Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

ServiceNow (NYSE:NOW)

Q1 2013 Earnings Call

April 24, 2013 5:00 pm ET

Executives

Robert Specker - General Counsel and Secretary

Frank Slootman - Chief Executive Officer, President and Director

Michael P. Scarpelli - Chief Financial Officer and Principal Accounting Officer

Analysts

Thomas Ernst - Deutsche Bank AG, Research Division

Raimo Lenschow - Barclays Capital, Research Division

Rob D. Owens - Pacific Crest Securities, Inc., Research Division

Walter H. Pritchard - Citigroup Inc, Research Division

Jennifer Swanson Lowe - Morgan Stanley, Research Division

Brent Thill - UBS Investment Bank, Research Division

Tim Klasell - Northland Capital Markets, Research Division

Jason Maynard - Wells Fargo Securities, LLC, Research Division

Philip Winslow - Crédit Suisse AG, Research Division

Stewart Materne - Evercore Partners Inc., Research Division

Abhey Lamba - Mizuho Securities USA Inc., Research Division

Bradley H. Sills - Maxim Group LLC, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Q1 2013 ServiceNow Earnings Conference Call. My name is Alice, and I will be your operator for today. [Operator Instructions]

As a reminder, this call is being recorded for replay purposes. I'd now like to turn the call over to Mr. Robert Specker, General Counsel. Please proceed, sir.

Robert Specker

Good afternoon, and thank you for joining us on today's conference call. We'd like to apologize for the late start. Management's been on the line waiting for the bridge to open as well. We'll get right to it now. This call is also being broadcast live over the web and can be accessed at our website at investors.servicenow.com for the next 30 days.

With me on today's call are Frank Slootman, Chief Executive Officer; and Michael Scarpelli, Chief Financial Officer. After the market closed today, ServiceNow issued a press release with results for its first quarter of 2013. If you would like a copy of the release, you can access it online at our website.

We would like to remind you that statements made on this conference call that are not historical fact may be forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements include, among other things, information concerning our possible or assumed future results of operations, business strategies, financing plans, operating model, competitive position, industry environment, potential growth opportunities, potential market opportunities and the effects of competition. Words such as may, will, expects, intends, plans, believes, targets, estimates and variations of these words are intended to identify forward-looking statements. These forward-looking statements involve risks and uncertainties that could cause our results to differ materially from those expressed or implied by such forward-looking statements. The risks and uncertainties include any weakening of general economic and market conditions and customer budgets; our ability to react to trends and challenges in our business; our ability to anticipate market needs or develop new or enhanced products to meet those needs; our ability to scale our sales channels; our ability to recruit and retain personnel; our ability to compete in our industry; and other risks and uncertainties described more fully in our documents filed with or furnished to the Securities and Exchange Commission. All forward-looking statements are based on information available today, and we assume no obligation to update these forward-looking statements. Any future product feature or related specifications that may be referenced in today's call are for information purposes only, and are not commitments to deliver any technology or enhancements. ServiceNow reserves the right to modify future product plans at any time.

In addition, we will reference non-GAAP financial measures on this conference call. The company reports non-GAAP results for gross margins, operating margins, net income or loss, basic and diluted income or loss per share, free cash flow and billings in addition to, and not as a substitute for or superior to, financial measures calculated in accordance with GAAP. Management believes that this supplemental non-GAAP information is useful to investors in analyzing and assessing the company's past and future operating performance. To see the reconciliation between these non-GAAP results and GAAP results, please refer to our press release filed earlier today and for prior quarters' previously filed press releases, all of which are posted on our website at investors.servicenow.com.

I would now like to turn the call over to ServiceNow's CEO, Frank Slootman.

Frank Slootman

Thanks, Rob. Good afternoon, and thank you for joining us on today's call. We are pleased to announce all-time record revenues for the quarter. Revenues grew year-on-year 81% to $86 million. Both billings and deferred revenue were marked by strong growth, with total billings of $110 million, up 13% sequentially and 88% year-on-year, and a deferred revenue balance of $195 million, up 14% sequentially and 68% year-on-year. Even as we surpassed $282 million of trailing 12-month revenue, this marks the 27th consecutive quarter of 80% plus year-on-year revenue growth.

Our billings performance in the first quarter of 2013 was the result of strong contribution from each of our 3 growth engines: new customer acquisition, contract renewals and upsells. The top line results would have benefited from a number of initiatives. First, our sales organization is now more balanced in terms of existing account focus and new logo acquisition. Second, our sales effort is benefiting from sustained investment in both deeper and broader service areas, both foreign and domestic. Third, we increasingly benefit from the presence of global system integrators in our ecosystem. And finally, our expanding professional services organization has been a key enabler of our growth.

In terms of new customer wins, we added 128 net new customers in the first quarter, ending the quarter with a total of 1,640 customers. We continue to focus on the Global 2000 as defined by Forbes Magazine, adding 17 new Global 2000 Enterprises to our customer roster during the quarter. As a result, we're not counting 282 of the Global 2000 as ServiceNow customers, representing 14% penetration. Global 2000 accounts added in the quarter include Yamana Gold, W.W. Grainger, Transocean and Dollar General.

The results reflect the company's focus on time-to-value. According to one large financial services organization based in the Midwest who went live with ServiceNow in the quarter, "With ServiceNow, we accomplished in 7 weeks what took 4 years with HP."

In the quarter, our average annual revenue per customer was 198,000, up from 164,000 in the first quarter of 2012, a 21% increase year-on-year. This increase was driven primarily by user growth within our install base. Renewals and upsells are key indicators of ServiceNow's increasing adoption in the enterprise.

