about. And if you think about where Lightstep plays really effectively, it’s all in the cloud-native architectures. So it allows us to be lower cost and it allows us to — it’s not and/or, it’s and/and with some of the legacy technologies.
So really excited about the opportunity there. It’s certainly an area where we are continuing to invest. And it’s the natural adjacency to kind of the core of what ServiceNow does.
Raimo Lenschow
And I mean, we had like a few of the observability guys here at the conference. Like there’s always that kind of notion of core petition like because like a lot of them feed into your ITSM platform, it’s kind of really important to have that connectivity and work together. Like how do you see Lightstep in that respect in terms of like where you want to kind of own the whole kind of chain versus like kind of sharing it out?
Gina Mastantuono
Yes. Well, I think that many customers have both legacy as well as cloud native. And so this is where I think the cloud native is where we play well. And so this is the conversation that we have that we can absolutely continue to partner with the other players in that space, while at the same time, growing our capabilities in Lightstep.
Raimo Lenschow
Okay. Perfect. And then the last few minutes, I want to talk a little bit about profitability. It’s kind of much more in focus these days. So — but you always have been a very disciplined organization. So it’s kind of I almost feel bad asking. But like what do you see at the moment? Like this morning, I had like several CFOs here and a lot of them, like all made the same point of, like, look, the interest rate is higher. That means my ROI for an investment is higher, which basically means that kind of explains where we kind of need to be more disciplined. I feel almost it’s slightly different for you, but like how are you sitting on that kind of notion?
Gina Mastantuono
Yes. So like I said earlier, we are really focused on continuing to invest for growth. And so we absolutely see the very quick ROI on our sales hiring and our sales capacity. The ROI on our investment in innovation and R&D is pretty remarkable because, again, all the innovation that we put into the platform goes across the product line. And so ROI remains strong there.
Where you’ll continue to see us get leverage is on the operational efficiency. So we are the first customer of all the innovation that comes out of ServiceNow. So when I talk about the fact that we’re driving efficiencies and productivity for our customers, well, we’re doing that for us, too. It’s one of the reasons why we were able to offset more — almost 100 basis points of FX to our margin this year, while at the same time, continue to hire for go-to-market and innovation.
So you’ll continue to see us find leverage there as well as in the support related as well as on kind of sales and marketing efficiency. Because so much of our sales come from existing customers, we’re really able to get pretty strong efficiencies out of our sales and marketing machine. So you’ll continue to see us be disciplined on both top line and bottom line with a keen focus on investing for growth, first and foremost.
Raimo Lenschow
And is there like it’s — I remember like the ServiceNow years ago, had like a slide where they sound like, well, the growth is here, the margin is going to be here and of course, slowing down then margin is going to go there. Is there like — how do you think about — is there like a — there must be a handbook for a CFO that nobody shared with us, like in terms of how you need to think about growth versus margins and what’s good for an organization. Like how do you kind of make that decision in there?
Gina Mastantuono
Yes. I mean, I think that what you’ve come to see from ServiceNow different than some others is always a focus on top line and bottom line, right? And so there’s not a handbook to say if growth slows to this, the margin accretion needs to be that. That being said, we get what drives shareholder value, and we’re really focused on that.
And so again, really focused on the growth. We are committed to giving back margins at the 100 bps that we talked about even despite some of the pressures that we’re seeing. And so you’ll continue to see us focus on that. But at the same time, we’re not going to give up the opportunity to invest behind the growth that we see. So clearly, that opportunity is stronger than ever. And so you’ll continue to see us take a very disciplined approach to driving both top line as well as the bottom line.
Raimo Lenschow
Yes, yes, yes. And then how does that translate into cash and first cash generation? I guess, it is a very kind of close relationship for you and then I was thinking more about cash usage as well.
Gina Mastantuono
Yes. So listen, we’ve been pretty open about the fact that we were looking to give back about 100 bps on both operating margin and free cash flow margin a year. At the same time, what worked really well for us in 2020 when customers needed some support on timings of cash flow that really worked well in our favor to solidify those relationships. So we want to be able to be mindful and not change payment terms but allow for some flexibility in the macro that we’re seeing. That being said, that’s short-term timing. Long-term, midterm guide, we’ll be able to continue to accrete margins like we have committed to.
Raimo Lenschow
And are you — like I talked with other vendors about that as well. And they were like, it was kind of different in 2020 because back then, people were really like, oh my god. And if I don’t have to pay you now, that would be great. And so we are cash starved. Some of the business had to shut down, so that we had to preserve cash. It doesn’t feel we’re in the same situation now. Like what are you seeing there? What do you…?
Gina Mastantuono
It’s a little bit different. It’s a little bit different. So in 2020, certainly early in the year, you got the, oh my gosh, I got to preserve cash. Let’s be smart about this. But what also happened in that same year, especially for us, where we are so enterprise-focused, is that T&E spend went to zero. Marketing events went to zero. So by the end of the year, there was flush with cash. So they were like, let me pay more.
Now, a little bit different this year where supply chain inventory levels, there’s other pressures on balance sheet that I think will just create a different type of environment that customers are — might be looking for a little bit of leeway. And I just want to be able to be mindful of that and work with them on that, especially if it’s short term.
Raimo Lenschow
Yes, yes, yes. Okay. Last couple of minutes, like on that node like cap, you’re very cash generative. You have a very strong cash position. M&A like — or maybe like usage of cash, M&A, like how do you think about that?
Gina Mastantuono
Yes, yes. I’m not under duress of phone calls from bankers for a position of some M&A. What I’ll say is, and I’ll go back to the comment earlier, we organically built 11 businesses greater than $200 million in ARR. What that means is the bar is really high for us on acquisitions. And so we wouldn’t be doing our jobs if we’re not looking and keeping our eye on the market and thinking about what’s beneficial and going to drive incremental value for our customers. If they’re a better together story.
That being said, the bar is really high. And it would have to not only drive significant customer value but strong shareholder value as well. And so we wouldn’t be doing our jobs if we weren’t looking at that, but it’s certainly not the strategy of what we need to achieve the top line goals that we’ve set forth.
Raimo Lenschow
Yes, yes. Actually, it’s a very good closing statement, I thought like. So thank you. You want me to ask one more macro question.
Gina Mastantuono
I think we covered that. Thanks so much, Raimo. Really appreciate it.
Raimo Lenschow
Thank you. Thank you for coming back. Thank you.
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