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ServiceNow, Inc. (NYSE:NOW)

2013 Credit Suisse Technology Conference Call

December 3, 2013 6:00 pm ET

Executives

Michael Scarpelli - Chief Financial Officer

Analysts

Unidentified Analyst

Thank you everyone for joining us. I'm very excited to have ServiceNow in attendance. As we talked about after last earnings call, your growth rates, your revenue are really starting to I'd say as a standout here in the SaaS industry, just the rate you're growing, the revenue size, the billing size that you are. I don't think people realize just actually how big sort of ServiceNow has gotten. So very excited to have you and it's exactly like what you were saying earlier that really makes us confident. So thank you for taking the time to come down.

So I guess my first question when we think about sort of the core business, ITSM, obviously a big part of the ServiceNow story is share gain really disrupting in market with disruptive cloud-based technology. Since you were here last year, what's changed, what stayed the same in terms of your ability to disrupt these existing competitors but also to expand your market?

Michael Scarpelli

I think what's really – there's been nothing new out of the legacy vendors at all. Just to kind of refresh people that really the legacy vendors who we displace the most are BMC, HP, 40% to 60% of our displacements every quarter are at the cost of one of those companies, principally BMC, and then it kind of drops off pretty quickly to CA and IBM and a bunch of others, and history has shown that legacy technology vendors can't reinvent themselves and we don't see these guys making any investments in that space. I don't know why you think they'd do investments now when they haven't done it for the past 10 to 15 years.

But it's good and bad. The systems we're replacing are very sticky. It's kind of as I said they're 10 to 15 years old, so they are sticky and it makes for a long sales cycle, but once you're in, you see our renewal rates. Our customers don't look to switch out their ITSM system every few years. It's generally once you're in, you're in for a while, unless there is something radically different in terms of new technologies that are coming up.

What really kind of surprises us that we don't see any new technologies in the enterprise space coming out to compete with us. You see some people on the lower end of the market but no one really that has the whole product offering the depth of the ITIL applications as well as the ability to do custom app development on the platform.

Unidentified Analyst

And then actually sticking along those things because we have seen basically no response from the legacy guys, start-ups that try competing against large enterprise as you said sort of don't exist, but let's put this in the context of obviously just your go-to-market strategy and your sales headcount growth, when you think about your strategy to gain share in terms of all the dispute on the street and go-to-market, how should we think about sort of what your strategy is and how you think about that in terms of [indiscernible]?

Michael Scarpelli

So our go-to-market strategy has pretty much been the same for the past few years and we don't see it changing any time soon. We sell into IT. We have a dedicated sales force that just sells into IT, and once we sell into a company, it is a long sales cycle. This isn't ERP type sale, it is a nine month plus sales cycle in these accounts, but once we are in the accounts, they generally take – it used to take us about on average six to eight months to do a Phase 1 implementation, now it's taking more in the four to six months to do a Phase 1 implementation and then we'll do a Phase 2 implementation. So that time that IT starts to play around with what the product is able to do on the platform and then we see it move beyond the IT as the lines of business.

But it's becoming more and more common, especially when a lot of companies are trying to adopt more of a shared service model and we're ideal for that. When we talk about service relationship management, we try not to talk about calling it a platform as much, and the reason being is because everyone today talks about a platform and it causes a lot of confusion, but what our platform is really great at doing tends to be more service relationship oriented application similar to IT service management. The whole framework for IT service management, we talk to IT people and they say, we need this in facilities, we need this in HR. None of those systems had that type of defined instant problem change request.

Think of it that you can pretty much apply what you apply in an IT service management framework to most things that happen in a daily life in lines of business. Read your e-mails today, about half of them are some type of someone reporting something to you or requesting something to you, you need to respond to that. A lot of those things can be done in a custom app developed on ServiceNow and we see that overwhelmingly that customers are taking things that we have done in Lotus Notes SharePoint, Microsoft Access, Excel, e-mail, and putting them into ServiceNow.