Our renewal rate during the quarter was 96%. We also saw significant contribution from upsells during the quarter, representing 1/3 of our annual contract value signed during the quarter. One upsell example is a Global 2000 diversified manufacturing company based in the Northeast, which purchased 200 user licenses in the third quarter of 2012 and returned this quarter to purchase an additional 1,300 user licenses to facilitate replacement of a number of legacy applications with ServiceNow as IT single system of record. We're replacing CA with Incident, Cherwell with Change and BMC Remedy with Asset Management as this customer takes the first step to standardize and consolidate IT globally.

We continue to make good strides on the international front. An example is a first quarter win with Capita Secure Information Solution, a subsidiary of the largest professional support service provider in the U.K., with over 45,000 employees serving the Blue Light public service forces, such as the police, firefighters, ambulance police and prison management, which each require their own secure instant responses and database. Capita SIS was running a legacy instant response system that could not scale past 600,000 incidents per year and elected to adopt ServiceNow.

We're seeing more evidence of global system integration partners pulling us into new engagements. For example, Chicago-based Grainger is North America's leading broadline supplier of maintenance and repair products and has been working with our partner, KPMG, on high-level business process transformation. The IT organization was working on an unsupported version of a legacy vendor's product, and the KPMG team introduced ServiceNow to the key decision-makers despite the fact that they were already down the path with one of our competitors. ServiceNow prevailed, and Grainger will be implementing Incident, Problem, Change and Knowledge Management in its Phase 1 deployment.

We grew our professional services revenue 17% quarter-on-quarter and achieved 8% non-GAAP gross margins. In the quarter, we completed our largest training project to date at Carlson Wagonlit Travel. Carlson has been a ServiceNow customer since 2009 and recently added 560 new users as they replaced their legacy system with ServiceNow. As part of this go-live, we and several SI partners trained 1,200 users on Incident, Change and Configuration Management in over 50 virtual and live sessions conducted around the world in 3 different languages.

Our business is driven by the opportunity to fundamentally transform the enterprise IT discipline. While IT has historically been the most tech-savvy of enterprise functions, it also has trailed in terms of management sophistication. This is no longer tolerable, the pressure on IT budgets and escalating demand for system support.

The ServiceNow platform is widely regarded by our enterprise IT customers as their ERP, a single system of record that massively consolidates, globalizes and standardizes the IT processes and workflows. IT staff typically represents 5% to 10% of the enterprise workforce worldwide, but our customers routinely aim for 100% of the IT staff to be enabled on our platform. Everybody in IT is an actor and a participant in the workflow of IT.

The second vector of transformation is what we call the consumerization of the service experience. Why should enterprise users be denied the online service model as popularized for some time now by banks, retailers and other online service providers? Younger generations joining the workforce today expect a modern service experience that is online, structured and intuitive and includes things such as search, chat and community. ServiceNow enables IT to deliver itself as such a service.

The third level of transformation is the automation of workflow in IT as well as throughout the enterprise. Automation is applicable to activities that are repeatable and can be standardized. The result is efficiency, transparency and process execution at the speed of light. IT organizations tend to be overstaffed and under-automated. The ServiceNow platform is the enabler of workflow automation in the enterprise.

ServiceNow adoption in the IT organization typically opens doors to other enterprise service domains, either to modernize legacy applications or to develop structured workflows for activities not previously automated. For example, a large retail customer deployed ServiceNow to help support the rebalancing of their supply chain between suppliers, distribution centers and stores. It does not get much more mission-critical for a retailer to ensure the right products at the right time and place.

We continue to see encouraging growth in platform adoption. One example, a new Global 2000 customer that is a leading services firm, providing advice and solutions in risk strategy and human capital with over 50,000 employees worldwide, was looking for a case management application to front-end their existing PeopleSoft system. The primary users of this ServiceNow implementation will be employees within the North American HR department with a plan to expand globally. We competed with HR solution vendors and won a contract valued in excess of $500,000 based on the ease of configuration.

In another example, an existing Global 2000 customer in the pharmaceutical industry increased its commitment to ServiceNow in the first quarter by adding over 50,000 end user seats across the enterprise. This customer is using ServiceNow to support an employee-facing learning and certification system containing training curriculum, scheduling and certification tracking. This is typical of how we see IT organizations extending ServiceNow into the enterprise and driving service automation as a management discipline.

In summary, we believe we have a remarkable opportunity in front of us to continue to drive new customer adoption of our IT application portfolio, what we call the ERP for IT, and expansion of our management platform into other service domains in the enterprise.

Before closing, please note our upcoming Annual Users Conference, Knowledge13, in Las Vegas, May 12 through the 16th. We expect 4,000 IT professionals and ServiceNow experts to convene for 5 days to share IT service automation strategies and to learn how other IT professionals achieve results in the cloud. On May 13, as part of the event, we will be holding an Analyst Day for professional financial analysts, for which many of you on the call today are already registered. We have a great lineup of speakers, including members of our management team that are not regular attendees at investor events and customers who will discuss their experience with ServiceNow. For those who cannot join our Analyst Day in person, we will hold a webcast of the event that will be accessible on our website.

With that, I will turn the call over to Mike Scarpelli, our CFO, to go over the numbers in more detail.

Michael P. Scarpelli

Thank you, Frank. During today's call, we will review our first quarter financial results and discuss our financial guidance for the second quarter and full year 2013. Before we begin, we'd like to point out that all financial figures we discuss today are non-GAAP unless we state otherwise, with the exception of revenue numbers, which are GAAP. You can find the reconciliation of GAAP to non-GAAP results in our press releases on our website.

With that, let us take you through some of the numbers. Total revenues for the quarter were $85.9 million, representing 81% year-over-year growth and 14% sequential growth over fourth quarter revenues of $75.2 million. Revenue was above our outlook, primarily due to strength in new business and upsell bookings during the quarter and an acceleration of our services business.