In terms of the headcount growth and what we are doing just to get back to the question, so we have grown our sales force pretty rapidly this year. We entered the year with 350 people on our sales and marketing. Our plan was to add 250, we are going to exit the year with around 610, 615, slightly ahead of plan as we are planning for 2014 right now. We think we're going to add at a consistent rate somewhere in the 250 to 300 people for 2014. And what gives us the confidence of that, when we look at our productivity per ramp, we've actually stayed pretty consistent over the last number of quarters and we are seeing that ramp time for splitting territories. It is a nine month ramp, and then new territories we are going into it's a 15 month ramp, and it seems to be turning out to be the case as we look at our experience for 2012 and 2013 now.

Unidentified Analyst

And one of the things you're talking about to is time to sort of repeat purchase or second purchase where that window is trying to shrink down, and I know that was the case at Credit Suisse in fact where you got the deployment in there and then our guys were back in talking with you faster and then I think we expected and probably you expected too. Maybe talk about, obviously not just the Credit Suisse example but probably what you're seeing in terms of shrinking of that time?

Michael Scarpelli

Yes, so generally what – we had our Analyst Day last May at our Users Conference. We went and looked at the cohort of customers from Q1 of 2010 and said, how do those customers look today, so we compared it to Q1 of 2013, and those 49 customers became 46 customers, and those 49 customers factoring in the three losses in aggregate we doubled ACD and we doubled the user account, and we looked at Q2 2010, compared that with Q3 2010 and once again factoring in the losses and everything, they doubled again. I have not looked at the data for Q3. I will in our January call, I'll call out that data for Q3 and Q4, some people have been asking me. And it's pretty consistent that we see that.

The one thing that has surprised me more and Credit Suisse as an example as they just saw it the other day, generally it used to be, you did the deployment for a customer, you did a PS engagement, they got up and running and they'd buy more licenses. Now, we are seeing coming back, it's customers coming back not just for more licenses, more PS and ordering a lot more, and that's what then giving them – Credit Suisse had a big PS order the other day which I was surprised about because you guys were up and running. It's because you guys want to do more than what you were doing just within ITSM and that's an overwhelming thing we are seeing with our customers. And whether we do the PS or not, we are happy for the system integrators and our partners to do it, our focus is really on subscription revenue, and it leads to more license revenue if people are doing the PS.

Unidentified Analyst

[indiscernible] one example of one of those guys that's using it for IT but are pivoting it to the use of facilities management.

Michael Scarpelli

Connect.

Unidentified Analyst

As a service offering, not just the IT service alone.

Michael Scarpelli

The logical places to grow outside of IT first tends to be in areas that are shared under the domain at the CFO facilities procurement, and you have seen HR and all kinds of lines of business in that area.

Unidentified Analyst

Now let's kind of continue down the path about you expanding your up-selling into existing customers. Obviously you've had your Runbook Automation. That product is one, you keep expanding the portfolio. Which are the ones that you've had the add-on products that are the most successful and how big are they right now, how big do you think they start to get, because one thing – I mean it's a good problem to have because the core product is growing so fast too that sometimes it's hard to have the percentage of revenue go up sometimes?

Michael Scarpelli

Yes, so we in 2012 was when we really started selling Runbook Automation and we seeded a lot of accounts with Runbook Automation with one year free. What we have seen is, we have seen a 50% growth in Runbook Automation if I look at last quarter versus the year ago and we continue to see Runbook being a great add-on sale to customers, but the vast majority of our up-sells and add-on sales is not through additional product, it's additional licenses, getting more users in the Company whether it's within IT, we still think there is a lot of runway within our accounts to grow within IT, but also then getting outside of IT and getting into the lines of business.

Unidentified Analyst

Then also circling back to that platform comment you made earlier, that's one of the questions I get is sort of your platform, everybody has got a platform now so to speak, but how do you differentiate sort of your platform versus the others that you talk about in the market?

Michael Scarpelli

What we say is that there's a number of kind of – we say we're kind of on up top here in terms of our platform versus you got AWS way down below and in terms of skill set to develop on top of those different platforms from the Azure to the Force.com, actually you have to be a really, really skilled developer to develop down here. For our type of application, if you understand Excel relational databases, you can learn within a day how to develop applications, simple applications on top of our platform. To develop on the Force.com platform, you need to be a programmer. Our platform, there is no programming language that's declared, it's click to drop. The beautiful thing about our platform is because you are already deployed within ITSM, you have all the employee user profiles in there, so to create workflows and routing things is very easy because everything is in the system.