Subscription revenues for the quarter were $71.6 million, representing 81% year-over-year growth and 14% sequential growth. Subscription revenue growth was driven by strong bookings in prior quarters coupled with a retention rate of 96% in the current quarter. 1/3 of our annual contract value signed in the quarter came from upsells in our existing customer base. Our average new business contract length was 32 months, and our average renewal contract length was 25 months, which compares to an average of 33 and 24 months on a trailing 4-quarter basis, respectively.

Professional services and other revenues were $14.4 million for the quarter, growing 82% year-over-year and 17% on a sequential basis. Professional services and other revenues are generated primarily from fees related to the implementation and configuration of our subscription service, as well as training fees.

Total revenues based on geography were $60.1 million in North America, $20.3 million in EMEA and $5.5 million in the rest of the world, representing 70%, 24% and 6% of total revenues, respectively. By comparison, in the first quarter of 2012, we recorded revenues of $33.9 million in North America, $11.9 million in EMEA and $1.6 million in the rest of the world, representing 72%, 25% and 3% of total revenues, respectively.

Our total billings were $110.3 million for the first quarter compared to $58.6 million in the first quarter 2012 and $97.6 million in the prior quarter, representing 88% year-over-year growth and 13% sequential growth. Additionally, approximately 7% of our billings in this quarter were for periods greater than 1 year, compared to 22% in the first quarter of 2012 and 10% in the prior quarter. In the future, we expect 5% to 10% of our billings will be for periods greater than 1 year. 1 year is our typical billing term.

Before we turn to expenses, I'd like to point out that we ended the quarter with 1,269 employees, an increase of 541 employees for the same period in the prior year and an increase of 192 employees from the prior quarter. Please note that we recorded a pretax amount of $12.0 million related to stock-based compensation expense. This impacted our earnings per share in the first quarter by a tax-adjusted amount of $0.09 per diluted and basic share.

Our subscription gross profit was $55 million, representing a gross margin of 77% compared to 73% in the same period last year and 70% in the prior quarter. During the quarter, we added 16 net new employees to subscription cost of sales. This number is inclusive of 15 employees transferred out of subscription cost of sales as part of an internal reorganization, ending the quarter with 234 employees.

In the first quarter, we stopped incurring costs related to the migration of customers to our new generation of data centers. This migration spanned a majority of 2012, concluding in the fourth quarter. The costs associated with the migration included double rent as we wound down our contractual obligations and accelerated depreciation for certain assets. In addition to the cost savings from the migrations, subscription cost of sales decreased by approximately $800,000 due to the previously mentioned employee transfers, the majority of which went to sales and marketing.

Our professional services and other gross profit was $1.2 million, representing a positive gross margin of 8% compared to negative 27% in the first quarter of 2012 and positive 5% in the prior quarter.

During the quarter, we added 21 net new employees to professional services and other cost of sales. This number is inclusive of 11 employees transferred to sales and marketing who will now be responsible for assisting in the professional services sales cycle, ending the quarter with 204 employees. The sequential improvement in professional services and other gross margin was driven by improvements in billable utilization and average hourly rates in addition to approximately $600,000 reduction in costs associated with the previously mentioned transfers.

Our total gross profit was $56.2 million, representing a gross margin of 65% compared to 57% in the prior quarter -- prior year, sorry, and 60% in the prior quarter.

Moving to operating expenses for the first quarter. Sales and marketing expenses were $34.2 million, or 40% of revenues, compared to $17.8 million, or 38% of revenues, in the first quarter of 2012 and $26.1 million, or 35% of revenues, in the prior quarter. In the first quarter, we incurred $1.3 million in expenses associated with our annual sales kickoff event, which was previously held in July. During the quarter, we added 102 employees to sales and marketing, ending the quarter with 452 employees. It is important to note that in the second quarter of 2013, we expect to incur expenses in sales and marketing of approximately $8 million to $9 million related to our Knowledge conference next month, compared to $3.6 million incurred for the event in the second quarter of 2012 due to a significant increase in the size of the event.

Research and development expenses were $12.9 million or 15% of revenues compared to $6.1 million or 13% of revenues in the first quarter of 2012 and $10.9 million or 14% of revenues in the prior quarter. During the quarter, we added 31 employees to research and development, ending the quarter with 231 employees. We expect research and development expenses to increase on a dollar basis as we continue to make significant investments in our services, primarily in the areas of application, platform and cloud development.

General and administrative expenses were $9.9 million or 12% of revenues compared to $5.4 million or 11% of revenues in the first quarter of 2012 and $8.1 million or 11% of revenues in the prior quarter. During the quarter, we added 22 employees to general and administrative, ending the quarter with 148 employees. We expect general and administrative expenses will continue to increase as our business continues to grow, but we expect these costs to decrease as a percentage of revenue.

Our operating loss in the first quarter was $0.9 million compared to an operating loss of $2.4 million in the first quarter of 2012 and an operating loss of $0.2 million in the prior quarter. This equates to a negative operating margin of 1% compared to a negative 5% margin in the first quarter of 2012 and an operating margin of 0% in the prior quarter. During the quarter, we reported a non-GAAP tax expense of $1.1 million.

Net loss for the first quarter was $1.9 million, or a net loss of $0.01 per basic and diluted share, compared to a net loss of $2.5 million, or a net loss of $0.11 per basic and diluted share, in the first quarter of 2012 and a net loss of $0.6 million, or a net loss of $0.00 per basic and diluted share, in the prior quarter.

Our basic weighted average shares outstanding for the quarter were approximately $130 million. If we had operated at a net profit in the quarter, our diluted weighted shares outstanding would have been approximately $155 million. Fully diluted shares at the end of the quarter were approximately $167 million. Our net loss was driven by significant investments we are making at our business. We're continuing to invest in the business to ensure we have the ability to scale and sustain growth. This includes continued hiring and investments in sales and marketing, infrastructure, systems and other resources.

During the first quarter, we generated $15 million in cash flows from operations. We used approximately $10.4 million for capital expenditures, resulting in $4.6 million in free cash flow. This compares to $7.5 million of free cash flow in the first quarter of 2012 and $6.8 million in the prior quarter. We ended the quarter with $338.9 million in cash and short-term investments and no debt, an increase -- an increase of $242 million over the prior quarter -- sorry, $24.2 million over the prior quarter.

Our total GAAP deferred revenue balance was $194.8 million at the end of the first quarter, up 14% over the $170.4 million reported at the end of the prior quarter.

Let's turn to guidance for the second quarter and full year 2013. Please note that our margin and EPS guidance is on a non-GAAP basis, which excludes stock-based compensation expense and the related income tax impact. For the second quarter of 2013, we expect total revenues between $94 million and $96 million, representing year-over-year growth between 66% and 69%. Revenues are expected to consist of subscription revenues between $77 million and $78 million and professional services and other revenues between $17 million and $18 million. We expect subscription gross margins between 74% and 75%, down from 77% in the first quarter of 2013, primarily due to additional investments in our data centers and cloud infrastructure personnel. We expect professional services and other gross margin between 23% and 25% and overall gross margin between 64% and 65%. Please note, we expect to recognize approximately $4 million in professional services and other revenue related to our Knowledge event, with approximately $8 million to $9 million of expenses recorded in sales and marketing. We expect an operating margin between negative 6% and negative 5% and a net loss per basic and diluted share between negative $0.06 and negative $0.04, with weighted average shares outstanding of approximately $135 million.

Our negative operating margin will be primarily driven by our continued rapid expansion, specifically our headcount growth, and also the impact of Knowledge on sales and marketing in the second quarter. We expect our employee count to increase by over 200 employees in the second quarter of 2013 and approximately 740 employees for the full year 2013. Included in these headcount additions are sales and marketing employees of approximately 65 and 250 for the second quarter and 2013, respectively.

For the full year 2013, we are raising our outlook and expect the revenues to fall within the range of $394 million to $398 million, representing year-over-year growth between 62% and 63%. Our total annual revenues estimate consist of subscription revenues between $332 million and $334 million and professional services and other revenues between $62 million and $64 million.

With that, operator, you can now open up the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And your first question comes from the line of Tom Ernst of Deutsche Bank.

Thomas Ernst - Deutsche Bank AG, Research Division

So you mentioned a couple of interesting customer anecdotes on the Platform business. I wanted to ask you -- I'm sure you're not disclosing the revenue level there, but can you tell us about the nature of the Platform business as you're seeing it come together this year? Are they similar-sized deals to the application product? Are you finding they're typically upsells or new customers? What's the makeup of what your pipeline looks like in Platform, please?

Frank Slootman

Tom, it's Frank. What's interesting about the Platform business is that historically, this has always been part and parcel of our -- the sale of our IT applications portfolio. What we're starting to see more of is standalone Platform deals, and this is a direct result of our go-to-market cadence being much more deliberate in terms of positioning and messaging around Platform. It's still relatively early to characterize the makeup of the business. It's all sort of all over the map. They're certainly very substantive opportunities, and I mentioned one during the prepared remarks, but we signaled in prior quarters that it's going to be towards the latter end of this year before we're going to be more systemic in how we talk about our Platform business and how we report on it.

Thomas Ernst - Deutsche Bank AG, Research Division

Great. And maybe just one follow-up. Your perspective on the market opportunity for you in Platform vis-à-vis the opportunity for building out more applications. With your early experiences here, how large an opportunity do you think the Platform is relative to continuing to build out more applications in the IT arena?

Frank Slootman

Yes, it's hard to be very authoritative on it, but we have historically said that we think that the Platform business is at least as large as the IT businesses. But as we get further into this, many of our enterprise customers are really sort of beginning to understand and grasp the nature of the opportunity. And the reason is, we don't just go in and automate or re-implement legacy application that have previously been built on, whatever it is, Microsoft Access or SharePoint or Lotus Notes. They're also starting to tackle processes that have never been automated before that are really running through e-mail and spreadsheets and so on. So as a result of that, we think the Platform opportunity is still unfolding right in front of us and potentially can be much larger than what's currently even visible to us.

Operator

And your next question comes from Raimo Lenschow of Barclays.

Raimo Lenschow - Barclays Capital, Research Division

A quick question on the -- related to the Platform as well. You talked a little bit about you guys kind of working outside of the core domain that we've previously talked about, and you mentioned the HR Example. Can you talk a little bit about how we have to think about you addressing it? Is this kind of more opportunistic as customers are kind of evolving there? Or is it something that we could think about a proper strategy there?

Frank Slootman

Raimo, this is Frank again. This has been true historically. Our business -- we always land in the enterprise -- most of the time, not always, but most of the time on the IT applications portfolio. And as everybody knows, we typically replace either homegrown or other legacy systems that have been in place for 10, 15 years or even longer. Once IT organizations, a, sort of get well established in terms of rolling out the new IT systems and become familiar with what the capabilities of our platform are, this is typically when they start branching out into other service domains. And other service domains are the other corporate support functions. So human resources, very typical; legal case management, very typical; travel, facilities and so on. We call those the other service domains. But it usually doesn't take long before we start to bleed into other service areas that can be either customer-facing or more line-of-business oriented that support core product operations. I mentioned the supply chain example. Anything that is request, response, workflow-oriented typically is a very good fit, especially when IT is involved in undertaking those kinds of projects.