Unidentified Analyst

And then I guess when you do think about your time [indiscernible], you have the platform, you have the core business, you have got at the management facilities, I mean all these sort of applicable areas, one of the questions I get is sort of do you need to build out not just the sales force but more specialized sales force in the field, how do you think about that?

Michael Scarpelli

Yes, we think about it a lot. Right now because we are not changing our go-to-market, our go-to-market is going to continue to be for the foreseeable future selling into IT. In 2014, we don't think we're going to have to develop another or add another type of salesperson. That may be the case in 2015 but right now for 2014 we think we can do with our existing sales force and just adding on to that existing sales force.

If we get into other areas outside of where we are today, such as if we try to do more in IT operations management, the problem with moving into IT operations management, some of those sales are different type of skill set to sell those things. That's why we haven't really moved that much into that area because we really want to stay focused. It's hard when you see as many opportunities as what we see in front of us to really stay focused and you don't want to have that shiny object syndrome because if you do that you are going to defocus yourself and slow down your growth.

Unidentified Analyst

Let's talk about another opportunity which is international expansion. Like you are saying you are not starved for opportunities but how do you think about – I mean obviously you've been very successful in the U.S., you have been expanding, what is your strategy to continue to penetrate other markets?

Michael Scarpelli

Sure. So our international growth plan has been to go where the Global 2000 accounts are, and so in 2013 we opened Japan for the first time. Why? They have 10% of the Global 2000. We went into South America, principally in Brazil. Why? They have above 40 Global 2000. So we are going where the Global 2000 accounts are. The markets where it's going to be a long time before go into, we have no intention anytime soon to go into China, we have no intention anytime soon to go into Russia, doesn't mean we won't go there but we are in no rush to go there. Until we have scale and we see the traction in the markets that we have gone into, in particular Singapore, Hong Kong, Japan, Korea, and then in some of the other European countries, we are not going to rush into those other markets right there.

Unidentified Analyst

And just to circle back a little bit just to add-on products and extending the features, when you think about sort of penetration of whether it'd be Runbook Automation or Discovery, where are we right now in the customer base, and then when you do look out two years, five years, what are the levels you want to take that up to?

Michael Scarpelli

Sure. So in terms of Discovery and Runbook, very different products, so Discovery is the tool that goes out, we put it in server behind the customer's firewall and then it goes and discovers the devices out there and populates the CMDB. A customer can choose to use our Discovery tool or you can use one of the many discovery tools that are out there. 80 something percent of our customers use our CMDB which probably only, and I'm guessing, I think it's only in the 30% or so that are using our CMDB are using our Discovery tool because there you had another discovery tool, there is no need to buy our Discovery tool.

In terms of Runbook Automation, that is a growing product and more meaningful. It is a very important piece of the automation, but once again the vast majority of our license revenue is coming from the licensing of our core ITSM suite of applications where people are paying on a per process user basis.

Unidentified Analyst

Another question I get to is your adoption inside of specific verticals. I mean you target many different vertical markets but is anything there, is any particular vertical that sort of jumped on you guys, that's been particularly strong, and then similarly, is there a vertical that you think is a big opportunity that's been slower to see adoption, and then if so, what is the thing that changes that?

Michael Scarpelli

So the biggest vertical where – or our most important vertical where we have seen the best traction has been financial services, and the reason being is if you look at, most of you guys have worked in banks in your career. Most banks today are large IT organizations. In many cases, close to 20% of the employees are IT employees. Hence why we have seen such traction within the financial services. But we have also seen huge traction within pharma. You look at the big pharma, Johnson & Johnson, Bristol-Myers, Amgen, they are all customers of ours. We have also seen it in large conglomerates like GE, Siemens, their customers and big-box retail.

So I wouldn't say we have a disproportionate amount of revenue that comes out of financial services but they have a disproportionate number of IT users in their companies. The one area where we think there is a huge opportunity for us where we have not gained much traction today is good and it's bad, it's the federal government. It's good because the federal government [indiscernible] for most companies and it's good that we don't have that much traction today but it's a huge opportunity for us and a growing opportunity and we think 2014, 2015 will be good federal years for us.