Raimo Lenschow - Barclays Capital, Research Division

But is -- and the question from me was more like, is that kind of something that you can do, or is it just a natural evolution to -- that you just rolled out everyone's IT and then you just kind of have to wait and see until it gets rolled out further?

Frank Slootman

Well, no. I mean, we -- I mean, historically, it was very much a viral thing that sort of happened with or without us. At the start of this year -- now first of all, we've rebalanced our sales organization that we now have dedicated people on existing accounts that get paid on this class of software and application development. In terms of our whole go-to-market approach, we are now very specific in terms of demonstrating what our platform is capable of doing, not just in terms of modifying and configuring the existing applications there, but also how you stand up brand-new applications. So our approach to the market is much more deliberate and specific in terms of showing people, a, what the platform can do, and then, b, how this actually gets done. So we're driving this effort now as opposed to sort of letting it happen naturally, which has historically been the way this business has unfolded for us.

Operator

And your next question comes from Rob Owens of Pacific Crest Securities.

Rob D. Owens - Pacific Crest Securities, Inc., Research Division

Mike, maybe you can help us understand duration a little bit. You gave some comments around average contract length, but I guess what I'm looking for is maybe a little more help around book-to-bill, and I think you gave the metric that 7% of billings were for periods greater than 1 year. And just as we're trending long-term deferred, as we're thinking about billings moving forward, does this number here kind of represent a loan we should base off of this, given you're in the middle of that 5% to 10% range? Or just how should we think about that moving forward?

Michael P. Scarpelli

Good question. As I told most of the analysts before, we had changed our comp plan for our sales force, where in the past, we had heavily incented them, pre- being public, to get as many years billings in advance as possible, and salespeople were paid quite handsomely on that. Given we're now a public company and cash flow is not as a concern with multiple year billings in advance, we changed our comp plan, and we're seeing the results of that right now where most of our billings, you should assume, are going to be 1 year in advance, with only a small portion being multiple years. And it's that multiple year that goes into the long-term deferred revenue movement. And hence, why we say roughly 5% to 10% is what we forecast of our billings will be multiple years in advance. And unfortunately, that's a number that we generally don't find out about until the very end when the deal is coming in, so it's hard to forecast. It's a multiple-year component. Does not change, though, the average contract length or anything, which is what we focus more on.

Rob D. Owens - Pacific Crest Securities, Inc., Research Division

And then second, as we look at the FISMA, I guess you gave a bunch of FISMA ATO GSA from the press release, but just the government opportunity, and is that in your existing data centers? Does that require a new data center being built? And just where are you in terms of federal adoption right now?

Frank Slootman

So a couple of things. First of all, we have a separate pair of data centers for the federal business. We have had that for some time. That's not new. FISMA data centers, they have very different access controls than our regular commercial data centers, and they're specifically set up and run for this class of business. We started well over a year ago in really establishing and building out our federal team, and that organization has done very well and is sort of growing in leaps and bounds. Obviously, in the last quarter, just about every vendor was affected by sequestration. It created a huge amount of inertia in the business. But we think that has pretty much cleared, and for the rest of the year, I think we have -- we're going to have a lot more clarity on the federal business. But everybody knows that federal business can easily represent 10% of our total revenue or better. It's a very, very good business for us to be in. It's hard to get in because of the requirements in terms of compliance and security, which is why the authority to operate for us is a very significant milestone. There aren't that many vendors in our business that have acquired that ability, and you just cannot get to do business with the federal government till you have those kind of credentials.

Operator

And your next question comes from the line of Walter Pritchard of Citigroup.

Walter H. Pritchard - Citigroup Inc, Research Division

Frank, I'm wondering if you could talk about just on the deals you've been seeing in the last couple of quarters, any metrics on what percentage of the users you're having signed are for a non- -- non- sort of incident and problem kind of help desk type functionality, and how much of the user count are you seeing in areas like asset and change and config and some of the areas that you've introduced more recently, let's say, over 12 to 24 months?

Frank Slootman

Walter, it's pretty unusual these days to find customers that are approaching our business really as a help desk system. It does happen at the low end of the spectrum, and that's where sort of a lot of the sort of the new competitors are coming from that are principally trying to replace legacy help desk management systems with sort of newer hosted versions. Our class of customers has a very different perspective. They're not trying to reinvent the help desk; they're trying to retire it. They want to get to a single system of record. And to them, the evolution of help desk is really the creation of the ITIL framework, where you have defined processes around incident management, problem management, change management, configuration management. And it's almost difficult to actually even recognize the old mode of help desk management in those kinds of applications. So with our customers, we typically don't talk about help desk management anymore. But what incident management really represents is the initiation of a structured workflow, either related to a problem or to a request or some other events. Right? So the whole motion of help desk is really a bit of a remnant of the 1990s time frame. So it's really not part of our nomenclature the way we go to market with ServiceNow.

Walter H. Pritchard - Citigroup Inc, Research Division

And then, Mike, just on the hiring, it looks like your margins are going to come in a little lower than we were modeling for Q2. I guess it seems like you're executing well in terms of getting productivity out of the people you're adding. And I'm wondering if could talk about, just relative to the plans you laid out on the Q4 call around increasing your hiring, how do you fine tune or change those plans now with another quarter under your belt?

Michael P. Scarpelli

Well, first of all, we were very pleased with our hiring last quarter. The 192 that we hired in the quarter was actually well above the financial plan that I had looking at historical hirings, so we feel very good about our hiring right now. Hence, in our original plan, we were looking at more like 170 employees that we'd be actually able to onboard. Now we think we can do 200 in Q2, and that's the big driver.

Walter H. Pritchard - Citigroup Inc, Research Division

So it's simply adding people earlier that drove the lower margin in Q2. Got it.