Unidentified Analyst

I've got several more questions here before I'm going to open it to audience, but audience think about what your question will be for Mike here, but let's turn to [indiscernible] for a second. One of the things that have been positively surprising, every quarter seems that you guys reportedly burst our model of screening has been gross margin and it continues to improve. I mean how should we think about sort of the near and the long-term goals on the gross margin side?

Michael Scarpelli

So let's separate the gross margin into two line items of subscription and the professional services. For subscription, our gross margin our longer-term target is 78% to 80%, we were 77% last quarter. As we continue to open new data centers, there is a cost associated with those data centers. You don't really get to that long-term target until we get denser within some of those data centers internationally that we have opened up. There is upside to our longer-term subscription gross margin. There are different things we could do from a hardware conflagration to go denser within our data centers and reduce some of our power cost, but that's stating an upside and we'll talk about that more in January.

In terms of the professional services margin, we were historically running at negative professional services. That's something that the management team and in particular professional service management really started working on two, two and a half years ago. When I joined the Company, we used to have negative like 34% margins at one point in time. We now sell more professional services on time and material and we really try to create where we are at the more expensive price offering because we want to create a healthy partner ecosystem to allow some of the guys like Cloud Sherpas and Fruition and some of these other boutique firms to really be successful in this market space.

And longer-term we don't want our professional services to be more than 14% to 16% of our revenue, and based upon that we think we can be in that 13% to 15% margin. I think we guided to 8% margin on professional services this quarter and we'll gradually increase that as we go, but the first goal of professional services is to keep our customers happy because if they are happy, they renew, if they renew, they buy more.

Unidentified Analyst

Switching gears, I mean one of the things that obviously differentiate you guys has been the quality of products and as the products and platforms continue to expand, also can you walk us through some of the R&D kind of your near-term plans how you are thinking about that especially since you continue to expand the products and the platform, but then also your longer-term as this Company scales?

Michael Scarpelli

Sure. So if you look back at our R&D for 2012 and 2013, it was really focused around making the platform more resilient, increasing the features within our existing suite of ITIL application and also within our cloud provisioning, our cloud infrastructure group, we spent a lot of money on R&D there. In 2014, our real focus within R&D and a lot of our adds that we are doing are going to be in the application development outside of IT. We announced a couple of weeks ago our HR Case Management application. Why are we doing this? Our customers are asking for these custom apps that are kind of more generic that go across all over. We hired a guy that actually came out of Oracle. His name is Dave Stephens. He's our VP of Application Development. He joined us in July. He used to run a 1,200 or 1,300 person organization within Oracle running all their internal apps. He is focused on building a lot of these applications on procurement and other things. We are going to be rolling out facilities and a number of things.

So 2014, that's where you're going to see a lot of R&D as the apps outside of core ITIL applications as well you are going to see us come out with an app exchange. Don't think of this as an iTunes app exchange where we are going to get a percentage of revenue. It's more where our partners and our customers can share applications because a lot of our customers they don't view these applications as proprietary to them and they are proud of what they have done. Our partners want to share their applications because they will get branding in front of these customers and those customers will call them to come in and do PS organizations to deploy their PS implementations, to deploy these applications. We want this to happen because if customers want to use these things, they're going to have to license our platforms and be able to do this. So that's one of the things we are very much focused on for 2014.

Unidentified Analyst

So that app exchange we're calling it ExchangeNow?

Michael Scarpelli

Maybe that's what it will be called.

Unidentified Analyst

Maybe it will soon be out there. Actually I'm going to pause for a moment. I have got several more questions here but just in case anybody from the audience, just raise your hand and just wait for the microphone to come over, or maybe we're hitting all the high points.

Question-and-Answer Session

Unidentified Analyst

Okay, I'll just continue then. The other one obviously is sales and marketing. We talked a little bit about you got to feed the beast and you have the time to ramp and it seems like what you hired this year is really about your growth next year, but how should sales and marketing scale over time, especially I have to think you would think of this in context of renewal rates and recurring revenue and new business, but how do you think about this model scaling from sales and marketing perspective? It is tough right now because you're going so fast.