Michael P. Scarpelli

Correct.

Operator

And your next question comes from the line of Jennifer Lowe of Morgan Stanley.

Jennifer Swanson Lowe - Morgan Stanley, Research Division

Maybe just a follow-up on Walter's question. It looks like you're pacing ahead on the sales and marketing headcount, in particular. And I guess there are 2 question on that. One is, how much of that is purely related to the reallocation of headcount from some of the cost-of-goods groups into sales and marketing? And then related to that, were those people who had been performing similar sales-type roles in those -- you had mentioned that some of them were people doing service or sales. Are they doing similar roles, it's just a reallocation? Or are they being -- getting a whole new job and really contributing overall to the sales capacity that you have?

Michael P. Scarpelli

The people who were transferred from the subscription support line down into sales and marketing are performing a new role. They're now performing a client account manager role, and I believe that was 11 people we transferred down -- or sorry, 15 people that we transferred down out of subscription into predominantly sales and marketing. There were some of them that actually went into engineering that were -- that used to perform a support function that went into engineering. And then on the professional services side, 11 people that we transferred down are performing a new role. In the past, they performed a bit of a mixed role between presales and actually doing implementation with our customers. We did a whole reorganization of our go-to-market from a sales standpoint, January 1, we talked to you a little bit about that at the call then. And those 11 people now who were in our professional service organization are only focused on the presales activities of professional services. And hence, they're in sales and marketing now.

Jennifer Swanson Lowe - Morgan Stanley, Research Division

Great. And just one more question on sales. Now that you are moving to a calendar year end in your comp plans versus the midyear end previously, and this being sort of the first year that you've had that, is there anything we should be thinking about in terms of your ability to sign new business in Q2, just so we should be more careful about for modeling out deferreds and billings and potentially having maybe a tougher comp there because of the comp year end?

Michael P. Scarpelli

Yes, historically, June has been an extremely good quarter because of that year end. But if you look at most tech companies, Q4 by far is going to be your strongest quarter, and we saw that this past quarter. We're still expecting a strong quarter in Q2. But we kind of expect going forward with the federal business in September, Q2 to Q3 are pretty much going to be flat quarters from a bookings perspective, but still a very strong quarter relative to Q1.

Operator

Your next question comes from the line of Brent Thill of UBS.

Brent Thill - UBS Investment Bank, Research Division

Mike, I was just curious if you could just address what you're seeing in the overall environment. There's been a wave of cold air, if you will, that's come over the software industry, including some of the subscription-based models, and you obviously bucked the trend in Q1. But can you just give us your sense of -- are you seeing any change in customer behavior in terms of what you saw on the linearity of the quarter on new signings or any other details that you're seeing that would be helpful?

Michael P. Scarpelli

I'll answer the first part, then I'll turn it over -- the last part of your question and turn it over. In the last 3 quarters, we pretty much had identical linearity between the first 2 months of the quarter and the third month, which we were very pleased to see. And so there has been no change in terms of the amount of business we book in the third month of the quarter, and that's been consistent for 3 quarters now. I'll turn it over to Frank, who's in front of the customers a lot more than I am.

Frank Slootman

Yes, Brent, I've been on the road a lot in Q1, and I've seen a ton of people. I definitely noticed, as did many other vendors that have reported, that the general sentiment is a little bit more cautious than what we saw last year. Now I cannot determine whether that is cyclical or just seasonal. Q1 for all companies of our type is just a difficult quarter because you tend to really take down your mature pipeline, and rebuilding it in a short period of time is always difficult. So if you try to sort of push business along and you detect sort of that you're doing -- you're pushing the customer harder than they want to get pushed, it may come across as a waning sentiment. In reality, it might just be normal friction, and we're just trying to push it harder than it wants to be pushed. So that's why I said, it might just be seasonal, it could be cyclical. And I think we need to have at least another quarter under our belt before we can really be more intelligent about characterizing it.

Brent Thill - UBS Investment Bank, Research Division

Okay. Frank, just to follow on that. You've been doing this for quite some time. And I mean, from your perspective, it feels a little more seasonal and it feels like -- is there anything in terms of what you're seeing for Q2 or Q3 that would lead you to believe to it could be more back-end loaded this year?

Frank Slootman

No, not really. I mean, we are much more sort of governed by secular trends that are unique and specific to our business than anything relating to the macro, so we're feeling really good about where we are in our business. As a matter of fact, we're feeling better about it than we ever have, and the reason is the company is so much higher profile than it was a year ago, our ability to engage in conversation at a high level is so much better than it's ever been. We've really opened up a huge gap to the rest of the competition and people that are vying for this kind of business, and it's really benefiting us in the whole go-to-market cadence. So I'm not down at all on the rest of the year in any way, shape or form.

Operator

And your next question comes from the line of Tim Klasell of Northland securities.

Tim Klasell - Northland Capital Markets, Research Division

Just a quick question on the competition. Clearly, we know your traditional competitors. But as you do expand into the new use cases, you did mention that you ran into some of the HR tech companies, at least as far as on one deal. Do you expect that trend to continue, and how should we think about that going forward?

Frank Slootman

This is Frank again. Yes, we absolutely expect to see and contest against nontraditional competitors. And we've already mentioned some. You mentioned some. Depending on what class of applications we're getting into, we can see a completely different set of competitors. And it's really a sort of a reordering and a realignment and a re-platforming that's going on in the industry, where people may have historically worked with very narrow point solutions relative to specific requirements, they may all of a sudden look at this, "Hey, this can actually be addressed on a platform basis rather than on using some hard-coded application from a specific vendor." So that dynamic is shaken up in the marketplace. And this is not the first time this has happened in our industry. You can go all the way back to the early '90s, when there were a lot of a one-off tools out there. And when Windows came on with Visual Basic and things like that, they completely realigned the marketplace. We're sort of seeing flavors of that dynamic playing out. So I think you will see us on the platform side go up against a whole variety of different players that are out there. Usually legacy companies, people that have been around for a long time.

Tim Klasell - Northland Capital Markets, Research Division

Okay, great. And then just a follow-on for Mike. The professional services gross margin came in better than we were -- or at least where I was looking for. Is that a reflection of just better efficiency as you gained scale? Or have you been tweaking your prices up or did a price increase this quarter?

Michael P. Scarpelli

Well, part of our whole strategy to ultimately get our professional services and other gross margin to the 13% to 15% has been to shift more of our business from fixed price to time immaterial, and we're seeing the impact of that now. And it's still a gradual process. But also, we hired a lot of people on the management side in our professional service organization and build it for scale. And as we add more people to actually do the implementations, you get better scale out of your management layer within your professional service organization. So I do expect that. But this quarter, it was really -- part of it is the timing of deals that are more profitable in terms of the hourly rate we're able to get; as well, the utilization was very strong this quarter. And there's always a mix every quarter of how much work we do ourselves versus we subcontract out to some of our professional service partners, where we just don't have the bandwidth to do all the work. That has an impact as well on our margins. And as I said, I do expect our gross margins for professional services, when you back out the impact of the Knowledge revenue, that will actually come down slightly. It's going to be kind of 0% to 4% in Q2 standalone without the Knowledge revenue being in there.

Operator

And your next question comes from the line of Jason Maynard of Wells Fargo.

Jason Maynard - Wells Fargo Securities, LLC, Research Division

I just have one question, maybe a multipart, on working with partners. And Frank, maybe get a little bit of color from what you're seeing in terms of the breadth and depth of the relationships and how that's actually translating into consumption of multiple products, partners starting to work with the platform and then driving that into some of your big accounts.

Frank Slootman

Jason, a very broad question, but there are different classes of partners that we work with. I mean, by far the largest class of partners that's very important to our ecosystems are the implementation partners, not just because they enable our business and they're able to implement for the customers that we sell, but also because they typically have relationships in their particular vertical or their particular locale that they can leverage very, very quickly to the benefit of our business. We've seen a lot of partners come over from other legacy vendors and deciding they don't want to play over there anymore, and they'd rather be in our business because of the growth and the sort of fresh dynamic that we have around it. We've been very deliberate in creating really a really good atmosphere to develop an ecosystem. So one of the reasons why our professional services rates are kept up is we really want to have a pricing umbrella that other companies can operate underneath with lower tier of services. And they appreciate that, so that we don't crowd out our own ecosystem and then we don't compete with our partners as much as we can help it. It does happen from time to time. What you'll also see, as we are developing, and those of you who are coming to Knowledge, you probably would amazed to see how many partners will actually be at the conference. It's a very, very large number of companies. There's lots of software companies now that are building tools and add-on capabilities that work in conjunction with the ServiceNow platform and are really selling. We've become market trend because there is now 1,600, 1,700 customers out there that now is market for people that are working either on our platform or with our platform. A lot of those are technology partners. I mean, there's tons of people that do analytics and reporting type of applications, people that do release management. So all these different product niches that are developing around the platform are making this very dynamic, sort of a rich place and a lot of options for our customers to build out their use of what we do.

Operator

And your next question comes from the line of Phil Winslow of Credit Suisse.

Philip Winslow - Crédit Suisse AG, Research Division

Just had a question about win rates. Obviously, you continue to have phenomenal growth. Have you seen any changes in the win rates versus any particular competitors? And also, some of your competitors have talked about their SaaS or really just kind of hosted client server offerings. Have you seen any change for customer interest in those at all?

Frank Slootman

Phil, it's Frank again. We always like to say that our #1 class of competition we have is inertia. In other words, customers that are just not ready or able to engage at a particular point in time just because they're overwhelmed with other issues or they don't have budget right now, or whatever else is going on. It is a "do nothing, kick the can down the road" type of a thing. Now in the end, everybody is going to move, because time is our friend. Because every day, what they have is getting older and more unmanageable. But it's just very, very common. The systems that we replace are 10, 15 years old. There's a reason why they're that old, because they're that difficult to -- not so much difficult to pull out, but difficult to modernize. And all the planning and project management, it's a considerable undertaking. Right? And that is typically the friction that we encounter out there. Our win rates, when we come up against direct competition and the customer actually is going to make a move and actually embark on the journey, is extraordinarily high. I mean, it's very, very unusual for us to not get the win on products. So I'm feeling good about it. But the nature of our business -- and this is oftentimes why our customers refer to this as their ERP, is because it has a lot of the characteristics of ERP. It is a very serious undertaking. These are also systems, when you replace them, it's like changing the engines on a plane that's in the air. It's a delicate undertaking. It takes a lot of planning, and it's something that people really have to be ready for to undertake. If they've got a lot of other things going on in their lives, they may want to say, "Well, I'm going to take another 6 months or 9 months or 12 months before I'm ready to do this." So obviously, customers talk to us, then they back off for a period of time, come back, and then finally they will bite the bullet and they embark on the journey, and then that goes on and on. This is a very dynamic business. Our customers are always evolving their applications, expanding their use, developing new things. This is not sort of a one-time "I build it and then I run it" type of business at all. That's sort of the way that in the past these systems were being run. It's not the way it is with ServiceNow.

Operator

And your next question comes from the line of Kirk Materne with Evercore Partners.