Michael Scarpelli

If you actually look at those sales and marketing as a percentage of revenue for a SaaS company, we are actually running at one of the lower sales and marketing at this stage with our growth rate. But ultimately where you get leverage in our model and our longer-term target on sales and marketing is about 29% to 31%. That's more when our growth rate normalizes. That will be the last place in our model that you see leverage. The first place you're going to see the leverage is on the gross margin subscription and PS which will be delivered relatively soon hitting those targets. Then you're going to see the leverage coming out of G&A and R&D and sales and marketing is when our growth rate more normalizes, and we feel pretty good that we can get down to that level longer-term.

Unidentified Analyst

And last four minutes here, I mean it's going to sound like a strange question but [indiscernible] there are so many things that are sort of going right in your favor right now, so like the competition is not from the legacy guys not really bouncing back, not a lot of new start-ups, expanding the toolset, ability to hire, I guess what do you worry about, because it seems like so many things are going in your favor, there is always something that keeps management up at night, like what is the thing that you are really focused on to make sure that it doesn't catch up with you?

Michael Scarpelli

So it's easy to compete against what you can see. So the legacy vendors don't concern us in any way. What concerns us more is it surprises us every day that there is not some new innovative company coming out to try to do what we are doing. We just haven't seen that and that's what – so it's not what we see today, it's what's happening in someone's garage or apartment and Silicon Valley and is there someone else trying to develop some other type of platform in IT service management offering.

Now the one thing is there's very few people we think in the world that have the domain expertise that Fred Luddy have. He used to be the CTO of Peregrine Systems and at Remedy and the HP products. So he kind of knows that domain inside and out. And so I don't know if someone is going to be able to do it but that's kind of the biggest worry we have.

And then the other worry is really just managing the pace at which we are growing. When you are adding – now this year we will have added close to 800 employees, next year we are going to add 800 plus employees again. Just then the problem is, it would be one thing if you're adding them all into one location but when you are geographically diverse trying to plan around that hiring, that's a challenge that you have.

Unidentified Analyst

And then actually just to expand on that last point, there's one thing here, there are so many companies that are hiring, especially in Silicon Valley especially for enterprise sales people, just how difficult it is right now to hire and to retain those sales people because obviously that's a big feeling of your growth is to capture that pie?

Michael Scarpelli

So the best source for hiring is your referrals from your existing salespeople and how you get referrals from your existing salespeople is when they are making really good W2 compensation in terms of they want that – salespeople want to go to a plan where they know they can get double their – they can double their quote and double their on-target earnings and we have a very rich commission plan in place. We have a lot of reps that are making a lot of money and that's what attracts good people and we tend to – we could still find good people. We have a number of people coming to us and they come out of your traditional enterprise software companies like SAP, Oracle. We have a number of people, we have got people that come out of Salesforce, we get people from BMC, we have most good people out of BMC on the sales, but a lot of good [SCs] (ph) are BMC still and we are getting good SCs. SCs are kind of the last [indiscernible] in companies. Salespeople tend to leave sooner. And we've historically – in Europe we have been very successful with guys out of CA and the old Mercury-Interactive. We continue to hire people out of HP in that area. So it hasn't been a problem for us.

Unidentified Analyst

There are a lot of guys to take folks from.

Michael Scarpelli

Yes.

Unidentified Analyst

The last question here from me in the last minute or so that we have, but when you are here a year from now, hopefully you will come again next year, so what do you think that we're going to be talking about, what do you think is going to sort of surprise people when you sort of put your forward thinking cap on? I mean is it the penetration of new products, is it the up-sell, is it the…?

Michael Scarpelli

No, I think what's going to surprise people the most is the adoption that we start to see outside of ITSM now that we have separate price in separate SKUs and we start to report on that through 2014. I think people are going to really start to see the market opportunity beyond ITSM because I think a lot of people still don't see that opportunity – don't get me wrong, ITSM is still going to be the core driver of our revenue, but as a percentage of our new bookings, you're going to see more and more that non-IT use being a larger percentage of our bookings. Each quarter we think it will continue to increase.

Unidentified Analyst

I'm looking forward to seeing that. Thank you for your time.

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