Stewart Materne - Evercore Partners Inc., Research Division

I guess, Frank, just a quick question on the platform and, I guess -- sorry if this has been answered -- or asked and answered already, but I was just curious what you guys are thinking in terms of setting up templates in terms of different types of business processes that might make sense that are sort of best practices that you all have seen versus leaving that sort of open for partners to build upon themselves, sort of what Salesforce has done with their own AppExchange. I guess, how are you guys going back and forth to try to make sure you get people on the platform having success versus you leaving some opportunity for app partners to show up?

Frank Slootman

This is Frank. We've left that core capability of building templates of apps very much to our partners at this juncture. It doesn't mean that we will always have that kind of a posture. We have focused much more on enabling the platform to have better and better capabilities to sort of reduce the friction that customers might encounter in terms of using it for application development. So we're investing a huge amount in mobile support, scalability, the approachability of the development platform itself to really allow people to have a better and better experience in terms of standing up applications for the first time in our platform and sort of grow our -- their involvement with us in that way rather than having the application sort of readymade to be put at them. We do see a lot of our partners moving down this path, and we think that's a very positive thing. The whole notion of ecosystem is very important. We start doing everything, that creates a lot of friction and angst in our ecosystem, and we don't want that. We really want to create ample room for our partners to start to do what they want to do and bring their unique bit of value added to our marketplace. And again, coming to Knowledge in Vegas next month is an incredible display of what all those capabilities are.

Operator

And your next question comes from the line of Abhey Lamba of Mizuho Securities.

Abhey Lamba - Mizuho Securities USA Inc., Research Division

Frank, I just want to dig a little bit deeper into your platform offering. Can you talk a little bit about the sweet spot of the types of applications where you see the most success? And who are the key competitors that you expect to see the most in that space?

Frank Slootman

The most important thing for people to realize is that we're not a generic application development environment -- or we're not suitable as a generic application development environment you can sort of build any type of app on. There's a reason that our platform is so highly abstracted and so approachable by people without programming skills is because it is designed to build a certain class of applications. And we typically refer to that class of apps as service-oriented apps. And these are apps that typically initiate structured workflow in response to a request. It could be a request for a product, request for a service, request for information, all kinds of different things. Right? This is much more common in the world than most people realize, because most business processes in the enterprise are actually executed through e-mail with a little bit of Excel thrown in. So we have this incredible opportunity to sort of start chipping away at a lot of business process that has never been automated before in the enterprise, and we're just ideally suitable to stand-up applications. We typically teach our solution consultants, our presales people to really show our customers how to build applications in minutes, not in days or weeks, but literally minutes and hours. So it's an order of magnitude different, the speed at which we can stand up fully operable database or recordkeeping application. That is really our sweet spot. Now when you start peeling away the onion, incident management systems exist in IT, but they exist in all kinds of line of businesses, they exist in other service domains, they exist in relationships to customers, to partners, to investors. That really is what has led to the proliferation and sort of the viral adoption of ServiceNow, because people are starting to understand that a lot of the work that previously was done on e-mail and on the phone and in spreadsheets and one-off local databases is actually now capturable in full-blown ERP industrial-grade systems, and that's what IT organizations like about ServiceNow.

Abhey Lamba - Mizuho Securities USA Inc., Research Division

And competitors-wise in that space, who do you think -- who do you expect to see the most in that space?

Frank Slootman

There really is no pure-play competitor the way I just characterized it. We're sort of the only one. What you see out there are platforms like Microsoft with Azure. But that's really .NET-hosted, which is very much a programming platform evolution of the former Visual Basic Visual Studio. You've got VMware really for the Java crowd. You got Force.com, also with the proprietary procedural line, which is also really for a programming audience. We really exist for the highest-level audience and also the largest audience. These are the people that have good grasp of relational concepts, people that can use Excel pretty well or Microsoft Access but do not have programming skills. And in that class of platform, ServiceNow is really the only thing that is really out there with an industrial-grade type of system.

Operator

And our last question comes from the line of Brad Sills of Maxim Group.

Bradley H. Sills - Maxim Group LLC, Research Division

Just a quick question on where you're seeing the most traction cross-selling. You mentioned good strength there cross-selling to more users. I assume customers are starting with Incident/Problem for support, personnel and then expanding into operations with Asset developers for configuration release management. Maybe just a little bit of color on where you're seeing the most strength on just -- within IT, the viral adoption that you're talking about of more users?

Frank Slootman

This is Frank. You pretty much characterized it the right way. It is most common for people to go after the core drivetrain of IT workflow, and that really is the Incident, Problem, Change, Config. Those are sort of the 4 horsemen of IT service management, and those 4 go together. Incident has the highest penetration in our customer base, Config or the CMDB and related Discovery technologies is a close second, Request Management really turning the IT organization into a sales service delivery vehicle. Those things are typically top priority. After that, we see people go to SDLC. You mentioned Asset, that's another big one. Compliance, governance applications. And then what we're starting to see a lot of as well is people going after automation, really looking for workflows that are being conducted right now in predominantly manual manner that are automatable. Right? It's all about dis-intermediating workflows where, right now, lots of different people are sort of been touching different parts of the infrastructure, and applications to figure out how software can take that over. So those are our typical progressions. It also happens that we start somewhere else. I mean, I mentioned earlier, we're starting to do stand-alone platform deals now, whereas -- in other words, they are completely outside the realm of IT, whereas previously, that was always downstream business. And that's really a function of our go-to-market cadence, now really focusing on opportunities like that, where previously we would just go after the IT opportunity and then let the other opportunities sort of unfold from there.

Operator

Thank you. We have no further questions for you, so I'd now like to turn the call back over to management for closing remarks.

Robert Specker

Thank you for joining us on the call today. This concludes our call, and we look forward to our next update in July following the close of our second quarter.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect, and good day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: ServiceNow Management Discusses Q1 2013 Results - Earnings Call Transcript
This Transcript
All Transcripts